“They say any landing you can walk away from is a good one”
In our last piece, we discussed the iterative Fed communication and its continuing importance as the dominant driver of global positioning and sentiment - outside the acute energy price issues of the eurozone which we will leave to one side for today.
Ultimately, we have argued for some time now that there is a path between unanchored and pernicious inflation expectations and a sharp rise in the unemployment rate that has been dubbed the ‘soft landing zone’ - A concept that the market sentiment has acute difficulty with, instead swinging between the dominance of growth risks and inflation risks. The glide path to soft landing may be thought of theoretically as a (gentle) straight line to a period of sub-equilibrium (but still positive) growth concurrent with a rebalancing of demand with respect to supply (particularly on the labour market) - and thus lower inflation pressure.
We continue to see a soft landing as a likely outcome (although there are clearly risks in both directions - growth and inflation) and recent market reactions as oscillations around its glide path.
In our last piece we referred to the recent debate about the monetary policy evolution following the July Federal Open Market Committee (FOMC) meeting. The broad market interpretation was that the accompanying statement and press conference (following a 75bp hike) constituted a ‘dovish pivot’. We wrote:
“…and at the centre of the debate was a criticism of Fed’s Chair communication, and what some had referred to as a dovish pivot. We disagree.
In short, the point we are trying to make is that the Chair of the Federal Reserve narrative, in July, was completely in keeping with the June SEP’s and the June dots, and was in no way suggestive that the Fed will not live up to its clear forward guidance contained therein (i.e. most specifically, the 3.25-3.50% median dot, for end ’22, but also the 3.75-4.00% median dot for end ‘23). However, until this point, the 2nd derivative of Fed policy had been positive (i.e. the iterative policy path became increasingly hawkish - taper, faster taper, 25bp hike, 50bp hike plus (passive) QT, 75bp hike); the July meeting validated the June projections of the terminal rate, and thus the change in the second derivative - from positive to negative, as the hike increment slows.”
We continue to hold a more positive, glass half full view of the US economy and the view that the Fed’s narrative is still consistent with the June SEP projections.
Last week, at the Jackson Hole Symposium “Reassessing Constraints on the Economy and Policy”, there was again a significant market response to the Fed narrative. This time in the opposite direction. However, while commentators have all been very quick to term the most recent Fed iteration as uniformly hawkish, much like in the aftermath of the July FOMC, we disagree.
The Chair of the Federal Reserve’s very brief speech from Jackson Hole (just 8 minutes) reiterated the argument that it will likely become appropriate to slow the pace of tightening “at some point” as per the July FOMC press conference. However, the language (likely influenced by the market reaction to the July FOMC press conference where the market saw a dovish pivot - counter to our interpretation and likely that Fed’ Chair ahead of time), was more careful, more specific but we would continue to argue, is still entirely consistent with the June SEP’s and dots - i.e. a rate path consistent with that outlined in June.
The Fed’s Chair stated that the economy will “likely require restrictive policy for some time” and that the Fed is taking “forceful and rapid steps to moderate demand”. From my perspective the message was really a reinforcement of the importance of communication in maintaining control of the inflation narrative (perhaps also motivated by the recent slight uptick in the long end inflation expectations).
There were a number of specific points: (i) an emphasis of the importance of acting aggressively in a front-loaded manner to realign demand and supply, (ii) a clear pushback to market expectations/pricing that rates will automatically come down quickly simply due to being in restrictive territory (It has subsequently been argued that if the exact level of r* is uncertain, then its gravity over the near term should be reduced - seems fair)... and three lessons: 1. Central banks should take deliberate responsibility for delivering low and stable prices – through an unconditional commitment to price stability (emphasising this further through the statement that current high inflation may be the function of strong demand and constrained supply – but this will not diminish the Fed commitment to deliver low and stable prices) 2. Public expectations about future inflation plays an important role – and that there is no ground for complacency in this regard and 3. The Fed must keep at it until the job is done – Volcker failures were not going far enough fast enough, leading to higher, longer, more painful rate hikes.
Ultimately, my interpretation of the Jackson Hole narrative is that it was all about targeted communication. If the biggest risk to maintaining price stability comes from inflation expectations then the central bank communication needs to convincingly maintain control of the inflation narrative. If market interpretation of the July FOMC implied a prematurely looser Fed reaction fund then it is not surprising that the Fed tightens some of the language around its inflation fighting intentions. However, from my perspective, the Jackson Hole language is still consistent with an unchanged terminal rate (admittedly with evolving confidence bands) as per the June SEP’s.
Some have argued that the Jackson Hole speech takes us back to the doom loop thesis of financial conditions. I am more inclined to think of recent policy emphases as oscillations in guiding the US economy to a softy landing - the July FOMC trimmed the tail risk of significantly higher rates (reduced the inflation risk premium), the Jackson Hole speech reduced the rate cut pricing in 2023 and 2024 (arguably reducing the growth risk premium, albeit in an unconventional manner).
Lastly, I have also heard the term ‘hawkish hold’ to define the Fed process of reaching terminal rate and keeping them in restrictive territory for a period while inflation continues its path lower. Firstly, this is consistent with lower Treasury volatility and capped yields (likely a necessary precursor to eventual USD weakness) and secondly, by encouraging the market to price out rate cuts in ‘23 and ‘24, the Fed likely further caps the terminal rate in 2022. While markets oscillate on near term uncertainties, there are increasing signs that such oscillations will reduce over time.
There are clearly still risks to the global backdrop and to both sides of the US growth and inflation dilemma. Indeed, these risks will remain front and centre with the upcoming August employment report and CPI print both key to the growth/inflation, and thus, policy narrative.
American astronaut Alan Shepard said “any landing you can walk away from is a good one”. I wonder if Powell and the Fed would agree?
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Fed Minutes July 2022 - https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20220727.pdf
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