'Anti-Goldilocks' And The Fed-Equities Nexus
Some in the markets think that the Fed effectively targets equity prices, meaning that to predict Fed policy, one merely needs to track the US stock market. There is a curious circularity to this view, however: the Fed will not launch QE3 so long as stock prices are high, yet the stock market is high because it anticipates QE3. BofAML's chart-of-the-day is intrguingly similar to our 'QE Hopeyness' chart as it shows that stock and bond prices have decoupled since the summer, as QE3 expectations overwhelmed the weaker macroeconomic data to buoy equities. Now that recent data have improved, yields have risen - but so too have stocks. This "heads I win, tails you lose" aspect of stock prices rising regardless of the macro backdrop, BofAML believes, makes them a far less useful signal for Fed officials. Moreover, it creates the risk that the equity market could sell off after the 12-13 September FOMC meeting if the Fed disappoints.
BofAML: The Fed-Equities Nexus
Stocks as a signal for policy makers...
The stock market is just one component of financial conditions, and financial conditions are just one driver of the outlook for growth and inflation. The Fed wants to be forward-looking in light of the transmission lags of monetary policy. In the words of Dallas Fed President Richard Fisher, quoting hockey legend Wayne Gretzky, the Fed must “skate to where the puck [ie, the outlook] is going to be, not where it has been.” Financial conditions can signal where the outlook is going to be, but that role breaks down when financial markets are largely driven by policy expectations. No central banker wants to tie policy to a financial variable that itself is driven by policy expectations.
As Chart 1 above shows, financial conditions more broadly are not very far from where they were ahead of QE2. Chart 1 plots three measures produced by Fed researchers: a National Financial Conditions Index from the Chicago Fed and two Financial Stress Indexes, one each from the St. Louis and Cleveland Feds. All three are normalized measures in which higher values indicate more stress. The Chicago and St. Louis indexes co-move quite closely (95% correlation coefficient) despite their different construction and units; the correlation of the Cleveland measure with the other two exceeds 70%. Even though rising stock prices are indicative of better financial conditions, in some sense the equity market appears to have it right: broader financial conditions are not so strong to price out QE3.
...but not as a policy goal
On the other hand, the Fed is not targeting the stock market. True, the Fed wants to see financial conditions improve because this is a channel through which monetary policy has a positive impact upon the economy, including wealth effects and confidence. But Fed officials do not see targeting equity prices as even an intermediate goal of policy, let alone an end in itself. Despite market speculation about the strike price of the so-called “Bernanke put,” one never finds Fed officials themselves talking up stock prices or mentioning a specific target value. Rather, Fed officials are focused on their dual mandate — price stability and maximum sustainable employment — to the point that they augmented their statement in June with “sustained improvement in labor market conditions” as well as “a stronger economy recovery” as policy objectives that would potentially warrant additional accommodation.
On the inflation front, the data for the headline personal consumption expenditure (PCE) deflator — the Fed’s preferred measure — have softened to just a 1.5% annual inflation rate after running at 2-3% for a year (from March 2011 to 2012). This measure bottomed out at 1.4% ahead of QE2 in 2010. That said, core PCE inflation is running higher now (1.8%) than prior to QE2 (1.2%). But both headline and core inflation are not only below the Fed’s 2% long-run inflation target, but Fed officials expect them to remain there for some time. And although the Fed’s preferred computation of 5-year, 5-year forward breakeven inflation (Chart 2 above; FED5YEAR in Bloomberg) had not reached its 2010 low, it has remained in the range that preceded QE2. A little more weakness in the inflation data is probably necessary to make a compelling case for QE3 in September.
Conversely, many Fed officials have acknowledged that they are significantly underperforming the other part of their dual mandate: the unemployment rate has crept back up to 8.3% in July, where it stood in January, while the employment-topopulation ratio has shown no net improvement for the past several years (Chart 3 below). Even a positive surprise of 163,000 on July payrolls is unlikely to impress most Fed officials: in a normal recovery, in which job growth exceeds 200,000 for a while, 163,000 would be considered a modest disappointment.
What if the Fed disappoints?
This mixed data outlook makes the Fed call for the September meeting especially close. There is little doubt for us that if the data resume sliding to the downside, the Fed will step in and ease further this year. Right now, however, we are in an anti-Goldilocks period in which the data are too hot for clear-cut Fed easing, but too cold to support a sustained rebound — anything but “just right”.
Meanwhile, discussions with investors suggest that the equity markets have not yet priced in the fiscal cliff or resumption of risks from Europe once policy makers there return from vacation. Our equity strategists have highlighted downside risks to the equity market, now that the S&P 500 index is within striking distance of their year-end target. Another on-hold Fed meeting — or even an extension of the forward guidance when the market really wants QE3 — could be a catalyst that begets a sell-off, in our view. Look out below.