With every financial ear listening in, and millions of pairs of eyes glued to their screens, market watchers from around the globe tuned in, as Governor Powell spoke at the first session of the Jackson Hole Economic Policy Symposium.
Naturally, high inflation has got everyone’s attention. Equally, the Fed’s accelerated front-loading of hikes has been a bit of a surprise to markets, with rates surging 225 bps in a matter of 4 meetings.
The Governor’s speech summed up in one sentence, you ask? “We must keep at it.”
That’s right. Chair Powell has firmly reiterated the Federal Reserve’s resolve to prioritize price stability and bring inflation closer to its 2% target.
This was despite plenty of mixed economic data. For instance, GDP contracted for the second quarter in a row and PMI crashed earlier in the week. However, unemployment stayed low, business sentiment improved and 1-year ahead inflation expectations were meaningfully lower.
Given the moderation in CPI and stable consumption data, some market watchers believed that Powell and Co. may choose to slow the pace of rate hikes, having already equalled the peak of the 2019 cycle.
However, it was clear that the Governor wanted to decisively quash any speculation around a “quick pivot to rate cuts.”
Labour market considerations
A crucial driver for Powell’s hawkishness was the jobs situation. Unemployment currently stands at a half-century low of 3.5%. Interest rate sensitive sectors such as housing and technology have faced the brunt of losses, while other areas have been relatively immune.
However, policymakers fear that without a return to price stability, labour market conditions are destined to deteriorate.
Powell added that the 2% target would require “sustained below trend growth” and “very likely be some softening of labour market conditions.”
If the Fed fails to act decisively, higher inflation expectations could get cemented, making the task of monetary authorities even more challenging.
Despite the hardship this would cause, “a failure to restore price stability would mean far greater pain.”
Powell conceded that in the past, “a lengthy period of very restrictive monetary policy was ultimately needed to stem high inflation,” but insisted “our aim is to avoid that outcome by acting with resolve now.”
Central bank speak
Central bank communication remains a mystery wrapped in a riddle. Gauging the pulse of the crowd, balancing this with what should be done with an allowance for what may come is a delicate balancing act. As an immensely subtle art far from being mastered, monetary authorities have accumulated battle scars far more routinely than resounding successes delivered with pinpoint precision.
The world’s foremost central bank has been struggling to maintain its sway over the markets too.
Today, was an opportunity for Powell to exorcise many of its demons including the 2019 reversal, insistence on ‘transitory’, the ill-timed Average Inflation Targeting policy and near limitless stimulus amid the pandemic.
He chose to talk tough on inflation with a view to restoring the Fed’s credibility, a central piece in conducting effective monetary policy and managing public expectations.
Despite being largely in line with expectations in spirit, the market appears to have focused on the expected hardship for homeowners and small businesses over the coming year, and Powell’s comments on imminent slowing growth. Following this, the Dow plunged more than 1000 points. Other major stock indexes also fell between 3% and 4% today
But the Fed is credible
Optimistically, one could argue that the Fed’s restrictive policy has already begun to bear fruit, with July inflation dipping to the mid-8s.
However, one better month does not a successful policy make, and the FOMC would need to see much more evidence of a continued decline in prices before even considering any easing. In addition, it usually takes at least a few quarters for monetary policy to be transmitted throughout the economy.
Citi economist Andrew Hollenhorst noted that the softer reading may merely be a reaction to cuts in the Medicare program or falling equity prices, which may prove temporary at best.
Although the Governor spoke a tough game, this narrative was largely anticipated. It is yet to be seen if the FOMC can follow through once a deeper slowdown takes hold.
According to the CME FedWatch Tool, the latest data shows that after Jay Powell’s remarks there was a 58.5% probability of a third 75-bps hike, while a 41.5% chance of a 50-bps increase.
Interestingly, CME data also shows that there is a 100% chance of rate hikes continuing without pause until the July meeting in 2023, with a staggering 95.6% probability that the FOMC will hike to the 400 – 425 bps range between December 2023 and July 2023.
In this regard, it would appear that the Fed’s messaging has been largely successful in restoring the Fed’s credibility by convincing the market of its steadfast intentions.
However, not everyone seems to be a believer in the robust portrayal of the Fed, with well-known commentators such as Peter Schiff anticipating a reversal at some point within the next few months.
Personal consumption expenditures
In its latest round of PCE data released by the Bureau of Economic Analysis earlier today, consumer spending edged 0.1% higher, although June data was revised slightly downwards.
The marginal improvement in spending was driven by external factors, specifically the end of the summer vacation driving season which likely freed up household budgets in response to easing gasoline prices.
Annual PCE rose to 6.3%, while the annual core PCE (minus food and energy), the Fed’s favoured inflation gauge, rose 4.6% YoY, easing slightly from the 4.8% recorded in June.
Monthly core PCE dropped sharply from 0.6% in June to 0.1% in the latest release.
Despite the moderation in consumption, which makes up 70% of US economic activity, Q2 GDP stayed negative. It contracted 0.6% but improved substantially over the decline of 1.6% in Q1.
Although two consecutive quarters of economic contraction is a terrible sign, it must be noted that much of the fall in output was driven by supply-side shocks that saw inventories balloon. The higher stocks compressed intermediate goods production, subtracting an estimated 1.3% from overall GDP. (Intermediate goods are not counted as a part of GDP.)
Arguably, once supply chain disruptions are resolved, inventory flow should improve considerably. However, given the persistence of bottlenecks thus far, it is to be seen how quickly these can be untangled.
The University of Michigan’s sentiment index for August was recorded at 58.2, above both preliminary estimates of 55.1 and considerably better than July data of 51.5.
Public estimates of 1-year ahead inflation were recorded at 4.8% versus 5.2% during the previous month, a welcome sign for the Fed.
Despite the improvement in outlook, Powell made it abundantly clear that this is not the time to pause rate hikes while invoking former Chairman Volcker, that the central bank must “break the grip of inflationary expectations.”
It is also worth noting that the Governor himself admitted that central bank policy is demand focused. With much of today’s inflation stemming from pandemic-era bottlenecks, and broken international supply chains, the Fed would likely need to hike rates substantially higher to bring down inflation meaningfully, with investors like Schiff feeling that the current efforts have been “wholly insufficient.”
A recent study by the Federal Reserve Bank of New York estimated that 40% of prevailing inflation was supply-led.
Yet, contrary to suggestions of Stiglitz and Baker, the overarching emphasis appears to remain on the demand side interventions and perhaps not enough on easing supply side blockages.
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