Markets and Fed may disagree more as one-sided inflation fight eases.
The Federal Reserve will face a greater risk of sparking market volatility as it continues to tighten policy to fight inflation even as the economy slows, former Fed visiting scholar and MIT professor Ricardo Caballero told MNI.
That danger runs against recent clarity from policymakers playing catch-up against big price gains according to Caballero, who has done research at the Fed's main board and the Boston branch of the central bank.
"Tantrum risk will rise substantially once the tradeoff between activity and inflation becomes more balanced," Caballero said. "Stay tuned."
The MIT economics professor is studying mismatches between Fed and market outlooks, arguing that ideally the FOMC incorporates some investor views and gradualism into its actions to blunt any miscalculations.
"They were doing a great job early on, both during the worst of the Covid shock and the early stages of the recovery," he said by email. "The Fed was constantly communicating its plans to the market. The problem was of a different nature: they just fell behind the curve, so they could no longer afford that gradualism."
STOCK MARKET DISAPPOINTMENT
Debate has shifted to a potential recession as the FOMC upped rate hikes to 75 basis points at the last two meetings. Officials say they could tighten another 75 at the next meeting, one of the steepest tightening campaigns in decades.
But slowing inflation from around 9% now may lift record low unemployment and bring questions about meeting the Fed's maximum employment goal. The job market could also be weaker than officials expect based on what could be misleading vacancies data, ex-Bank of England MPC member David Blanchflower has told MNI. (See MNI INTERVIEW:US Jobless Rate Masks Slack – Blanchflower)
"We are going through a very complex scenario, where there is much more scope for disagreements than we are used to," Caballero said. "One lesson from our papers is that by becoming very data-dependent, the Fed implicitly tells the market that if they make a mistake, it won't last for very long. This stabilizes the impact of potential mistakes."
Bond investors are still pricing in tame longer-term views of inflation, with 10-year Treasuries yielding 2.79% Wednesday morning. Economists at ING argued Tuesday the Fed will find it hard to keep hiking its fed funds target rate, now at 2.25%-2.5%, and "there is no modern example" of continually taking it higher than the 10-year bond yield.
Stock investors may also be in for an unpleasant surprise, Caballero suggested. "The equity market seems to be taking the news from the bond market as good news, without pausing to think about what the Fed may have to do to the economy," he said. "Unless we get lucky with commodity prices and supply chain bottlenecks, which may well happen, inflation may be a lot harder to tame than the equity market is assuming."