Navigating by Flashes of Lightning

Central banks may be reluctant to hike further, but as long as they tie themselves to incoming data their hands may be forced.

Given a week to digest the commentary from the Jackson Hole Economic Policy Symposium, market participants are apparently reassured by what they heard. Following a sustained sell-off in both bond and equity markets leading up to the conference—triggered by surprisingly strong growth, inflation and labor market data—investors have been buying again.

There was a marginally hawkish tone on inflation in the major speeches and a focus on the topic of uncertainty that makes us see continued two-way risk to the outlook for monetary policy. At the same time, however, there was arguably a sense that the U.S. Federal Reserve, in particular, is reluctant to raise rates further. Under current policy approaches, the balance is being decided, day-by-day, by incoming data.

Excess Demand

First, let’s consider the hawkish elements in the economic outlook, and the theme of uncertainty.

Fed Chair Jerome Powell’s keynote speech, “Inflation: Progress and the Path Ahead,” was blunt in its opening assessment that inflation “remains too high.” The central bank is “prepared to raise rates further if appropriate,” and maintain restrictive policy until it is confident that inflation is “moving sustainably down toward our objective.”

There has not been enough weakening in economic and inflation data to build that confidence, Powell insisted, particularly as that weakness has been mild relative to how monetary policy and financial conditions have tightened.

U.S. GDP growth has beaten expectations and come in above its long-term trend. The housing sector is “showing signs of picking back up.” Most important, while labor supply has improved, and job growth, nominal wage growth and job openings have slowed, there has been no rise in unemployment—“a highly welcome but historically unusual result that appears to reflect large excess demand for labor.”

Persistent

In her speech, European Central Bank President Christine Lagarde focused even more directly on the theme of uncertainty—what Powell described, poetically, as “navigating by the stars under cloudy skies.”

Leaving the immediate outlook aside, Lagarde put forward a structural argument that we’ve been making for two years, in papers such as The Inflation Inflection and Investing at a Crossroads: the idea that old models may be unreliable, given “a fundamental change in the nature of global economic interactions.”

Lagarde notes, as we have done, that labor markets and the nature of work are in flux; our energy infrastructure is in transition; and geopolitics and a desire for more secure supply chains are fragmenting the globalized economy—and that all three “shifts” can be inflationary.

“Whether all these various shifts will prove to be permanent is not clear at this stage,” she conceded. “But it is already evident that, in many cases, their effects have been more persistent than we initially expected.” 

That sounds a lot like what we have called “a return to the old normal” of sustained higher inflation, rates and volatility—and that’s what made Lagarde’s rather theoretical speech sound hawkish.

Lagged Effects

Nonetheless, markets generally greeted these speeches as moderately reassuring, even though further rate hikes still appear to be at the top of investors’ list of concerns.

We think that is partly because Powell’s commentary on the lagged effects of monetary policy offered some dovish balance.

There was little of the anticipated discussion of how the neutral rate is estimated and where it might be. However, Powell was clear that the Fed thinks real rates are “well above mainstream estimates” of the neutral rate, and therefore “restrictive, putting downward pressure on economic activity, hiring and inflation.” He suggested there may be “significant further drag in the pipeline.”

He observed that goods inflation had eased and there were early signs of housing services disinflation. Prices rises in the dominant non-housing services parts of the CPI basket remain stubborn, but Powell noted that this was likely because these are the least sensitive to post-pandemic disruptions and the most sensitive to traditional demand pressures, making them more responsive to the lagged effects of current, restrictive monetary policy.

It is the uncertainty about these lagged effects that led Powell to assure markets that the Fed will “proceed carefully as we assess the incoming data”—as one might expect when navigating under cloudy skies.

Two-Way Risk

As Niall O’Sullivan wrote in this post a few months back, “when central banks go ‘data-dependent,’ it makes every data release a ‘set piece’ with the potential for volatility around it.”

If Fed officials do indeed think policy is restrictive enough already, and are reluctant to hike further, last week’s U.S. data releases will have come as a relief.

U.S. job openings slumped to their lowest level in two-and-a-half years, and the ADP estimate of private sector job growth came in lower than expected. Friday’s non-farm payrolls release showed slightly more new jobs than expected, but a surprise uptick in the unemployment rate and declining wage inflation. The second-quarter GDP growth estimate was revised down and the Conference Board’s consumer confidence survey suggested cooling optimism in general and on the jobs market in particular. And, critically, the Core Personal Consumption Expenditures Index held steady, in line with expectations, for July.

Together with the cautiousness expressed at Jackson Hole, that is enough to explain the market recovery of recent days. But it comes off the back of a longer period of stronger data, it contrasts with somewhat stickier eurozone inflation prints, and, as Powell himself said, a handful of data points does not constitute a trend.

The Fed may be reluctant to hike further, but as long as it claims to be data-dependent, it cannot credibly ignore the data if it starts to strengthen again. That’s why we continue to see two-way risk in monetary policy—and the potential for further volatility around data releases. Central banks—and investors—are not just navigating under cloudy skies, but by flashes of lightning.