US economy Mamba mentality?

A factually true statement, but the rest of Powell’s comments weren’t consistent with Kobe’s Mamba mentality, which entails a relentless, resilient, obsessive, and fearless passion to achieve one’s goals. Investors have wondered if Powell is so obsessed with taming inflation and avoiding a legacy as the Fed chair who let it get out of control that the risk is strongly skewed towards the Fed hiking too much and inducing an otherwise avoidable and unnecessary recession.

You wouldn’t have gotten that impression from Powell’s press conference, which explains why equities rallied and Treasury yields fell as it was happening. The consensus expectation going into the FOMC meeting was for a hawkish 25bps rate hike. Powell could have delivered by reiterating that the December dot plot—where the Fed hikes rates to 5–5.25% and keeps them there through year-end—is still the appropriate policy expectation. That would have pushed back against more dovish market pricing. Powell also could have explicitly said the easing of financial conditions over the last few months were counter-productive to the Fed’s goals. He did neither, with comments that were more qualified than definitive. If Powell was channeling his inner-Kobe during his Jackson Hole speech, which was short, clear, and unambiguous that the Fed will do what’s necessary to bring down inflation, the same wasn’t true yesterday.

There’s little investment value in over-analyzing a central banker’s mindset. But we can make four conjectures about the investment environment following the FOMC meeting.

First, the basic investing set-up last year was a Fed focused on tightening financial conditions as long as inflation was high and the labor market too tight, which made for challenging and volatile markets. By not strongly pushing back against easing conditions, which didn’t occur at the December FOMC meeting either, that set-up appears to be over, at least for the time being. That doesn’t make the Fed investor-friendly, but in a way the Fed has already paused. If the tightening or easing of financial conditions is what really determines economic growth impulses, more so than rate hikes or cuts, then the Fed has already effectively inflected its policy path by tolerating easier financial conditions. That may be an underappreciated reason why asset prices have rallied so much in the past few months.

Second, expect the debate about the transmission mechanism of monetary policy to the real economy to intensify, with important investment implications. Conventional wisdom has been that interest rate hikes operate with “long and variable lags” that take 12 months to fully weigh on the economy. There’s now growing acceptance that tighter financial conditions are what matter most for slowing growth, and the lag is only about two quarters. If that’s true, the negative impulse to US growth due to the tightening conditions last year is happening this quarter, with growth set to improve thereafter. But if the conventional wisdom is correct, then the real economic pain won’t begin until about mid-year. No one really knows which argument is correct, though the financial conditions view seems to be holding sway right now. That can keep market momentum going because easier financial conditions increase the odds of a soft landing. But that will also make it more painful for investors down the line if the conventional wisdom does hold.

Third, equity and interest rate market-implied volatility declined yesterday after Powell’s comments, but this may end up being a temporary reprieve that actually results in higher volatility later on. Lower volatility can fuel market momentum in the short term by enticing more investors to add risk. But while investors may welcome a less-hawkish Fed now, the Fed’s policy reaction function is arguably less clear post- versus pre-FOMC meeting. Not only do investors have to deal with an uncertain economic outlook, there’s the question of how the Fed will respond to it, which sets the stage for a potentially volatile March FOMC meeting.

Fourth, Powell talked about how disinflation is underway, with a long way still to go, but this process may well be the dominant market driver for the year. I say that with self-interest because disinflation was my prediction for the 2023 finance word of the year back in mid-December. "Soft landing" was the clear phrase-of-the-month for January, and is still a strong contender for the annual title. But the rationale for choosing disinflation is that its magnitude, not whether it will occur, will influence the eventual path for the US economy, whether soft or hard. If disinflation stops when inflation is still far above 2%, then the Fed will have to hike more than currently expected, perhaps after a pause, and that will greatly increase the probability of a hard landing. But rapid and robust disinflation, including in non-shelter core services, makes a soft landing more likely. Thus, the type of “landing” for the economy is a function of the magnitude and breadth of disinflation. Signs of structural disinflation should be as important as growth data for evaluating the likely paths for the economy, as well as the markets, this year.

The bottom line: Far from putting an end to market momentum, as the Jackson Hole speech and September FOMC meeting did, yesterday’s FOMC outcome is more likely to exacerbate it for the time being. That will heighten investor FOMO at the same time that the risk-reward trade-off for many assets becomes less attractive.

Main contributor: Jason Draho, Head of Asset Allocation, CIO Americas

Original report - Mamba mentality?, 2 February, 2023.

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