Lower for longer?
No trip to the Grand Tetons this year, but the Fed presented a monumental announcement.
Bottom line In perhaps the Federal Reserve’s most significant shift in monetary policy since it established 2% as its core PCE inflation target in January 2012, it outlined a new framework yesterday with a more flexible form of inflation targeting over time. The Fed will allow the economy to run hotter than normal without making a corresponding interest-rate response, essentially abandoning the historical Phillips curve trade-off between employment and inflation. This dovish, risk-friendly policy shift is bullish for equities, in our view, as it likely will keep the fed funds rate at the zero bound for longer.
Chair Jerome Powell delivered his keynote speech on the “New Economic Challenges and the Fed’s Monetary Policy Review” at the Fed’s annual monetary policy symposium historically held in Jackson Hole, Wyo. It was held remotely, and it was the first time that the public could live-stream the conference.
We think Powell’s remarks and the Fed’s shift in policy could have wide-ranging implications for inflation, employment and interest rates, economic and corporate profit growth, the management of the Covid-19 crisis, financial-market performance and the presidential election.
Why is Jackson Hole important? This prestigious symposium, started by the Kansas City Federal Reserve in 1978, routinely draws top central bankers from around the world to discuss global economic issues. This year’s theme was “Navigating the Decade Ahead: Implications for Monetary Policy.” The Fed chair typically delivers a high-profile speech on new developments. Some highlights of past years include Chair Ben Bernanke discussing his plans for “Quantitative Easing 3” and European Central Bank President Mario Draghi outlining a European QE plan.
Expanding the dual mandate? Congress assigned goals of maximum employment and price stability to the Fed. But Powell said the persistent undershoot of inflation poses a serious risk to the economy. “Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations,” which “can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.” U.S. policymakers’ takeaway is the importance of sustaining a robust labor market, “particularly for people from low- and moderate-income communities.”
In the new policy framework, if inflation runs below 2% following economic downturns but doesn’t rebound when the economy strengthens, the Fed will target inflation that averages above 2% temporarily. Powell characterized this as “flexible” and not dictated by a formula.
Inflation firming After plummeting in the first half of this year due to the coronavirus, inflation has begun to recover. Core CPI halved from 2.4% in February to 1.2% in June, while core PCE fell from 1.8% to 0.9% in the same time period. But in July, core CPI rebounded sharply to 1.6% and core PCE bounced to 1.3%. Over the past quarter century, core CPI has averaged 2.1% within a range of 0.6% to 3%, while core PCE averaged 1.7% within a range of 0.9% to 2.5%. To Powell’s point yesterday, we believe the Fed has signaled it will tolerate core PCE inflation in the 2.25-2.50% range for a period of time if that increases employment for low- and moderate-income workers.
GDP improves The Commerce Department revised its second-quarter GDP flash estimate higher yesterday, from -32.9% to -31.7%. All six major contributions strengthened: personal consumption, housing, corporate spending, inventory liquidation and net trade were not as poor as originally estimated, and government spending was slightly stronger. How did this happen? April represented the trough of the economic cycle, but the recovery was in full bloom in June and those strong results were included in the calculation for the first time. Importantly, the recovery has accelerated into the current quarter. Wall Street believes third-quarter GDP growth (to be flashed Oct. 29) will rebound about 20% (in a range of 15% to 25%), which would represent the strongest quarterly growth on record.
Second-quarter earnings not as bad as expected We are more than 95% complete, and second-quarter profits, expected to plunge 45%, instead declined 32%. Some 80% of the companies reporting beat consensus by a record 22.5%. With visibility starting to improve, estimates are now moving higher for the second half of this year and for full-years 2021 and 2022, at which point we believe the economy will have recovered and corporate profits will have risen to record-high levels.
Covid-19 trends easing After the initial spike in coronavirus infections in mid-April, the dreaded second-wave in the so-called FCAT states (Florida, Southern California, Arizona and Texas) arising in late May appears to have peaked in mid-July. Importantly, deaths diverged from this rising trend and remain relatively low. Moreover, researchers around the world continue to make solid progress on vaccine development, with one or more potentially available as early as the fourth quarter. As more businesses re-open and the government’s weekly unemployment bonuses have expired, we expect that more workers will return to the labor force, which should help to accelerate economic activity into year-end.
Financial markets getting it right Recognizing that the economy is strengthening, inflation is rising, the labor market is healing and the Fed is highly accommodative, benchmark 10-year Treasuries sold off this month, with yields rising from a low of 50 basis points on Aug. 4 to nearly 80 basis points earlier today. After a cleansing 8% correction during June, the S&P 500 has been on a tear ever since, rallying by more than 17% to a new record high today of 3508. The dollar, whose recent weakness is a partially a function of the Fed’s accommodation, is a tailwind for domestic large-cap stocks. It makes their goods and services relatively more attractive compared with their overseas competition, which can enhance their export volume. In fact, this month’s 7% rally (as of today) is the S&P’s strongest August since 1986.
Election implications Perhaps unwittingly, Powell’s announcement yesterday of a unanimous Fed vote to keep interest rates lower to run the economy hotter and strengthen minority employment may have enhanced his chances of being reappointed to a second term in January 2022, regardless of who wins the election. President Trump is delighted the Fed will keep rates low for the next several years, while Joe Biden is contemplating a controversial “racial diversity” third mandate for the Fed if he wins, to boost minority employment and wealth creation.
Rather than the overwhelming “Blue Wave” that the polls and pundits are predicting, however, we believe that the contentious presidential election will be a coin flip. With the conventions now behind us, we note with interest the S&P’s 7% rally in August. Stock-market performance during August, September and October has historically been the most accurate predictor of election results over the past century. If the stock market is positive in those three months, the incumbent party retains control of the White House 100% of the time since 1984 (nine out of nine elections) and 87% of the time since 1928 (20 out of 23 elections).