Will Fed Chair Powell Push Back on Markets?

Posted by Lawrence Gillum, CFA, Fixed Income Strategist

Tuesday, August 23, 2022

Since 1978, the Federal Reserve Bank of Kansas City has played host to central bankers, policymakers, academics and economists from around the world at its annual economic policy symposium in Jackson Hole, Wyoming. This year’s symposium, “Reassessing Constraints on the Economy,” will take place from Thursday to Saturday and Federal Reserve (Fed) Chairman Jerome Powell will headline the event. While the topic of his keynote speech hasn’t been released yet, it is largely expected to provide additional clarity on how the Fed plans to keep raising short-term interest rates to get inflation under control. Whether markets believe him or not is a different question.

“Despite assurances of an unwavering commitment to bring down inflationary pressures, markets continue to think the Fed will “pivot” and cut rates in 2023 if economic growth slows,“ noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Markets have a very different view of monetary policy over the next few years, which we think is a bit premature.” The chart below shows market expectations for where the Fed funds rate will end each year (purple line) versus the dot plot expectations from Fed officials with a pronounced divergence in 2023 and 2024. While markets and Fed officials seemingly agree on the near term trajectory of the Fed funds rate, markets expect the Fed to reduce interest rates by nearly 100 basis points (1.0%) in 2023 and 2024.

Economic forecasts set forth may not develop as predicted and are subject to change.

View enlarged chart.

The current goal of the Fed is to bring down the persistent increases in consumer prices. The primary tool it uses to achieve those objectives is through the adjustment of short-term interest rates. These changes in short-term interest rates flow into the real economy and are measured through financial conditions, which reflect the cost of funding in the economy and are strongly correlated with future economic growth. These financial conditions influence consumer and business spending, savings, and investments. The Fed needs tighter financial conditions to help align aggregate demand with aggregate supply, which in turn, helps bring down inflation.

As financial conditions tightened earlier this year, investors expected that the Fed wouldn’t have to be as aggressive in its interest rate hiking campaign. That is, the market believed in the Fed’s commitment to price stability.  However, as seen in the LPL Chart of the Day, which shows the Goldman Sachs U.S. Financial Condition index, because of this expected shift in monetary policy, financial conditions have eased recently. And now that financial conditions have eased, the Fed may actually have to be more aggressive in order to slow aggregate demand and bring down inflationary pressures. And while the Jackson Hole symposium isn’t a Fed monetary policy committee meeting per se, it is an opportunity for Powell to push pack on market expectations. Historically, markets have done a pretty good job of predicting rate cuts, but with inflationary pressures still significantly above the Fed’s target, Powell may need to reset market expectations. If he doesn’t, the Fed’s job may get tougher and the prospects of a softish landing could get harder.

View enlarged chart.


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