With Crucial Powell Speech On Deck, Consider This ‘Key Nuance’

For markets, the week ahead will likely be defined by what Jerome Powell says about the Fed’s policy framework review during a speech at Jackson Hole.

Of course, it’s not properly “at” Jackson Hole this year. Rather, in keeping with efforts to contain COVID-19, the Fed’s annual symposium will be a virtual, livestream event. That won’t detract from the drama for the bond market, even as the format will be yet another reminder that “we’re not in Kansas anymore”, as Dorothy would say.

Presumably, Powell’s remarks will set the stage for the September Fed meeting, and perhaps help clarify things in the wake of markets’ somewhat adverse reaction to the July FOMC minutes which, according to some, were notable for what they didn’t contain. Specifically, disappointment centered around a perceived lack of commitment to rolling out new forward guidance or a tweaked bond-buying plan in September. That, combined with the apparent shelving of yield-curve control, pushed up the dollar, undercut gold, and weighed on equities.

Some (including myself) characterized the knee-jerk reaction to the minutes as overdone — a symptom of belabored attempts at tasseography. “(Over)interpreting the immediate market reactions to the Fed minutes was probably more a navel-gazing exercise than anything else”, Nomura’s Charlie McElligott said Friday. “I found almost nothing of substance in them myself”.

That said, Powell will likely try to avoid giving anyone the impression that the market’s interpretation of the July minutes was “correct”. That is, he won’t want to suggest (even tacitly) that the Fed isn’t prepared to deploy strong forward guidance or tweak the pace and duration of its bond-buying at a moment’s notice should conditions warrant.

The Fed has, of course, always struggled to keep inflation at or near target on its preferred gauge and the pandemic served as a severe setback. The coronavirus’s impact on aggregate demand and the plunge in crude prices was a deflationary supernova, even as it led to spikes in prices for items affected by supply chain disruptions (most notably US meat).

There are, of course, all manner of angles from which one can approach the inflation debate.

“Regular” people (or, more often, commentators purporting to speak on their behalf) will argue that inflation is not just alive, it’s borderline out of control in the “stuff that matters”.

“Stuff that matters” isn’t usually a well-defined concept, but critics often point to college tuition and housing/shelter prices in certain locales as evidence. And that’s to say nothing of asset prices. Everything from equities to artwork has pretty clearly benefited from a dozen years of monetary largesse.

In any event, what the market is most anxious to hear about are the details around average inflation targeting and the countenancing of overshoots.

In a Friday note discussing this hottest of hot topics, BMO’s Ian Lyngen takes a look at PCE and CPI, both headline and core, at YoY and 10-year annualized levels. The “the key nuance”, he says, is that “neither headline nor core PCE inflation have moved above 2% on a 10-year annualized basis since 2014”.

That’s an interesting insight. The takeaway, Lyngen writes, is that had “the Fed’s reaction function to inflation been predicated upon a 10-year annualized core-PCE, rather than YoY, it’s not obvious that the central bank would have raised rates during the last cycle, or at least not as aggressively”.

He then dryly notes that using the term “aggressively” assumes you count “a well-telegraphed quarterly hiking campaign in even increments to neutral” as “aggressive”.

So, that’s some helpful context for Powell’s hotly-anticipated virtual speech. It comes on the heels of a week during which 10-year yields fell the most since June (green).

The red bar in the figure represents the back-up in rates that accompanied the record refunding earlier this month. That move higher in yields wasn’t actually very dramatic considering the circumstances.

This week features $148 billion in auctions across 2s, 5s, and 7-year notes.

In addition to the inflation framework discussion, the market will be keen to know whether the Fed is willing to ramp up buying at any maturity going forward should it become “necessary” at some point.