This guest commentary was written by Mike O'Rourke of JonesTrading
For the first time in a long time, the US equity market was actually spooked by news developments. The day started in typical fashion with the Teflon tape rallying nearly 1% in the first hour of trading. Then, at 2 pm, the release of what we would describe as being the most hawkish FOMC minutes in over a decade prompted a 1% selloff in the final hours before the close.
When one considers the monetary policy of the past decade, it does not take much to earn that “most hawkish” moniker. It goes without saying that the following excerpt from the March FOMC minutes clearly caught the market's attention:
"Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months."
It is rare to hear the Federal Reserve try to jawbone markets and asset prices down. This is not a total surprise considering the recent comments about asset prices from officials like Boston Fed President Eric Rosengren. It is also worth highlighting that the Fed is noting that a few members believe the equity move is rooted in “stronger risk tolerance” and not “stronger economic expectations.”
Will The Fed Address Asset Bubbles?
The Fed's leadership has spent years warning about the financial stability risks of tightening too slowly while doing exactly that. Maybe the Central Bank is finally seeing those risks emerge. For decades, standard Fed policy has been not to use the “blunt” tool of monetary policy to address asset bubbles.
There is no reason to expect that to change. Nonetheless, it is the hawkish tone of the rest of the minutes that is disconcerting. The March rate hike was executed without an upgrade in the outlook “that the increase in the target range did not reflect changes in their assessments of the economic outlook…” A
Although developments did not merit an upgrade in the outlook, it was clear that views on the economy had firmed as “upside risks” to the US economy were rising while “downside risks” associated with Europe and China were fading. What more could a Central Bank ask for.
In discussing the key measures related specifically to the dual mandate, the comments about labor markets and inflation were also hawkish. According to the minutes, both goals were met and:
“In the view of these participants, such circumstances could warrant a faster pace of scaling back accommodation than implied by the medians of participants' assessments in the SEP.”
There was a fair bit of focus that the larger problem in the labor market is a skill mismatch. The Committee noted anecdotal accounts of companies having “difficulty recruiting qualified workers and indicated that they had to either offer higher wages or hire workers with lower qualifications than desired.”
Furthermore, the Committee noted that “Tight labor markets were said to increasingly be a factor in businesses' planning.” Those comments are inconsistent with a Fed Funds rate below 1%. As far as inflation is concerned, there was some verbiage about making sure the message is sent that 2% is not a ceiling and that level needs to be sustainable.
Doves Moving the Goal Posts on Inflation
The members noted that inflation was accelerating - “a few other participants commented that recent inflation data were stronger than they had expected and that they anticipated that inflation would reach the Committee's objective of 2 percent this year.” Unbeknownst to the Committee, inflation hit 2.1% in February, but the data had not been compiled and reported yet.
In what was likely another attempt by doves to once again move the goal posts, more attention was placed upon the Core PCE since it remains below the 2% target. It is fair to say that Core Inflation is likely a better and less volatile metric for monetary policy purposes.
That being said, 2% is probably not the correct target. The 1.5%-1.75% range in which Core PCE has been since the start of last year is more appropriate. Over the past two decades, Core PCE has averaged 1.7% and has only been above the 2% level 21% of the time.
If one wants to drop the deflationary post crisis era, one can consider 1996 through the end of 2006. Over that time period, Core PCE has averaged 1.75% and was above the 2% level 25% of the time. The highest reading over the past two decades is 2.45%. That should make it clear that if Core PCE is above 2%, the FOMC definitely needs to be tightening.
On the other side, Core PCE has only registered 7 readings below 1% over the past two decades. In short, if a proper level of Core PCE were the Fed’s inflation target, policy would be much less volatile and would have been far less accommodative in recent years.
The last item of note in the FOMC minutes was the policy for balance sheet normalization. There were several critical observations regarding this process. If the economy continued to perform as expected, then the normalization process can commence later this year. That means after the next two rate hikes, we can expect the Fed to commence this process.
The Committee wants this process to be dependent upon economic and financial conditions, while many participants wanted a quantitative threshold as a timing trigger tied to the Fed Funds rate. Those two forecasted hikes equate to a 1.375% mid-point on the Fed Funds target range.
Once balance sheet normalization commences, the Committee wants it to be “passive and predictable.” Essentially, once the trigger is met, the Fed wants the runoff to be secondary, and hopes it will not have to re-start reinvestment or commence new purchases. Lastly, the FOMC wants the Fed Funds rate to remain the “primary means for adjusting the stance of monetary policy” assuming the Fed Funds rate is above its lower bound.
In conclusion, we have high asset prices, inflation and employment at target and improving, balance sheet normalization on the horizon and an extraordinarily accommodative monetary policy. It does not get more hawkish than that.
This is a Hedgeye Guest Contributor research note written by Michael O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.