Jackson Hole Reality Check

The August speech at Jackson Hole by Federal Reserve Chairman Jerome Powell turned the tide on US markets. Many market participants were hoping for a cut to the Fed Funds rate beginning as early as next year. The speech ruled out that possibility and reset expectations for a restrictive environment until inflation returns to the 2% target. The effects on markets since the address have been consistent with a more hawkish central bank. Yields on US Treasury securities have risen steadily since the speech across all tenors. Interest rate-sensitive sectors have turned down markedly, while defense sectors have held up. We have been writing for months that the most significant risk to markets is a policy mistake and it seems we may be on the cusp of one. Let us explain.

August Employment: 315,000 Jobs | 3.7% Unemployment Rate | Improved Participation

The Fed has two distinct mandates; to maintain maximum employment and to keep inflation and inflation expectations anchored at 2 – 2 ½%. The labor environment is robust and will likely remain so. Inflation is a different story, but not in the way one might assume. It’s important to remember that the Fed has been wrong about inflation throughout the pandemic. First, they were not vocal enough about the risks of overstimulating the economy during a supply crunch. Then they erred by describing inflation as transitory and being unclear about what they meant by that phrasing. Now, it seems, right when inflation is trending down, they are ratcheting up their hawkish rhetoric and warning about a 1970’s style inflation boom. The latest inflation statistics show a consistent pattern of easing inflation. More importantly, inflation expectations have fallen since March of this year, close to the Fed’s target.

Economic Activity: ISM Manufacturing 53% | ISM Non-Manufacturing 57%

We are still hopeful for a “soft landing” for the US economy, but the window of opportunity has been greatly reduced. While the first half’s GDP fell, weakness was largely concentrated in the housing sector. The two ISM surveys are perhaps the best gauge of activity and they both point to solid growth. The ISM component indices show easing pricing pressures along with improving supply chains. This is nothing but good news for inflation moving forward. If improving inflation isn’t enough to give the Fed pause, overseas economic weakness should. China is amidst cascading real estate development company failures and rolling COVID lockdowns. The war in Ukraine shows no signs of abating and is leading to surging energy prices in Europe. Lastly, the strong dollar puts pressure on both developed and emerging economies.

Bottom Line

The Fed dashed hopes of US markets with their hawkish Jackson Hole speech. While inflation continues to be a real threat to the US economy, there are increasing signs that improving supply chains along with rate increases have had a dampening effect. The Fed historically overshoots on rate increases and another policy mistake may be in the offing. The good news is that the market has priced in aggressive Fed action making additional market damage less likely. Our best hope for avoiding a hard landing is a weak CPI report on April 13th, giving the Fed a reason to pause.