Every August, for more than 40 years now, the Federal Reserve has held a retreat in Jackson Hole, Wyoming. It has become an important venue for Fed communications and investors this week will be focused on Jerome Powell’s speech, to be delivered at 10:00AM eastern time (or 8:00AM Wyoming time) on Friday.
The topic of this year’s conference is “Reassessing the Effectiveness and Transmission of Monetary Policy”, a subject that is well worth careful reconsideration. This, no doubt, will be the focus of Chairman Powell’s remarks.
An Updated View on the Economy
However, before fully diving into his topic, the Fed Chairman may feel entitled to a modest victory dance. Four years ago, when the symposium was virtual, due to the Covid pandemic, the unemployment rate stood at 10.2%. At the symposium two years ago, in the aftermath of the pandemic, the policy response and Russia’s invasion of Ukraine, the most recent reported year-over-year CPI inflation rate was 8.4%.
This week, the latest readings on unemployment and inflation are 4.3% and 2.9%, respectively, numbers which, when combined, are lower than their sum has been 80% of the time over the past 50 years. In addition, relative to five years ago, (before the pandemic so disrupted the economy and distorted the data), payroll employment is up 5%, non-farm productivity is up 9%, and, after adjusting for CPI inflation, we estimate that both S&P500 earnings per share and the total wealth of American households are up by 19%.
There are clearly problems – real average hourly earnings are up just 2% over the past five years, income inequality appears to have worsened and a combination of higher mortgage rates and higher home prices have put homeownership out of reach for millions of American families. On balance, however, the economy is strong and still slowly improving.
The Effectiveness and Transmission of Monetary Policy
However, while the Fed Chair may express some satisfaction on how far we have come, investors will undoubtedly be focused on what the Fed intends to do next.
These actions will, to some extent, be determined by how the Fed assesses the impact of monetary policy on the economy. Chairman Powell’s view, expressed at many press conferences, is that monetary policy is powerful but that it operates on the economy with long and variable lags. However, while this seems to tally with empirical observation, it is not clear, in a world of instant information, why this is or should be the case. If raising interest rates slows the economy simply by increasing the cost of borrowing for consumers and businesses, it shouldn’t take consumers and businesses long to respond. Similarly, cutting rates, in this simple view of the world, should instantly stimulate demand.
Unfortunately, that is not how monetary policy operates in the real world. In particular, it appears that, in the economy of the 2020s, cutting interest rates first slows the economy and then stimulates it, in a sort of “J-curve” effect.
Cutting short-term interest rates reduces yields on CDs and money market funds, thus reducing interest income, which is particularly significant for older and more affluent households. Fed easing can also have negative psychological effects by convincing potential borrowers that the Fed is worried about the economic outlook and that they will likely cut rates further, two good reasons to wait and see before making business decisions – a perspective that further slows demand. Once rates have hit their lows for the cycle and the Fed starts to talk about raising rates, these last two psychological effects fade and lower rates probably do stimulate demand. But in the short run, monetary stimulus isn’t just ineffective – it’s counterproductive.
The Fed’s Most Likely Path and Investment Implications
This may explain some of the recent volatility in expectations concerning the Fed. The latest Fed “dot plot”, produced at their June Meeting, forecast just one 25-basis-point cut in the federal funds rate by the end of 2024 and a further 1% reduction by the end of 2025. However, by August 4th, following slightly elevated unemployment claims and a weak July employment report, the market was more than pricing in a 1% cut by the end of 2024 and cuts of more than 2% by the end of 2025.
One of the reasons for this sharp turn in expectations is likely a recognition that if the Fed were to start to cut aggressively, it would likely continue to do so. If, for example, the Fed cut 50 basis points at their September meeting, the economy would likely be weaker, not stronger by the time of the November meeting, putting pressure on the Fed to institute further 50-basis point cuts. This is a path that the Fed would clearly like to avoid, preferring to normalize rates slowly in an economy that was maintaining steady growth, even as inflation drifted down to their 2% target.
Data from last week make this seem more likely.
- Unemployment claims, having climbed to 250,000 in the last week in July, have fallen back to 227,000 in the latest week.
- Retail sales came in much stronger than expected for July, showing a 1% headline increase for the month.
- Gasoline prices continue to drift down, as does CPI inflation, providing a small boost to consumer confidence.
- Very high frequency data, such as open-table restaurant bookings and TSA checkpoint numbers, show steady consumer traffic.
- Equally importantly, a sharp fall in the stock market has mostly been reversed. The S&P500 fell 8.5% from a record high between July 16th and August 5th but has since regained over three-quarters of those losses.
While housing and manufacturing remain weak, data overall suggest that economic growth is slowing rather than slumping. The Fed will, of course, take account of data and events from the week ahead. However, it seems likely that, at his speech on Friday, Chairman Powell will try to reinforce the idea that monetary easing should be, and will be, gradual, setting the stage for a 25 basis point rate cut in September, with the potential for only between 25 and 50 basis points in additional cuts before the end of the year.
For investors, this should actually be regarded as good news. The truth is, that while active monetary policy can be quite effective at times of financial stress, such as in stabilizing financial markets in the Great Financial Crisis, it has proven itself to be very ineffective in stimulating a slow economy or cooling a hot one. Luckily, outside of times of crisis, the economy appears to retain the ability to heal itself – as it has largely done over the past few years – and this should support a further rise in stock prices and a slow drift down in long-term interest rates.
In short, in the mid-2020s, both the economy and financial markets would probably benefit more from a Fed that was willing to ponder the effectiveness of aggressive monetary policy, as they will do in Jackson Hole this week, rather than put it to any further real world test.