The Fed Has a Third Mandate, and the Market Has a New Imaginary Friend
Much has been made of the market’s relationship with the Fed in recent months. It is hard to find an investor who has not given at least some thought to what happens to the markets if the Fed chooses to raise rates more or less than expected. Indeed, this relationship between monetary policy and cost of capital is as old as the markets themselves. But what has only been mentioned in passing, it seems, and has not been investigated as fully is the impact on market psychology of past Fed actions. When paired with a Fed that is hyperaware of those market psychologies, we find ourselves seeing an interesting dynamic develop today as the Fed battles inflation on one hand and the risk of a recession on the other.
To give context to this discussion, we will paint a simplified picture of the dilemma facing the Fed. Years of loose monetary policy has flooded the economy with cheap capital. Meanwhile, the Fed’s frustration with a lack of legislative resolve led Chairman Jay Powell to leave the free money policy in place during the Covid pandemic. Congress eventually did act, albeit in a more limited capacity than originally intended, but in a way that, when compounded with the Fed’s attempts to offset a prior lack of such fiscal policy, led to an even more aggressive explosion of demand. This, in turn, set the stage for the demand-side impacts exacerbating the current out-of-control inflationary environment.
Of course, inflation at rates not seen in decades is not entirely due to a failure to effectively apply a combination of fiscal policy (which tends to be more precise and surgical) and monetary policy (which tends to be more crude and harder to direct) to manage demand. A collection of supply-side shocks has been as much to blame, including Russia’s invasion of Ukraine and massive supply chain disruptions. Here in the United States, the impact on local supply chains has, in part, been fueled by a shortage of workers needed to efficiently move products from port to storefront.