Fiscal Stimulus Bails Out The Fed

At face value, the equity market’s initial reaction to the Fed Minutes was very confusing. The Fed boosted its economic projections and said it expected “further gradual rate hikes.” Objectively, these are hawkish statements. The market rallied on signals of further hikes even though a few years ago it couldn’t handle one rate hike without falling. Stocks rallied on news they would have hated 3 years ago. This is a sign of how far the economy has come. It is strong enough to handle the rate hikes and the Fed balance sheet unwind. The market is being helped by the tax cut. The Fed said “upside risks” to economic growth exist because of the tax cuts. I think the fiscal stimulus is a Fed bailout because it is now going to be able to normalize rates without an immediate recession.

The worry is that the stimulus came too late in the cycle, but with the employment to population ratio for ages 25-54 below previous cycle peaks, we may be in a Goldilocks scenario where inflation doesn’t get out of control because of economic growth, but growth is strong enough to withstand a more hawkish Fed. Without the stimulus, the worry would be about an immediate recession in 2018 as rates rise. Worrying about the Fed raising rates too much because the economy is growing is a much better situation to be in than worrying about a potential recession especially because the Fed funds rate is low and the economy is late in the cycle.

FOMC Was Dovish: Stocks Rally

As I mentioned, I’m reviewing the initial market reactions to the Minutes, before the sentiment shifted. I’ll review why it shifted after I finish this discussion. I think investors initially were happy about the statement because even though it was hawkish, there wasn’t any action. For the fear of 5 rate hikes in 2018 to be realized, there will need to be intra meeting hikes, hikes at meetings without press conferences, or more than 1 hike per press conference meeting. This fear of an aggressively hawkish Fed appears to be misguided based on the Minutes. I had mentioned in a previous article that 2 hikes in the March meeting is possible. That would put a damper on stocks, not only because the Fed funds rate would be higher than expected, but also because investors would need to price in an uncertain Fed which can surprise the market with a hike.