This Is The ‘100-Trillion Dollar Question’

In the aftermath of Jerome Powell’s overtly hawkish address in Jackson Hole, markets are compelled to ponder a “100-trillion dollar question.”

Powell left little doubt last week about the Fed’s near-term reaction function. Policymakers are, in fact, working from a de facto single mandate. Inflation is all that matters. Officials aren’t just prepared to countenance a loss of economic momentum, they’re actively trying to facilitate a slowdown. The same goes for the labor market. Job losses are acceptable. Desirable, even, although decorum means never saying as much out loud.

No “pause,” let alone outright dovish pivot, is possible until inflation is on a “sustainable” path back down to target. It was apparent from Powell’s remarks that the Fed believes there’s virtually no chance of inflation meeting that condition prior to policy rates exceeding neutral.

Given all of that, “the ‘100-trillion dollar question’ is whether, in this ‘post-Jackson Hole’ world, bad news is bad for markets, because the Fed is telling you that neither recession nor (initial) job losses will stop them from finishing the inflation task at this still-early point in the adjustment process,” Nomura’s Charlie McElligott wrote Tuesday.

This is the furthest thing from a trivial discussion. Indeed, it’s the most important discussion in the macro universe currently. For almost the entirety of the post-financial crisis era, risk assets operated in a “bad news is good news” regime, mostly because, with but a few exceptions (e.g., the European debt crisis) “bad” was never overtly bad. “Bad” might mean evidence of too much disinflation or muted, but not recessionary, growth. In such instances, the assumption was that central banks would take the opportunity to double, triple and quadruple down on forward guidance, as subdued inflation was everywhere and always plausible deniability. “Lower for longer” became “lower forever,” and large-scale asset purchases became a mainstay, notwithstanding sporadic attempts to slow the pace or gradually shrink bloated balance sheets.

Now, in the post-pandemic inflation era, markets face the worst possible scenario: Bad news could be overtly bad and policymakers are, for the first time in living memory, unable to lean on disinflation to justify interventions, verbal or otherwise.

In addition, officials are now openly hostile to risk assets. Or at least they claim to be. “I was actually happy to see how Chair Powell’s Jackson hole speech was received,” Neel Kashkari told Bloomberg on Monday. He was referring to the selloff on Wall Street. “People now understand the seriousness of our commitment to getting inflation back down to 2%.”

Of course, bad news will eventually be good news for stocks. At some point, assuming the US does slide into a real recession (not the “technical” recession the world’s largest economy is already in), a succession of negative monthly payrolls prints will surely compel a pause, then a pivot. Committed or not, there’s virtually no chance that a modern Fed would continue to hike rates into a deep recession regardless of how “sticky” inflation proves to be in the 3.5% to 5% range many see looking out six months to a year.

But the key is “eventually.” Negative payrolls at any point this year would be extremely vexing. The Fed can’t turn right around after Powell’s big moment in Wyoming and pivot in November or December if, by some stroke of bad luck that could only happen to Powell, NFP turns negative in 2022. That has to be a 2023 outcome at the earliest. Otherwise, we’re in a lot of trouble. Bad news wouldn’t just be bad news, it’d be really, really bad news. You’d have job losses and a Fed that’s angrily hiking rates into restrictive territory in a bid to exact revenge on an inflation impulse which spent the last 18 months embarrassing them.

McElligott described conversations with clients, who he said are “voicing a growing view that the FOMC is trying so hard not to indicate or acknowledge any semblance of ‘dovish policy pivot’ scenarios next year” that officials are being perceived as likely to “intentionally downplay softer MoM inflation numbers, along with eventual job losses.”

That, Charlie said, could mean that “the Fed’s eventual policy turn is going to come ‘fast and furious,’ because the moment they acknowledge the conditions for a hard slowdown, the market would ‘take a mile'” by pulling forward pricing for 2023 easing. Recall that after overshooting during this summer’s growth scare (which, in true “bad news is still good news” fashion, helped catalyze the stock rebound from the June lows), markets came to their senses and (mostly) priced out rate cuts for H1. But, as noted here repeatedly last week, pricing will likely reflect cuts later in 2023 (figure below) until there’s overwhelming evidence to the contrary.

Currently, it’s not clear what would constitute sufficient evidence to definitively rule out at least one cut in the back half of next year — certainly not a wide-eyed Kashkari talking tough in interviews, and not Jim Bullard undermining his own efforts to scare markets by adopting a casual, soft cadence while hammering home an otherwise aggressive message, either.

“Most I speak to are now agreeing… that even just the first nonfarm payrolls negative print could be violently bought in equities as the perceived ‘all-clear’ signal, even before the Fed would acknowledge anything close to it,” McElligott went on to write, before emphasizing that in the very near-term, things absolutely can’t “go left” — that’d open the door to a left-tail outcome.

“It’s a very different dynamic to get a bad jobs prints now or over the next few months, when you have no Fed willingness to yet acknowledge it as justification for a premature pivot,” Charlie wrote. “They are adamant about avoiding that, because the inflation data can’t yet show ‘clear and sustainable progress.'”

On Tuesday, John Williams suggested rate cuts in 2023 are very unlikely. “We need to have somewhat restrictive policy to slow demand and we’re not there yet,” he said, during a Wall Street Journal event. Once rates are into restrictive territory, they’ll likely need to stay there for “some time.”