Stock and bond markets still don’t know how to deal with the Fed

On Wednesday, the S&P 500 stock index rose 3 percent, as if all was well with the world. On Thursday, stocks crashed, with the tech-heavy Nasdaq index falling 5 percent as if the end times were in sight.

Things on Friday aren’t much clearer: Stocks swung back and forth in early trading.

If you’re looking for patterns in these crazy swings, the answer is simple: financial markets are facing a surprising policy change by the Federal Reserve.

Over the past two decades, financial markets may have become so used to Fed stimulus that they simply don’t know how to react now that the central bank is doing everything it can to slow the economy.

But the Fed’s intentions are obvious, if you read and listen.

Jerome H. Powell, chairman of the Fed, said unequivocally during a press conference on Wednesday that the central bank is really and truly committed to reducing inflation. A transcript of Mr. Powell’s remarks is available on the Fed’s website. So is the text of the Fed’s latest policy statement. See for yourself.

The Fed is willing to increase unemployment in the United States if that is what it takes to get the job done. And while they would much prefer that the United States not slide into a recession, Fed policymakers are willing to take the pressure if the economy falters.

This can be hard to accept, and for good reason.

Virtually since the start of the great financial crisis that began in 2008, loose monetary policy by this same Federal Reserve has repeatedly propelled financial markets to dizzying heights. By cutting short-term interest rates to virtually zero and buying trillions of dollars in bonds and other securities, the central bank kept the financial system from freezing up, and then some. It stimulated business activity, effectively lowered yields on a wide range of bonds, and encouraged investors to take risk. That sent the stock market up.

These extraordinarily generous policies are, at least in part, responsible for the current burst of inflation, the most serious episode of rising prices since the 1980s.

However, at its latest policy-making meeting on Wednesday, the Fed made it clearer than ever that it has fundamentally changed its policy. That is understandably extremely difficult for the financial markets to digest.

“This is a very big change, and markets are having trouble processing it,” Robert Dent, senior US economist at Nomura Securities, said in an interview.

Not surprisingly, markets have swerved wildly, falling one day, rising the next, but trending lower since the beginning of the year.

“Because the risks facing the economy and facing the Fed are so great, and because the Fed’s responses could be so significant, we’re seeing very large swings every day,” Dent said. “Changes that a year or 24 months ago would have been highly unusual are now the norm.”

However, the current situation is anything but normal.

The Covid pandemic has left millions of victims around the world, and it is not over. From the narrow point of view of economics, the pandemic has disrupted supply and demand for a wide range of goods and services, and that has baffled politicians. How much of the current bout of inflation has been caused by Covid and what can the Fed do about it?

Then there are the ongoing lockdowns in China, which have reduced the supply of Chinese exports and decreased Chinese demand for imports, both of which are disrupting global economic patterns. On top of all that, there is the oil price shock caused by Russia’s war in Ukraine and the sanctions against Russia.

Until late last year, the Fed said the inflation problem was “transient.” His response to a variety of global challenges was to flood the American economy and the world with money. It helped reduce the impact of the 2020 recession in the United States and contributed to huge wealth-building rallies in the stock and bond markets.

But now, the Fed has acknowledged that inflation has gotten out of control and needs to be brought down significantly.

That’s what Powell put it on Wednesday. “Inflation is too high and we understand the difficulties it is causing, and we are moving quickly to reduce it,” he said. “We have the tools we need and the determination it will take to restore price stability on behalf of American families and businesses.”

But his tools for reducing the rate of inflation without causing undue damage to the economy are actually quite crude and limited, he later acknowledged, in response to a reporter’s question. “We essentially have interest rates, balance and forward guidance, and they are famously blunt tools,” she said. “They are not capable of surgical precision.”

As if that wasn’t scary enough, for an operation as delicate as the one the Fed is attempting, he added: “Nobody thinks this is going to be easy. No one thinks it’s easy, but there’s certainly a plausible path to this, and I think we have a good chance of doing it there. And, you know, our job isn’t to rate the odds, it’s to try to make it happen. So that’s what we’re doing.”

As well. The Fed needs to try, but given the precariousness of the situation, high volatility in financial markets is exactly what you would expect to see.

The Federal Reserve has pledged to keep raising the short-term interest rate it controls, the fed funds rate, to well above 2.25 percent. Just a few months ago, that rate hovered near zero, and on Wednesday, the Fed raised it to the range of 0.50 to 0.75 percent. The Fed also said it would start cutting its balance sheet from $9 trillion in June by about $1 trillion over the next year, and continues to issue cautious “forward guidance” — warnings of the kind Powell did on Wednesday.

Watch out, he was essentially saying. Financial conditions will become much tighter, as tight as necessary to prevent inflation from taking root and being deeply destructive. The Fed will use blunt instruments on the US economy. There will be damage, inevitably. People will lose their jobs when the economy slows down. There will be pain, even if it is not intended.

In the financial markets, short-term traders cannot understand all of this. The daily changes in the markets are as informative as the wandering of a squirrel. But for those with long-term horizons, the outlook is pretty straightforward.

A period of harrowing volatility is inevitable. This happens periodically in the financial markets, but those same markets tend to produce wealth for people who can weather this turmoil.

It’s important, as always, to make sure you have enough money set aside for an emergency. Then assess your ability to withstand the impact of ugly headlines and ugly financial statements documenting market losses.

Cheap, widely diversified index funds that track the broader market are getting hit hard right now, but I’m still putting money into them. In the long run, that approach has led to prosperity.

Expect more market madness until the Federal Reserve’s struggle to beat inflation is resolved. But if history is any guide, chances are you’ll do just fine if you can get past it.

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