Next week, Jerome Powell will face the financial markets at the foot of the Teton Mountains in Jackson Hole, Wyoming, each standing in the summer heat daring the other to blink first.
The market has been “fighting the Fed” for about two months. Stocks fell on Friday to end a four-week winning streak, but make no mistake. The S&P 500 is up 15.3% since June 15. Spreads between junk bonds and ultra-safe US Treasuries have narrowed significantly. Mortgage rates have fallen. The 10-year Treasury yield fell 14.6%.
We expect Federal Reserve Chairman Jerome Powell to come to Jackson Hole next week, determined to show the market the mistake he made. Above all, it will be about correcting the way investors react to incoming data. From the Fed’s perspective, exploding job numbers or a bigger-than-expected increase in retail sales is bad news, not good news, for example. It signals the need for further tightening and indicates that the previous tightening was less effective than expected. Powell will want to show the market that it needs to start interpreting signs of “resilience” in the economy as signs of persistent inflation that will be overcome with further tightening.
The tricky part here is that Powell and his fellow Fed officials are aware that there is a risk of overshoot. They don’t want to lock themselves into a three-quarters of a percentage point increase at every meeting until inflation drops to two percent, because they believe that monetary policy influences the economic situation with long lags and variables. They would like to take their time with future increases, which means smaller increases and occasional pauses, to give the economy time to react.
To that end, Powell is likely to reiterate what we read in the July meeting minutes that the Fed is likely to slow the pace of hikes at some point in the future and that the rate of increases will depend on incoming data. What makes this tricky is that Powell has to be careful not to sound too dovish here, leaving room for the market to interpret that the main risk to the base case scenario of a “raise and hold” strategy of the Fed is a drop in the Fed. As we have seen in recent weeks, this dovish interpretation can quickly become the base case if the market does not receive a severe boost from the central bank. In fact, over the past few weeks, the Fed’s “pivot” from hikes to cuts has become the gold standard for many economists, even in the face of a severe setback.
So Powell will probably have to explicitly reject the idea of a pivot. San Francisco Fed President Mary Daly hinted at that in her remarks this week, saying the Fed was unlikely to move quickly from a rate hike to a rate cut. Powell will likely point out that the Fed’s projections released in June showed tight monetary policy extending through 2024. Where once the Fed’s mantra was “lower for longer,” Powell will now have to convince markets that his compass indicates “higher for longer”.
A big question mark will be how openly Powell discusses a recession or rising unemployment. Months ago, Powell seemed to indicate that he believed much of the job of cooling the labor market could be done by reducing unfilled job openings rather than causing layoffs. Does Powell still think that? If he says he does, the risk is that the market will believe the Fed will back down if monetary tightening turns out to be pushing Americans out of their jobs. According to estimates by some well-known economists, unemployment may need to exceed 5% to bring inflation back close to the Fed’s 2% target. Will Powell signal his agreement with this?
It seems increasingly likely that the US economy will slide into an undeniable short-term recession. Powell’s speech will signal the Fed’s reaction to this. Too much optimism that a recession can be avoided will likely convince markets that the Fed will pull back if the slowdown exceeds expectations. The market will believe that Powell will blink first.