It appears that Jerome Powell’s speech in Jackson Hole finally convinced investors that they could not fight the Fed.
The major indexes fell for the fourth consecutive day on Wednesday. The Dow Jones Industrial Average, the Nasdaq Composite, and the S&P 500 each closed out August lower than they started the month, as the selloff erased the gains from earlier this month.
Apart from Friday’s big decline, mostly the market has moved down in an orderly manner. But the downward momentum has been relentless, and so the losses have mounted. The Dow is down about 2640 points—or 7.7 percent—since its mid-August highs. The S&P 500 is down by 8.1 percent. The Nasdaq has lost just under 10 percent since August 15.
Stock trader Peter Tuchman works on the floor of the New York Stock Exchange during afternoon trading on August 29, 2022, in New York City. (Michael M. Santiago/Getty Images)
We had been warning for weeks that investors were defying the age-old Wall Street maxim that you can’t fight the Fed by bidding up stock prices. Chairman Powell has explained that monetary policy works through financial conditions. That is to say, when monetary policy is attempting to bring down inflation, it does so by making debt and capital costlier. This means interest rates rise and stock prices fall. So when stock prices are rising, they are basically sending a signal to the Fed that it needs to tighten even more.
Minneapolis Fed President Neel Kashkari explained this in a recent interview on Bloomberg’s Odd Lot’s podcast.
“I certainly was not excited to see the stock market rallying after our last FOMC meeting because I know how committed we all are to getting inflation down,” Kashkari said. “And I somehow think the markets were misunderstanding that, and I was actually happy to see how Chair Powell’s Jackson Hole speech was received.”
From right to left: Jerome Powell, Federal Reserve chairman; Lael Brainard, vice chair of the board of governors for the Federal Reserve System; and John Williams, president and chief executive officer of the Federal Reserve Bank of New York, during a break at the Jackson Hole economic symposium in Moran, Wyoming, on August 26, 2022. (David Paul Morris/Bloomberg via Getty Images)
One way of interpreting the market’s pre-Jackson Hole doubts about how tight financial conditions would get is Kashkari’s: investors doubted the Fed’s commitment. Indeed, many analysts have openly forecast that the Fed would back down from its inflation fight if the U.S. finds itself in a significant economic slump next year. Powell’s speech—and comments from other Fed officials since then—seem specifically designed to banish those doubts. That’s why Powell emphasized the pain that higher interest rates would inflict on businesses and households.
Back in the last decade, as the economy was slouching toward recovery from the financial crisis, the Fed faced a credibility problem that was both similar and the opposite of the one it faces now. Sometime around 2012, financial markets began to expect that the economy would, in the near or medium term, recover enough for the Fed to start raising interest rates again to prevent inflation from rising above the two percent target. The Fed, however, expected economic conditions to remain sluggish. The idea emerged that what the Fed needed to do to spur more investment by businesses was to convince them that it was a bad idea to hold on to cash because the Fed might let inflation get out of control. This was described as having the Fed “credibly promise to be irresponsible,” a phrase that originated with Paul Krugman.
That’s sort of what Powell is engaged in now: convincing markets to believe that he will be a bit irresponsible about the economy. He’s trying to convince investors and businesses that financial conditions will tighten no matter how bad economic conditions get, just as his predecessor Ben Bernanke was urged to convince markets that he’d keep interest rates low even if inflation rose to a high level.
Will it work? It’s hard to say. Despite the pleadings of Krugman and similarly minded economists, neither the Bernanke Fed nor Janet Yellen’s ever seriously attempted to implement Irresponsibility Monetary Policy. They preferred quantitative easing, which probably works—to the extent it does—by communicating a long-term commitment to keep rates lower, although not necessarily a commitment to allowing inflation to break upward from the target.
Krugman always imagined Irresponsible Monetary Policy as a solution to the “zero bound” problem, or how the Fed could keep loosening financial conditions even though interest rates had hit zero. There’s no reason, however, to suppose it could not work to tighten financial conditions if inflation remains high even though the economy has been contracting.
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