Inflation » Tonkin Financial Solutions

What did Powell say

Three key messages

Not convinced inflation has peaked - " Lower prints for July are welcome, a single month's improvement falls far short of what the Committee will need to see before we are confident that inflation is moving down,"
Doesn't see itself stopping rate hikes soon - "The Federal Open Market Committee estimates the federal funds rate will settle at a range of 2.25 to 2.5 percent in the longer run. But "with inflation running far above 2 percent and the labor market extremely tight, estimates of longer run neutral are not a place to stop or pause,"
Is wary of stopping prematurely - "We must keep at it until the job is done," Mr. Powell said. He points out that, historically, the labor market had tended to take a greater hit when the Fed hasn't acted forcefully and swiftly enough to contain inflation. "Our aim is to avoid that outcome by acting with resolve now, he said.

Powell's three lessons from the 1970's and 1980's

Central banks can and should take responsibility for delivering low and stable inflation.
Inflation expectations can play an important role.
Must keep conditions restrictive until the job is done.

But first - a quick recap of the year to date

Worst first six months of the year for US equity market in 50 years
Summer rally - and recent weakness
Interest rates have resumed an upward track
Central bank pressure on policy rates would imply short-end yield curve pressure
But duration has still been a detractor from portfolio performance
NZD weakness is starting to develop into a trend
Giving a tailwind to unhedged offshore equity exposures.

The 60's and 70's - Quick reminder of the key players
US Presidents

Fed Chair

Great Society Programs 1964-1965

He's worried about a repeat of rampant inflation - The Great Inflation of the 70's
Began in the early 60's
What was happening;

War in Vietnam - Lyndon B. Johnson was President
Wartime spending was pumping the US economy
The Great Society programs - Medicare
Taxes were not increased proportionally
This was the era of the Phillips Curve and the belief that inflation and unemployment were inextricably linked.
Fiscal deficits (during Johnson and Nixon terms).
Abolition of the gold standard in 1971.
Ability of foreign countries to convert US dollars to gold.
Introduction of a price and wage freeze.
Oil shock in 1973-1974'
Federal Reserve did increase interest rates but didn't keep them high.

But there were other issues
Energy cries

Q Caps

Regulated and capped interest rates on checking and saving accounts.
When inflation ran rampant this led to a massive outflow of deposits from the banking system, increased aggregate demand.

The collapse of Bretton Woods

Repeal of Wage and price controls (in place from '71 to '74)

There are some parallels with the 70's that are unsettling
Energy price shocks

Commodity price boom

Large increase in fiscal spending

History repeating or what's changed?

But the key theme appears to be that inflation expectations matters as does preception that the Fed will fight inflation

Former Vice Chair- Richard Clarida

Argued 20 years ago that inflation was at risk of spiralling out of control in the pre-Volcker era because individuals (correctly) anticipated that the Fed will accommodate a rise in expected inflation"
So my take is that the Federal Reserve will really talk tough.
But what happens in the labor market becomes critical to avoid the wage - price spiral.

Second Tier data seems to be unequivocally weaker

Outlook

Interest rates to remain high.
Is 4% - 4.25% high enough.
Not enough supply - second round inflation impacts are starting to feed through.
Demand needs to be reduced.
Unemployment needs to rise or job insecurity increase.
In the United States, two job openings for every unemployed person.
Where have all the workers gone?
Aging populations in the developed world.

Outlook Continued

Negative signs

Financial Markets

Good news is bad news and bad is good. But Powell has shed some doubt over this paradox - its not as simple as that anymore - all news is not equal, some news is more equal than others.
Markets will be looking for signs that inflation is falling.
But, lower demand is not good for company profitability.
Short-term outlook is uncertain, long- term positive.

Investments views and Portfolio positioning

Caution regarding growth assets.
Valuation compression but earnings concerns.
This is likely to be the key determinant of portfolio performance over next six to twelve months.
Value style versus growth.
Reducing the underweight exposure to Australia
Fixed Interest
Favor domestic over global exposure
Still cautious of duration.

My Take

The labor data is key to interest rate expectations
Equity markets will react to what's happening in labor markets - it will be a rocky ride
But there is the ongoing background of the degree to which monetary policy tightening and money supply tightening will constrain corporate profits
We are not living in the 70's
It took a long time for authorities to figure out what to do - we do now have the benefit of hindsight.
We aren't starting from 1963!!!