THAT’S NOT HOW IT USED TO BE

Indeed. Investors have grown accustomed to the idea that the Fed cares about the equity market. The Fed put. But that was in the disinflationary regime when tightening financial conditions would suck any inflation out of the economy fast. If equity prices fell too far, the Fed could ease without risking inflation expectations becoming unanchored.

Today, the economy has more momentum, thanks to the monetary and fiscal stimulus during the pandemic. So, especially given banks’ preference for Main Street lending over Wall Street financing, greater tightening of financial conditions is needed to slow things down.

But, if a proper tightening of financial conditions destabilises the treasury market and threatens financial Armageddon, policymakers will intervene. Hence, the treasury market put. How might this play out?

The Fed continues with tight monetary policy and draining of reserves until it gets closer to what it considers the biting point. In 2019, it turned out to be $1.4 trillion, well above the expected $800 billion (Figure 8, previous page). Various commentators and ex Fed governors have suggested the biting point today is $2-2.5 trillion. That implies between $600 billion and $1 trillion of reserves drain is still possible before the Fed lifts off QT.

This drain of reserves will put pressure on risky assets. If that starts to unsettle the treasury market, expect to see the treasury market put deployed. While supportive of equity markets, it would be from much lower levels than today, and the prime beneficiary would be treasuries, not equities.

“So policymakers are hostage to Goldilocks. Inflation must quickly prove transitory without needing a financial dislocation to make it so.”

NO ANGEL BORN IN HELL COULD BREAK THAT SATAN’S SPELL

So policymakers are hostage to Goldilocks. Inflation must quickly prove transitory without needing a financial dislocation to make it so.

The early signs of slowing inflation have allowed the Fed to give the market greater confidence about where the peak in rates might be. But the Fed is at pains not to clarify how long rates will stay at that level. In fact, it assumes it will have to maintain peak rates for longer than the market expects.

Markets have leapt out of the frying pan and into the fire. Unless recession pours water on the flames.

The longer we spend at peak rates, the more policy will drain reserves and the more portfolios’ asset allocations are likely to be adjusted away from risky assets, reinforcing negative investment flows.

These flows don’t appear to have happened yet (Figures 9 and 10).

Goldilocks still has a lot of work to do to bail out the Fed.