Fed Speak: Jerome Powell on why the Fed is treading carefully

20 Oct 2023 , 12:44 PM

In the US, the Federal Reserve does not communication only through the Fed statements and the Fed minutes. While they remain the principal communication channels, the Fed also uses the speeches given by various FOMC members at different forums as a channel for communication. Now, the Fed does take its communication on monetary policy very seriously. The Fed believes, and rightly so, that the communication of the Fed policy is as important as the actual content and context of the monetary policy. That is why even as individual view may differ, the amalgam of all these view generally tends to reflect the broad Fed view on monetary policy, inflation, and interest rates.

Why this Powell speech is specifically important?

Speaking at the Economic Club of New York, Jerome Powell underlined that the Fed would continue to remain committed to its avowed target of bringing inflation to 2%. In other words, any Fed action going ahead would be predicated on the evidence that the inflation rate is decisively moving towards the 2% mark. However, with 525 bps of rate hikes already done, Powell also admits that other considerations are also beginning to play. About a year back, the Fed could afford to say that they wanted to curb inflation at any cost. 

After 525 bps of rate hike, that luxury is no longer available. That is why Powell in his speech emphasized that going ahead, any decision would have to be carefully weighed and calibrated. It would have to factor in multiple parameters like inflation, labour market conditions, GDP growth, consumer spending, bond unwinding etc. In his speech at the Economic Club of New York, Powell has given his views on recent data flows pertaining to inflation, labour market and GDP growth. He also spoke at length on the decision dilemma.

How Powell sees the incoming inflation data?

According to Powell, notwithstanding the recent data fluctuations, the overall data showed that there was continuous and perceptible progress toward the Fed’s dual mandate of maximum employment and stable prices. Here is what Powel said about the recent progress on the inflation control front.

• It was already clear at the start of the rate hike cycle in March 2022 that, restoration of price stability would require 2 things. Firstly, it needed the unwinding of pandemic-related distortions to supply and demand. Secondly, it also needed sufficiently restrictive monetary policy to cool strong demand and give supply time to catch up. A quick look at the fall in inflation from the peak levels shows that the strategy has broadly worked.

   

• There has been progress on the headline inflation front and the core inflation front. Fed considers the PCE inflation and not the consumer inflation. The PCE (personal consumption expenditure) inflation, peaked at 7.1% in June 2022 and is now pegged at 3.5% for September 2023. The core PCE inflation (excluding food and fuel), is more stable and reliable. That has fallen from a peak of 5.6% in February 2022 to an estimated level of 3.7% in September 2023.

   

• Powell underlined that the positive takeaway was that the inflation readings had turned lower in the summer months, which is in contrast to the general trend of inflation. The Fed is not only worried about actual inflation but also expected inflation. The inflation expectations are kept in check only if the consumers are confident that in the event of any spike in inflation, the central bank will intervene and set things right.

   

• However, Powell has been quite emphatic that the path to 2% is still far off despite nearly 19 months of relentless hawkishness shown by the Fed. Also, Powell expressed some degree of disappointment in the fact that in recent months the inflation reading has gone farther from the eventual target of 2% inflation. 

To sum it up, inflation has moved down since the start of rate hikes, albeit not to the extent that the Fed would have preferred. Higher levels of rates mean that the central bank has to be sensitive and responsive to multiple factors, apart from inflation.

Considering the labour market factor

Labour plays a very paradoxical role in the macros. Strong labour conditions and being close to maximum employment are essential for consumption spending and GDP growth. However, when the labour market is tight and the wages are high, it does offset some of the efforts made by the central bank towards inflation control. That is because, wages are rising and that offsets any consumer spending crunch imposed by higher interest rates. However, according to Powell, there is a shift happening, rather silently in the US labour market.

For instance, strong job creation has met a welcome increase in the supply of workers. This is due to higher participation and also a rebound in immigration to pre-pandemic levels. In short the much anticipated cooling of the labour market is happening, albeit at a much slower pace. For example, the job openings have moved well below their highs and are now just marginally above the pre-pandemic levels. Recent surveys of workers and employers show a return to pre-pandemic levels of tightness. Even the pace of wage growth has been gradually declining toward levels that would be consistent with 2% inflation target. Labour market may be still tight, but some respite is already visible.

What Powell said about GDP growth and economic activity?

In the middle of the rate hike cycle, there were several voices that called for caution on rising rates as it would impact growth. Economists had warned that a hard landing was imminent and growth could take a long term hit. Nothing of that kind has happened. Just look at the GDP data for 2023. The data for the first two quarters shows annualized GDP growth at 2.1%, a full 100 bps above the original estimates. In addition, the third quarter GDP for September 2023 is likely to grow at 3.5% at the bare minimum. In short, the series of rate spikes towards controlling inflation has not come in the way of GDP growth. This may be a welcome development, but also as Powell says, a rather unusual development if you go by the history of the US economy.

The reasons for this unusual phenomenon are not far to seek. The gradual improvement in the supply chains, combined with the rebalancing of demand and supply in the labour market has allowed disinflation without meaningfully weakening the economic activity. It would not be wrong to say that the economic growth has consistently surprised on the upside during the current year. That is where the dilemma comes in. Past data suggests that a sustainable return to the 2% inflation goal is likely to necessitate a period of below-trend growth and some further softening in labour market conditions. If that does not happen, it only underlines that the journey to the 2% inflation mark may be more long-winding.

Geopolitical tensions are the new X-factor

Powell also dwelt at length in his speech on the changing geopolitical equations West and East Asia. In East Asia, China and Russia are getting much closer to each other, a situation that the US is not entirely comfortable with. It could be a friendship driven by sheer necessity amidst the war in Ukraine and China coming under pressure from US companies. However, the immediate area of concern is what is happening in West Asia. The war between Israel and the Hamas is leading to massive human casualties. 

There are also concerns that if the war escalates, then other powerful nations in that region like Saudi Arabia and Iran would also be compelled to take sides. There are also concerns that the US may extent its Iran sanctions due to their alleged support for the Hamas. Iran controls the Straits of Hormuz so any aggressive action from their side in retaliation could spike oil prices. This is not adding what is already happening in Ukraine over the last one year. How these geopolitical tensions impact growth macros remain to be seen, but it is a major headwind for the global economy.

Monetary Policy – Doing too much versus doing too little

The rather weird linkages between rates, inflation, growth, and labour market have brought back the debate into focus. Is the US in a dilemma between doing too much and doing too little? In a sense, the answer is yes. In the last 18 months, the Fed has hiked the Fed rates by 525 basis points to a 17 year high. At the same time, the Fed has also unwound its securities holdings by roughly $1 trillion. That has magnified the hawkishness of the Fed. However, the fact that inflation is still 175 bps away from the 2% target means that the Fed may have to remain hawkish for a longer period of time.

On the one hand, the rates  are already above the neutral rates and so impact on growth could now be more intense. On the other hand, if inflation stays above the target for longer and if the tightness in the labour market does not ease, then the Fed would have no choice but to hike rates further and even consider a new normal in terms of the terminal rates. The recent spike 10-year bond yields, not only shows that more rate hikes are possible, but also underlines that the markets are unhappy with the Fed going slow on rate hikes, which had prompted a sell-off in bonds. That is where the real dilemma arises.

The intent of the Fed was best captured by Powell in his concluding part of the speech. “Given the uncertainties and risks, and how far we have come, the FOMC is proceeding carefully. We will make decisions about the extent of additional policy firming and how long policy will remain restrictive based on the totality of incoming data.” That may sound ambiguous, but that is perhaps the best that Powel can say at this point of time.