By Ritika Chhabra
Jerome Powell’s 9-minute speech in Jackson Hole on Friday was short, crisp, clear. The event was a chance for Powell to reset investors’ expectations after the July FOMC meeting on his commitment towards controlling inflation and he made sure that his message goes out strongly with no room for any alternate interpretation. The speech was unequivocally hawkish and Powell made several remarks that spooked the markets with S&P 500 and Nasdaq 100 tanking 3.3% and 4.1% respectively to close the day.
The Fed chief started the address by saying that the central bank’s overarching focus is to bring price stability and get inflation within 2% target even though it will entail sustained periods of below trend growth, softening labor market and pain for households and businesses. He hinted at another ‘unusually large’ increase in Fed fund rate in the coming FOMC meeting in September. This sent the probability of 75 bps rate hike soaring to 61%, up from 26% a month ago.
The investors in ‘Fed pivot’ camp were in disbelief as Powell made a reference to Paul Volcker twice in his speech. “The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years,” Powell said. Four decades ago, when the inflation in the US was running as hot as today, Paul Volcker became one of the most successful Fed chairpersons who took dramatic steps to rein in the runaway inflation of more than a decade. Within a few months of taking over his office, Volcker raised interest rates from around 11% to 17.5%. He also took the radical step of switching Fed policy from targeting interest rates to targeting the money supply.
The days of “easy credit” turned into the days of “very expensive credit” and the prime lending rate exceeded 21%. What distinguished Volcker from his predecessors was his single-minded resolve to fight inflation at all costs. He kept the monetary conditions tight, maintained a high benchmark interest rate and resisted the political pressure to ease during the 1981-82 recession till the inflation came down at comfortable levels. His commitment to price stability was the defining phase and a regime change into a low inflation era for decades to come. Powell’s echo of this resolve “to keep at it till the job is done” irrespective of economic conditions or political pressures dashed the hopes of investors who were thinking that the Fed will pivot as soon as it sees the first signs of crack in the labor market.
Whether the Fed will walk the talk is yet to be seen. So far, the Fed has been hiking into a strong labor market. The unemployment is close to all time lows and the labor market is still tight. But the real test of the Fed is going to be when the unemployment rate inches higher and inflation while moving lower is still elevated, well above the 2% target. Will it keep the interest rates higher than the neutral rate or will it pivot to avoid a full blown recession? We will know these answers in the coming months but for now, looks like bears will be back in action as the probability of rates easing in Q1 2023 is highly overpriced in the markets.
(Ritika Chhabra is an Economist and Quant Analyst at Prabhudas Lilladher. The views expressed are the author’s own. Please consult your financial advisor before investing)