Fed Chair Powell’s 1970s Lesson Casts Doubt on Quick Pivot; S&P 500 Falls

Federal Reserve Chairman Jerome Powell said Friday in his much-anticipated speech in Jackson Hole, Wyo., that policymakers cannot let their guard down too soon or risk allowing high inflation to take hold. Following the release of the transcript, the S&P 500 turned sharply lower.

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“Restoring price stability will likely require maintaining a restrictive policy for some time,” Powell said. “The historical record strongly warns against loosening policy too soon.”

Powell said bringing down inflation would require “a sustained period of below-trend growth” for the US economy. He acknowledged that Fed policy tightening will bring “some pain to households and businesses.” But “far greater pain” would result from a failure to restore price stability.

The big question ahead of Powell’s speech was whether he would try to undo the dovish impression he gave with his July 27 press conference. Those comments helped the S&P 500 rally as much as 18% from its June 16 trough, leaving a bear market.

In the short term, markets are focused on whether the Fed will hike by 50 or 75 basis points on September 21. The odds shifted slightly in favor of a smaller move with the release of soft inflation data from July ahead of Powell’s speech. The Fed chairman, who suspended forward guidance at his July 27 press conference, did not take sides on the size of the next rate hike. But the odds leaned back against a third straight 75-point ride after Powell spoke.

When Will The Fed Pivot?

The medium-term outlook for Fed policy is particularly strong for investors’ risk appetite. The S&P 500 rally is at least partly built on hopes that the Fed will stop raising interest rates in early 2023 and begin considering a rate cut around the middle of the year.

A message that the Fed could keep interest rates “higher for longer,” as St. Louis Fed President James Bullard said recently, was the last message investors want to hear from Powell. The Fed chairman didn’t exactly use those words. But he delved into the history of the Fed’s failures in the 1970s, illustrating the risks of reversing rate hikes too soon. Current decision-makers clearly have this experience at the forefront of their minds.

Takeaway: Even if the economy enters recession, the Fed may be slow to cut its benchmark interest rate—a sharp break from how monetary policy has been conducted in recent disinflationary decades.

The inflation rate is falling

Powell’s speech came as the Fed’s preferred inflation gauge showed price pressures easing. The price index for personal consumption expenditures fell 0.1% in July, lowering the annual inflation rate to 6.3% from 6.8% in June.

Core prices rose 0.1% from June, as core inflation fell to 4.6%, the lowest since October.

Inflation is clearly coming down from its peak, with energy prices falling and supply chains healing. The unknown is to what extent strong wage growth and large rent increases will keep inflation above the Fed’s 2% target.

Powell noted the lower inflation readings for July. But he added that “a single month’s improvement falls far short” of what is needed for the Fed to be convinced that inflation is falling enough to stop rate hikes.

Federal Reserve history lesson

In a remarkable speech on March 21, Powell took a stroll through the history of the Fed’s soft landings to support his claim that the current tightening could produce a similar result. Powell noted 1965, 1984 and 1994 as evidence that Fed tightening need not result in a recession.

He also cited Federal Reserve tightening from 2015 to 2019 to bolster his case. And while recession followed in 2020, it was Covid – not the Fed – that was to blame.

Federal Reserve meeting minutes Trim big interest rate hikes

Some economists predicted that Powell might give a somewhat less uplifting history lesson at Jackson Hole. Nomura economists Aichi Amemiya and Robert Dent wrote in their preview that Powell’s speech may contain “an emphasis on the experience of the 1970s.”

“A number of Fed participants have recently pointed to that era with some degree of caution, usually to emphasize their preference for avoiding a ‘stop and go’ tightening,” they wrote.

“Tighter For Longer” Fed?

Except for just before the pandemic, the last time unemployment was as low as 3.5% was in 1969. The Fed responded by raising interest rates to 9% to try to short-circuit a bout of wage-led inflation.

Still, the Fed reversed course in 1970. It cut the federal funds rate to less than 4% in early 1971. That helped push the unemployment rate up to 6%. But it “was not high enough to dampen wage pressures,” Jefferies financial economist Aneta Markowska wrote in a June 3 note.

“The Fed did not create enough slack to push inflation and stabilize inflation expectations,” she wrote. “Policymakers repeated the same mistake in the mid-1970s, moving aggressively and causing another recession, but then easing too early and allowing inflationary pressures to resurface.”

The lesson, in Markowska’s view: “When faced with a feedback loop between prices and wages, the Fed needs to stay tighter longer.”

Powell’s Take On The 1970s

“During the 1970s, as inflation rose, the expectation of high inflation became embedded in the economic decision-making of households and businesses,” Powell said. “The more inflation rose, the more people expected it to remain high, and they built this belief into wage and price decisions.”

Then-Fed Chairman Paul Volcker finally succeeded in breaking the back of inflation in the early 1980s after “several failed attempts to lower inflation over the past 15 years,” Powell said. “Our goal is to avoid this outcome by acting decisively now.”

To ease financial conditions

Powell’s message may have been intended as something of a wake-up call for financial markets, which have already been looking forward to a reversal of Fed tightening. This view of interest rate cuts in 2023 has eased financial conditions, reflected in lower market interest rates and higher S&P 500, Dow Jones Industrial Average and Nasdaq.

Minutes from the Federal Reserve’s meeting on 26–27 July highlighted a “significant risk” that “increased inflation could take hold if the public began to question the committee’s decision to adequately adjust its stance on policy”.

The minutes noted: “If this risk materialized, it would complicate the task of returning inflation to 2% and could significantly increase the economic costs of doing so.”

The CPI inflation rate is finally falling – much more than expected

To counter that risk — that the recent easing of financial conditions is keeping inflation higher than usual — some economists have said Powell may want to cast more doubt on a central bank rate cut anytime soon.

S&P 500 reacts to Powell’s speech

In Friday’s stock market action, the S&P 500 moved sharply lower in volatile fashion as investors digested Powell’s speech. The S&P 500 fell 3.4%, the Nasdaq 3.9% and the Dow Jones 3% in Friday’s action.

Through Thursday’s close, the S&P 500 is 12.5% ​​below its Jan. 3 high, but up 14.5% since June 16. The Dow Jones Industrial Average has fallen 9.5% from its peak, while climbing 11.4% from its 52-week close. low on June 17. The Nasdaq is still 21.3% below its most recent close, having risen 18.7% from its June low.

Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.

Follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.

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