Stock market has room to fall as Fed steps up fight against inflation

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Federal Reserve Chairman Jerome Powell.

Al Drago/Bloomberg

The Federal Reserve is serious about fighting inflation – perhaps more serious than investors give it credit for. And that means there’s more pain ahead for the stock market.

That may seem hard to believe, with the Fed known to back down at the first sign of market weakness. But the central bank hasn’t had to deal with such inflation for decades. May’s consumer price index is due Friday morning, and it’s expected to rise 0.7% from April, good for an 8.2% increase from a year earlier, according to FactSet. That would be a slight deceleration from April’s 8.3% annual inflation rate, but not enough to be a relief.

The Fed, however, prefers to monitor another measure of inflation: the Personal Consumption Expenditure Price Index, which is released by the Bureau of Economic Analysis as part of its monthly Personal Income and Expenditure report. This measure of inflation rose 0.24% in April, for a 6.3% year-over-year gain. Excluding food and energy prices, the core PCE index rose 0.34% in April and 4.9% from a year earlier. The PCE is below the CPI, but it’s still far too hot, and the next reading, due June 30, is unlikely to give a clear signal.

And it probably won’t be for some time. That monthly rate needs to drop to around 0.17% to be in line with the Fed’s 2% annual inflation target, key to its price stability mandate. This target is the single number that matters most to Fed officials and investors. While the Fed doesn’t need to see the number hit the target, it does need to see it start to approach to undo its rate hikes. Absent something dramatically negative in the labor market, monetary policy will be geared towards tightening.

The markets seem to understand this. The fed funds futures market forecast a rate hike of half a point at its June 14-15 meeting, according to the CME’s FedWatch tool, and then another half a point each in July and September. What the market might be underestimating, however, is just how much inflation is out of the Fed’s control today. It cannot fix supply chain issues that have caused shortages or force consumers to revert to old habits that have been altered due to Covid-19. People will not return the checks they received from the Trump and Biden administrations, while energy and food price spikes caused by Russia’s invasion of Ukraine and retaliatory sanctions by Western allies are not expected to disappear anytime soon.

The Fed cannot solve supply problems, so it will have to use its tools to hit demand. By raising interest rates, it reduces the affordability of personal and business loans, home mortgages and other borrowings. It also increases returns on less risky places to store money, such as treasury bills or consumer savings accounts, rather than funding free-spend start-ups or other larger businesses. risky. Credit spreads could widen as benchmark interest rates rise, making it more expensive for companies to issue debt to fund investment or other spending.

All other things being equal, tougher borrowing conditions will translate into less demand from businesses and individuals. If all goes well, the balance of the economy would be restored and inflation would come down, all without plunging the economy into a recession, or at least not a deep one.

Even a legendary “soft landing” for the economy will not necessarily be one for the markets, if the Fed gets its way. Rising interest rates and quantitative tightening have already weighed on the value of assets, from stocks and bonds to cryptocurrencies. It is a roundabout way of reducing people’s income and expenses via the wealth effect. People might think twice about splurging on luxury SUVs if their investment portfolio is down 25% in the last six months, because the


Nasdaq Compound

is now. And that’s exactly what the Fed wants. Unless asset prices in general – including stocks, housing, etc. – do not fall so much that they risk harming the real economy, there is no so-called Fed put option.

And this is the rosiest scenario. The biggest risk is that the Fed overshoots and suppresses demand and financial conditions to the point of pushing the US economy into a recession. This could solve the inflation problem, while creating a host of new ones instead. Still, officials could be doing the math that a recession is worth it to pull the US economy out of its current inflationary slump. This is especially true if the war in Ukraine were to escalate, forcing the prices of food, oil and other commodities even higher, a risk that probably doesn’t get enough attention. But a recession would mean higher unemployment, lower corporate profits and an even steeper drop in stock prices.

For investors, the mantra remains “Don’t fight the Fed”. It’s time to heed this advice or pay the price.

Write to Nicholas Jasinski at [email protected]

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