The Fed says stock-market investors must ‘make more losses’ to control inflation

Lots to fade.

This is what William Dudley, former president of the powerful New York Fed, argued in a guest column on Bloomberg that his former colleagues would not handle the ongoing inflation at nearly 40-year highs unless investors were hurt.

There are countless uncertainties that the Fed must navigate, he acknowledged, including the impact of reducing supply-chain disruptions and the historically tight labor market. But the impact of the Fed’s austerity measures on the financial situation – and the impact that austerity will have on economic activity – is the biggest unknown, Doodley wrote.

Unlike many other economies, the United States does not respond directly to changes in short-term interest rates, Dudley said, in part because most U.S. home buyers have long-term, fixed-rate mortgages. But many U.S. families, unlike other countries, have significant amounts of their assets in equity, which makes them vulnerable to their financial situation.

Doodle’s call for the Fed to hurt investors stands in stark contrast to the long-held notion of a metaphorical Fed Put, the notion that the central bank will either impose monetary austerity measures in the event of heavy losses in financial markets or otherwise resort to rescue. Doodley, who ran the New York Fed from 2009 to 2018, was formerly the chief U.S. economist at Goldman Sachs and is now a senior research scholar at Princeton University’s Center for Economic Policy Studies.

Read: Why the stock market could be on a ‘rough ride’ as the Fed prepares to shrink balance sheets

Investors have been talking about a metaphorical Fed since at least the October 1987 stock-market crash persuaded the central bank, led by Alan Greenspan, to cut interest rates. An actual put option is a financial derivative that gives the holder the right to sell the underlying asset at a certain level but not the obligation, known as strike price, to act as an insurance policy against market collapse.

Stocks lost ground in 2022, partly in response to Fed signals that it is poised to be aggressive in raising interest rates and shrinking its balance sheet to keep inflation under control. But with the S&P 500 the losses are moderate
SPX,
-1.26%
6% off the January 3 record until Tuesday ends. Large-cap benchmarks are down more than 6% for the year to date, while the Dow Jones Industrial Average
DJIA,
-0.67%
More than 5% and Nasdaq Composite decreased
COMP,
-2.48%,
Consisting of more rate-sensitive technology and growth stocks, it fell more than 11%.

The pain has intensified in the bond market. Treasury yields, which go in the opposite direction of prices, have also risen from historically low levels. The first quarter losses in the bond market were the worst in a quarter of a century.

Still, 10 years of Treasury yields
TMUBMUSD10Y,
2.603%
The 2.5% remained close to just 0.75 percentage points from a year earlier and remained below the inflation rate, Doodley said. This is because investors expect higher short-term rates to slow economic growth and force the Fed to reverse in 2024 and 2025, he said – “but these very expectations are holding back the tightening of financial conditions that will make such results more likely.”

Need to know: Here is the first Wall Street recession call of the new inflation era

Investors should listen to Fed Chair Jerome Powell, who has made it clear that the financial situation needs to be tightened.

“If this doesn’t happen by itself (which seems unlikely), the Fed will have to push the market to get the desired response,” Doodley said. This means that hiking rates are currently much higher than market participants expect because the Fed said, “One way or another, to bring inflation under control … bond yields need to be higher and stock prices lower.”

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