Imagine the following scenario: Termites are eating the foundation of your house. You call a pest control company for a cost estimate to get rid of them. After a thorough assessment, they report the following:
“There is bad news and good news. The bad news is, solving the problem will cost $10,000. The good news is, things could have been much worse. If you wait another six months, it will cost you $50,000.”
In our metaphor, Federal Reserve Chair Jerome Powell is the homeowner. The house is the U.S. economy, and the termites are inflation.
The point of the metaphor is that the Federal Reserve has run out of choices. If termites (inflation) continue to gnaw at the foundation of the house (the U.S. economy), the house will eventually collapse.
The Federal Reserve has to stop this from happening, no matter what. That is its most important job.
And if the stock market is hurt by the Federal Reserve’s actions, the Fed won’t care. Addressing the inflation problem is simply too important
The Fed Never Cared About the Stock Market (Not Directly, Anyway)
The Federal Reserve never cared about the stock market anyway — or not directly, at least. The notion it ever did was a myth.
The Federal Reserve officially has something called a “dual mandate.” The twin pillars of the dual mandate are stable prices and maximum employment.
This means that, first and foremost, the Fed is tasked with keeping inflation in check. It is also responsible for keeping the economy healthy.
Along with stable prices and maximum employment, the Federal Reserve cares about political optics because it wants to maintain independence.
The Federal Reserve knows that if politicians in Washington get angry enough, Congress could vote to curtail or even revoke the Fed’s independence. The Fed doesn’t want that to happen, which is why it stays attuned to politics.
Based on its historic pattern of actions, and the way the stock market has responded positively to every rescue effort, it certainly looks like the Fed cares directly about the stock market. But this is an optical illusion that arises from acting on other concerns.
For example: If the banking system collapses or the corporate debt market freezes up, millions of jobs would be lost.This is why, when a financial crisis unfolds, the Fed steps in with liquidity and credit market support. That support winds up helping the stock market — but the stock market gains are a secondary effect.
Then, too, in the aftermath of the 2008 financial crisis, the U.S. economic recovery stayed subpar and sluggish for years.
The Fed introduced quantitative easing (QE) in that environment to try and create a “wealth effect” — a theory that rising asset prices would make consumers feel more confident and thus more willing to spend and contribute to economic growth.
The key thing to know is that supporting the stock market has never been a direct concern. Investors have just gotten used to thinking that way, because every time the Fed responds to a crisis, its actions tend to support asset prices.
The Federal Reserve today is no friend to the stock market. One might even consider it an enemy. Why?
Because in 2022, fighting inflation is the Fed’s No. 1 concern. That means tightening up monetary conditions and hiking interest rates. The market is pricing in at least four rate hikes over the next year or so, and it remains entirely possible there could be more.
If it sounds strange to think of the Fed as the enemy of the stock market, that is just because we are used to recent history. Think of the Federal Reserve under Fed Chair Paul Volcker in the late 1970s and early 1980s.
Volcker was so determined to beat inflation, he was willing to trigger a brutal recession (via sky-high interest rates) to achieve his goal. Today’s Federal Reserve isn’t likely to go as far as the Volcker Fed, but nor does it have to.
Speaking of recessions: Some will argue that if the stock market goes down in value too much, the Fed will have to step in because a weak stock market threatens the economy.
That might have been true in the 2010s — the decade that followed the financial crisis — because the economy was weak and sluggish. But today the unemployment rate is 3.9%, which is historically quite low, and there are credible arguments that the U.S. labor market is the tightest it’s been since the 1950s.
Then, too, not only is the U.S. growth picture robust in 2022, but one could argue that demand is too robust relative to the output capacity of the U.S. economy itself.
Consumers are so flush with cash, they are buying more goods than ever before, and it is largely the force of this demand that is straining supply chains and pushing prices up.
At the same time, the Fed is worried about inflation expectations becoming entrenched. With inflation readings at 40-year highs, it is not just the inflation itself that poses a problem. It is the risk that an inflationary mindset gets embedded in the public consciousness.
If the stock market falls hard against a backdrop like this, it won’t necessarily hurt the U.S. economy. Stock valuations in some corners of the market were looking highly inflated, the strongest companies have plenty of cash on the books, and housing demand and labor demand look rock-solid.
In fact, companies with excessive valuations (meaning extraordinarily high price-to-earnings or price-to-sales ratios) can see their share prices fall a long way before day-to-day business is impacted.
The nosebleed valuations in many areas of the stock market right now — particularly the tech sector — further explain why the stock market is so vulnerable to an extended correction, or even a multiyear bear market decline
Strong Banks and Balance Sheets Mean No Financial Crisis on Dec
What about the possibility of a new financial crisis if the Fed hikes interest rates too much? Some argue the Fed will have to be careful to avoid this risk, and that financial crisis dangers will limit the number of hikes they can push through.
Except this argument doesn’t hold up either, because the banks are in great shape today.
After the financial crisis of 2008, the banking system was battered and bruised, having barely survived a near-death experience. But in 2022, the banks are robustly profitable with solid balance sheets.
Not only that, but the banking sector actually likes it when interest rates go up, because higher interest rates at the long end of the curve means fatter profit margins on lending activity.
This is why, thus far in 2022, there is little surprise that financials are the No. 2 best-performing sector in the S&P 500. (No. 1 is energy, which is no surprise either, with oil on its way to $100 per barrel.)
It is also no surprise that, according to Bespoke Investment Group, the Nasdaq — which officially entered 10% correction territory as of the Jan. 19 close — is having its fourth-worst start to a year in history. Most of the extreme froth that built up in markets over the past two years was concentrated in tech stocks.
To sum up, the Federal Reserve doesn’t care about the stock market, and it never did.
This is important to understand because far too many investors still think the Fed will save them — or that Powell cares about saving them — in the event their favorite stocks continue to fall.
In reality, the Federal Reserve engages in stimulative rescue-type actions when the U.S. economy is weak or sluggish, or when a financial crisis in the corporate sector or the banking system looks imminent.
Those conditions do not apply today.
Instead we have inflation read-outs at 40-year highs, wage pressures across the full spectrum of income levels, an oil price heading for $100 per barrel, and a Federal Reserve worried about the pain of waiting too much longer to act.
If you put all those factors together — along with the fact that the market itself is signaling at least four rate hikes in 2022 — you get a picture in which the Fed is prepared to fight inflation aggressively, even if its extended rate hike campaign winds up hurting the stock market.
Until and unless a new financial crisis percolates or the threat of a new downturn or recession looms — and remember, the banks look fine right now, and unemployment is historically low at 3.9% — the Fed
simply won’t care about valuations falling back to earth, or the Nasdaq following its correction path deep into bear market territory.