The Federal Reserve has been telegraphing to the market that it intends to keep raising rates both to stave off high inflation and to prevent financial markets from getting unhinged.
The market, though, seems to stop reading after the “inflation” part.
As a result, a disconnect has built between the two sides. Wall Street remains more sanguine about future interest rate hikes than Fed projections indicate, and one issue seems to be the market is missing the signals about the central bank’s desire to keep asset prices under control.
That’s come even though minutes from the Federal Open Market Committee’s September meeting released Wednesday again underlined the policymakers’ focus on the performance of stocks, corporate bonds and other risk assets.
The FOMC again emphasized the issue when it said that “a number” of committee members indicated the Fed would have to push its benchmark interest rate above what it considers the longer-run level “in order to reduce the risk of a sustained overshooting” of the 2 percent inflation target “or the risk posed by significant financial imbalances.”
Market experts chose to focus on the inflation part.
Going above the so-called neutral rate “is contingent [on] keeping inflation from overheating,” wrote Jim Caron, managing director at Morgan Stanley Investment Management. “Only” a few members thought policy would need to become restrictive, noted Paul Ashworth, chief U.S. economist at Capital Economics, who added that most members want to hike because of inflation concerns. Robert Frick, corporate economist with Navy Federal Credit Union, also noted that accelerated rate hikes would be necessary “to head off the possibility of inflation.”
The Fed has come under fire, from President Donald Trump and elsewhere, for continuing to increase rates even in the face of little inflation pressure. The minutes noted that most gauges show inflation rising around 2 percent or a little more, with little expectation that it will continue to heat up.
But Fed officials are concerned about more than price and wage pressures.
Chairman Jerome Powell, speaking at the Fed’s annual retreat in Jackson Hole, Wyoming, in August, made clear his concerns. Powell said then that by the time inflation shows up in the economy, it’s often too late to do anything. Instead, he said it usually shows up first in financial markets, then spreads.
“Whatever the cause, in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses,” he said then.
Powell comes to the Fed from a different path than his predecessors. He does not have a PhD in economics, with his experience being more market-based.
It’s somewhat natural, then, that he is focused more on imbalances than others who have held the central bank’s top position.
Though it’s been a bumpy road lately, stocks are in the midst of the longest bull run ever. The S&P 500 is up 322 percent from its financial crisis low and is trading at 15.7 times forward earnings, above the 14.5 times average over the past decade. Another measure that looks at valuation over the past decade, the Cyclically Adjust Price to Earnings ratio, developed by Nobel laureate economist Robert Shiller, shows the index trading below the dotcom bubble record but around the same levels as the crash of 1929.
“There may be a greater risk associated with financial market excesses rather than traditional inflation,” said Kathy Jones, chief fixed income strategist at Charles Schwab.
As things stand now, though, the market and the Fed still are apart on what is ahead. The Fed has telegraphed another rate hike in 2018, which the market has priced in, as well as three more in 2019, which it has not.
—CNBC’s
Thomas Franck
contributed to this report.
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