As the stock market correction drags into its third week, some analysts are looking to an unlikely ally to step in and put a stop to it: The Federal Reserve.
Of course, the Fed can’t just halt a market correction, but some traders still expect the central bank to respond to the recent turmoil in a way that could calm markets. Let’s take a look at how the Fed could do that.
The Fed’s Third Mandate
Officially, Fed policy is driven by two goals:
- Full Employment
- Moderate Inflation
These two goals are called the Fed’s “dual mandate.” Currently, the Fed thinks that unemployment of around 4% is “full” and annual inflation of about 2% is “moderate.” Both metrics are currently close to, but a little shy of, their targets.
But some economists think the Fed also has a third, secret mandate:
- Financial Stability
Financial stability means keeping asset prices—like home prices and stock prices—relatively stable, and preventing bubbles like the one that caused the 2008 financial and economic crisis.
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This third mandate is not officially part of the Fed’s job. When explaining their decisions, the Fed governors always back them up with plenty of measures of employment, inflation and economic performance, but rarely mention asset prices. (That’s why it made headlines when Janet Yellen privately said stock prices were “high” last week.)
But because the Fed’s decisions are pretty subjective—for example, they raised rates three times in 2017 even though inflation was below 2% the whole year—some Fed watchers say the governors must be taking asset prices into account when assessing the strength of the economy, even if they don’t say so explicitly.
The Fed does have a bit of a workaround that sometimes allows them to consider stock market prices when setting policy. As New York Fed President William Dudley put it this week:
“If the stock market were to go down precipitously and stay down, then that would actually feed into the economic outlook, and that would affect my view in terms of the implications for monetary policy.”
In other words, if the stock market pulls back enough that it depresses the outlook for economic growth, the Fed will respond to the change in the economic outlook, thereby responding to the stock market decline by proxy.
But not many economists think this stock market correction is big enough to derail the economy yet.
And yet, expectations of what the Fed will do next have already shifted since the correction began.
Rate Hike Expectations Fall
As the stock market fell 10% over the past two weeks, the odds that the Fed will hike rates in March (as determined by futures market bets) fell from 79% to 72%. And the odds that the Fed will hike rates four times this year (probably in March, June, September and December) have fallen to 18%, down from 24% a week ago.
Inflation, employment and economic readings haven’t really changed in the past two weeks, so the stock market correction is really the only explanation for the more dovish readings. So, either:
- futures market participants think the stock market correction is going to drag down inflation, employment or economic data in the next few weeks, or
- they think the market correction might persuade the Fed to hold off on the rate hikes for a bit.
Fed Won’t End Stock Market Correction
Either way, the odds are still on a rate hike occurring at the Fed’s March 21 meeting. And a lot of economic data will be released between now and then, including inflation data this Wednesday and February unemployment numbers at the end of the month. In other words, this correction probably won’t tell us much about how responsive the Fed is to stock market moves. And the Fed certainly won’t be the one to end it.
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