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The Fed May Be To Blame

Feb. 23, 2021 10:51 AM ET
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  • Weakening Stock Market May Fear Tighter Money.

I hesitate to draw conclusions from so little data, but there are hints that monetary policy is tightening. That is, monetary policy is tightening, if markets think it is tightening. That is the essence of increased money demand.

The 5-year forward inflation rate has been falling consistently since last Tuesday, and has been on an overall downward trend since February 5th.

inflation-expectations Meanwhile, Treasury yields are rising:

treasury-yields-rising In broader context though, these fluctuations don’t yet seem significant. For example, look at the last year’s worth of 5-year forward inflation rate data: five-year-inflation-expectations

The current downward trend in inflation expectations is nothing special in the context of such movements, going back to last year. There’s no reason to predict a sustained trend, at least yet.

And the Treasury rates are only moving up right now for maturities longer than 3 years, indicating no expected rate increases prior. Of course, the cumulative effect of policy decisions in all future years will loom much larger than decisions over the next few years, so the entire expected reaction function is critical.

I model the Fed’s reaction function, in part using various pieces of year-over-year data, with 2 sigma deviations from a simple moving average signalling significant stock market moves. Right now, deviations are still within 1 sigma, hence there are no signals other than continuation of the general upward trend that has characterized the pandemic recovery.

That can always change, however, and I will let you know if it does.

By the way, you may wonder what I mean when I say most of the volatility in the stock market is caused by Federal Reserve policy. I mean that, if the Fed both conducted its policy more effectively, say by level targeting NGDP, and made adjustments to policy daily, as needed, most stock market volatility would be eliminated.

Happy trading.

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