For those who have not been paying attention, here is a potted history of the recent market turmoil. At its Wednesday July 31 meeting, the Federal Reserve indicated it was set to cut rates in September with a soft landing in sight, while the Bank of Japan earlier that day raised its interest rate to 0.25 per cent with a hawkish message in defence of the yen. Market reactions were minimal, with stocks up a little both in Japan and the US.

Things kicked off on Friday August 2 after the yen had risen sharply and disappointing jobs figures in the US triggered the “Sahm rule” that had previously identified recessions. By the end of Monday August 5, the S&P 500 US stock market index was down 6 per cent with the Nikkei 225 down almost 20 per cent. Click on the chart to see these falls both in local currency and US dollar terms, where they are smaller because the yen was simultaneously appreciating.

US equities have now regained all the lost value and are trading higher than they were at the close on the day before the July 31 Fed meeting. The same is true of Japanese stocks valued in dollars, and they are down just over 3 per cent measured in yen.

For 2024 as a whole, the chart below shows equities have had a great year and are significantly higher, both in dollar and local currency terms. It is lucky, therefore, that the Fed did not heed the advice of many in early August that it needed an emergency rate cut because financial conditions had deteriorated so much. Nobel laureate Paul Krugman, for example, reasoned that because the markets were already alarmed, such a move was necessary and would not be a sign of panic in the Fed.

Other financial markets have also calmed down. The US forward interest rate market gave an 85 per cent probability of the Fed cutting rates in September by 0.5 percentage points on August 5, a probability that was down to just under 25 per cent when I last looked this morning.

But these markets have not quite regained the poise of late July. The forward US rate market still thinks there is a greater than 50 per cent chance of US interest rates ending the year at least 1 percentage point lower, which would imply the Fed implementing at least one large rate cut in the remaining three meetings of the year.

How did markets get things so wrong?

It should surprise no one that financial markets overreact to news sometimes, create plausible but often exaggerated narratives such as the unwinding of the yen carry trade and can be remarkably thin in August. Katie Martin is worth reading on the truth about the narratives, while the Bank of England in 2022 published a neat paper highlighting just how thin some of the forward UK interest rate markets were even outside summer holiday months, with 81 per cent of trades among the top three market participants. Of course, the US market will be bigger and deeper, but to assume these are efficient markets is quite a stretch.

One market narrative that was clearly important during the latest crash was that the US soft landing might be fading from view. The jobs data that set off a number of US recession warnings was a trigger. It is ironic, however, that while the US uses a recession definition that relies on a committee to look at all the evidence, financial markets reduced this to the movement of one indicator — unemployment — over a relatively short period. As the chart below shows, other labour market indicators have cooled, but are not flashing warning signals.

How will the Fed respond?

With financial markets back close to levels at the last Fed meeting, further good news on US inflation and better indications from weekly US unemployment claims, it is likely that Fed chair Jay Powell will deliver a “steady as she goes” message.

Other Fed officials, including Mary Daly and Raphael Bostic, have indicated a gradual move towards rate cutting from the Fed this year. Powell is more likely than not to follow suit in his big speech on Friday, although he probably will not give a definitive steer.

A half percentage point cut in September would indicate that the Fed previously made an error because in his July press conference, Powell said it was “not something we’re thinking about right now”. Central banks hate to admit to errors.

For sure, the median Federal Open Market Committee’s fourth-quarter unemployment forecast from June of 4 per cent looks as if it will need updating given the most recent reading of 4.3 per cent. That will allow the Fed to concentrate more on the labour market aspect of its dual mandate and cut rates more than the one to two times indicated in June. But there will be little urgency to do more, especially during an election season.

The main requirement from Powell will be for him to set out his thinking and the likely reaction to further movements in the data. That will be pretty different from and much better than how financial markets saw things at the beginning of the month.

How will Taylor cut his cloth?

The UK government has appointed Professor Alan Taylor of Columbia University to be an external member of the Bank of England’s Monetary Policy Committee, starting in September.

Given the finely balanced nature of the committee, his stance will be important to the path of UK monetary policy. He is replacing Jonathan Haskel, who has voted recently with the more hawkish members, and while I am hesitant to predict his current views, I can report that this Taylor has cut his cloth in a dovish direction in response to two big shocks in the past 15 years.

After the global financial crisis, Taylor was firmly on the side that thought there had been unnecessary demand destruction with too much fiscal consolidation. I criticised this stance about a decade ago. Early in the pandemic, he argued that that type of crisis was also more likely than not to lower the neutral rate of interest in the longer run.

Let’s be clear, none of this is remotely definitive and everyone is allowed to change their mind.

What I’ve been reading and watching

• After a month of glowing headlines, Kamala Harris’s big economic speech on Friday did not land smoothly. Although the vibes of hinting at price controls are well understood, the Democratic presidential candidate’s policies came in for some criticism from economists and from me in my latest column

• Soumaya Keynes effectively argued that simplified US recession indicators are flawed and the past might not be a perfect guide to the future, especially when the sample size is nine

• Robin Harding warns that low yields in Chinese bonds are a sure sign that the country’s economy is flagging and requires fiscal stimulus, not a central bank fretting about a bubble in bond prices

• In the Unhedged weekly interview, Jason Furman of Harvard covers a lot of ground and I loved his characterisation of those who claim we are returning to the 1970s on inflation. It’s a “self-unfulfilling prophecy”, Furman said, reasoning that the frequent warnings will prevent a return

A chart that matters

When central bankers think about scenarios, these are generally of the sort that warns about some external upward shock to prices. Following an excellent Bloomberg article on falling grain prices after good harvests, perhaps we need a scenario on plunging food prices. Here are some grain wholesale prices for your delight.

This is good for inflation, good for poorer families and good for poorer countries. Dare I say, it is much better than price controls.