Jerome Powell Stepped Down as Federal Reserve Chairman With a 7-Word Warning That Speaks Volumes for Stock Investors

Jerome Powell ended his two-term tenure as Federal Reserve chairman this month. During his time in charge of the central bank, he was tasked with battling the highest inflation rates the country had seen in over 40 years. Many believe inflation wouldn’t have reached such a high level if he had pushed the Fed to act more quickly.

Now inflation is rearing its ugly head once again. The war in Iran has pushed oil and other commodity prices higher as the Strait of Hormuz remains closed. In his last press conference as chairman, Powell left investors with a seven-word warning about how this bout of inflation could impact the broader market, and investors should be paying attention.

Image source: Federal Reserve.

The seven words from Powell that investors must hear

After the FOMC kept rates steady once again at the Fed’s April meeting, journalists asked Powell how the current inflation caused by spiking oil prices could impact future Fed rate decisions.

Inflation has climbed considerably since the start of the war in Iran. March saw the CPI climb 3.3% year over year, and that climbed to 3.8% in April. The Fed’s current forecast for May expects a 4.2% increase.

Energy prices are the biggest driver, with gas prices up 28.4% year over year and fuel oil prices up 54% in the April CPI report. The Federal Reserve Bank of Dallas published a study in April that found that the longer the Strait of Hormuz remains closed, the higher oil prices will climb and the slower they’ll fall once reopened, with severe knock-on effects for consumer inflation.

In Powell’s response at the press conference, he noted there’s more to inflation than just gas prices. But that shouldn’t put investors at ease.

Remember, when gas prices go up, that’s disposable income coming out of people’s pockets, so they’re going to spend less on other things. So, there will be a hit to GDP.

Those last seven words, “there will be a hit to GDP,” are not the words typically associated with the S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC) trading near all-time highs. They’re a massive warning for investors that can’t be ignored.

Has the economy met a breaking point?

Powell’s comments were meant to imply that lower consumer spending can act as a disinflationary counterbalance to high energy prices. But that’s not the way a healthy economy combats inflation. Shrinking GDP means a decline in earnings for American businesses.

Later in the press conference, Powell noted that the U.S. has faced a barrage of shocks to its system since the start of the COVID-19 pandemic. “The U.S. economy has just powered through shock after shock. And consumers are still spending,” he noted.

Powell said the decline in consumer spending has yet to show up in the data, and businesses will likely say consumer spending remains strong in public statements and quarterly earnings reports. However, he maintains that discretionary spending will take a hit if consumers spend more on gas and other essentials.

We may, in fact, be starting to see it happen. The University of Michigan Consumer Sentiment Index hit a record low this month amid concerns about inflation. If that translates into lower consumer spending, it could be bad news for many businesses’ earnings results through the rest of the year.

The challenge facing the stock market right now

Powell’s warning should be taken seriously. Any slowdown in GDP growth could have a huge impact on the stock market. That’s because investors are pricing stocks to continue their rapid earnings growth for years to come.

The S&P 500 and Nasdaq-100 currently trade for forward price-to-earnings (P/E) ratios of 22 and 26, respectively. That’s well above their historic averages in the teens. If growth slows, the market could compress those multiples closer to their historic averages.

On the other hand, much of the current GDP growth stems from big tech companies building out data centers. Powell notes that spending is unlikely to decrease anytime soon. So, some of the artificial intelligence (AI) stocks propping up the market’s overall valuation could be less affected by a slowdown in consumer spending.

That said, many of the largest companies in the market that are also building out those data centers will see a tremendous impact on their core cash-flowing businesses if there’s a slowdown in consumer spending. When the GDP is shrinking, people don’t buy as much stuff online and companies spend less on marketing.

Overall, the potential for disappointing earnings results increases the longer gas prices remain elevated. Powell’s warning about inflation doesn’t seem to be priced into the market yet.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.