Few months ago, Jerome Powell, the Fed Chairman expressed the desire to smooth out past wild swings in the economy by fine-tuning its monetary policy.  Those are not mere words, but the Fed is already putting it into practice.  Note the statements made by the various Fed members. 

In the past, after the election, the Fed would slam the brakes to clean out the excesses.  After the Mid-term election, it would start to stimulate the economy.  Hence, the “Four-Year Cycle”.  The Fed has been tapping on the brakes instead of slamming them.  Hence, the slowing in the economy.  Many, however, are jumping to the conclusion that a recession will take place next year.

The Fed’s new goal is not easy to achieve, but if successful, the U.S. will experience a period of unparallel prosperity and the stock market will continue to climb to heights no one ever believe possible.

Despite its importance, few paid attention to Powell’s announcement.

Eoin Treacy's view

One of David’s clearest lessons is monetary policy beats most other factors most of the time. Last year I was writing about the fact that the Fed was asking for trouble by planning to reduce the size of the balance sheet and raise interest rates concurrently. They have delivered a medium-term correction in stocks the big question now is what’s next?

If the Fed wanted to iron out the cyclicality of the market it really should have started back in 2013 when the expansion was already well underway. Since then asset prices have risen much faster than wages with the result that inequality has risen and populism is rising.

One of the points Jeff Gundlach made was that $200 billion in QE or QT equated to about a 25-basis point move in the Fed Funds rate. The Fed has raised rates by 200 basis points but they have removed $400 billion from its balance sheet which is the equivalent of another 50 basis points. The projected $600 billion run-off projected for next year would equate to another 75 basis points even without interest rate hikes.

Therefore, the monetary environment is at a very important juncture right now because if the Fed persists in tightening that is gong to continue to represent a headwind against a background where confidence has already deteriorated. If they pause both levers of tightening that is likely to be a green light for continued speculation and the market could evolve into a bubble. In fact, that is usually what happens when officials thing they can banish the cyclicality of the economy.

The most likely course of action then is to pause one lever but persist with the other. That will still represent a headwind but a weaker one than is currently underway.