Implications Of Fed Tightening For Equities

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Includes: DIA, QQQ, SPY
by: Tim Duy

Gavyn Davies at the Financial Times questions the Federal Reserve's employment target:

On the wider issue of general monetary policy, the behaviour of inflation and unemployment remain the key drivers, and here the Fed has a headache. Its forward guidance on unemployment is in danger of giving misleading signals about the need for tightening, and it probably needs to be changed.

I agree. Davies cites research indicating that recession-driven underemployment makes the unemployment rate a poor measure of resource utilization. The policy implications:

What does this imply for policy? It implies that the Fed will have a bias to keep policy aggressively easy long after the unemployment rate has fallen below 6.5 per cent, and even after it has fallen below the estimated natural rate of 5.25 to 6 per cent, provided that the inflation threshold is still intact. This is because the reserve army of disguised unemployed people will exert a downward force on inflation which will not be correctly picked up by the official unemployment statistics.

See my related piece on structural (or lack thereof) unemployment here. Davies raises an often-forgotten point: Even though the Federal Reserve is turning its attention to ending quantitative easing, the timing of the first rate hike is most likely much farther off in the future.

A challenge for the Fed is that asset purchases are at least in part a communications device that signals commitment to a given policy path. Thus, the Federal Reserve will need to take care to avoid the impression of imminent rate hikes as they scale back asset purchases. Indeed, I thought this was the most important takeaway from Friday's Jon Hilsenrath article in the Wall Street Journal:

Officials are focusing on clarifying the strategy so markets don't overreact about their next moves.

Overreaction can come in many forms:

For example, officials want to avoid creating expectations that their retreat will be a steady, uniform process like their approach from 2003 to 2006, when they raised short-term interest rates in a series of quarter-percentage-point increments over 17 straight policy meetings...An abrupt or surprising end to it could send stocks and bonds in the other direction, but a delayed end could allow markets to overheat. And some officials feel they've ended other programs too soon and don't want to repeat the mistake.

This sounds as if Fed officials are cognizant of this from Davies:

The more precise the forward guidance given, the more the Fed exaggerates the degree of knowledge which the central bank can possibly have about its own future actions, since these actions will depend on many factors which cannot be exactly predicted in advance.

Which also speaks to the inclusion of "increase or decrease" phrase in the last FOMC minutes. Back to Hilsenrath:

The Fed said in its postmeeting statement that it was "prepared to increase or reduce the pace of its purchases" as the economic outlook evolved.

The suggestion that the Fed might boost its bond buying was a change in the policy statement that seemed to some an acknowledgment that more aid for the economy might be needed...

...But many officials believe the recovery is on track and aren't yet concerned about the inflation slowdown. Instead, the most recent statement seems more aimed at signaling the Fed's broader flexibility in managing the programs.

Bottom Line: We need to be very careful in extrapolating the implications of the next policy move to future policy moves. The Fed has only a general strategy for exit, but policymakers lack enough certainty about the future to determine the exact nature of that exit. Still, even given that uncertainty, the current state of labor force utilization and inflation suggest that while the end of QE may occur this year, the first rate hike is not likely until some point well into the future.

Update: Thinking further about this from Friday's Jon Hilsenrath Wall Street Journal article:

Stocks and bond markets have taken off since the Fed announced in September that it would ramp up the bond-buying program, and major indexes closed at another record Friday. An abrupt or surprising end to it could send stocks and bonds in the other direction, but a delayed end could allow markets to overheat. And some officials feel they've ended other programs too soon and don't want to repeat the mistake.

Although past performance is no guarantee of future performance, it strikes me that previous instances of tighter monetary policy did not trigger immediate widespread declines in equities:

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Just an eyeball look at past behavior suggests that equities are mostly flat in the initial stages of monetary tightening, and rise in later stages. Generally at least two years before the Fed inverts the yield curve and triggers recession. In addition, we are not expecting the Fed to begin raising rates until late 2014 or 2015. So policy is likely to remain supportive for what, at least three or four more years?

Fears of an imminent policy-driven collapse in equity prices are likely greatly over-exaggerated. See also Mark Dow here.