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.

The Sum of all Fears: It is Far More than the Fed*

The stock market by declining 7.1% thus far this month is having a December to remember putting it on track to have its worst December since the depression year 1931. Indeed the S&P 500 is now off 18% since its September high. While most market participants have been blaming Fed Chairman Jerome Powell's remarks last Wednesday, the market's troubles extend well beyond the Fed. (See https://shulmaven.blogspot.com/2018/12/no-powell-put.html) Why? On Friday New York Fed President John Williams at a live CNBC interview walked back most of the comments made by Powell perceived to be bearish by stating that the Fed remains data dependent, two rate increases next year are not cast in stone and the timing and the extent of the Fed's balance sheet reduction program is dependent upon market conditions. 

The market got everything it was asking for and remember everything that Williams said was pre-cleared by Powell. In response stocks quickly rallied and then sold off hard ending the day much lower. So if it is not only the Fed, what is it? The market's weakness has everything to do with Trump's trade policies especially with respect to China that is throwing a monkey wrench into business capital spending plans. Further complicating the situation the USMCA Treaty (the new NAFTA) is in big trouble with the Democrats in House. 

Overlaying everything is the increasing erratic behavior of President Trump. His abrupt pull-out from Syria and his firing of Defense Secretary James Mattis were hardly confidence builders. Now throw in a partial shut-down of the government, Trump musing about firing Powell and more indictments coming from the Mueller probe you have witches brew of chaos that is hardly market friendly. Moreover there are no calming figures in the Administration.  Treasury Secretary Steve Mnuchin is no Hank Paulson and he is no Bob Rubin. Knock, knock nobody is home.   

As a result the biggest fear in the market is that things will get worse and that weakness in the market transmitted via the wealth effect to economy will lead to a recession. Our 3-2-1 forecast for 2018-2020 GDP growth could very well turn out to be 3-0- Minus 2. 

The big question is whether or not all or most of this is priced in, if not we are headed lower; if it is we will soon find a bottom. As they say, only time will tell.

*-With apologies to Tom Clancy.