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The stock market slide is unlikely to budge the Fed from tightening

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The Marriner S. Eccles Federal Reserve building in Washington, D.C., on Friday, Sept. 17, 2021.
Stefani Reynolds | Bloomberg | Getty Images

The current slide in the stock market may be spooking some investors, but it’s seen as unlikely to scare Federal Reserve officials enough to deviate from their current policy track.

In fact, Wall Street is looking at a Fed that might even talk tougher this week as it is seemingly locked in a fight against generational highs in inflation amid market turmoil.

Goldman Sachs and Bank of America both have said in recent days that they see increasing chances of an even more hawkish central bank, meaning a better chance of even more interest rate hikes and other measures that would reverse the easiest monetary policy in U.S. history.

That sentiment is spreading, and is causing investors to reprice a stock market that had been hitting new historic highs on a consistent basis but has taken a steep turn in the other direction in 2022.

“The S&P is down 10%. That’s not enough for the Fed to go with a weak backbone. They have to show some credibility on inflation here,” said Peter Boockvar, chief investment officer at the Bleakley Group. “By kowtowing to the market so quickly without doing anything with respect to inflation would be a bad look for them.”

Over the past two months the Fed has taken a sharp pivot on inflation, which is running at a nearly 40-year high.

Central bank officials spent most of 2021 calling the rapid price increases “transitory” and pledging to keep short-term borrowing rates anchored near zero until they saw full employment. But with inflation more durable and intense than Fed forecasts, policymakers have indicated they will start hiking interest rates in March and tightening policy elsewhere.

Where the market had been able to count on the Fed to step in with policy easing during previous corrections, a Fed committed to fighting inflation is considered unlikely to step in and stem the bleeding.

“That gets into the circular nature of monetary policy. It gooses asset prices when they are pedal to the metal, and asset prices fall when they back off,” Boockvar said. “The difference this time is they have rates at zero and inflation is at 7%. So they have no choice but to react. Right now, they are not going to roll over for markets just yet.”

The Federal Open Market Committee, which sets interest rates, meets Tuesday and Wednesday.

Comparisons to 2018

The Fed does have considerable history of reversing course in the face of market turmoil.

Most recently, policymakers turned course after a series of rate hikes that culminated in December 2018. Fears of a global economic slowdown in the face of a tightening Fed led to the market’s worst Christmas Eve rout in history that year, and the following year saw multiple rate cuts to assuage nervous investors.

There are differences aside from inflation between this time and that market washout.

DataTrek Research compared December 2018 with January 2022 and found some key differences:

A 14.8% decline then in the S&P 500 compared to 8.3% now, as of Friday’s close.
A slide in the Dow Jones industrials of 14.7% then to 6.9% now.
The CBOE Volatility Index peaking at 36.1 then to 28.9 now.
Investment grade bond spreads at 159 basis points (1.59 percentage points) then to 100 now.
High-yield spreads of 533 basis points vs. 310 basis points now.

“By any measure as the Fed looks to assess capital markets stress … we are nowhere near the same point as in 2018 where the central bank reconsidered its monetary policy stance,” DataTrek co-founder Nick Colas wrote in his daily note.

“Put another way: until we get a further selloff in risk assets, the Fed will simply not be convinced that raising interest rates and reducing the size of its balance sheet in 2022 will more likely cause a recession rather than a soft landing,” he added.

But Monday’s market action added to the rough waters.

Major averages dipped more than 2% by midday, with rate-sensitive tech stocks on the Nasdaq taking the worst of it, down more than 4%.

Market veteran Art Cashin said he thinks the Fed could take notice of the recent selling and move off its tightening position if the carnage continues.

“The Fed is very nervous about these things. It might give them a reason to slow their step a little bit,” Cashin, the director of floor operations for UBS, said on CNBC’s “Squawk on the Street.” “I don’t think they want to be too overt about it. But believe me, I think they will have the market’s back if things turn worse, if we don’t bottom here and turn around and they keep selling into late spring, early summer.”

Still, Bank of America strategists and economists said in a joint note Monday that the Fed is unlikely to budge.

‘Every meeting is live’

The bank said it expects Fed Chairman Jerome Powell on Wednesday to signal that “every meeting is live” regarding either rate hikes or additional tightening measures. Markets already are pricing in at least four hikes this year, and Goldman Sachs said the Fed could hike at every meeting starting in March if inflation doesn’t subside.

While the Fed isn’t likely to set concrete plans, both Bank of America and Goldman Sachs see the Fed nodding toward the end of its asset purchases in the next month or two and an outright rundown of the balance sheet to start around mid-year.

Though markets have expected the asset purchase taper to come to a complete conclusion in March, BofA said there’s a chance that the quantitative easing program might be halted in January or February. That in turn could send an important signal on rates.

“We believe this would surprise the market and likely signal an even more hawkish turn than already expected,” the bank’s research team said in a note. “Announced taper conclusion at this meeting would increase the odds we assign to a 50bp hike in March and another potentially 50bp hike in May.”

Markets already have priced in four quarter-percentage-point increases this year and had been leaning toward a fifth before reducing those odds Monday.

The note further went on to say that a market worried about inflation “will likely continue bullying the Fed into more rate hikes this year, and we expect limited pushback from Powell.”

Boockvar said the situation is the result of a failed “flexible average inflation targeting” Fed policy adopted in 2020 that prioritized jobs over inflation, the pace of which has garnered comparisons to the late 1970s and early 1980s at a time of easy central bank policy.

“They can’t print jobs, so they’re not going to get restaurants to hire people,” he said. “So this whole idea that the Fed can somehow influence jobs is specious in the short term for sure. There’s a lot of lost lessons here from the 1970s.”

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