What You Need to Know
- Why were investors taken by surprise by the Fed's recent hawkishness, and what are the implications for future price moves?
Many have viewed the pullback in markets this week, including the sharp fall in the Nasdaq, as a reaction to the release of minutes from the Federal Reserve’s December policy meeting that were more hawkish than expected.
That raises two interesting issues for markets and the economy: Why were investors taken by surprise, and what are the implications for future price moves?
The market-moving aspect came from the higher combined probability of three policy moves in 2022: the end of large-scale asset purchases; a series of interest rate increases; and the possibility that the Fed will start to reduce its balance sheet.
The catalyst for this was twofold: The recognition by the Fed, albeit a belated one, that inflation has and will continue to be higher and more persistent than what was expected and, therefore, well above its target; and the judgment that the labor market will soon meet, if it hasn’t already, the second element of the central bank’s dual objectives, that of maximum employment.
What Your Peers Are Reading
Given the economic data in the run-up to the December Fed meeting, let alone what has come since then, neither of these two contributing factors should have come as a great surprise to markets.
The fact that they were can be attributed to another less-than-full alignment between the content of the Federal Open Market Committee discussions and how they were portrayed in the press conference that immediately followed them. This is particularly the case for the treatment of a potential contraction of the Fed’s balance sheet.
What happens next will depend in large part on whether the evolution of inflation and employment validate the now more hawkish expectations.
While the Fed still has a window to deliver an orderly policy normalization, there are two reasons this opening is uncomfortably tighter than it was a few months ago or ever needed to be. (Consider my repeated advocacy, as early as April of last year, for the Fed to start its tapering process.)
First, the Fed’s prolonged misjudgment of the inflation dynamic means that it now has to move virtually simultaneously with three measures that reduce monetary accommodation, greatly increasing the risk of a policy misstep.
Second, this withdrawal of accommodation risks coinciding with other contractionary winds emanating from a de facto fiscal tightening and the erosion of household savings, threatening a bigger reduction in the momentum of economic growth.