How the Federal Reserve’s Attempt to Engineer a Soft Landing has Increased Volatility
Global equity indices, particularly in the US, have exhibited increased volatility as the year has progressed. This surge in volatility reflects broader uncertainties in the U.S. economy, driven by inflationary concerns, Federal Reserve policy shifts, and fluctuating labour market data.
The Dow Jones Industrial Average (DJIA) started the year on a positive note, buoyed by optimism around robust economic data, resilience in corporate earnings, and interest rate cuts. However, as inflation remained stubborn, market dynamics shifted. The Federal Open Market Committee (FOMC) held the federal funds rate in the range of 5.00-5.25% from the beginning of the year until its September meeting, refusing to bow to investor pressure in its fight to stamp out inflation. Whilst the central bank did not cut until September, members of the FOMC adopted a strategy of teasing a shift in policy in order to avoid the market losing patience. This drew increased investor attention to the bank’s policy signals, resulting in increased market volatility to remarks by Fed officials, as well as to the release of economic data.
One key aspect of this volatility stems from how the market interprets economic data, particularly related to the labour market. Throughout 2024, the narrative of “bad news is good news” played a central role in market behaviour. For example, when labour market reports, such as non-farm payrolls data, came in weaker than expected, markets often rallied. This was because weaker data was perceived by market participants as a signal that the Federal Reserve would not tighten monetary policy further, or even reverse its interest rate hikes, thereby providing relief to investors concerned about higher borrowing costs. In contrast, strong labour market data indicated a robust economy and therefore made interest rate cuts less likely, often even sparking fears of further rate increases, leading to market selloffs.
Federal Reserve officials have frequently commented on the delicate balance they aim to strike, attempting to engineer a “soft landing” where inflation is brought under control without spiking unemployment and choking off economic growth, leading to a recession. However, achieving this has been challenging, as inflationary pressures have not quite been as transitory as the Fed anticipated. This led to conflicting signals from the central bank, with some members hinting at potential pauses in rate hikes and eventual easing in policy, while others advocated for further tightening. These mixed messages from meeting-to-meeting added to the market’s unpredictability.
This unpredictability can be seen in the performance of financial markets this year, with corrections and recoveries in the DJIA becoming increasingly more pronounced as the year has progressed. This is also something that the Fed have had to balance. If financial markets run too hot, this can have the effect of increasing business and consumer optimism over the state of the economy, resulting in increased investment and spending, stoking the flames of inflation. In such instances, Fed rhetoric has been to signal that inflation has not yet been stamped out, and policy may have to remain restrictive until it is brought sufficiently under control. This in turn tempers business and consumer perceptions of the economy and can help to control price growth.
Looking ahead, the market will continue to be influenced by monetary policy and economic data as the central bank attempts to steer the economy towards a “soft landing”. Additional factors including the US presidential race, as well as the increased threat of a regional conflict in the Middle East have the potential to fuel sustained volatility through to year end.