At the Jackson Hole meeting, the Federal Reserve (Fed) and the other major central banks remained focused on their most important mandate: maintaining low and stable inflation at around 2% despite higher unemployment and the threat of a recession. Fighting inflation is their top priority in this phase of monetary policy normalization. Central banks are looking to restore public confidence and regain credibility following calling inflation last year “temporary” and waiting too long to react to the rise in prices fueled by fiscal and monetary policy responses to the pandemic became. However, the main risk, particularly for the Bank of England and the European Central Bank (ECB), is that they will “overreact” to inflation given the fallout from the energy crisis and supply shocks, both of which are beyond their control.
Fed Chair Powell’s speech was dead clear and hawkish. It made the usual anti-inflation statement and met aggressive market expectations. The Federal Reserve will have to keep interest rates tight for some time to ensure inflation does not become entrenched any further. Powell stressed that “a failure to restore price stability would mean far greater pain.” He also said that if monetary policy tightens further, it will likely be “appropriate to slow the pace of rate hikes.” Fed members need to see “clear and compelling evidence” of falling inflation to stop raising rates. Despite the encouraging July inflation numbers, inflation is still far too high (CPI is 8.5% versus 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 helping households with its student loan relief plan. According to data from Bloomberg, this new stimulus package might increase inflation by regarding 0.2 percentage points in 2023. Chairman Powell did not provide an exact figure for the final interest rate, nor did he comment on when the Fed might stop raising interest rates. He reminded financial markets of the committee’s June interest rate forecast, which said the median policy rate would be slightly below 4% by the end of 2023, allowing inflation to approach 2% by the end of 2024. After a “brisk” hike in interest rates, the Federal Reserve will keep them “at a higher level for longer”. Most Fed members expected interest rates to remain at restrictive levels for at least two years, according to the June roundup of economic forecasts. Jerome Powell wanted to counter expectations of a rate cut next year. However, the Fed’s comments failed to dampen market expectations that the Fed will cut interest rates next year.
The annual Jackson Hole conference wasn’t the “dovish change of course” that risky assets wanted. Financial markets had been expecting a more balanced tone from the Fed since the July FOMC meeting. At the July meeting, the committee raised interest rates close to neutral, which many policymakers see at 2.5%. Jerome Powell also stated, “As monetary policy tightens further, it will likely be appropriate to slow the pace of rate hikes while we assess how our overall monetary policy adjustments are affecting the economy and inflation.” July Fed minutes suggest that given the lag between tightening and the impact on the economy, the central bank may pause to allow the hikes to take effect. Also, since June, the Fed has reduced its balance sheets by selling maturing securities. According to the central bank, the quantitative tightening, i.e. tightening of monetary policy, corresponds to an increase in the key interest rate by 0.50 percentage points. The key interest rate peak might be lower in the current cycle due to quantitative tightening.
As a result, US stocks tumbled Friday following the Jackson Hole meeting (S&P 500 -3.3%, Nasdaq -3.9%), while the Treasury markets’ reaction was relatively muted (2-year T-Notes +0.03% at 3.39%, 10-year T-Notes +0.015% at 3.04%). The 2-year T-Notes traded 15 basis points below June’s high. In terms of expected rate hikes, futures markets priced in 4% through the end of 2022 with three sessions remaining in 2022. (Source: Bloomberg)
Despite the hints in the July Fed minutes, a rate hike does not seem imminent. For the next monetary policy meeting on September 21, Chairman Powell gave no indication of whether the FOMC will hike rates by 50 or 75 basis points. He reiterated that the Fed is dependent on current economic data. Traders largely anticipate a third straight rate hike by 75 basis points rather than any lesser amount.
At the Jackson Hole meeting, leading central bankers – with the exception of the Bank of Japan – announced a unified, hawkish strategy to contain high inflation. They will continue to tighten even in a recession. In an environment characterized by tightening financial conditions and a deteriorating global economic outlook, we remain cautious on risk assets and believe the US yield curve will flatten further. The US dollar should remain strong on higher real yield expectations in the US, weak growth momentum abroad and geopolitical risks.
