The Federal Reserve finds itself in a complicated position due to decades of questionable practices. Their extreme market interventions have set the stage for a potential economic downturn.
Key indicators such as price inflation, unemployment, interest rates, and stock market valuations are currently misaligned, making the anticipated “Powell put” difficult to realize in the near future.
Inflation is soaring at a level not seen in 40 years, with the unemployment rate resting at 3.8 percent, close to its historical low. The yield on the 10-Year Treasury note stands at 2.15 percent. While this essential interest rate is climbing, it remains near historic lows.
Despite recent volatility and widespread concern, the S&P 500 has only decreased modestly. As of market close on Thursday, March 17, it stood at 4,411, just 7.83 percent down from its record high of 4,786 reached on January 3, implying it could still slide another 12.17 percent before entering bear market territory.
Furthermore, the current ratio of total market capitalization to GDP is approximately 185 percent, which many experts consider significantly overvalued.
It is our view that the S&P 500 has further to decline in 2022. Given the current landscape of price inflation, unemployment rates, and interest scenarios, the predictability of the Powell put seen in the last 35 years is likely to change.
A drop of 50 percent in the S&P 500 and an increase in unemployment to over 10 percent may be prerequisites for the Fed to intervene on Wall Street again. Additionally, significantly higher interest rates will be required to combat rampant consumer price inflation.
Simply put, raising the federal funds rate by 25 basis points is insufficient. Let’s delve deeper into the matter.
Extreme Intervention
When Alan Greenspan launched the “Greenspan put” following the Black Monday crash in 1987, the financial landscape was ripe for such a coordinated action. At that time, interest rates, which had peaked in 1981, were still relatively high. The yield on the 10-Year Treasury note was around 9 percent, allowing room for declining borrowing costs.
The mechanics behind the Greenspan put are quite straightforward. When stock prices tumble by about 20 percent, the Fed steps in to lower the federal funds rate. This generally results in negative real yields and an influx of affordable credit.
This strategy produces two observable effects. First, the liquidity boost raises the threshold for how far the stock market can drop, offering a safety net. Second, the reduction in interest rates drives up bond prices, as they tend to move inversely to interest rates.
Since the late 1980s, bolstered by the Greenspan put, the Fed has effectively implemented a policy of countercyclical monetary stimulus aimed at the stock market. The approach escalated under Ben Bernanke, who introduced quantitative easing (QE) in response to the financial crisis of 2008-09. That’s when things really spiraled out of control.
QE essentially involves generating credit from thin air to provide to the Treasury, which then circulates this “money” into the economy through various spending initiatives. It can also include bailing out major banks by exchanging the Fed’s created money for hazardous securities.
In essence, for over thirty years, U.S. financial markets have been manipulated. The unintended consequences of this manipulation have permeated every sector of the economy. With both asset price inflation and consumer price inflation now rampant, any future crack in the stock market would render the execution of the Powell put impossible without exacerbating consumer price inflation.
These developments spell grim prospects for buy-and-hold investors…
What is the Strike Price of the Powell Put?
The current Consumer Price Index (CPI) stands at 7.9 percent. However, when using measurements from the 1980s, the inflation rate doubles.
This week, the Federal Open Market Committee (FOMC) raised the federal funds rate by 25 basis points and announced plans for six additional hikes this year.
Some financial media labeled this as “hawkish,” which many may find humorous. However, there’s a possibility the Fed could adopt a more serious stance and raise rates by 50 basis points at their next meeting.
Regardless, it’s a case of too little, too late. Inflation is rampant, and the Powell put is considerably weakened.
The Bank of America Global Fund Manager Survey puts the Fed’s put for the S&P 500 at 3,636. But can we trust these estimates?
It seems that some participants in the survey lack foresight. A little critical thinking reveals alternative scenarios.
For instance, what if we enter a bear market while consumer price inflation soars to 10 percent (officially)? How could the Fed provide support to Wall Street at such a time?
What if the economy contracts yet inflation escalates, pushing the misery index—unemployment plus CPI—skyward?
What would then be the strike price of the Powell put?
Such scenarios have become increasingly plausible.
In the past two years alone, approximately $6 trillion in artificially created money has been injected into the U.S. economy, primarily fueling the current wave of consumer price inflation. Contrary to President Biden’s claims, this isn’t solely due to Vladimir Putin.
The crux of the matter is clear: the Fed must control inflation before it can stabilize the stock market and stimulate economic growth. The two objectives cannot coexist.
Any strategy aimed at boosting the stock market or stimulating the economy without first addressing inflation will only serve to drive prices higher.
So, how far must the S&P 500 decline—and how much must unemployment and interest rates increase—before Powell can unleash further monetary measures?
Would a drop to 2,500 suffice? What about 2,000 or less?
In truth, it’s likely that Powell—or his successor—would resort to these measures much sooner, and the results could be dire.
Sincerely,
MN Gordon
for Economic Prism
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