Warsh’s first Jackson Hole Symposium opening remarks as Fed chair were less opaque than his July FOMC presser, as he used fewer process words than in his last two press conference opening remarks (see Figure 1).
Fig. 1
Improving Clarity
Share Of Sentences With Process Words* At FOMC And Jackson Hole Opening Remarks
Sources: Federal Reserve, Payden Calculations
*Process words refers to mentions of communication and meeting procedure, such as task force, press conference, forward guidance, communication, transparency, dissent, framework, and my colleagues
The new Fed Chair, “100 days into the job,” fondly recalled past “hiking” adventures on the trails around Jackson Hole with former Vice Chair Don Kohn and former Fed Chair Ben Bernanke. He also railed against providing forward guidance, instead calling his speech more of a “trail map.” Then he went on to expound on seven principles regarding his view of the economic backdrop.
Markets got the hint: the Overnight Index Swap (OIS) market moved from pricing in a 30% chance of a September hike to 60%, bringing the market in line with our view, as current trends, should they persist, suggest the FOMC will hike rates.
We retain our view that hikes are coming, sooner rather than later. And we find support in Chair Warsh’s reaction function, even though he frames it as principles that “guide the conduct of monetary policy.”
First, Warsh said that he prefers to look at aggregate data trends rather than single data points.
So what do the data trends tell us?
Core PCE inflation registered 0.246% month-over-month in July after a soft June. The three-month average monthly inflation rate is also right around 0.25%. If that trajectory is sustained (a reasonable guess), core PCE would end the year at 3.4%, higher than July’s year-over-year reading (3.3%) and well above the Fed’s 2% inflation target (see Figure 2).
Fig. 2
3%, Not 2% Trend:
Core PCE Inflation Versus Forecast Based On The 3-Month Average Rate
Source: Bureau of Economic Analysis, Payden Calculations
Warsh himself mentioned this trend later in his speech, saying “While this summer's PCE and CPI readings were better than expected, they do not tell me that underlying trends have meaningfully improved.”
Aside from the traditional two inflation measures, Warsh also noted that he gauges underlying inflation by looking at the individual components of PCE and that “over the past 12 months, 54 percent of goods and services in the PCE basket showed price increases above 3 percent. This is well below the post-pandemic highs of about 77 percent, but it remains well above the level of 32 percent in the two decades that preceded the pandemic.” Our math arrives at similar conclusions (see Figure 3). In other words, inflation is not accelerating but remains elevated.
Fig. 3
Warsh's Pick
Share Of PCE Components With Annualized Monthly Inflation Above 3%
Sources: Bureau of Economic Analysis, Payden Calculations
*2000-2019 ex. recession average
Warsh also dismissed a popular bond market narrative that cooling wage growth implies moderating inflation, observing that “wage growth has not proven a reliable indicator of future inflation for a very long time.” Indeed, our analysis suggests that wage growth has explained only about a third of the variation in core inflation from 1980 to today, even when excluding the Covid-19 episode (see Figure 4). To be fair, moderating wage growth makes us less worried about inflation re-accelerating, but doesn’t indicate that today’s stickiness will dissipate anytime soon either.
Fig. 4
Weak Link
Lagged Regression Results Of Quarterly ECI Change On Various Inflation Measures
Sources: Bureau of Labor Statistics, Bureau of Economic Analysis, Federal Reserve Bank of Atlanta, Payden Calculations
Second, Warsh observed that the policy rate can affect aggregate demand but not supply.
What do we know about aggregate demand and supply today?
We don’t think aggregate demand is overheating today, nor is it materially weakening. The labor market is stable but not tightening; consumer spending has weakened moderately due to the oil shock, but consumer income continues to hold up and drive growth.
Aggregate supply is harder to observe in real time, but we suspect Chair Warsh attributes changes in supply to productivity gains. While he spent a third of his opening remarks discussing trends he sees in AI, Warsh suggests that AI's impact on productivity remains ambiguous today.
But we can observe the actual supply of AI-related hardware and software today, and that’s a key reason why core PCE inflation has been elevated—over the last six months, a single component, information processing equipment, has driven nearly half of the core goods inflation we are seeing. That reflects real-time demand for AI outpacing supply.
So, if the long-run impacts are ambiguous, but we are seeing a short-run supply shortage in a single sector that doesn’t react to the fed funds rate, what should policymakers do? Chair Warsh is not sure, but Fed Governor Waller offered a solution: hike rates to restrain aggregate demand for goods and services across the economy and rein in overall inflation.
Third, Warsh reiterated that the Fed’s inflation target is fixed at 2% and that policymakers must take action to bring inflation back to target.
Beyond Warsh’s own observations that underlying inflation has not improved, he emphasized the criteria for taking action: “We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.”
It seems like we are in that “otherwise” scenario today. “Price stability is not self-executing, nor is inflation necessarily mean-reverting,” Warsh added.
Fourth, Warsh emphasized that the Fed also wants to achieve the maximum employment mandate.
Our previous note highlights that while the July jobs report shows weak headline job growth, the underlying labor market remains in solid shape.
Chair Warsh, too, agrees that “as of now, [he] believes the labor markets are consistent with full employment.”
Further, Warsh emphasized that “the Fed’s dual mandate works at cross-purposes…[as] high inflation itself is very harmful to economic prosperity.”
In other words, Chair Warsh tied full employment today to the Fed’s focus on stable prices, as continued elevated inflation will eventually dampen hiring and hurt the labor market. The two mandates are not in a tug-of-war, and raising rates to rein in inflation will support the labor market in the long run.
Fifth, Warsh emphasized that the Fed will continue to use front-end rates as the main tool for conducting monetary policy.
In other words, if the Fed were to act in response to elevated inflation, it would raise rates but refrain from using QT as a tightening tool. Some clients and several colleagues have inquired as to the Fed’s balance sheet becoming a more central policy tool; at least from Warsh’s perspective, such a shift is unlikely.
Sixth, Warsh emphasized that policymakers must pay attention to the money supply and financial conditions.
Money supply monitoring fell out of favor over the last few decades, but has made a quiet comeback via the Fed’s recent Monetary Policy Report to Congress and Warsh’s comments at Jackson Hole. Our tracking of the money supply shows that it has returned to its pre-pandemic average (see Figure 5). Meanwhile, Warsh later also observed that “on balance, [he] would be hard pressed to describe broad financial conditions as restrictive.”
Fig. 5
Money Supply
M2 Money Supply Change
So, if money supply growth is normalizing, capital expenditures “are rising rapidly,” corporate “profits have grown by more than 20 percent over the past year,” and financial conditions are hardly restrictive, is monetary policy restrictive? “I would be hard pressed to call financial conditions restrictive,” Warsh said.
Finally, Warsh wants a quieter Fed that’s more purposeful in its communications.
Warsh may have his wishes, but will a Committee of 19 policymakers comply? By design and function, the Federal Reserve System is decentralized; regional Reserve Bank Presidents have long had divergent views, and with the centrality of social media and 24-hour news, we look forward to seeing how, from his seat on the Fed Board in DC, Warsh plans to police the public speeches.
The bottom line is that following a widely panned July FOMC press conference that offered little substance, the Fed Chair trotted out a “trail map” of “principles” to guide his approach, sprinkled with data he is watching. On balance, we think his framework tilts the scales toward a September hike.
Happy Hiking,
The Payden Economics Team
