The Federal Reserve essentially tightened monetary policy last week, though it took a few days for markets to begin to catch on. Despite the initial S&P 500 sell-off after Chairman Jerome Powell cast doubt on a March rate cut, markets at first interpreted his comment as a delay, not a possible change in the destination to much-lower rates.
The S&P 500 proceeded to rally to a record high on Friday, despite a January employment report that blew away estimates with 353,000 new jobs and a revision that raised December's gain by 117,000 to 333,000.
Yet, gradually, reality began to set in — especially following Powell's "60 Minutes" interview that aired Sunday night. By Monday, markets expected four quarter-point rate cuts this year, down from a likelihood of six cuts before last week's Fed meeting.
That view is in flux, with odds on Wednesday having tilted back toward 1.25 percentage points in Fed rate cuts this year, or five quarter-point cuts, from the current 5.25% to 5.5% target range.
Fed Turns Focus To Neutral Interest Rate
Still, last week's Fed meeting pronouncements and Powell's "60 Minutes" interview have changed the conversation. Instead of a focus on how fast and how deeply the Fed will start "dialing back to the amount of policy restraint in place," in Powell's words, policymakers are now assessing how restrictive today's rates really are, given the fast pace of economic growth.
The answer to that question, though far from clear, has major implications for the path of Fed rate cuts, the 10-year Treasury yield and potential upside for the S&P 500. Yet, up until now, Powell and a solid majority of policy committee members had found it convenient to largely ignore that question as they aimed to nail a soft economic landing.
However, Minneapolis Fed President Neel Kashkari, a nonvoting member of the Federal Open Market Committee this year, put the question front and center in a Monday essay.
Recently strong economic reports "lead me to question how much downward pressure monetary policy is currently placing on demand," he wrote. Policy "may not be as tight as we would have assumed."
The upshot is that future data surprises, either positive or negative, are likely to be met with extra volatility for the S&P 500. Strong data will bolster the case that the neutral interest rate is higher, meaning fewer Fed rate cuts are needed. Softer data will suggest Fed policy is about as restrictive as markets had believed, so deep cuts are merited.
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The Fed Language Shift
Powell made clear that rate cuts are still coming, reiterating last week that the Fed's policy rate is "well into restrictive territory." He told "60 Minutes" that the Fed's "confidence is rising" that inflation is moving sustainably to 2% and that policymakers are "actively considering" cutting rates.
Yet Powell's own words and the latest Fed policy statement have changed in important ways.
The statement omitted what had become customary since the regional banking crisis broke out last spring. The Fed dropped its assertion that "the U.S. banking system is sound and resilient" and its assessment that "tighter financial and credit conditions" were likely to restrain hiring and inflation.
The omissions surely weren't because the Fed no longer thinks the banking system is strong. Rather, the Fed no longer sees bank fragility as a key concern in setting its policy rate. Further, the Fed seemed to imply that financial conditions, which largely reflect equity prices, market-based interest rates, bond spreads and the strength of the dollar, may no longer be much of an impediment to growth.
On Dec. 13, the Fed believed the economy had slowed in Q4 and would continue to moderate in 2024. The new quarterly projections raised 2023 GDP growth to 2.6%, but pared the outlook for 2024 to 1.4%. "We see good evidence and reason to believe that growth will come in lower next year," Powell said after last year's final Fed meeting.
But the first official estimate of Q4 GDP showed a 3.1% rise from the year-ago quarter and the Fed characterized the current pace of economic growth as solid on Jan. 31.
Fed Shifts To Risk Management
At first blush, Powell's press conference sounded bullish. Asked if the economy was a little too strong, Powell answered, "I'm not so worried about that."
Powell also said that the Fed wants a strong labor market, which helps explain why the S&P 500 rallied on the strong jobs report. Saying that inflation had come down even without a growth slowdown or significant rise in unemployment, he added: "There's no reason why we should want to get in the way of that process."
But even if the Fed isn't actively trying to get in the way of strong growth, that doesn't necessarily mean it will promote stronger growth through active rate-cutting.
"We're really in a risk-management mode," Powell said, weighing the risk of moving too soon, which would lead inflation to settle above 2%, against moving too late and unnecessarily hurting the job market. If job creation stays robust, the Fed can downplay the latter concern.
Powell's One-Two Punch
In the most recent set of economic projections released in December, Fed policymakers stuck to the view that the neutral long-term federal funds rate is 2.5% — a half-point above the target inflation rate. The Fed's presumption of the neutral rate has held at 2.5% since 2019, after gradually falling from 4% over the prior five years.
The Fed's estimate of a 0.5% real neutral rate would imply that policy is extremely tight, with the federal funds rate more than 2.25 percentage points above the 2.95% rate of core PCE inflation over the past 12 months.
At last week's news conference, Powell was essentially asked why the Fed isn't ready to cut rates when inflation has come down most of the way to 2% and various rules for guiding monetary policy suggest it is too tight.
Powell offered a two-part answer. He said that Fed policymakers "don't know with great confidence where the neutral rate of interest is at any given time," meaning it's unclear how tight policy is. That suggests a possibility that the neutral rate is currently well above 2.5%.
He also said, "we look at more than just the fed funds rate" to assess how tight policy is. "We look at, broadly, financial conditions."
The implication is that the level of the Fed's key interest rate may not be as restrictive as believed, and that the booming S&P 500 may have something to do with it.
Three Key Rates In Flux
The path of inflation is, of course, the key. More sub-0.2% monthly increases in the core PCE price index should alleviate doubt about deep Fed rate cuts this year.
But the inflation rate isn't the only thing investors need to keep in mind. The real interest rate and term premium also determine the level of the 10-year Treasury yield, which analysts use as the risk-free rate for valuing stocks based on future cash flows.
Deutsche Bank chief U.S. economist Matthew Luzzetti wrote on Monday that he now sees the neutral Fed funds rate at 3.5%, or 1.5 percentage points above the inflation target. Even 4% is plausible, he says.
To the extent that the neutral interest rate is higher than the Fed's long-term estimate of 2.5%, that contributes to a higher 10-year yield. The 10-year yield also builds in a term premium to compensate investors for the risk that market rates will rise, lowering the value of previously issued bonds.
Last fall, as the 10-year Treasury yield spiked to 5%, Powell and others cited a higher term premium as a primary factor. Big federal deficits and the rising public debt as a share of GDP fueled concern of too much Treasury issuance, driving up the term premium.
But rapid disinflation progress, the prospect of major rate cuts in 2024, a shift in Treasury borrowing to shorter-term bonds help quash those concerns, at least temporarily. Yet the term premium might rise again.
Apollo chief economist Torsten Slok wrote in a recent note that "someone will need to buy more than $10 trillion in U.S. government bonds in 2024. This may be a particular challenge when the biggest holders of U.S. Treasuries, namely foreigners, continue to shrink their share."
S&P 500
After ending last week at a record high, the S&P 500 inched down 0.3% on Monday as Powell's message began to seep in. But the S&P 500 took off again on Wednesday, rising 0.8% to another record. If the Fed is subtly trying to put a leash on the S&P 500 with its new message on financial conditions and the rate-cut outlook, it isn't yet working.
However, investors' placidity may be tested by the next round of key inflation reports next week.
Be sure to read IBD's The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
