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"A Sustained Period of Below-Trend Growth."

Why Jerome Powell's speech in Jackson Hole shocked the markets.

30 Aug

Unfortunately, We’re Just Getting Started..

“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. 

While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation.”

— Jerome Powell (source)

In this post, we’re going to:

  • Revisit mid-April predictions about the Fed and the stock market

  • Provide the Fed’s updated POV on inflation and the economy

  • Add our own thoughts and reaffirm the actions we’re taking

Don’t Fight the Fed

Financial conditions are incredibly important here in the United States. As confirmed by Jerome Powell himself — they directly impact monetary policy. When we shared this post on April 14, the Fed had yet to do much to tighten financial conditions.

The market was only -4% off its recent highs and bond yields were hovering ~2%.

In that post, we featured ex-Chief Economist at Goldman Sachs, Bill Dudley, who said in an interview with Bloomberg, “If stocks don’t fall, the Fed will need to force them.”

The reason he said this was because the stock market at the time seemed to be pricing in some sort of “soft landing” by the Fed — where they’d tighten financial conditions enough to lower inflation to historical norms, but not so tight they’d force the economy into a recession.

Jerome Powell has stated this is his ultimate goal — which is exactly what we should be aiming for. No one wants a recession.

However, a soft landing is incredibly hard to pull off, especially with inflation at 40-year highs. In the post, I explained how the markets weren’t pricing in what is coming — but instead this “soft landing” scenario.

“Right now, the markets aren’t reflective of what I think is coming. To me, the markets think the Fed bumps rates, the economy slows, the Fed eases policy in 2025 or so, then things go back to normal. These “back to normal” outcomes have happened in the past, but every time they’ve happened the unemployment rate kept trending lower because the economy didn’t slow enough to push up the unemployment rate.

Today, the unemployment rate hovers around 3.5% — and inflation is hotter than ever. In our opinion, the Fed will need to really slow down the economy to make any sort of dent in inflation. This will more than likely force the unemployment rate higher — and every time the Fed has done exactly that in the past, we experience a recession. Every single time.”

The stock market fell some -14% before the end of the second quarter — creating a “local bottom,” before trading higher as we experienced what was determined to be a bear market rally.

My explanation from this post for the bear market rally is below.

“To summarize, the markets rallied on better than expected earnings, cooling inflation, and a handful of other catalysts. There seems to be no immediate catalysts for a market sell-off on the horizon — however, the Jackson Hole Economic Symposium in late-August could become that catalyst.”

It was indeed a catalyst for a sell-off — the S&P 500 fell -3.5% and the Nasdaq fell -4.0% after the event.

But why?

Monetary Policy and Price Stability

On Friday, August 26, Jerome Powell took the stage at the Jackson Hole Economy Symposium — and the country was watching. Below is a detailed breakdown of the most important takeaways from the speech.

— Inflation

“The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone.”

Jerome started the speech off by getting straight to the point — reaffirming the country that the Federal Reserve’s number one goal right now is the cool inflation to historical norms. To me, this means “by any means necessary,” and I’ll explain why further on in this post.

“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.”

This is the statement, that shocked the markets.

Jerome Powell just told everyone that in order to restore price stability, there needs to be a sustained period of below-trend growth (recession) — which will cause a “softening” labor market (unemployment), bringing pain to households and businesses.

This is one of the main reasons why we saw a lot of red in the markets immediately after the Jackson Hole speech.

“If the public expects that inflation will remain low and stable over time, then, absent major shocks, it likely will. Unfortunately, the same is true of expectations of high and volatile inflation. The more inflation rose [in the 1970s], the more people came to expect it to remain high, and they built that belief into wage and pricing decisions.”

Jerome is directly telling us to stop assuming inflation will remain elevated for years to come. It won’t — and if we continue to act like it will, it will slow down the process of bringing it down.

— Interest Rates

“While the lower inflation readings for July are welcome, a single month's improvement falls far short of what the Committee will need to see before we are confident that inflation is moving down. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent.

July's increase in the target range was the second 75 basis point increase in as many meetings, and I said then that another unusually large increase could be appropriate at our next meeting.

Restoring price stability will likely require maintaining a restrictive policy stance for some time.”

To me, this was the Fed saying they’re happy to see inflation come down a little in July, but they need inflation to come down a lot — and quickly. To accomplish that, not only do they need to continue being aggressive, but they’re going to continue to be aggressive even after inflation is back to normal to keep it there.

As mentioned above, the market was pricing in some sort of “easing” to begin in 2024 or 2025. This statement just completely got rid of those hopes — which is another reason why we saw a lot of red on Friday.

“It is also true, in my view, that the current high inflation in the United States is the product of strong demand and constrained supply, and that the Fed's tools work principally on aggregate demand. None of this diminishes the Federal Reserve's responsibility to carry out our assigned task of achieving price stability. There is clearly a job to do in moderating demand to better align with supply. We are committed to doing that job.”

Another interesting point to mention — supply and demand drive prices up and down, and the Fed knows that despite their inability to impact the supply side, it’s their job to rebalance the demand side of the equation. This could mean tightening financial conditions more than if supply constraints didn’t exist.

The NY Fed recently released a report that quantified the world’s supply constraints on inflation — “inflation in the US would have been 6% instead of 9% without supply bottlenecks.”

“We must keep at it until the job is done. The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.”

The above is a sign of relief.

As you all remember from this post, I don’t believe the stock market will experience a true “bottom” until inflation is under control. A worry of mine was we’d revisit The Lost Decade — a prolonged time of up and down movement in the stock market catalyzed by preemptive loose monetary policy.

Jerome Powell is telling us he will not be doing this. He will not prematurely loosen monetary policy (like the Fed did in the 70s that caused this lost decade), and instead continued to tighten until it is obvious the worst of inflation is past us.

Defense, Defense, Defense!

As I shared just two weeks ago (below) — I’m playing defense right now. I’m taking chips off the table, nibbling at what I believe are oversold tech companies, doubling down on big winners (UNH, PANW, etc.), and leaning into what is probably the largest secular growth trend of our generation — cloud computing.

Another post worth reading is this (Hold on to Your Pants..) — we hear from technical analysis expert Katie Stockton as to why she’s playing defense and believes we’re headed much lower, listen to what the bond markets are telling us, and learn more about the September Effect.

Summary — Jerome Powell informed us that the Fed…

  • Is laser-focused on bringing inflation down to 2% — by any means necessary.

  • Recognizes businesses will falter and unemployment will rise — and they’re completely fine with that reality.

  • Has yet to see what they’re looking for in order to know they’ve begun adequately tightening enough.

  • Realizes that the supply side of the equation is tight — which means they need to tighten the demand side even more to match it.

  • Will not create a Lost Decade in the stock market — which means they’ll tighten until it’s painfully obvious it’s time to stop.

As we’ve been saying for nearly 9 months now.. things are likely to get much, much worse before they begin to get better.

Disclaimer: This is not financial advice or recommendation for any investment. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.

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