Investors Realize the Fed Changed the Playbook

Investors finally are realizing the Federal Reserve changed its playbook. That’s why market interest rates rose in recent months even as Fed officials indicated the end of the tightening cycle was approaching.

When the hedge fund Long-Term Capital Management (LTCM) failed 25 years ago, it roiled the financial markets and Fed officials worried the effects could drag down the economy. The Fed adopted the policy of cutting interest rates to near zero and increasing the money supply as needed to support financial markets.

The policy continued for decades after LTCM’s effects wore off. Investors realized the Fed would keep interest rates low and would pump money into the markets whenever stock prices declined. The Fed could inject money into the economy without triggering inflation, because several global trends maintained a disinflation bias in the economy.

Those days are behind us. Investors were slow to realize this, so they’ve been wrong about Fed policy for a while. A year ago, investors expected the Fed to begin slashing interest rates well before the end of 2022 because people believed the inflationary surge of 2021 and 2022 was caused by supply and demand imbalances that would correct quickly. But the Fed’s extraordinary stimulus during the pandemic, coupled with the end of disinflationary trends, such as globalization and outsourcing, caused much of the inflation.

Over the summer, investors finally realized the Fed threw out the LTCM playbook. Investors saw that inflation had become persistent and sticky, and that an easy monetary policy would keep inflation above the Fed’s 2% target. Also, as I pointed out in a recent Bob’s Journal, the U.S. Treasury has to flood the market with a lot of new debt. The Fed and banks won’t be the big buyers of federal debt they were the last few years. Interest rates must rise to entice investors to buy the bonds. The Fed is back to the pre-LTCM playbook.

It is as concerned about inflation as it is about the economy. The Fed also wants interest rates to gradually rise toward historic averages. It doesn’t want interest rates near 0%. Investors are recognizing that, absent an economic crisis, interest rates are going to be higher than anticipated only a few months ago and will stay there for a while.

In 2022, interest rates increased at one of the most rapid paces ever, causing one of the worst bond markets ever. But declines in stock prices haven’t matched historic responses to significant interest rate increases and much of the economy has been resilient.

Strength in the economy and stock markets are among the reasons inflation’s been persistent. Inflation is likely to stay above the Fed’s 2% target until incomes and economic growth decline further. It is possible the Fed will accept a higher target rate for inflation. The more likely scenario is the current policy is maintained until inflation falls to the target. The Israel-Hamas war complicates the outlook for investors and the Fed. The suddenness of the war shows the importance of having diversified portfolios. Unexpected events can have sudden, significant effects on markets.

In the near-term, the immediate market effects shouldn’t be as broad-based or significant as after Russia invaded Ukraine. The main effects will be on the price of oil. Other commodities shouldn’t be affected. The influences on both the oil market and the broader economy could be more significant if the war becomes a broader regional conflict.

It is also possible oil supplies will be disrupted by either tougher sanctions against a major supplier such as Iran, a withdrawal of oil from the market by suppliers (as happened in 1973), or disruption of production or shipping activities. The uncertainty increases the importance of diversification and balance.