Blunders By Fed Spells Trouble For Risk-Assets
Try to recall a period when the Fed has misjudged inflation and labor market dynamics as poorly as they have in the past year. The Fed initially called the inflation jump "transitory," only to back away from that assessment when it continued to move higher and broaden. Consumer price inflation will end the year near 7%, the highest in several decades. At the same time, despite growing evidence of labor shortages, the Fed continued to argue it still did not meet its full employment mandate. If an unemployment rate of 3.9% at year-end, down nearly 300 basis points in a year, and a 5.8% increase in average wages for non-supervisory workers, the highest jump in several decades, is not evidence of an economy well-beyond full employment, then what is it?
Never before has the Fed continued to ease policy in the face of sharp increases in prices and wages. As flawed as the current monetary policy stance is nowadays, the more significant issue is how policymakers undo the past year's mistakes. Because of adhering to rigid rules of communicating a policy change well before and only at regularly scheduled meetings, policymakers cannot lift official rates for a few more months. Being late on rate adjustments suggests that modest policy steps to contain inflation and emerging imbalances would not be enough. Uncertainty over monetary policy spells trouble for the economy and deepens the downside for risk-assets.
A few weeks ago, Randall Forsyth, Associate Editor, Up & Down Wall Street columnist at Barron's, interviewed Mr. Felix Zulauf, a longtime member of the Barron's Roundtable. Mr. Zulauf expects a sharp drop in the S&P 500, falling to 3000, as "the markets are about to be slammed by a reversal of the extraordinary fiscal and monetary stimulus applied to fight the pandemic. While policies remain loose, what counts is the change in, rather than the absolute level of, stimulus.
Mr. Zulauf did not offer a forecast for fed funds, Yet, history shows that it requires a fed funds rate above consumer price inflation to reverse or stop inflation cycles. That does not mean the Fed needs to raise rates equal to peak inflation. Policymakers are more concerned about persistent inflation, running well ahead of its 2% target. Suppose we assume roughly half the rise in consumer price inflation in 2021 is pandemic-driven, probably an overly generous assumption. In that case, that still results in an underlying inflation rate in the 3.5% to 4% range and a policy rate of equal scale. Yet, policy rates might never reach that scale as it would trigger declines in asset prices similar to or greater than Mr. Zulauf's forecasts.
Mr. Zulauf did not offer any timeline for the sharp drop in equity prices. But he felt the sharp decline would "shake authorities," forcing them to stop and reverse course at some point. An equally bullish view follows Mr. Zulauf's bearish outlook. He believes the Fed will turn on the monetary spigots again, triggering a rally in the S&P 500 to 6000. A u-turn of that magnitude is not a 2022 event.
In my view, with the market valuation of equities trading 2X times GDP, above the tech-bubble levels, risk assets are most vulnerable to a rapid change in Fed policy. An increase in official rates spells trouble for equities, and a decision to shrink the balance sheet at some point would be doubly bad as the latter would lift long-term rates and reduce the present value of future cash flow. Blunders by the Fed in 2021 come with a cost---higher rates, increased volatility, and sharply lower equity prices in 2022.