If the Kansas City Fed's annual conference in Jackson Hole is Woodstock for economists, the sitting Federal Reserve Chair is its Jimi Hendrix.
This year Jerome Powell didn't disappoint. While his speech lacked any of the fireworks of some grand new policy plan, Powell did a masterful job of explaining how the Fed is thinking and what could come next.
Here is my summary of both what he said and how you should be investing around it.
Not Too Fast, Not Too Slow
Powell used a nice rhetorical device to shape his talk, starting the meat of his remarks by calling out the criticisms the Fed faces from both sides:
"A good place to start is with two opposing questions that regularly arise in discussions of monetary policy both inside and outside the Fed:
- With the unemployment rate well below estimates of its longer-term normal level, why isn't the FOMC tightening monetary policy more sharply to head off overheating and inflation?
- With no clear sign of an inflation problem, why is the FOMC tightening policy at all, at the risk of choking off job growth and continued expansion?"
This is, in essence, a debate between those that have a traditional view of macroeconomics (#1) vs. those that think (borrowing from the conference's title) that the market's structure has changed in such a way that we should continue to worry about inflation being too low (#2). Powell walked us through how the Fed is thinking about both.
Old School Economics
Powell briefly described what he called the "conventional view of macroeconomic structure." It is a bit ironic (and telling) that he included this since the room is full of economics Ph.D.s, most of whom have probably taught Macroeconomics 101 at some point in their lives.
Powell himself is a lawyer by training, so arguably, he's one of the least qualified people in the room to give a quick survey of "conventional" macroeconomics. But here we are.
In a conventional economic model, as Powell tells it, the economy has a set of "normal" or "natural" outcomes. It is most desirable to be close to these natural levels as possible, not too high nor too low. This includes metrics like inflation, GDP growth, and unemployment. Monetary policy is meant to guide the economy toward these natural rates.
These natural rates are often referred to with a "star", e.g., r* is the natural rate of interest, u* for unemployment, π* for inflation, etc. Hence you raise rates above r* whenever u* is too low and vice versa.
This section is Powell trying to show that while the Chair is plenty aware of these "conventional ideas," he knows he can't make monetary policy decisions solely on these concepts:
"Navigating by the stars [r* and the like] can sound straightforward. Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly."
The Sins of the Past
Powell then details how the "shifting stars" have fooled the world's best economists historically. Immediately after the crisis, many economists thought that the natural rate of unemployment had risen, maybe into the 6% area. Turns out that was way too high.
In the 1970s, economists assumed that unemployment above u* would keep inflation under control. That turned out to be way wrong.
In the late 1990s, as unemployment fell to 4% (and even lower), conventional wisdom said that the Fed needed to hike quickly. Greenspan held off, though, and he turned out to be correct: inflation never moved meaningfully higher and the economy boomed.
All this might have felt a bit chastising to the crowd at Jackson Hole. He's speaking to a room full of people who make their living building economic models, and here he is reminding them of how off those models have been in the past.
However, it is a crucial message for the markets to digest right now. The market seems to have a high degree of confidence that the Fed will pause once it gets to r*. Powell is saying quite explicitly that even if they wanted to stop there, he doesn't actually know where r* is.
"... when you are uncertain about the effects of your actions, you should move conservatively. In other words, when unsure of the potency of a medicine, start with a somewhat smaller dose."
Powell wraps up the speech by saying that since they don't know what the neutral rate of interest is, nor the level of growth or unemployment that the economy can handle, they should do everything with caution. They are afforded this luxury by the fact that inflation remains low and employment growth strong, hence they aren't pressed into urgency from either direction.
Critically thought caution doesn't mean inaction. Caution means moving slowly but purposefully.
Does This Suggest the Fed Might Pause Soon?
Not at all. In fact, I'd argue just the opposite.
If you don't know where r* is, then the "conservative" thing to do is to keep hiking as long as unemployment keeps falling. Indeed, Powell referenced Okun's law, which implies that unemployment will keep falling as long as GDP growth is above potential. Since you can't observe potential GDP, if Okun is right, then you can assume that we're running above potential GDP if unemployment is falling.
I'd argue the exact same idea holds for r*. If the Fed pegs rates at exactly r*, monetary policy would be neither accommodative nor stimulative.
If unemployment is falling, we can reason that monetary policy is still accommodative. Hence we aren't yet at r*. While Powell didn't say this directly, it is a clear implication of his whole "shifting stars" metaphor he weaved through the speech.
Since we cannot observe these critical variables like r* and u* directly, we have to impute their value by observing how the economy is behaving.
The Fed Will Keep Hiking Until It Causes Damage
This brings me to a point I've been hammering for months now. The Fed has two choices: guess where r* is and pause when you get there, or feel your way to r*, knowing that you inevitably will hike too far before you realize you blew past r*.
Powell has clearly chosen the second option.
My Trade Ideas
This gives us a few clear conclusions.
- Short-term interest rates will keep rising as long as the economy is performing. If you are a bull on stocks, it can't be because you are betting on an accommodative Fed. You have to be betting on strong core earnings growth. I like shorting 3-7 year Treasuries.
- Long-term interest rates are probably about as high as they are going to be. We don't know when the Fed will hike to far, but 10-year bonds already have three to four more hikes priced in. Unless you think they go more like six-to-eight hikes, holding 10-year bonds is a good trade. I like owning 10+ year bonds, and particularly like a pair trade of long 20-30 year and short 5-year.
- The Fed is likely to hike more than other big central banks. This should be a positive for the U.S. dollar intermediate-term. DXY was overbought but looks a lot easier to own now. I like being long USD.