Nervous reaction on Wall Street to Fed minutes

The high degree of sensitivity in financial markets to the prospect of an interest rate hike was exemplified yesterday when Wall Street saw a significant drop after the Fed minutes released showing it was considering tightening monetary policy at a faster rate than expected.

The Fed announced its intentions at its December 14-15 meeting when it decided to complete its financial asset purchases by March. The meeting minutes provided more details on the move, leading to a massive sell-off in the last two hours of trading when they were released.

The tech-rich NASDAQ index fell 3.3%, its biggest drop since February 2021, the S&P 500 fell 1.9%, after hitting a record earlier this week, and the Dow Jones , who also set a record, lost 392 points or 1.9 percent.

A woman walks past a bank’s electronic board displaying the Hong Kong Stock Index on the Hong Kong Stock Exchange on Wednesday, January 5, 2022 (AP Photo / Vincent Yu)

According to the minutes: “Some participants felt that a less accommodative policy would likely be warranted and that the committee should express a firm commitment to tackle high inflationary pressures. “

Another attention-grabbing paragraph was: “Participants generally noted that, given their individual outlook for the economy, labor market and inflation, it may become warranted to increase the fund rate. federal governments earlier or at a faster rate than participants previously anticipated. . “

The reference to the labor market underscored the remarks made by Fed Chairman Jerome Powell during his press conference on December 15. Announcing the decision to move the end of asset purchases forward to March rather than June, he said: “There is a real risk now… that the risk of higher inflation taking hold has increased. . This is part of the reason for our decision today… to put ourselves in a position to face this risk.

Inflation ‘entrenchment’ refers to a situation in which high price increases – headline inflation in the United States well over 6% – lead to workers’ demands for higher wages, which has resulted in higher wages. already started to happen. Concerns have also been expressed in the business community about the reintroduction of cost of living adjustments in some wage contracts.

These issues were reflected in the minutes. They highlighted concerns that persistent supply chain problems and labor shortages meant that the price hike was likely to continue and “last longer and be more widespread than previously thought. initially ”.

The Fed’s official commitment is to keep interest rates near zero until inflation averages 2% over time and maximum employment is reached.

The minutes noted that the first condition had been “more than met” with “several” participants indicating that labor market conditions were “broadly in line” with the second target. Most of the participants believed that they could “quickly approach” this goal if current trends continue.

But with eyes firmly fixed on wages and the labor market, some officials have suggested the Fed may start raising interest rates before the peak employment rate has been reached.

The general expectation was that the first rate hike would come sometime after the March meeting, when asset purchases ceased.

But Fed Governor Christopher Waller suggested the first hike could come at the March meeting itself. “The whole point of accelerating the reduction was… so that the March meeting could be a live meeting. That was the intention, ”he said two days after the Fed meeting. By “live” meeting, he meant a meeting in which the Fed could announce a rate hike.

Another important element of the meeting revealed by the minutes was the discussion of reducing the size of the Fed’s asset holdings, which now stand at just under $ 9 trillion. It more than doubled following the financial crisis of March 2020 at the start of the pandemic.

According to the minutes, some participants suggested that a move to reduce the Fed’s asset holdings could begin “relatively soon” after the interest rate hike. This is a sensitive issue for Wall Street, as the Fed’s asset holdings are a crucial part of the speculative surge that sent the stock market to record highs as the pandemic continued to rise.

The last time a cut was discussed was in 2018, when Fed Chairman Powell indicated that the Fed’s asset holdings would be cut by $ 50 billion per month to normalize monetary policy. and that the reduction was on “autopilot”. At that time, asset holdings stood at around $ 4 trillion due to the quantitative easing program following the 2008 stock market crash.

This produced a furious market reaction, following which the Fed hastily retreated, removing the interest rate hikes planned for 2019 and canceling the asset reduction plan.

There may well be a repeat of these events. In a note published yesterday, cited by the the Wall Street newspaperChris Zaccarelli, chief investment officer at Independent Advisor Alliance, said his organization’s belief was that the Fed was “likely to raise interest rates faster and potentially shrink its balance sheet sooner than many realize because they signal that fighting inflation is more important than protecting against a decline in economic activity.

“What’s more difficult to predict,” he continued, “is how much liquidation in the market they’re willing to tolerate before they change course.”

The fear is that Wall Street’s reliance on low rates to fund its speculative frenzy will be such that even a relatively small rate hike and minor tightening in monetary policy overall could precipitate a crisis.

These concerns were reflected in the Fed minutes, with “several” participants pointing to “vulnerabilities”, especially in the US Treasury market which collapsed in March 2020. This could limit how quickly the Fed was able to reduce his record.

The fine line the Fed is following – seeking to suppress wage demands without triggering a market collapse – was highlighted by a commentary by financial analyst Mohamed El-Erian published in the Financial Time Tuesday.

“The possibility of the Fed losing its temper, as it has done several times in recent years, would be seen by markets as constructive in the short term,” he wrote.

In effect, this would keep central banks “committed to offsetting the impacts on asset prices”, particularly equities. He questioned the sustainability of any cycle of interest rate hikes because “a system conditioned by more than a decade of low interest rates and plentiful liquidity would quickly prove unable to tolerate higher rates.” .

“Tighter financial conditions, although justified by persistent inflation, would promote a very unfavorable combination of financial instability and falling private demand,” he wrote.

This would lead in the extreme to “stagflation” – including a “sharp decline in economic activity” – and to policies that become “much less effective at a time when markets are grappling with the trifecta of the economy. hitherto undervalued liquidity, credit and solvency. risk.”

Nervousness on Wall Street in response to the Fed minutes is a harbinger of underlying instability in the entire financial system.

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