The Fed Is Losing Control of the Financial Markets

One takeaway from the U.S. Labor Department Dec. 12 report showing consumer price inflation moving closer to the Federal Reserve’s 2 percent target is that the central bank has scope to continue raising interest rates. Another is that keeping market rates under control is no longer within the remit, or the power, of the Fed, making for a more perilous environment for investors as the central bank seeks to bring its monetary policy closer to normal levels.

There are already signs that the Fed is losing control of the markets. Despite five rate increases this cycle, the start of balance sheet tapering, and three more rate hikes projected for 2018, financial conditions have eased in both the U.S. and globally. In addition, the dollar has weakened, stocks are soaring, volatility is low and investors show unwavering appetite for high-yield assets. Not only is there no sign of tightness, risk markets look positively euphoric, and, significantly, are moving in the opposite direction to the Fed’s actions.

One could argue this is exactly what the Fed has desired, which is an environment of reflationary stimulus amid a normalization of monetary policy. Loose financial conditions are also a sign that the Fed’s policy rate is below the neutral level that would neither stimulate nor restrict growth. Still, the conspicuous lack of market responsiveness to Fed tightening despite historically rich bond and equity valuations raises questions about the central bank’s ability to control market volatility when inflation does return. The flip-side of tolerating easier financial conditions while U.S. growth is robust is valuation distortions in markets.

In theory, market pricing reflects investor expectations about the future state of the economy. But in practice, it is hard to square a sub-2.60-percent yield on 10-year U.S. Treasuries -- up less than a quarter of a percentage point over the past year -- with the three Fed rate hikes in 2017, an economy that grew in excess of 3 percent in real gross domestic product terms in the second and third quarters of last year, and a labor market that is near full employment. Nor is it apparent that static long bond yields tally well with the robust pace of corporate earnings growth or household sector data.