"The Fed's Megaphone": Powell Faces a Crucial Moment in Deciding the Economic Fate

If he successfully achieves an economic soft landing, that is, reducing the inflation rate without a significant increase in the unemployment rate, it will be a historic achievement worthy of being recorded in the central bank hall of fame. If he fails, under the heavy pressure of high interest rates, the economy will inevitably fall into recession, proving the ancient adage about the Federal Reserve.

In recent weeks, Powell and his colleagues have signaled that they are ready to start cutting interest rates at the next meeting in September. Currently, price pressures have eased, but the job market is cooling down.

This has led people to start paying attention to how quickly officials should lower interest rates from their twenty-year highs.

For Powell, the final stage of the Fed's fight against inflation is the moment of decision. The central bank's annual meeting held this week in Grand Teton National Park, Wyoming, including his highly anticipated speech on Friday, will be overshadowed by Powell's policy planning.

Two years ago, when Powell made a commitment that shocked the market while people were skeptical about the Fed's ability to lower inflation, it was during a speech there. He cited the example of former Fed Chairman Volcker, indicating a willingness to accept an economic recession as a cure for high inflation.

In the early 1980s, the Fed raised interest rates to very high levels, leading to a difficult recession that ultimately curbed high prices. The Fed under Powell's leadership also raised rates rapidly in 2022 and 2023. Nevertheless, Powell still believes that the Fed may be able to avoid an economic recession this time because the inflation in 2021-23 is different from the situation in the 1970s.

The Fed's Desire for a "Soft Landing"

For Fed officials, sticking to a soft landing will be the ultimate redemption. Three years ago, they mistakenly predicted that inflation would be temporary. Successfully achieving a soft landing will show that the cost of the Fed's delay in ending aggressive stimulus policies in 2021 is not as catastrophic as many critics warned.

Dario Perkins, an economist at GlobalData TS Lombard, said, "This will be their most brilliant moment in history. They can say, 'Not only did we prevent a situation similar to the out-of-control inflation of the 1970s, but we also successfully managed to avoid any serious economic costs, that is, a perfect soft landing.'"

In this way, Powell has the opportunity to emulate his two heroes, successfully combining Volcker's determination with Greenspan's skill. When Greenspan served as Fed Chairman in the late 1990s, he resisted calls to slow down the economy, and the economic prosperity at that time hardly produced any inflation.

It is worth noting that Powell is working against the backdrop of the U.S. presidential election, and the Fed's decisions will impact the economy inherited by the next president.

Democrats, including Senator Elizabeth Warren of Massachusetts, have criticized Powell for not cutting interest rates sooner. They openly blame any potential economic recession on Powell Former President Trump, who appointed Powell as chairman in 2018, stated that if he regains the presidency this fall, he hopes to have greater influence on interest rate policies. An economic downturn may embolden this Republican candidate to shape the institution more according to his preferences.

Powell is well aware that many things could still go wrong. The mild-mannered Fed chairman has said that avoiding an economic derailment keeps him up at night.

According to people who have worked with or spoken to Powell, the 71-year-old Powell avoids using the term "soft landing" to avoid giving the impression that he is preparing for the worst. Instead, he indirectly refers to it as a "good outcome" or "what we all want."

He is not alone. Richmond Fed President Barkin also said last week in an interview, "I try not to use that term. It's a jinx."

Recently, Powell mentioned that he and his wife no longer dine out. "People at the next table are always listening," he told hundreds of business people at a luncheon in Washington last month.

The Economic Script Has Begun to Reverse

Concerns about the labor market have raised questions about how quickly the Fed will cut interest rates.

The U.S. inflation rate has dropped from over 7% two years ago to around 2.5%, not far from the 2% target. However, the unemployment rate has risen from 3.7% at the beginning of the year to 4.3% in July. While historically still at a low level, it may not stay that way. Typically, when the unemployment rate starts to rise slightly, it quickly spikes. This line of thinking advocates for the Fed to lower interest rates at a reasonable pace.

However, some officials are concerned that rate cuts could trigger new price pressures, jeopardizing hard-won gains.

Over the past two years, despite persistently high interest rates, the U.S. economy has weathered predictions of an impending economic downturn. Now, more and more evidence suggests that the buffers that have protected the economy so far, including the savings during the COVID-19 pandemic and the immigrant influx that boosted spending, may gradually diminish in several areas.

Budgets of middle- and low-income consumers are starting to tighten. More companies are indicating that they are refocusing on cost-cutting to attract budget-conscious shoppers.

The U.S. housing industry has avoided the downturn typically seen with sharp rate increases but faces a bleak outlook.

Compared to buyers two years ago when mortgage rates first soared above 6%, potential buyers today are weaker in terms of income and wealth. Many homeowners have kept their homes off the market, initially limiting competition for homebuilders. Now, with increasing inventory, this situation is changing. Meanwhile, the apartment construction boom that kept construction workers on site has passed. In the past year, the number of units under construction has dropped by nearly 10%, the largest decline since 2011.

In the labor market, companies have slowed down hiring. While layoffs are currently minimal, the seemingly orderly decline in labor demand may cross a critical point The U.S. Department of Labor said on Wednesday that job growth over the past 12 months as of March may be revised down from the initial report of nearly 3 million jobs to 2.1 million, indicating more moderate job growth for most of 2023 compared to the first three months of this year.

BCA Research's Chief Global Strategist Peter Berezin said, "If job vacancies decline further, unemployed individuals will find it difficult to find work."

Reasons for the seemingly robust economy

Many economic recessions initially appear to be soft landings. Since World War II, the United States has only convincingly achieved a soft landing in 1995. At that time, Greenspan attempted to preempt inflation pressures by rapidly raising interest rates from 3% to 6%. He then reversed course, lowering rates to 5.25% within 6 months.

Whether Powell can accomplish this feat depends not only on whether the economy is slowing down, but also on whether lower rates can stimulate new borrowing and spending to offset any weakness.

Investors are optimistic because the Federal Reserve still has a lot of room to cut interest rates. However, even after the Fed lowers borrowing costs, some borrowers may still face the squeeze from the lagged effects of the Fed's past rate hikes.

This is because before the Fed started raising rates, borrowers enjoyed historically low borrowing costs for over a decade, and many companies and households still have debt with low fixed interest rates. If this debt matures next year, even if the Fed cuts rates by a whole percentage point, they may face a significant increase in borrowing costs.

So far, the economy is closer to the optimistic scenario put forward by Fed officials two years ago.

When officials began raising rates from near-zero levels in 2022, prominent economists argued that it would take a prolonged period of high unemployment to create enough economic weakness - such as unemployed workers and idle factories - to lower inflation. They believed that inflation was being driven by an overheated labor market.

But officials said another path was possible, as the driving force behind inflation was not the labor market, but the collision between strong demand and disrupted supply chains. They believed that post-COVID, as businesses reopened and competed to hire workers, the labor market experienced severe imbalances, and a cooling demand could lead businesses to simply cancel unfilled positions rather than lay off workers.

Luck played a role in this outcome to some extent. The U.S. supply chain recovered last year, and the economy avoided new shocks such as a sharp rise in oil prices or a financial market collapse. A surge in immigration boosted output while alleviating labor shortages. Powell told lawmakers last month, "We now have a better understanding of the sources of this (inflation) because we can see what made it disappear."

Earlier this year, when economists were puzzled as to why rates were not doing more to slow the economy, Powell suggested that the influx of immigrants may have masked the impact of tightening rate policies. He was concerned that the effects of restrictive policies would evolve gradually and then suddenly erupt.

Risk of consensus within the Federal Reserve being broken

Within the Federal Reserve, the uncertainty of the economy may end a period of unity. Even for a committee that advocates consensus, this period is unusual. Since June 2022, Federal Reserve officials have not dissented at policy meetings, the last time this happened was between 2003 and 2005.

Hawks including Federal Reserve Governor Bowman and Kansas City Fed President Schmidt are concerned that cutting rates too early will reignite inflation or keep inflation stagnant around 3%, well above their target. With the unemployment rate at historic lows, this camp asks, "What's the rush?"

This group is also skeptical of the pessimism in the labor market. They point out that the recent rise in the unemployment rate is due to temporary rather than permanent layoffs and an increase in the number of people entering the job market.

They believe that rates are only moderately restrictive, meaning the Fed may not need to cut rates significantly.

Doves, on the other hand, are concerned that the slowdown in labor demand is too complacent. Inflation-adjusted rates have reached their highest levels in decades, prompting officials in this camp to ask, "What are we waiting for?"

Chicago Fed President Gülsünbi said in an interview, "In a normal business cycle, the unemployment rate rises like a rocket but falls like a feather. While the current cycle may be unusual, the job market has been cooling down, which is at least cause for concern. It needs to stop cooling down."

Many are prepared for rates to start falling by 25 basis points next month, but are unsure how fast the easing should proceed thereafter. The key question is how much current rates are above the "neutral" level that neither stimulates nor slows economic activity.

At the September meeting, Federal Reserve officials will have to fill out their forecasts for rates over the next three years. Minneapolis Fed President Kashkari expressed concern about this, as he is unsure about the "degree of tightening in current policy."

Barkin said he and Richmond Fed staff surveyed hundreds of companies to understand if demand is weakening and if these companies are prepared to lay off workers as a result. Apart from a few industries, he did not see this happening in other sectors. He is also undecided: "You could make a mistake by being too aggressive or not aggressive enough."

Overall, the Federal Reserve will face two paths in the coming months. Firstly, officials could cut rates by 25 basis points at each of the upcoming meetings, then adjust or reduce the pace and magnitude of cuts based on the economic conditions early next year; secondly, if the economy experiences a more significant slowdown, they may cut rates by 50 basis points to bring rates close to 3% before spring next year. (The Fed's benchmark rate is currently set between 5.25% and 5.5%).

Powell may maintain an open stance in his speech this week. The August employment data to be released early next month, if as disappointing as the July data, may incline Powell to increase the rate cut Goolsbee said, "The reason for taking gradual action is that it gives you the choice, but the downside is that when things change, you no longer have that luxury."

A few investment banks such as Morgan Stanley and Wells Fargo, as well as former Federal Reserve economists, said, "Evidence that the labor market may be excessively weak should prompt officials to cut interest rates on a larger scale ahead of time, abandoning their long-standing preference for gradualism."

Jay Bryson, chief economist at Wells Fargo, said, "They have a lot to do, they have to get started. But this is a very consensus-driven place, and they haven't reached a consensus to do so yet, which is unlikely in the eyes of the Federal Reserve unless there are shocking developments or a series of weak data that suddenly shift the consensus towards faster action."