Fed Speak: Jerome Powell douses dovish market enthusiasm

15 Nov 2023 , 10:09 AM

When the Fed proposed and Jerome Powell  disposed

You can call it a case of the Fed proposes and Powell disposes. Better still you can call it, “Fed announces, CME Fedwatch proposes and Jerome Powell disposes.” Just as the global markets were digesting the euphoria signified by the CME Fedwatch on aggressive rate cuts, the speech delivered by Jerome Powell at the Jacques Polak Annual Research Conference of the IMF, sent the markets into jitters. Here is what Jerome Powell said in his speech.

“The Federal Open Market Committee is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2% over time; we are not confident that we have achieved such a stance.” The last part of the statement by Powell was almost like an affirmation that in the event of any dichotomy between the Fed statement and the CME Fedwatch, it is the Fed statement that will prevail. But that was just one part of the story. The speech by Jerome Powell had a lot many interesting takeaways.

Global inflation and US monetary policy

For the last few months, the global markets have been trying hard to decipher the undertone of the Fed action. In the last 4 meetings of the Federal Open Markets Committee (FOMC), the rates were held in 3 out of the 4 meetings. The latest Fed meeting on November 01, 2023, which once again held the Fed rates in the range of 5.25% to 5.50%, let to sharp change in the market perception. Not only did the CME Fedwatch almost declared this as the end of the current cycle of rate hikes, but even suggested that the Fed may cut rates by as much as 150 basis points by end of 2024, in spite of the Fed clearly indicating that it would not take up more than 2 rate cuts of 25 bps each by end of year 2024.

The rather strongly worded statement by Jerome Powell was meant to douse this sudden optimism in the market. Suddenly, markets were factoring in the end of rate hikes and also factoring in 5 to 6 rate cuts by end of 2024. For a central bank, that still takes its communication very seriously, the speech at the IMF conference was just the opportunity to show the global market, who is the boss. The bond yields bounced and the dollar index got back to 106 levels. But, the message from Powell was crystal clear; “When it comes to US monetary policy, just let the Federal Reserve have the last word.”

Inflation progression; not yet good to great

As Jerome Powell would have loved to put it, the progress made by the Fed on controlling inflation was good, but not great. The reasons for this perception are not far too seek. The US inflation has come down sharply over the last one year but remains well above the target of 2% envisaged by the Fed as the long term equilibrium inflation level. In short, the message was that the process of getting inflation sustainably down to 2% still had a long way to go. As Fed has repeatedly pointed out in the past, the strong labour market had been one reason the inflation was not coming down. Labour market was tight and demand was more than supply. 

Hence wage growth was strong and that was offsetting any tightness that the Fed was trying to introduce. That had reduced the power of higher interest rates to curb inflation. In between, the latest GDP growth reading at 4.9% also shows that hard landing is not a concern any longer for the Fed or for the markets. It looks like the US economy has managed to contain inflation even while ensuring a soft landing for the US economy. That also explains why the inflation has not fallen decisively towards the 2% mark. In short, what Powell meant that there was room for more rate hikes in the future, a view backed by Michelle Bowman too. Interestingly, Jerome Powell’s speech at the IMF conference focused on 3 key questions to be addressed.

Question 1: What we learn from 30 months of policy action?

This not only pertains to the rate hikes but even the rate uncertainty which began in mid-2021. If we take the last 30 months as the reference period, then the first signs of a spike in inflation globally was visible in March 2021. That was something most economic forecasters did not see coming. At that point, most of the economists and policy experts had projected core PCE inflation running at or below target over next 3 years. So, the question starts with what caused inflation in the first place. In retrospect, Powell fells that the sudden upturn in inflation was largely a function of post-pandemic shifts in the composition of demand. In addition, there were major disruption of supply chains (the China effect), as well as a sharp fall in labour supply. Inflation, post March 2021, was actually an outcome of the combination or confluence of these three factors. 

The outcome of this confluence was huge supply-demand imbalances, which resulted in substantial increases in the prices of a range of products. The assumption at that point was that as demand picked up, supply would catch up with immediate speed. However, the supply chain disruptions was not factored in and that is what led to the huge mismatch between demand and supply resulting in a sharp spike in inflation. The massive helicopter money infusion led to higher demand, but supply just could not match up. However, the real spike in inflation began in the last quarter of 2021. As there were couple of relapses in COVID pandemic, in different forms, the supply remained constrained widening the gap even further. The result was more inflation. Inflation would have probably tempered after the spike but Russia invaded Ukraine in February 2022 and that resulted in a spike in oil prices as supply chains of oil got disrupted. It was this last development that led the US central bank, followed by other central banks, to embark on a massive rate hike program. 

Question 2: Did monetary policy underestimate supply shocks?

In the past, the general trend in monetary policy has been to ignore the supply shocks to the extent that they are temporary and idiosyncratic in nature and are also self-correcting in most cases. Now, economists are veering around to the view that supply disruptions in the future could be a lot more frequent and, at times, even persistent. That would be a divergence from what we have seen in the last 40 years. So, can central banks still afford to ignore such supply shocks?

There is something interesting one must understand about supply shocks. For instance, supply shocks tend to move prices and employment in opposite directions. On the other hand, the traditional approach of monetary policy is to push prices and employment in the same direction. The learning, according to Jerome Powell, is that the response of monetary policy to higher prices stemming from an adverse supply shock should be attenuated or calibrated. That is because, otherwise it has the potential to amplify the unwanted decline in employment. Also, if you look at recent supply shocks; they have arisen from volatile food and energy categories and have passed quickly. The big learning, and what is relevant to the RBI at present, is that responding aggressively to quickly passing or ephemeral price increases can only exacerbate macroeconomic volatility without supporting price stability.

Talking of the aggressive policy tightening by the Fed in 2022, Powell underlined that policy restraint can be a good risk management exercise. Here is why. Supply shocks that drive inflation high enough for long enough can affect longer-term inflation expectations of households and businesses. Remember, as the Fed has said time and again, its focus is not just on inflation but also on inflation expectations. Monetary policy must immediately and urgently address any risks of a potential de-anchoring of inflation expectations. That is because, well-anchored expectations facilitate bringing inflation back to target. The policy tightening in 2022 largely contributed to keeping inflation expectations well anchored.

Question 3: What is the equilibrium level of interest rates?

This is really the million dollar question and should be seen in normal conditions. If you look back at the pre-COVID period, then by 2019, the level of nominal interest rates had fallen steadily over several decades. During the pandemic, as in the global financial crisis, inflation targeting was very simple. The central bank had to only ensure that rates were kept near zero levels so that growth and liquidity were not hampered. In such phases, inflation is automatically low and it takes time to pick up. The challenge is determining what is the equilibrium level of interest rates at the current juncture. That is an uncertain area. Today, inflation and policy rates are at fairly elevated levels. Currently, there are numbers being thrown around like 5.75% or 6% or even higher. However, the actual decision would be a lot more complex and nuanced. 

To sum it up, the speech by Powell had two clear mandates. Firstly, it did not want to allow the CME Fedwatch to hijack the interest rate and monetary policy debate. That is justified and, in that, Powell also succeeded. Secondly, he has underlined that monetary policy is work in progress. More so, at the current juncture, wherein there are tectonic shifts in the global economy and many of the traditional economic ideas and thinking may have to be jettisoned. But that is the subject of a different debate altogether.