Jerome Powell’s speech was crystal-clear and markets are reacting.
Jerome Powell’s speech of 26.8.2022
In his eagerly awaited speech, the Fed Chair could hardly have been more explicit without snubbing notorious bulls. The Fed’s primary goal is to bring inflation down to the target level of 2%. According to Mr. Powell, price stability is currently the Fed’s most important goal as it is the foundation of a robust economy. Without price stability, the economy does not function properly, and a sustainably healthy labor market is not possible. And if high inflation gets baked into expectations it becomes entrenched in prices and wages and a wage-price spiral can develop. This must be avoided. Failure to fight inflation would have serious consequences for the economy. The low inflation of the last two years has contributed to a high degree of planning security for companies and made recent high growth possible in the first place. The current unusually high rate of inflation is also undesirable because it hits hardest those sections of society least able to bear it.
However, the US economy is still in good shape. The labor market is very robust and qualified workers are hard to find.
Price stability requires a balance in the supply of, and demand for, goods and labor. A weaker labor market, higher interest rates and less growth will bring inflation under control but will burden businesses and households.
The first signs of an economic slowdown are already visible. The recent fall in inflation to 8.5% is welcome but by no means a reason for complacency. The Fed will continue to tighten monetary policy decisively and vigorously until inflation is clearly moving towards the 2% target.
Consequently, an unusually large interest rate hike is now to be expected in September. Powell points to three lessons from the Fed’s fight against inflation: (1) the goal of price stability can be achieved but changes in the Fed funds rate only work on the demand side, (2) inflation expectations play an essential role in planning certainty, and (3) the 2% inflation goal will be pursued consistently.
Conclusions
Tight monetary policy will inevitably lead to a US recession, with seriously negative consequences such as rising unemployment and a consequent fall in household demand. Mr. Powell’s speech must be interpreted as a relaunch of a “Volcker-like” monetary policy. Fed funds futures are currently pricing in a rate hike of at least 75 basis points for the next FOMC meeting in September. But this will by no means mark the end of the Fed’s rate hiking cycle.
The clear words of the Fed Chair have impacted capital markets. On the day of his speech, US equity markets plunged more than 3% while interest rates were very volatile across the yield curve although they closed almost unchanged from the previous day. In early trading this week, yields on two- and ten-year government bonds rose, respectively, from 3.39% to 3.48% and from 3.04% to 3.12%. The yield curve has thus become somewhat more inverted, suggesting an increased probability of recession. We see these trends continuing and they are likely to further weigh on the equity markets, at least in the short term. For risk-averse investors, we recommend realizing any profits from the rally in markets in late spring/early summer.
Contact: Christoph Sieger, Portfolio Manager
Telephone: +41 58 680 60 56
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