How we interpret the Congressional testimony of Chairman Powell

23 Jun 2023 , 10:11 AM

This part of the protocol and each time the half yearly Monetary Policy note is issued by the US Fed, the Fed Chair testifies before the US Congress. In fact, the Fed Chair first appears before the Financial Services Committed and later in front of the Senate Banking Committee. 

The Fed chairman’s testimony is looked at quite closely because it is a statement by the topmost monetary official of the US (and perhaps of the world) testified in from the elected representatives on oath. This is normally closely tracked, apart from the Fed statement and the Fed minutes. In fact, the Fed chair testimony helps the market to better understand the medium to long term trajectory of US monetary policy. The Fed takes it communication seriously and hence it is very particular about the perception that it creates in the market.

Why the Powell Testimony assumes significance?

This time around the Powell testimony assumes special significance as it comes exactly a week after the first rate pause in 15 months. The Fed had started hiking rates in March 2022 and over the next 10 meetings spread across 15 months, the Fed hiked rates by a full 500 basis points. Effectively, the Fed rates during this period went up from the base range of 0.00%-0.25% to the current range of 5.00%-5.25%. It is in the background of such aggression that the testimony by Powell assumed added significance. 

However, if the markets were looking at the testimony for any hints of sobering in Fed hawkishness, it would have been an outright disappointment. One of the big and unambiguous messages from the Powell testimony was, “The Fed is not yet done fighting inflation. The Fed is planning some far reaching changes to banking regulation, but the focus will still be on the large banks. Above all, the Fed is fully conscious of its employment mandate. Here are some key takeaways from the Powell testimony to the US Congress.”

About inflation; Fed still remains a hawk

In the Fed statement issued last week and the Powell testimony, one thing came out very clear. The June pause by the Fed cannot be interpreted as a turnaround in its monetary stance. The Fed, in its statement had underlined that the high inflation justified another 2 rate hikes of 25 bps each, taking the terminal rate to the range of 5.50%-5.75%. According to the Fed, even if you consider the latest consumer inflation reading of 4% for May 2023, it is 200 bps away from the Fed target of 2%. 

Hence, there was no question of relenting on hawkishness unless the Fed had decided to move the inflation goal posts. No such thing is being planned by the Fed at this point of time. In fact, even in the testimony, Powell underlined that it was perfectly logical to assume another 2 rounds of rate hikes in the current calendar year. It is not just about the consumer inflation target being 200 bps away, but also about how the fall in headline inflation is not being accompanied by core inflation.

To sum up the inflation approach of the US monetary policy, it still stays hawkish. Powell wants the inflation pressures to come down visibly and also palpably and that is only possible if inflation expectations also come down. The only way inflation expectations will come down is if people are confident that the Fed will not relent on hawkishness till the time inflation is full under control and close to its medium term target of 2%. 

According the Fed testimony, it would be 2 rate hikes in a scenario of price instability, 1 rate hike on a more conservative basis and the worst case scenario would just mean static rates. Powell underlined in the testimony also that rate cuts were ruled out in 2023.

Hawkishness without major job losses

Powell was aggressively grilled by the Democrats on the possibility that sustained hawkishness by the Fed could lead to an industrial slowdown and loss of jobs. While Powell reaffirmed the central bank’s commitment to successfully defeating inflation, he also acknowledged the Fed’s employment mandate. 

One example given was when the regional banks got into stress and the Democrats had called for halting rate hikes. However, Powell held on to his view that Fed policy should only focus on price stability and jobs and leave the bank risk management to the individual banks. 

On the subject of jobs, Powell underlined that there was still no evidence that the hawkishness had led to job losses. For instance, through the months of hawkishness, the unemployment rate was consistently falling and fell to a low of 3.3%. it has recently gone up to 3.7%, but the general definition of full employment is an unemployment rate in the range of 3% to 4%. 

By that definition, the US economy is still enjoying full employment and hence job losses are not a concern as of now. Powell reminded the US Congress that the US economy still had historically low unemployment rates, high labour force participation and a very strong labour market. To quote Powell, the jobs situation is very comfortable.

 

Banking regulation will still leave out small banks

Obviously, the Republicans were worried about the regulation of smaller sized banks. Post the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank; there have been a series of small sized banks that went bust. However, the Fed is still not considering more stringent regulations for small banks. The general view has been that small and mid-sized banks should not be subjected to the same elaborate regulations as the bulge bracket banks. The idea is to allow the smaller banks to show strong regional growth with the help of less stringent regulations. That is unlikely to change at a conceptual level.

According to Fed, the need of the hour was to sharpen risk management in the smaller banks rather than subjecting them to excess regulation. The incremental benefits of such a move were unlikely to be positive. Powell therefore preferred to focus on the importance of ensuring appropriate rules and supervisory practices for banks of this size. Regulating mid-sized banks like large banks would only kill regional banking innovation. 

On the issue of subjecting smaller banks to higher capital requirement, Powell felt that it would constrain credit provision. That would hit consumption and hit demand; something the Fed was trying to prevent at this juncture. Powell also felt that higher regulation for smaller banks would increase their cost of credit and it could be inflationary. 

Fed will continue to be data driven

In the last few months, the Fed has abstained about giving any specific time bound or level bound guidance. They have restricted themselves to saying that the Fed would work towards ensuring price stability and maximum employment that is in tandem with price stability. 

That means; the Fed may allow unemployment to increase marginally if that helps curb consumption and contain inflation. That is what has been happening in the last couple of months, when the fall in inflation has been accompanied by a spike in unemployment. Even the Fedwatch is pencilling in a probability of more than 70% of a rate hike in the next policy in July. 

What the Fed is addressing now is just the existing situation. However, more than 2 years of loose economy policy by the Fed post COVID left the economy with a mountain of liquidity to contend with. That ensured that prices were going up consistently as consumer demand remained robust. 

According to Powell, the entire process of the rate hikes trickling into lower inflation may take more than a year to fructify. However, even Powell admitted to being ignorant how things would pan out on the monetary front. As Powell put it very disarmingly, “Monetary policy does impact the economy with a lag, but it is extremely difficult to nail down when exactly rising interest rates will take a deeper hold on the economy.” For now, the Fed will be dictated by data flows alone.