The stock market continues to shrug off any August seasonality concerns and recovered losses from the prior week. Economic and market headlines shifted to the Federal Reserve as Fed Chair Jerome Powell gave an address at the “Macroeconomic Policy in an Uneven Economy” economic policy symposium. There was a modest chance that Powell would give in to policy hawks and announce quantitative easing taper plans, but instead, the dove took flight.
On Friday, U.S. Federal Reserve Chairman Jerome Powell addressed investors and market pundits virtually rather than from Jackson Hole, Wyoming – the typical setting of the Fed’s annual economic symposium. The virtual setting was somewhat fitting for the remarks, which focused on an improving economy with some near-term risks from the Delta variant of COVID-19.
Powell’s address was the most anticipated economic event of the week, especially with some of the hawkish speeches leading up to it. On the day prior, St. Louis Fed President James Bullard said the central bank should begin curbing its monthly stimulus efforts soon and have bond purchases shut down by the end of March to prevent the U.S. economy from overheating. There were similar messages from Fed Presidents of Dallas (Kaplan), Cleveland (Mester), and Atlanta (Bostic).
So, what did the Fed Chairman convey?
The Fed is tasked with a dual mandate – price stability (i.e., inflation control) and maximum sustainable employment. They have been explicit during this pandemic recovery that they will allow inflation to run over their 2% target rate during the near term to achieve their maximum sustainable employment goal. To that end, Powell noted that while inflation is solidly around their 2% target, they still have considerable ground to cover to reach maximum employment.
The July jobs report showed a strong improvement in the labor market as the economy makes progress toward full employment. Total nonfarm payrolls increased by 943,000 last month, beating consensus expectations, with the leisure and hospitality industry continuing to drive hiring momentum. The unemployment rate fell to 5.4% from 5.9%, while the labor force participation rate edged up to 61.7%. The still lagging labor participation rate was specifically mentioned by Powell, as it stood at 63.4% pre-pandemic, and helps understate the amount of labor market slack.
Regarding inflation, the U.S. Bureau of Economic Analysis reported on Friday that inflation in the U.S., as measured by the Personal Consumption Expenditures (PCE) Price Index, edged lower to 0.4% in July. On a yearly basis, the PCE Price Index rose to 4.2% from 4% in June and came in higher than the market expectation of 3.5%. More importantly, the annual Core PCE Price Index (excluding food and energy prices), the Fed’s preferred gauge of inflation, stayed unchanged at 3.6% as expected.
Powell noted, “inflation at these levels is, of course, a cause for concern. But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary.” Those factors include:
1. The absence (so far) of broad-based inflation pressures – The spike in inflation is so far largely the product of a relatively narrow group of goods and services that have been directly affected by the pandemic and the reopening of the economy.
2. Moderating inflation in higher-inflation items – As supply problems have begun to resolve, inflation in durable goods (other than autos) has slowed and may be starting to fall.
3. Wages – Broad-based measures of wages that adjust for compositional changes in the labor force, such as the employment cost index and the Atlanta Wage Growth Tracker, show wages moving up at a pace that appears consistent with the Fed’s long-term inflation objective.
4. Longer-term inflation expectations – Longer-term inflation expectations have moved much less than actual inflation or near-term expectations, suggesting that households, businesses, and market participants also believe that current high inflation readings are likely to prove transitory and that, in any case, the Fed will keep inflation close to their 2% objective over time.
5. The prevalence of global disinflationary forces – Since the 1990s, inflation in many advanced economies has run below 2% even during good economic expansions. The pattern of low inflation likely reflects sustained disinflationary forces, including technology, globalization, and demographic factors, as well as a stronger and more successful commitment by central banks to maintain price stability.
The biggest talking point going into Friday was whether Powell was going to outline a plan for the Fed to start reducing their level of monthly bond purchases – currently $120 billion of U.S. Treasury bonds and mortgage-backed securities – at the September FOMC meeting. Taper talk has been in full force for the better part of three months now as the Fed continues to balloon their balance sheet to nearly $8.5 trillion while the economy grows at an impressive clip.
However, there was no definitive announcement of a taper outline. “If the economy evolves broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year.” In the meantime, the Fed will be reviewing data but also watching for any impact from the Delta variant. The statement was very much “wait-and-see” while also inching closer towards a likely November announcement and December action.
Stocks in general reacted positively to the remarks. While quantitative easing monetary policy is hugely supportive of risk assets, we do not see a reason to fear the taper announcement. It is confirmation that the economy is well beyond needing intervention. The Taper Tantrum of 2013 is brought up often when unwinding QE is discussed. The “tantrum” connotation was mostly confined to the bond market after the surprise announcement by former Fed Chair Ben Bernanke. Following a roughly 6% pullback post-Fed taper announcement, the S&P 500 finished 2013 almost 30% higher.
Although tapering bond purchases was on the table, there has been no expected change in zero-interest rate policy. Powell reiterated the Fed’s stance on interest rates. “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test.”
It makes intuitive sense for the Fed to not start raising interest rates while they are still purchasing any bonds, but the “different and substantially more stringent test” remark implies that rate hikes are not just around the corner. We may very likely have easy monetary policy and low short term interest rates for some time.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist