Fed must ‘inflict more losses’ on stock-market investors to tame inflation, says former central banker

There are myriad uncertainties the Fed must navigate, he acknowledged, including the effect of easing supply-chain disruptions and a historically tight labor market. But the effects of the Fed’s tightening of monetary policy on financial conditions — and the effect that tightening will have on economic activity — is one of the biggest unknowns, Dudley wrote.

Unlike many other economies, the US doesn’t respond directly to changes in short-term interest rates, Dudley said, partly because most US home buyers have long-term, fixed-rate mortgages. But many US households, also in contrast to other countries, have a significant amount of their wealth in equities, which makes them sensitive to financial conditions.

Dudley’s call for the Fed to inflict losses on investors stands in contrast to the longstanding notion of a figurative Fed put, the idea that the central bank would halt monetary tightening or otherwise ride to the rescue in the event of heavy losses in financial markets. Dudley, who ran the New York Fed from 2009 to 2018, was previously chief US economist at Goldman Sachs and is now a senior research scholar at Princeton University’s Center for Economic Policy Studies.

Read: Why the stock market could be in for a ‘rough ride’ as Fed prepares to shrink balance sheet

Investors have talked of a figurative Fed put since at least the October 1987 stock-market crash prompted the Alan Greenspan-led central bank to lower interest rates. An actual put option is a financial derivative that gives the holder the right but not the obligation to sell the underlying asset at a set level, known as the strike price, serving as an insurance policy against a market decline.

Stocks have lost ground in 2022, partly in reaction to the Fed’s signals that it is prepared to be aggressive in raising interest rates and shrinking its balance sheet to get inflation under control. But losses remain modest, with the S&P 500 SPX,
-0.94%
less than 6% away from its Jan. 3 record close as of Tuesday’s finish. The large-cap benchmark is down more than 6% for the year to date, while the Dow Jones Industrial Average DJIA,
-0.49%
is down more than 5% and the Nasdaq Composite COMP,
-1.93%,
made up of more rate-sensitive tech and growth stocks, has failed more than 11%.

The pain has been more intense in the bond market. Treasury yields, which move the opposite direction of prices, have soared, albeit from historically low levels. First-quarter losses in the bond market were the worst in a quarter century.

Still, the 10-year Treasury yield TMUBMUSD10Y,
2,594%
above 2.5% remains up around just 0.75 percentage point from a year ago and remains well below the inflation rate, Dudley said. That’s because investors expect higher short-term rates to undermine economic growth and force the Fed to reverse course in 2024 and 2025, he said — “but these very expectations are preventing the tightening of financial conditions that would make such an outcome more likely.”

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Investors should listen to Fed Chair Jerome Powell, Dudley said, who has clearly stated that financial conditions must tighten.

“If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock the market to achieve the desired response,” Dudley said. That would mean hiking rates much higher than market participants currently anticipate because the Fed, “one way or another, to get inflation under control…will need to push bond yields higher and stock prices lower.”