Federal Reserve Chairman Jerome Powell, at his latest news conference, offered at least five reasons why policymakers chose at their Jan. 31 meeting to punt on Fed rate cuts for a while. Yet he left out what may be the most straightforward explanation: the S&P 500's historic AI-driven tear — and the risk of fanning the flames.
One wise Wall Street veteran has no doubt that the rally led by artificial intelligence stocks such as Nvidia has gone far enough and lasted long enough that it has now become an important factor for Fed policy. And his contention is borne out by the Fed's sudden circumspection over too-easy financial conditions.
"The Fed may not directly signal concern about a hot stock market," strategist Ed Yardeni told Investor's Business Daily, "but I think it is top of mind."
Minutes of the January Fed meeting merely take note of new highs for the S&P 500 led by large-cap tech stocks, hinting that they've ascended to lofty valuations.
Yet Powell "has to be concerned about irrational exuberance and fueling it" with rate cuts, Yardeni said, using former Fed Chair Alan Greenspan's catchphrase from 1996, early in the dot-com boom.
The Greenspan Fed made the mistake in 1998 of overreacting to the fallout from overseas currency crises with several rate cuts, which helped inflate an S&P 500 bubble. That led to a dizzying crash.
Now, the Powell Fed, having set the stage for rate cuts, appears wary that it might feed an S&P 500 melt-up akin to the late 1990s. That might turn the expected soft landing into a boom and bust.
That unease arose over mere weeks. At its Dec. 13 meeting, the Fed was at peace with surging stock prices. By the Jan. 31 meeting, policymakers saw them as a big enough inflationary threat that they decided to put a leash on the S&P 500 — and the economy.
That's not to say that the Fed will keep the S&P 500 from rising — or that it even wants to. But further gains may come at a cost — higher Treasury yields and delayed rate cuts. That would make for a harder climb for stock prices and raise the risk of backsliding.
Fed Rate Cuts Pushed Back
After the Fed penciled in three quarter-point cuts for 2024 in December's quarterly projections, Wall Street went into the January meeting seeing a March rate cut as likely and a May cut as a slam dunk. And why not?
Keep in mind that as of Jan. 31, the hot CPI and PPI reports for January were still a few weeks away. Seven months of benign inflation data had seen the Fed's primary measure, the core PCE price index, sink to less than 2% at an annualized rate.
So when the Fed said on Jan. 31 that it would hold off on rate cuts until policymakers had "greater confidence that inflation is moving sustainably toward 2 percent," markets initially interpreted it as a slight delay — not a possible change in the path to much lower rates.
Yet the formal shift in the Fed's bias from tightening to easing overshadowed other messaging that seemed to strike a less-dovish posture.
The first sign was the Fed dropping the assessment that in its policy statement that "tighter financial and credit conditions" likely would restrain hiring and inflation.
The omission of tight credit conditions suggested that the Fed no longer sees the potential for bank fragility as a key concern in setting its policy rate, despite ongoing concerns about commercial real estate loans.
That might signal that the Powell Fed has learned from the Greenspan Fed's mistakes and won't unnecessarily ease policy to combat financial disarray if it means letting its guard down against a potential asset bubble.
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Easing policy too soon, Powell said, "could result in a reversal of the progress we've seen on inflation and ultimately require even tighter policy."
He stressed that a decision to start a rate-cutting cycle is a "highly consequential" one that the Fed wants to get right.
Powell didn't explain why that first cut matters so much. But it would send an all-clear signal on inflation and amplify expectations that a series of cuts will follow.
This also may have been on Powell's mind: In the 11 rate-cutting cycles since 1982, the S&P 500 has averaged a nearly double-digit gain in the six months following the first cut. That includes a 25% surge in the half year after the first rate cut in 1998.
Powell's most-telling explanation came in response to a question as to why it was too soon to start cutting even though the Fed's 5.25%-5.5% target rate looked extremely tight at about 3 percentage points above expected inflation for the year ahead.
"We don't know with great confidence where the neutral rate of interest is at any given time," Powell admitted.
The implicit message was that Fed policy might not be as tight as it looks. That could be the case if changes in the economy had raised the neutral rate of interest — the rate that neither boosts nor restricts economic growth.
Financial Conditions And Fed Rate Cuts
Further, Powell added that policymakers "look at more than just the fed funds rate. We look at — broadly — financial conditions."
Fed policy works by affecting financial conditions throughout the economy, from stock prices to the dollar's exchange rate to borrowing rates and demand for credit. No matter how high rates are, the Fed has more work to do if those conditions are too robust.
Fed minutes from the January meeting, released Feb. 21, underscored that concern: "Several participants mentioned the risk that financial conditions were or could become less restrictive than appropriate, which could add undue momentum to aggregate demand and cause progress on inflation to stall."
How The Fed's S&P 500 Leash Works
Powell's two-part response helps explain what's been playing out as the S&P 500 has climbed to new heights and Treasury yields have responded.
First, look at how financial markets reacted to the Feb. 2 employment report showing 353,000 new jobs in January, more than twice forecasts.
Despite reasons to take the jobs data with a grain of salt, the 10-year Treasury yield jumped 17 basis points to 4.03%. The two-year yield, which is much more closely tied to the Fed rate outlook, rose a similar amount. So the gap between the 10-year yield and two-year yield was basically unchanged.
Essentially, markets were pricing in a higher neutral rate across all durations of Treasuries. That signaled that higher rates — and smaller Fed rate cuts — were needed to keep the economy from overheating.
Now look at what happened Feb. 22 after AI chip leader Nvidia's blowout fourth-quarter earnings report. As the S&P 500 surged 2.1% to a new high, the two-year Treasury yield climbed six basis points to 4.71%. But the 10-year Treasury yield didn't budge.
The market message was that over-easy financial conditions would require the Fed to further scale back rate-cutting plans. The 10-year Treasury yield didn't need to rise because more-restrictive short-term rates would hold back growth.
Stepping back, since Jan. 30, the day before the Fed's latest policy update, the 10-year Treasury yield has climbed 16 basis points to 4.22%. The two-year Treasury yield is up about 30 basis points to 4.6%.
The markets' answer to the "Why not cut now?" question appears to be both that the neutral rate is higher and financial conditions are too easy — but more of the latter.
Wall Street, Main Street Disconnect?
The 10-year Treasury yield is used to set rates for auto loans and 30-year mortgages. Wall Street analysts use the 10-year yield as the risk-free discount rate for putting a current value on future earnings. All things equal, a higher rate means a lower stock price.
Meanwhile, the rise in short-term Treasury yields and the outlook for fewer Fed rate cuts hurt those with credit card balances and those who need bank credit. The National Federation of Independent Business says its members paid an average 9% rate on short maturity loans in January. With the ebbing of inflation limiting firms' pricing power, those high rates — and higher inflation-adjusted rates — may bite more.
While the Fed's leash might be slowing the ascent of the Magnificent Seven stocks and the S&P 500, the higher rates certainly haven't stopped them. If that keeps up, the Fed's balancing act may get tricky. If conditions on Wall Street stay too easy, financial conditions on Main Street could get overly tight, sandbagging growth.
Treasury yields have fallen in recent days amid economic reports hinting at a possible slowdown ahead. But chair Powell will likely make clear in his monetary policy testimony to Congress on Wednesday morning that the Fed has set a high bar for rate cuts.
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All of this begs a question: Is the Fed really obsessed with stock prices?
Generally, no. "We've got a maximum-employment mandate and a price-stability mandate, and those are the two things we look at," Powell has said. The level of the S&P 500, like the pace of GDP growth, only matters to the extent it influences the way the Fed goes about doing its assigned job.
One thing is indisputable: The Fed's stance with respect to financial conditions changed dramatically between the December and January meetings. But what happened to prompt that shift?
Along with stock prices, the 10-year Treasury yield, mortgage rates and the exchange rate are key to the Fed's own financial conditions index. While the 10-year yield tumbled between the Fed's November and December meetings, the overall level only slipped modestly from Dec. 13 to Jan. 30. Likewise, mortgage rates and the dollar remained rangebound.
"Borrowing costs remained elevated" for households and businesses, Fed meeting minutes indicated.
The only major change was that the S&P 500 broke out to its first record high in over two years on Jan. 19, then kept powering higher.
"The Magnificent Seven has helped ease financial conditions substantially," Deutsche Bank said in its Feb. 20 House View.
The Fed minutes didn't suggest any particular concern over stock prices. They noted that "equities appeared priced for continued economic resilience," with "more subdued" valuations outside Nvidia and the other Magnificent Seven stocks. Still, the S&P 500 has now climbed over 40% from its late-2022 bear-market low.
The Fed is "aware of the wealth effect and its impact on the economy," Yardeni said. "All the more reason not to lower interest rates if the (rising) stock market is going to continue to ease financial conditions."
Yardeni added that Powell is a student of history and has surely been studying the Greenspan Fed's dot-com bubble experience.
Greenspan's Conundrum
We may have to wait five years, when transcripts are published, to find out how much AI stocks influenced the Fed's messaging shift in January. But Fed transcripts from 1998 and 1999 show that the Greenspan Fed was obsessed with stock prices.
What most stands out is that the Fed kept expecting dot-com stocks to fall. Powell clearly doesn't intend to repeat that mistake.
Even after markets had largely recovered from their September 1998 dive, the Fed went ahead with a third rate cut in November. That was partly because officials expected a stock market correction and less of a wealth-effect boost to consumption.
As the Fed finally began to reverse the prior year's cuts in June 1999, policymakers ruled out a half-point hike. One Fed governor cautioned that the stock market was "very fragile" and "shock prone."
In some ways, Powell's challenge of getting inflation down to 2% amid a surging stock market is more straightforward than what Greenspan faced. Even as the U.S. economy boomed and dot-com stocks soared, inflation tumbled to around 1% in 1997 and stayed there into 1999. That was partly due to a strong dollar, but mainly to a surge in U.S. productivity growth.
"Something seems to be happening that none of us has ever witnessed before — perhaps a once-in-a-century structural shift in how goods and services are produced," Greenspan said at the June 1999 Fed meeting.
Policymakers didn't focus on whether they should prick the emerging dot-com bubble. The big question was whether they should let the U.S. economy enjoy the fruits of a productivity boom by limiting rate hikes.
Roaring '20s And The S&P 500
Wall Street is increasingly confident in a Roaring '20s scenario, with generative AI spurring a new productivity boom that promises fast growth, low inflation and a bountiful era for investors.
After a long productivity drought, the U.S. enjoyed something of a revival in 2023. Powell attributes that less to transformative technology than more pedestrian things, such as healing supply chains and less labor-force turnover.
Despite the breakneck pace of technological innovation, broad AI-related productivity gains — and the economy's path to cruising altitude — will take time. Before that, the ride may get bumpy as the Fed goes the last mile to battle inflation.
Stealth Interest Rate Tightening?
Confidence in Powell's ability to nail a soft landing soared in December, as he gave assurance that the Fed was "very focused on not making that mistake" of holding rates high for too long.
Yet by the January meeting, the minutes revealed, most participants stressed the risk of cutting rates too soon. Just a couple of policymakers highlighted the potential economic fallout from keeping policy too tight.
Still, market observers expect the Fed to ease up on its restraint as further inflation progress and slower growth become evident.
The Fed "is more market friend than foe at this time," Jason Draho, head of asset allocation at UBS Global Wealth Management in the Americas, wrote in a Feb. 20 post. Despite the Fed's mixed message lately and its reeling in of rate-cut expectations, recent market action, along with the easing bias adopted in January, confirms that the Fed "put" is back, Draho wrote.
A put option gives investors downside protection if a stock falls below a certain level. The Fed put means that if the economy starts to weaken, policymakers won't hesitate to provide support. And that could mean giving the S&P 500 more slack, if not unleashing it altogether.
We'll find out just how much of a market friend the Fed is on March 20. While a rate cut is essentially off the table, the Fed will issue new projections showing the extent of rate cuts likely this year and next.
The Fed could take away one of the three quarter-point cuts it penciled in for 2024 back in December. If so, we'll know that January's rate-cut delay was really a stealth tightening.
