PMC Weekly Review - September 23, 2016
A Macro View – A Stock Market Mandate: The Tail Wagging the Fed
For the sixth time this year, market participants around the world set their sights on the Federal Reserve (Fed). Once again, there were slim prospects of a decision from the Federal Open Market Committee (FOMC) to hike interest rates, and based on the market’s expectations, the Fed did not disappoint. In 2016, FOMC is batting one thousand: six-for-six with no changes in monetary policy or the fed funds rate. Despite the lack of policy modification, the Fed has changed some of its language, speeches, and the wording of its policy statement. A closer look at these updates reveals that the Fed has been either more dovish or hawkish, depending on the current stock market sentiment. This leaves one to question whether a robust stock market is an additional FOMC mandate and the tail wagging Fed policy?
Based on the Federal Reserve Reform Act of 1977, the FOMC is tasked with a dual mandate that holds the Fed accountable for fostering maximum employment, stable prices, and moderate long-term interest rates. Whereas the Fed’s attention to the dual mandate has been clear over the past forty years, its new directive of a rising stock market has more recently crept into focus. The concern with the stock market’s reaction to Fed policy has never been higher than in the post- financial- crisis era. This year, each glimpse into a hawkish stance by the Fed has been followed by heightened volatility, a pause in the grind higher, or a selloff in equities, before a shift back to an accommodative stance.
Following a December 2015 rate hike, the FOMC started backpedaling early in 2016 (when U.S. stocks experienced the worst 10-day start of the year in history), proceeded to lighten its hawkish tone, and held off tightening at its next few meetings. Similarly, the heightened volatility experienced post-Brexit in June led to both a weaker Fed stance and language at the July FOMC meeting. Despite the indications of a solid labor market (with the unemployment rate below 5%), and stable price levels, it seems the FOMC would like to raise rates, but a strong force is holding it back.
Although the Fed’s accommodative stance has expanded the money supply, pushing businesses and consumers to spend, in a much larger way it also has increased asset prices, boosting investors’ account balances. This positive externality has helped drive market indices to all-time highs, and pushed Americans (who have been very pleased with their 401K statements over the past few years), to spend, driving the roughly 70% personal consumption component of GDP higher. Removing the accommodation and the stock market support may have unintended consequences that lead to a larger-than-expected growth slowdown.
In looking at all the motivations for continued accommodation, one can understand why the FOMC would vote in favor of holding off on raising rates. However, this action is difficult to defend through the lens of the Fed’s dual mandate. In her comments following the policy statement, Chair Janet Yellen hinted that the FOMC intends to hike rates before the year ends. With only November and December FOMC meetings remaining this year, we are left to wonder if the Fed can raise rates (without concern for the stock market) and regain control of its tail.
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