Friday's Market Minute: The ECB Joins The Fed In Drawing A Hard Line Against Inflation

The stock market is being hit by several crosscurrents in early September, some positive and some negative. Oil prices have fallen, which should support the notion that headline inflation may be peaking, yet the Fed is determined to tighten financial conditions to ensure inflation remains subdued. There is still good reason to be concerned about a recession. The yield curve remains inverted, GDP contracted for two consecutive quarters, and industrial metals have fallen, highlighting concerns about global demand. Despite tight supplies, the commodity markets are suggesting fears of continued economic slowdown across the globe.

Higher interest rates impact economic activity with a lagged effect, and central bankers around the globe must work in tandem to ameliorate the devastating effects of inflation. The ECB recently raised the E.U.’s main refinancing rate to 1.25%, their highest level since 2011, as inflation is becoming increasingly broad and is at risk of getting entrenched. Western central banks are raising rates as global economic growth is clearly decelerating. The only way central bank tightening can slow inflation is to negatively impact aggregate demand.

The three are a variety of uncertainties as to where the overall U.S. equity market could head into late 2022 and 2023. With energy prices falling, aggressive tightening may be a policy mistake that will drive the U.S. into a very choppy economy. Two-year treasury yields suggest the main policy rate should be closer to 3.5%. Unless the market begins to fully discount the recession, or if the Fed makes a dovish pivot, there is a possibility of the market retesting the June lows.

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