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JED GRAHAM

Fed Meeting: What Will Double-Fisted Tightening Mean For Stock Market?

The abrupt shift in monetary policy — from easing to double-fisted tightening — in focus at this week's Federal Reserve meeting already has triggered a stock market correction for the Dow Jones, S&P 500 and Nasdaq composite. With the stock market rebounding Monday from steep intraday losses and last week's heavy selling, might Wall Street's increasingly hawkish bets finally have caught up with Fed policymakers' tightening plans?

If so, the stock market could see something of a relief rally on Wednesday, following the Fed meeting announcement and Fed chief Jerome Powell's news conference. But there are a few reasons to treat any immediate bounce with skepticism.

Federal Reserve U-Turn

First, consider the big picture: As recently as November, the Fed had intended for the transition from easing to tightening to be a graceful arc. Asset purchases would gradually wind down by midyear. Then, after a brief pause, gradual rate hikes would follow, with balance-sheet tightening further off in the future.

Instead, the Fed is about to execute a sharp U-turn. The shift from asset purchases to rate hikes to shrinking the balance sheet may be complete by midyear, possibly sooner.

The suddenness of the Fed's shift alone might explain the stock market's reaction. Yet what's driving that shift and what it portends for the Federal Reserve policy outlook suggests that investor concern will linger.

Way Behind The Curve

The Federal Reserve, having sworn off preemptive tightening amid too-little inflation during the last cycle, has got itself into a fix. It has badly misjudged both the persistence of high inflation and the tightness of the labor market in the Covid era.

So now policymakers find themselves dramatically behind the curve. With the labor market knocking on the door of full employment, the Fed's benchmark lending rate is 0%-0.25%, even as inflation is running about 6%, based on the Fed's favored measure.

The main takeaway is that the Fed has its work cut out for it to shift monetary policy from being wildly accommodative to something close to neutral. That means policymakers will tighten with both fists — hiking the federal funds rate and shrinking the balance sheet. And they'll likely want to keep at it for a while, despite any modest softening of economic data. The main risk now, in most policymakers' view, is that inflation will continue to run too hot amid easy financial conditions. If that happens, the Fed would be forced to tighten even more aggressively. That's the typical recipe for a recession.

When Will Fed Asset Purchases End?

At the Dec. 14-15 Federal Reserve meeting, policymakers decided to wind down asset purchases in March, rather than June. However, Nomura economists predict that the Fed will move the end date for bond buys up to mid-February at the two-day meeting that wraps up at 2 p.m. ET. That would seem to make sense, if the Fed's overriding concern is that the policy is way too loose.

While a modest adjustment, it could signal a quicker start to balance-sheet normalization than some on Wall Street expect. Since March 2020, the Fed has purchased about $4.5 trillion worth of Treasuries and government-backed mortgage securities.

Wall Street economists expect that the Fed will want to shrink the balance sheet by about $2.5 trillion in coming years. That will happen naturally as the bonds mature, unless the Fed reinvests the principal.

Deutsche Bank economists are expecting the Fed to start small over the summer but ramp up balance-sheet reduction to $105 billion per month by December. These economists figure that $1.5 trillion in assets would run off the balance sheet by the end of 2023, roughly equivalent to between 2.5 and 3.5 quarter-point rate hikes.

Fed chief Powell's comments, starting at 2:30 p.m. ET Wednesday, will be key as investors try to gauge how aggressive policymakers will be with rate hikes and quantitative tightening.

What Does Fed Policy Mean For Stock Market?

When the Federal Reserve last combined rate hikes with balance-sheet tightening, the stock market tanked in the fall of 2018, flirting with bear-market territory. Eventually, policymakers signaled retreat in early 2019, as rate hikes turned to rate cuts and the Fed renewed bond purchases.

"In dealing with balance sheet issues, we've learned that it's best to take a careful sort of methodical approach," Fed chief Jerome Powell said at his Dec. 15 news conference. "Markets can be sensitive to it."

However, it was a pretty simple matter for the Fed to backpedal in early 2019 because inflation was tame.

That raises a big question on the mind of investors: Where is the Powell put?

A put option gives investors downside protection if a stock falls below a certain price. There's certainly some stock market level and some economic circumstances that would spur Powell and other policymakers to ride to the rescue.

Powell's 2018 Response A Clue

But Powell's answer to that question back in 2018 suggests the stock market would have to fall further. For the Fed to react to financial market weakness, there would have to be a "significant correction and lasting correction," Powell said at the September 2018 meeting.

The stock market is in a correction now. The major indexes rebounded for modest gains Monday after the Nasdaq fell 4.9% intraday while the Dow Jones and S&P 500 fell more than 3% at their session lows.

The 10-year Treasury yield edged lower to 1.735% after pulling back from a two-year high late last week.

Make sure to read IBD's daily afternoon The Big Picture column to get the latest on the prevailing stock market trend and what it means for your trading decisions.

Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.

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