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The Fed ‘Put’ Applies to Both the Economy and Markets

Tim Duy

(Bloomberg Opinion) -- The stock market isn’t the economy, but it is sufficiently connected with the economy that it can’t be ignored by the Federal Reserve. Eventually, central bankers must respond to protracted turmoil in financial markets. That means it will be very difficult — if not impossible — to differentiate between a “Fed put” on the economy versus on the stock market. Rather than complaining about the “Fed put,” market participants should embrace it — or at least not bet against it.

In the opening remarks to his post-Federal Open Market Committee press conference Thursday, Fed Chairman Jerome Powell noted that financial “conditions tightened considerably late in 2018, and remain less supportive of growth than they were earlier in 2018.” This is a fairly clear indication that the Fed’s declaration that they will be “patient” before making its next policy move was driven in part by the market turmoil in the fourth quarter.

Did Powell surrender to the markets? Sort of. I have long said that there is a “Fed put” on the economy, and that it can’t indefinitely ignore market turmoil. To be sure, the Fed will tend to dismiss normal market volatility in favor of data, but persistent, substantial market volatility suggests rising downside risks to the economy.

The issue for the Fed is that it can’t react to the downside risks to the economy without looking like they are reacting only to the markets. The two can thus be observationally equivalent. A “Fed put” on the economy will look like a “Fed put” on the markets, despite the fact that the Fed clearly doesn’t react to every dip, even substantial ones, in the stock market. After all, the Fed kept hiking even after the S&P 500 Index fell some 10 percent between late January and the start of April 2018.

The possibility that pessimism on Wall Street spreads into Main Street is another reason the Fed can’t ignore market turmoil indefinitely. Although the Institute for Supply Management said on Friday that its manufacturing index for January jumped 2.3 points, the increase only partially recouped the big 4.5-point decline for December that was likely magnified by the big slide in equities that month.

In other words, persistent declines in equity prices can induce pessimism in other sectors of the economy that could become self-sustaining. Similarly, concerns about the stock market may also have precipitated weakness in December pending home sales. To place a floor on the economy, the Fed in such a case needs to short-circuit the pessimism before it builds into a recession. That means shifting to a more dovish policy stance and, again, a Fed “put” on the economy can’t be distinguished from a “put” on the markets.

More generally, the Fed’s job is to sustain the same upward path of economic activity, which propels profit growth and higher stock prices over time. To be sure, the Fed makes mistakes. Sometimes they tighten too much and other times too little. Maybe they don’t react to a negative shock as quickly as they should, and sometimes a shock overwhelms them. But on an average the Fed largely succeeds in placing a floor under the economy.

Market participants would be best served to embrace the Fed’s role in putting a floor under the economy and by extension financial markets. Sooner or later, the Fed will turn dovish in the face of persistent market declines. It’s a feature, not a bug, of policy. Don’t complain when the Fed responds to market pressures, and don’t bet that they won’t indefinitely. Bet instead against pessimism. There is a reason to follow the old maxim of “Don’t fight the Fed.”

To contact the author of this story: Tim Duy at duy@uoregon.edu

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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