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Don't Kid Yourself -- the Federal Reserve Isn't Done Raising Interest Rates -- Barrons.com

DOW JONES & COMPANY, INC. 7:29 AM ET 1/17/2019

In the emotional tug of war between Wall Street and the Federal Reserve, investors are winning right now.

The market has a hissy fit every time Chairman Jerome Powell says he will continue doing what the Fed has done for the past couple of years -- gradually raising the federal-funds rate and reducing its balance sheet, which ballooned to $4.5 trillion in the years after the financial crisis.

Never mind that the very same people trashed Powell's predecessors, Janet Yellen and Ben Bernanke, for keeping rates too low and engaging in three rounds of massive bond buying (aka "quantitative easing"), which kept the markets rising while the economy made a long, slow recovery from the Great Recession. Now it's "Please, please, please don't take away the punch bowl."

Related: The Size of the Fed's Balance Sheet Matters, but So Does Its Substance

We can see it in the market reactions to Powell's recent comments:

-- On Oct. 3, he threw markets into a tizzy when he said rates were "a long way from neutral at this point, probably." The Dow Jones Industrial Average, which had closed at its all-time high of 26,828 that day, shed nearly 1,800 points over the next six trading sessions.

-- In a speech before the Economic Club of New York on Nov. 28, Powell appeared to backtrack, saying the fed-funds rate was "just below" the neutral range. Traders concluded the Fed was nearly finished raising rates, and the Dow tacked on 600 points.

-- On Dec. 19, the Federal Open Market Committee raised the fed-funds range by a quarter-point (to 2.25%-2.5%) for the fourth time in 2018. It also said there would be "some further gradual increases in the target range," but suggested there would be two rate hikes in 2019, rather than the previously projected three, and softened some of its language. Still, the Santa Claus rout began, driving the Dow down another 1,800 points by Christmas Eve.

-- At a conference in Atlanta on Jan. 4, Powell said the Fed would be "patient" in weighing how its rate decisions were affecting the economy and that it would be "waiting and watching" in coming months as it made its decisions. Interpreting that as a signal the Fed would pause raising rates, investors sent the Dow soaring more than 700 points that day, continuing its post-Christmas rally.

No change in outlook

Clearly the pattern is that when Powell sounds the slightest bit "hawkish" -- meaning he believes the economy is strong enough to raise short-term rates -- Wall Street freaks out and stocks plunge. When he appears to be softening his language, stocks rally.

But I have seen no evidence he's fundamentally changed his outlook. Although he has used the same language Yellen did -- calling for "gradual" rate increases -- he's moved far more aggressively than she did. Of the nine hikes in the fed-funds rate that have taken place since Yellen's Fed started raising it in December 2015, nearly half have occurred under Powell's watch, which will have its first anniversary on Feb. 5.

Related: Why the Fed Backed Off on Interest Rates

Of course, the economy was boosted by the short-term sugar high of tax cuts for big corporations and wealthy individuals: GDP grew at a projected 3% in 2018, the highest since the 2.9% of 2015. And employment growth was a healthy 2.6 million last year, up from 2.2 million in 2017, without much sign of wage inflation.

Meanwhile, as of June, the economic recovery will be a decade old, and fed funds is still 2.25-2.5%. That's pretty paltry, considering that during the previous economic recovery, it took Alan Greenspan and Bernanke's FOMC only 2 1/2 years to raise rates from 1% to 5.25%, which was the lowest cyclical fed-funds peak since October 1966.

Now or never

I can't read Powell's mind, but he knows well that Bernanke's Fed cut rates 10 times, or five whole percentage points, to combat the financial crisis and Great Recession. It also added more than $3.5 trillion to the balance sheet. Unless Powell gets the fed-funds rate higher -- at least to the "neutral" 3% level -- he won't have much ammunition to fight the next recession. And if he doesn't reduce the balance sheet now, while the economy is strong, it might never happen.

Remember, this is the same Powell who back in 2013 urged Bernanke to announce that the Fed would stop buying securities, a move that resulted in the "taper tantrum." "The only question is, to which roof are we going to jump, across which alley? So there is no risk-free path," recently released FOMC minutes quote him as saying.

Right now, he's had to back off to avoid a much more severe market selloff that could hurt the economy. But if the economy remains strong and markets stabilize, I expect him to continue reducing the balance sheet and hiking the fed- funds rate, though maybe a bit more slowly than promised. This is a tactical retreat, not a surrender.

This article originally appeared on MarketWatch.

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