Many in the financial world listened to Federal Reserve Chair Jerome Powell’s speech in Jackson Hole on Friday for clues as to the magnitude of the central bank’s next rate hike, to be announced at its September meeting. But they have something even better.
Rather than focusing short-sightedly on the near term, the typically circumspect Fed Chair provided a succinct and poignant reflection on the role of monetary policy in the economy. He also provided a history lesson on the greater pain when a central bank loses focus on its overarching mission.
Powell took no words to describe his mission: price stability is paramount, along with maintaining the Fed’s hawkish stance until inflation returns to its 2% target.
He recognized that the other half of the Fed’s dual mandate – full employment – would likely suffer. The impact of inflation on the labor market is complicated by the current imbalance between labor supply and demand.
However, the existence of known supply-side drivers of inflation (labor shortages and ongoing supply chain dislocations) is no excuse for the Fed not to focus on price stability. The Fed will continue to use the tools at its disposal – namely raising interest rates – to dampen demand in a leverage-driven economy.
The high price of inaction
Chairman Powell introduced a necessary reminder into the conversation of why price stability is the bedrock of monetary policy. Persistent inflation makes an economy less efficient. If left unchecked, inflation can become a self-fulfilling prophecy, weighing on consumer and business confidence. In extreme cases, social unrest can also occur.
Importantly, Chairman Powell noted that the negative impact of inflation is disproportionately hitting lower-wage workers and other vulnerable cohorts. But as history has shown, the price of inaction increases with time.
The economy is taking a smaller dose of bitter medicine now than it will take a much heavier dose later, which almost inevitably leads to a recession.
Unlike last year’s virtual conclave in Jackson Hole, there was strong consensus among Fed officials at this year’s meeting, with even the dovish recognizing the need to curb generational high inflation. The Fed famously touts that it is data-driven, and the data shows there is little choice but to maintain a hawkish stance.
The current gap between the CPI, which includes food and energy, and hourly wages is 3.3%. That is, in real terms — that is, adjusted for inflation — the average American worker has taken a pay cut of that magnitude over the past year.
Annual change in US headline inflation, nominal and real wages
One measure of the severity of this inflationary spurt is the extent to which real wage growth has turned negative, and the Fed will likely need to tighten until that gap is closed.
Source: Bloomberg, Kapstream Capital
Calling the market’s bluff – or vice versa?
We believe the Fed’s work will not be complete until this gap is filled. Consequently, we have watched with some amazement as futures markets suggest that the Fed’s task will be easy.
As recently as last week, futures prices were conveying the view that the Fed would not only halt rate hikes by the second quarter of 2023, but cut rates just a few months later. Friday’s speech showed that Powell dismissed the idea of a fulcrum, citing the Fed’s mistakes in the 1970s and early 1980s. Back then, inaction only exacerbated the problem until 1980, when then-Chairman Paul Volker took the draconian step of raising the federal funds rate to 20.0%.
Number of rate hikes and policy rates by 25 basis points implied by the futures markets
Over the past month – and particularly over the past week – futures markets have backed away from their forecast that the Fed’s job of containing inflation would be complete by mid-2023.
Source: Bloomberg/Kapstream Capital
What’s the price?
Chairman Powell stressed that there will be no such turning point until inflation is tamed. The price for this could be a sustained streak of below-trend growth. We believe that the market has underestimated the task at hand. It will also take time to narrow the gap between headline inflation and wage growth.
Another important barometer will be the health of the labor market. Job growth remains strong, with the US adding an average of 486,000 new jobs per month year-to-date.
But in a services-based economy like the US, labor demand is a key variable that the Fed can seek to manage as it seeks to ease upward pressure on prices. Other factors to watch are debt-heavy corporate investment and home buying by consumers. A slowdown in these demand-side segments would also indicate that higher rates are having the desired effect.
More questions to answer
As inflation raged earlier in the year, the market and the Fed briefly agreed that interest rates must rise, and significantly so, to dampen rising prices. During this period, the focus has been on whether – or by how much – interest rates should exceed the Fed’s expected long-term neutral rate – that is, the rate that is neither inflationary nor a drag on labor markets.
Only last December did Fed officials see no need to raise rates above the neutral expectation of 2.5%. Six months later, the Fed’s June “dots” survey suggested that the federal funds rate is likely to remain well above 2.50% through 2024. Chairman Powell confirmed that view on Friday.
Unspoken – and yet to be determined – is whether the 2.50% neutral interest rate should be revisited.
In a move that’s hard to reconcile with recent developments, the March Dots survey actually saw the Fed’s median forecast for the neutral interest rate slip to 2.375%, only to revisit 2.50 in June % to be revised. Does it have to keep going up? The answer lies in the Fed’s ability to tame inflation sooner rather than later.
The inflationary forces of deglobalization are not abating, nor are the disruptions to global food and energy markets caused by Russia’s invasion of Ukraine. In the immediate vicinity, workers are likely to demand higher wages as long as real wages remain negative. All of this points to the possibility that not only could the Fed’s interest rate remain above 2.50% in the short term, but also that the central bank’s specter of neutral could rise again.
If so, markets will finally have to reconcile an era of higher nominal interest rates and ultimately higher real cost of capital as the Fed continues to look for price stability.
As evidenced by the swooning in prices of riskier assets after Chairman Powell’s speech, it will take some time to get used to a scenario in which the extraordinarily accommodative policy of the salad days is firmly over.
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