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02 02 2016 | by Victor Xing | Central Banks

FOMC’s maximum employment mandate and equity valuation

The Federal Reserve’s pursuit of maximum employment may impact equity prices both positively and negatively, but in practice it has been largely positive.

Federal Reserve’s monetary policy transmission mechanism

Equity valuation is part of the Federal Reserve’s monetary transmission mechanism.  Prior to joining the New York Fed, Goldman Sachs Chief Economist William C. Dudley and Jan Hatzius (who is the bank’s current Chief Economist) created the GS Financial Conditions Index, which has the following components:

  • Short-term bond yield (short-term funding cost)
  • Long-term corporate yield (sum of the 10-year swap rate and 10-year credit default swap spread)
  • Exchange rate (dollar valuation)
  • Stock market variable

President Dudley’s views carry significant weight within the FOMC, which elevates the importance of GS FCI as well as the connection between monetary policy and equity valuation.

Monetary policy transmission mechanism at work

In pursuit of its maximum employment mandate, the FED seeks to use its interest rates (and later unconventional) policies to foster accommodative financial conditions, i.e. affect current state of financial variables (including stock valuation) that influence economic behavior, which in-turn affect the future state of the economy.  The below charts show the following:

  • U3 unemployment rate
  • NAIRU, or commonly known as the “moving goal post” of maximum employment
  • Consumer Price Index (CPI)
  • Effective federal funds rate
  • S&P 500 cumulative price returns
Federal Reserve's maximum employment mandate vs. equity prices
Source: Federal Reserve, authors’ calculations
Federal Reserve's maximum employment mandate vs. equity prices
Source: Federal Reserve, authors’ calculations

The charts contain the following narrative, and it is worth noting that Federal Reserve’s dual mandate was officially codified in the Humphrey–Hawkins Full Employment Act in 1978 – prior to the act, the Federal Reserve was focused on full employment:

  • During run-up to the Great Inflation (1965 – 1982), policymakers allowed inflation to rise in their pursuit toward full employment. Equity returns steadily rose during this period of loose financial condition
  • In the late 60s and early 70s, the Federal reserve raised rates to fight rising inflation, which resulted in the recession that began in late 1969 and ended in late 1970. Equity returns initially declined following the rate hike but was able to recover as FED lowered rates amid rising unemployment
  • Following the end of Bretton Woods System in 1971, inflation again spiked following the 1973 oil crisis, and Federal Reserve’s reaction to hike rates again tightened financial conditions.  Economic growth slowed, equity market sold off, and inflation eventually cooled.  The Federal Reserve later proceeded to lower rates, but unemployment only inched down, and equity market recovered some of the losses by 1976
  • Stagflation worsened in the following years.  The old assumption of “stable trade-off” between inflation and unemployment proved to be anything but (as Milton Friedman had predicted), and by mid 1980s, inflation was over 12%, and unemployment was above 7.5%.  Equity market was again weighed down by higher rates and a slowing economy, before recovering as FED Chair Paul Volcker concluded his crusade against high inflation and began to lower rates
  • Federal Reserve’s quick response following the dotcom bubble burst (and the 9/11 shock that followed) was implemented specifically against rising unemployment, and the rate cuts that followed helped fuel the equity rally and financial condition loosening that defied FED Chair Greenspan’s effort to deflate the housing bubble
  • Following the 2008 financial crisis, the Federal Reserve’s focus on labor market conditions played a large role in the formulation of unconventional policies, and in doing so, investors were induced to take risk and participate in the equity market

From the above case studies, one can draw conclusion that the Federal Reserve’s pursuit of maximum employment have often contributed to the rise in risk asset valuation (an intended effect of easing financial conditions), and such policy would only be reversed during times of acute (or perceived) inflation risk.

Next article02 01 2016 | by Victor Xing | Economics

December PCE and the curious case of durable goods