Jerome Powell chairs the Board of Governors of the U.S. Federal Reserve. His speech at the Fed’s Jackson Hole Symposium disappointed and even shocked many people. It’s been widely cited as the cause of plunges of between 3% and 4% in American markets on that day, as well as falls of almost 2% in Australia on 29 August. Further falls occurred in the U.S. on the 29th and again on the 30th.
This article summarises my interpretation of his speech and its implications for investors. It also puts the frequently occurring and damaging phenomenon of investor surprise into a broader context. Four points are paramount:
- so-called experts are unable to predict the economic and financial future – and the more confident they become, the less accurately they foresee;
- ironically, their consensus and the magnitude of their errors – particularly when they become extreme – can help investors to reduce the incidence and severity of surprise;
- in crucial respects, the consensus has recently become extreme;
- that’s why Powell’s speech didn’t surprise me. Much more importantly, nor should be a recession and consequent bear market in the U.S. within the next year.
The Jackson Hole Symposium
The U.S. Federal Reserve System comprises 12 Federal Reserve Banks and their branches. The Federal Reserve Bank of Kansas City oversees the FRS’s 10th district, which includes middle-western states from western Missouri across to northern New Mexico and up to Wyoming.
Each northern summer since the late-1970s, FRBKC has hosted dozens of central bankers, policymakers, academics, and economists from around the world at its annual economic policy symposium in Jackson Hole, Wyoming. The symposium is one of the longest-standing central banking conferences in the world, and its purpose is to discuss policy issues of mutual concern. The most recent Symposium, entitled “Reassessing Constraints on the Economy and Policy, occurred on 25-26 August.
What Did Powell Say?
Three preliminary points are worth making. First, you can read or watch his speech, entitled “Monetary Policy and Price Stability,” and decide for yourself. A second point: in previous years, Powell’s addresses to the symposium, like those of his predecessors, tended to range widely and delve into considerable detail. In contrast, this year his remarks were much shorter (8 minutes, versus half an hour or more previously), his focus much narrower and his message more direct.
Thirdly, Powell did not utter the word “unemployment” even once (he said “job” four times, but he meant his task rather than an individual’s source of salary; he also used the phrase “labor market” four times).
Similarly, he mentioned “interest rates” just twice and “growth” three times, but “inflation” no less than 47 times (not counting related phrases such as “price stability”).
“The Federal Open Market Committee’s (FOMC) overarching focus right now,” Powell began, “is to bring inflation back down to our 2% goal. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone.” – Jerome Powell
“Restoring price stability,” he continued, “will take some time and requires using our tools forcefully … reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
If listeners missed his main point the first time, Powell repeated it: “we are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2% … Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”
What about the “Fed pivot” that so many people have been expecting? If Powell is credible, then forget it!
Powell concluded: “we must keep at it until the job is done.” History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting.
“The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year.
“Our aim is to avoid that outcome by acting with resolve now. We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.” – Jerome Powell
The repeated use of the phrase “keep at it” in the preceding paragraph is, it seems to me, no accident: Paul Volcker, Powell’s predecessor as Fed chairman (1979-1987) and the destroyer of the second Great Inflation (see Why inflation is and will remain high), used it as the title of his memoirs. Does Powell regard the conquest of the latest bout of inflation – a conflagration that, more than anybody, the Fed ignited – as his legacy?
The Mainstream Interpretation
In order to reduce “inflation” – that is, the annualised rate of growth of the Consumer Price Index and related indexes – below 2% (it presently exceeds 8%), the FOMC will lift one of its target rates of interest, the federal funds rate (the rate at which commercial banks borrow and lend their excess reserves to each other overnight), higher and longer than many were expecting. This will likely tamp the growth (or perhaps even cause the contraction) of credit, which in turn will decelerate or even reduce debt-financed investment and consumer expenditure. These effects, in turn, may increase the rate of unemployment and cause the rate of growth of Gross Domestic Product (GDP) to decelerate further or even contract.
To subdue inflation, Powell announced, in effect (but not overtly), that the Fed will tolerate rising joblessness and even a recession.
A recession, in turn, implies (both as a result of lower earnings and the prices investors are prepared to pay for them) potentially much lower prices of stocks – and a bear market in the U.S. (and perhaps, as a result, in Australia).
The mainstream’s interpretation is fine as far as it goes, but I don’t think it goes far enough. My hunch is that, just as astute or cynical politicians never waste a crisis, particularly a crisis they’ve caused.
That is to say, they use crises as pretexts to do what they had previously wanted to do but couldn’t, Powell doesn’t want to waste a “hard landing.” During the past 6-12 months it’s become apparent that such a thing is a real and rising possibility in the near future – regardless of what Powell says or does now. Two key pieces of evidence support this supposition.
First, in a post to its blog on 17 June, staff economists at the Federal Reserve Bank of New York summarised the updated economic forecasts of its dynamic stochastic general equilibrium (DSGE) model. This model’s forecasts aren’t official, but they provide one input into the FRBNY’s forecasts.
“The (DSGE) model’s outlook is considerably more pessimistic than it was in March. It projects inflation to remain elevated in 2022 at 3.8%, … and to decline only gradually toward 2% thereafter (2.5 and 2.1% in 2023 and 2024, respectively). This disinflation path is accompanied by a not-so-soft landing: the model predicts modestly negative GDP growth in both 2022 (-0.6% versus 0.9% in March) and 2023 (-0.5% versus 1.2%).”
The FRBNY’s economists continue: “According to the model, the probability of a soft landing – defined as four-quarter GDP growth staying positive over the next ten quarters – is only about 10%. Conversely, the chances of a hard landing – defined to include at least one quarter in the next ten in which four-quarter GDP growth dips below -1%, as occurred during the 1990 recession – are about 80%.”
FRBNY’s economists can’t bring themselves to say it – and Jerome Powell certainly didn’t at Jackson Hole – but if their model is valid and reliable then there’s a 4-in-5 chance that a recession like the one in the early-1990s will occur within the next 12 months.
Figure 1: Probability of Recession during the Next 12 Months, WSJ Survey, June 2015-June 2022
As the second piece of evidence, The Wall Street Journal’s sample of experts (approximately 70-80 academic and professional economists, forecasters at major commercial and investment banks, etc.) increasingly agree.
For most months since 2015, they have estimated the probability that a recession will occur during the next 12 months (see chart above).
Until late 2018, the consensus (average monthly estimate) was below the overall mean (24%). During 2019 the consensus estimate climbed steadily, reaching 35% in September, and abated to 24% in January 2020. Then came COVID-19: the consensus estimate skyrocketed close to 100% in April-May 2020, and then collapsed to 12% in July of last year.
That estimate was extremely exuberant in the sense that it was lower than any since early-2015 (10%). Over the past year, in sharp contrast, the WSJ’s experts have become much more despondent: their estimated probability of recession has increased every month and reached 49% in July of this year.
In this context, it’s very odd that Powell’s speech disappointed and even shocked many people. They were expecting lower interest rates and stronger GDP growth – and therefore higher prices of equities – next year. FRBNY’s model and the WSJ’s panel, on the other hand, are increasingly expecting recession (and, by implication, lower prices of equities). Clearly, somebody was going to be disappointed – and on 26 August many people used Powell’s speech as the trigger to belatedly realise that they’re the patsies.
Yet in another sense, it’s hardly surprising that Powell’s speech surprised the crowd.
They’ve long been accustomed to Fed chiefs like Alan Greenspan: he reliably dispensed the easy money and asset price booms they crave; equally reliably, he rescued them when the booms he ignited turned to busts.
The herd’s surprise reflects the sudden realisation that Jerome Powell may be the first Fed chief since Paul Volcker who’s willing to risk a recession in order to vanquish inflation. If Powell accepts that a recession within the next year is very possible or even likely, regardless of anything he says or does today, then perhaps he has resolved: “why not use it to ensure that I kill inflation stone dead?”
Whatever his reasoning, the material risk of recession bodes ill for equities.
Why experts’ GDP forecasts often surprise and harm most investors
Powell’s speech didn’t surprise, disappoint or shock me – and not merely because I ignored it! I disregarded it because I take no notice of virtually any pronouncement from central bankers.
I share Warren Buffett’s view: “If (the) Fed Chairman … were to whisper to me what his monetary policy was going to be over the next two years, it wouldn’t change one thing I do.”
Instead of attempting to foresee the actions of a single monetary central planner, and react every time he pontificates, I focus on the study of history and the analysis of the consensus of error-prone experts.
“The trouble with not knowing history,” noted James Grant (“Monetary Regime Change,” Grant’s Interest Rate Observer, 13 September 2002), “is not that one is condemned to repeat it … The trouble is rather that the history-deprived person meets a surprise at every cyclical bend in the road. He (or she!) lives in a childlike sense of wonderment” – and, I might add, occasionally of bewilderment.
The consensus of experts, I wrote recently (see How experts’ earnings forecasts harm investors), “is heavily biased in the direction of over-optimism. Unrealistic expectations must eventually confront reality – and when they do, they become nasty surprises. Overconfidence is much more likely to produce financial loss than gain (for details, see Why you’re probably overconfident – and what you can do about it). Experts encourage overconfidence; hence they induce investors to suffer losses.”
Those comments referred to analysts’ consensus estimates of corporate earnings; but they also apply to economists’ estimates of GDP growth, the risk of recession, etc.
Their consensus estimates, as well as their rising deviation from actual rates of change of GDP, have for a year flashed warning signals. Those who noted experts’ overconfidence last year haven’t been blindsided this year.
The next chart plots consensus estimates, sourced from FactSet, of U.S. GDP over the past 30 years. In June 1992, the consensus was that during the next 12 months GDP would grow by 2.8%; since June 1992, the consensus estimate has averaged 2.7%. For most of last year, the consensus was strongly upbeat: from March to December, it exceeded 4% and rose as high as 4.35% in July.
That was the most extreme (bullish) consensus in almost 20 years: it was the highest estimate, in other words, since the 4.43% in December 2003.
Since then, however, the optimism has cooled considerably: by June of this year, the consensus estimate had more than halved to 1.8%. That’s one of the most extreme (biggest and fastest) deteriorations on record.
Figure 2: Consensus Estimates, GDP Growth for Next 12 Months, Monthly Observations, June 1992-June 2022
Figure 3 expresses changes in consensus estimates of GDP growth over rolling 12-month periods. In June 1993, for example, the consensus estimate of GDP growth during the next 12 months was 2.77%; in June 1994, it was 3.02%; accordingly, during the 12 months to June 1994 the consensus increased by 0.25%. Conversely, in June 2021, the consensus was 4.12%. In June 2022, it was 1.76%. Accordingly, during these 12 months, the consensus estimate of growth decreased by more than 2.3%.
Figure 3: Percentage Point Changes, Consensus Estimates of GDP Growth, 12-Month Periods, June 1993-June 2022
Not only did the consensus reach an extreme one year ago; since then, it’s collapsed at one of the fastest rates of the past 30 years.
Only during the Global Financial Crisis (3.4% in December 2008) and the Dot Com Bust (2.65% in November 2001) did the consensus deteriorate by a greater amount than during the 12 months to June.
How accurate has the expert consensus forecast actual GDP been? Figure 4 answers this key question. We’ve seen that in June 1992 the consensus estimate of GDP growth 12 months hence was 2.77%; in the 12 months to June 1993, actual GDP growth was 2.69%. Hence the consensus overestimated actual growth in the latter month by 2.77 – 2.69 = 0.08 percentage points.
The greater the over-optimism of the consensus vis-à-vis reality, the higher the numbers in Figure 4 rise above zero; and the more pessimistic compared to reality is the consensus, the more the number falls below zero. Today, the bullishness of the consensus remains above the post-GFC average — and greater than at almost any point pre-GFC.
Figure 4: Consensus Estimates versus Actual GDP Growth, Monthly Observations, June 1993-June 2022
On average since 1993, the consensus has over-estimated actual GDP growth by 0.66 percentage points.
That mightn’t seem like a big miss, but it is: expressed as a percentage of actual GDP growth, the consensus estimate has erred 0.7 ÷ 2.7 = 26%. This doesn’t surprise me: as I’ve emphasised, the consensus is usually biased in the direction of over-optimism
Moreover, the consensus estimate of GDP growth has become more overoptimistic over time. Before the GFC (that is, from June 1993 to December 2007) on average it was unbiased: it neither over-nor underestimated GDP.
That’s largely because it greatly underestimated actual GDP growth after the recession of the early-1990s and before the Dot Com Bust. Since the GFC, on the other hand, the consensus has been strongly biased in the direction of over-optimism:
The average over-estimate is 1.33 percentage points; actual GDP growth has averaged 2.6%; hence the consensus estimate has erred by an average of 1.3 ÷ 2.6 = 50%. That’s plenty of scope for disappointment!
I’m not surprised that Jay Powell’s speech disappointed and even shocked many people. They want desperately to believe that somebody is in charge, that somebody has their back, and above all that somebody has a reliable crystal ball.
Central bankers certainly wield enormous power (they mostly do a lot of damage), but it’s demonstrably untrue that they know the future better than anybody else. Indeed, they’re just as blind – and as prone to emotions including panic – as the average man in the street.
Most investors should therefore ignore the pronouncements of monetary central planners and the consensus estimates of macro-economic experts (and stock and market analysts). What you don’t heed can’t surprise you.
More fundamentally, authorities don’t merely err almost continuously and sometimes enormously: they also blunder systematically. Indeed – and ironically – their biggest blunders of overconfidence tend not merely to precede but to foretell crucial events.
The consensus is usually unable to predict bear markets, corrections, financial crises, and recessions: but the non-random nature of experts’ errors allows investors who ignore the consensus and think for themselves to undertake pre-emptive action. Extremes, if you observe them in time, usually won’t harm you.
So never mind Jerome Powell’s (and Philip Lowe’s) speeches. Instead, notice today’s extremes and prepare for a possible recession and bear market.