Let me start with Powell, head of the Fed, and my mental model of him. Based on his words and actions, I think Powell leans towards to the hawkish side of the Fed, as:
- He was on the record in favor of hikes when Yellen was chair.
- He hiked in 2018, despite the markets going down.
- He mentioned Volcker a lot in his speeches. Less so Greenspan. (Volcker was a hawk when he led the Fed from 1979 to 1987).
Now, some people may point out that Powell blinked and reversed course in 2018, stopping the hikes after markets turned down. That’s partially correct – he did do that, but I don’t believe he did it willingly.
If you’d recall, the former president Trump was very upset about Powell hiking, and repeatedly bashed Powell in public, press conferences, Twitter, etc. He also repeated threatened (and was rumored to be exploring options) to fire Powell before Powell’s term was up. It was only after a long time of this abuse did Powell relent.
That said, from all the facts above, it seems to me that Powell is a pragmatist, a technocrat. He recognizes that low interest rates forever is not a good thing as it distorts markets, and he’s willing to let the market take a hit to restore balance.
The Federal Reserve, or commonly known as the Fed, is an institution that has only 2 official mandates – price stability and full employment.
We are currently very near full employment (though some may argue the employment rate is too high, given the labor shortages). But we have very high inflation, i.e. no price stability.
At this point, inflation is so high that the Fed cannot simply jawbone it down, neither can they just get it down with a few symbolic hikes. At the same time, it’s way too high that they can claim “mission accomplished” just by changing the trajectory of inflation (i.e. disinflation) – no, it’s too late for that. now, to restore public confidence, it seems like they’ll need to get absolute level of inflation down to some reasonable level, say 2-3%.
President Biden is the last piece of the puzzle. Recall that in 2018, when Powell wanted to hike, Trump stopped him so as to bolster the stock markets. Well, will Biden do the same if stock goes down?
First of all, Trump was an unconventional president. While Biden is not. And conventionally, presidents tend to avoid overly influencing the Fed.
Secondly, Biden is on the record as saying that he believes inflation is too high. Indeed, inflation is currently seen as the most important topic for the midterm elections later this year.
And finally, Biden has expressed that he believes the Fed will tame inflation. I’m not much of a politician-speech expert, but I think that means “Powell, you’re it! Please get inflation down!” Which is to say, Biden seems like he’s more concerned about controlling inflation, than about stock markets taking a beating or two.
Now, it seems like the 3 entities most able to control the inflation vs. stock markets balance are all leaning towards “taming inflation”. maybe they’ll be able to find a soft landing, maybe not. I honestly have no idea.
But either way, it does suggests that volatility in the market is here to stay.
For reference, historically, the trough of the S&P500 tends to occur when its P/E ratio is from 5-15, or 18, as what happened in the Dotcom bubble era.
And a P/E ratio of 5 for the S&P500 implies SPX is around 989, 15 implies 2968, and 18 implies 3561.