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Investors may be giving central banks too much credit—or blame—for whatever happens to inflation

June 06, 2022
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Investors may be giving central banks too much credit—or blame—for whatever happens to inflation. Stocks remain volatile even after late May’s relief rally, showing a tight inverse link with indicators of global financial conditions such as Treasury yields, corporate-debt spreads and demand for the U.S. dollar.

Pessimists see a recession coming, as often happens when the Federal Reserve raises interest rates, whereas optimists think the central bank can hit a sweet spot to balance inflation and economic growth. Which appears to be happening even though it is not totally due to the Fed.

In periods of high inflation, central-bank policy can’t be understood through rates or bond yields alone. A popular gauge of “real” U.S. financial conditions are yields on inflation-protected Treasurys. In March and April, these were still negative even as regular yields climbed, implying that investors saw future inflation going higher because they didn’t find the Fed’s hawkish stance aggressive enough. (Remember, investors tend to be wrong on timing and action by the Fed)

But then inflation expectations started a steady decline, as a trickle of data released in May pointed to a slowdown in parts of the economy—the housing market, for example. U.S. inflation for April came in at 8.3%, from March’s 8.5%, raising hopes of a peak.

“The Fed has already done the job of pushing monetary policy to neutral,” said AXA Investment Managers fund manager and inflation-market connoisseur Jonathan Baltora. He prefers to look at short-term inflation-adjusted rates which, as they rose, damaged stocks. But they have now settled around 0%, suggesting the adjustment may be over and that markets have learned to see the Fed’s stance as broadly on point.

“If the market is pricing all this correctly, it shouldn’t bode too ill for stocks, even if uncertainty keeps them volatile. Unadjusted for inflation, interest rates would peak around 3%, which is close to what happened in the prepandemic bull market, when there was no alternative to embracing risk. And while the economy is slowing and corporations’ earnings guidance is turning more negative, figures published Wednesday confirmed that the labor market remains robust,” says Baltora.

But investors’ newfound confidence in the Fed raises an oft-neglected question: Do central banks truly possess this kind of granular control over inflation and growth?

The post-2008 period belies this notion, as does the current bout of inflation. In the eurozone, where fiscal stimulus was much tamer, inflation came in this week at a record 8.1%. Inflation could as easily fall from here as jump again. Either way, I believe the Fed could matter little. Nor will it have much say over the longer-term impacts of bringing supply chains onshore and transitioning to green-energy production. The Fed just does not have that kind of power.

But rates do affect stocks, and a central bank that reacts without much actual power is bad news for them, even without a recession. If inflation slows from here, rates will be given credit for it and be left higher than perhaps necessary. Equities may still be the only attractive investment, but valuations remain historically slightly elevated even after the latest selloff, and governments’ appetite for activist fiscal policy has diminished. The downturn in stocks is despite the upturn in earnings. When the uncertainty of the war, inflation, Fed policy, and unemployment subside, the markets will breathe a sigh of relief and continue up.

While all 12 Fed districts reported continued growth, the central bank's periodic "Beige Book" indicated that four of the regions showed "that the pace of growth had slowed" during the previous period, which I have shared. That is the reason I have reduced my expectations of 10% per year verses the 18% we have experienced in the past four years.

The earnings reports in July will tell us most of the story on growth and the slowdown. Until then, I recommend to stay the course as selling now could be one of those regrettable decisions that reduces overall growth.

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