The Wall Street tail wags the monetary policy dog

The Fed Chairman Jerome Powell's ill-advised testimony to the Congress early this week and the market's reaction reflects several features which characterise the Fed and Wall Street.

Despite signatures to the contrary (or atleast be less alarming), including a strong June Jobs report and a truce in the trade war with China, Mr Powell repeatedly said that the Fed was committed to preventing a slowdown in US expansion,

“Economic momentum appears to have slowed in some major foreign economies, and that weakness could affect the US economy. Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit. And there is a risk that weak inflation will be even more persistent than we currently anticipate.”

This is perhaps the most craven example of the Fed being bullied into submission by the President. It should put to rest all the talk about Fed's independence. Sad, since Powell started out with so much promise.

And, as has become typical of the markets in responding to such announcements, the yield curve dived dramatically,

Clearly, there is no reasonable explanation - theory or change in conditions - for this level of decline. It only re-affirms the unique psychology of the markets - overshoot and undershoot in response to transient news, and as the bubble inflates the magnitudes of these shifts only increases.

And, this excessive shift in turn hardens expectations and sets in motion another set of self-fulfilling dynamics. And the expectations from the next FOMC meeting end of this month naturally gets baked in. The result is that the Fed's monetary policy decision becomes a case of the dog wagging the tail. Sample the reactions from the market that highlights the shaped expectations,

“There is really no good excuse for cutting rates at all,” said David Kelly, chief global strategist at JPMorgan Asset Management. “They’re doing so to avoid a market meltdown.” Seema Shah at Principal Global Advisors said: “The Fed is cutting rates not in response to the economy, but in order to avoid a market fallout . . . The Fed put itself in a corner. We’ve had a run of stronger data which at any other time would not have led them to cut rates.”