Opinion
The US Fed should not succumb to market pressure
Summary
- America’s central bank shouldn’t alter its course of monetary policy only because market players have begun to lose their nerve. Reactive Fed action is likely to backfire. Jerome Powell could use his Jackson Hole speech to tighten his grip on the economic narrative.
Family Feud, a popular game show when I was growing up, would ask contestants to guess how a group of people had answered a specific question. It served as a regular reminder of the importance of supplementing one’s thinking with external perspectives.
If, in the tradition of Family Feud, we were to poll market participants about the turmoil we’ve seen since the worse-than-expected US jobs report, I suspect we would get quite specific responses on what is causing the global stock selloff as well as what would be the best circuit breaker to avoid further big losses.
Let’s consider what I think that list would look like before departing from the game show’s format and exploring what I believe the answers should be. Five things have come together to destabilize what seemed to be fundamentally solid stock markets. Here they are in order of declining importance.
First are worries that a slowdown in US growth would meaningfully undermine the ‘American exceptionalism’ we’ve seen over the past few years. Such a deceleration would damage corporate earnings and turn the strongest engine of global growth into a possible detractor.
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Second is concern that an economic downturn will be worsened by the Federal Reserve’s decision not to cut interest rates, which left its policy stance too restrictive for the current environment and heightened the risk of another policy mistake.
Third is crowded investment positions being caught offside by the sudden change in both the economic and policy narratives. This squeeze was amplified by concerns of a Japanese-related deleveraging and sky-high valuations in certain segments of the market such as technology stocks.
Fourth would be geopolitical worries centred on the possible escalation of the conflict in the Middle East, which, in turn, would cause a stagflationary spike in oil prices and complicate the functioning of international supply chains.
Finally, there are US political developments resulting in what is likely to be a messy run-up to the presidential election.
How about views on the best circuit breakers? Again, in order of declining importance, the markets favour: First, the Fed signalling a 50- or 75-basis-point cut in September.
Second, an emergency inter-meeting cut of that magnitude. Next, verbal intervention from the Fed to calm markets. And finally, market bottom-fishing/dip buyers; followed by verbal intervention from the Joe Biden administration.
What about my own assessment?
The first list corresponds closely to my thoughts about the contributing factors, but I disagree on the circuit breakers. Given what we know today about the US economy, every circuit breaker listed above that requires Fed intervention would constitute a policy overreaction that could backfire in the longer run.
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I say this despite having argued in the run-up to last week’s policy meeting that the central bank needed to begin its easing cycle with a 25-basis-point reduction.
Rather than allow itself to be bullied by markets, as occurred in the fourth quarter of 2018, the Fed should stand on the sidelines and let the market overreaction play out.
This would need to be followed by the Fed making a credible attempt to regain control of the policy narrative by being more strategic in its guidance, adding a serious forward-looking component to what has been its excessive backward-looking data dependency.
Its efforts will only be effective if it is more explicit about several open policy questions detailed here, including where it sees neutral interest rates (a level at which policy is neither holding back nor stimulating the economy); and an examination of the secular and structural changes taking place in the domestic and global economy.
Chair Jerome Powell’s keynote speech at the Jackson Hole conference will offer an opportunity to take charge of the narrative and ensure the Fed starts acting as a stability anchor rather than an amplifier of market volatility.
Failing to do this risks two bad outcomes: undermining US economic exceptionalism and its contribution to global economic well-being; or adding to the already notable moral hazard in markets, where too many have been conditioned to believe that it is the Fed’s role to protect them from the unsettling volatility that comes from excessive risk-taking.
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Little did I know decades ago that Family Feud would serve as my early introduction to the value of the insights provided by behavioural economics and finance.
It is always important to ask what is expected, how these expectations influence actual behaviour, and how far they are from what we think is appropriate. It is also important to recognize the risks involved when what is expected and what is appropriate fail to converge. ©bloomberg
