Powell’s Path Forward

For the past few weeks, the economic news has moved against my relatively hawkish view of the Fed. There was a third soft PCE inflation reports. July growth data was modestly weak, with a strong retail sales report offset by a weak jobs report.

Alternative facts

The bigger news was the release of the preliminary benchmark revision of payrolls, lowering them by 818k in March 2024. Of course, a downward revision was widely expected, but the size of the revision was on the upper end of expectations. If the BLS extrapolates forward a slower pace of job gains, growth in the last three months will be revised from 170k per month to close to 100k (we won’t know for sure until next February). This impacts the outlook in two ways. First, it aligns the payroll numbers closer to what other data are showing—trend-like growth. Second, and related, it shows that the economy is being hurt a bit more by Fed policy than it appeared. My Fed view is getting stale.

Recall that at the start of this year the Fed signaled that it was close to cutting rates and only needed confirmation of the softness in inflation. In my view, had they known the weaker path of payrolls they would have cut by 25 bp at the start of the year, paused while the four strong core PCE numbers came out, and then restarted the cuts in July or September. With the benefit of hindsight they look a bit behind the curve.

Powell’s pivot 

On Friday at Jackson Hole, as expected, Powell confirmed the sharp shift in Fed focus:

·      “It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions.”

·      “An important takeaway from recent experience is that anchored inflation expectations, reinforced by vigorous central bank actions, can facilitate disinflation without the need for slack.”

·      “The upside risks to inflation have diminished. And the downside risks to employment have increased.”

·      Hence, rate cuts are coming.

This is a dramatic change from his message at Jackson Hole two years ago when he warned that getting inflation back to target might require a recession.

Comparing his remarks to recent commentary from his committee, he confirmed that he leans toward the dovish end of the FOMC. My suggestion for Fed watchers is that if you want get a sense of where Powell is leading the committee put more weight on the doves than the hawks.

Inquiring minds want to know 

The big missing piece here was that he gave virtually no guidance on the speed or duration of rate cuts. He simply said, “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” He deliberately avoiding categorizing the cuts. Will they be “gradual?” Will the road be long or short? Is this a mid-course correction or the start of a full-blown cutting cycle? Does the Fed have any catching up to do?

This ambiguity is a hallmark Powell’s communication strategy. Bernanke’s tenure marked the height of Fed transparency as he tried to manage the markets and offered a variety of thresholds as guidance. Looking back at those days, I felt the markets did a very poor job of listening to the caveats in the guidance.

Powell likes to maintain maximum optionality. He tends to focus mainly on directional guidance rather than offering baseline scenarios, He also seems to have a love-hate relationship with the FOMC forecasts—most of the time he downplays them, but when the Fed is moving quickly he highlights them. Otherwise he likes to keep his cards close to the chest.

While Powell made no attempt to push back against dovish market pricing, I don’t think that means he agrees with the market. Again, his modus operandi is to avoid commenting on market pricing. What he is saying is that the markets could be right or could be wrong: it depends on “the data.”

What happens next?

According to the CME FedWatch Tool the markets are certain the Fed cuts at the September 18th meeting, with a 76% chance of 25 bp and 24% chance of a 50 bp cut. From there the market expects a regular diet of 25 bp cuts, with perhaps a 50bp cut tossed in for good measure. They see a 100 bp of cuts this year and another 100 to 125bp next year, pushing the funds rate down to just above 3%.

What do I think? Pinning down a specific schedule for the Fed is hard to say the least, but it is the only way to make a forecast transparent and testable. Like the Fed my view is data dependent. I think core inflation should stay low enough to be a nonfactor in Fed decisions in the coming months—I think they will be comfortable if core PCE inflation settles in the low twos. For the growth data, my base case is that they get their soft landing, with payroll growth dipping to around 100k and the unemployment rate peaking at 4.5%.

Here is my stab at the sequencing:

·      Unless the macro data over the next four weeks are much weaker, I expect a 25 bp cut on the 18th. Anything else would signal panic and hence could be counterproductive.  

·      I now expect rate cuts at each of the next three meetings, so another 25 bp in November and December. My old view was that they would cut every other meeting.

·      I don’t think the data need to be particularly weak to keep them moving at the start as they still the “neutral rate” at below 3%. Bigger cuts are only likely if the data increasingly hint at a hard landing.

·      Next year I expect them to downshift to feeling their way forward, cutting every other meeting with two or three 25 bp cuts.

Along the way I expect continued gradual upward revisions to estimates of the “neutral” rate –the level of the funds rate (and, importantly, the associated financial conditions) that neither stimulate nor constrain growth. Hence they settle in at about a 4% funds rate until the next shock hits.

Some final thoughts

I still think an outright recession is a low risk. Recessions result from the one-two punch of a major external shock and the Fed fighting persistent inflation. At this stage there is no major shock; most important, oil prices are well below their peaks. Meanwhile, with the sharp drop in inflation the Fed no longer “wants” to risk recession—they are trying to wound, not kill, the economy.

Are they acting too late? The answer would be “yes” if the markets were not forward looking. However, a lot of the benefits of expected rate cuts are already priced into financial markets, with a weak dollar and rising stock and bond prices.

Recession calls lean heavily on two rules of thumb—the Sahm Rule and the yield curve inversion. However, I’m not big fan of having one or two indicators drive my forecast. While the rise in the unemployment rate has triggered the “Rule,” the unemployment rate looks like an outlier relative to other macro indicators. And yes, the yield curve has been inverted for many months, but most financial indicators point to healthy growth ahead, including the stock market and credit spreads.

There has also been some talk about how “base effects” for inflation could delay Fed cuts. As the chart shows, a year ago there was a string of very weak annualized month-over-month core PCE prints. In the months ahead, even if they are “replaced” with target-like monthly prints, year-over-year inflation will accelerate slightly. The Fed is well aware of this and has been trying to get the markets to focus more on six-month inflation. Afterall, with reasonably good seasonally adjusted data there is no reason to obsess about year-over-year numbers.