Powell’s Masterplan allows for earlier intervention

In his headlining speech at the Jackson Hole Economic Symposium on Friday, Federal Reserve (Fed) chair Jerome Powell’s message to the market was clear.

While summarising the drivers of post-Covid inflation and labour market dynamics (and how they have moved back into balance recently), Powell said the “time has come for policy to adjust” and the primary driver of the direction and pace of rate cuts in the coming months will most likely be the labour market.

All of this we already knew. What struck us was the forcefulness of Powell’s words, particularly around the recent weakening in the labour market. While he did note the recent uptick in the unemployment rate has been driven not just by weakening labour demand but very strong supply, he described the cooling in labour market conditions as “unmistakable”. Until very recently Powell was saying the labour market was about as tight as 2019 levels; now he has chosen to highlight that the labour market is less tight than 2019 levels, with both hiring and quit rates below the level that prevailed in 2018-19.

The Fed (or more specifically Powell) has evidently regained confidence on the inflation side of the dual mandate after the blip back in Q1, a change driven in part by labour market weakening itself; given stickier services inflation, a softer labour backdrop reduces the risk of higher wage growth, with Powell saying it “seems unlikely” that the labour market would be a source of elevated inflationary pressures “anytime soon”. Most importantly, Powell said the Fed would not “seek or welcome” any further weakening in labour market conditions, and that it would do “everything we can to support a strong labour market”.

Looking at these comments in the knowledge that the Fed’s next meeting on September 17-18 will bring an update to the ‘dot plot’ of committee members’ future rate projections, we suspect Powell’s individual forecast will pencil in three 25bp cuts for the remainder of this year (a September cut plus two more). While we think the ‘core’ of the Federal Open Market Committee (FOMC) will follow him, the median projection might be for fewer cuts given the more hawkish comments from other members recently. Importantly, this is contingent on a sound labour market report on September 6. Consensus is currently for a small decline in the unemployment rate (to 4.2% from 4.3% in July) and an increase in non-farm payrolls (to 160k from 114k in July).

While we don’t know what the data will show next month, what Powell has now offered the markets is clarity on the reaction function of the Fed. In June’s Summary of Economic Projections the Fed’s longer run projection for the unemployment rate was 4.2%, which is obviously in line with consensus for next month’s print. With confidence regained that inflation will continue to subside, and given the pace of the weakening in labour data over the past six months, we think Powell has essentially indicated the Fed will be quick to act if it sees any more weakening in unemployment. This tells us that, while the first cut is likely to be 25bp, a 50bp cut is certainly on the table if the labour data does not stabilise, and it will be on the table rather quickly given Powell’s “whatever they can” comment above.

We believe the US economy is robust enough to swerve a recession, for reasons we have discussed many times before (strong consumer and corporate balance sheets, consumption, housing and so on). However, we think the strength of Powell’s words indicate the Fed will now react earlier, or with larger rate cuts, to any further deterioration in the data, particularly if accompanied by another bout of panic in the markets. This will help reduce volatility in risk assets as the cutting cycle begins and we move through the next 6-12 months, and it is a sensible tone for the Fed to strike. Core Consumer Price Index (CPI) inflation is already at 2% on a three-month annualised basis, and if the month-on-month print comes in line with expectations on Friday then core Personal Consumption Expenditures (PCE) inflation will be too. The Fed should be overweighting the risks of labour market weakening relative to a potential spike in inflation.

In other words, even if growth does slow more than expected, or if the labour market weakness continues, the Fed will react appropriately and quickly. Given the driver of this cycle has been a restrictive central bank due to a surge in inflation that has now largely subsided (as opposed to the global financial crisis of 2008 or the asset bubble crisis of 2000), and the fact that the Fed is clearly now highly restrictive, we think a ‘buy the dip’ mentality will continue through periods of spread volatility. If the data doesn’t weaken, then carry will continue to provide solid returns given the high all-in yields in fixed income.