Should the Market Be Concerned About the Fed’s Neutral Stance?

The United States Federal Reserve

Our latest Fed meeting resulted in the committee leaving interest rates alone, in the face of inflation that has dipped from the last meeting. Should we be concerned?

Wednesday’s Federal Reserve announcement to leave interest rates unchanged was met with widespread disappointment by the U.S. stock markets, resulting in widespread sell-offs of some significance. By the time the dust settled, around mid-day on Thursday, the Dow had given back 600 points and gave back all the gains of the last 3 weeks in less than one trading day.

The market sold off during the last Fed meeting as well, when the Fed’s message was very market friendly under any interpretation, so it’s not as if we needed bad news to do this. It isn’t even that standing down right now is really bad news, but it would be if people were thinking that this new data should have them lowering rates and given that they didn’t, and they therefore may be concerned about what it would take to get the Fed to act.

That’s a fair point, but we do need to go into the rationale of the Fed here beyond just seeing the 1.6% inflation number, comparing it with the Fed’s goal of 2%, and then thinking that they should have done something.

From the bottom at mid-day on Thursday, we have come back half the amount that was lost over this already, which wasn’t surprising given how these events unfold. You hear a lot about people selling on news or intending to do so, and some sell on good news as well, but these aren’t your typical investors who are doing this, because these things are just way too small in significance to matter.

If we are looking at our portfolios many years from now, we won’t really be thinking that if we just got out when the Fed didn’t do anything in April 2019, things would have turned out differently. For longer-term investors, it takes a lot to get them to sell, and this or anything that has happened lately don’t come close, even when all added together.

The smart money that is in for the long haul actually waits for this selling to run its course and then jumps in and buys stock at the discount that they have just received as a result of the sell-off, and that’s exactly what we are seeing now and have seen when these things have happened this year. When you don’t see this happen, when we just keep going down, then it’s time to worry.

When it was all said and done, this week ended up coming in pretty close to where we started, helped no doubt by Friday’s non-farm payroll report, which came in higher than expected and added credence to the Fed’s opinion that things are fine right now and we don’t need their help.

Haste is the Enemy of Monetary Policy, and the Fed Is Resisting This

It’s not that the Federal Reserve, the guardians of the American economy, are infallible, and they have made plenty of mistakes in the past and will make plenty more in the future. They do not want to cut rates to just raise them again though, and any real stimulus at this point may indeed put us in a position where that would happen.

We need to remember that the Fed had planned for no rate decreases and two rate increases for 2019, and people were complaining that the economy was slowing down then. Their telling us that they are just going to be doing two more this year was a big relief for the markets, and they have rallied strongly ever since, but if things pick up very much from here, we’ll be back to the increases again, with or without a rate cut.

The worry about lower inflation, such as the 1.6 number we just got, is that it may impact growth rates, and it is growth rates that matter here on this side of the ball, when the concern is that things are too stagnant. No inflation at all would be perfect actually, as long as an acceptable level of growth was sustained, although that is not really possible.

The GDP numbers are still coming in pretty nicely though, and did not go down with inflation, which is one of the reasons why the inflation number did not concern the Fed as much as some would have thought. If we see GDP growth go down that far, that may be another matter, although even this could be viewed as “transitory,” as the Fed sees this dip in the inflation rate.

There is a lot of talk out there about this that focuses way too much on the inflation number, but lower inflation doesn’t necessarily mean a corresponding change in growth, and the two are distinct enough that they need to be viewed separately. In fact, the most important number here is neither of these, but net growth, when you subtract inflation from economic growth. This is how much we actually have grown the economy.

Net growth has increased this time around, which is what we want, and certainly nothing in itself to become alarmed about. We also tend to underestimate the power of monetary policy and often think that we have to be more proactive than we actually need to be in managing economic slowdowns, possibly thinking back to the recession of 2007-09, which was a huge challenge to manage with monetary policy.

The Fed Can Afford to Bide its Time Here

The reason it was so challenging wasn’t because we needed to jump in earlier though, it was because expansionary monetary policy can only do so much to increase the money supply when it has been trashed by the massive credit defaults that this era saddled us with. When it’s just your run of the mill slowdown, as this is, where credit default rates are very low, increasing the money supply by lowering rates works pretty well and we don’t really need to get ahead of the game as much as some think.

If we’re wondering what the Fed might do to curb inflation, it’s inflation that we need to look at. We’re on the opposite side of the table though, and when this is the case, we need to instead focus on growth rates, as long as inflation is in check, which it clearly is.

Things can change though, and perhaps when the next Fed meeting comes around, they will have a real reason to be concerned, if GDP growth starts dropping too far below forecasts, as inflation just did. Until then, it’s business as usual, and that’s the case with the stock market as well, and we’ve shed ourselves of some very fair-weather traders along the way, and anyone who would sell on matters of so little significance would certainly qualify.

It is actually the shorter-term traders that pile on these things, and it makes sense to get out if you are only around for a short period and that period becomes bearish, and they may even accelerate the move for a time by trading short. This is not something that investors who are not looking to get out now regardless should ever concern themselves with.

This move was actually a trader’s delight, taking their profits that day from the market running up until the announcement, and then going short to make money from the downward move that ensued, and the moves were very easy to trade in fact. However, if you’re in it for the longer or even medium term, you just need to look away here when these things happen. If a real trend happens and not a transitory one, we will know soon enough, but it takes a lot more than this to produce them.

We’re still very much in a bull market, one that has taken some blows from the Fed with their interest rate hikes, and hikes are always going to matter to stocks, although nowhere near as much as they should. They do bring down the money supply and do impact the ability to grow our businesses, although the fear factor plays into this a lot as well. We should not be too afraid of not messing around with something that continues to do very well, especially when there really isn’t much reason to meddle.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

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