Markets look to the Fed

---

It is through the financial markets that monetary policy affects the real economy, and central banks such as the Fed play a key role in fueling investor expectations.

There continues to be ongoing tension in the current configuration of monetary policy, economic performance, and asset valuations. The first is that risky asset pricing seems to reflect a lot of optimism about the growth outlook. So, when early data on the coronavirus outbreak seemed to threaten this, the impact on asset prices was extreme. The equity price fall per death was, frankly, astonishing, especially since the probability of this being more than a temporary economic problem was, and remains, very low. Still, we have to acknowledge that this probability is not zero.

Certainly, the economic effects seem to be on track to be bigger than we thought likely when the virus story first broke. The S&P 500 Index started January strong before giving back gains and closing flat for the month. U.S. stocks outperformed international indices, with steep losses in emerging-market equities in January. However, U.S. Treasuries and the dollar rallied as investor piled into safer havens.

We think that asset markets often seem to price in only two outcomes: the very good and the very bad. We're either booming or in recession. To the extent that market valuations are based on expectations of strong growth in 2020, we should prepare for disappointment. That doesn't mean recession is likely. Indeed, recession probability remains low. But growth prospects are mediocre, with not much upside risk and plenty of downside.

U.S. economy is coasting along

In the United States, overall growth has been slow and steady. There has also been little change in our recession probability models, and we still think a recession is not likely. The Conference Board's Leading Economic Index (LEI) is hovering right around zero and is sending a message similar to that of 2012 and 2016: very weak momentum and not an imminent recession. The LEI, which tracks swings in the U.S. business cycle, comprises 10 factors including initial claims for unemployment benefits, factory orders, building permits, and changes in the S&P 500.

That said, there are worries about risks from the trade war, about the downside from the coronavirus pandemic, and that, at the current pace of growth, we are a bit too close to stall speed. A shock is more damaging when the economy is just bumbling along. We also worry that the U.S. economy is a bit unbalanced and a bit too dependent on the continued willingness of households to spend.

Assessing the Fed's role

The role of central banks in all this matters, and asset markets have become a key part of the policy transmission mechanism. The Fed's monetary policy meeting in January illustrated this. Members of the Fed's Open Market Committee (FOMC) left the federal funds rate at a range of 1.50% to 1.75%. However, the FOMC raised the interest on excess reserves (IOER) by 5 basis points to 1.60% from 1.55%. This is the interest the Fed pays banks on the reserves that it holds on its balance sheet, and is one of a few short-term rates used to keep the fed funds rate within its target band.

The Fed insisted that this was a "technical" adjustment and not a policy signal. Even so, the fed funds rate rose 5 basis points, as did the overnight repo rate. So, it was a tightening. It came at the height of the coronavirus scare, and on a day when the yield on the 3-month Treasury bill rose above the yield of the 10-year Treasury note. Yield curve inversions matter. The inversion didn't last very long, but it was an indication that the Fed's move was, at best, an ill-timed misstep and, at worst, a policy mistake.

Policy tools and growth

Remember that we spent much of 2018 worrying that the Fed would tighten too much. It is now clear with the benefit of hindsight that the Fed did indeed over egg the pudding and then spent much of 2019 undoing that mistake. The risk of inappropriate central bank hawkishness is almost always greater than the risk of inappropriate dovishness, and it's certainly greater at the moment. This matters for the outlook.

If asset markets don't get the strong economic growth they seem to be expecting, they'll have to rely on policy support instead. If we are right about the growth outlook — that it's OK, but not as good as consensus expectations — then this is a recipe for volatility. As we have argued in the past, there is a central bank put under asset markets, but the strike price of that put is well below current levels.

And it's worth emphasizing that we are virtually certain to get a few ugly data points in the next few months from China and a few other countries. It will be hard to interpret them, and it would be inappropriate to extrapolate the weakness into a story about a collapsing world economy. But, if they cluster and dominate the headlines, some investors are going to start running for the exits.

Overall, we are on the bearish side of consensus, not expecting a recession but expecting somewhat slower growth and bouts of asset market volatility.