The Fed is a Prisoner of the Stock Market

After a 6% sell-off from its all-time high the S&P 500, New York Fed Governor John Williams said on Friday that “I still see room for a further adjustment in the near term to the target range for the federal-funds rate to move the stance of policy closer to the range of neutral,” Stocks immediately responded to the signaled rate cut with a strong rally ending the day well off their highs, but up 1% at the close.  Yes, the Fed put is still alive and well.

 

It was no accident that Williams spoke when he did. Put bluntly the economy is being fueled by the bull market in stocks which is enabling the huge investment boom in artificial intelligence and spending by high income investors. Should the stock market falter, both investment and consumption will stall out, triggering a recession.

 

While the stock market has been chugging along the labor market has been weakening and inflation is running at a 3% rate, 1% above the Fed’s target. Were it not for the recent stock market weakness, the Federal Reserve Open Market Committee would be facing a close call in its upcoming December meeting in trying to meet its dual mandate of maximum employment and price stability.  Instead, it will likely opt to lower interest rates to appease the stock market.

 

By lowering rates, the Fed will run the risk that investors will soon realize that supporting stock prices will be added to the dual mandate. In the short run that could add fuel to the bull market, but over time investors will realize that the 2% inflation target has given way to 3% or higher to the detriment of both the inflation and labor market mandates. Thus, by being a prisoner of the stock market the Fed will have lost control of its dual mandate and ultimately it will fail because the stock market is too big for the Fed to tame.