The stock market fell 3.3% on Friday, following Fed Chairman Jay Powell’s speech on monetary policy at the Jackson Hole Fed meeting. Mr. Powell affirmed the Federal Reserve’s commitment to bring inflation down, which will probably take some time and hurt lower-income people and businesses.
Despite Mr. Powell’s expressed determination and the stock market’s negative reaction, his message probably had little impact on the views of financial market participants: The Fed will remain data dependent, responding to developments that will shape its outlook for inflation and economic activity as they occur. While the target Fed Funds rate will continue to rise probably at least through the end of the year, the Fed will begin to taper its increases when it sees clear evidence that inflation is cooling.
The bond market, which took the news in stride, was little changed on Friday. The 2-year and 10-year Treasury yields were up two bp and one bp to 3.37% and 3.03%, respectively. The 5-year Treasury yield increased 5 bp to 3.20%; while the 30-year Treasury yield fell 4 bp to 3.21%. Taken together, the moves in the 5-year and 30-year suggest perhaps that the bond market now thinks that rates could remain higher for a little longer, but that yields will be lower in the long-run.
Broad-based measures of the U.S. fixed income market, such as the ICE BofA U.S. Broad Market Index, were essentially flat on Friday. Even the high yield market, which is much more sensitive to moves in the stock market, declined by only 0.25%.
While Mr. Powell’s speech was short – only eight minutes in length – it was very well crafted, addressing the key points in support of the Fed’s position. It explained the importance of bringing down inflation, maintaining price stability and keeping long-term inflation expectations low and “well anchored.” The Fed’s mandate to achieve price stability is well established. The speech also described the importance of sustaining the effort until the job is finished, when the Fed is confident inflation has been brought down to and is likely to remain at or near its long-term target range of 2%. One data point is insufficient to declare victory; the Fed will likely have to see several months of slowing inflation before it begins to ease up on the brakes.
Mr. Powell also acknowledged the key challenges that this policy shift will face. It will likely require a sustained period of below-trend growth that will bring some pain to households and businesses. Many of the factors that have sparked inflation are supply-related, which may not respond to the Fed’s monetary policy tools. Other factors, such as the war in Ukraine’s impact on energy and food prices, and even the effect of this summer’s drought on crop yields, could serve to sustain the pace of inflation, regardless of what target is set for the Fed Funds rate or how fast the Fed tapers its balance sheet. Consequently, it might take longer than expected or hoped to bring down inflation.
While giving no clues about how much the Fed Funds target will be raised in September – as that will be determined by income data and any changes in the outlook – Mr. Powell said that at some point, after some further tightening, it probably will be appropriate to taper the pace of increases. In its June Summary of Economic Projections report, which summarizes the individual views of FOMC members, the target Fed Funds rate was forecasted to be slightly below 4% through the end of 2023. An updated SEP report will be released following the FOMC’s September meeting.
The financial markets were comforted by the headline Consumer Price Index for July, which was flat, a noticeable slowing from June’s 1.3% monthly gain, due primarily to declining energy prices. On Friday, before Mr. Powell delivered his speech, the Bureau of Economic Analysis reported that price index for personal consumption expenditures, widely viewed as the Fed’s preferred measure of inflation, was flat in July (declining by less than 0.1%), which was also good news.
It seems unlikely that the August CPI, when it is reported on Sept. 13, will be quite as favorable. On the positive side, near-term futures contracts for WTIC crude oil and gasoline are down 5.6% and 14.0%, respectively, through August 26. Gasoline carries a fair amount of weight in the CPI. However, heating oil and natural gas are up 10.9% and 12.6%, owing to the tightness of global supplies as Europe seeks to prepare for the winter with significantly reduced supplies of natural gas from Russia. Consequently, energy will probably be less of an offset to increases across other CPI components in August. On balance, energy will probably restrain the rise in the CPI less in the August report than July.
Beyond the energy complex, the prices of many commodities, including coffee, copper, corn and sugar, have started to rise off of their June/July lows. The Reuters/Jeffries CRB Index, a broad-based index of commodity prices, is up 2.4% so far this month. House prices and apartment rental rates have added 0.2% to the monthly increase in the CPI for six consecutive months. Although there are widespread reports that house prices have softened, it will probably take a few months at least for that to show up in the CPI. Supply chain disruptions have eased, but they are still popping up often unpredictably due to ongoing labor shortages and other factors.
Based upon my back-of-the envelope estimates, I anticipate that the CPI will rise 0.4% in August (from July) which equates to a 4.9% annualized increase. If so, the year-over-year increase would be 8.7%. (Even though the business media focuses on year-over-year increases in the CPI, monthly rates are more indicative of the current pace of inflation, but three or more months of data are necessary to confirm a trend.) Based upon Mr. Powell’s comments, I think that the FOMC is likely to opt for another 75 bp point increase if the August employment report indicates continued tightness in the labor market and the August increase in the CPI is 0.4% or greater.
The housing market could present a special challenge for the Federal Reserve. With house prices having risen at an increasing double-digit pace over the past two and a half years, the rate of increase has reportedly slowed dramatically in July and August. Investors, which account for roughly 15% of all housing sales, have largely stepped away from the market. Most first-time buyers cannot qualify for a mortgage at current rates and price levels. The seasonally-adjusted annualized pace of new home sales was clocked at 511,000 units in July, a level last seen in 2016. Mortgage rates, estimated at 5.55% by Freddie Mac last week, are likely to rise above 6.00% by the fall, possibly by the FOMC’s September meeting. Efforts by the Fed to reduce its holdings of agency mortgage-backed securities could put further upward pressure on mortgage rates.
All of this could cause a further slowing of the housing market. Although a slowdown is to be expected after the frenzied pace seen during the pandemic, the Fed must be careful to prevent a collapse in house prices, which could cause dislocations in the mortgage market. Under the circumstances, the Fed might need a hand from fiscal policy, which could conceivably provide some targeted support to the housing market by offering reduced rate mortgage loans to well qualified, first-time buyers or forgiveness of a certain amount of student loans for those purchasing a home. Of course, there would be a cost for these programs, but it might be money well spent.
The ideal outcome would be if inflation slows as the Fed Funds target rate approaches 4.00%. The Fed could then pause as inflation continues to fall back toward its 2.00% target. In time, it could reduce the Fed Funds rate back towards what it has expressed as a likely normalized level of 2.25%-2.75%, as the economy recovers to its estimated 2.0% long-term growth rate.
August 29, 2022
Stephen P. Percoco
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