Markets tumble following Governor Powell’s “We must keep at it” speech

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on Aug 26, 2022
Updated: Nov 29, 2022
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  • Governor Powell made the opening remarks at the much-awaited Jackson Hole symposium.
  • Powell's key objective was to restore credibility for the Fed and manage inflation expectations.
  • Consumer sentiment data showed that 1-year ahead inflation expectations had reduced to 4.8%.

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The long-awaited day has finally arrived. This morning, Governor Powell spoke at the first session of the Jackson Hole Economic Policy Forum, organized by the Kansas Fed.

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The Governor’s speech summed up in one sentence, you ask? “We must keep at it.”

That’s right. Chair Powell has firmly reiterated the Federal Reserve’s resolve to prioritize price stability and bring inflation closer to its 2% target.

Naturally, inflation has got everyone’s attention. Equally, the Fed’s accelerated front-loading of rate hikes has been a bit of a surprise to markets, with rates rising 225 bps in a matter of 4 meetings.

Since consumption data was stable in the economy, while inflation eased last month, some market watchers earlier believed that Powell and Co. may choose to slow the pace of rate hikes, having already equalled the peak of the 2019 cycle.

However, it was clear that the Governor wanted to decisively quash any speculation around a “quick pivot to rate cuts.”

Labour market

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One crucial driver for Powell’s hawkishness was the employment situation. Even though the labour market is very tight, with unemployment currently at a half-century low of 3.5%, only interest rate-sensitive sectors such as housing and technology have been significantly affected.

In the words of the Governor, achieving the goal of price stability would require “sustained below trend growth” and “very likely be some softening of labour market conditions.”

However, policymakers feared that without price stability labour market conditions are destined to keep deteriorating.

Powell re-iterated that “a failure to restore price stability would mean far greater pain.”

How much will rates rise?

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Perhaps the Fed’s restrictive policy has already begun to bear fruit, with July inflation dipping to the mid-8s.

However, one better month does not a successful policy make, and the FOMC would need to see much more evidence of a continued decline in prices before even considering any policy easing.

Citi economist Andrew Hollenhorst noted that the softer reading may merely be a reaction to cuts in the Medicare program or falling equity prices, which may prove temporary at best.

Although the Governor spoke a tough game, this narrative was largely anticipated. It is yet to be seen if the FOMC can resist the temptation to ease rate hikes once a deeper slowdown takes hold.

Powell conceded that in the past, “a lengthy period of very restrictive monetary policy was ultimately needed to stem high inflation,” but insisted that “our aim is to avoid that outcome by acting with resolve now.”

This would suggest that with a 6%+ gap between CPI and the Federal Funds Rate, the FOMC plans to continue to hike interest rates well into the future.

According to the CME FedWatch Tool, the latest data shows that after Jay Powell’s remarks there was a 58.5% probability of a third 75-bps hike, while a 41.5% chance of a 50-bps increase.

Interestingly, CME data also shows that there is a projected 100% chance of rate hikes until the July meeting in 2023, with a staggering 95.6% probability that the FOMC will hike to the 400 – 425 bps range between December 2023 and July 2023.  

This would suggest that the Fed’s messaging has been largely successful in restoring the Fed’s credibility thus far.

 Source: CME

Some analysts, such as Phill Carr of the Gold and Silver Club believe that the Fed may even be looking to surprise the market to the upside with a super-sized 1% hike.

However, not everyone buys into the robust portrayal of the Fed, with well-known commentators such as Peter Schiff anticipating a reversal at some point within the next few months. With the US being an especially credit-driven economy, hiking rates could soon prove highly unpopular, while debt servicing would also rise.

Personal consumption expenditures

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In its latest round of PCE data released by the Commerce Department earlier today, consumer spending for July edged 0.1% higher, although June data was revised slightly downwards.

The marginal improvement in spending was driven by external factors, specifically the end of the summer vacation driving season which likely freed up household budgets.

Annual PCE rose to 6.3%, while the annual core PCE (minus food and energy), the Fed’s favoured inflation gauge, rose 4.6% YoY, easing slightly from the 4.8% recorded in June.

Monthly core PCE dropped sharply from 0.6% in June to 0.1% in the latest numbers.

Source: Investing.com

Despite this, GDP for Q2 contracted 0.6% but improved significantly over the decline of 1.6% in Q1.

Although two consecutive quarters of economic contraction is a terrible sign for the world’s top economy, it must be noted that much of the fall in output was driven by supply-side shocks that saw inventories balloon. The higher stocks compressed intermediate goods production, subtracting an estimated 1.3% from overall GDP (Intermediate goods are not counted as a part of GDP).

Arguably, once supply chain disruptions are resolved, inventory flow should improve considerably. However, given the persistence of bottlenecks thus far, it is to be seen how quickly these can be untangled.

Consumer sentiment data

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Data from the University of Michigan was another example of mixed economic signals. The sentiment index for August was 58.2, above both preliminary estimates of 55.1 and considerably better than July data of 51.5.

Public estimates of 1-year ahead inflation were recorded at 4.8% versus 5.2% during the previous month.

However, inflation expectations have proved to often be self-fulfilling prophecies with dire consequences that have a nasty way of sneaking up on policymakers.

To combat this, Powell made it abundantly clear that this is not the time to pause rate hikes while invoking former Chairman Volcker, the central bank “must be to break the grip of inflationary expectations.”

Supply-side components

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It is also worth noting that as the Governor himself admitted, central bank policy is demand focused. With much of today’s inflation stemming from pandemic-era bottlenecks, and broken international supply chains, the Fed would likely need to hike rates substantially higher to bring down inflation meaningfully.

A recent Fed study estimated that 40% of current inflation is supply-led.

Yet, contrary to the suggestions of Stiglitz and Baker, the overarching emphasis appears to on-demand side intervention and not on easing supply side blockages.

Equities and credibility

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The Dow Jones fell over 1,000 points shortly following Powell’s speech, while the Nasdaq slid nearly 500 points, the biggest single-day drop since June.

During the speech, which Brian Jacobsen, a senior investment strategist at Allspring Global Investments described as “mercifully short”, Jay Powell’s primary objective was to convince markets that the FOMC will stay the course of rate hikes.

The drop in the markets seems to suggest that at least in the near term the markets expect the Fed to continue hiking.