Bridgewater’s Rebecca Patterson on the Fed's Unenviable Position
Federal Reserve Chairman Jerome Powell delivered a stern commitment Friday to halting inflation, warning that he expects the central bank to continue raising interest rates in a way that will cause “some pain” to the U.S. economy.
In his much-anticipated annual policy speech at Jackson Hole, Wyoming, Powell affirmed that the Fed will “use our tools forcefully” to attack inflation that is still running near its highest level in more than 40 years.
Even with a series of four consecutive interest rate increases totaling 2.25 percentage points, Powell said this is “no place to stop or pause” even though benchmark rates are probably around an area considered neither stimulative nor restrictive to growth.
“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,” he said in prepared remarks. “These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
Stocks fell after the Powell speech, with the Dow Jones Industrial Average off more than 500 points. Treasury yields were off their highs of the session.
The remarks come amid signs that inflation may have peaked but is not showing any marked signs of decline.
Two closely watched gauges, the consumer price index and the personal consumption expenditures price index, showed prices little changed in July, owing largely to a steep drop in energy costs.
At the same time, other areas of the economy are slowing. Housing in particular is falling off rapidly, and economists expect that the huge surge in hiring over the past year and a half is likely to cool.
However, Powell cautioned that the Fed’s focus is broader than a month or two of data, and it will continue pushing ahead until inflation moves down closer to its 2% long-range goal.
“We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2%,” he said. Looking into the future, the central bank leader added that “restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”
The Fed is using a lesson from the past as its guidepost for current policy.
Specifically, Powell said the inflation of 40 years ago provides the current Fed with three lessons: That central banks like the Fed are responsible for managing inflation, that expectations are critical and that “we must keep at it until the job is done.”
Powell noted that the Fed’s failure to act forcefully in the 1970s caused a perpetuation of high inflation expectations that led to the draconian rate hikes of the early 1980s. In that case, then-Fed Chairman Paul Volcker pulled the economy into recession to tame inflation.
While stating repeatedly that he doesn’t think recession is an inevitable outcome for the U.S. economy, Powell noted that managing expectations is critical if the Fed is going to avoid a Volcker-like outcome.
In the early 1980s, “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,” Powell said. “Our aim is to avoid that outcome by acting with resolve now.”
One concept molding Powell’s thinking is “rational inattention.” Essentially, that means people pay less attention to inflation when it is low and more when it is high.
“Of course, inflation has just about everyone’s attention right now, which highlights a particular risk today: The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched,” he said.
And Greg Jensen, co-CIO of Bridgewater Associates, expects that equities are facing a significant drop to align them with the real economy.
“In aggregate, the asset markets will decline from 20% to 25%,” he said in an interview with Bloomberg Television speaking with Kailey Leinz and Guy Johnson on “Bloomberg Markets.”
“The market is pricing a decline in inflation to occur in a relatively stable economy,” he said, but isn’t factoring in the impact of higher interest rates and the Federal Reserve’s quantitative tightening.
Jensen expects that QT and rate hikes will drive down both inflation and economic growth, and “unfortunately the inflation will be more stubborn,” resulting in higher interest rates across the curve, particularly on the long end.
Asset prices will also fall, he said. “They need to decline,” citing a big disconnect between the financial economy and the real economy. “We’re still 25% to 30% above the normal relationship between cash flows and asset prices.”
If the Fed is forced to tighten longer in the face of stubborn inflation and an expected easing in six to nine months doesn’t materialize, he added, this will make “a tough road for assets” in which liquidity dries up as profits and economic growth are weak.
Let's hope he's wrong but if he's right, there will be plenty of opportunities for Canada's large pensions to pick up assets during the next downturn.