Market Turmoil Unlikely to Sway Fed on Interest Rates

(Bloomberg View) -- The turmoil in equities continued this week with the S&P 500 Index down about 10 percent from its record high in January. Although the sell-off implies tighter financial conditions, don’t expect the Federal Reserve to change course yet.

Central bankers will need more evidence that Wall Street’s problems threaten to spill over onto Main Street before they abandon plans for further interest-rate increases. Friday’s employment report is more important for the path of rates than recent financial market action.

When asked about financial imbalances in his most recent press conference on March 21, Fed Chairman Jerome Powell described the risks as moderate due to improved capitalization, liquidity and risk management for large financial institutions. He specifically commented on stock prices:

In some areas, asset prices are elevated relative to their longer-run historical norms. You can think of some equity prices. You can think of commercial real estate prices in certain markets. But we don’t see it in housing, which is key. And so, overall, if you put all of that into a pie, what you have is moderate vulnerabilities in our view.

Powell’s remarks likely dominate the thinking at the Fed. Some asset prices, such as equities, look high by historical comparison. Unsaid is that a correction like the one currently underway would not be unexpected. But not unexpected is not necessarily problematic. Falling equity prices would become a problem if they triggered systemic failures in the financial sector, leading to a broad contraction of credit that spreads from Wall Street to Main Street.

Central bankers are sufficiently confident in the strength of the financial system that they are focusing their attention on the incoming economic data rather than the stock market. And that data, including the recent acceleration in personal consumption expenditures inflation and strength in the manufacturing sector, tends to support the Fed’s plans for further rate hikes. Countering this data would require a much deeper equity correction. At this point, expect another rate boost in June.

The Fed’s most recent Summary of Economic Projections shows that policy makers still expect to boost rates three times in 2018. But this is somewhat deceptive. The two low estimates in the survey anticipate no more hikes this year. The vast majority of Federal Open Market Committee participants are split between three and four increases, while one anticipates five. Eliminating the two low estimates on the Fed’s “dot plot” would place the median projection at four hikes.

Given this split opinion, continued weakness in equity markets could be a factor in swinging the FOMC to three rather than four hikes, all else equal. Recall that Fed Governor Lael Brainard cited easy financial conditions as a tailwind supporting growth this year. Remove that tailwind, and the case for four hikes rather than three might weaken somewhat.

But such speculation is premature. The declines in equities so far are unlikely to have much impact on rate policy given the current environment where, according to the Fed, the economy sits near or beyond full employment. More important for the path of monetary policy is this week’s employment report for March. A mix of continued strong job growth, a further decline in the unemployment rate, and stronger wage growth would overshadow recent equity declines and further cement the Fed’s case for additional rate hikes.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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