Each year since 1982, the Federal Reserve Bank of Kansas City sponsors an Economic Policy Symposium in Jackson Hole, Wyoming. This event is attended by Central Bankers, Economists, Academics, and Financial Industry participants to discuss economic policies. Participants typically go on a hike after these discussions and enjoy a dinner together afterwards. This event is keenly watched by investors looking for clues on the future monetary policy path. Given that the year-to-date price action in the financial markets has been driven by narratives on inflation and interest rates, the industry participants focused primarily on comments made by the US Federal Reserve Chair, Jerome Powell.
The message from Mr. Powell left little room for misinterpretation with the opening sentence being - “Today my remarks will be shorter, my focus narrower, and my message more direct.” Succinctly, Mr. Powell emphasized that though inflation has come down in July, a single month’s improvement falls “far short” of the evidence required by the committee that inflation is heading back towards its goal of 2%. The committee is moving “purposefully” to restrict economic activity enough to ensure that inflation heads back to 2%. The Fed Chair acknowledged that there will be a softening of labour market conditions, hardships on households and businesses, and indicated that the Central Bank is prepared to endure the unfortunate economic costs of reducing inflation.
According to Statistics Canada’s August reports, inflation in Canada has dropped to +7.6% from +8.1%, while the unemployment rate remained at +4.9% as in the previous month. In the US, the Bureau of Labor Statistics’ August reports indicated that inflation dropped to +8.5% from +9.1% and unemployment rates dropped to +3.5% from +3.6% in the previous month. In summary, inflation is still running uncomfortably high, and unemployment is at historic lows. This backdrop, put together with the US Fed Chair indicating a softening of labour market conditions, and the advice from the Bank of Canada Governor, Tiff Macklem, urging companies to not adjust wages for inflation indicates that the wage-price spiral remains a top concern for the Central Banks.
The initial reaction of financial markets on expectations of a turning inflation trajectory is now knocking against risks to economic growth as Central Banks firmly remain on the path of policy rate hikes. Investors’ expectations of a pivot after the last FOMC (Federal Open Market Committee) meeting found resistance in the subsequent unofficial remarks from the committee members and finally, a firm pushback in Mr. Powell’s speech at the Jackson Hole event. The markets reacted with initial gains on hopes of a Fed pivot, however retreated during the latter part of the month after the pushback. As per data from the CME Group (Chicago Mercantile Exchange), the probability of a 75-basis point hike implied in Fed Futures contracts increased to 74.5% on August 29th (post Jackson Hole speech) after having receded to 26% on 28th July (post FOMC July meeting) (See Figure 1).
Figure 1: Target probabilities for 21 September 2022 Fed Meeting
Source: CME Group
As indicated in our previous updates, the Central Banks may have no choice but to induce a recession to bring back a balance between supply and demand. This message from the Central Banks is becoming forthright, and the unfortunate costs to this will be higher unemployment and reduced corporate profitability. In the coming months, volatility is likely to stay elevated as it reacts to the ebb and flow of weakening economic data, reports of corporate profitability, outlook on unemployment, and inflation trajectory.
Overall, the markets may have no choice but bear with the Central Banks as they go hiking. We continue to advocate overweighting on a defensive exposure in investment portfolios to navigate the near-term challenging macroeconomic environment.