What’s Next After The Stock Market’s Jackson Hole Meltdown

In the wealthy resort town of Jackson Hole, Wyoming, roughly 120 central bankers, economists, and journalists met last week to discuss monetary policy. The attendees came from as far as New Zealand, England, France, South America, and Japan. On the agenda: A coordinated global effort to bring down inflation and finally restore price stability. US Federal Reserve Chair Jerome Powell got the ball rolling with a carefully choreographed eight-minute speech on Friday morning. By the afternoon, the value of global stock markets was collectively down by trillions of dollars. The S&P 500 (SPY) ended the day down roughly 3.4%. As of my writing this, stocks look set to extend the selloff today as well. If you’re reading this, you might be wondering – what the heck happened in Wyoming on Friday that caused stocks to melt down?

By and large, the Fed’s recent messaging on inflation has been consistent. But since June, the financial markets have increasingly placed bets on flimsy evidence that the Fed will pivot and cut rates if the stock and/or housing markets fall (presumably to 0% or negative rates). But Powell hammered home the point on Friday that there would be no such pivot, causing stocks to plunge.

Key Ideas From The Jackson Hole Speech

1. 2.5% is not “neutral.” In the Fed’s last press conference in July, Powell was faced with a question in the Q&A about what the neutral rate of interest is. Powell essentially said he thought 2.5% was a neutral rate that would neither slow the economy down nor speed it up. The stock market responded by skyrocketing. 2.5% in the long run with 2% inflation is indeed a “neutral rate.” But with core inflation running at about 5% per year, 2.5% is not an appropriate rate of interest to slow inflation. A cash rate of 4% might do the trick if the Fed aggressively shrinks its balance sheet, but raising rates to 2.5% and quitting was never going to fix inflation. Time after time, other Fed speakers have come out in the days after Powell’s previous press conferences to walk this back, but this time the damage was done and money poured into stocks. One difference between the Jackson Hole speech and the earlier press conferences was that this time the Fed could craft its message ahead of time. Powell answering questions at press conferences created ambiguity for markets, which forced the Fed to come out and defend after. The Fed used this chance to slap down speculation by traders who placed bets expecting the Fed to not follow through on its earlier promises and made it clear that rates would need to go higher than traders had hoped.
2. Restoring price stability will take years. In this section of the speech, Powell alluded to mistakes of the 1970s where rates were cut and inflation immediately surged (weaker dollar, stocks going back up, etc.) In addition to this, Powell appeared to take responsibility for the mistakes of his earlier tenure and seemed willing to take the necessary steps to fix them. Powell and others implied that interest rates need to stay higher for a couple of years, not the 3-6 months that bulls had pinned their hopes on. This busted traders’ hopes for a quick resumption of QE and rate cuts in 2023.
3. Cash rates of 4% or higher are likely needed. Powell clarified what kind of rates would likely be needed and various Fed chairs’ comments after Powell. Hammering it home, Fed speakers after Powell reiterated their rate expectations, which are higher than the market has previously priced. With expectations for much tighter money, traders were faced with the cold reality that the Fed would not be coming to the rescue. Once the selloff got going, it accelerated into the close, with little ambiguity over the Fed’s plans.

So Why Is Inflation Bad?

Why does the Fed care about this? What’s really wrong with letting inflation just chill at 10% per year, or even go to 20% annually? Pundits and even some Fed researchers have made the case for keeping rates low and doing more quantitative easing, because in their minds the Fed can’t do anything about the supply chain, and they think high inflation is good for the job market.

This argument fails on a few fronts.

First, contrary to the fashionable beliefs of some high earners with large fixed-rate mortgages, inflation is bad for the economy. Of course, some people benefit at the expense of others, but it’s been thoroughly proven that inflation causes more harm than good and ultimately results in a lower standard of living. This is known as the “welfare cost” of inflation. In general, inflation causes people to do things that they would not do in an economy with stable prices, and these things are bad for the economy. Just a few examples:

• Businesses ordering inventory that they don’t need for fear that it will shoot up in price (which causes other businesses to do the same, often by borrowing money to do so).
• Suppliers intentionally withholding inventory from the market to take advantage of rising prices (i.e. home sellers).
• Companies raising wages by less than inflation to try to protect their profit margins.
• Workers constantly changing jobs to protect their purchasing power (i.e. the Great Resignation).

Millions of people and businesses like this acting in their self interest end up causing damage to the broader economy, and this damage increases exponentially with the rate of inflation. Modeling the welfare cost of inflation was mostly an academic exercise when inflation ran at 2% annually or less, but now it’s a real-life science experiment. Over the last 12 months, prices were up 8.5%, and inflation-adjusted earnings for workers were down 3.6%.

Second, there’s clear and convincing evidence that current inflation was mainly driven by demand. Supply chain problems magnified the impact, but the economy was always going to break at its weakest points when flooded with money, whether those points were port infrastructure, trucking, or semiconductors. Everyone blamed the supply chains, but when you look at data for the ports, they handled much more traffic in 2021 than they were handling for the previous few years before the pandemic.

Third, when countries try to keep rates at zero and ignore inflation, what happens is inflation doesn’t just hover above the target range. In these cases, inflation continually accelerates higher as people lose faith in the currency, wrecking the economy in the process. This has recently played out in Turkey, whose president has some highly unconventional monetary views. There, inflation has risen from 5%-10% per year to over 80% annually.

Think of Turkey whenever you see people on TV selling the swan song of Modern Monetary Theory! Similarly, inflation isn’t as good for the US government as is commonly believed. Many of its largest obligations are tied to inflation, including Social Security. And doing anything to hurt faith in the US dollar and the perceived ability of the government to repay its debts leads to higher interest rates in the end. While the government might benefit a little from inflation, be wary of assuming that the 4% rates will bring the economy/world to an end, or thinking that the government can’t pay the debt.

American voters (and even politicians) have figured out that inflation is bad, so everyone is pretty much in agreement on what the Fed needs to do to stop it. Therefore, to get the economy to start functioning again, the Fed needs to curtail demand to kill inflation. This means rapid rate hikes and shrinking the balance sheet. Again, while many people seem to be betting on the Fed to pivot and cut rates, far fewer people actually think it would be beneficial in the long run to do so. Everyone thinks the Fed will cut rates to bail out speculators, but no one really wants them to.

What This Means For Stocks

I’ve modeled where the Fed needs to take interest rates to slow inflation, and my figures are in line with several recent Fed speakers. Cash rates will need to go to 4% and possibly a bit more, and the Fed will need to aggressively shrink its balance sheet.

What does this mean? Well, as an investor you have a choice.

1. You can put your money in Treasury bills and earn 3% annually until the end of the year and then 4% per year risk-free.
2. Or, you can put your money in stocks, which have returned 9% or so over the long run, but if you time it wrong, you can lose 50% or more of your money over a few years.

If somebody gave you a few million dollars in cash today, what would you do? I think I’d lean towards taking the guaranteed 4%. If stocks crash, then I could turn around and buy low.

To this the second point above, stock valuations are really high compared with historical norms, on top of earnings have been juiced by stimulus. The dual-engine motor of interest rate decreases and stimulus is now working against you, and the US is about to face a huge demographic shift. Millions of people are aging out of the workforce expecting Social Security and Medicare, but there’s not enough tax revenue to pay for them. Corporate profits have been repeatedly juiced by tax cuts and stimulus over the past 10 years, but what happens when taxes not only can’t be cut more but have to go up? It’s not the end of the world for stocks, but you want more compensation for these trends than you’re getting at current prices. If you’re buying stocks here and you’re holding for 5-10 years, you’ll make money, but not much. I think people are starting to figure out that they’re not getting very much compensation by buying stocks at current prices, so they’re pulling back on buying.

Key Takeaways From Jackson Hole

• Interest rates are going higher than the market thinks – to 4% or higher. Additionally, the Fed is set to accelerate the reduction of its balance sheet starting Sept. 1. They may do more still.
• Interest rates will stay higher for longer than the market thinks – restoring price stability will take years.
• Investors can take advantage of this process by placing money in Treasury bills to earn risk-free returns or can fight this by plowing money into stocks at high valuations. I’d go with the flow here as much as you can.
• With valuations high and earnings pumped up by 2021 stimulus, stocks are expensive and risky. This shouldn’t dissuade you from investing in the stocks of businesses you like, but the top 10 holdings of the S&P 500 by market cap are pretty overvalued.
• Stocks need to be around 20% lower to reach my estimate of fair value and provide sufficient compensation for the risk you’re taking.