The Fed: Dissecting the "Fed Put"
How the Fed is using its "tools" to keep growth elevated and employment full while reducing inflation.
Programming Note
I started writing this note pre-market on April 4 before losing power for 24 hours starting at 10am EST. As such, none of it has anything to do with financial market price action the last two trading days.
Discussion
FED Chair Jerome Powell made a very subtle, yet critically important tweak to his press conference opening statement at the November 2023 FOMC, saying:
Reducing inflation is likely to require a period of below-potential growth and some softening of labor market conditions.
The opening statement the meeting before said “below-trend”. THAT was the pivot - not the rate cut guidance that led the market to price in more than 6 rate cuts in 2024. And THAT is why the equity market has continued to rally despite the market going from more than 6 cuts to less than 3 cuts.
Powell has since elaborated on what THAT entails from a policy perspective, and it is incredibly powerful and I believe continues to be misunderstood. I only recently fully grasped its power, but once I did it allowed me to completely adjust my mindset.
The Fed Put
I am a FED nerd and listen to Powell’s press conferences multiple times, so it’s easy for me to pick up on even subtle changes changes in both his written and off-the-cuff statements. I picked up on the “below-potential” immediately. And one would think that I would have immediately adjusted my thinking and positioning. But of course not - I remained ensconced in the notion the Fed was pleased with circa 500 bps UST 10s and 30s as a way to keep and maintain tight enough policy in place to bring inflation back down to 2% without further hikes to Fed Funds. I started to get it at the December press conference, but it was until Powell’s March testimony to Congress that I started to grasp what was going on.
To the Senate Banking Committee on March 7 Powell said:
We are going to use our tools to try to keep that strong economy, keep that strong labor market, while we continue to make progress on inflation.
Think about that. The Fed is using the Fed Funds rate to attack inflation and it continues to run QT in the background - yet Powell is talking about “tools” to keep economic growth and the labor market strong.
But I still didn’t fully get it, as evidenced by the fact I thought pre-FOMC communication suggested Powell would be hawkish. Powell’s decisively dovish March press conference closed the coffin on my prior mindset, and then the final nail in the coffin was his Q&A at Stanford this week where he reiterated the use of the Fed’s tools to keep economic growth and the labor market strong while bringing inflation down to 2% “over time” (a phrase he used with emphasis multiple times).
The Fed’s “Tools”
These “tools” to keep economic growth and the labor market strong while bringing inflation down over time are actually quite simple: The Fed wants rates and equities “higher for longer” (H4L).
They believe H4L rate policy narrowly targets interest-sensitive spending and keeps inflation under control and trending toward target at the margin, while H4L equity policy keeps economic growth and the labor market strong.
As Julian Brigden has spoken about ad nauseam, the US economy is “hyper-financialized” insofar as the equity market leads the labor market and economic activity, not the other way around as traditional economic/market orthodoxy would suggest. With stock prices up, consumers feel confident and keep spending high, while corporates see no reason to conduct lay-offs with their stock performing well.
As discussed at length in the March WOTE Report, there are five puts that currently sit beneath the S&P 500 with the Fed being “just” one of them. But boy, oh boy, is it a powerful one.
When the chairman of the most powerful central bank on planet earth says that he will use his “tools” to achieve a particular outcome, you don’t fight those tools.
Don’t fight the Fed.