On my mind: The Fed—do you hear me now?

Federal Reserve (Fed) Chair Jerome Powell delivered a forceful and unequivocal speech at Jackson Hole today—the speech he should have given six months ago, in my view.

Powell realized he needed to push back against financial markets: investors still expected this hiking cycle to be short-lived and quickly followed by new rate cuts; this belief translated into easier financial conditions, making the Fed’s inflation-fighting job even harder.

In a concise speech, Powell therefore set out a clear and well-structured message:

1. He stressed at the outset that price stability is “the responsibility of the Federal Reserve and the bedrock of our economy,” because without price stability we cannot have a “sustained period of strong labor market conditions that benefit all.” This is a crucial statement: it signals that today the Fed’s dual mandate boils down to the single goal of reducing inflation.
2. Restoring price stability will take time; history shows the dangers of prematurely loosening policy, and the Fed will therefore maintain a tightening stance until it is convinced that its job is done.
3. This will be painful for households and businesses: to reduce inflation, the Fed has to reduce aggregate demand and raise unemployment. But any delays in disinflation would make the employment cost even higher—which signals that the Fed will not waver as the labor market begins to deteriorate.

The speech stressed the need to cool off economic activity: Powell noted that the US economy still enjoys strong underlying momentum. He pointed out that while supply shocks have contributed to global price trends, US inflation is also driven by excess demand. The US labor market in particular is “clearly out of balance.”

It also acknowledged that the longer inflation remains elevated, the greater the risk that inflation expectations will become unanchored and embedded into higher price and wage-setting behavior.

Powell indicated that further forceful policy moves lie ahead—in other words, another 75 basis-point hike at the September meeting cannot be ruled out. He repeated, as in previous speeches, that once the monetary policy stance has tightened further, the Fed could slow the pace of rate hikes. This is a rather obvious point that I think he could have left out, because on previous occasions the market read it as dovish. In this case, however, the context is much clearer: at some point the Fed will slow the pace of hiking, but will keep a restrictive policy for some time.

The past few weeks have shown that the Fed has a serious credibility problem: several Fed officials reiterated that they envision a sustained period of tighter policy, but markets kept expecting a quick reversal to rate cuts early next year.

Today’s speech seems to have given investors some pause: markets are beginning to expect a higher terminal rate and to price out some of the rate cuts expected for next year. The market’s adjustment still has a ways to go, in my view: I believe the risk to the June median dot plot peak rate of 3.8% is decidedly to the upside.

The adjustment in asset prices will not be smooth. Powell today went out of his way to convince all of us that the Fed will not waver once unemployment starts to rise. He argued clearly that higher unemployment today is a necessary precondition for a strong labor market in the long run—in other words, there’s actually no tradeoff between employment and inflation in the current set of circumstances. But once unemployment does move up, the markets will test the Fed’s resolve. And the central bank will need to show it can stomach not just higher unemployment, but wobblier asset prices as well.

At Jackson Hole, Powell has taken the first steps to boosting the Fed’s credibility, and therefore its effectiveness. To win the fight against inflation will require more forceful policy action and sticking to today’s clear message.