If it’s clear that the Fed is in full-on inflation-fighting mode, it’s equally clear that markets have not always been quick to believe and act with that fact in mind.
During the third quarter, for instance, the S&P 500 Index rallied roughly 13% from mid-July through mid-August partly because of some investors’ expectations that inflation may have peaked and that the Fed would be in a position to start cutting interest rates in 2023. However, it soon became clear to investors that inflation was still far too high—the Consumer Price Index rose 8.3% in August (year-over-year), down marginally from 8.5% in July—and that the Fed was not entertaining the idea of rate cuts anytime soon.
The S&P 500 responded by plummeting nearly 17% from mid-August through September.
It’s not difficult to understand why the market and the Fed weren’t always on the same page. The current high inflation and rising interest rate environment is strange and unfamiliar to both investors and policymakers. As seen in Exhibit 1, inflation as measured by the Fed’s preferred gauge, Core Personal Consumption Expenditures (PCE) has been benign for nearly the past 25 years—averaging just 1.7% annually from 1995 through 2019 and rising above 2% just about one-quarter of the time during that period. Many investors have never experienced a spike such as the one we’re currently seeing.
For much of this time, the Fed could effectively ignore inflation safely and instead focus on supporting the labor market and overall growth. That’s exactly what it did when it cut interest rates following the 2008 global financial crisis, and later left rates at historically low levels (2016) or cut them further to help shore up growth (2019). As Chairman Powell stated back in 2020: “A robust job market can be sustained without causing an unwelcome increase in inflation”—a very different point of view than his latest comments convey.
The upshot: Until very recently, the Fed had been operating under a decision-making framework in which rates could easily be cut to spur additional growth because inflation was essentially a non-issue. Over those many years, investors became used to buying risk assets (knowing that Fed policy was likely to stay accommodative) and leaping into the market whenever there was a downturn. Indeed, “buy the dip” became something of a mantra to many investors—an action often taken without question because it usually worked. Likewise, the market often reacted positively to bad economic news because it likely meant more accommodative monetary policy from the Fed.
Today, of course, that framework is fundamentally different—and some old models of investment decision-making are no longer as effective as they once were. Buying the dip now is likely to mean there will be another dip to buy tomorrow and another the day after that. Assets and market sectors that benefit from a low-rate environment are now facing the headwinds of higher borrowing costs, wage pressures due to a tight labor market, and demand uncertainty due to higher prices being shouldered by consumers. In addition, bad economic news is viewed as bad news that will drive the Fed to tighten its policy rather than loosen it.
Ultimately, the situation has flipped upside down—and done so in short order. That’s forcing market participants across the board to retrench and shift their thinking on the fly. One result: Implied volatility of U.S. Treasuries and equities have spiked in recent weeks, as seen in Exhibit 2.
It’s also worth noting that this is many people’s first experience managing their money in a world of stubbornly high prices and a Fed that’s aggressively raising interest rates to combat them. Pivoting to a mindset that can chart a course through this particular fog can be challenging if you haven’t done it before.