Federal Reserve Chair Jerome Powell delivered a speech at Jackson Hole, Wyoming on Friday. His words were more hawkish than expected, causing the S&P 500 to dip by around 4%.
In this discussion, I will outline the key takeaways from his speech, which has rocked markets and the psychology of investors.
Inflation is still too high
Powell reiterated the overall goal of the Fed, which is to bring the rampant inflation back down to the 2% target rate.
“Price Stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy doesn’t work for anyone," he said. “Without price stability we will not achieve a sustained period of strong labor market conditions.”
He highlighted that the high inflation currently being experienced is a global phenomenon and not just in the U.S. He also believes it is a result of “strong demand and constrained supply," which is really a positive type of inflation in my eyes.
"The burdens of high inflation fall heaviest on those least able to bear them," Powell said.
High inflation increases input costs for businesses (such as energy, labor and capital) and thus eats away at company earnings. High inflation also affects households as higher energy and food prices means people have less spare cash and are less likely to splash out on discretionary purchases.
Interest rates expected to rise
The central bank leader went on to note that higher interest rates and softer labor market conditions will bring down inflation. This is likely to "bring some pain to households and businesses," but Powell reiterated that failure to get inflation under control would result in "greater pain."
"Restoring price stability will take sometime and requires using our tools forcefully to bring demand and supply into better balance," he said. "Reducing inflation is likely to require a sustained period of below-trend growth."
The U.S economy is slowing from the historically high growth rates of 2021, which reflected the reopening of the economy following the pandemic recession. The “latest economic data is mixed,” but Powell in an upbeat tone stated the “economy continues to show strong underlying momentum.”
He also noted that the "labor market is particularly strong, but also out of balance as the demand for workers is exceeding the supply of available workers."
"Inflation is running well above 2%, the lower inflation numbers in July are a welcome improvement but this still falls far short of what the committee will need to see before we are confident that inflation is moving down," he said.
In this case, Powell is referring to the 8.5% inflation rate for July, which was below the 9.1% rate in June but again still vastly above the 2% target. This is a positive sign, but more data points will be required to identify a trend.
Source: tradingeconomics.com
At the last meeting in July, the committee raised the target range for the federal funds rate to 2.25% to 2.5%. The rate is the overnight borrowing rate banks charge each other to meet their regulatory capital requirements. This figure impacts interest rates, but despite a common misconception, the Fed does not control interest rates directly, only the federal funds rate.
"With inflation running far above 2% and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause," Powell said.
A worrying sign for markets is when he paraphrased a past meeting, where he stated another “unusually large increase could be appropriate at our next meeting." The good news is the decision of a large interest rate hike is not finalized yet and will depend upon the "totality of the incoming data."
How long will high interest rates last?
“Restoring Price stability will likely take a restrictive policy stance for some time," Powell said. "The historical records caution strongly against prematurely loosening policy."
Committee predictions show the federal runds rate running slightly below 4% through 2023. This means there is a lot more pain to come and a sharp increase is expected from the 2.25% and 2.5% figure currently, hence the market sell-off.
Lessons from history
In the words of billionaire investor Howard Marks (Trades, Portfolio), “History doesn’t repeat, but it does tend to rhyme."
As a result, analyzing past high inflation scenarios such as that in the 1970s can help us to judge future policy. However, it should be noted the rampant inflation at that time was caused by the Arab Oil Embargo and a few other factors. But today, the U.S. is one of the largest oil suppliers thanks to advanced technologies and techniques that make the supply and demand balance very different.
In addition, Powell emphasized that "central banks can and should take responsibility for delivering low and stable inflation."
He also noted that former Fed Chairman Ben Bernanke was questioned on his role in taming inflation after the Fed’s intervention during the financial crisis of 2008.
Expected inflation
The second lesson from history is that high expected inflation can cause a self-fulfilling prophecy. For instance, if businesses think input costs are going to rise, they may raise prices beforehand, but then this does actually cause inflation. Other businesses may also decide to bulk buy certain products in advance in order to lock in the lower prices before they are expected to rise. This extra buying activity can cause a demand surge and thus higher inflation.
The good news is there is not too much of this self-causing inflation just yet. According to Powell, the "expected inflation" consensus seems well "anchored" currently, which is "broadly true from surveys of households, businesses and forecasters."
But Powell does warn against complacency since “expectations of high and volatile inflation” can cause problems. As inflation ran rampant in the 1970s, the expectations of high inflation became entrenched in economic policy and this "belief of high inflation was built into wage and price decisions."
Quoting former Fed Chairman Paul Volcker in 1979, “Inflation feeds on itself, so part of the job of returning to a more productive economy is to break the grip of inflation expectations.”
“If the public expects inflation to remain low over time then in the absence of major shocks it likely will," he said.
The Fed believes that acting fast and hard now is a better strategy for the long term. Short-term pain is expected (especially for markets), but longer term this will mean less pain overall.
What does this mean for investors?
In the words of Warren Buffett (Trades, Portfolio), “Inflation swindles everybody.” But to get inflation under control, interest rates need to rise. This will increase the debt servicing costs for floating loans and mortgages, squeezing both households and businesses. In addition, higher interest rates increase the discount rate when valuing stocks (especially growth stocks) and cause a devaluation in them (lower price-earnings ratios).
Thus, in the short term I expect the market to remain muted, with growth stocks remaining particularly low. However, the macro situation changes regularly as do inflation expectations. As such, the market is already pricing in the worst-case scenario, so any changes from this would cause a sharp increase in stock prices. But if the current consensus becomes true, longer term that should also mean stocks should continue upward momentum as inflation comes under control, but that would be into 2023 onwards at least.
