The Impending Pain
At the Federal Reserve’s annual conference in Jackson Hole, Wyoming last week, Fed Chairman Jerome Powell alerted attendees and along with them the American Public in general that they should prepare for “some pain.” In relatively brief remarks that Powell himself said would be “shorter, narrower, and more direct” than usual, the Chairman expounded:
The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone…
…Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
So what does it all mean? What kind of pain are people in for? And where does the economy go from here? Let’s dig in.
Some Pain
In order to tame red-hot inflation in the early 1980s, Fed Chairman Paul Volcker purposely and admittedly helped take the U.S. economy into a recession by dramatically raising interest rates, which significantly cooled things off. As shown in the graph below, the unemployment rate went from 5.6% in May 1979 to 7.8% in July 1980 as interest rates rose before leveling off. Then the unemployment rate jumped again to 10.8% in November 1982. The grey areas in the chart below represent periods during which the economy was in an actual recession. It was a challenging and, yes, painful period for many as the Fed hiked interest rates and the economy and labor market froze up.
By noting this past week that there is likely to be a “sustained period of below-trend growth,” the Fed Chairman is signaling he believes the U.S. economy will go into a recession (if we are not in one already) as a result of the Fed’s recent and impending actions to raise interest rates. This will mean job freezes, layoffs, and reduced economic activity. It will be harder for businesses to expand and consumers will pull back from spending, sending further cooling ripple effects throughout the broader economy.
The unemployment rate today sits at 3.7%, a historically low level. In his Jackson Hole speech, Chairman Powell said specifically, “There will very likely be some softening of labor market conditions,” which means that he expects hiring to slow and layoffs to occur. This prompted Senator Elizabeth Warren (D-MA) to respond by saying, “Do you know what's worse than high prices and a strong economy? It's high prices and millions of people out of work.” She added further:
"I am very worried about this because the causes of inflation -- things like the fact that Covid is still shutting down parts of the economy around the world, that we still have supply chain kinks, that we still have a war going on in Ukraine that drives up the cost of energy, and that we still have these giant corporations that are engaging in price gouging…
…there is nothing in raising the interest rates, nothing in Jerome Powell's tool bag, that deals directly with those, and he has admitted as much in congressional hearings when I've asked him about it.”
There is bound to be a game of political football over rising interest rates, as it is not in the party-in-power’s advantage to have an economic downturn. Then again, it’s also not in anyone’s best interest including politically for inflation to be running as hot as it is.
As I’ve written before, I think inflation is already on its way down. There is a risk that the Fed overshoots on trying to tame inflation and makes the pending recession worse than it needs to be. But the Fed Chairman is resolved, saying in the Jackson Hole speech, “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy,” and, “We must keep at it until the job is done.” In other words, this period of higher interest rates is likely to drag on. The Fed Chairman signaled in his speech that there may not be interest rate reductions for the entirety of 2023, so it is likely that we will see 2-3 more rate hikes this year and then a prolonged plateau at these higher rate levels with perhaps even some further rate hikes in 2023.
How to react
The Dow Jones shed 1,000 points in the immediate aftermath of Powell’s speech or just over 3.0%. The S&P 500 dropped 3.4%. In fact, Minneapolis Fed President Need Kashkari even said he was pleased with the stock market drop because it showed that investors were taking the Fed’s warning seriously.
I’ve written a lot about the perilous housing market recently, but without a doubt the next 12-24 months are going to be a challenging time for both buyers and sellers. Goldman Sachs is now projecting 0% price growth for all of 2023 and no recovery until 2024. Bill McBridge of the Calculated Risk blog flagged that after easing down in recent weeks, the 30-year fixed rate leapt to over 6.00% in the days following Chairman Powell’s Jackson Hole speech:
Pain is right.
So what’s going well right now? Well, gas prices continue to drop, which will have a significant impact on overall inflation numbers when the next CPI report comes out on September 13th. Consumer Sentiment actually improved from a rating of 51.5 in July to 58.2, a notable uptick likely fueled in large part by lower prices as the pump. If you are a conservative saver, the more rates risk the better returns you’ll get on safe investments like bonds, treasuries, and CDs.
But the storm clouds on the immediate horizon are dark indeed. Rising interest rates will have exactly the impact that the Federal Reserve wants them to: it will be more costly to borrow, so both consumers and businesses will borrow less, which means there will be fewer home and car purchases, fewer business expansions, and less overall economic activity. Those with variable rate loans (either residential or commercial) will soon see higher monthly payments, which will cut margins and mean less profit to the bottom line. If the stock market remains down and continues to show strong volatility, it will start to unnerve people as they see their 401(k)’s and other investment accounts suffer.
The goal in all of this has been a soft landing, but with the hawkish comments from Chairman Powell last week it is clear that he sees clear danger in the current economic environment. He added this in his speech that the Fed would be particularly aggressive now, because the risks of not being aggressive enough and letting inflation run on are greater than the risks of acting too forcefully. Those listening should be mindful of the risks of this strategy and the volatile times ahead.
Read the text of Jerome Powell’s Jackson Hole speech here: https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram. Opinions and analysis do not represent First National Bank.