Once upon a time, in another millennium, I worked at the Federal Reserve Bank of New York. It was during the reign of Chairman Volcker, first of his name. One thing I did was prepare statistical packages for the officers to use in the run-up to the FOMC meeting. The tables and charts covered inflation measures, the non-financial economy, interest rates and exchange rates. Perhaps it was a simpler time or just a different time, but the stock market was barely, if ever, mentioned during my tenure. From the reign of Maestro Greenspan down through the present day, it has become an article of faith among stock market commentators that the Fed reacts to the equity market. Is this true? Should it be true?
The Fed’s objectives were established by Congress in The Federal Reserve Act in 1977. They are maximum employment, stable prices, and moderate long-term interest rates. This is called the “Dual Mandate”. It focuses on the real (non-financial) economy.
- Stable prices has been defined as a core inflation rate of around 2%. Inflation means changes in the overall price level of goods and services. Asset price inflation, or the perceived overvaluation of financial markets, is not a policy target.
- Maximum employment is defined as getting to an unemployment rate that will not cause inflation to accelerate. Unemployment, beyond that amount, results from the economy running below its capacity. The current unemployment rate, despite being below the Fed’s estimate of the appropriate rate, is not a cause for concern. Inflation is below its target too.
- Moderate long-term interest rates get no attention as a policy target. Perhaps because they should result if the first two goals are fulfilled.
Note that the stock market doesn’t get a mention, not even a footnote.
While the stock market may provide signals about economic growth, they are noisy signals. The equity market does tend to top out and fall prior to recessions, but it also has a maddening tendency to top out and fall frequently between downturns. It’s not for nothing that Paul Samuelson said the stock market has forecast nine of the last five recessions.
If the Fed is going to care about a financial market, it should be and is the bond market. Equity markets provide important signals for the economy’s future. Equity bubbles that arise during the advent of new technologies allow those innovations to get financed, but the day to day financing of the economy occurs in the credit markets. The bond market and its private analogs, bank lending and direct lending, are the circulatory system of the US economy.
The difference between issuance in bond and equity markets is astonishing. From 2000 through May 2019, almost $122 trillion in bonds have been issued in the US. Equity? Just $4 trillion. Much of the difference in issuance comes from maturities, making it extremely important for the credit markets to stay open. A sudden stop in refinancing can permeate rapidly through the economy, throwing it into a deep slump. Example: 2008.
Arguably, widening credit spreads, the differences in interest rates between risky debt and treasuries, and the fact that there was not one high yield issue in December 2018, may have been more of a factor in the Fed’s January turnaround than the fall in the stock market.
The bond market has a better record than the stock market in warning about economic slowdowns. An inverted yield curve, consisting of the difference between a short and long maturity security, has preceded every recession since 1962 with just one false positive in 1966.
Forward looking indicators from the real economy should also be in the toolkit for analyzing the potential for a downturn and a concomitant Fed move. Manufacturing and housing are small, but highly cyclical components of GDP. They punch above their weight because of their cyclicality. Manufacturing purchasing managers’ indexes are indicators that warrant close monitoring. They are surveys of items like orders, employment and inventory and are released in a timely manner at the beginning of each month. Indicators like GDP and industrial production lag by months and are unreliable in the moment. They are plagued by revisions. The final results often look nothing like the original releases. The US PMI has been trending down since last August, which may be stoking the Fed’s concern.
History does not reflect Fed concern for the stock market. The one exception I can recall was the ease after the 22.6% fall in the Dow on Black Monday in 1987. The Fed shows concern for credit markets and the non-financial economy, as it should given its mandate. Yes, there are and have been lively discussions of the Greenspan put, the Bernanke put, etc., but do not confuse correlation with causation. If you are concerned about what the Fed is going to do, monitor indicators of financial conditions and the real economy. The equity market can be an input into financial conditions indices, but be aware that it has a low signal to noise ratio.