We've been here before.
June 30, the
raised rates, expressing concern about lots of things the market hates: inflated asset prices, tight labor markets, potential for wage inflation. Two months later, just before
today's rate hike, the 30-year bond yield was 12 basis points
, and the
points, thank you very much.
"In a sense, the Fed tightened, and the markets eased," says David Jones, chief economist at
Aubrey G. Lanston
The Fed is, in a way, dealing with a Catch-22: It's trying to slow demand, but absent an outbreak of inflation, raising rates only gives the market extra confidence that inflation will remain under wraps. That would produce lower long-term rates. That helps companies and individuals save money, giving them more spending cash, fueling the stock market and demand, which worries the Fed, now forced into raising rates -- again.
Obsessed With the Markets?
This is what makes the Fed's job harder: The strength in consumer demand hasn't resulted yet in an outbreak of inflation, which would justify anything the Fed wanted to do. But it's enough to fuel higher asset prices and lots of spending -- a burr in Fed officials' collective sides because it makes them worry about possible shocks to the economy should the markets stumble.
"What it does is raise the bar each time for how high interest rates have to go to get to an equilibrium where demand doesn't exceed supply in terms of labor and resources," says Tony Crescenzi, chief bond market strategist at
Miller Tabak Hirsch
. Right now, "financial conditions haven't tightened all that much."
Obviously, one would think the Fed's chief concern is not the stock market. But as so much of the economy's strength has been linked to the so-called wealth effect and the catalysts of lower interest rates and high stock prices, the Fed's seemed a little obsessed lately.
"The danger is that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable even if risks in the future become relatively small," said Fed Chairman
in his semiannual
This Is a Rate Hike?
Though the Fed certainly doesn't want a crash (it's anticipating a so-called soft landing -- if and when the economy slows) and is reluctant to identify this environment as an "asset bubble," its officials sometimes talk that way, in the style of, "I'm not saying you're stupid or nothing, but ..."
"Yesterday's rally in the stock market and rally in the bond market is almost like a challenge to the Fed," says Paul Kasriel, chief economist at
. "I think the Fed would like to keep some degree of uncertainty so these asset markets don't take off on them without some degree of caution."
But all of the Fed's expressions of worry -- or jawboning -- about tight labor markets won't mean jack with the markets until its words are backed up by data (such as rising average hourly earnings, currently at a 3.8% year-over-year rate, compared with 4.3% in July 1998) or price inflation, which is not alarming yet. Internet stocks may have been deflated, but stocks are still firmly entrenched in a bull market, as the Fed's attempts at influencing market psychology have mostly fallen on deaf ears.
That may be why it's taken a muted approach in today's
statement accompanying the rate hike -- the Fed displays confidence that the policy actions "should markedly diminish the risk of rising inflation going forward."
The yield curve, or the difference in basis points between the 30-year bond and two-year note, is now 31 basis points, compared with 43 just before the previous Fed meeting. Mortgage rates and key lending rates are calculated off the long bond's yield. Even if short-term rates rise, if the long-term yield remains steady, that's a continued benefit for companies and individuals (it was key to the most recent equity rally). Those financial conditions promote more spending and more demand, which the Fed believes could lead to economic imbalances.
"They've got to control the financial markets' psychology as well as economic reality," says Jones. "In June, we had a huge stock market rally and that set the backdrop for a nice rebound in growth in the third quarter. The sense was, that was set up by the reaction to the idea that the Fed goes once and not again. Now, people think it's another 25 and that's it. It gives you a sense of how powerful the speculative forces are in the financial markets and how it works against the Fed's purpose."
Grin and Bear It
The Fed's response to what seems like out-of-control demand this year has been tempered by the effect productivity gains have had on the economy -- specifically on labor and production costs. The worry that productivity gains will not continue to nullify production costs somewhat explains why, at times, it seems to be attacking growth. There's also little price inflation, so the financial markets and the labor markets have become its chief concerns.
Crescenzi believes the Fed has two options to its demand dilemma. It can take an aggressive approach and focus on the wage and price measures without worrying about the markets, "which would foster an environment of more tightening than less." Alternatively, it can try to more carefully massage the market's reaction. But Crescenzi says that kind of caution could "cause imbalances that would draw the employment rate up."
As with all decisions on monetary policy, future decisions will continue to rest on data. Significant signs of wage inflation are still limited to the
, an anecdotal survey of economic conditions around the country, and a recent spike in the
Employment Cost Index
, which is still only growing at a 3.6% year-over-year rate.
Most likely, the Fed's future decisions will not be made easy by virtue of a gigantic increase in labor costs right before a Fed meeting. The signs will be subtle, so the Fed will, as Crescenzi says, "need to surprise the markets with an action that goes beyond its expectations." If the increase doesn't materialize, despite the markets, the Fed will have to, as Kasriel put it, "grin and bear it."