Higher for longer
Powell uses Jackson Hole keynote to reiterate Fed’s vigilance to lower inflation.
Federal Reserve Chair Jerome Powell is pleased inflationary pressures have eased in response to aggressive interest-rate hikes and balance-sheet reduction. But core CPI remains more than double policymakers’ target. This morning, he used his keynote address at the annual central-bank symposium in Jackson Hole, Wyo., to remind investors they remain vigilant.
“It is the Fed’s job to bring inflation down to our 2% goal, and we will do so,” Powell said. “We are prepared to raise rates further if appropriate and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.”
The big picture Started in 1978 and hosted by the Kansas City Fed, monetary officials from around the world gather to discuss global economic issues. This year’s theme was “Structural Shifts in the Global Economy,” and the Fed chair typically delivers a high-profile speech on the theme. But the financial world mostly pays attention to his comments on U.S. policy both immediate and long-term.
Not moving the goal posts For the latter, Powell settled a controversy within the economic community. Speculation has arisen recently that the Fed is considering raising its long-held inflation target to 3%. That potentially would alter its tightening campaign. We’d likely see rate cuts shortly. Powell addressed that issue head-on, declaring 2% “will remain our inflation target.”
What’s next for the Fed? Powell admitted he can’t be as decisive in the short-term. The macroeconomic environment is confusing, causing policymakers “to navigate by the stars under cloudy skies,” even as they have raised the fed funds rate from near zero to an upper band of 5.5% and shrunk its balance sheet from $9 trillion to $8.1 trillion in just past 18 months
The Fed stayed put in June, but resumed the tightening cycle in July with a 25 basis-point hike. We think it will forgo action at its September meeting, and may well continue the recent pattern with another quarter-point hike in November. And while the Fed may be close to achieving its terminal rate, we do not expect them to pivot to rate cuts before the middle of 2024.
Inflation divergence Our reasoning is due to the significant divergence between the improvement in headline inflation—which appears to be the market’s focus—and the muted progress of lower core inflation, which is the Fed’s emphasis. Core CPI does not take energy and food costs into account because they tend to be volatile and say less about the path of the economy.
Headline CPI fell from a 41-year high of 9.1% year-over-year (y/y) in June 2022 to 3.2% last month (a 5.9% drop), while core peaked at a 40-year high of 6.6% in September 2022 but only declined to 4.7% (a 1.9% drop). Similarly, the headline Personal Consumption Expenditure (PCE) index fell from a 40-year high of 7% y/y in June 2022 to 3% in June 2023 (a 4% drop), while core (the Fed’s preferred inflation measure) has fallen from a 39-year high of 5.4% in February 2022 to 4.1% in June 2023 (a 1.3% drop). In its most recent Summary of Economic Projections (SEP) published in June, the Fed forecasted core PCE will eventually hit 2.2% by year-end 2025.
Black diamond? Jackson Hole is a renowned for its ski slopes, but the Fed is concerned it will face tough sledding. The Fed remains concerned about a possible reversal in those trends, especially as the housing and labor markets remain strong.
Housing has been in a recession for the past nine quarters, as mortgage rates have more than doubled to a 22-year high of 7.65%. But there’s enormous pent-up demand for shelter, with a national housing shortage of some four to five million units, and rents and home prices have not yet declined noticeably.
The labor market remains firm, with the unemployment rate (U-3) at a half-century low of 3.5% and wage growth at a healthy 4.4% y/y in July. The Fed expects U-3 to rise to 4.1% by year-end and reach 4.5% by the close of 2024. But many labor unions have been demanding—and some receiving—double-digit, multi-year wage gains. These could narrow profit margins and spark higher inflation as companies pass those costs onto consumers in the form of higher prices. Slower economic growth and higher inflation is a recipe for stagflation, which likely has the Fed concerned. Certainly Powell is: “Getting inflation sustainably back down to 2% is expected to require a period of below-trend economic growth as well as some softening in labor market conditions.
In this regard, energy costs still could be crucial, despite not being included in core. Prices have soared recently, with crude oil (WTI) jumping by 30% this summer, rising from a low of $65 per barrel in March to a recent peak of $85 per barrel last month. That has driven gas prices at the pump up by 25% so far this year, rising from $3.10 per gallon last December to a recent peak of $3.88 per gallon in August.
Data dependent Powell explained that risk-management considerations are critical for the Fed. Officials will assess progress based upon the totality of the data and the evolving outlook and risks. “We will proceed carefully as we decide whether to tighten further or, instead, to hold the policy rate constant and await further data. We will need price stability to achieve a sustained period of strong labor market conditions that benefit all.”