Federal Reserve chief Jerome Powell

Fed Chair Powell’s 1970s Lesson Casts Doubt On Quick Pivot; S&P 500 Falls

Federal Reserve chief Jerome Powell, in his much-anticipated Jackson Hole, Wyo., speech, said Friday that policymakers can’t let their guard down too early, or they’ll risk letting high inflation become entrenched. After release of the transcript, the S&P 500 turned sharply lower.

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“Restoring price stability will likely require maintaining a restrictive policy stance for some time,” Powell said. “The historical record cautions strongly against prematurely loosening policy.”

Powell said that bringing inflation down will require “a sustained period of below-trend growth” for the U.S. economy. He acknowledged that Fed policy tightening will bring “some pain to households and businesses.” But “far greater pain” would result from a failure to restore price stability.

The big question ahead of Powell’s speech was whether he would try to undo the dovish impression he gave with his July 27 news conference. Those comments helped the S&P 500 rally as much as 18% from the June 16 closing low, exiting a bear market.

Near term, markets are focused on whether the Fed will hike by 50 or 75 basis points on Sept. 21. Odds shifted slightly in favor of a smaller move with release of soft July inflation data ahead of Powell’s speech. The Fed chairman, who suspended forward guidance in his July 27 news conference, didn’t take sides on the size of the next rate hike. But the odds did lean back toward a third-straight 75-basis-point hike after Powell spoke.

When Will Fed Pivot?

The intermediate-term outlook for Fed policy looms especially large for investors’ risk appetite. The S&P 500 rally has been built at least partly on hope that the Fed will stop hiking rates in early 2023 and begin to consider cutting rates around midyear.

A message that the Fed could keep interest rates “higher for longer,” as St. Louis Fed President James Bullard said recently, was the last message investors want to hear from Powell. The Fed chairman didn’t use those words exactly. But he delved into the history of the Fed’s failures in the 1970s, illustrating the risk of reversing rate hikes too soon. Current policymakers are clearly keeping that experience top of mind.

The take-away: Even if the economy goes into recession, the Fed may be slow to cut its benchmark interest rate — a sharp break from how monetary policy has been conducted in recent disinflationary decades.

Inflation Rate Ebbs

Powell’s speech came as the Fed’s favored inflation gauge showed price pressures easing. The personal consumption expenditures price index fell 0.1% in July, lowering the annual inflation rate to 6.3% from 6.8% in June.

Core prices edged up 0.1% from June, as the core inflation rate eased to 4.6%, the lowest since October.

Inflation is clearly coming down from its peak, with energy prices falling and supply chains healing. The unknown is the extent to which strong wage growth and big rent increases will keep inflation above the Fed’s 2% target.

Powell noted the lower inflation readings for July. But he added that “a single month’s improvement falls far short” of what it will take for the Fed to be convinced inflation is falling enough to pause rate hikes.

Federal Reserve History Lesson

In a notable speech on March 21, Powell took a walk through the history of Fed soft landings to back up his contention that the current tightening could yield a similar result. Powell noted 1965, 1984 and 1994 as proof that Fed tightening need not result in a recession.

He also cited the 2015 to 2019 Federal Reserve tightening to bolster his case. And while recession ensued in 2020, it was Covid — not the Fed — that bore the blame.

Federal Reserve Meeting Minutes Trim Big Rate-Hike Odds

Some economists anticipated that Powell might give a somewhat less-uplifting history lesson at Jackson Hole. Nomura economists Aichi Amemiya and Robert Dent wrote in their preview that Powell’s speech might feature “an emphasis on the experience of the 1970s.”

“A number of Fed participants have recently pointed to that era with some level of caution, usually to emphasize their preference to avoid a ‘stop and go’ tightening path,” they wrote.

‘Tighter For Longer’ Fed?

Other than just prior to the pandemic, the last time unemployment got as low as 3.5% was 1969. The Fed responded by hiking its key interest rate to 9% to try and short-circuit a bout of wage-led inflation.

Yet the Fed reversed course in 1970. It cut the federal funds rate to less than 4% by early 1971. That helped nudge the unemployment rate up to 6%. But it “wasn’t high enough to dampen wage pressures,” Jefferies chief financial economist Aneta Markowska wrote in a June 3 note.

“The Fed did not create enough slack to squeeze inflation and stabilize inflation expectations,” she wrote. “Policymakers repeated the same mistake in the mid 1970s, hiking aggressively and causing another recession, but then easing too soon and allowing inflationary pressures to reassert themselves.”

The lesson, in Markowska’s view: “When faced with a feedback loop between prices and wages, the Fed has to remain tighter for longer.”

Powell’s Take On The 1970s

“During the 1970s, as inflation climbed, the anticipation of high inflation became entrenched in the economic decision-making of households and businesses,” Powell said. “The more inflation rose, the more people came to expect it to remain high, and they built that belief into wage and pricing decisions.”

Then-Fed chair Paul Volcker finally succeeded in breaking the back of inflation in the early 1980s after “multiple failed attempts to lower inflation over the previous 15 years,” Powell said. “Our aim is to avoid that outcome by acting with resolve now.”

Easing Financial Conditions

Powell’s message may have been meant as something of a wake-up call for financial markets, which have already been looking ahead to a reversal of Fed tightening. That view of rate cuts in 2023 has had the effect of easing financial conditions, reflected in lower market interest rates and a higher S&P 500, Dow Jones Industrial Average and Nasdaq.

Minutes from the Federal Reserve’s July 26-27 meeting highlighted a “significant risk” that “elevated inflation could become entrenched if the public began to question the Committee’s resolve to adjust the stance of policy sufficiently.”

The minutes noted: “If this risk materialized, it would complicate the task of returning inflation to 2% and could raise substantially the economic costs of doing so.”

CPI Inflation Rate Is Finally Falling — Much More Than Expected

To address this risk — that the recent easing of financial conditions keeps inflation higher than otherwise — some economists have been saying that Powell might want to instill more doubt that a Fed pivot to rate cutting is coming anytime soon.

S&P 500 Reacts To Powell Speech

In Friday’s stock market action, the S&P 500 moved sharply lower in volatile fashion as investors digested Powell’s speech. The S&P 500 fell 3.4%, the Nasdaq 3.9% and the Dow Jones 3% in Friday’s action.

Through Thursday’s close, the S&P 500 is 12.5% below its Jan. 3 record closing high, but up 14.5% since June 16. The Dow Jones Industrial Average has fallen 9.5% from its peak, while climbing 11.4% from its 52-week closing low on June 17. The Nasdaq remains 21.3% below its all-time closing high, having rallied 18.7% from its June low.

Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.

Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.

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