Powell’s Message: Curb your Enthusiasm for a Soft Landing
August ushered in indications of inflation potentially peaking with housing market data decidedly slowing. However, labor market reports reflected continued strength. In light of economic crosscurrents, investors kept Federal Reserve policy front of mind. Also notable, the Democratic majority broke its political logjam to pass additional fiscal spending and taxation legislation.
The Bureau of Labor Statistics reported Friday, August 5th, July jobs report payrolls increased by 528,000, more than double the expectations, for the number of jobs created in July. In addition, wage growth is over 5%, and the participation rate declined. Headline unemployment decreased from 3.6 to 3.5%. The jobs strength was accompanied by a hotter-than-expected wage inflation average as hourly earnings jumped 0.5% for the month and 5.2% from a year ago, higher than estimates. Surprising labor market strength swung the market angst pendulum from recession fears to persistent inflation and whether the Federal Reserve will make additional outsized rate hikes.
The strong jobs data refocused the public economic debate from “when is recession a recession?” to “Can inflation decrease while the economy maintains full employment?” It’s an essential question as Federal Reserve members asserted that it’s possible to lower inflation without increasing unemployment (a.k.a. engineer a soft landing). However, prominent Keynesian economists disagreed, referencing the Beveridge Curve (presented below) as a historically well-documented relationship between job openings and unemployment as proof that to subdue inflation, the Federal Reserve must slow the economy to the point of increasing unemployment.
Fed Governor Waller asserted in a speech that labor demand could fall sharply without unemployment increasing due to twice as many job openings as unemployed workers. The Fed has published papers observing a shift in the Beveridge curve, which in economic parlance means the relationship between the two variables has changed and is non-linear. Looking at the graph, it seems reasonable to think that with the extreme vacancy rates and tight labor conditions, some job postings could be withdrawn without impacting employment. However, perhaps with a 5% vacancy rate, it will return to its historical relationship at some point. And if it is not enough to achieve the Fed’s 2% inflation objective, the Fed will have to do more.
In the waning days of summer, the Federal Reserve gathered in Jackson Hole, Wyoming, for a central bank symposium. Last Friday, Fed Chair Powell delivered hawkish comments as the markets responded with a “Taper Tantrum.” Both his demeanor and message were resolute. His message was as brief and to the point as Powell can be. The Federal Reserve’s overarching focus is achieving its 2% inflation goal. Without sustained price stability, economic prosperity is not possible. The public and the market’s expectations are “anchored” to the notion that inflation will recede and be stable near the Fed’s 2% objective in the next few years. Below is a chart from the Federal Reserve Bank of Cleveland, which maps out the inflation expectations investors currently have in the bond markets. However, those expectations can break anchor if inflation stays persistently high for too long. Powell reminded listeners of the hard lesson central bankers learned in the 1970s. If the public expects elevated long-term inflation, they will rationally consider it when making financial decisions. Expectations for higher inflation beget more persistent inflation. Powell’s stern message was that the Fed will take action on inflation until they’ve achieved their objective. Delaying action or pussyfooting around will only mean a bigger inflation problem and more extensive policy with more severe economic slowing.
The market sold off on the expectation the Fed, favoring recession over inflation, would choke off growth. On Friday, August 26th, the S&P 500 (1) was down approximately 3%, and the NASDAQ (2) nearly 4%.
Powell clearly intended to flip the script from debating whether a soft landing is possible to the Fed will tame inflation ASAP, regardless of consequential pain. To keep the inflation problem from worsening, he needs to keep the public’s intermediate-term inflation expectations anchored in the belief that inflation will recede. He needs the public and markets to believe that if a hard landing is the cost of taming inflation, it is a consequence he will accept.
It is important to note that during his comments, Powell acknowledged, “In my view, our economy continues to show strong underlying momentum.” Beyond the strong labor market, Barry Knapp of Inronsides Economics offers interesting insights that expand on Powell’s observation of strong underlying economic momentum, “2Q real Gross Domestic Income (GDI) was positive at 1.4% quarter-on-quarter annualized, down marginally from 1.8% in 1Q. Nominal GDI accelerated in 2Q to 10.5% from 10.2% in 1Q. Income drives investment in capital and labor, and given 11.5% year-on-year growth in core capital goods shipments, S&P 500 adjusted capital investment (CAPEX plus R&D spending) of 19.9% from a year ago, and 10.3% labor income growth (hours worked multiplied by nonsupervisory average hourly earnings), it appears output and productivity are still expanding. The expenditure method of output (Gross Domestic Product) is misleading. This is a critical flaw in the bearish narrative that the Fed will be forced to drive the US economy into a ditch to slow inflation.”
Though it may strike you a bit wonky, Knapp has an interesting point as to how the growth of the economy is commonly measured by GDP and makes a compelling case the GDI is what matters most. “Our preferred measure of total output, gross domestic income (GDI), may be having its day in the sun that leads to a change in focus for policymakers, market participants, and government statisticians. Income, not the output of ‘stuff’ (GDP), drives investment in capital, labor, and technology, which are the inputs to productivity growth. Income matters, the Bureau of Economic Analysis should focus on it just as investors do. If you use GDP as an input to a macro corporate earnings model, you are doing it wrong.”
As the Federal Reserve jawbones and takes measures to dampen inflation, we will stay focused on what we can control and remain committed to investment strategies informed by your financial plan and portfolios that are well-diversified, cost-effective, and tax conscious. We will stay true to our long-term, strategic asset allocation principles and belief that equities will outperform bonds over the long run.
Thank you for your continued trust!
Tim
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1. S&P 500 Index – The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.
2. NADAQ – The NASDAQ is an unmanaged group of securities considered to be representative of the stock market in general.
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