Today’s economic landscape is similar to the part in a Shakespearean play where the protagonist makes a crucial speech which addresses the play’s complication. In this case, our hero is Federal Reserve (the “Fed”) Chairman Powell, his complication is inflation and the setting is in picturesque Jackson Hole for the Fed’s annual offsite Economic Policy Symposium.
We think it telling that this year’s Jackson Hole theme is “Reassessing Constraints on the Economy and Policy”, reflecting a transition to better understand the structural and evolving elements of inflation and how to best incorporate into their policy framework.
As you may recall from last years’ Fed gathering, the sound bite out of that meeting was from Chair Powell who reiterated that inflation was transitory. The wheels on his plane had barely touched down back in Washington when the wheels on the bond market started to fall off—with inflation, yields and inflation expectations all steadily increasing afterwards. Clearly this wasn’t an accurate forward-looking view for investors in retrospect. It was another seven months before any Federal Open Market Committee (FOMC) action took place.
The Past is Prologue
But the speech Powell gave on inflation in 2021 illustrated the Fed’s inflation playbook at the time as Powell laid out the five variables they were studying. Nearby is a scorecard of those variables and our thoughts on potential messaging for the 2022 Jackson Hole gathering:
There is nothing good or bad, but thinking makes it so…
The Fed looks at many forward looking growth and inflation variables. One item the Fed is adamant about is anchoring future inflation expectations, they are well aware that thoughts about where inflation is headed is one of the variables it may be able to influence more strongly through traditional rate policy.
All the Yield Curves a Stage…
…and fixed income investors are merely the players. They have their own set of unique views expressed in an abnormal yield curve at the moment. Most notably, the Treasury bond market’s inverted yields imply that the Fed will actually begin cutting rates as soon as 2Q 2023. This is incongruent with the Fed’s most recent policy outlook where only two members forecast a rate cut in 2023 and could be the source of future volatility stemming from the meeting.
It is too early to tell if this play ends in a tragedy but regardless of how it plays out inflation will likely remain too high for the Fed’s mandate for the foreseeable future even in the face of slower growth. The soundbite this time could be similar to one Chair Powell made in his semiannual testimony to Congress in June 20221:
“Over coming months, we will be looking for compelling evidence that inflation is moving down, consistent with inflation returning to 2 percent. We anticipate that ongoing rate increases will be appropriate…”
But there could be a nod to some recent forward-looking data points showing the economy is slowing (on track) or to changes in the structural and global assumptions that have been used previously. The problem is in the title of the symposium, there are constraints to the Fed’s tools for dealing with these issues.
As a result, we continue to be an advocate for inflation protection (commodities, real estate) within an overall balanced approach. In fixed income sectors, actively managed offerings may become an attractive option as more data is released. As the yield curve portends it should be an interesting Act III.
Important Disclosures & Definitions
1 Federal Reserve Chair Jerome Powell, Semiannual Monetary Policy Report to the Congress, 06/22/2022.
Basis Point (bps): a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
Fed Funds Rate: the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which the Fed suggests commercial banks borrow and lend their excess reserves to each other overnight.
Inflation Expectations: the rate at which people, including consumers, businesses and investors, expect prices to rise in the future.
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