Is the Federal Reserve data dependent when setting monetary policy?

is the federal reserve data dependent

This is by far the most interesting chart I have seen all year and serves as a great visual aid to the case that the Federal Reserve is not data dependent.

The chart clearly shows that the rise of the stock market since March 2009 correlates perfectly with the expansion of the Federal Reserves balance sheet. The Federal Reserve did not stimulate the economy during the last uptick in the market. The most recent jump is do to the “Trump bump.” So what are the reasons for the Trump bump? And will the Fed hike in the face of deteriorating economic conditions in the US?

Financial Reform

There are three things that the market heard in Trump’s campaign rhetoric that led to this uptick in the S&P 500. The first is Trump’s promise to roll back financial regulations that were past during and since the Clinton era. In February Trump signed an Executive order that gave the Treasury department 120 days to file a report detailing suggestions on how to move forward on financial reform. The obvious target will be to roll back Dodd-Frank legislation.

It is likely that Trump and the Republicans in Congress will not be aggressive with the attempt to roll back legislation. Instead they will propose legislation that has a decent chance of passing through Congress.

Tax Reform

The tax reform Trump proposed during his campaign pleases both the individual American worker and corporate America. Trump laid out dramatic tax cuts for the Federal income tax and the corporate income tax. Couples making under $50,000 a year would pay no income tax in his plan. And he has proposed drastic cut in the corporate rate from the current 35% all the way down to 15%.

Tax reform will not happen until 2018 instead of in the first 100 days as the markets expected.

$1 Trillion in infrastructure spending

Trump constantly lamented the state of America’s “bridges, airports and highways” during his campaign. Trump has put economic advisor Steve Cohn in charge of the project. Cohn has publicly spoken of having a “tax holiday” to repatriate the hoards of US dollars currently sitting overseas in order to help pay for the infrastructure overhaul. The markets would reflect that the tax holiday sweetens the deal.

Unfortunately the timeline on the infrastructure stimulus spending (that would also create thousands and thousands of jobs) is unclear.

It is unlikely that the “Trump bump” in the markets will continue if infrastructure spending and tax reform delayed until next year. Add to that the additional rate hikes from the Fed and the Fed talking of shrinking their balance sheet and we have the formula for a major correction in the market.

What to look for from the Fed

If both infrastructure spending and tax reform fail to work their way through Congress this year, look to see if the Fed continues with their plan to raise rates and shrink their balance sheet. My guess is that they would reverse their publicly declared course and at the very least hold rates where they are now. And if the market were to begin to correct substantially they could use the two recent rate hikes as ammunition in the form of rate cuts. Also expect the talk of shrinking their balance sheet to fall silent.

The Fed is currently staying on course with their rhetoric of rate hikes and shrinking balance sheet. They are doing it in the face of terrible economic data. The consensus on Wall Street is for no hike at the May meeting but a .25% hike at the June and September meetings.

The last week delivered a huge miss in job creation (98k to 174k expected) and another huge miss in CPI (Consumer Price Index) which was -0.2% instead of the 0% expected. If that was not enough Retail Sales also missed by 0.2% and the Atlanta Fed is predicting that first quarter GDP will clock in at .5%. That puts the US on pace for a meager 2% GDP growth for the year.

Why would the Fed raise rates while facing this environment?

The Fed could potentially be loading up on ammo now by hiking rates, so they will have room to cut later if the market begins to turn. Also by hiking rates they may think they are signaling to the markets, “nothing to see here,” and keep the “Trump bump” train going.

What is not up for debate is that the Fed is not data dependent. They are more concerned about the level of the S&P 500 than maximum employment or the rate of inflation. So if any investor wants to know what the Fed will do next he can look at the direction of the S&P and he will have his answer.

Irrefutable historical evidence that the Fed is not data dependent

It was the Martin Luther King holiday in 2009. US markets were closed on that Monday. The futures markets were signalling a bloodbath in international markets going into Monday. The Federal Reserve’s Federal Open Market Committee called an emergency meeting and cut the interest rate by 75 basis points. That is a bigger cut in a surprise meeting than they have raised rates in the last several years. This cut saved the markets and by the time US markets opened on Tuesday the panic was over.

The Fed had no idea what was causing the free fall in the markets. They simply wanted to stop it. It turns out a rouge French trader at a French bank had accumulated an enormous position and this superiors thought they could unwind the position on a US holiday with minimal effect. Had the Fed known this they would not have cut, but this story proves that their eyes are firmly fixed on the level of the US equity markets and nothing else.

Hedge fund manager of Greenlight Capitol David Einhorn explained this story well to Charlie Rose back in 2010. The whole interview is worth a watch but the story is in the last three minutes of the interview.