Jerome Powell spoke at Jackson Hole this morning and offered a measured message about the past, present and future path of inflation and interest rates. Here are some highlights and general conclusions from his remarks:

  1. Inflation causes. I enjoyed his remarks on the causes of inflation as being both supply and demand driven. Many of the media narratives in recent years depicted this as one or the other when the empirical evidence shows that there was excessive demand (largely from excessive government deficit spending) and severe supply constraints from the pandemic.
  2. Inflation has peaked? Powell strongly inferred that inflation has peaked. But he’s still playing it cautious. He’s brought the plane to a comfortable cruising altitude, but he’s not ready to start the descent towards a landing just yet because he’s still worried that he might have to take the plane higher to reduce risks of turbulence.
  3. Monetary Policy is working. Powell explained in clear terms how Monetary Policy has worked in certain sectors to help bring down inflation. He specifically discussed the soft housing market as a prime example. The evidence there has become undeniable. Despite relatively strong pricing in residential real estate the overall activity in housing and especially in commercial real estate has slowed and slowed in a very significant way. He also explained how much of this has lagged. He specifically discusses the lagging effect in rents and his expectation that rents will continue to moderate.
  4. Risks to the upside. He discussed the risks to the upside including persistently strong consumer spending and housing prices. Powell also discussed the easing labor market, but emphasizes that the labor market remains relatively robust and could contribute to upside price pressures. He said a resurgence in prices due to these factors could warrant further monetary tightening.
  5. The 2% target isn’t changing. There has been some discussion in recent weeks about whether the Fed should change their inflation target. Chairman Powell made it abundantly clear that this is not something they’re considering. I love this response.
  6. Higher for longer. Powell had a great line here where he said “we are navigating by the stars under cloudy skies”. His emphasis here is on risk management. He’s not quite sure where the bigger risk is at this point. He acknowledges that overtightening creates deflation risks while remaining too loose creates inflation risks. He seems confident that they’ve done most of their heavy lifting, but acknowledges the risks they can’t predict. This leaves them in a tough position where inflation is still too high and therefore warrants the current restrictive rate stance. Given that inflation is moderating more slowly then they’d like this means the Fed is likely to remain higher for longer.

Our thoughts:

These were very honest and measured remarks. I thought they were well balanced and as objective as they could be. I especially like the emphasis on the causes of inflation and the ways in which Monetary Policy is working even if it’s not working as quickly as they’d like. I also especially liked the risk management approach here. We’d like to think of the Fed as an omnipotent entity with perfect foresight, but the reality is that they’re guessing just like the rest of us. And while that might be an uncomfortable view it is the reality of navigating the economy and markets. We all have to make educated guesses about what’s going to happen and an important part of good risk management is understanding what could go wrong, even if you don’t expect things to go wrong.

Speaking of markets – the broad conclusion from all of this is that interest rates are likely to stay higher for longer. This is a tough situation for the Fed. Inflation has come down meaningfully, but remains too high. This creates what I’ve described as a bimodal distributional outcome here and it’s part of what makes the Fed’s job so difficult. In simple terms, the longer the Fed remains tight the longer they grind credit markets. And that creates more and more default risk across time as firms and households have to roll old debts into new higher interest rate debt. This creates a highly asymmetric risk in credit markets where economic slowdown, defaults and deflation could eventually put significant downward pressure on markets and the economy. At the same time, the Fed needs to stay tight in order to ensure that inflation is under control. But if they stay tight for too long they could exacerbate that credit market risk. Which will happen? It’s cloudy, to be sure.

This is both good and bad for markets as a whole. As I’ve emphasized more recently, all of this is great for short-term investors who just want to clip a real return in T-Bills at 5.5%. But it creates a good deal of uncertainty across anything that is longer duration. Long duration corporate credit and equity are especially at risk here. Although our base case remains modest economic expansion that bimodal distribution creates a smaller, but asymmetric risk where longer duration instruments continue to generate meager risk adjusted returns consistent with the performance of the last two years (the S&P 500 is up 1% over 24 months with a standard deviation of 20 – not great). An outlier credit event isn’t our base view, but the current rate position makes that a meaningfully higher risk than it otherwise would be. And that warrants caution, not because we expect it to happen, but because we have to hedge that risk in case the Fed is wrong.1

This remains an incredibly confusing period in economic history and describing it as “cloudy” might be an understatement. The solution to this, in our view, is to optimize certainty by establishing clear time horizons across portfolios. As our Defined Duration strategy emphasizes, investors should have a specific understanding of time within their portfolio so that these matters do not unduly influence behavior.

Have a great weekend.

1 – This is one reason why inverted yield curves often portend recession in the USA. The yield curve doesn’t predict recession, but it does create elevated risk of credit events and recession because the restrictive rate policy creates downside risks in the economy if the Fed remains tight for longer than the economy can sustain.