The Federal Reserve has been front and center during the past couple months, and for good reason. After raising interest rates once again in December, markets reacted with uncharacteristic violence. Indeed, many analysts and commentators believed that the rate-induced selloff was the start of a full-blown bear market.
While the overriding concern of a Fed-induced bear market - or even recession - has dissipated a bit in recent weeks, fears about an increasingly brittle economy and stock market have been mounting.
The sheer violence of the market’s reaction to the December hike shook actors across financial markets, from investment bank CEOs to Federal Reserve governors. It also sparked unprecedented political commentary from President Trump.
Thus, the Federal Reserve’s decision to keep rates stable in January was not terribly surprising. That said, it marks the first tangible sign that Fed Chair Jerome Powell is wavering in the face of market and political pressure.
Powell blinked in the face of external pressure, but the true impact of his about-face has yet to be felt. Investors should buckle up for a bumpy ride in 2019 as wavering Fed policy combines with heightened volatility to create a level of market uncertainty not witnessed in perhaps a decade.
Capital market participants must prepare themselves for a coming storm. Opacity, volatility, and uncertainty are all on the menu for 2019.
At the Brink
Until the December rate hike (and subsequent market tantrum), Powell had been chugging along with his policy of interest rate tightening. His confidence was evident as recently as November, when he informed markets that the Fed would be providing less guidance on future policy than it had done in recent years. Markets had grown used to a soft touch from the Fed under Ben Bernanke and Janet Yellen, yet they responded to Powell’s harder line with nary a blink.
Yet, when Powell made good on his promise and raised interest rates yet again in December, markets seemed to lose their minds, sending stocks into a downward spiral and sparking the first mass media talks of recession in years.
Despite the market reaction to the December hike, and his own partial capitulation in its wake, Powell made it clear during the first two weeks of January that he was not yet willing to throw in the towel on his hawkish policy quite yet. In a January 10th speech, Powell insisted that he still intended to shrink the Fed’s balance sheet “substantially” during his tenure.
Unfortunately, the opacity of Powell's January statements left financial analysts scratching their heads and markets in doubt. What constituted “substantial” became a major point of contention among experts. Ultimately, this was just one more question mark added to an already muddied outlook within capital markets.
As a result of the market’s unexpectedly extreme reaction to the latest rate hike, the Fed began an unusually intense campaign of damage control. In early January, Powell made an attempt at conciliation, softening his stance on future interest rate increases. Other influential Fed governors made similar efforts to calm the market. The Atlanta Fed, for example, trimmed its estimates on 2019 hikes in January.
Powell’s efforts to calm markets did not end with his slightly more dovish stance on interest rate hikes. In early January, the Fed chair stated that there were no signs of near-term recession risk. Powell has repeatedly stressed the virtue of patience with regard to interest rate hikes in recent, a significant shift from his prior uncompromising stance.
For better or worse, Donald Trump has linked the economic success of his presidency with the performance of the stock market. Tightening Fed policy is an obvious headwind that could spoil his narrative. Thus, it is unsurprising that Powell has bent in the face of buffeting political winds from the Trump administration, which has already threatened to interfere directly with the Fed in a major break with long-standing government norms.
While Trump has been the most vocal critic of recent Fed policy, he is far from alone. Other policymakers, faced with the prospect of economic and market turmoil as a result of Fed tightening, have begun to contemplate direct interference, or indirect pressure, to degrees not seen since the foundation of an independent central bank before the Second World War.
In theory, the Federal Reserve is independent of petty party politics, but in reality it is affected by many of the same political pressures that afflict any governmental institution. Powell has no desire to be the catalyst of a bear market, let alone a recession. He is aware that his legacy will be recorded in history books as much as any elected official.
Powell is cognizant not only of the material impacts of his policy actions but also of how those actions may be interpreted by the political class. Thus, his conciliatory moves in late January, topped off by the decision to keep interest rates steady, was far from surprising.
Soft Landing Not Secured
For better or worse, the Fed has been propping up the stock market for years. Jerome Powell’s tentative efforts to move away from the long period of near-zero interest rates have thus been met with a perfectly understandable negative reaction. The market has thrived on the easy money and suppressed interest rates. But the Fed’s role as the central driver of monetary policy means it must sometimes make unpopular decisions that will support the overall strength and resilience of the economy.
Interest rates are certainly well below “normal” even now. Just because the market has grown complacent during the decade of ultra-low rates does not change the underlying economics involved, nor does it absolve the Fed of responsibility to make difficult - and sometimes unpopular - decisions.
Investor’s Eye View
Powell & Co. blinked in January and are guiding for a softer stance than they had in 2018. That may be fine overall, since extreme gradualism is arguably the best method of ensuring a soft landing for the U.S. economy.
If Powell falters, trading gradualism for inaction, it could prove disastrous for the both capital markets and the broader economy in the longer-run. Ultra-low rates may feel great in the moment, but they leave the Fed with little in the way of monetary policy firepower to combat future recessions. Thus, it is crucial that interest rates normalize before the next downturn.
For investors, the current wavering at the Fed - combined with its continued opacity toward market participants - makes for an unusually volatile and uncertain situation. Therefore, the best advice is to tread with extreme care in the months ahead.
Be prepared for opaque, or even outright conflicting, guidance from the Fed. And expect the lately renewed volatility to stick around; it is going to be far more apparent in 2019, so market actors had best be ready.
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.