Quick Thoughts: Jackson Hole—Limited visibility, bumpy landing

In his day, Federal Reserve (Fed) Chairman Alan Greenspan was (in)famous for his irascible obscurity—often speaking without being fully understood.

In this year’s much-anticipated speech at the Fed’s annual central bankers’ gathering in Jackson Hole, Chairman Jerome Powell appears to have employed Greenspan’s speechwriter. Powell said a lot about the economy and inflation, but he obscured a great deal about future Fed policy. Yet beneath the (intended?) fog of his remarks was a worrisome message for devotees of soft-landing scenarios. Fasten seatbelts—the arriving passengers won’t enjoy a view of the majestic Tetons and should brace for a bumpy landing.

The initial market response has been minimal. Equity and bond prices bounced around immediately after the speech, but diverged somewhat by the close as stocks finished higher while bond yields rose. We’re not sure that’s right and here’s why:

Powell’s key points

To begin, Powell’s speech was a somewhat dull resuscitation of recent economic data, with a focus on the details of core personal consumption expenditures inflation (the Fed’s preferred measure). Having noted welcome declines in goods inflation and a probable decline in shelter inflation, Powell emphasized that non-housing core services inflation has been less responsive to either changes in the economy or to Fed tightening.

Powell also remarked that current Fed policy is already “restrictive,” meaning that the real (inflation-adjusted) fed funds rate is above broadly accepted ranges of what constitutes its “neutral” level.

But Powell carefully avoided saying what comes next. He noted that it could be a longer pause or additional rate hikes. But by failing to mention rate cuts, he sent his clearest message of the speech, namely that the Fed is either on hold with an already restrictive stance or might hike rates further. Easing anytime soon, however, is off the table.

Slave to dead economists?

That’s the clearest message from Powell. Parsing his other “Greenspan-esque” remarks, it seems the Fed is sticking to the view that the achievement of its 2% inflation objective requires “slack” in the economy. “Slack” is, of course, a euphemism for job losses.

That idea stems from the Phillips Curve—first developed over 60 years ago—which purports to show an inverse relationship between inflation and unemployment (i.e., higher unemployment leads to lower inflation). But many economists are less certain. The Phillips Curve has never depicted a stable relationship between joblessness and inflation, and in recent decades it has been even less reliable. In fact, many measures of US inflation have fallen significantly this year without the unemployment rate rising.

However, it seems as though most Federal Open Market Committee members side with Powell’s Phillips Curve approach. If so, then the Fed is indeed laying down a marker for investors. Specifically, the implication is that policy must remain restrictive (or become more restrictive) until the unemployment rate rises. Also, the Fed’s threshold level of “slack” appears to be at least a 4.0% US unemployment rate (up from 3.6%).

If so, the Fed is signaling that despite (or because of) the fog that surrounds our understanding of inflation dynamics, a bumpy landing is an unavoidable necessity.

Investment implications

What does Powell’s Jackson Hole message mean for investors?

• First and foremost, interest-rate cuts are not coming soon and will only occur once US unemployment rises above 4%. That could be well into 2024.
• Second, the US economy must now slow, which puts at risk the expected sharp recovery of corporate profits currently expected by the consensus of Wall Street analysts for 2024.
• Third, the Treasury yield curve will likely remain inverted and could invert further. That’s because the Fed must be willing to risk recession in an effort to restore price stability, which is likely to occur. It rarely pays to “fight the Fed,” and an inverted yield curve is the logical way to express that view.
• Finally, if the Fed is wrong in the sense that inflation can fall without the need for “slack” in the economy, then it has embarked on a policy error. If so, reversing course later means undoing today’s tightening much faster and more aggressively than would otherwise be the case. Ultimately, investors may be surprised by how rapidly the Fed might eventually be forced to unwind its tightening stance.