Powell testimony hints at rate cuts, but stays ambivalent

7 Mar 2024 , 02:51 PM

FED CHAIR POWELL TESTIFIES BEFORE THE CONGRESS

On March 06, 2024, the Fed Chair, Jerome Powell testified before the Committee on Financial Services, US House of Representatives (US Congress) on the half year monetary policy. This is a routine practice wherein the chairperson of the Federal Reserve is required to testify on oath before the US Congress. Obviously,  since this is done under oath, this has much greater significance for the markets than a speech that can be interpreted in multiple ways. The Fed chair typically also takes questions from the representatives in the Congress after the testimony before the Committee is completed.

Broadly, the testimony included a number of important aspects pertaining to monetary policy which had national ramifications. It dwelt on elaborate review of the current macro-economic situation in the US and also around the world. The testimony also focuses at length on how the Fed has progress on the dual mandate of promoting maximum employment and at the time keeping prices stable. It must be noted here that GDP growth is not treated as a mandate for the Fed, since it comes under the realm of fiscal policy. The testimony also elaborates at length on the specifics of the monetary policy; like whether the interest rates could be hiked further, what is the time table for rate cuts, how fast would the Fed winddown its bond book etc. Let us start off with the macroeconomic review by Powell.

HOW IS THE CURRENT MACROECONOMIC SITUATION?

On the review of the current economic situation, Jerome Powell (in his testimony to the Congress) dwelt on 3 items; viz. GDP growth, labour markets and inflation regulation. Here is a quick look at each of these items of macroeconomic review presented by Powell.

• The GDP or the economic activity expanded at a strong clip compared to the previous year. According to Powell, the Second Estimate of Q4 GDP had come in almost at par at 3.2%. This raises the full year GDP expectation to 3.1% for 2023, although the third and final estimate of Q4 is yet to come in. However, the final impact may not change much. According to Powell, the economic growth amidst persistent tightening may look anomalous, but was largely an outcome of solid consumer demand and improving supply conditions. For a long time, the GDP growth in the US had been constrained by the global supply chain constraints post-COVDI, but that was abating. However, Powell did underline that housing activity still remained very tepid. This could be largely an outcome of high mortgage rates on account of the 500 bps interest rate hike by the Fed.
• The US labour market had presented a rather anomalous situation and the strong wage growth due to demand exceeding supply, had kept wages high. This had ensured that the consumer demand was not overly hit by the interest rate hikes. However, it also meant that the inflation game was taking longer than expected and the last mile was especially proving to be very difficult. For instance, since the middle of 2023, payroll job gains have averaged 239,000 jobs per month. Despite the labour moving gradually towards a balance, the unemployment at 3.7% is still very close to full employment. However, Powell also pointed that in recent months; even as demand for labour has been robust, there has been a steady supply of workers aged 25 to 54, as well as strong pace of immigration. This has reduced the job vacancies, reduced the nominal wage growth, and also kept the labour market in balance. According to Powell, this type of situation was consistent with 2% inflation for the US economy.
• Finally, we come to Powell’s update on inflation. According to Powell’s testimony, Inflation has eased notably in the last one year but continues to stay above the FOMC’s longer-run goal of 2%. However, in his testimony, Powell also added that the recent PCE inflation reading at 2.4% and the PCE core inflation reading at 2.8% have given room for hope that the Fed may be on target to achieve the 2% inflation target. Powell also pointed out that the sharp fall in core PCE inflation was a signal that supply chain constraints were coming under control. Above all, household expectations have also come down due to persistent Fed hawkishness and that also had an impact on reining in the current levels of inflation in the US.

To sum up Powell’s review of the US economy, even as the Fed had adopted a persistently hawkish path between March 2022 and July 2023, the inflation came down without causing too much of labour imbalance or hitting growth. In other words, the US economy had avoided the much-dreaded hard landing.

WHAT POWELL TESTIFIED ON THE MONETARY POLICY CONTOURS

Testifying before the US Representatives Committee, Powell explained that the policy rates had been significantly tightened since early 2022 as the rates were raised from a level of 0.00%-0.25% to the current level of 5.25%-5.50%. However, the Fed has maintained status quo at this level since June 2023 as the idea was to let the lag effect of the rate hikes play out fully and hold the rates higher for longer, rather than hiking rates further. In addition, Powell explained that the impact of the rate hikes had been magnified by also shrinking the balance sheet of the Fed. Since the middle of 2022, the Fed balance sheet had been shrunk from $9.2 trillion to the current level of $7.5 trillion. This is still much higher than the pre-COVID balance sheet levels, but further tightening would be done in a calibrated manner without stifling domestic liquidity beyond a point.

On the monetary policy direction, the Fed has abstained from giving very forwards guidance and has stuck to take its decisions based on data flows. However, in the December policy statement, the Fed did indicate that it may have reached the peak of the interest rate cycle and also hinted that it would under take 3 rate cuts in 2024 and 4 rate cuts in 2024. That led to the CME Fedwatch becoming overly enthusiastic about the pace of rate cuts, something that the Fed has not been too forthcoming about. However, at a broad level, Powell said in his testimony that the Fed would begin dialling back the rate hikes only when there was some degree of assurance from the market conditions that inflation was well and truly journeying towards staying at 2% on a sustainable basis.

As Powell highlighted in his testimony, the Fed was still reconciling with the dilemma of too little versus too much. For example, if the Fed was too frugal in cutting rates, then it could have an impact on the economic growth, now that the high wage buffer was no longer available as a cushion. Secondly, if the Fed cut rats too fast, and if inflation started rising, it would create a different kind of problem for two reasons. Firstly, when inflation rears its head, it is very difficult to reverse the situation by raising rates. That is because, the impact on inflation is normally felt with a lag. For instance, the Fed started hiking rates in March 2022, but inflation only peaked around September 2022. Secondly, inflation tends to hit the most vulnerable sections of society who cannot afford that hit. Hence it would be economically, socially, and even politically unacceptable.

The broad message from the Fed testimony by Powell was that, at no cost, would the Fed relent on its inflation battle. It will also need more concrete evidence of sustainable lower inflation before embarking on rate cuts. After all, a few swallows do not a summer make!

WHAT WE READ FROM POWELL’S POST-TESTIMONY INTERACTION?

Responding to question after the Fed testimony before the US House of Representatives (Congress), Powell also took a slew of questions. Here is a gist of some key readings we could find in the Q&A session.

• Responding to a query on the rate cut time lines, Powell highlighted that the Federal Reserve was in no rush to cut interest rates. Incidentally, this means more pain for American households, who have faced almost 2 years of rising household bills and higher borrowing costs on everything from car loans to mortgages.
• There was the first explicit admission of rates having peaked out. In the testimony, Powell said that it was unlikely that there will be any rate hikes this year. As Powell put it, “Policy rates are likely at its peak for this tightening cycle,” However, Powell also affirmed that rate cuts were on the table, but for that the US economy would have to cooperate with the Fed.
• In the interaction after the testimony, Powell also asserted that recession or even hard landing was now ruled out with the present situation and the future outlook for the US economy looking robust. Powell also added that the Atlanta Fed GDP estimates were also painting a very positive picture of GDP growth numbers in 2024.
• Responding to the query on whether growth could make inflation control difficult, Powell asserted that there had been a clear slowdown since summer when Americans had virtually splurged on concerts, films, and goods. Powell assured that the Fed wanted to see more of the same: A slower economy and slower inflation.
• On the subject of whether work from home (WFH) had hit commercial property demand, Powell admitted that it definitely had impacted. Powell also underlined that empty office buildings did pose a serious threat to property values, and therefore an asset quality issue for banks that had funded such assets. While Powell admitted that vacancy rates were still high despite fall in prices and lower rentals, Powell also assured the House that the situation was manageable. He also told the house that the Fed was specifically keeping an eye on banks with significant exposure to commercial real estate assets on their balance sheet.
• In continuation to the stress on commercial real estate, Powell also fielded questions on the New York Community Bank, which had been recently facing trouble after the stock price had fallen by 40%. The bank has substantial exposure to commercial real estate and is naturally at risk. However, Powell assured the house that robust risk management practices and pre-emptive action could prevent such situations.

The message of the Fed testimony is quite clear. Growth is robust, inflation is coming down, unemployment is low and the US economy had avoided a hard landing. However, the Fed has new problems like the commercial property loans and implementation of Basel III regulations. That would be for another debate altogether.