At the Jackson Hole Economic Symposium, the Fed and other major central banks remained focus on their principal mandate, delivering low and stable inflation of around 2%, despite higher unemployment and recession risk. Reducing inflation is their top priority at this stage in the normalization of monetary policy.
Central banks want to restore public confidence and regain their credibility after describing inflation as “transitory” last year and waiting too long to react to the surge in prices induced by fiscal and monetary policy responses to the pandemic. However, the main risk, namely for the Bank of England and the European Central Bank (ECB), is the cost of “overreacting” given the impact of the energy crisis and supply shocks, both of which are out of their control, on inflation.
Fed Chair Powell’s speech was perfectly clear and hawkish. He delivered the same inflation-fighting message and matched aggressive market expectations. The Federal Reserve needs to keep rates restrictive for some time to ensure that inflation does not become further entrenched. Fed Chair Powell underlined that “a failure to restore price stability would mean far greater pain”. He also said that as the stance of monetary policy tightens further, it likely will “become appropriate to slow the pace of rate increases”. The FED members need to see “clear and compelling evidence” of falling inflation to stop hiking rates. Despite the encouraging July inflation print, inflation remains far too high (Consumer Price Index at 8.5% down from 9.1% in June). Wage growth has accelerated (6.7% according to the Atlanta Fed wage tracker).
The labor market is still very tight. And on the political front, the Biden administration is supporting household spending with its student loan relief plan. According to Bloomberg, this new stimulus package could increase inflation in 2023 by around 0.2 percentage points. Chair Powell did not provide an exact figure for the terminal rate or allude to when the Fed might stop hiking rates. He reminded financial markets of the Committee’s June rate projection which showed that the median federal funds rate would run slightly below 4% through the end of 2023 in order for inflation to move closer to 2% by the end of 2024. After raising rates “expeditiously”, the Federal Reserve will hold them there “higher for longer”.
Most Fed members expected to keep the federal funds rate at a restrictive level for at least two years according to the June summary of economic projections. Jerome Powell wanted to push back against rate cut expectations next year. However, the Fed’s comments did not discourage future markets bets that the Fed would cut rates next year.
The annual Jackson Hole Conference was not the “dovish pivot” risky assets were looking for. Since the July FOMC, financial markets expected a more balanced tone from the Fed. In the July meeting, the Committee increased rates close to the neutral rate which is considered to be 2.5% by many policymakers. Jerome Powell also indicated “as the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation”. The Fed’s July minutes suggested the central bank may pause to allow the hikes to take effect, given the lag between tightening and the consequences on economy. Furthermore, since June, the Fed has been reducing its balance sheets by running off maturing securities. According to the central bank, quantitative tightening is equivalent to a 0.50 percentage point increase in the federal funds rate. The peak in the federal funds rate might be lower in the current cycle because of quantitative tightening.
Therefore, on Friday, U.S. stocks plunged (S&P 500 -3.3%, Nasdaq -3.9%) while treasury market reaction was relatively muted (2-year T-Notes +0.03% at 3.39%, 10-year T-Notes +0.015% at 3.04%). 2-year T-notes traded 15 basis points below the highest June level. On rate-hike expectations, futures markets priced 4% by the end of 2022 with three remaining meetings for 2022. Source: Bloomberg
A Fed pivot does not seem imminent despite hints in the Fed’s July minutes. For the next policy meeting on September 21, Chair Powell did not provide any guidance on whether the FOMC would raise rates by 50 or 75 basis point. He reiterated that the Fed is dependent on incoming economic data. Traders largely predict a third consecutive increase of 75 basis points rather than a smaller basis point hike.
At the Jackson Hole symposium, top central bankers, except for the bank of Japan, delivered a unified hawkish message to tame high inflation. They will pursue tightening even in a recession. In an environment punctuated by tightening financial conditions and a deteriorating global economic outlook, we remain cautious on risky assets and believe that the US yield curve will continue to flatten. The dollar should remain strong because of higher US real yield expectations, soft growth momentum abroad and geopolitical risk.