Markets won't go back to normal until the Fed stops hiking rates

New York(CNN Business) Stocks lost ground again on Monday following a turbulent week that saw market volatility at its bumpiest level since July.

These mercurial markets come as investors overreact to data in eager anticipation of the Federal Reserve's next interest rate policy decision, said Alan Blinder, former Fed Vice Chair and Princeton University economist.

Expect the swings to continue until the Fed declares "mission accomplished" in its fight to lower inflation and pivots away from its current regime, likely some time in 2023, he told me.

What's happening: Markets and the Federal Reserve have conflicting temperaments, said Blinder. Markets are capricious while the Fed remains calm. Markets and the central bank generally have the same interpretation of incoming data -- a hot employment or inflation report means more tightening is ahead -- but markets greatly exaggerate the data's magnitude, he said.

Markets on average, said Blinder, overreact to inflation-related data by a factor of three to 10 times more than they should. "That's what's going on now," he said.

Federal Reserve Chair Jerome Powell knows this, he said, and has been "very aggressive" in his attempts to signal that a pivot away from interest rate hikes won't happen anytime soon. But that doesn't mean investors will listen.

"I hope it's not another year," until markets become less volatile, said Blinder, "but it might be." Expect the whiplash to continue as long as "the Fed is raising interest rates or believed by the markets to be on the verge of raising interest rates."

We've only just begun: Investor memory is very short, said Blinder. It was only a year and a half ago that policymakers were worried about inflation being too low. "Inflation is young," he said, and we're a long way from inflation expectations becoming deeply entrenched into economic activity the way it was in the 1970s and 1980s. So while Wall Street may be shouting fire, there's no reason yet for Main Street to worry about the economic meltdowns seen the last time inflation was this elevated.

Last week's unemployment number may have been too low for investors' liking, he said, but it's important to remember how much growth has slowed since the Fed began tightening earlier this year. The US economy added 263,000 jobs in September, but that's a lot lower than the 431,000 jobs added in March 2022.

Sticking the landing: It would be a real stretch to say we're currently in a recession, said Blinder, but the chances of a recession in 2023 are better than 50%. For now, he expects the Federal Reserve to raise rates again by three-quarters of a percentage point in November.

Read more: Blinder's latest book, A Monetary and Fiscal History of the United States 1961-2021, is out today.

Truss-induced trauma continues in UK

The Bank of England is still attempting to quell the economic panic stoked by the new UK government's plan to slash taxes while boosting borrowing.

The central bank announced Monday that it would provide extra support to UK markets, beefing up its efforts to ensure financial stability, reports my colleague Julia Horowitz. The bank said that it was ready to buy up to £10 billion ($11 billion) of government bonds each day this week, double the daily limit it set when it announced its emergency intervention on Sept. 28.

It confirmed that the bond-buying program would end Friday, but said it would extend extra support "beyond the end of this week" to banks still reeling from the fallout of a meltdown in some pension funds.

But that wasn't enough, reports my colleague Mark Thompson, and the central bank was forced to act again Tuesday, saying it would extend its bond-buying program to include inflation-linked UK government debt (or index-linked gilts) after a sharp sell-off posed a "material risk to UK financial stability." 

See here: The UK government sold index-linked gilts due in 2051 at a yield of 1.55%. That's the highest yield since October 2008, according to Reuters. 

The Bank of England's moves send more signals to investors that the central bank is prepared to do whatever it takes to restore more normal trading conditions to the bond market, which is necessary to keep down borrowing costs for UK households and businesses.

The yields on long-dated government bonds, which move opposite prices, fell sharply after the Bank of England announced its initial action in late September, but they've been climbing again since.

The central bank has said that it was forced to act to prevent a "self-reinforcing spiral" after the market experienced historic selling in the wake of the budget plans revealed by Finance Minister Kwasi Kwarteng and Prime Minister Liz Truss.

Truss has since backpedaled on her plan to cut taxes for the wealthiest Brits, but the partial U-turn was not enough to stabilize markets.

The Bank of England stressed on Monday that funds have made "substantial progress" over the past week, but that it would continue to work with them to ensure the "industry operates on a more resilient basis in future."

Ben Bernanke wins the Nobel

Former Federal Reserve Chair Ben Bernanke was awarded the Nobel Memorial Prize in Economic Sciences on Monday for reshaping the way the world thinks about the relationship between big banks and financial crises.

Bernanke, alongside two other academics, won the prize for research that showed how bank failures worsen financial meltdowns and how the system can be made safer.

Bernanke presided over the Fed during the 2008 financial crisis that led to the collapse of Lehman Brothers and took other "too big to fail" banks, including JPMorgan Chase (JPM), Goldman Sachs (GS), Bank of America (BAC) and Morgan Stanley (MS), to the brink of catastrophe. Those banks were partially saved by an emergency government bailout.

Under Bernanke, the Federal Reserve implemented a policy of "stress tests" in 2009 for major US banks that test whether they are prepared to withstand a severe recession and upheaval in financial markets. The tests are used to determine whether banks can increase dividends or repurchase shares.

The research is especially relevant today as rapid interest rate hikes to combat inflation have sent markets into turmoil, drawing comparisons to 2008.

The research papers, said the Nobel Committee, "offer important insights into the beneficial role that banks play in the economy, but also into how their vulnerabilities can lead to devastating financial crises."

Bernanke and economists Douglas Diamond and Philip Dybvig will share the prize money of 10 million Swedish kronor, or $886,000.

Up next

The IMF is set to release its semi-annual world economic outlook.

Coming later this week:

▸ Third quarter earnings season begins. Expect reports from big banks like JPMorgan Chase (JPM), Wells Fargo (WFC), Citigroup (C), Morgan Stanley (MS), PNC (PNC) and US Bancorp (USB) and consumer staples like Pepsi (PEP), Walgreens (WBA) and Domino's (DMPZF). 

▸ CPI and PPI, two closely watched measures of inflation in the US are also due to be released.