To The Moon

This week, central bankers will meet in Jackson Hole, Wyoming. From 25 to 27 August, the Federal Reserve of Kansas will hold a meeting. The agenda will be announced the evening before (on the 24th). This meeting is held every year and foreign central bankers also visit. The event is often used as a platform to communicate important policy changes.

Powell is likely to give a speech on the morning of 26 August. The timing of the symposium is again impeccable, as investors are looking for clues as to how aggressively the US central bank will continue to raise interest rates. It has not happened before at this conference that inflation has been so high. The latest US inflation figure may have shown a decline, but at 8.5 per cent it is still extremely high. Moreover, Powell reacted to this figure by saying that he would like to see more evidence that inflation is heading towards the target of 2 per cent. According to most analysts, the Fed will not act until core inflation (core PCE, now 4.8 per cent) falls below 4 per cent.

Over the past week, comments from various Fed members have created more questions than answers. After the reasonably balanced minutes from the last FOMC, Bullard, Kashkari and George came out with comments on Thursday that raised the odds of a 75 basis point rate hike in September. Most parties are banking on a 50 basis point rate hike after the earlier 'better than expected' inflation data. This will be followed by another 50 basis points and then another quarter after which the Fed will pause and cut rates in May next year, at least according to what is currently priced into the market. With inflation at 8.5 per cent (or core inflation at 4.8 per cent), it is strange that the market is already counting on rate cuts, as interest rates are still well below (core) inflation. However, looking back at recent policy adjustments by the Fed, this is not so strange. In the summer of 2007, the Fed raised interest rates, but then cut them again a year later. Furthermore, the Fed raised interest rates in December 2018 only to change course again in January 2019. Markets are conditioned on this recent past, despite the fact that there is a clearly different regime (i.e. much higher inflation) than in recent years.

The data on inflation and wages in the United States are simply too strong to suggest that the Fed can take it easy. Moreover, the labour market appears to be picking up, even before the latest jobs report. Core inflation rose by 7 per cent over the past six months on an annual basis. The same figure for the past three months is 8 per cent. Wage growth briefly appeared to slow to a level of 3.5 to 4 per cent, but now the Atlanta wage growth tracker shows that wage growth rose to 6.7 per cent in June. The data on average hourly wages were also revised upwards. The Fed's favourite indicator is the Employment Cost Index (ECI), which showed private sector wages rising 6.5 per cent year-on-year. Now, the labour market mainly looks back and not forward, so as a predictive indicator you can't do much with the labour market. But rising wages can ensure that inflation remains high for longer. It will not be easy for the Fed to get inflation back to 2 per cent if wages rise by 6 per cent. Although central bankers do not like to admit it, the primary objective of monetary policy at the moment is to make people lose their jobs. If only enough people are unemployed, wages will rise less quickly, so the thinking goes.

Monetary policy works with a long delay. That is why, in the past, central bankers based policy on forecasts. The actual figures were not even allowed to be the basis for policy. Nowadays, the Fed first wants to see evidence that inflation is rising, and now that it is falling. The danger here is that policy will overshoot (both upwards and downwards). Moreover, this makes the Fed's policy unpredictable. In itself, this can also be an objective of the central bank. In the past, the Bundesbank was able to get the economy in line simply by threatening to raise interest rates. On the other hand, Bernanke's interest rate hikes, which were probed well in advance, from 1% in 2004 to more than 5% in 2006, made the market more willing to use leverage because, thanks to Bernanke, people knew exactly where they stood. This contributed to the Great Financial Crisis, not the interest rate increases, but the predictability.

This time the credibility of the central bankers is at stake. It has not been this low since the 1970s. Incidentally, inflation in the 1970s did not go up in straight lines. There were also fluctuations, with sky-high inflation one year inevitably having the effect of moderating inflation the next. That is the nature of measuring inflation. There are still plenty of structural factors that make inflation higher than the 2 per cent target set by the Fed and many other central banks. In this context, it is unlikely that Powell will indicate in Jackson Hole that the central bank will cut interest rates again next year. Rather, it seems that the Fed has not finished raising interest rates and that the final target level is much higher than what the market is now counting on. At the end of last week, the market also seemed to be moving in that direction, given the losses in the bond market and the rise of the dollar towards parity with the euro.