Powell Needs to Side With Markets at Jackson Hole

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When Federal Reserve Chairman Jerome Powell kicks of the central bank’s annual Jackson Hole symposium with a speech on Friday, he should do nothing less than signal that a more aggressive approach to easier monetary policy is warranted by opening the door to a 50-basis-point cut in the target federal funds rate next month.

The market clearly wants the Fed to get more aggressive by signaling more rate cuts at a faster pace. Indeed, the fact that yields on 10-year Treasury notes have been consistently below three-month Treasury bill rates since May suggests that the current fed funds range of 2% to 2.25% is too high. With the yield curve at a negative 36 basis points, a 25-basis-point cut in the funds rate will not be enough to un-invert the curve. A positive curve would signal the market is backing off its aggressive view about rate cuts. And the plunge in yields culminating in a new record low for 30-year bonds last week suggests fear that the U.S. economy may be headed into a recession.

Traders are pricing a 100% likelihood that the Fed will cut rates again in September, with a 67% chance of a 25-basis-point reduction and a 33% probability of 50 basis points. Traders are also pricing in three additional cuts through year-end. Contrast this with the latest Bloomberg survey of 66 economists taken on Aug. 8, where 40% think the Fed won’t move at all in September and 60% think it will only cut rates by 25 basis points. And the majority, or 56%, don’t expect the Fed to lower rates between September and the end of the year. The rest either see one or two cuts.

Clearly, markets have diverged from economists, but this is not new. In fact, it is covered by an old saying in the bond market that “the Fed decides when to hike and the market decides when to cut.” And getting in the middle of this difference of opinion is not new for Powell. Jackson Hole might be the fifth time in a year that Powell has offered an opinion at a time when markets and economists have not seen eye-to-eye. Powell should side with the market’s view.

Economists push back on more aggressive rate cuts fearing the Fed will “run out of bullets.” This makes little sense. If rate cuts are stimulative for markets and the economy, they will work now to halt a worsening situation. If they do not work, which is entirely possible, then they will be equally ineffective if policy makers wait for the economy to worsen before easing.

Economists also fear a stock market bubble should the Fed aggressively ease monetary policy. But not doing so has had the opposite effect, falling equity prices and plunging market rates. Should a bubble form in the wake of aggressive cuts, the Fed can deal with that via regulations or macroprudential rules.

The stock market responded well on Jan. 4 when Powell spoke before the American Economic Association in Atlanta where he said the Fed would be “patient” and “flexible.” thus signaling rate hikes might be off the table. They also responded well again on June 4 when Powell opened a Fed conference in Chicago by saying the central bank would “act as appropriate,” signaling that policy makers were open to rate cuts. Such gains are accompanied by a steepening yield curve, giving broad market approval that the Fed has the correct policy.

As this table shows, the week following these dovish comments accounted for most of the gains this year.

Contrast that with Powell’s Dec. 19, 2018 press conference, where he said the fed funds rate was far from neutral and that Fed’s balance sheet reduction was on “automatic pilot.” These hawkish comments badly hurt the stock market, as did the “mid-cycle adjustment” comment at his July 31 press conference (To be sure, this overlapped with the President Donald Trump’s tweet of more tariffs coming).

As the next table shows, the week following these comments saw big losses in the stock market.

So, any comment by Powell on the direction of monetary policy at Jackson Hole has the potential to be just and impactful as these previous instances. Hopefully he chooses to be more dovish rather than less dovish.

But why does the market want the Fed to get aggressive? As we wrote in a Bloomberg Opinion column last month:

Market participants need to break themselves of this absolute thinking and recognize the funds’ rate is on the wrong end of the relative interest rate world. It is an outlier and the yield curve and market pricing are screaming this needs to be fixed.

At that time, we suggested the Fed cut rates by 50 basis points at its July 31 meeting, but it only lowered them by 25 basis points. The subsequent plunge in U.S. Treasury yields and deeper inversion of the 3-month/10-year part of the yield curve suggests the market was disappointed policy makers did not reduce rates by cut 50 basis points. The market is signaling the federal funds rate is too high and cutting more aggressively sooner rather than later will correct this ongoing problem.

The yield curve’s message should be respected. Every time Powell sides with economists and expresses caution about cutting rates, the stock market plunges and the yield curve sinks deeper into inversion. Every time he sides with the markets and signals a more dovish stance, the stock market soars and the yield curve steepens.

Powell will have to pick a side again on Friday.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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