THE UNEASY DANCE BETWEEN THE FINANCIAL MARKETS AND THE FED

The reports of persistent, high inflation we have been getting lately mean the Federal Reserve will almost certainly raise interest rates even higher and keep them there for a long while.

But wayward inflation isn’t the only thing likely to spur the Fed to raise rates further.

Good news in the financial markets could do it, too. That may seem perverse. After all, sharply rising prices at the supermarket or the gas pump are bad news for just about everybody who relies on a paycheck or a pension, or income from an individual retirement account, 401(k) or Social Security. It’s easy to see why the Fed would want to take action.

But the Fed doesn’t have many tools at its disposal in its battle against inflation. Raising short-term rates is its most powerful one, and if a steady diet of rising interest rates is truly needed to squelch runaway inflation, then perhaps we have to put up with the consequences.

Yet the markets have been remarkably buoyant over the past several months, despite the Fed’s efforts. Why should this good financial news worry the Fed? Basically, because positive financial news, aka “easing financial conditions,” could prevent the Fed’s interest rate increases from combating inflation.

Good news

Positive financial news includes an array of developments. A stock market rally, a jump in bond prices or an easing of mortgage rates — all of these things qualify.

They are welcome events for most people, and they have all actually happened in recent months.

For example, while the S&P 500 plummeted in the first half of last year, it rose 15.7 percent from Oct. 12 through Tuesday, according to Factset. And while the average 30-year mortgage rate leaped to 7.08 percent by Nov. 8 from 3.1 percent at the beginning of last year, it dropped to 6.09 percent by Feb. 2, according to the Federal Reserve Bank of St. Louis. Mortgage rates dropped because they are linked to bond yields, which declined over the same period. What all of these things had in common is that they were an improvement in the markets, signaling optimism about the path of inflation and interest rates. The effect was to give people more money to spend, as well the motivation to spend it.

Exuberance in the markets wasn’t entirely unfounded. Annual inflation has fallen a great deal by now — slowing to 6.4 percent in January from a peak of 9.1 percent in June, as measured by the Consumer Price Index. And the federal funds rate has risen from near zero a year ago to a range of 4.5 percent to 4.75 percent, the biggest and quickest increase in 40 years.

Expectations among some experts in the fixed-income markets at the end of 2022 were that the Fed would begin cutting the federal funds rate sometime in the first half of this year, essentially declaring victory in its battle against inflation.

The optimism problem

The idea is that by making it more expensive and more difficult to borrow money, the Fed can slow the economy — and squeeze rampant inflation out of it. But this isn’t a straightforward process. It happens through the very channels that showed signs of optimism — prematurely, from the standpoint of the Fed.

Two sets of measurements

suggest what has been happening. First, a project at the Federal Reserve Bank of Chicago, which uses more than 100 indicators to come up with a National Financial Conditions Index for the overall economy, shows that financial conditions tightened — as the Fed wanted — through October. But even though the central bank persisted in raising the federal funds rate, conditions loosened through the latest reading of the index on Feb. 10.

Second, the Federal Reserve Bank of San Francisco’s Proxy Funds Rate — which uses an array of data to assess broader financial conditions on a monthly basis — shows a tightening of financial conditions through November, followed by a loosening in January and February.

The Labor Department’s monthly jobs report was perhaps the single biggest piece of good economic news of recent weeks. It suggested that instead of slowing in the face of repeated rate increases, the economy was surging. Hiring in the United States heated up in January with the creation of 517,000 jobs on a seasonally adjusted basis.

Uh-oh.

As Deutsche Bank put it in a research report, “Financial conditions have failed to tighten enough for the Fed to have confidence” that it is winning the inflation fight. Much more tightening may be necessary. The bank now expects the Fed to raise short-term rates nearly a full percentage point higher.

A precarious loop

Financial markets seem to be hoping for some sort of “immaculate disinflation.” The term may have been coined by economist and New York Times columnist Paul Krugman. It is used to describe hopes for taming inflation without the messiness of rising unemployment or a recession that economic theory predicts.

“Higher for longer” has become the Fed’s unofficial mantra, and, unfortunately, it applies not just to interest rates but also to the rate of inflation. Until inflation drops much more sharply, the short-term federal funds rate controlled by the central bank won’t come down either.

The Fed and the markets are locked in an uneasy dance, one that isn’t likely to proceed smoothly without some nasty interruptions.

That’s why it might be unwise to become too optimistic about the stock market until the inflation battle is over.

Another big market rally is likely to persuade the Fed that it needs to raise rates even higher and stifle some market exuberance.

That could be rough on investors. But the usual advice still stands. First, make sure you have enough money stashed away to pay the bills. Then, with broadly diversified low-cost index funds that mirror the entire market, you should be able to withstand the turbulence ahead.

Be prepared. It is likely to be a wild ride.

CASEY STEFFENS NYT The Federal Reserve has been fighting high inflation by raising short-term rates, which has affected everything from food prices to the cost of a gallon of gas.