The Federal Reserve’s dual mandates, approved by Congress, are price stability and maximum sustainable jobs. These goals are intended to dictate monetary policy and the Fed’s longer-term goals and strategies. Recent experience, however, asserts that preventing financial and market instability trumps congressional decree.
The illustration below of the Federal Reserve Bank of Chicago helps visualize its mandates. The “Dual Mandate Bullseye” puts forward its objectives of an underlying inflation rate of 2% and an unemployment rate of 4.1%.
The Fed is currently way off the mark. As we share below, it sits about 4% above the Fed’s target, and about 0.5% below its target.
Fed Dual Mandate Update
To deal with soaring inflation, the Fed is taking aggressive action that could increase unemployment and slow the economy, but hopefully reduce inflation.
Higher interest rates and balance sheet reduction (QT) are not good for stock prices. Investors need to consider the pain the Fed is willing to inflict on stock prices to hit their target. Moreover, besides significantly lower inflation or a surge in the unemployment rate, what could allow the Fed to deviate from its objectives and save stock prices?
We present the third self-imposed objective of the Fed, the prevention of financial and market instability.
History of the third objective
As the “bankers bankthe Fed has made clear through its actions that monetary policy will also be used to maintain financial and market stability and protect the financial sector. Financial and market stability encompasses the proper functioning of capital markets. Many times in the past, when financial markets became illiquid and stressed, or even when instability seemed imminent, the Fed came to the rescue with liquidity.
Just look back to 2019. In August 2019, the Fed lowered the fed funds rate, restarted QE, and offered liquidity to institutional investors through repo transactions.
Then, the unemployment rate was 3.7%, 0.4% below its target. , the Fed’s preferred inflation measure, was 1.85%, 0.15% below its target. The Fed relieved. Given their mandates, the Fed should have tightened monetary policy.
Rather than forcing some investors to deleverage, which could destabilize markets, they provided liquidity. The Fed has thrown its Congress-mandated targets out the window. Instead, the protection of large investors and the prevention of financial and market instability prevailed.
The Fed Put Option
Over time, financial instability has become the Fed’s key call to action. In the minds of many investors, financial instability is not only about helping financial institutions in need, but also about stopping falling stock prices. Such a Fed reaction is often referred to as a Fed Put.
The influence of the Fed, directly, indirectly and in the mindset of investors, has increasingly resulted in a positive correlation between returns and Fed policy. When monetary policy is accommodative, stock prices and valuations tend to rise. Conversely, when the Fed tightens policy, stocks tend to show weakness.
With a very hawkish Fed pushing interest rates higher and embarking on an aggressive QT program, the Fed’s third target may be investors’ only hope that the Fed will stop the market’s hemorrhage.
Federal funds and leverage
The Fed chart below shows that the Fed used an abnormally low federal funds rate to help fuel debt-led growth. Fed Funds should trade at or above the rate of inflation. When fed funds are below the rate of inflation, as it has been for the past 20 years, it implies that the Fed is pushing rates below what economic conditions and a free market would warrant.
Financial instability increases as the real Fed Funds rate becomes positive. The reason for this is that too much financial/speculative leverage relies on low rates. As rates rise, liquidity fades and leverage must be reduced. Consider the brief period when real fed funds were positive in 2019 and the “financial instabilitywhich ensued. 2006 and 2007 is another example.
The Fed isn’t just interested in fed funds or Treasury yields as a measure of stability. They are also concerned about corporate borrowing rates. In particular, the spread between corporate borrowing rates and Treasury yields. The wider the spread, the more illiquid the market conditions for corporate debt. Illiquid market conditions can lead to bankruptcy, as we saw in 2008.
Corporate and Bank Yield Spreads
Below, we share some popular bond market metrics to gauge where corporate and bank bond yield spreads stand today relative to historical spreads.
The chart below shows that the spreads between BBB and B-rated corporate bond yields relative to Treasury bill yields of the same maturity are high. However, the current spreads pale in comparison to those seen in 2008 and other liquidity events. While corporate bond market spreads can widen rapidly, these sectors do not have financial stability issues today.
The TED spread or the Treasury Eurodollar spread measures the cost of borrowing in dollars for foreign banks relative to Treasury yields. Similar to the analysis of corporate bond yield spreads, widening spreads can be a precursor to potential liquidity issues.
As shown below, the spread recently reached its highest level since the financial crisis. Since then, it has tightened. Like many other measures of financial stability, the TED spread is above normal but not close to worrying levels.
Stock volatility
The Fed Put is the market’s way of telling the Fed to support the market if it falls enough. “Enough” is often considered a loss of between 10 and 20%.
In , we state:
More importantly, volatility is not just a mathematical calculation. Volatility measures liquidity! And liquidity defines risk.
In illiquid markets, price fluctuations tend to be extreme and often lead to financial instability. Accordingly, we compare current levels of implied and realized volatility to historical readings.
Realized, or historical, volatility is retrospective. It is a statistical measure of the price movement of an asset over a previous period.
Implied volatility is derived from option prices. It gauges what investors think the volatility will be in the future.
The chart below shows that annual and implied volatility is high but well below the levels seen during the financial crisis and the early days of the pandemic. Currently, both levels are only an extended standard deviation from their standards. A variation of three or more standard deviations would probably be destabilizing.
Summary
We can measure financial stability in several ways. The most popular ones we highlight show that financial instability is not a current problem.
However, like summer storms, financial instability can appear quickly and cause significant damage. We hear that there are liquidity issues in the short-term mortgage and treasury markets. So, while traditional measures of volatility are not alarming, we need to remain vigilant as liquidity problems spread rapidly.
It is crucial to keep in mind that the threshold for a Fed “instability” U-turn is much higher than in the past. Given the stubbornness of the recent inflation spurt, the economic damage it is inflicting on much of the population, and mounting political pressures, the Fed will not be able to react quickly to premonitions of financial instability. . Unless inflation comes down quickly, it will tolerate above-normal volatility. This can likely lead to higher credit spreads and lower stock prices.
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