Fed: Importance of Jackson Hole

A recurring theme in SriKonomics (for example, here) has been that while the Federal Reserve supposedly has a twin-mandate, growth and inflation, it has tended to put its emphasis on the first objective. That tendency, in turn, has led to the Fed inflating equity prices repeatedly through monetary expansion and low interest rates, because the central bank always had the ability to bail out the financial system if stocks threatened to crash. What about inflation? Sorry you brought it up!

That was why Chairman Jerome Powell and his colleagues deemed inflation “transitory” as they pumped up markets last year through continued expansion of the balance sheet and near-zero interest rates even though it was clear that the economy was in recovery from covid. That was also why even though Powell shifted on November 30 to accepting that inflation may have legs, he did not start the tightening process until mid-March. After all, the Fed is there to primarily support equity holders and provide a backstop, right?

Such doubts about the Fed’s persistence in following an anti-inflationary policy led to the gyrations in markets last week. Minutes of the Federal Open Markets Committee meeting on July 26 and 27 released on Wednesday indicated that members “judged that, as the stance of monetary policy tightened further, it likely would become more appropriate at some point to slow the pace of policy rate increases . . .” This echoed the sentiment expressed by Powell at his press conference on July 27 and caused Treasurys to rally in the immediate aftermath of the minutes’ release.

Publicly discussing the possibility of slowing rate increases even before inflation has shown a clear downward trend is a surefire way to boost markets but further lose credibility for the Federal Reserve.

Alarmed that markets were becoming too sanguine about the central bank’s tightening intentions, some Fed members spoke up on the need to continue with a hawkish posture. James Bullard, President of the St. Louis Fed, told the Wall Street Journal that he would support another large rate increase at next month’s meeting. Bullard stressed that “we should continue to move expeditiously to a level of the policy rate that will put significant downward pressure on inflation.” In a similar vein, Minneapolis Fed President Neel Kashkari suggested that it is “unrealistic” for markets to believe that the central bank would start cutting rates in early 2023 when inflation remained well above target.

On the other side of the hawk - dove spectrum, Esther George, head of the Kansas City Fed, cautioned that monetary policy operates with a lag and warned against over-tightening. Mary Daly of the San Francisco Fed warned that the central bank should not “overdo policy,” ending with an unforced error.

The whiplash resulting from these conflicting views resulted in a choppy equity market during the week, and a sharp rise in Treasury yields Friday after the short-lived rally following release of the Fed minutes on Wednesday. Following four weeks of gains, the S&P 500 average had a losing week because of the drop on Friday. Ten-year Treasurys followed their rally in July with a 9 basis point run up in yield at the end of the week, putting the yield just short of 3%.

The volatility in markets in recent weeks is a boon for traders but a deterrent for those who would like to use the markets as a destination for their savings.

And all this uncertainty puts a premium on Powell’s talk on Friday at the Jackson Hole, Wyoming conference of global central bankers. If he continues to take the dovish position he adopted at the Q&A portion of his press conference on July 27, expect both equities and Treasurys to be off to the races. But the Chairman will not be able to sustain the rally — just as his repeated expressions of inflation being “transitory” did not make it so.

On the other hand, if he unambiguously stresses the importance of lowering inflation without mixing messages as he did on July 27, equities would take a hit, bond yields would surge, but the Federal Reserve would start on the path to honoring the long-ignored portion of its mandate. This is the less likely outcome, in my opinion, given Powell’s 4 1/2 year record as Chairman.

Irrespective of which Powell shows up at his much-awaited press conference, the yield on ten-year Treasurys is likely to rise from the 2.98% it closed on Friday. The uncertainty would be on on whether it will do so in almost a straight line. The alternative would be to reach the higher yield following a Powell-induced rally that subsequently fizzles out.

In one case, Powell can actually behave like Paul Volcker who he claims is his hero. In the other case, it would be just talk to cover the Chairman’s predilection for favoring equity holders.

We don’t have to wait long to find out.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

August 20, 2022

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities.  Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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