U.S. equity markets declined a fourth straight day to end August, with the S&P 500 falling nearly 6% since Fed Chair Jay Powell’s speech at Jackson Hole, Wyoming.1 Before the speech on August 26, the S&P 500 equity stock index had risen nearly 11% since mid-June. These swings put the VIX volatility index, a measure of expected volatility in stocks, at its highest level in over two months.2
In this note, we’ll review Fed guidance from Jackson Hole and discuss recent policy actions before looking ahead.
Investors were quick to parse Fed messaging at the annual Jackson Hole conference. Jay Powell firmly dispelled any doubts about the Fed’s resolve to fight inflation, insisting that interest rates are headed higher and will stay there “for some time.”3
Powell’s remarks stood in stark contrast to last year, when he argued that price pressures were narrow and transitory. Since then, inflation has turned out to be more persistent and stronger than expected. The Fed’s preferred inflation measure (the PCE, or personal consumption expenditures, index) rose 6.3% in July, still far from the Fed’s 2% target.4
The message from other Federal Reserve board members was similar. Atlanta Fed President Raphael Bostic commented that rates should rise by 1% to 1.25% above current levels. Additionally, the economy needs to weaken first before inflation starts moving down, which could require holding rates at higher levels for over 18 months.5
Over the summer, we discussed a shift in interest rate expectations, with markets betting that the Fed would need to cut rates next year as growth slows. The idea of a pivot boosted positive sentiment, which drove the market’s summer rebound. But at Jackson Hole, officials put to bed any possible speculation of a 2023 shift to cutting rates.6 Markets slid as a result.
During the COVID-19 pandemic, governments around the world took measures to support their economies. In the process, funding stimulus may have contributed to record inflation rates. With that said, it’s important to note that without measures to rein in fiscal spending, central banks could struggle to control inflation, and may even end up propelling price growth higher, according to a paper presented to policymakers at Jackson Hole.7
The paper argues that the risks of entrenched inflation has increased, and in the worst-case scenario it could spark a vicious cycle of rising interest rates, rising inflation, and economic stagnation, otherwise known as stagflation.
Coordinated government fiscal policy, alongside appropriate monetary policy, would offer a better shot at managing inflation. U.S. government spending remains elevated –Even though this year the U.S. budget deficit is smaller than previously projected at 3.9% of GDP, it’s still historically high.8 However, staying restrained on spending may be tough with Congressional midterm elections coming up in November.
In what is hopefully a step in the right direction, President Joe Biden signed the Inflation Reduction Act of 2022 into law on August 16th.9 The law has broad investment implications across sectors like health care, energy, technology, and more.10 It attempts to fight rising health care costs and raise an estimated $737 billion in total revenue, while reducing the deficit by $300 billion.11
Biden also announced a student loan debt forgiveness program under which up to $20,000 of federal loan debt could be canceled for individual borrowers,12 a measure that impacts over 40 million Americans. According to the Committee for a Responsible Federal Budget, the cost of student loan relief would be around $500 billion over 10 years, which would likely offset the deficit shrinking benefits of the Inflation Reduction Act.13
In addition to causing potentially larger federal deficits, student loan cancellation has raised concerns that the plan will boost longer-term inflation.14 However, Goldman Sachs economists expect any impact on inflation from the plan to be small, with middle-income households benefiting the most from debt cancelation.15 While borrowers may cheer debt forgiveness, the broader economic impact may not be clear for some time.
Inflation remains top of mind as renewed Covid lockdowns in China prompt further concerns about supply chain disruptions.16 In addition, the upcoming August jobs report will provide important metrics for upcoming Fed policy. Unemployment is still expected to hold steady at a five-decade low 3.5%.17 Strength in employment will help the Fed continue with aggressive rate hikes to tame inflation.
Following a summer bear market rally, markets declined sharply after the Fed dashed investor hopes of a soft landing or an early end to the rate hike cycle. We anticipate continued volatility and a continued focus on inflation from policymakers going into the fourth quarter.
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The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Bloomberg Barclays U.S. Aggregate Bond Index measures the investment-grade U.S. dollar-denominated, fixed-rate taxable bond market and includes Treasury securities, government-related securities, corporate securities, residential and commercial mortgage-backed securities, and asset-backed securities. The S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad U.S. stock market. The MSCI All Country World Index (ACWI) is designed to represent the performance of large- and mid-cap stocks across 23 developed and 26 emerging markets and represents approximately 85% of the free float-adjusted market capitalization of each market. The MSCI Europe Index captures large- and mid-cap representation across 15 developed market countries in Europe and covers approximately 85% of the free float-adjusted market capitalization across the European developed market equity universe. The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging market countries and covers approximately 85% of the free float-adjusted market capitalization in each country.
