The Fed is undergoing a major change, and the market is having a fit


To be sure, the market’s most recent upset also has been tied to a particularly strong run of economic reports. But that, too, is tied into the Fed, as the outperformance has led to a belief that inflation is heating up and the Fed will keep raising rates.

That realization was compounded when much of Wall Street drew the wrong conclusion from the Fed’s most recent meeting. Officials voted to remove the word “accommodative” from the post-meeting statement to describe policy, and many market participants took that to mean that the Fed had done most of its work normalizing interest rates and soon would stop.

Since the meeting, several Fed officials and Chairman Jerome Powell in particular have sent the message that the Fed intends to keep raising rates — gradually — so long as economic conditions dictate that it’s appropriate.

That includes through periods of market discontent and even as President Donald Trump continues to criticize the central bank for the rate hikes.

“There is no Powell put,” said Joseph Brusuelas, chief economist at RSM. “They are absolutely moving in the direction of normalization of monetary policy and withdrawal of what is essentially the stance of the Bernanke/Yellen Fed.”

Doing so won’t be easy, though. After all, the Fed went where no central bank has gone before, and undoing all that easing won’t be easy. In addition to raising rates, the bank is reducing its balance sheet by allowing up to $50 billion a month in bond proceeds to roll off while reinvesting the rest.

“How do you exit that? That’s a tricky phenomenon and one I’m not sure these central banks are able to do that as seamlessly as they want,” said Joe LaVorgna, chief economist for the Americas at Natixis. “They shouldn’t talk too tough. The market is going through a tantrum.”

There are also no guarantees on how long the economic boom will last.

As things stand, the Fed plans on hiking once more this year and is indicating three more in 2019 and one more in 2020. However, Powell has been clear that the forecast is always open for revision, even though he subscribes to the current plans.

“We think that the cumulative effects of the Fed’s rate hikes, in particular the surge in market rates, are going to start taking an increasing toll on rate-sensitive sectors of the economy,” said Andrew Hunter, U.S. economist at Capital Economics. “If we’re right and the economy continues to slow, there’s a fairly good chance that by early 2020, they would definitely start to think about if not actually go ahead with rate cuts.”

For now, though, the path seems to be away from knee-jerk market reactions.

And with so much strength in the economy, Yoshikami thinks the market eventually will accept the Fed’s new role.

“It’s going to initially be startling to some folks that the Federal Reserve could take their hands off the wheel,” the Destination Wealth founder said “But I think given what we know today, there’s enough other positives in the economy that the Federal Reserve can do this and the market can adjust.”