Inflation Becomes The Fed’s Top Priority, Changing The Game For Wall Street

For years, the nation’s central bank has made the “maximum employment” mandate its top priority. As a result, it added liquidity into the economy to keep short-term and long-term interest rates low to stimulate aggregate demand and economic growth (monetary accommodation). Meanwhile, liquidity has been a good thing for Wall Street. It helped push the prices of financial assets like Treasury Bonds, Mortgage-Backed Securities (MBS), and equities higher.

The trouble is that the Fed cannot pursue the goal of maximum employment forever without running into supply-side constraints, which lead to higher inflation.

At times, the Fed’s full employment policy is complicated by fiscal stimulus, supply chain constraints, and geopolitical events that create shortages in the food and energy markets. They add fuel to the inflation fire, as has been the case lately. In February, the Consumer Price Index (CPI), a measure of inflation at the retail level, rose at an annual rate of 7.9%, the highest inflation has been in 40 years and well above the Fed’s target of 2%.

That’s why the nation’s central bank has been changing its priorities in recent months, making price stability rather than maximum employment its top priority. As a result, the Fed is now pursuing a restrictive policy, as evidenced by the FOMC March meeting minutes released this week.

“All participants indicated their strong commitment and determination to take the measures necessary to restore price stability,” state the minutes.

“They acknowledge the possibility of multiple 50 basis point hikes may be warranted and prepared the market for a near-term start to the balance sheet reduction without committing to the next month or two,” says Eric Merlis, managing director, global markets at Citizens.

Simply put, the Fed is getting ready to take liquidity out of the economy by applying restrictive conventional (raising short-term interest rates) and non-conventional monetary policies (raising long-term interest rates).

“The FOMC minutes were as hawkish as one would expect given the recent hawkish commentary from a range of FOMC participants, including Chair Powell and Governor Brainard,” adds R.J. Gallo, senior portfolio manager and head of the duration committee at Federated Hermes.

“The FOMC is manifestly focused on fighting inflation and using their various communications—press conferences, post meeting FOMC statements, minutes, summary of economic projections, media interviews and speeches—to repeat over and over that inflation is too high, the Fed will tighten a lot and the balance sheet will be reduced.”

Higher interest rates are changing the game on Wall Street in several ways. One, they lower equity valuations across the board, as interest rates are the discounting factors in nearly every equity valuation model. Two, higher interest rates help slow-down aggregate demand and economic growth, hitting the top line of publicly listed companies. And three, they make it harder for companies to raise capital either by issuing shares or debt, pushing companies with weak financials off the cliff.

Investors should begin paying attention to balance sheets, staying with companies with solid balance sheets that can wither away the storm ahead.