Markets misread Fed chairman’s maiden testimony as hawkish

It was an inaugural event as Federal Reserve Chairman Jerome Powell stood before Congress Tuesday morning to testify on the state of the U.S. economy.

The chairman reiterated a generally optimistic assessment of domestic growth as well as a “gradual” pathway for rates, as depicted in the January Federal Open Market Committee (FOMC) statement itself.

{mosads}He spoke neither of accelerating rate hikes above the anticipated three rate increases already priced into the market, nor did he highlight a need to slow the pace of future increases.

Offering little in the way of new information in terms of the pace or direction of monetary policy, Powell’s upbeat assessment, nevertheless, seemingly convinced at least some market participants to read a more hawkish tilt in his remarks.

At first a minimal reaction, after digesting the more positive stance from Chairman Powell, fears of an overly aggressive Fed reignited selling and raised the probability of four rate hikes over the next 10 months.

Of course, if taken at his word, the committee now faces a relatively high bar; should inflation fail to “move up” in the near-term, the Fed will find it increasingly difficult to justify a further adjustment to policy.

In other words, while the market is pricing in the upside risk of three or four (or more) rate hikes this year, with subdued price pressures and a further loss of momentum in topline activity, the larger risk appears to be to the downside with conditions failing to justify more than one or two rate hikes all year.

While toeing the usual party line of the FOMC, there were a number of notable takeaways from Chairman Powell’s testimony. 

The new Fed chairman is optimistic about the U.S. economy.

In his prepared remarks, Powell reiterated the generally positive sentiment regarding domestic growth outlined in the latest January FOMC statement. Highlighting improvements in the labor market and “solid” gains in household spending, as well as a recent step-up in business investment, Powell painted a relatively rosy picture of current conditions.

Looking beyond the near-term, the Fed chief noted that “some” of the headwinds that the U.S. economy has faced in previous years “have turned into tailwinds,” suggesting an increased positive trajectory for growth.

But is there an upside risk to growth? This week’s second-round GDP revision showed fourth-quarter growth accelerated at a 2.5 percent. While solid, the pace of domestic activity in the final months of 2017 was a noticeable decline from a 0.3-percent pace April to September. Furthermore, initial data reported in the first quarter suggest a further loss of momentum with a disappointment in trade, durables, new homes sales and retail sales.

The pathway for rates will remains data-dependent.

As expected, Powell repeated the message from the January FOMC statement — and every other statement since December 2015 — that a “gradual” adjustment in monetary policy “will best promote” the committee’s ability to reach the dual objectives of maximum employment and stable prices.

When asked specifically about the potential for a faster rate path, the chairman, however, did note that some factors indicate tighter policy may be “appropriate.” Stopping well short of suggesting the possibility of more than three rate hikes over the course of 2018, the chairman, however, noted his expectation for a continuation of existing “gradual” policy and policy tools.

Despite the chairman’s apparent intention to limit the impact of his comments on the market, Powell’s positive view on the economy coupled with simply acknowledging the possibility of a faster rate path fueled expectations of a greater number of rate hikes than previously anticipated. According to the CME, odds of four rate increases in 2018 rose to 33 percent from near 20 percent prior to Powell’s testimony. 

Some worried a lack of traditional training as an economist left Chairman Powell in a position of weakness. He is, after all, the first to lead the FOMC without a Ph.D. in economics since Volcker in the 1980s. After this week’s performance, however, there is no argument that a Ph.D. is not a requirement to master the art of “Fed-speak.”

Of course, the market’s interpretation of the Fed chairman’s lengthy statements offering little substance or specifics as support to a specific policy pathway is an entirely different art of communication.

Price pressures and wages are expected to rise.

The central bank has been struggling with low inflation for years and despite ongoing evidence to the contrary, it continues to anticipate a near-term rise in prices. In the January FOMC statement, the committee specifically indicated that price pressures are expected to “move up” this year.

This week, Chairman Powell again reaffirmed the committee’s expectation for a continued rise in inflation back towards the Fed’s 2-percent objective in the coming months. The shortfall in inflation, he said, was more likely the result of transitory influences as opposed to longer-term structural barriers.

Of course, with the Fed’s primary inflation indicator below the central bank’s target for most of the past five years, one has to wonder what the chairman considers transitory. 

Specifically addressing the minimal wage growth in the U.S. during the recovery, Powell also dismissed the lack of improvement, this time as a likely result of low gains in output per hour and productivity.

Powell however, may be at odds with at least some of his colleagues. According to the FOMC meeting minuets, many committee members are far from confident in an improved trend in prices. Some members expressed concern about the outlook for prices, seeing little evidence of a meaningful improvement in the underlying trend in inflation, measures of inflation expectations or wage growth.

Among those voicing skepticism of rising price pressures, a few noted that the recently enacted corporate tax cuts might lead firms to cut prices in order to remain competitive or to gain market share, which could result in a transitory drag on inflation.

With the impact of tax reform still unclear, the recent uneven data suggest the potential for both upside and downside risks to the inflation outlook.

Powell’s comments were perceived as hawkish.

While delivered in a more direct and matter-of-fact manner, at least relative to the more amiable and pleasing tone of former Fed Chairwoman Janet Yellen, the message from the new chairman deviated little from his predecessor: data-dependent, gradual and optimistic.

Nevertheless, with the Fed chairman failing to specifically commit to a slower-than-expected pathway — meaning fewer than three rate hikes this year — the market seemed to blur the message, reading a more hawkish tone than actually existed.

In other words, the baseline expectation given the recent jitters in the marketplace was for the chairman to specifically argue against a faster pace of tightening in order to ease fears of a faster-than-expected increase in rates.

Investors fear a more aggressive Fed could stomp out the modest improvement in the economy over the past year. Of course, the recent volatility in the market, while unsettling for investors, will not act as a deterrent to further Fed action.

Downplaying the volatility of the past weeks, Chairman Powell said the recent correction in the stock market should neither “hamper growth” nor restrain Fed policy.

Lindsey Piegza, Ph.D., is the chief economist for Stifel Fixed Income. Her research has been published in the Harvard Business Review and in textbooks for Northwestern University’s Kellogg Graduate School of Management. She’s a regular guest on CNBC, Bloomberg, Fox News and CNN.