How the Fed chief sent Wall Street off a cliff in minutes

The Federal Reserve didn’t give financial markets what their participants hoped for but, not to worry, there’s always next time, or at least that seems to have been the investors’ response.

Ahead of this week’s meeting of the Fed’s Open Market Committee (FOMC) investors and analysts were confident that the Fed would foreshadow the first rate cut in two years of a cycle that has seen the federal funds rate (the equivalent of the Reserve Bank’s cash rate) raised from near-zero to a target range of 5.25 to 5.5 per cent.

Fed chair Jerome Powell said a March rate cut was not likely but investors remain hopeful. Credit: Bloomberg

They were anticipating a 25 basis point cut as early as next month’s meeting but, after reading the statement issued by the FOMC at the conclusion of the meeting and hearing chairman Jerome Powell’s comments at the post-meeting press conference, the odds on a March cut had fallen to a still quite (overly?) optimistic 50:50.

The Fed has pushed back on expectations of an early rate cut. While the committee members dropped language from earlier statements that showed a bias towards tightening monetary policy, they also said they didn’t expect it would be appropriate to reduce the target range for rates until they had greater confidence that inflation was moving sustainably towards their 2 per cent target.

Powell buttressed that cautionary sentiment by saying that, based on the meeting’s deliberations, he didn’t think it “likely” that the committee would reach a level of confidence (that the inflation rate was moving sustainably towards 2 per cent) by the time of the March meeting.

The US sharemarket, which has been posting records on the basis of a conviction that there will be a series of rate cuts this year, had its worst day of the year, with the S&P 500 falling 1.6 per cent. The biggest technology stocks, which have been driving the market up, fell a collective 2.9 per cent.

Bond yields actually edged down, but that might have been due to an announcement from the US Treasury that, while it would conduct some of its biggest ever auctions of Treasury bonds over then next three months, it expected future auctions of the bonds (needed to fund the yawning US budget deficits) would be smaller.

While equity investors have been fixated with what the Fed might or might not do, bond investors have been concerned about the huge supply of Treasuries at a time when foreign investors have been largely out of the market and the Fed is effectively adding to the supply with its $US95 billion ($145 billion) a month quantitative tightening program, under which it allows its vast hoard of bonds acquired during the pandemic to mature without reinvesting the proceeds.

That has kept bond market yields elevated even as expectations of rate cuts – the Fed itself has projected at least three 25 basis point cuts – have strengthened.

The reason that equity investors still think there is an even-money chance of a March cut and have been factoring in five or six of those rate reductions this year is that US inflation is tracking nicely towards the Fed’s target of 2 per cent.

Indeed, even though the US economy grew solidly and faster than the Fed expected last year, on the measures that the Fed is most focused on the inflation rate is close to or below the target.

December quarter data showed that the personal consumption expenditures index that the Fed favours rose 2.6 per cent in the December quarter but the annualised rate for either the quarter or the December half would be below the target.

Data this week showed some weakening in job creation and a modest slowing of wages growth. They’re signs that the economic growth rate might be tapering slightly, which also supports the case for future rate cuts.

It is understandable, however, that the Fed wants to see more data before it starts lowering its policy rate.

The risk to the central bank’s credibility as well as the US economy of leaving rates too high for too long is, given that the FOMC meets every six weeks, probably lower than moving too early and allowing the inflation rate to re-ignite.

The RBA will face a similar risk assessment when it meets next week.

This week’s inflation data showed the rate has fallen back to a 2-year low and clearly tracking towards the RBA’s targeted range of 2 to 3 per cent. Clear signs of economic stress in the form of cost of living pressures and a big slump in retail sales over Christmas support the argument for early interest rate relief.

Central bankers are, however, cautious by nature and very conscious that their credibility is an essential monetary policy tool.

RBA governor Michele Bullock. Australia’s Reserve Bank will have a lot to talk about next week. Credit: Wolter Peeters

Having badly misread the emergence of the post-pandemic supply chain-driven outbreaks of inflation at the start of the rate cycle, when they were convinced it was transitory, they will be very aware of the damage they could cause by similarly misjudging the inflation rate trajectory as inflation subsides, particularly as there is a view that the “last mile” of the efforts to bring inflation rates sustainably under control could be the more challenging period of the cycle.

While the US economy has performed better than expected and its sharemarket has been booming, there are some vulnerabilities.

The US government debt ($US34 trillion) and deficits ($US1.7 trillion) last financial year and still expanding) are potential sources of financial instability, as is the potential for a crisis sparked by the hyper-partisanship and dysfunction in Congress.

Another threat lies within America’s commercial real estate markets, where the impact of the pandemic and the shift towards remote working has had a disconcerting impact on property occupancy rate and values.

Even though the US economy grew solidly and faster than the Fed expected last year, on the measures that the Fed is most focused on the inflation rate is close to or below the target.

With more than a quarter of the $US4.6 trillion of US commercial real estate debt due to mature over the next two years, the sector represents a point of vulnerability for the banking sector and the economy.

On Wednesday a relatively small bank, the New York Community Bancorp, disclosed a $US252 million loss for the December quarter and slashed its dividend after increasing its provision for commercial property and multifamily property loan losses by more than 10 times their previous level.

Its executives explained that away by saying that, after acquiring most of the assets of Signature Bank, one of the banks that failed during last year’s regional banking crisis, it had more than $US100 billion of assets and had therefore moved into a regulatory category that required more capital and stronger provisioning.

That might be true, and it does make sense that banks exposed to commercial property (regional and local banks do most of the commercial property lending) would try to ensure they had more than sufficient provisioning and capital to deal with a spate of losses if they were to eventuate.

A commercial property-related regional banking crisis – and the extent of the additional provisioning suggests the NY Community Bank executives do see something potentially nasty lurking in their loan book –would destabilise the US economy, force the Fed’s hand and, given there is a degree of ownership and investor integration within the global commercial property markets, have spillover effects elsewhere.

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