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Trading  | June 28, 2017

When it comes to Goldman’s reaction (function) to the Fed’s own reaction function, so to speak, it has been a love-hate, but mostly confused, relationship over the past three months.

First, back in March, Goldman’s Jan Hatzius was stunned to note that the market reaction following the Fed’s first rate hike was not the reaction the Fed wanted, when “the Fed’s 0.25% rate hike had the same effect as a 0.25% race cut” and prompted it to ask if Yellen has lost control of the market.

Two months later, in May Goldman once again wondered of the Fed has lost control of a market, where financial conditions have become progressively “easier” the higher the Fed Funds rate rose. It then added that “we find that the sensitivity of financial conditions to monetary policy shocks has been quite high recently, at least when we identify these shocks using bond market moves around FOMC meetings. This suggests that the easing of financial conditions is due to other factors.”

Well, yesterday Yellen – and Fischer and Williams – explained what one of those factors is: stocks are overvalued and remain overvalued, and scariest of all for the Fed, refuse to drop no matter what the Fed does or says (case in point, today’s ramp).

* * *

Which brings us to today, when Goldman again looks at this topic which has become quite prominent among the already skeptical investing crowd (and perhaps even at the FOMC, judging by yesterday’s comments): namely, whether the Fed has made a policy error by hiking rates into a slowing economy.

In the note titled “Is the Fed Making a Policy Error?“” this is how Goldman explains the ongoing debate:

The argument that the Fed is making a hawkish policy error has been a popular market theme since the June FOMC meeting. Many investors point in particular to the downward drift in the 10-year Treasury rate as evidence that the Fed is tightening monetary policy more than the economy can handle.

Here Goldman responds with two counter arguments: “the thesis that the Fed has made a policy error would seem to imply two
claims: that the Fed’s hawkish stance has led to excessive tightening in
financial conditions, and that this in turn has caused the economy to
slow more than intended. Neither of these has happened.

Looking at economic activity, Goldman claims that “activity growth and job creation remain solidly above trend, as shown in Exhibit 2, with our current activity indicator still well above our 1.75% estimate of potential GDP growth and monthly payroll growth solidly above our 85k estimate of the “breakeven” rate.”

To be sure, even Goldman admits that the bond market may be discounting the future, where stocks are so broken they no longer have any clue (this is the thesis laid out by Citi’s Matt King). As Goldman adds, “of course, financial conditions play two roles: they influence the economy’s growth trajectory and also offer signals about it. Some might worry that the 10-year rate is pointing to a slowdown that has yet to emerge in the data—the second role. But with few signs of recession risk, it is not surprising that Fed officials have instead seen the first role as more relevant, with NY Fed President Dudley concluding on Monday that “when financial conditions ease—as has been the case recently—this can provide additional impetus for the decision to continue to remove monetary policy accommodation.

Which brings us to the next, far greater, point, one which we have made repeatedly over the past few months: if accusing the Fed of having made a policy error, the error is not that the Fed has tightened, it is that it hasn’t tightened as much. To wit:

Since the Fed moved to a quarterly pace of tightening last December, our financial conditions index (FCI) has eased meaningfully, as shown in Exhibit 1. While the June FOMC meeting delivered a hawkish surprise, the market impact of the meeting was modest and the FCI remains little changed since.

Goldman’s conclusion: “So far, the Fed’s efforts to tighten financial conditions have achieved too little, not too much.

And there it is: the Fed’s error, if one wants to call it that, is that contrary to the market’s expectations of a much shallower rate hike slope, Yellen is hiking much less than she should. And, judging by the Fed’s comments yesterday, the Fed is now aware of its error. The only question is: when will the market do the same.

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