A Jackson Hole Lot of Trouble…

Summary

• The message from 2022’s Jackson Hole Symposium was clear: taming inflation will be harder than markets expect.
• Despite the grim warnings, global central banks are still too modest in their tightening plans.

Market Implications

• For the Fed, I still expect 175bp of additional hikes by end-2022 and continued pricing of rate cuts in 2023.

Striking a Different, Darker Tone

Last year’s Jackson Hole Symposium was an upbeat affair. Fed Chair Jerome Powell lauded the ‘vigorous’ recovery and stressed that ‘elevated inflation readings are likely to prove transitory’. He noted ‘the absence so far of broad-based inflation pressures’, ‘moderating inflation in high inflation items’, especially used cars, and ‘little evidence of wage increases that might threaten excessive inflation’.

How times change! The past few months have seen record inflation in the US. And although headline CPI slowed more than expected to 8.5% in July, from 9.1% in June, inflationary pressures are becoming embedded deeper within the economy as trimmed mean and median CPI continue their uphill slog. And wages are following suit.

This year, Powell opened Jackson Hole with warnings that ‘reducing inflation is likely to require a sustained period of below trend growth that will bring some pain to households and businesses.’ In other words, a soft landing was out of the window, and a hard battle against price rises was ahead.

Three Clear Reasons

The presentations had a common theme: it would be harder to go back to low inflation than market consensus expects. These warnings fall into three categories: the post-pandemic inflation regime will turn out much less benign than pre-pandemic; monetary policy alone cannot stabilize inflation; and reducing the balance sheet (quantitative tightening) will be much trickier than expected.

In this note, I examine just one of those themes: the post-pandemic inflationary backdrop.

Four Factors Working Against Lower prices

BIS General Manager Augustín Carstens, IMF Deputy Managing Director Gita Gopinath, SNB President Thomas Jordan, and ECB Board Member Isabel Schnabel agreed that the post-pandemic inflation backdrop would be more difficult. This was due to factors such as:

• Deglobalization.
• Weaker labour supply.
• Climate change.
• Structural reform fatigue.

These views are credible because they refer to long-term trends playing out in the background but largely ignored until the pandemic and Russia’s invasion of Ukraine.

For instance, I think deglobalization, structural reform fatigue and weaker labour supply have a common thread: the decline in labour income’s share of national income has reached its political limits (Chart 1). 

This has translated into populist politics, a weaker consensus for structural reforms, deglobalization and a decline in participation that started well before the pandemic. 

The pandemic has worsened long-term inflation dynamics by giving some extra market power to workers. This came, for instance, through large government transfers and a recovery in labour demand that beat expectations. 

This extra market power is translating, to some extent, into increased labour militancy.  However, union density remains low in the US, and the prevalence of gig employment makes it harder to organize. As a result, workers seem to be voting with their feet: limiting their participation in the labour market recovery.

Participation may not recover unless employers pay higher wages. Real wages (adjusted for changes in the composition of labour) have been falling since Q2 2020 (Chart 2). Meanwhile, the gap between advertised vacancies and actual hires is at an all-time high. Eventually, employers will have to offer more money to fill their openings.

Meanwhile, with strong resource pressures, employers enjoy market power and could try to recoup higher wage costs by raising prices. I think the acceleration in wage inflation signals that a feedback loop between wages and prices, the much-dreaded wage-price spiral, is currently taking root. 

The post-pandemic economy could therefore see the Fed facing a deepening wage-price spiral plus generally stronger inflation pressures.

Are Central Banks Doing Enough?

There is a huge discrepancy between the warnings from Jackson Hole and central banks’ current policy plans.

The Fed Barks, But Does It Bite?

Take the Fed, for instance. For all the bark of inflicting ‘some pain to households and businesses’, the June Summary of Economic Projections (SEP) shows only a 40bp increase in unemployment to a historically very low 4.1% in  2024. So as of June, the Fed was not planning to bite too hard.

In addition, the June SEP rather optimistically shows core PCE inflation slowing from 4.3% in 2022 to 2.7% in 2023. This is despite it projecting its federal funds rate to peak at 3.8%, which one measure (the Taylor Rule) suggests is far too low to tackle the price rises.

Markets got the message: despite Powell (and other FOMC members) warning of blood, toil, tears and sweat to come, markets are still pricing rate cuts worth 35bp between March and December 2023. In other words, they think the Fed will ease their foot off the economic brakes.

If the Fed really means business, it must show a much more realistic macroeconomic scenario in this month’s SEP. Otherwise, the market will continue to doubt its commitment to inflation stabilization, and the Fed will continue to struggle to tighten financial conditions.

The ECB Has Departed From Reality

Similarly, for all of Schnabel’s hawkishness, the ECB has yet to commit to a tightening path commensurate with inflation risks. CPI inflation in the US and euro area are about the same, around 9%, but PPI inflation is 36% in the euro area against 15% in the US! Inflationary pressures are stronger in Europe but less apparent than in the US because European government have not allowed a full passthrough of higher commodities prices to consumers. 

In June, the ECB’s macro projections showed inflation returning to 2% in 2024 based on market pricing of the policy rate at 0% in 2022, 1.3% in 2023, and 1.6% in 2024!  While markets are now pricing 2%, this appears woefully short of what will be required.

Market Consequences

Jackson Hole has not changed my expectations on the Fed hiking 75bp in September and 50bp each in November and December. These are based on my expectations of a pick-up in H2 US growth and possibly inflation.

I am expecting a limited increase in the federal funds rate and unemployment trajectories in the forthcoming SEP, an increase not large enough to restore the Fed credibility. I therefore expect markets to continue to price rate cuts in 2023.

The Fed is unlikely to move closer to my 8% call until the data shows that growth is not slowing and inflation is accelerating again. That is unlikely to be available until Q1 2023.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.