Someday down the road, whenever Jay Powell has decided to retire from his role as Chairman of the Fed, I hope someone asks him about the month in between the July 2022 Fed meeting on 7/27 and his Jackson Hole speech on 8/26. After his press conference following the September meeting last Wednesday, I went back and watched his July press conference again, I re-read the July FOMC minutes, and then racked my brain the rest of the week about what might have caused him to change his tune so drastically during this period. I’m still pretty confused.
All year long, Powell and Co. have done their best to make it clear to the public that they were going to do whatever it took to get inflation back down to 2%. They were doing this of course because they didn’t want the pernicious psychology of inflation to plant its roots in people’s heads. They were, and are, rightly fearful of people getting used to seeing large price increases every time they go to the store, and then subsequently asking for large wage increases in turn, thereby creating a “wage price spiral” that ingrains price instability into the economy. By being so vocal all year long about doing whatever it takes, and by both raising rates aggressively and, more importantly, providing forward guidance about additional rate hikes in the future, the Fed had done an excellent job at keeping inflation expectations “anchored,” and bought itself a lot of time to fix the problem as a result. They correctly realize, as was made more clear in an interview with Ben Bernanke in May (https://www.youtube.com/watch?v=8y5T7n-cfE4), that anchored inflation expectations were the concrete that they could use to pave the road to a “soft” landing.
Sometime during the month of August, however, Powell seems to have decided to change tactics. Rather than use the runway that he and other Fed officials had built for themselves all year long to try and fix our inflation problem gradually, he instead decided that he needed to fix the inflation problem now. Nick Timeraos of the Wall Street Journal (WSJ) put out an article with some insights into this change of tactics on September 19th that is definitely worth a read (https://www.wsj.com/articles/jerome-powell-inflation-volcker-fed-11663595217). The article essentially makes the case that the pivot in August was driven by the Fed’s annoyance at seeing the stock market rally following their July meeting. Here are some key comments from Timeraos’ article:
“After another 0.75-point increase in July, Mr. Powell vaguely hinted at the Fed eventually moderating rate rises. Investors reacted with glee, betting on the sort of rally that accompanies the Fed turning from rate rises to rate cuts. The market reaction flummoxed Fed officials and many private-sector analysts who follow the central bank closely because the Fed hadn’t signaled such a pivot.”
“Fed officials thought investors were misreading their intentions given the need to slow the economy to combat high inflation. In a widely anticipated speech, Chairman Jerome Powell decided to be blunt. He scrapped his original address, according to two people who spoke to him, and instead delivered unusually brief remarks with a simple message—the Fed would accept a recession as the price of fighting inflation.”
“Markets seemed to expect the Fed would act as it did in the 1970s, when under then-Chairman Arthur Burns, the central bank raised rates aggressively to bring down inflation but then reversed course prematurely for fear of inflicting more pain on the labor market than the public and Congress would tolerate.”
“Worse, the rally was making the Fed’s job harder. The Fed aims to restrain investment and spending through higher interest rates. Rate increases slow the economy by cooling interest-rate sectors such as housing and pushing down prices for stocks and other assets. The market’s rally—the S&P 500 gained 17% between mid-June and mid-August—was doing the opposite.”
“The Fed’s annual gathering in Wyoming, which occurred in person this year for the first time since 2019, gave Mr. Powell his biggest stage of the year. ‘I thought what was appropriate was a very concise and focused message,’ he said at a conference earlier this month, describing the Jackson Hole speech as ‘more direct.’”
“One Fed official took the unusual step of publicly endorsing the market reaction. ‘I was actually happy to see how Chair Powell’s Jackson Hole speech was received,’ said Minneapolis Fed President Neel Kashkari in a podcast with the Bloomberg news service. ‘I certainly was not excited to see the stock market rallying after our last Federal Open Market Committee meeting because I know how committed we all are to getting inflation down,’ he added. Markets got the message. The S&P 500 has slid nearly 7% since Aug. 26, and the 2-year Treasury yield, which is particularly sensitive to monetary policy, has hit its highest level since 2007.”
First, as I’ve argued several times (mainly here: https://www.citizenanalyst.com/post/thanks-to-the-financial-press-the-odds-of-a-fed-policy-mistake-have-gone-up-dramatically), the financial press seems to have contributed to confusing the Fed, or at best, scaring the Fed into thinking that the press was going to confuse the public (or both), about what markets were actually saying the Fed would do. The press kept hammering on this notion that the market was pricing in rate cuts in 2023 because the market didn’t believe the Fed, implying that investors didn’t think the Fed had the political courage to finish the job on getting inflation back down to 2%. This was, and remains, completely wrong. Markets simply thought that we were already in a recession in the first and second quarters of this year, and thus, expected that as further rate hikes filtered their way through the economy, things would get even worse. This would produce a recession deep enough to meaningfully slow inflation, and that is why the Fed would cut in 2023. Because it would finish the job, not because it wouldn’t. Said differently, the market thought the Fed would finish the job sooner than the Fed did. The key difference behind the disconnect was that the Fed did not think the economy was in a recession earlier this year, whereas the markets did. Viewed in this context, the confusion at the Fed makes more sense. If you’re at the Fed, and you don’t think you’re in a recession today, or that you’re going to cause a recession later, why would you cut rates next year?
Second, this notion that Timeraos puts forth in his article about markets assuming Powell was going to be Arthur Burns 2.0 also just doesn’t make sense. Burns of course was one of the Fed Chairs during the Great Inflation that let inflation persist for far too long, mostly by easing policy too soon just after he would try to clamp down. If markets were telling you Powell was Burns reincarnate, then inflation expectations (as measured by breakevens between TIPS and nominal Treasury rates with the same maturity) would have gone up considerably after the July meeting. As shown in the chart below, this did not happen. After jumping about 18 bps on the day of the July Fed meeting, July 27th, breakevens settled back into a level within a few weeks that was only modestly higher than they were before that meeting, and well below the ranges they were in from earlier this year. They simply were not suggesting a repeat of the stagflationary 1970s because Powell all of a sudden lost his courage.
This brings us to the question of the stock market “misreading” the Fed’s intentions following the July meeting. As noted above, after the September meeting this week, I went back and re-watched the July press conference, and this notion that the market badly misread the Fed is just really hard to understand. For the sake of brevity, I’ll spare you the long list of evidence suggesting that Powell was preparing the market for reducing the size of the hike per meeting, but still significantly doing more hikes in total, but I plan to do another post on that subject later. Given the Fed’s history of overdoing interest rate hikes and causing recessions, to think that the notion of slowing rate hikes in response to an economy that most Americans, let alone most investors, already thought was in a recession would somehow not produce a stock market rally indicates just how out of touch the Fed is with how the market thinks or works. Perhaps more importantly, if the Fed was that focused on where the stock market was in August, why weren't they in July? The market had already rallied considerably after the June lows prior to the July Fed Meeting. If the market being too high was of that much concern, why not smack it down at the July meeting too? If the Fed did have a better feel of what's driving the market, they’d realize in about two seconds that the market can rally all it wants in the short-run, but these would only be “Bear Market Rallies” until inflation was permanently better under control. The market knows this is a war on inflation and not to overreact to any individual battle. But because of its view that recession was imminent and likely to get worse, and because signs of inflation getting better were rapidly accumulating, it rallied because it thought the Fed was winning the war, and more importantly, it rallied because it thought the Fed was acknowledging that it was winning the war too. The latter is just as important as the former.
Interestingly, what was not mentioned much in Timeroas article was any discussion of economic data during the month of August (he mentions August CPI, but this came out after the Jackson Hole speech, so was unlikely to be a factor in his pivot). An obvious question would be, did the data change significantly in August to warrant this kind of abrupt Fed policy change? In the interest of time, the answer appears to be no. If anything, the data for growth and inflation had generally gotten weaker since the July meeting. The official confirmation of two quarters of negative GDP—a common technical definition of a recession—happened the morning after the July meeting on 7/28. July core CPI and PCE both surprised nicely to the downside in mid and late August respectively (the better-than-expected PCE data for July actually came out the morning of the Jackson Hole speech). July’s ISM Manufacturing PMI, which came out on August 1st, decreased slightly compared to June in the aggregate (52.8 vs. 53), but notably, the Prices Paid component of the Manufacturing PMI index dropped a massive 18.5 points (to 60) compared to the prior month to its lowest reading since August 2020 (it would subsequently drop another 8 points in the August reading that came out on September 1st). Then on August 23rd, S&P’s Flash PMI for August showed the US PMI Composite Output Index at 45, a 27 month low, and that survey also indicated firms increased their selling prices at the softest pace in 18 months. The Citigroup Economic Surprise Index below does a good job of summarizing the generally weak economic data we saw during the summer (the chart, courtesy of Reuters, can be found here: https://graphics.reuters.com/GLOBAL-MARKETS/RECESSIONRISK/mopanaabnva/index.html).
This got me thinking: if this supposedly “data dependent” Fed didn’t see the data get worse, is the reaction from the stock market after the July meeting really what caused this abrupt shift in tone and temperament after the July meeting? As noted above, why weren't thy as concerned about the rally off the lows in June? There’s certainly evidence to suggest the Fed is focused on the stock market. Throughout most of the last decade prior to COVID, the Fed did often seem to be sensitive (and in some cases hyper-sensitive) to market reactions to changes in its policies (though certain instances of this lack of courage are often mispresented, especially the Dec. 2018 Fed pivot). The Taper Tantrum in 2013 (https://fredblog.stlouisfed.org/2021/08/no-taper-tantrum-this-time/) is, however, a famously good example of this. The quantitative easing policy put in place following the Great Financial Crisis was done partially to drive markets up to make people feel wealthier. This would in turn hopefully boost consumer spending, which would hopefully create jobs, and reduce the substantial levels of unemployment. While we’ll save the discussion on the research behind this theory for another day, it’s worth highlighting that the market quadrupled during the last decade (from March 2009 to January 2020), and for most of that time, economic and job growth was quite tepid, and inflation was actually too low in the eyes of the Fed. So it’s not like a good stock market automatically produces rampant inflation. Furthermore, even after the 17% rally off the lows in June, stocks were still 9% off their highs set late last year, so it’s not like we are making new highs again post July Fed meeting.
That being said, it's quite likely the Fed is going to take a “portfolio” approach to trying to get demand down. This was more clearly seen in Powell’s quite vocal commentary at the September meeting about housing prices needing a “correction” too (more on this later). Thus, keeping the stock market low is likely better for the Fed than not, at least at the moment. Former New York Fed President Bill Dudley’s article from this past April about forcing asset prices down appears to be becoming a more central tenet of Fed policy (https://www.bloomberg.com/opinion/articles/2022-04-06/if-stocks-don-t-fall-the-fed-needs-to-force-them).
Additionally, while Fed officials are probably reluctant to say it, I think there is another factor behind Powell’s August pivot: fiscal policy. Between the July Fed meeting on 7/27 and the Jackson Hole speech on 8/26, the Biden Administration passed and implemented the Inflation Reduction Act (on 8/17) and the student loan forgiveness initiative (on 8/24). The Inflation Reduction Act, per the Wharton Budget model (https://budgetmodel.wharton.upenn.edu/issues/2022/8/12/senate-passed-inflation-reduction-act), actually does not seem to be much of a problem for the Fed in that it doesn’t create much net new spending or tax cuts over the next few years (roughly $10B in 2023, and $30B in 2024). The bigger deal may have been the student debt forgiveness initiative and its potential wealth effects. The Wharton Budget model estimates this will cost over $600B (https://budgetmodel.wharton.upenn.edu/issues/2022/8/26/biden-student-loan-forgiveness), which is a pure wealth increase (and wealth transfer). Regardless of what you think of the merits of the policy, it seems hard to believe that having $10,000 - $20,000 of debt wiped off your balance sheet isn’t going to make you feel a little more comfortable about spending money. And more consumption, regardless of whether it stems from the wealth effects of the stock market, housing, or from having less student debt, is not what the Fed wants right now. It’s therefore likely that both of these factors—the stock market and the student loan initiative—is what drove Powell to come out more aggressively at Jackson Hole in August. August’s disappointing CPI number, which importantly came out on 9/13 (after the JH speech), even though July’s CPI and PCE were very encouraging, only allowed him to solidify this new position.
I have no issue with the Fed trying to get this high inflation down. What I don’t understand, however, is why the Fed no longer feels like it can use the runway it worked so hard to create. Why do we all of a sudden need to fix inflation right this second and abandon the plan to get it down gradually over the next two years? Why did the definition of "restrictive" policy just jump 100-150 bps from ~3-3.5 to 4.5? This is what I don’t get. Inflation, in aggregate, is definitely getting better (see charts below), and the Fed knows there is a long lag in monetary policy. As recently as 8/30, the Atlanta Fed put out a blog post discussing this, and indicating that most research suggests rate hikes have a roughly 18 month lag to affect inflation (https://www.atlantafed.org/blogs/macroblog/2022/08/31/can-1970s-help-inform-future-path-of-monetary-policy). The Fed just got to restrictive territory with this latest interest rate hike in September. How much progress did they possibly hope to see at this point given that? Given the tendency for this long lag period, if anything, the progress we’ve made to date has been quite substantial. Additionally, as shown in the charts below, expectations for inflation remain very well anchored (something Powell himself also routinely admits), and in some cases continue to actually get better as well.
Given all this, why abandon the runway now? Why not stick to the more gradual approach like you planned—and keep the risks of a bad recession low—to fix the problem instead? Especially if the stock market is not going to sustainably rally anyways until inflation comes under better control? To be clear, I am not saying to stop hiking today (though as noted above, it wasn’t too long ago that many Fed officials were calling 3% sufficiently restrictive to take a pause and let the lag effects of the recent policy changes take hold), but we seem to have somehow gotten into a position where hiking anything less than 75 bps is somehow easing policy. Even at the press conference this week, Powell kept talking about slowing the economy to get to “below trend” growth, but even he acknowledged that we’re already there today. We had negative GDP growth in the first two quarters of the year—historically a common definition of a recession—and the most recent forecast from the Atlanta Fed’s GDPNow model shows another tepid forecast for 0.3% growth in the third quarter (https://www.atlantafed.org/cqer/research/gdpnow). Even if you look at Gross Domestic Income (GDI) instead of Gross Domestic Product (GDP), we’ve been well below trend all year (at roughly 0.5% growth). Steve Liesman from CNBC asked him about the lag effect in rate hikes, and he responded “it's likely to take some time to see the full effects of changing financial conditions on inflation. So, we are very much mindful for that. And that's why I noted in my opening remarks that at some point, as the stance of policy tightens further, it will become appropriate to slow the pace of rate hikes while we assess how our cumulative policy adjustments are affecting the economy and inflation.” What no one asked him about after that, sadly, is why doubling rates again when he already slowed the economy to tepid growth with rates still in “accommodative territory” is now the appropriate place to theoretically take a pause. Doesn’t the fact that the economy already slowed this much already indicate the economy is not nearly as strong as the Fed thinks?
Importantly, because growth has slowed, inflation has slowed with it. Powell made this comment that “If you look at core PCE inflation, which is a good measure of where inflation is running now, if you look at it on a 3, 6, and 12 month trailing annualized basis, you'll see that inflation is at 4.8 percent, 4.5 percent, and 4.8 percent. So that's, those, that's a pretty good summary of where we are with inflation. And that's not where we expected or wanted to be.” But as I’ve argued elsewhere, looking at the year-over-year figures is going to continue to overstate inflation because it was higher earlier this year than it is today. Said differently, looking at the year-over-year figures overly emphasizes inflation that already happened 6-12 months ago. If you annualize the last 3 and 6 months of both PCE and CPI, rather than looking at the year-over-year figures, this does show meaningful improvements compared to earlier this year (especially at the category level). This isn’t manipulating the data. It’s simply better adjusting for current inflationary momentum, just as stock prices are priced much more on forward estimates of a company’s expected earnings rather than on trailing reported figures.
Furthermore, other indicators of inflationary improvement are abundant. Gas prices are down $1.40 since June, a decline of 27%, and at one point declined for 70 days in a row through August. Home prices and rent prices are increasing at dramatically slower rates than they did earlier this year, and in many cases are even starting to fall. Used car prices are rolling over significantly. Ocean freight prices have declined 80% this year. Truckload freight rates have declined for 7 months in a row, and spot rates are now back to 2018 levels. Even food inflation, though it takes longer to hit retail grocery stores, is getting better, and in restaurants are starting to call out food deflation at the wholesale level. These declines in key input and supply chain costs take to work their way through the system, but company commentary suggests this is definitely happening. Are we where we need to be yet? No, of course not. But we’re underappreciating just how much progress we’ve made to date, and additionally, how much progress is already coming “in the pipeline” from the actions we’ve already taken. By “keeping at it” at this unprecedented pace, rather than letting the lag effects from existing rate hikes play out, we’ve not only increased the odds of a recession dramatically, but we’ve increased the odds of a bad recession dramatically too.
Another disadvantage of going with this huge “front-loading” strategy is that the Fed will almost assuredly have to back off sooner, whereas if they go slower, with smaller hikes, you can stay in front of the public for longer and continue to show that you’re doing something on the fight. Raising rates for 75 bps or even 50 bps a meeting is not only unsustainable, but it also means you use your bullets sooner, before you are able to see the lag effects from the bullets you’ve already used. Raising by 25 bps from here instead of 50-75 not only gives the Fed more time to see what the lag effects are, but it also allows them to stay in front of the public for 2x or even 3x as long. We shouldn’t forget that while the Fed is theoretically independent from politics, Powell’s decision to have public press conferences after each meeting, and his decision to have the other Fed governors be so vocal as well, has likely resulted in them having to worry about messaging and narratives just like any other politician. This more “public” strategy that Powell has embarked on as Chairman may now be forcing him to focus more on shaping public opinion than on being “data dependent.”
Now, its certainly possible that the Fed is just more aggressively posturing (I don’t want to use the word bluffing, because that word has already got us into enough trouble as is), and that the Fed just wanted to get on the other side of this situation for once. Now they’re in a position to talk the market down from the ledge on its own terms and on its own timing, this theory goes. Powell himself made a somewhat surprising comment that supports this theory towards the end of the press conference. When asked how restrictive 4.6% policy would be next year, Powell started his reply by saying “So I think if you look, when we get to, if we, let's assume we do get to that level, which I think is likely.” (emphasis mine) Perhaps rather than trying to walk the line and “not make a mistake” then, as Powell said at the July meeting, now they may be trying to “out-hawk the Hawks,” to steal Steve Liesman’s term. This is all certainly possible. But the issue is that now, while maybe they can pivot in 6-8 months, they’ve sort of politically backed themselves into a corner where they almost have to do what they’re going to say at least over the next 3-4 months, and that’s to hike rates to at least 4% (which by the way would amount to 400 bps of rate increases in 9 months). So sure, maybe they don’t get all the way to 4.6%, but even 4% has the potential to do a decent amount of damage to the economy from here. Let’s not forget that it was only a few weeks ago when one Fed official after another said they wanted to raise policy into a “moderately restrictive” position to slow growth—which most had said was somewhere in the 3-3.5% range—and then hold them there to avoid having to cut them (see here: https://www.bloomberg.com/news/articles/2022-08-18/fed-may-need-to-raise-rates-above-3-to-cut-inflation-daly-says, here: https://www.reuters.com/markets/europe/fed-officials-see-us-interest-rates-rising-further-2022-08-30/ here: https://www.wsj.com/articles/fed-officials-see-need-for-continued-interest-rate-increases-but-less-certainty-over-destination-11660760110, here: https://www.bloomberg.com/news/articles/2022-09-08/fed-s-evans-sees-another-jumbo-rate-hike-on-table-in-september and here: https://www.clevelandfed.org/en/newsroom-and-events/speeches/sp-20220907-an-update-on-the-economic-outlook-and-monetary-policy.aspx) . This new approach significantly increases the chances they put themselves in the same position Fed officials did during the late 60’s and 70’s. By essentially planning to double rates again in the next three months when growth is already barely positive, they have set themselves up to overhike, and then if we’re in the middle of a bad recession, there will be tremendous pressure to cut. This is exactly the kind of situation they said they wanted to avoid. If Powell never thought he really had two years to get inflation down in the first place, or if he was expecting rates in accommodative territory to “get them where they wanted to be,” then why didn’t we hike rates by 200 bps per meeting so that we could see what progress we could make faster? This is what needs more explaining. What is it that spooked him so badly in August?
When monetary historians write the history of the pandemic era, there are likely to be two “critical periods,” to steal John Fiske’s term from his book on the 1780’s. The first one was in March of 2020. The second one in my view will likely be in August of 2022. Though we can now look back at the first “critical period” and argue that we probably did too much, it is pretty unfair to be overly critical of the Fed for the excesses in pandemic response policy. Fiscal policy almost assuredly played a much bigger role in creating the inflationary issues we’re now dealing with (the third stimulus in March of 2021, and the unemployment insurance policies seem like particularly easy targets for criticism in this regard). But while the Fed didn’t have much choice to do what it did in March of 2020, this time, I think it’s different. This is where the second “critical period” differs considerably, not so much in that they have any less room to fail, but rather in that they have many more paths to take to get to the same goal. Back then, you probably needed the bazooka approach. Now, its really not clear that you do. All year prior to this summer, the Fed had worked hard to aim for a “soft landing,” and to “not make a mistake.” That strategy appears long gone now. Given the new strategy is still likely to work, however, albeit with much more pain, historians will only be able to criticize them for doing too much too fast, a counterfactual that cannot really be proven one way or the other. But those of us who will have to live through it in the meantime ought to remember how quickly the Fed threw in the towel on the soft landing strategy after they worked so hard to build up the political capital to achieve it. History may only show a counterfactual, but those of us living through it will likely remember it differently.
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