The beginning of the end of ultra-cheap money
U.S. equities wound up nearly unchanged on Wednesday, despite some volatile trading, after the Federal Reserve announced it would begin winding down its bloated $4.4 trillion balance sheet in October. This "quantitative tightening" will start off slowly, at just $10 billion a month before increasing every three months to a $50 billion monthly pace.
The Fed has a long way to go if it's going to return to its pre-crisis balance sheet of less than $900 billion.
In what could be considered a hawkish outcome, Fed officials also stuck to their expectation of another interest rate hike in December. In her post-announcement press conference, Fed Chair Janet Yellen admitted that the tepid behavior of inflation was puzzling, but she maintained a focus on evidence of labor market tightness -- something that historically has been a strong antecedent of "wage-push" inflation pressure, in which rising wages spark a cycle of rising inflation.
The short-term Treasury bond market is behaving in a typical manner in this environment: Interest rates are pushing up to levels not seen since 2008 (chart above) in anticipation of tighter monetary conditions and higher inflation -- which is the outlook the Fed maintains.
Other markets, however, are acting like this is a policy mistake. Or that the Fed won't be able to stick to its guns on its rate hike expectations into 2018 and 2019, with a trio of quarter-point hikes penciled in for next year. The failure of long-term Treasury bond yields to decline as one would expect is a sign of that market sentiment.
Bank stocks didn't seem to care, however, as the market's Teflon enthusiasm remains intact. It has been more than a year since investors had to suffer the ignominy of a 10 percent market correction.
The path forward for the Fed depends in large part on what inflation does. History suggests that inflation can quickly and unexpectedly manifest from a tight labor market, as it did in the 1960s. In 1964, core inflation (excluding food and energy) was running at a 1.7 percent rate and dropped to just 1.2 percent in 1965 amid a 4.5 percent unemployment rate, same as today.
But by the end of 1966, inflation was out of control and didn't fall back below 2 percent again until nearly 30 years later.
Last month's Consumer Price Index data points to a possible reacceleration in prices: The year-over-year rate increased to 1.9 percent, thanks largely to a surge in housing costs. Fed officials expect this upward momentum to continue even as economic growth slows as the cost of borrowing goes up.