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Federal Reserve Policy Debate Drives Stock Market Volatility

December 10, 2018

The stock market has become increasingly focused on Federal Reserve policy and the future path for interest rates. So much so that the comments from various Federal Reserve Open Market Committee (the committee tasked with setting short-term interest rate targets) members have caused the stock markets to swing wildly in recent weeks. When the public statements were dovish (signaling fewer interest rate hikes in the future) the market has rallied, while more hawkish statements (signaling the need for more rate hikes in the future) have led to large drops in the major market averages.

On November 28th Federal Reserve Chairman Jerome Powell gave a speech to the Economic Club of New York in which he stated “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.” This statement was considered to be far more dovish than those the Chairman has made in the past as it signaled that the Fed is nearing its target for short-term interest rates. This implies that while the Fed may continue to hike rates in the short-term there is a greater likelihood that they will not push interest rates too much higher. The stock market responded positively with the S&P 500 index increasing 2.30% that day alone.

Meanwhile, on December 4th New York Federal Reserve Bank President John Williams, arguably the second most powerful person at the Fed, offered a different conclusion. Williams stated: “Given this outlook I describe of strong growth, strong labor markets, inflation at our goal, and taking into account all the various risks around the outlook, I do continue to expect that further gradual increases in interest rates will best foster a sustained economic expansion and sustained achievement of our duel mandate.” This far more hawkish statement sent the markets reeling with the S&P 500 index declining 3.24%.

Given the mixed signals being sent one would love to be a fly on the wall during the Fed’s upcoming December meeting. The debate is likely to be heated with voting members appearing to take different sides on the long-term path for interest rates. Most economists still expect that the Fed will hike their short-term interest rate target in their December meeting. However, the language used in the Fed statement that follows the meeting will likely be scrutinized even more than normal given the uncertainty about the longer-term outlook.

Meanwhile, parts of the Treasury yield curve (the graphical depiction of the interest rates paid for various maturities) have inverted. This means that in some instances shorter-term bonds are paying a higher interest rate than longer-term bonds. An inverted yield curve is considered a sign that a recession may be just 6 months to a year away. Although it should be noted that as the most commonly used indicator, the yield differential between the 2-year Treasury note and the 10-year Treasury bond, has narrowed but remains positive. However, should the Fed continue to hike short-term interest rates it may increase the likelihood that even this part of the yield curve may invert in the coming months. In this case the yield curve indicator may become a self-fulfilling prophecy should enough people believe that a recession is eminent and act accordingly by cutting spending and investment.

A divided Fed may prove to be a good thing - as with any major decision it is good to have dissenting opinions and a healthy debate. However, should the Fed continue to send mixed signals to market participants, the heightened level of volatility in the financial markets may persist.