Wall Street is nervous about Federal Reserve chief Jerome Powell’s big speech in Jackson Hole, Wyo., on Friday. The S&P 500 rally came under pressure alongside a ratings change favoring another 75 basis point rate hike on September 21.
But what is there really to fear from Powell’s speech? After all, the Fed Chairman suspended his forward guidance at his July 27 press conference. This makes it doubtful that he will take sides on the magnitude of the next rate hike.
The concern is that Powell will try to undo the dovish impression he gave with his July 27 press conference. Those comments helped the S&P 500 rebound 18% from the June 16 closing low, emerging from a bear market.
Still, Powell will stick to his bullish view that the Fed still has a chance to engineer a relatively soft landing for the US economy. And while policymakers may not be mad about the stock market rally, which runs counter to their efforts to cool the economy and tame inflation, Powell is too cautious to target stock prices directly.
So what could Powell say that could upset the S&P 500? These two words: “The 1970s”.
Federal Reserve History Lesson
In a notable March 21 speech, Powell went through the history of the Fed’s soft landings to back up his claim that the current tightening could yield a similar outcome. Powell noted 1965, 1984, and 1994 as evidence that Fed tightening need not cause a recession.
He also cited the Federal Reserve’s tightening from 2015 to 2019 to bolster his case. And while recession ensued in 2020, it was Covid – not the Fed – that bore the blame.
Now, some economists think Powell might decide to give a less edifying history lesson. Nomura economists Aichi Amemiya and Robert Dent wrote in their Jackson Hole overview that Powell’s speech could “emphasize the 1970s experience.”
“A number of Fed participants have recently underscored this era with some caution, generally to emphasize their preference for avoiding a ‘stop and go’ tightening path,” they wrote.
“Tighter for longer”?
Other than just before the pandemic, the last time unemployment hit 3.5% was in 1969. The Fed responded by raising its key interest rate to 9% in an attempt to short-circuit a surge in unemployment. wage-driven inflation.
Yet the Fed reversed course in 1970. It cut the federal funds rate to less than 4% in early 1971. This helped push the unemployment rate up to 6%. But it “wasn’t high enough to ease wage pressures,” Aneta Markowska, Jefferies’ chief financial economist, wrote in a June 3 note.
“The Fed has not created enough slack to reduce inflation and stabilize inflation expectations,” she wrote. “Policymakers repeated the same mistake in the mid-1970s, rising aggressively and causing another recession, but then easing too soon and allowing inflationary pressures to reassert themselves.”
The lesson, according to Markowska: “Faced with a feedback loop between prices and wages, the Fed needs to stay tighter longer.”
“Tighter for longer” is the last message investors want to hear, and a term Powell is unlikely to touch. Indeed, the S&P 500 rally was built at least in part on the hope that the Fed would stop raising rates in early 2023 and switch to lowering rates around the middle of the year.
Easing of financial conditions
Financial markets are already eyeing a reversal of Fed tightening. This, in turn, had the effect of easing financial conditions, which resulted in lower market interest rates and a rise in the S&P 500, Dow Jones Industrial Average and Nasdaq.
Minutes from the Federal Reserve Meeting of July 26 and 27 highlighted a “significant risk” that “high inflation could take root if the public began to question the Committee’s determination to adjust policy direction sufficiently”.
The minutes noted: “If this risk materialized, it would complicate the task of bringing inflation down to 2% and could significantly increase the economic costs of doing so.”
To deal with this risk – that the recent easing of financial conditions will keep inflation higher than otherwise – Powell might want to sow more doubts that a Fed pivot to lower rates is imminent. .
This might not be great for the S&P 500 or the US economy in the near term. However, the economists at Nomura write, Powell can argue that the Fed’s failures in the 1970s and the Fed’s eventual “resolute efforts to bring inflation down” under President Paul Volcker show that the pain in the short term will be worth it.
Be sure to read the IBDs The big picture column after each trading day for the latest information on the current stock market trend and what it means for your trading decisions.
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.
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