Are investors right in expecting a dovish Fed pivot?

Following last week’s meeting of the Federal Open Market Committee (FOMC), the policymaking arm of the Federal Reserve (Fed), U.S. Treasury yields fell sharply and stock prices surged higher. Even though the FOMC raised the policy rate by 75-basis points, financial markets rallied as investors concluded that Chairman Jerome Powell’s comments during the follow-up press conference were indicative of a dovish monetary policy tilt.

Specifically, the following statement by Powell was taken by market watchers as suggestive of a policy shift: “As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.”

Investors felt further emboldened when the first estimate of second quarter GDP appeared to suggest that the U.S. had experienced two consecutive quarters of negative GDP growth. Financial market signals indicate that participants not only are expecting the Fed to reach the terminal policy rate by early 2023 but are in fact betting that the U.S. central bank will be forced to make a U-turn and start easing policy soon thereafter.

Yields on U.S. Treasury securities have swung wildly since early March. The benchmark 10-year Treasury note (T-note) yield initially surged from about 1.72 percent on March 1 to around 3.49 percent on June 14, and then fell to around 2.68 percent on July 29. The sharp drop in 10-year T-note yield during the past few weeks suggests that bond investors are pricing in an economic downturn. Furthermore, investors in long-dated U.S. Treasury securities appear to be discounting the risk that the American economy may have entered a new inflationary regime.

Meanwhile, stock markets are also factoring in a dovish tilt at the Fed — the benchmark S&P 500 Index has rallied sharply since hitting a bottom on June 16. The problem with the recent financial market rally is that it implies an easing of financial conditions and a positive wealth effect, and neither of these developments will help the Fed in its ongoing battle to cool demand and ease inflationary pressures.

The 30-year mortgage rate and corporate bond yields closely track the yield on the 10-year T-note. The recent drop in the benchmark T-note yield will lower borrowing costs and potentially reenergize the demand-side of the economy and complicate the Fed’s battle against high inflation. The recent equity market rally, if sustained, is also likely to create headaches for the Fed.

This is especially likely if the market belief that we have already seen the worst of the bear market generates a fresh wave of investor enthusiasm and if the nascent rally is further fueled by expectations that the Fed will soon pivot. Rapid recovery in financial asset values could encourage households to embark on a fresh spending spree, which in turn could keep prices at elevated levels. That would force the Fed to have to raise rates by even more than currently projected.

The monetary policy transmission mechanism is partly reliant on the proper functioning of the asset price channel — higher policy rates depress asset values, which in turn generate a negative wealth effect and result in a cooling down of aggregate demand. For this channel to operate effectively, the central bank must convince financial market participants that rate hikes will be sustained and that high interest rates will be maintained until monetary policy goals and objectives are achieved.

The Fed, however, currently faces a self-inflicted credibility problem. Given Fed’s penchant for supporting asset bubbles and bailing out investors in recent decades, it now faces a tricky challenge as it has to convince market participants that reliance on a “Fed Put” is no longer an appropriate strategy. Since inflation is expected to remain well above the 2 percent target level for quite a while, the central bank has to forcefully persuade investors that rate cuts will not be forthcoming anytime soon.

Given the Fed’s poor forecasting track record and recent struggles with forward guidance, it is no surprise that Chairman Powell indicated that maintaining some degree of optionality would allow the Fed to react quickly to changing circumstances. However, it appears that, in the absence of clearer guidance, markets misread the central bank’s commitment to its 2 percent inflation target and is ignoring or downplaying the severity of the inflation challenge.

Clearly, the inflation dragon is yet to be slain. While commodity prices have eased somewhat and goods price inflation will likely ratchet down in the coming months, there is still ongoing and broad-based upward pressure on prices. The trimmed-mean PCE (personal consumption expenditures) inflation rate suggests that underlying inflation is still at very high levels.

Furthermore, the employment cost index (ECI), a key measure of wage inflation, surged in June. Shift in consumer spending away from goods and towards labor-intensive services will delay any moderation in wage growth.

Additionally, rental inflation, which typically lags home price changes by about 12 months, is expected to remain high for several more months. Owners’ equivalent rent of residences and rent of primary residences account for a substantial share of the CPI basket, and, consequently, the rising cost of shelter will limit the pace of disinflation in the near term.

If investors are indeed misreading the Fed’s commitment to maintaining a tight policy for a prolonged period and are failing to adequately take into account future inflation risks, then recent stock and bond market rallies may well prove to be premature and even counterproductive.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.