Read Between the Lines - Jackson Hole Speech
When a speech that is normally slotted for a half hour is delivered in only 8 minutes, it behooves us to pay attention both to what was said, and what was not. For those accustomed to parsing meaning out of long-winded and sometimes contradictory “Fed-speak”, Friday’s address by Federal Reserve (Fed) Chairman Jay Powell was welcomely brief and to the point. The phrase “speak softly, and carry a big stick” comes to mind. Judging by the market reaction of the last 2 days, I would say the message was received and understood. As inflation threatens to unravel the credibility of central banks across the western world, the Fed remains resolute in a commitment to raise and keep interest rates elevated until inflation returns to near their stated target of 2%
Today we will discuss the challenges mentioned during the speech, as well as challenges unmentioned that remain. Then we will evaluate how these challenges might impact interest rates, inflation, and precious metals prices (see graphic 1). Like a car spinning on an icy road after over-correcting, the Fed finds itself on the opposite side of the 2% inflation target. For many years, the goal was to prod inflation higher to the 2% level, to no avail. Once achieved, the goal became to let inflation run hot for awhile, to help get the average inflation rate (over time) up to 2%. We first alerted our readers to this shift in policy back in December of 2019, just before the impacts of the pandemic took root. Suddenly it was not only Federal Reserve interest rate policy working to accommodate higher inflation, but a liberal US Treasury and Congress flooding the economy with “stimulus” funds in order to avoid a collapse.
Expanded Inflationary Pressures
With multiple rounds of economic aid to businesses and individuals, and government initiatives that allowed borrowers and renters to skip paying loan payments and rent, the United States became awash with currency. Lockdowns worldwide impacted supply chains negatively, and we had fewer goods being pursued by increasing amounts of dollars. This of course contributed to inflation, in a way that the Fed was not solely responsible for. Based upon Fed actions alone, they perceived that inflation would be “transitory”, and return to the 2% range after a few months in 2021. We explained in a brief Metals Minute video last May why that was probably unlikely. Then came the Russia-Ukraine conflict, which has roiled world energy markets and further compounded international supply chain shortages.
While many look to the Federal Reserve as the sole arbiter of inflationary concerns, and listen intently to speeches like the 8-minute speech we heard on Friday, there is only so much the Fed can do. As we have discussed above, there are multiple inputs feeding the inflationary conditions of today. The Fed has pledged to keep interest rates moving higher this year, and keep them there until inflation cries “uncle”. The word “pain” was acknowledged in the speech, in reference to the difficulties experienced as a slowing economy moves into recession. Reducing “demand” is a polite way to describe destroying the economy and individual finances, in a way that people cannot afford to make purchases. People and companies that cannot make purchases, generally don’t. In the past, loans were often the answer. But with interest rates rising and credit tightening, loans become increasingly out of reach.
What the Fed Means by “Pain”
Recent estimates indicate that it will take a 3.4% contraction in the economy, for every 1% reduction in the rate of inflation. Based on these calculations and the current rate of inflation, “pain” might be a mild word to describe the effects of the “forceful and rapid steps to moderate demand” the Fed is taking. By increasing interest rates while removing capital, pain will likely be felt in the housing market here in the United States. Rising inventories in the housing market are a typical leading indicator of lower stock prices (see graphic 2). As we know, stock prices have decreased significantly even before housing inventories peaked. Higher mortgage rates have put homeownership out of reach of many renters at a time when 3.8 million are facing eviction over the next 2 months. Mortgage applications have dropped 18%, to a 22-yr low. Many need housing but cannot afford it.
Mortgage rates have more than doubled in a year (see graphic 3), reaching nearly 6% as of today. This is evidence of higher interest rates “reducing demand” in the economy. But there are other factors impacting inflation which are more difficult for the Fed to address. Some economists believe the greatest threat to the U.S. economy, and a source of inflation going forward, is the imbalance between labor demand and supply. As the available workforce continues to shrink, the pressure to pay higher wages continues to build. Higher wages are considered to be inflationary, by any measure. Employers are offering the highest wages for job postings since 2017 (see graphic 4). In order to stop or slow this source of inflationary pressure, the pace of business itself must slow or stop.
With 25% of US companies having insufficient revenues to pay interest on existing loans, easy credit options have allowed them to roll old loans into new ones at attractive rates, to stay alive. As the Fed raises rates and tightens credit conditions, some of these companies will be forced into bankruptcy. People will lose their jobs, and there will be “pain”. Eventually, there will be an increase of people looking for work, fewer jobs available, and the pressure on wages should moderate, thereby eliminating this source of inflation. “Reducing demand” in the economy implies companies going out of business, and people losing their jobs. Yes, there will likely be “pain” on this quest for lower inflation. But the Fed believes there will be more pain involved if inflation is not reduced, than there will be from imposing recessionary conditions now.
Higher interest rates are also causing pain in emerging markets around the world, as the dollar strengthens relative to other currencies. Dollar-denominated debt become more difficult to service, as prices rise for necessities. Chairman Powell correctly pointed out that it will likely be those least likely to afford the pain, that will experience the most pain. To put a point on it, that means lower-income emerging nations and those who live there, and lower-income Americans struggling to secure food and shelter here in the United States. With the prospect of lower stock markets, lower real estate prices, and lower bond prices while interest rates rise, the few assets left that offer investment opportunity in this environment include energy and precious metals. They were also the best performing assets the last time we found ourselves here.