The stock market’s summer rally ended Friday as investors digested the aggressive comments of Federal Reserve Chairman Jerome Powell at the central bank’s annual symposium in Jackson Hole, Wyo.
Powell made it clear that fighting inflation is the Fed’s top priority and that even if some “pain” is needed, the central bank would continue to raise interest rates and shrink its balance sheet “for quite some time.”
The S&P 500 has fallen in all three trading days since the speech and is now down more than 5% from Thursday’s closing price. The tech-heavy Nasdaq, which is more sensitive to Fed policy, has fallen nearly 7% over the same period.
Paul Christopher, head of global market strategy at Wells Fargo, wrote in a research paper on Tuesday that during this summer’s stock market rally, investors had expected the Fed to “join” interest rate cuts amid mounting fears of a recession. But Powell’s speech quickly changed that opinion, sending stocks plummeting this week.
“The message from the central bank’s global economic symposium last week in Jackson Hole, Wyoming, was that persistent inflation in most countries will require continued aggressive policies. The Fed’s message to the US was particularly clear on this point,” he wrote.
Throughout 2022, the Fed raised interest rates in an effort to cool the economy and lower consumer prices, all without triggering a recession. But so far, his efforts have not yielded much, as inflation last month remained near a 40-year high.
This means the recent decline in the stock market is good news for Fed officials who will have to let asset prices fall if they want to get inflation under control.
Falling stock prices are a sign that the market has received the right message: the Fed is focused on inflation above all else, and a restrictive policy can be expected for at least the rest of the year.
As a result, Fed officials are celebrating the market’s negative reaction to Powell’s comments.
“I was actually happy to see Chairman Powell’s Jackson Hole speech being received,” Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis, told Bloomberg’s Tracy Alloway and Joe Weisenthal on the Odd Lots this week. podcast. “People now understand the seriousness of our commitment to bring inflation down to 2%.”
Kashkari pointed out that after the Fed’s June meeting, market participants misunderstood the lasting strength of the Fed’s inflation-fighting measures, leading to a roughly 17% rise in equities from June to mid-August.
“I certainly wasn’t excited to see the stock market soar after our last Federal Open Market Committee meeting,” he said. “Because I know how committed we are all to reducing inflation. And somehow I think the markets misunderstood that.”
Kashkari is not the first Fed official to emphasize that asset prices, including stock prices, must fall to reduce inflation.
In April, Bill Dudley, the former president of the New York Federal Reserve, wrote an article titled “If Stocks Don’t Fall, the Fed Needs to Force Them” outlining how part of the Fed’s purpose Raising interest rates should be to lower stock prices because they affect how Americans think about their wealth and therefore how they spend.
“To get inflation under control, the Fed will have to somehow drive up bond yields and lower stock prices,” explains Dudley.
Jeffrey Roach, chief economist at LPL Financial, said: Fortune that Powell’s speech and comments from current and former Fed officials are evidence of the central bank’s commitment to “keep the punch bowl away from the table.”
Roach’s “punch bowl” metaphor goes back to former Fed chairman William McChesney Martin, who said in a 1955 speech to the Investment Bankers Association that when the Fed cuts interest rates, it is in the position of “the chaperone who has ordered that the punch bowl be removed just as the party was really heating up.”
Roach argues that the Fed’s efforts over the past decade to boost economic growth through rate cuts and quantitative easing (QE) — a policy whereby the central bank buys mortgage-backed securities and government bonds to boost lending and investment — set up a party in risky assets.
This year, the Fed’s rate hikes put an end to that celebration, but investors believed the punchbowl (low interest rates and QE) might return amid fears of a recession. Jackson Hole’s speech made it clear that this is unlikely to happen anytime soon.
While removing the punch bowl may not bode well for investors, it may be necessary to cut inflation as the job market remains hot. Roach noted that in July, the number of job vacancies per unemployed climbed again to almost the peak of March.
“There are still about two job openings for every person available to work. So for now, the Fed has more reasons to keep talking hard about its inflation-fighting mandate,” he said.
Deutsche Bank’s Jim Reid also wrote in a research paper on Tuesday that the Fed is trying to avoid “repeating the mistakes of the 1970s” by continuing aggressive rate hikes until inflation is well under control.
The market weakness following the Fed’s comments is not surprising given this aggressive policy stance, said David Bahnsen, chief investment officer of The Bahnsen Group, an asset manager. Fortuneadding that the stock market is likely to continue to struggle as corporate earnings disappoint investors in coming quarters.
Jason Draho, head of asset allocation at UBS Global Wealth Management, said in a research note on Tuesday that this means investors need to prepare for a “high-volatility market regime.”
Sign up for the Fortune Features email list so you don’t miss out on our key features, exclusive interviews and surveys.