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US Federal Reserve
OpinionComment
Kerry Craig
Kerry Craig

Macroscope | Why Federal Reserve’s hard pivot over inflation has stock markets spooked

  • Investors are worried the policy support freely offered by central banks in the past two years will be withdrawn quickly and aggressively
  • Market volatility is expected to persist until there is greater clarity about the pandemic, snarled supply chains and the direction of interest rates

Reading Time:3 minutes
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Stock market information shown at the Nasdaq MarketSite in New York on February 3. Stock markets have had strong reactions to the prospect of central banks raising interest rates. Photo: Bloomberg
Kerry Craig

Capital markets have had a turbulent start to the new year as they adjust to more active central banks and tighter monetary policy. The US Federal Reserve has kick-started the hawkish tones, and other developed market central banks are following suit. Higher interest rates are not a negative given they signal a stronger economy, but the pace of increases could be if rates move higher in quick succession.

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It turns out the only thing transitory about inflation in the United States was the use of the phrase “transitory”. Based on the Fed’s January meeting and the increasing rhetoric from committee members in the subsequent days, inflation is an issue that needs to be addressed soon. The market reaction to this news should be viewed in the context of state of the US economy and the starting point of monetary policy.

The US economy is in remarkable shape. Jobs are plentiful for those who are looking for them, wages are rising and helping to offset some of the increased cost of living from higher prices. Meanwhile, companies are planning to spend and invest as demand looks strong and they seek to improve productivity.

Then there is the very easy stance of monetary policy from which the Fed is starting. Even if the Fed raises rates five times this year, the official cash rate will only be around 1.25 per cent in nominal terms and remain negative in real terms, or adjusted for the rate of inflation. They would still be some way from where they would be high enough to really hamper economic activity.

So why have equities reacted so sharply to the prospect of higher rates? It’s because of the pivot.

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In March 2020, the Fed and other central banks pivoted quickly to cut rates, buy bonds and provide liquidity to the financial system to stem the negative economic consequences of the Covid-19 pandemic. However, equities and credit markets quickly rose with all this policy support. Investors now fear the reverse will occur as the Fed pivots in the other direction.
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