Fed Chair Powell Awakens The "Sleeping Bear." Powell's Inflation Playbook Is Bearish
At the Federal Reserve Bank of Kansas City symposium at Jackson Hole, Fed Chair Jerome Powell said, " price stability is the responsibility of the Fed" and "restoring price stability will likely require maintaining a restrictive policy for some time to come." Those comments represent a sharp departure from Powell's remarks at the July 27 press conference following the FOMC meeting.
Only a month ago, Powell stated the Fed was moving "expeditiously to get to a range of neutral" and "we are at 2.25% to 2.5%", "right in the range of what we think is neutral." Investors interpreted these remarks as the Fed would soon be nearing an end to its inflation fight. Yet, Powell did a reverse pivot in making the most hawkish comments of his term as the Fed chair.
Following his remarks, the equity market sold off sharply. Mr. Powell and investors are equally responsible for the sell-off. Powell created the impression that the Fed's fight against inflation would be painless, and investors took the bait.
Reducing inflation is not a painless exercise. (See the August 16 report, "Investors Bet the "Bear" is Over, But the "Bear Cycle" in Lower Inflation and Less Profits is Not"). Price is what companies get for selling their products and services. In Q2, operating profits rose 8.1% from a year ago, and the GDP price deflator rose 7.5%. How much of the gain was price-related? A lot, so if the Fed intends to bring about a dramatic slowing of inflation unless companies cut costs quickly and dramatically, operating profits will take a big hit.
The significant risk now for investors is that Powell goes too far. Powell stated it's the Fed's "overreaching focus right now to bring inflation back down to our 2% goal." Yet, what is so magical about 2%? History clearly shows the economy performs better with low versus high inflation, but no policymaker or economist has offered any empirical evidence that the ideal inflation rate is 2%.
Policymakers and economists (including myself) are reasonably good at explaining why inflation is high or low but are very bad at predicting whether inflation will be high or low. In the two-decade span ending before the pandemic, consumer price inflation averaged about 2%. Was that low-price environment based on good luck or design? I would argue that the favorable inflation environment was a by-product of globalization, technological innovation, and other one-offs rather than a well-run monetary policy and the Fed's stated 2% goal.
What happens now if the unique factors that helped produce low inflation subside in intensity and inflation stabilize close to 3%? Does Powell force it to 2%?
Powell's Jackson Hole speech is the inflation playbook investors should follow now. And in my view, it raises the odds of a prolonged volatile and bearish investment environment as Powell supports a "restrictive policy stance for some time to come" and is "strongly against prematurely loosening policy."