Investors are on edge.

On Friday at 10:00 a.m., Federal Reserve Chair Jerome Powell will deliver remarks at the Jackson Hole symposium. The event draws top banking officials from around the world to discuss current issues facing the global economy.

In the past, Powell used this venue to broadcast important changes in the Fed’s interest rate policy. Last August, Powell’s Jackson Hole speech laid the groundwork for cutting interest rates. A month later, the Fed surprised investors with an outsized 0.50% rate cut.

But after a few cuts, the Fed stopped. Things have been on hold ever since.

Now investors are hoping that Powell will once again use Jackson Hole to kickstart a fresh round of rate cuts.

Yet history suggests that investors are getting their hopes too high.

And that poses a big risk to the economy…

Don’t Get Your Hopes Up

Expectations for interest rate cuts are running high.

Odds point to an 83% chance that the Fed will reduce rates by 0.25% at its next meeting in September. That’s relatively baked in at this point.

Hopes for rate cuts jumped after a weak payrolls report in July. We also saw huge downward revisions to jobs in May and June. The three-month average payroll gain is just 35,000 jobs. That’s the lowest since the pandemic.

But the economic picture grew more complicated last week.

A pair of inflation reports covering consumer and producer inflation came in higher than expected… and the numbers are moving in the wrong direction.

The core Consumer Price Index (CPI) excludes food and energy prices, which tend to be more volatile. It rose by 3.1% in July. That was higher than the estimates. Core CPI has also moved higher for two consecutive months.

But the Fed still has a 2% inflation target. While many hope that Powell will nod to coming rate cuts, high inflation may force the Fed to sit tight.

That could put us on a path to an economic crash…

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Recessions Drive Large Cuts

Powell could use the Jackson Hole spotlight to remind investors that the Fed must focus on low inflation too… not just the labor market.

The Fed tends to keep the short-term Fed funds rate about 1% above the rate of inflation on average. Based on the current core CPI, that means the Fed could make a 0.25% cut from the current target of 4.25%-4.50%.

But if inflation stays high, there may not be room for more cuts… until high interest rates cause a recession.

At least, that’s what history shows us.

The Fed targets high interest rates to slow the economy. Falling economic growth should lead inflation lower.

But the Fed almost always causes a recession in doing so. And it takes a recession to push the Fed to cut rates by a large magnitude.

Take a look at the chart below:

It shows the short-term Fed funds rate (blue line) going back to 1990, along with recessions (shaded areas).

Every time the Fed has quickly lowered rates, it has happened just before or during a recession.

So closely watch Powell’s speech at Jackson Hole. Will the Fed see a bigger risk in inflation… or the labor market?

If inflation keeps running hot, it’s probably going to take more than one lousy jobs report to drive the Fed to slash rates.

But as history shows us… by that time, it will likely be too late to avoid a recession.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict

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