Powell commits to hawkish stance

Jerome Powell’s speech at the Jackson Hole central banking symposium leaves no doubt that the Federal Reserve is committed to tightening policy further, even in the face of a slowdown in the economy or weakening of the labour market. Chair Powell noted the risks of letting inflation entrench at high levels for a prolonged period as more substantial than the impact tighter monetary policy will have in the near term. Pointing to the period of the 1970s and early 1980s when the Fed initially struggled to get inflation under control and then only managed to crush it with a “lengthy period of very restrictive monetary policy”, Chair Powell appears to want to avoid that eventuality by using heavy handed policy tools now, rather than later.

In his comments Chair Powell referred to the July FOMC when he said that another large hike in rates could be needed, after the Fed had already hiked by 75bps two meetings in a row. With a few more weeks ahead of the September FOMC (to be held on September 21 st), whether the Fed goes with another 75bps hike or slows down to a still large 50bps hike remains in the balance. According to Chair Powell, the September FOMC hike will “depend on the totality of the income data and the evolving outlook.” Between now and then we will get prints for August nonfarm payrolls (expected at a still strong 300k) and August CPI. The last inflation print for July showed a slowdown to 8.5% y/y from 9.1% in June but Powell noted that “a single month’s improvement falls far short” of what the FOMC needs to see as far as inflation moving in the right direction.

Economic data elsewhere from the US has been mixed, with personal income and spending coming up weaker than expected in July while the final reading of the University of Michigan consumer sentiment index for August came in better than its initial print. Inflation expectations have also declined. While inflation has remained high in the middle months of the year, the drop in commodity prices over the last several months will have helped to bring fuel prices lower in the US at least—benchmark gasoline futures have fallen almost 18% since the start of August alone.

For now we are holding to our expectation of a 50bps hike at the September FOMC followed by two more 50bps before the end of 2022. While slower than the large 75bps hikes used in June and July, another 150bps of hikes by the end of this year is still a considerable level of tightening and will bring policy rates well above the FOMC’s estimates of long-run neutral levels. As we move into 2023 we do not expect an early pivot toward cuts, as the market had been pricing for much of July and August, but rather that the Fed will maintain a bias toward fighting inflation even at the cost of slower growth and a weaker employment market. We expect the Fed Funds rate to peak at 4.5% by Q2 next year before the Fed can start to ease later in 2023 with a terminal rate of 3.5% by the end of next year.