Wall Street is nervous about Federal Reserve Chairman Jerome Powell’s big speech in Jackson Hole, Wyo., on Friday. The S&P 500 rally came under pressure along with a shift in odds to favor another 75 basis point rise on Sept.
But what is there really to fear from Powell’s speech? After all, the Fed chairman suspended forward guidance at his July 27 press conference. This makes it doubtful that he will take sides on the size of the next rate increase.
The concern is that Powell will try to undo the dovish impression he gave at his July 27 press conference. Those comments helped the S&P 500 rally as much as 18% from its June 16 low, exiting a bear market.
However, Powell will maintain his optimistic view that the Fed still has a chance to project a relatively soft landing for the US economy. And while policymakers may not like the stock market rally, which runs counter to their efforts to cool the economy and contain inflation, Powell is far too prudent 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 Class
In a remarkable speech on March 21, Powell took a tour of the history of the Fed’s soft landings to support his contention that the current tightening could produce a similar result. Powell looked at 1965, 1984, and 1994 as proof that tightening the Fed need not result in a recession.
He also cited the Federal Reserve tightening from 2015 to 2019 to bolster his case. And while the recession ensued in 2020, it was Covid – not the Fed – that took the blame.
Federal Reserve meeting minutes reduce high rate hike odds
Now, some economists think Powell might decide to give a slightly less encouraging history lesson. Nomura economists Aichi Amemiya and Robert Dent wrote in their preview at Jackson Hole that Powell’s speech may feature “an emphasis on 1970s experience”.
“A number of Fed participants have recently pointed to this era with some level of caution, usually to emphasize their preference to avoid a ‘stop-and-go’ squeeze path,” they wrote.
Fed ‘tighter for longer’?
Aside from just before the pandemic, the last time unemployment hit 3.5% was in 1969. The Fed responded by raising its interest rate to 9% to try to short-circuit a surge in wage-led inflation.
However, the Fed reversed course in 1970. It reduced the federal funds rate to less than 4% in early 1971. This helped raise the unemployment rate to 6%. But “it was not high enough to ease wage pressures,” Jefferies chief economist Aneta Markowska wrote in a June 3 note.
“The Fed has not created enough slack to tighten inflation and stabilize inflation expectations,” she wrote. “Policymakers repeated the same mistake in the mid-1970s, rising aggressively and causing another recession, but then slowing down too soon and allowing inflationary pressures to reassert themselves.”
The lesson, in Markowska’s view: “When faced with a feedback loop between prices and wages, the Fed needs to stay tighter for longer.”
“Tight longer” is the last message investors want to hear, and a term Powell is unlikely to touch. This is because the S&P 500 rally was built, at least in part, on the hope that the Fed will stop raising rates in early 2023 and pivot to rate cutting around the middle of the year.
Easing financial conditions
Financial markets are already looking at a reversal of the Fed’s tightening. This, in turn, had the effect of easing financial conditions, reflected in lower market interest rates and a higher S&P 500, Dow Jones Industrial Average and Nasdaq.
Minutes from the July 26-27 Federal Reserve meeting highlighted a “significant risk” that “high inflation could take root if the public begins to question the Committee’s determination to sufficiently adjust policy stance.”
The minutes noted: “If this risk materializes, it would complicate the task of returning inflation to 2% and could substantially increase the economic costs of doing so.”
CPI inflation rate is finally falling – much more than expected
To address this risk – that recent easing of financial conditions will keep inflation higher than otherwise – Powell may want to instill more doubt that a pivotal Fed rate cut is coming soon.
This may not be great for the S&P 500 or the US economy in the short term. However, the Nomura economists write, Powell can argue that the Fed’s failures in the 1970s and the eventual “resolute efforts by the Fed to reduce inflation” under Paul Volcker show that the short-term pain will be worth it. .
Be sure to read IBD’s The Big Picture column after each trading day to get the latest stock market trends and what that means for your trading decisions.
Please follow Jed Graham on Twitter @IBD_JGraham for covering economic policy and financial markets.
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