Fed not gunning for stocks, but may need to for inflation to fall

WASHINGTON (Reuters) -The Federal Reserve is not targeting equity markets in its battle against inflation, but that is "one of the avenues" where the impact of tighter monetary policy will be felt, Kansas City Fed President Esther George said on Thursday.

"What we are looking for is the transmission of our policy through markets' understanding that tightening should be expected," George said in comments to CNBC, a day after weak quarterly earnings from major retailers contributed to a sell-off of stocks. "It is not aimed at the equity markets in particular, but it is one of the avenues through which tighter financial conditions would emerge."

The rout on Wednesday marked one of the worst days for U.S. stocks since the onset of the coronavirus pandemic, with major indices down 4% or more. Equity markets have been volatile since the start of the year as investors absorbed the implications of higher inflation and the rising interest rates the Fed will use to fight it.

George's comments reflect an emerging discussion over how the pain of adjusting to high inflation will be distributed across the economy, with some analysts conjecturing that the U.S. central bank will need - or want - more of a hit to household wealth through equity prices, which also influences household spending, and less of one to income and jobs.

Fed policymakers including Chair Jerome Powell have been explicit that they want to limit the impact on employment of rising interest rates.

With household and corporate balance sheets in strong shape, there's financial wherewithal to pay the bills and cope with higher credit costs - a low-leverage environment that may keep the economy growing but make it harder for the Fed to curb spending. The housing market, often a main channel for monetary policy to clamp down on the economy, also remains strong, with prices expected to continue rising even with higher mortgage rates and slower sales.

That leaves equity prices as one of the quickest and clearest paths for the Fed's impact to be felt. Economists have noted that the rising exposure of a broader range of U.S. households to stock markets, through 401k retirement savings and other investments, means likely more impact for monetary policy through that channel.

Along with changing household plans and perceptions as net worth diminishes, falling equity prices have a direct impact on consumption at a rate some economists estimate at about 2 to 3 cents on the dollar. Some $8 trillion of paper wealth has been wiped off of balance sheets so far this year.

"You could kind of read (the Fed's) approach as almost endorsing the drop in equity prices and asset prices more broadly," Jonas Goltermann of Capital Economics said on Thursday, adding that in past hiking cycles the Fed used a gradual approach to minimize the impact on financial conditions.

DIFFERENT SITUATION

When it lifted rates beginning in 2015, the Fed moved in quarter-percentage-point increments, and sometimes only once a year. The S&P 500 index rose through much of that tightening cycle, and fell only as larger concerns about global economic growth took hold.

The situation is different now. Officials in 2015 were anticipating inflation that never arrived. Current prices, based on the Fed's preferred personal consumption expenditures index measurement, are rising at more than triple the Fed's 2% target.

That has touched off what amounts to a crisis response of half-percentage-point rate increases and a pledge this week by Powell to raise rates as high as needed to bring inflation down.

To do so means slowing the economy enough to trim the "excess" demand that Fed officials feel is driving prices higher, and, in the current situation, causing companies to eliminate hiring plans that have led to record levels of job openings and wage pressures as they compete for workers.

Some tech firms have announced hiring freezes as a result of their dimmed outlooks and falling stock prices, a sign the Fed's hoped-for narrative has begun to play out.

In the best case, inflation will fall before firms reach the point of actual layoffs, but getting there still means a blow to corporate earnings - a key component of stock pricing - as companies reset sales and growth expectations.

"The sell-off in equity markets may ultimately be as important as the rise in interest rates in moderating demand," Citi economists wrote on Thursday, arguing that higher interest rates may not on their own be enough, for example, to cool the housing market.

"Some of the work of tighter financial conditions will come through the now about 18% decline in equity prices. If the objective is to reduce job openings, it is easier to see a link between equity prices, corporate sentiment and hiring plans than it is between interest rates and job openings," the Citi team wrote.

(Reporting by Howard SchneiderAdditional reporting by Ann SaphirEditing by Chizu Nomiyama and Paul Simao)

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