The Fed's major dovish shift! Powell hints at rate cut: "It's time to adjust policy"

On Friday, August 23, at 10 a.m. Eastern Time, Federal Reserve Chairman Jerome Powell made a significant statement at the Jackson Hole Global Central Bank Annual Symposium.

Of note, Powell explicitly stated, "The time for policy adjustment has come. The policy direction is clear. The timing and pace of rate cuts will depend on subsequent data, changes in outlook, and risk balance."

Some analysts believe that while Powell confirmed the market's widespread expectation of a rate cut in September, this speech was somewhat dovish, providing some clarity for the financial markets in the short term, but did not provide many clues as to how the Fed will act after the September meeting.

For example, if there is another negative employment report, will there be a significant 50 basis point rate cut, and will rate cuts continue in the coming months. However, Powell's remarks at least confirmed that the Fed's struggle with inflation over the past two years is about to reach a critical turning point.

After finishing his prepared speech, Powell did not have a live Q&A session, and derivative traders' forecasts for the total rate cut by the end of 2024 remained unchanged at around 98 basis points. The probability of a 25 basis point rate cut in September also remained stable.

In market reactions, U.S. stock indexes continued to rise, with the S&P 500 up over 1% within the first hour of trading, the Dow rising 400 points at one point, and the tech-heavy Nasdaq and the more economically sensitive Russell 2000 leading the way, up 1.5% and 2% respectively. The U.S. regional bank index rose 5%, marking the largest increase in eight months, while U.S. bond yields and the U.S. dollar index saw short-term declines, all related to the logic of trading "Fed rate cuts imminent."

Powell expresses increasing confidence in inflation continuing to decline to target, clearly stating that rate cuts are the future policy direction

Powell participated in an economic seminar titled "Reassessing the Effectiveness and Transmission of Monetary Policy," where his speech not only reviewed the balance shift between the Fed's two main missions of "employment and prices" after the pandemic, pointed out how future policy direction should be adjusted, but also attempted to clarify why the unemployment rate can remain low even as inflation significantly decreases.

He first pointed out that the risk balance facing the Fed's two tasks of "maintaining price stability" and "achieving full employment" has changed, and emphasized the importance of maintaining a stable labor market at the current stage where inflation continues to fall to the 2% target:

"Four and a half years after the outbreak of the COVID-19 pandemic, the most severe economic distortions caused by the pandemic are fading. Inflation has dropped significantly, the labor market is no longer overheated, and conditions are now looser than before the pandemic. Supply constraints have normalized.

Our goal is to restore price stability while maintaining a strong labor market, avoiding a situation where early tightening of monetary policy leads to a sharp increase in the unemployment rate in a period of unstable inflation expectations."

When discussing inflation, Powell praised the progress in cooling inflation, stating, "After a pause earlier this year, we are once again moving towards the 2% target. I am increasingly confident that the inflation rate will sustainably return to the level of 2%. "

He believes that this is mainly due to the contractionary monetary policy helping to restore the balance between total supply and total demand, easing inflationary pressures, ensuring stable inflation expectations, and making "inflation now closer to our target, with prices rising by 2.5% over the past 12 months."

When evaluating the job market, he asserts that "today, the labor market has cooled significantly from its previous overheated state, and it seems unlikely that the labor market will become a source of rising inflationary pressures in the short term. We are not seeking nor welcoming further cooling of the labor market conditions."

Specifically, the US non-farm unemployment rate has been rising for over a year, currently at 4.3%, although still relatively low by historical standards, it has increased by a full percentage point compared to early 2023, with most of the rise occurring in the past six months.

However, Powell is trying to defend the solid nature of the current US economic conditions, stating:

"So far, the rise in the unemployment rate is not the result of an increase in layoffs, which is common during economic downturns. Instead, the rise in the unemployment rate mainly reflects a significant increase in labor supply and a slowdown in the previous frantic pace of hiring.

Nevertheless, the cooling of the labor market conditions is evident. Employment growth remains solid, but has slowed down this year. Job vacancies have decreased, and the ratio of job vacancies to unemployed persons has returned to pre-pandemic levels. Nominal wage growth has slowed down. Overall, the labor market conditions are currently not as tight as they were before the outbreak of the pandemic in 2019, when the inflation rate was below 2%.

Overall, the economy continues to grow steadily. However, the data on inflation and the labor market indicate that the situation is changing. The upward risks to inflation have diminished, while the downward risks to employment have increased. The Federal Reserve is attentive to the risks faced by each of its dual mandates."

Powell then stated that the Federal Reserve "will do everything in its power to support a strong labor market while further achieving price stability," and explicitly stated that rate cuts are the future policy direction:

"By appropriately reducing policy constraints, we have every reason to believe that the economy will return to a 2% inflation rate while maintaining a strong labor market. Our current policy rate level provides ample room to address any risks that may arise, including the risk of further deterioration in labor market conditions."

Powell: The collision between overheated and temporarily distorted demand and constrained supply has eased inflation, and there is no need for the economy to weaken

In the second part of the speech, Powell devoted more space to discussing the fluctuations in inflation before and after the COVID-19 pandemic, and explored why inflation could decrease significantly while the unemployment rate remains low, seemingly continuing to paint a rare "soft landing" for the US economy.

However, some analysts argue that during the COVID-19 pandemic, the Federal Reserve failed to raise interest rates in a timely manner to address soaring inflation, Powell's remarks highlight that in the current environment of slowing price growth, Fed officials hope to avoid making policy mistakes again. Their success or failure will determine whether the Fed can achieve the so-called "soft landing," that is, to restrain soaring inflation without causing the economy to fall into recession Federal Reserve Chairman Powell said that the rapid outbreak of the COVID-19 pandemic quickly led to a global economic shutdown. After experiencing the most severe but short-lived recession in history, the U.S. economy began to grow again from mid-2020, with Congress providing substantial additional fiscal support. This led to a strong recovery in spending in the first half of 2021, but with a change in pattern: historic surges in consumer spending on goods while service spending remained suppressed.

At the same time, the pandemic severely disrupted the supply situation. At the beginning of the outbreak, 8 million people in the U.S. left the labor market, and the labor force size in early 2021 was still 4 million lower than before the pandemic. It is not expected to return to pre-pandemic levels until mid-2023. In March and April 2021, inflation also manifested and soared significantly in shortage goods such as automobiles.

However, the Federal Reserve, most mainstream analysts, and central banks of developed economies mostly believe that the sudden rise in inflation is temporary. As long as inflation expectations remain well anchored, there is no need to use monetary policy to address the temporary inflation increase. "At that time, it was widely expected that the supply situation would improve quite quickly, the rapid recovery in demand would naturally follow, and demand would shift from goods to services, thereby reducing inflation."

However, starting from October 2021, inflation data contradicted the above assumptions, rising and expanding from goods to services. To maintain good stability in inflation expectations, strong policies must be implemented. The Federal Reserve began aggressive rate hikes in March 2022, with overall inflation rates exceeding 6% in early 2022, core inflation rates exceeding 5%, and new supply shocks from the Russia-Ukraine conflict and resurgence of the pandemic.

Powell stated that the high inflation rate at that time was a global phenomenon, reflecting people's shared experiences: rapid growth in demand for goods, tight supply chains, labor market tightness, and significant increases in commodity prices. The U.S. inflation rate peaked at 7.1% in June 2022, with severe labor shortages at the same time. However, the number of employed people increased by over 6.5 million compared to mid-2021.

Therefore, the Federal Reserve at the time made combating inflation a top priority, raising rates rapidly. It raised rates by 425 basis points in 2022, 100 basis points in 2023, and since July 2023, the benchmark interest rate has remained at a high level not seen in over two decades. This led to a 4.5 percentage point decrease in inflation from its peak two years ago, while the unemployment rate remained relatively low, which is quite rare in history.

Powell believes that the distortions in supply and demand caused by the pandemic, as well as the severe impact on energy and commodity markets, are important drivers of high inflation. The reversal of these factors is a key component of the decline in inflation, although the fading of these factors takes much longer than expected:

"Our tight monetary policy also helped to moderate total demand, along with the improvement in total supply, reducing inflationary pressures and allowing economic growth to continue at a healthy pace.

As labor demand moderates, the high ratio of job vacancies to unemployed has returned to normal, mainly achieved through a decrease in the job vacancy rate, without significant and disruptive layoffs, making the labor market no longer a source of inflationary pressure." Therefore, he believes that most of the reasons for the rise in inflation during the COVID-19 pandemic can be attributed to the "unusual collision between overheated and temporarily distorted demand and constrained supply." When this collision disappears, and with strong actions by the central bank to anchor inflation expectations, it is possible to promote a cooling of inflation "without the need for economic slack."

Finally, Powell concluded by stating that the Federal Reserve is committed to making appropriate adjustments to its principles through a comprehensive public review every five years. When this process begins later this year, it will maintain an open attitude towards criticism and new ideas, while preserving the advantages of its framework:

"The limitations of our knowledge - as evident during the pandemic - require us to remain humble and skeptical, focusing on learning from the past and flexibly applying it to current challenges."