The Financial Markets And The Federal Reserve: Out-Of-Touch

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by: John M. Mason
Summary

The stock markets dropped very dramatically when Fed Chair Powell announced the rate change on Wednesday, surprising many who seemed to think the markets had the rise already built in.

But, financial markets have been very negative lately, especially with the 40 percent decline in oil prices over the past three months, producing a major change in expectations of inflation.

The Federal Reserve economic projections, also released on Wednesday, show rising levels of inflation over the next several years, more closely linked to the Fed's inflation policy targets.

Mase: Economics and Finance. December 21, 2018

The Market and the Federal Reserve: Out-of-Touch

In another time, it seemed as if then Federal Reserve was much more in touch with markets than they now are.

In other words, it is not market pressure that is causing the Federal Reserve to raise its policy rate of interest.

Since the last move in the policy range for the Federal Funds rate, which came on September 22, 2018, the effective Federal Funds rate has never come less than 5 basis points of the upper limit set at the September 21 meeting of the Federal Open Market Committee (FOMC).

That is, there is no apparent pressure on the Federal Reserve to raise the policy range.

This is why I have argued over the past several months that the Federal Reserve actions, both of raising its policy rate of interest and reducing the size of its securities portfolio, were not really creating a “tightening” of monetary policy. There was plenty of liquidity around in the commercial banks and in the financial markets so that institutions and investors were being “squeezed.”

Wednesday, when the FOMC voted, unanimously, to raise the target policy range, there was no “market” pressure being experienced in the market to warrant the increase.

The Federal Reserve raised its target policy range because it is trying to “normalize” short-run interest rates.

In a previous time, the Federal Reserve wanted to keep the Federal Funds market “taut,” which has a dictionary definition of “stretched or pulled tight; not slack.”

The general picture here is of a fishing line, where a fisherman, while fishing wants his line “taut” so that he can feel when a fish has been hooked and can then begin to reel the catch in. If the line is not “pulled tight,” the fisherman will not know that he has a catch or not because the line is slack.

Similarly, the Federal Reserve wanted to keep the money market “taut” so it could feel the pressures the market was exerting on the Federal Funds rate. Therefore, if the Federal Funds rate started to rise and move toward the upper limit of its policy range, the could either inject more funds into the market to keep the rate within the Fed’s current “range” or it could consider the pressures that were being exerted and maybe consider that market conditions had changed and consequently the Fed’s target policy range should be changed.

If the Federal Funds rate began to fall, then the Fed could reassess whether or not it needed to withdraw reserves from the banking system so that the rate could rise back to a place where the market was more “taut” or the Federal Reserve could consider whether or not market conditions had changed and, in this case, the Fed’s target policy range might need to be lowered.

There is nothing like this going on in the Federal Funds market these days.

The Fed raises it target policy range and the effective Federal Funds rate moves within the new range where it will stay until the Federal Reserve decides to raise the target policy range again.

The increase in the target policy range on Wednesday was the ninth time the range has been raised since December 2015. At no time during this effort has the effective Federal Funds rate ever challenged the upper limit of the range.

The rate changes when the Fed declares that a change will take place. The market moves to satisfy the Federal Reserve. Nothing much of anything is achieved by these actions, except that the effective Federal Funds rate has moved up.

Federal Reserve officials have indicated that they want to get the rate back to a more “normal” range. But, what is “normal.” “Normal” is hypothetical. “Normal” is in the minds of Fed officials.

What I am looking for is some indication that the money market is becoming ill-liquid enough that the market becomes “taut” again. When that happens, we can really say that Federal Reserve actions are, once again, are really connected with current market conditions. Then the Federal Reserve can feel the market pressure and know that it is, once again, engaged with where the market is.

If, however, the Federal Reserve is not engaged with the market, can it be out-of-touch with the market.

For example, yields on US Treasury securities have fallen over the past 33 days. On November 8, the yield on the 2-year Treasury note was at 2.98 percent, while the yield on the 10-year Treasury note was right around 3.25 percent.

Friday afternoon, December 21, around 1:00 pm, the 2-year yield was 2.65 percent and the10-year yield was 2.80 percent, representing declines of 33 basis points and 45 basis points, respectively.

What was produced in this move was a Treasury yield curve that, in the short-end, is inverted. The yields on the 3-year Treasury note and the 5-year Treasury note are less than the yield on the 2-year Treasury note. The 7-year yield is only 6 basis points above the 2-year yield while the 10-year yield is just 15 basis points above the 2-year yield.

So, the market seems to be expecting that short-term interest rates will decline, on average, over the next five years before moving upwards once again.

Fundamentally, this is saying that market participants expect the economy will not be all that strong over the next five years. 60 percent,

In fact, if one looks at the inflationary expectations built into these nominal interest rates, the compound rate of inflation expected over the next five years is just under 1.60 percent, whereas the compound rate of inflation expected over the next ten years is about 1.75 percent.

Also, of interest, on November 8, the earlier date used in this argument, the inflationary expectations built into both the five-year nominal yield and into the ten-year nominal yield was 2.10 percent.

What are these results showing? First, over the past 33 days, inflationary expectations have fallen by 50 basis points for the 5-year horizon and by 35 basis points for the 10-year horizon. In other words, market participants are anticipating a substantially weakening of inflationary pressures in the future, especially in the nearer future.

Two major factors stand out: declining oil prices and slower economic growth around the world. These factors are impacting the stock markets, the bond markets, and other areas, like M&A activity, for one. There seems to be a concern growing that some areas of the world are not performing as well as captured by the remarks made by Fed Chairman Jerome Powell on Wednesday, or the most recent Federal Reserve projections.

Here too much liquidity in the banks and the financial markets might be separating what Federal Reserve officials are thinking and what they are trying to do. Again, stay tuned.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.