Well, so much for optimistic assurances about inflation, interest rates and recession. Federal Reserve Chairman Jerome Powell’s relatively sunny take on all three on Wednesday, after the latest Federal Open Market Committee meeting, had pleased investors. But they gave up all the market gains and then some on Thursday as the prospect of a rougher reality set in.
The Dow fell by more than 3%, and the S&P 500 by 3.56%, while the tech-heavy Nasdaq lost 5% in a single day. Shares could bounce back on Friday, but the sharp swing in prices over the last two days shows how uncertain investors are about the economy’s prospects as the Fed finally tightens monetary policy after years of essentially free credit.
The volatility isn’t surprising given the policy variables and risks. Investors are trying to judge how high the Fed will have to raise rates to break the highest inflation in 40 years. At the same time, the Fed is promising to shrink its bond portfolio, which means lifting its foot off the neck of long-bond prices. Markets are trying to make sense of a policy environment that no one has seen in four decades.
The market decline does not mean the Fed is wrong to tighten. In our view it has no choice if it wants to avoid a return to the long-term inflation woes of the 1970s.
But the economic risks are significant, notwithstanding Mr. Powell’s assurances on Wednesday that the economy is strong. Even normal monetary tightening cycles produce financial casualties as liquidity ebbs. This time around could be worse because the monetary excesses were so extreme in 2020 and 2021. The surprise will be if there are no nasty financial surprises—meaning credit failures—this year and next.
The best economic policy response would be for the White House to spur the supply side of the economy by dropping plans to raise taxes and punish business with new regulation and other harassment. It could also end the political war on fossil fuels.
But the Biden Administration seems unwilling to do any of this, so get ready for more financial and economic volatility ahead.
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