Chris Kamykowski CFA®, CFP® | Head of Investment Strategy & Research
Last week, despite the majestic and tranquil scenery of Jackson Hole, Wyoming, Fed Chairman Jerome Powell hoisted a dose of reality onto the markets and investors. There, he firmly stated the Fed’s unified commitment to reining in current inflation levels with the understanding this responsibility requires follow-through, even if economic conditions slow as a result. If there were any elements of doubt ahead of the meeting or an expectation of a “pivot” by the Fed, they were certainly laid to rest. Markets responded on cue, voicing displeasure – or simply facing reality – as the S&P 500 dropped nearly 6% to clearly end the recent bear market rally.
Why the disconnect?
Over the last 30 years, markets have grown accustomed to the idea – even if misplaced – of the “Fed Put”: that the Fed would step in to provide accommodative monetary policy in times of economic weakness, regardless of the degree of such weakness.
For markets, this spoke to lower rates, which boosted asset prices and allowed ample flexibility for companies’ capital needs. However, this assumption was within a pre-pandemic world where inflation was largely of no concern and persistent accommodative monetary policy which provided ample liquidity. The major concern of the Fed at the time was deflation (falling prices) as globalization, demographics, and technology dampened the threat of rapidly rising prices.
In today’s post-pandemic context, however, an immense surge in demand, troubled supply chains, and a war in Ukraine all mean the market requires a rewiring of its previous expectations to account for the Fed’s determination to fight inflation even if there is economic pain along the way.
Why is the Fed being so forceful?
The 1970s loom large over the current Fed, whose members are undoubtedly very familiar with the failure of the Fed to address inflation deliberately and thoroughly – something former Fed Chairman Paul Volcker ultimately did at the end of that decade. While no two economic cycles are the same, the Fed is keen to not repeat the “start and stop” policies of the 1970s, which saw inflation persistently move to higher highs over the course of the decade, as increasing prices became an economic norm.
Importantly, long-term inflation expectations today remain rather contained at this point, suggesting the market is either confident in the Fed’s efforts to combat current inflation and/or recognizes that the post-pandemic demand/supply mismatch will work itself out.
The Fed has shown that it prefers to act swiftly in this environment, attempting to keep those expectations from moving higher. While economic pain from this tightening in monetary policy may arise, Powell pointed out, “failure to restore price stability would mean greater pain.”1
Where do we sit today?
Inflation levels moved marginally lower recently, suggesting the economy is adjusting via lower aggregate demand, improved supply chains, lower energy prices, and tighter monetary policy. Money supply as defined by M22 is slowing, as is growth in home prices, with mortgage rates sitting at levels not seen since 2008. Economic growth is also slowing, as evidenced in slowing momentum in the manufacturing sector. All of this will likely aid in rebalancing the economy and arresting the growth in inflation in the post-pandemic world.
In addition, the inflation-fighting effort by the Fed has been complemented by fiscal policy recently. The Inflation Reduction Act (IRA) was signed by President Biden in mid-August, which should at least aid the efforts by the Fed through lower budget deficits. However, the White House announced a plan to cancel portions of student loan debt for eligible borrowers in late August, which could counteract the fiscal policy efforts as noted by three separate independent entities.3
In light of fiscal policy actions, the Fed has even more reason to remain independent-minded and committed to responding to one of its core responsibilities: price stability. After Jackson Hole, their resolve was loud and clear.
Sources:
1 https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm
2 https://www.stlouisfed.org/financial-crisis/data/m2-monetary-aggregate#:~:text=M2%20is%20a%20measure%20of,retail%20money%20market%20mutual%20funds
3 https://www.crfb.org/blogs/cancelling-student-debt-would-undermine-inflation-reduction-act
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