Why the Fed wants to see a strong dollar and falling stock prices

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Thursday, September 8, 2022

Today’s newsletter is by Jared Blikre, a reporter focused on the markets on Yahoo Finance. Follow him on Twitter @SPYJared.

The Nasdaq Composite (^IXIC) notched a 2.1% gain Wednesday, ending a seven-day losing stretch that had been frustrating the buy-the-dip crowd once again.

Problem is, surging stocks are the last thing the Federal Reserve wants to see.

Sudden reversals of fortune — both to the upside and downside — are common in illiquid bear markets.

But Wednesday’s rally flies in the face of a Federal Reserve doubling (or tripling) down on its steely resolve to curb runaway price inflation.

On Wednesday before the opening bell, a report from the Wall Street Journal’s top Fed whisperer Nick Timiraos caught investors’ attention, with the report suggesting another 75 basis point rate hike will be coming from the central bank later this month.

This move would mark a continuation of the Fed’s summer gambit to confront inflation by tamping down anything that stands in that fight’s way. Which in this case means tightening financial conditions.

The simple outline of tighter financial conditions is a stronger U.S. dollar, wider spreads across bond markets, and lower stock prices. Trigger-happy equity bulls should read that sentence again, as they remain, de facto, fighting the Fed.

All else equal, tighter financial conditions require investors and consumers to be more deliberate about where and how they spend and borrow.

In late August, when Fed Chair Jay Powell delivered a blunt speech in Jackson Hole, telling investors the Fed will raise rates “until the job is done” bringing inflation down, markets sold-off. Message received. Financial conditions tighter.

Minneapolis Fed president Neel Kashkari made waves last week when he acknowledged preferring this market reaction to what was seen after the Fed’s July FOMC meeting. Which was a market rally that saw the S&P 500 gain 2.6% and the Nasdaq rise more than 4%.

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“I certainly was not excited to see the stock market rallying after our last Federal Open Market Committee meeting,” Kashkari told Bloomberg in an interview.

And while the Fed does have a third “shadow mandate” of financial stability — its formal goals are stable prices, or 2% inflation, and maximum employment — there has not yet been an S&P 500 target added to the Federal Reserve’s Congressional mandate.

Still, these tighter financial conditions Fed officials are angling towards do carry some potentially significant positive impacts in the Fed’s inflation fight. A stronger dollar increases purchasing power for U.S. consumers, brings down global commodity prices, and in turn helps ease input prices. All of which is disinflationary, just what the Fed would like.

As Fed Vice Chair Lael Brainard said in a speech on Wednesday, profit margins in several industries remain elevated after last year’s boom and firms appear willing to accept lower margins as consumers respond negatively to higher prices.

And as an added bonus, the soaring greenback also puts pressure on cryptocurrencies — that perennial thorn in the side of U.S. regulators.

The Fed is also expressly content to see lower stock prices dampen the “wealth effect” of the nation’s most affluent and their attendant spending. Inasmuch as this “trickles down” to the working class, the Fed is willing to tolerate some increased misery if its broad strokes manage to stuff the inflation genie back in the bottle.

It may seem counterintuitive at best that the Fed’s dual mandate has been reduced to a Faustian bargain — balancing the need to reign in trillions in stimulus while taking a hot jobs market off the boil.

But that’s where we find ourselves in a topsy-turvy 2022.

And as Powell reminded investors last month, history remains the guide for his Federal Reserve.

“Our monetary policy deliberations and decisions build on what we have learned about inflation dynamics both from the high and volatile inflation of the 1970s and 1980s, and from the low and stable inflation of the past quarter-century,” Powell said, pointing to three lessons from history.

First: The Fed takes responsibility for inflation and pushes back at first sight. Second: Don’t let the public’s expectations get out of whack with your 2% inflation goal. Third: Keep policy tight “until the job is done.”

“These lessons are guiding us as we use our tools to bring inflation down,” Powell said.

“We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”

And we’ll watch the markets for signs we’ve reached this journey’s end.

What to Watch Today

Economic calendar

• 8:30 a.m. ET: Initial Jobless Claims, week ended September 3 (240,00 expected, 232,000 previously)

• 8:30 a.m. ET: Continuing Claims, week ended May 21 (1.435 expected, 1.438 previously)

• 3:00 p.m. ET: Consumer Credit, July ($33.0 billion expected, $40.15 previously)

Earnings

• American Outdoor Brands (AOUT), DocuSign (DOCU), FuelCell Energy (FCEL), National Beverage (FIZZ), RH (RH), Zumiez (ZUMZ)

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