Federal Reserve Chairman Jerome Powell’s carefully crafted remarks at the Council on Foreign Relations provided a great opportunity to reiterate the Fed’s key message going into the summer: “An ounce of prevention is worth a pound of cure.”
This puts the Fed on track to deliver two consecutive 25-basis-point “immunization shots” (i.e. rate cuts) in July and September.
Asked what had changed since the December 2018 rate hike, Powell noted that there were four specific developments that had led the Fed to adopt a much more dovish stance since the previous Federal Open Market Committee (FOMC) meeting in early May.
First, global growth had continued to weaken with weakness particularly visible across global manufacturing indicators. This aligns with Oxford Economics’ view that global growth will continue to slow through the year but that resilience in the non-manufacturing sector and increased global central bank accommodation should provide a buffer against a sharper slowdown.
Second, Powell noted that escalating trade tensions between China and the U.S. during the intermeeting period, along with threatened tariffs on Mexico, had increased the downside risks to the outlook.
The tariffs on Mexico have since been suspended for 90 days pending a solution to the deemed “immigration crisis,” and China and U.S. trade negotiators are once again communicating ahead of the upcoming Group of 20 meeting.
While this provides for a reassuring backdrop, the risk is that elevated uncertainty — as seen in recent confidence surveys — restrains business activity and consumer outlays.
Third, Powell highlighted the weak 75,000 jobs report in May as an indication of labor market softness. While we noted at the time that the employment trend remained solid, it appears Powell and his colleague were frightened by the unusually soft reading.
In general, I continue to believe in strong labor market fundamentals supporting income and consumer outlays and preventing a hard landing.
Fourth, Powell, noted the recent slip in inflation expectations emphasizing that the market-based inflation compensation had fallen sharply in the intermeeting period.
Interestingly, it appears the Fed is slowing coming to terms with the fact that the “inflation undershoot” relative the 2-percent target is more “persistent” than “transient” in nature.
I have been highlighting this low-inflation risk for multiple quarters now, and it seems the paradigm shift that started with Fed staff highlighting an increased likelihood of a “medium term inflation undershoot” and has now filtered to FOMC participants.
The fight for inflation
Reiterating his comments from last week’s FOMC press conference, Chair Powell noted a desire to strongly defend the 2-percent inflation target in the face of crosscurrents. This comes at a time when both Europe and Japan are experiencing core inflation rates around 1 percent despite extremely accommodative policies.
The major risk for the Fed would be a de-anchoring of inflation expectations whereby lower inflation leads consumers and businesses to reduces outlays, thereby further constraining inflation and pushing inflation expectations lower.
Indeed, such an environment would keep interest rates close to the effective lower bound and limit the Fed’s ability to provide accommodation in the case of downturn.
Justifying rate cuts amid three paradoxes
Chair Powell noted that reduced monetary policy space in the U.S., Europe and Japan suggested the Fed should “act preemptively” to prevent any potential economic slowdown from “gathering steam.”
In reference to the typical 500-basis-point rate cut the Fed has implemented in prior downturns, the current 2.5-percent level of the federal funds rate would seemingly only provide half of the usual ammunition against an economic downturn.
In Powell’s view, persistently low inflation and declining inflation expectations are considered valid reasons to provide additional policy accommodation. As such, Powell’s conditionality argument appears to be that if inflation fails to sustainably move toward 2 percent through July, the Fed will intervene by providing policy accommodation.
Powell noted that lower interest rates would support economic activity and, in turn, lift inflation. Interestingly, this traditional representation of monetary policy transmission represents a paradox for Powell and his colleagues.
Indeed, neither the European Central Bank (ECB), nor the Bank of Japan have succeeded in lifting inflation anywhere close to their 2-percent target despite massive amount of stimulus.
And, while Powell noted those two economies as reasons to act preemptively, their central banks’ failure to achieve their inflation objective via monetary policy stimulus is a reason to question the potency of monetary policy.
In that vein, Powell remarked that financial conditions represent both a transmission channel and an important signal for monetary policy, but he stressed that the Fed was not trying to influence short-term financial conditions.
This faint attempt at deflecting the impression of a “Fed put” represents a sure risk for the Fed. The financial conditions paradox, eloquently described by Morgan Stanley’s Ellen Zentner during the question-and-answer session, is that while conditions have loosened on the expectation of significant Fed policy loosening, a failure to deliver upon the expected rate cuts will lead to tighter financial conditions, thereby requiring more Fed accommodation.
Memories from the financial strains in the fourth quarter of 2018 will likely inspire a more dovish stance all other things being equal.
The trade issue is particularly delicate for the Fed. On the one hand, Powell acknowledged that tariffs hurt the U.S. economy and produce an undesired one-time increase in prices paid by U.S. consumers.
Assuming inflation expectations are anchored, this shouldn’t translate into a lasting rise in inflation, and the direct economic effect should be manageable.
However, the uncertainty shock and stock market impact stemming from a sudden escalation in global trade tensions could represent a significant risk for the economy.
Therein lies the trade paradox for the Fed: It doesn’t want to ease preemptively on the basis of tariff threats that may not materialize, but it also wants to avoid standing idle in the face of potentially damaging trade policy developments.
In all then, we must recall Powell’s prescient remarks at the 2018 Jackson Hole Symposium. At that event, the Fed chair mentioned that the Brainard principle recommends caution when consequences of actions are uncertain.
However, there are two exceptions: The first arises from severely adverse economic events; and the second from low and de-anchored inflation expectations.
While the Fed has yet to reach the ECB’s level of conditionality for further accommodation, it appears increasingly likely that economic and inflation conditions will lead the Fed to cut rates for the first time in over a decade this summer.
Gregory Daco is the chief economist at Oxford Economics.