Ditto
Fed Chair Powell reiterates hawkish Jackson Hole message.
Published September 23 2022
Bottom line
The Federal Reserve voted unanimously on Wednesday to lift interest rates by an outsized 75 basis points for the third consecutive policy-setting meeting, signaling that the central bank was not yet done in its battle to contain and reverse the worst inflation in the U.S. economy in four decades. Chair Jerome Powell could have saved everyone a lot of time and trouble this week by simply stepping to the podium and uttering a single word, “Ditto.” There were negligible changes in Wednesday’s FOMC statement, compared with the Fed’s last meeting on July 27, and Powell reiterated the uber-hawkish tone he took during his short but impactful Jackson Hole keynote speech late last month. Until the recent June meeting, the Fed had not raised interest rates by 75 basis points in one meeting since 1994. With the fed funds target range now at 3-3.25%, up from 0-0.25% six months ago, the Fed has raised interest rates at its most rapid pace since Fed Chair Paul Volker in the 1980s.
Higher, quicker & longer With this week’s new quarterly Summary of Economic Projections, Fed officials now expect to see the median fed funds rate at between 4.25% and 4.5% by year-end 2022. This implies another 75-basis point rate hike on November 2 and a half-point hike on December 14. The so-called dot plot now expects rates to rise further to a median of 4.5% to 4.75% in 2023, which implies another first-quarter hike, with no rate cuts expected before 2024.
Phillips Curve trade-off It appears that the Fed has finally found religion regarding its dual mandate. We expect the central bank to aggressively manage its Phillips Curve trade-off between unemployment (which is now sitting at 3.7% in August, just off a half-century low of 3.5% in July) and inflation (nominal CPI was at 8.3% in August, just under its 41-year high of 9.1% in June). To get inflation to fall to its 2% target over time, the Fed recognizes economic growth will decelerate to 0.2% this year and unemployment will rise to 4.4% next year, according to the latest Fed forecasts.
While the Fed’s projected increase in unemployment over the next 12-18 months may prove optimistic, our research friends at Evercore ISI point out that such an increase over the course of history has an unblemished record of sparking recession. To that point, the rate of unemployment for unskilled labor (those 25 years of age and older with less than a high school diploma) has already surged from 4.3% in February 2022 to 6.2% in August 2022.
Are financial markets forecasting a recession? 2-year Treasury yields have soared from 2.87% in early August to 4.2% today, while benchmark 10-year Treasury yields have surged from 2.6% at the beginning to August to 3.7% today. According to Piper Sandler, this 50-basis point yield-curve inversion is the largest since 1981, when the economy fell into recession.
After a sharp 25% correction in the first half of this year, the S&P 500 rallied by 19% from June 17 to August 16, as investors were expecting inflation to soon plunge and the Fed to begin cutting rates in short order. But persistently hot inflation and the Fed’s hawkish tone has dissuaded investors of that fantasy, and the S&P has corrected by more than 15% over the past month, nearly retracing all of its summer gains back to the mid-June lows.
Long and variable lags Using monetary policy to adjust the economy is not like flipping a light switch on and off. It’s much more akin to turning a battleship in the ocean, with 12-18 months needed for the full effect of an interest-rate change.
Working at cross purposes According to Sen. Elizabeth Warren, a Massachusetts Democrat, on Wednesday, “Chair Powell just announced another extreme interest rate hike while forecasting higher unemployment. I’ve been warning that Chair Powell’s Fed would throw millions of Americans out of work— and I fear he’s already on the path to doing so.”
The reality is that while the Federal Reserve is attempting to cool the worst inflation in 40 years by throwing cold water on it, Congress is simultaneously tossing gasoline on the same inflationary bonfire through stimulative fiscal policy. So we can expect inflation and economic growth to slow over the course of the next year, as the Fed continues to rip a page from Chair Volker’s playbook. But the Fed must remain vigilant and aggressive, to counter Washington’s fiscal stimulus, which is fanning the inflationary flames.
The Fed is horrified, we’re sure, by last week’s 24% wage increase the railway workers received over five years. Every labor union in America will be lining up hat in hand, demanding the same deal or better. That was exactly the wage-cycle expectations that Chair Volker was trying to control when he broke the back of inflation during the Jimmy Carter era.
To that point, the New York Federal Reserve Bank released a study in August which concluded that 60% of today’s inflation is explained by “expansionary fiscal policy” related to the $1.9 trillion American Rescue Plan (signed into law in March 2021). Nominal CPI was a benign 1.4% when President Biden took office in January 2021. In addition, last month’s Inflation Reduction Act will, ironically, increase inflation, and President Biden’s proposed $1 trillion student loan debt bailout will likely fuel more inflation, if it successfully passes legal hurdles.