Fynsa
In principle, the statement that accompanied the Fed's decision to raise interest rates by 75 bps to 2.5% and to continue with the reduction of the balance sheet brought no major surprises. The move was widely expected and incorporated by the market. While the statement's characterization of economic growth was downgraded slightly, acknowledging that "recent indicators of spending and production have softened." the characterization of the rest of the economy remained virtually unchanged, with the statement again noting that job gains "have been solid in recent months" and that inflation "remains elevated."
But things changed at the press conference. Despite openly acknowledging that economic growth is weakening, the Fed unanimously decided to hike 75 bp, i.e. the focus is still more on inflation than growth. But markets began to recover only when Powell noted that. "we are now at levels broadly in line with our estimates of neutral interest rates, and after anticipating our hiking cycle so far, we will be much more data dependent going forward"
The neutral rate is the prevailing rate at which the economy is operating at its potential, neither overheating nor cooling excessively. With this 75 bp increase, the Fed has just reached its estimate of the neutral rate.. From here, they are no longer contributing to economic overheating. But that also means that any increase from here will put the Fed into actively tightening territory.
In principle, the Fed's move makes sense. The dynamic that has developed in the bond market in recent months is that inflation will move down, and very fast. So, if Powell is no longer "on autopilot," and the markets have a strong view on the collapse of inflation and growth, they can also price all other assets around this baseline scenario. And if one looks at the market action in recent weeks it also validates this narrative, with a widespread drop in prime rates and a more than 10% recovery in equities from the mid-June lows.
Thus, it is possible to rationalize the narrative being constructed after the FOMC, including the positive market reaction to the news that the U.S. economy contracted 0.9% in 2Q22 (bad news is good news for the market) in its preliminary reading, data which, if confirmed, would add to the 1.6% contraction in 1Q22, i.e., the U.S. economy could already be in "technical recession".
But let me make some counterpoints to this market dynamic. The Fed's move also entails risks if actual inflation does not ease as quickly as expected.. Without "forward" guidance, the Fed's action may become "very volatile". One small "hawkish" twist and all the prevailing optimism will vanish.
The market has the expectation that the Fed will pivot to easing, perhaps next year, to support the economy if economic contraction deepens, as it has done time and again over the past two decades. But in those years, inflation was contained and low, often traveling below the committee's target. So, then, the logic of "bad news is good news," is anchored to the market playbook of recent recessions, but "the world is different now, inflation is much higher."
This is the biggest fight against inflation that central bankers have had to engage in for more than 30 years, therefore, there can be no realistic and sustainable pivot for markets unless real and convincing progress is made on actual inflation. So, for the time being, "bad news is bad news".
