Investors sometimes get the strangest notions, and the obsession that comments by Federal Reserve Chairman Jerome Powell caused last month’s stock-market meltdown is definitely an odd one.
Yet stocks on Wednesday had their best day since March, when Mr. Powell appeared to recant, while bond yields and the dollar fell. There are good reasons to think the market might be over-interpreting two words of his that investors latched onto: that interest rates are now “just below” where they should settle in the long run.
Back on Oct. 3, Mr. Powell made a brief aside about the so-called neutral interest rate, the theoretical rate that would keep an economy at full employment ticking over with steady inflation. He scared some Fed watchers when he said that “we’re a long way from neutral, probably.”
In principle, if the Fed thinks the neutral rate is a long way above current interest rates, there might be many more rises to come to remove stimulus from the strong economy.
At the time, Mr. Powell’s words had only a small immediate impact on the markets, with already-rising 2-year bond yields adding an extra 0.02 percentage points afterward, while stock futures fell slightly.
But with the benefit of hindsight, his comment appears more important because of what might be a coincidence: The next day stocks began a 10% correction. Either way, investors have become highly sensitive to comments about the neutral rate.
The simplest interpretation of Mr. Powell’s words is that on Oct. 3 he was saying rates would rise a lot more, scaring investors (even if it took them a while to wake up to the import of the remarks). On Wednesday, he reassured by saying that rates are “just below the broad range” of estimates of neutral, so rates won’t rise much more. Stocks soared.
The informed interpretation is that, both times, Mr. Powell was merely stating the obvious, not contradicting himself. Fed policy makers estimate the neutral rate at 2.5% to 3.5%, with a median of 3%. Thus, it was true in October that current federal-funds rates of 2% to 2.25% are a “long way”—three or four more increases—from the median of 3%. It was also true on Wednesday that 2% to 2.25% is “just below”—one or two increases—the bottom of the range.
That ignores that Mr. Powell knew full well that markets were closely watching what he said. The expert interpretation, then, is that this week Mr. Powell’s “just below” was a two-word effort to talk up stocks.
This level of Kremlinology was something I’d hoped that Mr. Powell was moving away from by speaking plainly in his early comments as Fed chair. But markets are sensitive creatures, and occasionally need to be stroked. The stock fall has reminded investors that equities are risky, which should deter wild exuberance for a little while, at least. The Fed doesn’t want the fall to gather downward momentum, because a really big fall in stocks would hit confidence and the economy; a couple of well-timed words might help to avoid that.
Mr. Powell has plausible deniability that he’s talking up the market, because he merely stated the obvious. This matters, because if investors believe the Fed will intervene if markets fall—a “Powell put”—they may take on too much risk. The Fed isn’t too worried about stock prices or mainstream lending at the moment, but it doesn’t want to encourage financial instability.
Bond markets were less convinced than stocks that anything really changed. True, bond yields fell a little, and the probability baked into federal-funds futures of two or more rate rises next year, after one next month, fell from 37% to 32% Wednesday, according to CME Group. But that’s little different from where it stood last week, before stocks rebounded.
Importantly, Mr. Powell also has plausible deniability when it comes to political influence. President Trump voiced his lack of confidence in his choice of Fed chairman this week in an interview with the Washington Post, saying he’s “not even a little bit happy” with Mr. Powell and that interest rates shouldn’t be going up.
If Mr. Powell bowed to White House pressure, it would imperil Fed independence and weaken investor confidence that inflation will be kept under control. But if all he did was state what should be obvious to anyone glancing at the Fed’s own forecasts, that doesn’t make him Mr. Trump’s lackey, right?
Ultimately what will matter for interest rates is what happens to the economy. If the feeble third quarter in Europe and Asia signals trouble ahead, rates will rise by less, and might even be put on hold. If the U.S. housing-market weakness is the start of serious difficulties, ditto. But if this is just a temporary soft patch and employment and wages stay strong, expect the Fed to stick to its course and keep raising rates.
There’s little reporting of Mr. Powell’s repeated assertion that the Fed is data-dependent, but really the only way the Fed can assess whether the economy is close to neutral is whether it seems to be slowed by interest-rate rises. Watch the data, not Mr. Powell’s statements of the obvious.
Write to James Mackintosh at James.Mackintosh@wsj.com