Will Investors Go Along With a Weaker 'Fed Put'?

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.

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.

Looking Ahead

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.

Given the extent to which the Fed's record injection of liquidity has boosted asset prices in the last few years, it should come as no surprise that the prospective reduction of that liquidity is causing anxiety about the prospects for a fourth consecutive year of double-digit returns for U.S. stocks.

Whether it will lead to outright losses depends in large part on whether the second driver of the "everything rally" — that is, behavioral — will also be reversed.

Dips & More Dips

For quite a while, the "Fed put" has deeply conditioned investors and traders to buy any and all market dips, regardless of their cause. It is a behavioral aspect that has been reinforced by FOMO (fear of missing out on yet another set of record highs for markets) and TINA (there is no alternative to risk assets given how repressed yields are).

All this has contributed to dips that have become generally shorter in duration and less intense in magnitude.

While Wednesday's signals from the Fed call further into question the automatic nature of the Fed put, they have not fully altered the behavioral conditioning. Indeed, there is still a significant segment of the investor base that continues to believe that, when push comes to shove, the Fed will prove either unwilling or unable to validate current expectations about monetary tightening.

After all, the Fed was forced to U-turn back toward accommodation several times in the last decade, including most famously after the so-called taper tantrum of 2013 and in January 2019. Yet for this to happen again this time around, inflation would need to come down materially. In the absence of that, the Fed would risk destroying its already tarnished policy credibility.

As I suspect that, despite recent moves, the central bank is still lagging economic developments on the ground, it is probable that its policy signaling in the next few months will further undermine markets' notion of an automatic Fed put.

The big question for the economy is whether policy actions by a Fed forced to play catch-up will end up so bunched together as to cause too abrupt a change in financial conditions. The additional question for markets is whether the long-standing conditioning to buy the dip will prove strong enough to withstand such a notable change in the liquidity regime.

(Photographer: Giulio Napolitano/Bloomberg)

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