Fed Chair Powell's 1970s Lesson Casts Doubt On Quick Pivot; S&P 500 Falls

Stocks tumbled after Federal Reserve chair Jerome Powell's speech highlighted the Fed's 1970s failures.

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May 14, 2023 • 5 min read

In his highly anticipated Jackson Hole, Wyo. speech, Federal Reserve chief Jerome Powell said that policymakers cannot let down their guard too soon, otherwise they risk allowing high inflation to become entrenched. The S&P 500 plunged sharply after the release of the transcript.

Powell stated that "restoring price stability is likely to require a restrictive stance in policy for a period of time." The historical record warns against loosening the policy too soon.

Powell stated that to bring down inflation, the U.S. will need "a sustained period below trend growth". He acknowledged that tightening Fed policy will cause "some pain" to businesses and households. The failure to restore the price stability would cause "far more pain."

Powell's July 27 press conference left many wondering if he would attempt to reverse the dovish tone he had given. Those comments helped to boost the S&P 500 by up to 18% since the closing low of June 16, ending a bearish market.

In the near term, traders are focusing on whether or not the Fed will raise rates by 50 basis points or 75 basis on September 21. The odds shifted slightly to favor a smaller hike after the release of July's soft inflation data, just before Powell's address. In his news conference on July 27, the Fed chairman suspended the forward guidance and did not take sides about the size of the rate hike. After Powell's speech, the odds shifted back in favor of a third consecutive 75-basis point hike.

Investors' appetite for risk is largely influenced by the intermediate-term outlook of Fed policy. S&P 500's rally is at least partially based on the hope that Fed policymakers will cease to raise rates by early 2023, and start considering cutting rates in mid-year.

Investors don't want Powell to tell them that interest rates can be "higher" for longer, as St. Louis Fed president James Bullard recently said. Powell didn't say it exactly. He did, however, go into detail about the Fed's failures during the 1970s to illustrate the danger of too early rate increases. The current policymakers have clearly kept that experience in mind.

Take-away: The Fed could be reluctant to reduce its benchmark rate, even if the economy enters a recession. This is a radical departure from the way monetary policy was conducted during the recent deflationary decade.

Powell's remarks came at a time when the Fed's preferred inflation gauge indicated that price pressures were easing. The index of personal consumption expenditures fell by 0.1% in July. This lowered the annual inflation rate from 6.8% to 6.3%.

Core prices increased by 0.1% in June as core inflation rates fell to 4.6%, their lowest level since October.

The peak of inflation is now clearly behind us, as energy prices are falling and supply chain problems are being resolved. Unknown is how long strong wage growth will continue to keep inflation above the Fed’s 2% target.

Powell cited the lower readings of inflation for July. He added that "a one-month improvement falls far below" what is needed for the Fed's to be convinced that inflation has fallen enough to pause rates hikes.

Powell, in a speech on March 21st, walked through the history soft landings of the Fed to support his argument that current tightening might have a similar outcome. Powell cited 1965, 1984, and 1994 as examples of tightening by the Fed that did not necessarily lead to a recession.

To support his argument, he also cited Federal Reserve tightening from 2015 to 2019. Covid, not the Fed, was to blame for the recession that occurred in 2020.

Federal Reserve Meeting Minutes Trim Big Rate-Hike Odds

Some economists predicted that Powell would give a less-uplifting history lecture at Jackson Hole. Nomura economists Aichi Amieya and Robert Dent predicted that Powell would focus on the experiences of the 1970s in his speech.

They wrote: "A number Fed participants have recently highlighted that era, with some caution. This is usually to highlight their preference to avoid an'stop-and-go' tightening pathway."

The last time unemployment was as low as 3,5%, other than immediately prior to the pandemic in 1969. The Fed raised its key interest rate from 8% to 9% in order to combat wage-driven inflation.

The Fed changed course in 1970. The federal funds rate was cut to less than 4 percent by early 1971. This helped push the unemployment rate to 6%. Aneta Marcowska, chief financial economist at Jefferies, wrote on June 3 that the rate "wasn't enough high to dampen wage-pressures".

She wrote that "the Fed failed to create enough slack in order to stabilize inflation expectations and squeeze inflation," "Policymakers made the same mistake as they did in the mid-1970s. They hiked aggressively, causing a recession, and then eased too soon, allowing inflationary forces to re-assert themselves."

Markowska believes that the Fed must be more tight when faced with a negative feedback loop between wages and prices.

Powell stated that as inflation increased in the 1970s, households and businesses began to anticipate high inflation. Powell said that as inflation increased, people began to expect it to stay high and built this belief into their wage and pricing decisions.

Powell stated that Paul Volcker, the then-chairman of the Fed, finally broke the back of inflation during the early 1980s. "Multiple attempts to lower inflation had failed over the previous fifteen years," Powell said. We want to prevent that outcome now by taking decisive action.

Powell's message could have been intended as a kind of wake-up for the financial markets. They had already begun to anticipate a Fed tightening reversal. This view of rate reductions in 2023 led to a easing of financial conditions. The S&P 500, Dow Jones Industrial Average, and Nasdaq all rose.

The minutes of the Federal Reserve meeting on July 26-27 highlighted that there was a "significant" risk that "elevated prices could be entrenched, if the public started to doubt the Committee's determination to adjust its stance."

The minutes stated: "If the risk materialized, this would complicate returning inflation to 2% as well as increase the economic costs."

CPI Inflation is Finally Falling -- More than Expected

Some economists say that Powell could want to create more doubt about the possibility of a Fed rate cut in the near future to address this concern.

As investors digested Powell’s speech, the S&P 500 fell sharply and in a volatile manner on Friday. In Friday's stock market action, the S&P 500 dropped 3.4%, while the Nasdaq fell 3.9% and Dow Jones dropped 3%.

The S&P 500 closed Thursday at a 12.5% lower level than its record high of Jan. 3, but it is up 14.5% from June 16. The Dow Jones Industrial Average is down 9.5% since its high, but up 11.4% from the 52-week low of June 17, when it closed. The Nasdaq is still 21.3% lower than its all-time high closing price, despite a rally of 18.7% since its low in June.

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