Actions speak louder than words.
But in the Federal Reserve’s case, words may speak louder than actions.
The Fed hiked 50 basis points on Wednesday, its biggest increase since 2000. Yet markets cheered as Fed chair Jay Powell talked about inflation, the job market, and mega hikes in a press conference after the decision came out. The S&P 500 rallied 3%, its biggest Fed day gain since 2011, before wiping out the entire gain on Thursday.
The Fed is known for controlling rates and buying bonds. But lately, it’s been leaning on another powerful tool – its megaphone – to guide markets through its most aggressive rate hike campaign in decades.
Investors are hanging on every word the Fed says — for better or for worse.
Loud and persistent
Markets have been stuck in what has felt like a Fed-induced spiral. Sure, we’ve had to digest a bunch of other unfortunate events ― the Ukraine invasion, China lockdowns — but the Fed’s rate hike plans have fueled a steady drumbeat of anxiety. The economy feels so unstable… yet the Fed still wants to move forward with rate hikes.
Or at least that’s what Fed officials told us. James Bullard has been championing for rate hikes since the beginning of the year, and most recently backed a 75-basis point increase. Lael Brainard said in January that the Fed could start hiking as soon as March. Powell himself has stuck to the script about raising rates “expeditiously” in the face of declining consumer confidence and rising mortgage rates.
The Fed talk was so loud and persistent that markets went from expecting zero rate hikes this year (back in September) to as high as 10 or 11. At the same time, the S&P 500 fell as much as 14% and the 10-year yield spiked above 3%. Financial conditions, measured by the Chicago Fed, have tightened to five-year highs if you exclude the COVID crisis. Fear among individual investors rose to the highest level in more than a decade, per the American Association of Individual Investors’ weekly sentiment survey.
And up until this week, the Fed had only hiked rates once.
The megaphone strategy
On Wednesday, the Fed was able to pull off an unusually big policy change, announce balance sheet runoff plans, warn America about inflation, and project big hikes over the next few meetings without upsetting investors. Until the next day, when the S&P 500 plunged 3.6%
Powell loosely defined what could be coming next — primarily by ruling out a 75-basis point rate hike and assuring investors that policy would be data-dependent. But investors slept on it, and they’re evidently still worried about Powell’s pledge to hike rates expeditiously without committing to an end date.
These are side effects of the Fed’s new strategy: prepare investors for change as much as possible before it actually happens, without leading them astray.
The Fed’s main goal — as defined by its dual mandate — is to control prices and promote maximum employment. But one could argue that its unofficial mandate is to keep investors calm in an era of rapid news dissemination. After all, markets and the economy are connected more than ever these days. Households own more stocks in their portfolio than ever before, so investor panic can easily devolve into an economic crisis. In that lens, it makes sense that the Fed is trying to control the narrative in what could be one of the swiftest hiking cycles since the 1980s.
It’s also easier than ever to communicate with the public, especially everyday investors like you and me. We’ve seen companies and public figures leverage this power — just look at Elon Musk’s campaign to buy Twitter. Powell’s press conferences are on YouTube, and his Wednesday presser has garnered over 190,000 views (or 12 times the number of economists employed in the US).
But here’s the problem. There are always two sides to a story, and Powell is known for talking about both of them. It’s anybody’s guess which side the market will get hooked on. Add in an indecisive market, and a single word may change the trajectory of your investments.
The Fed’s vocal nature has also created an interesting feedback loop. Yes, households own a lot of stock, but individual stock ownership may have helped get us to this point. The wealth effect of investment gains can add to consumer demand, and therefore, inflation. The Fed’s words hold extra weight when the listeners’ actions directly impact tightening conditions.
Still in control
To be clear, the Fed’s actual policy changes still matter. The Fed knows it can’t talk itself into fixing inflation. And some of the market’s nervousness could be from the Fed’s balance sheet sales — a somewhat-unprecedented move that could boost long-term yields and cause some market heartache.
Right now, the Fed’s biggest challenge is to guide the economy out of decades-high inflation without crashing. While it’s a tall order, it seems like the Fed has kept things under control so far, even if it hasn’t felt that way. As Powell said yesterday, consumer and business demand is still strong, and there are signs that core inflation — the prices the Fed can control better with interest rate policy — may have already peaked.
Ultimately, the megaphone strategy could work out. Gradually preparing the market for change is a prudent move, especially when the alternative is shocking the market with an unexpected rate hike. We also think the stock and crypto markets are pricing in too much fear compared to what the Fed may end up doing.
But it may not be an easy ride.
*Data sourced through Bloomberg. Can be made available upon request.