Jerome Powell: “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”

Every year in August, The Federal Reserve Bank of Kansas City hosts dozens of central bankers, policymakers, academics and economists from around the world at its annual economic policy symposium in Jackson Hole, Wyoming. Usually, the shindig passes without major market incident, however, this year it was used by the Fed Chair, Jerome Powell, to robustly remind financial markets what the Fed are now focused on – tighter financial conditions to rein in rampant inflation.

In many ways Jackson Hole was Powell’s ‘whatever it takes’ moment, as by uttering his quote above he was finally able to dispel the ghosts of his accommodative policy past. This is because hitherto, Powell had conditioned markets into believing the Fed would come to its rescue with interest rate cuts and quantitative easing whenever the US economy sailed into troubled waters.

Back in 2019, Powell commented that “Low inflation seems to be the problem of this era, not high inflation.” Then in 2020, as he debated the Fed’s review of their monetary policy framework, he said “The persistent undershoot of inflation from our 2 percent longer-run objective is a cause for concern”. And only recently in 2021 as inflation had risen above this target, Powell notoriously argued why the spike in inflation was only transitory, citing factors such as the absence of broad-based price pressures. This year, however, the message has turned distinctly different.

The Fed is prepared to do whatever it takes to bring inflation pressures down to lower levels, regardless of the initial impact of its actions on the economy through higher interest rates, borrowing costs, and levels of unemployment. With Powell explicitly warning against repeating the mistakes of the 1970s, where high interest rates were cut prematurely, investors moved to price in a more hawkish response from the Fed over the next year. Global bond yields had already been rising in August before accelerating post Jackson Hole, as investors’ hopes for a more accommodative Fed were dashed.

During the month, US Treasury bond yields shifted higher along the yield curve, with 3-month, 5-year and 10-year yields rising 58 basis points, 67 basis points, and 54 basis points, respectively. With this now baked into markets, we are slightly more comfortable with the prevailing levels of bond yields.

However, if core inflation remains stubbornly high and the US economy remains resilient in the near-term, then we expect further supersized 50 to 75 basis point rate hikes at subsequent Fed meeting into year end, possibly into early 2023, and consequently another shift higher in the yield curve.

Economic data continues to moderate, raising the probability of a recession over the next 12 months is becoming likely. This is accompanied by strong inflationary pressures that are broad based, but many cyclical goods and services are now decelerating from their post pandemic highs. Despite this, the Federal Reserve continue with their hawkish narrative and remain committed to prioritising lower levels of inflation.

The ECB is also strengthening its resolve to combat historically high inflation levels. Recession risks in Europe are primarily geopolitically driven, as high gas prices and elevated uncertainty are exerting a toll on the Eurozone. Base effects should bring energy inflation down across Europe in the quarters ahead, but contribution of energy to headline consumer price inflation will likely remain elevated.

Easing supply chain pressures are helping the economy, but a weak consumer and business services picture remains. A widening trade deficit is on course for the biggest annual contraction on record. Inflation remains high due largely to the energy price crisis and labour shortages, adding pressure on the Bank of England to maintain a tighter stance on financial conditions despite the negative impact on the UK economy. Liz Truss became the fourth British Prime Minister in 6 years after winning the Conservative leadership vote.

Japan’s economic recovery has lagged behind other major economies, but its long-term trend growth rate is amongst the lowest in the G20. Yen weakness worries some policymakers with headline inflation hitting 8-year highs. The central bank is notably out of step with its counterparts in North America, Europe, and Australasia where significantly tighter monetary policies are in motion, mounting substantial downward interest rate differential pressure on the Yen.

The Chinese economy continues to be weighed down by its ailing property market, which is experiencing its worst period on record, all exacerbated by the government’s zero Covid policies. Monetary (interest rate cuts) and fiscal (wider deficits and VAT rebates) stimulus continues. Unlike in western economies this year, Chinese and mostly Asian inflation pressures have remained benign, leaving the People’s Bank of China as the only major global central bank to cut interest rates and ease financial conditions in 2022.

A big driver of economic and market performance in EM and overall economic conditions in general is the strengthening US Dollar, which has so far in 2022 strengthened the most in a calendar year since 1984 (DXY Index) and contributed to 16 emerging market countries registering as severely distressed this year (Credit Default Swap spreads > 1000 bps), the highest since 2010.

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