No Pivot!
Hopes of a Fed pivot back to an accommodative interest rate policy were dashed after markets digested the contents of Powell’s Jackson Hole speech last week. Preceding the meeting, the S&P enjoyed a spirited rally of 17% from June lows to the August 16th high in hopes of such a pivot materializing by early next year. The forward-looking dot plot maps closely mirrored this projection. In a sign of premature exuberance, the rally appeared to be sustained around collective relief of inflation “easing” from a record 9.1% YOY increase in June to a mere 8.5% in July. Forget that even with the slightly lower July inflation reading, real interest rates were still deeply negative, as they have been all year long.
Reality aside, the cart got ahead of the horse, and Powell decided it was time to quell the optimism. He’s clearly seeing something more persistent in the inflation data than seen by market participants. Maybe it’s some combo of lingering COVID issues, dismantling of supply chains, the early stages of re-shoring, a stubbornly drawn-out Ukraine War, food and energy shortfalls, labor shortages , persistent apartment rent increases, a building wage spiral, or global inflation across all major countries punctuated by a worsening energy crisis in Europe heading into winter. Lots to choose from when thinking inflation may stick around for a bit longer than previously expected.
A notable Powell quote from the speech was “pain for households and businesses are a price to pay for bringing down inflation.” Such blunt word choice is a stunning message to the markets. The Fed knows inflation has been “painful” for consumers already, particularly for the low to middle class hammered by rising food and gas prices. But now “pain” and “price to pay” in one sentence? It’s like Powell is trying to convince us all to get on board with his game plan as a matter of loyal duty to our nation and central bank for the mess he created in the first place. With this next tightening of the vice, inflation will be taken to the shed by the Fed at a time when the economy is already showing early signs of softening (two negative quarterly readings so far this year = recession). The collision course is set with “the threat” of no Fed governor at the wheel willing to use his brakes until mission #1 is accomplished.
What will 2023 look like with the Fed Funds rate climbing, and potentially leveling off at 3.5 – 4%, while roughly $1T is sucked out of capital markets via the Fed’s $1T QT program. This could be the tightest liquidity conditions seen by markets in decades. And behind it all there’s a Fed, and future retired Fed governor, willing to battle inflation to no end, regardless of the cost to society and the economy. Is all this an attempt to regain shattered credibility and cement his legacy as the best inflation fighter seen since Paul Volcker? Or does he really see a persistent inflation threat worthy of such draconian proclamations? Or maybe now it’s clear to Powell that despite constant Fed official communication between rate set meetings, a lot more actual tightening will be needed to get us back to the Fed’s 2% inflation target? Time to roll up the sleeves and get to work, Powell.
When the word “pain” starts being thrown around in official Fed communication, I pay attention. It’s a proclamation with potentially harsh implication for policy that so far in 2022 has been wildly off the mark. And a stark departure from the consistent prior use of the “Fed put”, which the market had anticipated would be implemented this time again. That is, until Powell laid down the hammer, in what I’m guessing will be considered, in hindsight, as a monumental speech by the Fed last week at Jackson Hole.