A Jackson Hole preview: Are expectations finally rational?

The Federal Reserve’s annual Jackson Hole symposium is being held this week on August 25-27. Fed officials have fanned out across the land to deliver the message that market expectations of a dovish pivot are misplaced. The question for investors is, “Are market expectations finally rational?”

The CME’s Fedwatch tool shows the market expects two consecutive 50 bps hikes in September and November, followed by a 25 bps hike and a plateau into mid-2023.



Is the market still misreading the Fed? How will Powell steer expectations?



The Fed’s inflation challenge

The Fed has made it clear that its primary focus is getting inflation down to its 2% target. While it would like to avoid a recession, a recession may be necessary to achieve its task. Let’s see what challenges lie ahead.


Starting with inflation, the June core PCE stands at 4.8%. July PCE will be reported Friday and the market expects that it will decelerate to 4.7%. An analysis of the components of PCE is revealing.


The accompanying chart shows the evolution of the components of PCE, with the components shown on the left scale and core PCE on the right scale. Durable goods PCE (red line) peaked in April 2021 and it has decelerated considerably since as supply chain bottlenecks have eased to 2.7% in June. However, services PCE and non-durable goods PCE remain stubbornly high at over 9%. 



The Fed’s June Summary of Economic Projections (SEP) shows that it expects core PCE to fall to 4.3% by December 2022. The decline will largely be attributable to the easing of transitory supply chain induced inflation. Getting core PCE down to the 4% zone will be easy. The path from 4% to 2% core PCE will be much harder.


The good news is inflation expectations are not running out of control, which will make the Fed’s job easier.



For a different perspective, The Transcript, which monitors earnings reports, offered a bottom-up view of inflation and its effects on the economy:

Inflation and rising interest rates have put a lot of pressure on the economy but overall consumers have remained remarkably resilient. Still, we are finding areas of concern building in many sectors. Consumer electronics and used cars are two areas where demand is ebbing. Middle-income consumers may be starting to trade down.



Tight labor market

The Fed’s inflation fighting job is complicated by a hot labor market. As an indication of the tightness of the labor market, job switchers enjoyed a 6.7% median wage increase compared to 4.9% for stayers.



As well, the labor force participation rate (LFPR) hasn’t recovered to pre-pandemic levels, which is worrisome. An analysis of LFPR by education reveals that it’s the less educated and presumably lower paid workers who are missing from the workforce.



An Atlanta Fed study of the decomposition of the changes in the LFPR between Q4 2019 to Q4 2021 shows that most of the decline is attributable to behavioral factors.



If the behavioral factors were to hypothetically all disappear tomorrow, prime age LFPR would be above pre-pandemic levels.



All of these factors combine to make the Fed’s job of fighting inflation harder. All else being equal, it needs to tighten further to raise the unemployment rate to head off the risk of a wage-price spiral.



A hawkish path ahead

So where does that leave us? Here’s what we know. The good news is inflation expectations are well-anchored. The bad news is the reduction in transitory inflation will bring the inflation rate down to about the 4% level, but the path from 4% to 2% will be far more difficult. As well, the labor market is hot and the risk of a wage-price spiral is rising. 


I interpret these conditions as meaning the Fed will continue to pursue a hawkish policy. The title of the discussion at Jackson Hole is “Reassessing Constraints on the Economy and Policy”. Global central banks remain in tightening mode. Don’t expect the Fed to execute a dovish pivot in the near future.



11 thoughts on “A Jackson Hole preview: Are expectations finally rational?

  1. Economists always miss human nature. Workers are forming unions and unions at chokepoints in the economy are realizing their power and demanding big wage increases. This filters across the general population. This element will be effect inflations statistics much higher and longer than current expectations.

  2. I see that the Chinese government might be bailing out the unfinished homes. Chinese equities are the only thing up today. Could this be a important pivot for the Chinese market and maybe industrial commodities? Does anyone have seen posts from sources that look at this deeply.

    1. This from ING on:
      media reports that policy banks in China are going to provide CNY200bn in special loans with funds from the Ministry of Finance and the PBoC.
      But, says ING:
      With an estimated 225 million sqm of uncompleted housing, and assuming that the construction cost is CNY3000 per sqm, the total cost required to complete unfinished homes is CNY675bn. So, the government’s special loan is only enough to deal with around 1/3 of uncompleted homes, unless the average unfinished project is already more than 2/3 completed.
      We think that some developers sold homes at a much earlier stage of completion, meaning that the special loan pool would need to be bigger to calm the market further. But if this policy enables construction to keep going, without compromising quality of finished units, this could result in an improvement in sentiment as mortgage borrowers see homes completed satisfactorily.

  3. “but the path from 4% to 2% will be far more difficult.”

    Surely, the Fed knows that. Isn’t than an argument to pause at some point since going beyond a certain FFR rate only implies an economic crash and no relief in inflation?

    1. I believe so… 2% seems unrealistic. They may be lucky to get to 3% but will keep jaw boning to set expectants and fight the markets.

  4. Power rationing in China is another piece of bad news for global supply chains. “Sichuan is now facing the hottest temperatures and the worst drought of the past 60 years,” Morgan Stanley analyst Simon Lee said in a Sunday research note. Rainfall along the Yangtze River since July is 45% below normal, the lowest since 1961.
    Climate change has become an economically significant issue and at the same time we are facing an energy crisis of global scale.

  5. I think the LFPR is not going to improve. This pandemic and how our governments handle the situation really opened Americans’ eyes. Our gov is increasingly authoritarian. First it says the mRNA vaccines are very effective. Now they say those are not vaccines. So what are those? Many scientists and practicing doctors have a lot of reservation about these so-called vaccines. Have you heard about their studies? Now more and more studies come out detailing the long-term side effects of these mRNA vaccines. Quite serious. Are CDC and NIH concerned? Our Congress members and gov officials are more concerned with profiting from pushing the vaccines.

    The last two years our gov is engaged in all out propaganda war, pitting one group of people against the other who wants to see more data and more studies. Call people names and threaten their livelihoods. This is a large group of people. Americans have always had the attitude of “screwing the gov.” Now this group will only grow bigger and bigger. They will only rebel more and more against the gov. The level of distrust is probably at all-time high. A lot of them are not going back to work. What are they gonna do? They will find a way and they don’t care our gov likes it or not. The Prohibition did not work. But our gov did not learn the lesson.

    Some of our fellow readers will not agree with what I wrote here. I simply summarize what I observed and read the last two years. There is the other group who loves the vaccines. That’s also a fact. But we should be scientific and question the so-called authorities who are clueless just like the rest of us.

    All these word count is just to say it is going to be very interesting going forward. And our gov will increasingly feel impotent and flaccid. I have an algo calculating real-time randomness. it is unambiguously trending higher and higher. I also set an upper-bound which indicates an end-game self-termination of our entire system.

    1. wife works in a hospital….the vaccines did help…at what price down the road, I dunno….but maybe the troubles of the vaccines were less than long covid…who knows?

  6. Good to see the bears out in force this morning.

    Added a third allocation to SPY + second allocations to QQQ/ TLT. What started as a day trade on Friday is now a swing trade for the intermediate term that I feel pretty comfortable with.

  7. A fairly simple market breadth strategy based on % NYSE stocks above 50 day MA is pretty accurate in spotting tops and bottoms. This strategy began to cover on 8/23 and today 8/24, around 10:07 AM. This may be a short term counter-trend bottom until more sellers come in at $SPX 4190 to 4240.


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