The Fed shouldn’t get baited by stock traders

Federal Reserve policy makers don’t have an explicit target for US stocks or consumer borrowing costs, but they know something’s off when they see it, and there’s a chance that now is one of those times. The S&P 500 Index has rallied 17% from its June lows through August 16, and consumer credit is growing at one of the fastest paces ever — developments that seem antithetical to the Fed’s goal of curbing the worst inflation in 40 years.
The thing is, the problem isn’t uniform, and the Fed should avoid upsetting the whole apple cart. Instead of throwing out his interest rate road map, Fed Chair Jerome Powell is likely to try some deft jawboning when he speaks later this month in Jackson Hole. He just needs to convince markets that policy makers are committed to their fed funds projections and that they have no plans to cut rates in 2023.
The Fed, of course, fights inflation by raising interest rates and “tightening financial conditions,” which implies some combination of a stronger dollar, higher borrowing costs and shrinking stock portfolios. The Fed can push the short rate around all it wants, but its policy wouldn’t be terribly effective if financial markets didn’t react in turn.
The policies work in part by making it harder to finance homes and automobiles and making people who own financial assets feel a little bit poorer and less inclined to splurge on consumer goods. Many indexes track the broad concept of “financial conditions,” including one from Bloomberg that includes such factors as money market spreads, bond market spreads, the S&P 500 and the Chicago Board Options Exchange Volatility Index.
But how’s all this working out in the real economy? The Fed’s interest rate policy has rapidly cooled the housing market and helped bring the boil off automobile prices. For housing in particular, it’s hard to argue that the central bank needs to push much harder than it is at this juncture.
Housing starts are plummeting; buyers are retrenching; and the pace of home price appreciation is slowing drastically. As the newly released minutes of the July 26-27 Federal Open Market Committee meeting showed, “many participants remarked that some of the slowing, particularly in the housing sector, reflected the emerging response of aggregate demand to the tightening of financial conditions associated with the ongoing firming of monetary policy.”
Indeed, home values are declining month-over-month in about a fifth of the 100 largest metro areas, according to Zillow data. As such, the current 5.5% 30-year mortgage rate feels appropriate for the delicate task at hand: The Fed needed to douse the market without entirely scaring builders away because the country badly needs additional housing supply to set the market on a sustainable path.
If the Fed had a separate lever for housing (it doesn’t), its best play might be to leave mortgage rates be and see where the market settles. Certainly, this is no time to consider selling mortgage-backed securities from its balance sheet.
Next, consider the corporate bond market, which is in a reasonably good place itself.

—Bloomberg