Daily Brief - Fed worries rile the stock market (Nov 2, 2021)

It’s almost here! The day investors have long worried about is looming. On Wednesday, Fed officials are expected to begin withdrawing easy monetary policy launched in response to the pandemic.

The Fed has long passed the point where it dared to surprise investors. Momentous decisions now get telegraphed so far in advance they cause barely a ripple in the market by the time they are actually announced. That, in modern central banking, is the benchmark of successful communication with investors.

To wit, everyone and their mother (or father) is now expecting the announcement of a $15 billion reduction in monthly Treasury and mortgage-backed securities purchases that will go into effect this month. Tapering the measure at that pace means completion of the program by July 2022.

So, why are stocks acting all mopey?

There is a niggling question of the transitory inflation that stock investors are worried about. Up to this point, Chair Powell and Co. have confidently - externally, at least - held the view that rising prices are the result of uneven reopenings and therefore temporary. Abandoning that view could rattle investors (and, gosh, that’s just not done anymore …) and unhinge the front-end Fed-sensitive rates.

The problem is, the argument increasingly looks like the “emperor has no clothes” type situation. “Transitory” with respect to rising energy costs has been fully embraced by the establishment over the years (to the point that energy is now politely ignored in the “core” edition of the Consumer Price index”). This time, however, employment costs are surging, too.

Witness the much bigger-than-expected surge in the third quarter ECI (Employment Cost index). It marked the fastest pace of increase since the inception of the series 39 years ago. Labor costs are the largest business expense by far, and are therefore more difficult to absorb rather than pass onto the consumers.

Against this backdrop, investors are already betting that the Fed will raise rates sooner than the central bank has communicated. If the Fed drops the “transitory” language this week, investors who bought the story will get rattled and might sell their stocks. If instead the Fed opts for “it’s my story and I am sticking to it”, those who have doubted it all along might sell their stocks on the assumption that the Fed is blind, and will have to play catch up.

In summary, damned if they do, damned if they don’t.