Markets are left wondering if an equity market correction will stay the Fed’s hand in December. The short answer is no. The long answer is that short of a plunge along the lines of 1987 or 2008, Fed policy should not be impacted. This piece attempts to put some historical context behind our call.
Recall that the Fed has an official dual mandate to “promote maximum sustainable employment and price stability.” The unofficial third mandate is financial stability. This doesn’t mean it has to prop up the equity market. What it does mean is that the Fed can and will act if financial stability is being threatened by an equity collapse or any reason. Recall that in 2008, it wasn’t just a precipitous plunge in equity markets, but a near-collapse of the global financial system that led the Fed to act aggressively.
Thankfully, we’re nowhere near that yet. The S&P 500 is down only 8% from its record high from September 21 near 2941. The Dow Jones Industrial Average (DJIA) is also down around 8% from its record high near 26952 from October 3. Lastly, the NASDAQ is off 10% from its cycle high near 8133 from August 30. The US financial system remains healthy and so this correction seems hardly troubling for the Fed.
Beyond causing a financial crisis, the one major way that equity markets can impact Fed policy is by affecting overall financial conditions in an economy. The Chicago Fed provides its comprehensive National Financial Conditions Index (NFCI) on a weekly basis. There are 105 measures of financial activity divided into three categories: risk, credit, and leverage. A rising stock market typically leads to looser financial conditions, and vice versa for a falling market.
However, there are clearly other factors keeping financial conditions loose in the US. Even with this recent drop in US equity markets, the NFCI remains as loose as it’s ever been through October 12. To us, this should simply give the Fed even more confidence to tighten rates going forward.
A BRIEF HISTORY LESSON
In 1977, Congress amended the Federal Reserve Act. It required the Federal Open Market Committee (FOMC) to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” And thus, the dual mandate was born.
The notion of a third unofficial mandate for the Fed picked up after the Great Financial Crisis. As Minneapolis Fed President Neel Kashkari wrote last year,” we can’t ignore the implicit role the Fed also has to try to achieve financial stability.” In another essay, he wrote that “I don’t see a correction as being likely to trigger financial instability. Investors would face losses from a stock market correction, but it’s not the Fed’s job to protect investors from losses. Our jobs are to achieve our dual mandate and to promote financial stability.”
It’s worth noting that the Fed did not always target the Fed Funds rate. It is generally accepted that a central bank can control either the price of money or the quantity of money to meet its targets. Before 1979, the Fed tried to control the price of money, which meant the Fed Funds rate. Paul Volcker took over as Fed Chair from G. William Miller in August 1979.
In October 1979, Fed Chairman Paul Volcker changed the Fed’s approach and began to control the quantity of money, specifically non-borrowed reserves (M1). As a result of this new approach, the Fed Funds rate exhibited greater volatility until October 1982, when this experiment ended.
Let’s take a look at the Fed’s past easing and tightening cycles and what the relevant drivers were. This paper will focus on the post-Volcker period of Fed Funds targeting.
After the targeting of monetary aggregates ended, the Fed Funds rate was steady through 1983. In March 1984, the Fed started a tightening cycle as inflation accelerated to near 5% amidst a booming economy. GDP grew 7.2% in 1984. The Fed Funds rate peaked near 12% towards the end of that summer before the Fed started easing through 1985 and 1986. The Fed Funds rate fell just below 6% while inflation slowed to 1.1% in December 1986. Growth picked up in early 1987. Alan Greenspan took over as Fed Chair from Paul Volcker in August 1987.
The Fed started a tightening cycle in April 1987 until September 1987, hiking rates from 6% to 7.25%. The October 1987 stock market crash saw the Dow Jones Industrial Average (DJIA) fall nearly 40% and the S&P 500 by nearly 35%. As a result, the Fed cut rates 50 bp in November 1987 and 25 bp in February 1988 to 6.75%. As the economy and stock market recovered, the Fed hiked rates over the course of 1988 to 9.75% by December 1988. The economy did not tip into recession, nor was there truly any sort of resulting financial crisis. As such, this easing is probably the purest example of the so-called “Greenspan Put.”
Indeed, the US economy grew steadily and solidly during the 1980s. According to the National Bureau of Economic Research, the first recession after the deep 1981-1982 recession did not occur until mid-1990. The Fed responded by cutting rates that year. Easing continued into 1991 and 1992 as the recession deepened, and rates troughed at 3% in 1992. The US stock market fell during H2 1990, with the DJIA and S&P 500 both down 20% before rallying to new highs in the following years. We view this easing as a typical Fed response to a recession.
As the economy recovered, the Fed started a tightening cycle in February 1994 with a 25 bp hike in the Fed Funds rate to 3.25%. It continued to tighten until the last 50 bp hike in February 1995 to 6%. During this time, the economy remained robust and GDP grew 4% in 1994 even as inflation crept above 3%. However, the economy started to slow in early 1995.
The Fed started an easing cycle in July 1995 with a 25 bp cut to 5.75%. The Tequila Crisis of December 1994 in Mexico introduced some volatility in the financial markets, but the DJIA rose throughout the course of 1995. Growth slowed but there was no recession, and yet the Fed cut twice more to end up at 5.25% in January 1996. We view this easing as another example of the “Greenspan Put.”
The Fed cut rates in 1998 due to Asian crisis, which fed into Russian default and LTCM-related stresses in global financial markets. The US economy was remarkably unaffected by this global crisis, however, with GDP growing 4.5% in 1997 and 4.6% in 1998. And yet the Fed Funds rate went from 5.5% to 4.75% in November 1998. The S&P 500 dropped 22% during the fall of 1998, while the DJIA fell around 21%. We view this easing as another example of the “Greenspan Put.”
With the economy continuing to hum along in 1999 and 2000, the Fed tightened, and the Fed Funds rate rose as high as 6.5% in May 2000. The Dot Com Bubble burst in March 2000, with the NASDAQ plunging nearly 80% until it bottomed in October 2002. Yet the Fed did not start easing until January 2001, when the resulting recession took hold. Note that during this same period, the S&P 500 fell 50% and DJIA nearly 40%. We view this easing as a typical Fed response to a recession, as it did not react to the initial plunge in the Dot Com stocks.
The Fed had already cut rates by 300 bp to 3.5% in August 2001 before the 9/11 attacks. Even though the economy had exited recession by 2002, the Fed continued cutting rates throughout that next year to a low of 1% in June 2003. After the 9/11 attacks, the S&P 500 dropped an additional 14% and the DJIA by nearly 17%. This easing after the 9/11 attacks can be viewed as another example of the “Greenspan Put.”
GDP rose 2.9% in 2003 and 3.8% in 2004. As the economy recovered, the Fed started tightening aggressively in June 2004 until Fed Funds peaked at 5.25% in June 2006. Ben Bernanke took over as Fed Chair from Alan Greenspan in February 2006. And then all hell broke loose as the sub-prime market blew up.
Fed started easing in September 2007 and into 2008 as the Great Financial Crisis unfolded. Rates were cut to the rock bottom 0-0.25% at the December 2008 FOMC meeting. QE was started then too, followed by QE2 in November 2010 and QE3 in September 2012. Tapering of QE began in December 2013.
Janet Yellen took over as Fed Chair from Ben Bernanke in February 2014. After tapering was begun under Bernanke, QE ended in October 2014 and the tightening cycle began in December 2015 with a 25 bp hike. There have been eight total 25 bp hikes by the Fed during this cycle, with five delivered by Yellen and three by Powell that brings the current Fed Funds target range to 2.0-2.25%. Note that the Fed’s balance sheet reduction began in Q3 2017 under Yellen.
Jerome Powell took over as Fed Chair from Janet Yellen in February 2018. After Bernanke set the stage for the end of QE, Yellen had a fairly easy task in starting the Fed’s tightening cycle. Powell has the more difficult task of deciding when to stop it. We think short of a financial crisis and/or recession, Powell is determined to continue normalizing monetary policy.
Despite this drop in US equities, we think the market is still underestimating the Fed’s capacity to tighten. Financial conditions remain loose and the Fed is actively talking about moving to a restrictive policy. To us, this implies a Fed Funds target north of 3.5% (see our recent piece “Powell and Brainard Suggest Markets Underestimating Fed Hikes”).
What would it take in terms of equity market performance to get the Fed’s attention? Well, a big part of the answer is the speed, not just the magnitude. A “typical” equity market correction is framed as a 10% drop. When the market is coming off all-time highs like the S&P and DJIA, the threshold is even higher. Perhaps it takes something along the lines of 30-40% crash over the course of several weeks or months for the Fed to react. This is purely a guess, of course, based on past instances of the “Greenspan Put.”
Yet current Fed Chair Jerome Powell has yet to signal that there is any sort of “Powell Put.” Until he shows otherwise, we think investors should be prepared for intensifying stock market volatility with no impact on Fed tightening until monetary conditions tighten and/or the economy is pushed into recession.
Again, stock market moves must be framed within the context of financial stability. A standard stock market correction (-10%) or even bear market (-20%) over the course of several months would probably not move the Fed’s needle. Only if the drop were so quick and so deep as to 1) presage a financial crisis or 2) tighten financial conditions dramatically would the Fed be compelled to take equities into account. We believe the US financial system remains in good shape and should be able to withstand an equity market correction, even if it were to extend to 20-25% over the course of several weeks or months.
The FOMC next meets November 8. It is widely expected to do nothing. However, the statement will be scrutinized for any mention of stock market movements. We do not think the Fed will bring attention to what equities are doing. The FOMC meeting after that is December 19, where the Fed is widely expected to deliver its fourth hike of the year and ninth of this cycle.
It’s worth noting that Bloomberg’s WIRP page shows the odds of a December hike at 71% today. This is down from 80% yesterday and the 81% peak earlier this month. Furthermore, the market is no longer pricing in small odds of a third hike in 2019, as it had started to do a couple of weeks ago. We think much of this movement stems from this week’s drop in UST yields, which are due more to “flight to quality” flows than repricing of the tightening odds.