Hawkish Powell roils markets
Fed Chair uses Jackson Hole keynote to reset investor expectations.
Federal Reserve Chair Jerome Powell read financial markets the riot act in his hawkish Jackson Hole, Wyo., keynote speech this morning. He attempted to dissuade investors from their misperception that inflation will experience an immaculate decline in coming months and that the Fed will soon orchestrate a dovish policy pivot from hiking interest rates now to cutting interest rates by the middle of next year. Stocks plunged more than 3% today and more than 6% over the past seven trading days.
Stocks got ahead of themselves After a sharp 25% correction in the first half of this year, the S&P 500 rallied by 19% from mid-June to mid-August as investors were expecting that Powell would deliver a dovish speech this morning. The consensus view was that the inflation had peaked earlier this summer and would fall rapidly to the Fed’s 2% target in coming months. As a result, the Fed would successfully downshift from the 75 basis-point rate hikes they had implemented in June and July, to perhaps a half-point hike in September and a pair of quarter-points rate hikes in November and December. At that point, the consensus view was that the Fed was done hiking rates, and they would then start cutting interest rates in the second quarter of next year.
Federated Hermes disagreed with this bullish consensus On Monday, our macroeconomic policy and asset allocation committees took advantage of this bear-market rally. We continued to lock in some profits by reducing our overall equity allocation again, from neutral to a 1% underweight. Within equities, we now have a 4% overweight in domestic large-cap value stocks and a 5% underweight in domestic large-cap growth stocks. We added that money to cash, which now sits at an historically high level of 10%, which is 7% over a neutral allocation.
We fully expect that stocks will retrace some or all of this recent 19% rally over the next several months, as inflation is elevated and sticky and as the Fed remains hawkish and vigilant. We continue to expect a 75 basis-point rate hike on September 21, and a pair of half-point hikes on November 2 and December 14. That would take the fed funds rate to 4% by year-end. We do not expect a data-dependent Fed to begin cutting interest rates until inflation approaches its 2% target, which could be several years—rather than a few months—into the future.
Why is Jackson Hole important? This prestigious monetary-policy symposium, which was started by the Kansas City Federal Reserve in 1978, routinely draws top central bankers from around the world to discuss important global economic issues. This year’s theme was “Reassessing Constraints on the Economy and Policy,” and the Fed chair typically delivers a high-profile keynote speech to discuss important monetary-policy thoughts. For the first time in three years due to the coronavirus pandemic, the conference was conducted in person. Powell’s speech on “Monetary Policy and Price Stability” was thought to be a Fed chair’s shortest on record at less than nine minutes long.
Dual mandate We expect the Fed to aggressively manage its Phillips Curve trade-off between unemployment (now sitting at a half-century low of 3.5%) and inflation (nominal Consumer Price Index, or CPI, was at a 41-year high at 9.1% in June). To get inflation to fall to its 2% target over time, the Fed recognizes economic growth will decelerate and unemployment will rise.
“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance,” Powell explained in his remarks. “Reducing inflation is likely to require a sustained period of below-trend growth” with “some softening of labor market conditions. While higher interest rates, slower growth and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.” Powell said that while these are the unfortunate costs of reducing inflation, “a failure to restore price stability would mean far greater pain.”
Inflation peaking this summer To be sure, nominal Personal Consumption Expenditure (PCE) index fell from a 40-year high of 6.8% in June to 6.3% in July, while core PCE has fallen from a 39-year high of 5.3% in February to 4.6% in July. Nominal CPI declined from a 41-year high of 9.1% in June to 8.5% in July, while core CPI peaked at a 40-year high of 6.5% in March and has since dropped to 5.9% in July. Core measures strip out volatile items, such as food and energy.
“While the lower inflation readings for July are welcome, a single month’s improvement falls far short of what the committee [FOMC] will need to see before we are confident that inflation is moving down,” Powell explained.
To that point, the New York Federal Reserve Bank published a study on Wednesday which calculated that 60% of today’s inflation is explained by “expansionary fiscal policy,” according to our research friends at TrendMacro. While the inflationary impact from the American Rescue Plan (signed into law in March 2021) is beginning to fade, the recent Inflation Reduction Act and this week’s proposed $600 billion student loan debt bailout likely will fuel renewed inflation in coming months and quarters.
'Those who cannot remember the past are condemned to repeat it' In his speech this morning, Powell invoked three of his Fed predecessors (Chairs Paul Volker, Alan Greenspan and Ben Bernanke) over the past half century to emphasize the importance the Fed places on getting inflation back to 2%. Powell concluded by stating that the Fed will keep raising interest rates aggressively until they are confident that the inflation dragon has been slayed.
“The historical record cautions strongly against prematurely loosening policy,” Powell warned. “We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”