Wall Street is having a case of nerves over Federal Reserve chief Jerome Powell's big Jackson Hole, Wyo., speech on Friday. The S&P 500 rally has come under pressure alongside a shift in odds favoring another 75-basis-point rate hike on Sept. 21.
But what really is there to fear from Powell's speech? After all, the Fed chairman suspended forward guidance in his July 27 news conference. That makes it doubtful he'll take sides on the size of the next rate hike.
The worry is that Powell will try to undo the dovish impression he gave with his July 27 news conference. Those comments helped the S&P 500 rally as much as 18% from the June 16 closing low, exiting a bear market.
Yet Powell will stick to his optimistic view that the Fed still has a chance to engineer a relatively soft landing for the U.S. economy. And while policymakers may not be wild about the stock market rally, which works against their efforts to cool the economy and tamp down inflation, Powell is too prudent to target stock prices directly.
So what might Powell say that could upset the S&P 500? These two words: "The 1970s."
Federal Reserve History Lesson
In a notable speech on March 21, Powell took a walk through the history of Fed soft landings to back up his contention that the current tightening could yield a similar result. Powell noted 1965, 1984 and 1994 as proof that Fed tightening need not result in recession.
He also cited the 2015 to 2019 Federal Reserve tightening to bolster his case. And while recession ensued in 2020, it was Covid — not the Fed — that bore the blame.
Now some economists think Powell may decide to give a somewhat less-uplifting history lesson. Nomura economists Aichi Amemiya and Robert Dent wrote in their Jackson Hole preview that Powell's speech may feature "an emphasis on the experience of the 1970s."
"A number of Fed participants have recently pointed to that era with some level of caution, usually to emphasize their preference to avoid a 'stop and go' tightening path," they wrote.
'Tighter For Longer' Fed?
Other than just prior to the pandemic, the last time unemployment got as low as 3.5% was 1969. The Fed responded by hiking its key interest rate to 9% to try and short-circuit a bout of wage-led inflation.
Yet the Fed reversed course in 1970. It cut the federal funds rate to less than 4% by early 1971. That helped nudge the unemployment rate up to 6%. But it "wasn't high enough to dampen wage pressures," Jefferies chief financial economist Aneta Markowska wrote in a June 3 note.
"The Fed did not create enough slack to squeeze inflation and stabilize inflation expectations," she wrote. "Policymakers repeated the same mistake in the mid 1970s, hiking aggressively and causing another recession, but then easing too soon and allowing inflationary pressures to reassert themselves."
The lesson, in Markowska's view: "When faced with a feedback loop between prices and wages, the Fed has to remain tighter for longer."
"Tighter for longer" is the last message investors want to hear, and a term Powell is not likely to touch. That's because the S&P 500 rally has been built at least partly on hope that the Fed will stop hiking rates in early 2023 and pivot to rate-cutting around midyear.
Easing Financial Conditions
Financial markets are already looking to a reversal of Fed tightening. That, in turn, has had the effect of easing financial conditions, reflected in lower market interest rates and a higher S&P 500, Dow Jones Industrial Average and Nasdaq.
Minutes from the Federal Reserve's July 26-27 meeting highlighted a "significant risk" that "elevated inflation could become entrenched if the public began to question the Committee's resolve to adjust the stance of policy sufficiently."
The minutes noted: "If this risk materialized, it would complicate the task of returning inflation to 2% and could raise substantially the economic costs of doing so."
To address this risk — that the recent easing of financial conditions keeps inflation higher than otherwise — Powell might want to instill more doubt that a Fed pivot to rate cutting is coming anytime soon.
That might not be great for the S&P 500 or the U.S. economy in the near term. However, the Nomura economists write, Powell can make a case that Fed failures in the 1970s and the eventual "resolute Fed efforts to bring inflation lower" under chair Paul Volcker show that the near-term pain will be worth it.
