The Fed will be focused on “financial conditions” to the extent that they impact the outlook for employment and prices.
What does that mean? What “financial conditions” are they watching for?
In the simplest terms, bonds and stocks. The bond market is a hundred trillion dollars. The stock market is thirty five trillion dollars. Problems in these markets can create problems in the real world if they’re left to fester and spill over.
As the Fed drives toward the end of emergency stimulus and “normalization” of interest rates, the institution will have to monitor how its policies affect stocks and bonds and whether these effects will have economic ramifications that run counter to the dual mandate of “maximum employment, stable prices” originally established in 1977.
In the 70’s and 80’s, stock price movement was seen as a symptom of what was happening in the “real” economy. It was a sideshow. We had a stock market crash in 1987 that did not lead to a recession.
A generation later, in 2000, this was no longer true. Stocks had become important enough in the psyche of the middle and upper classes that the next crash did cause a recession. By organizing the nation’s retirement around self-directed, defined contribution retirement accounts reliant upon stock mutual funds, we’ve done this deliberately.
Consumers in the “real” economy behave according to how well off they may feel at any given time. This is called the “wealth effect” and it has been very well documented. The number one driver of this wealth effect had historically been home prices. Now stock market wealth has supplanted home prices for the upper class and upper middle class because of how large the market has become. The prevalence of stock-based compensation has been a big part of this. The proliferation of corporate and small business 401(k) plans and high employee participation rates too. There was $5.3 trillion in private equity assets in 2013. Now it’s $11 trillion.
In fact, I would say that after wages, the stock market wealth effect has actually become the leading driver of home price appreciation in the top 20 metro markets too. Especially given how easy it’s become to borrow against a portfolio of stocks to finance a real estate purchase. You can do this in under 72 hours with no underwriting necessary at many firms.
Many Wall Street strategists are pointing out that the “Fed put” is at a lower market level than it’s been historically. By which they mean that the Fed will let the stock market drop further than they used to before riding in to the rescue. This is because, they point out, inflation is so much higher than it has been in previous episodes – for example, 2018, when the stock market plunge forced the Fed to blink and reverse itself. Therefore, the thinking goes, the Fed will be much more tolerant of stock prices in free-fall so they can bring the price down for a Chevy Silverado or an Açaí Bowl in the mall.
This makes them sound smart and clever in their meetings and on television but they are smoking crack if they actually believe this.
The Fed is terrified about the stock market crashing because it will immediately cause massive dislocations and literally break everything from money market funds to commercial paper to bank lending to municipal finance to corporate bond issuance. The “real” economy would screech to a halt within weeks, undoing all of the repair of the last few years. If the Fed believes that there are many aspects of today’s inflation that will abate naturally as the economy reopens, it will give this abatement time to manifest itself rather than rush into a new crisis of its own making.
I could end inflation in 15 minutes. Announce the closure of the stock market for the next 30 days for maintenance. “We’ll reopen March 1st. Have a nice day.” Believe me you won’t have to worry about high prices anymore. They did this on the New York Stock Exchange before WWI began to keep the British banks from pulling all their money out. It stayed closed for months. Would be impossible now.
Hawkish talk makes sense given the headlines of the last few months and the political pressure that these headlines bring to bear on all parties involved. No one can afford to act sanguine with a high single-digit CPI on the nightly news. But Chairman Powell also knows that there is something worse than worker shortages and wage pressure on business owners out there. A stock crash would quickly bring that something worse out of the basement where it is currently biding its time and sharpening its tusks.
Here’s the reality: We have fully financialized our way of life and blurred all the lines between Main Street and Wall Street. “Financial Conditions” are no longer symptomatic of what’s happening in the economy. They are the economy.
