Powell's Dovish Turn

Powell did not react to the 100 basis point rate cut within the year, nor did he attempt to suppress such a significant rate cut bet. He actually confirmed what no one dared to say directly: the Fed is starting to worry about economic growth. But against the backdrop of recent good economic data, this shift seems somewhat abrupt.

Powell's speech at the Jackson Hole meeting firmly conveyed a signal of policy shift.

Although there was no explicit mention that the fight against inflation has been completed, there was very little ink on the inflation outlook throughout the entire text. Compared to the resolute "8 minutes" in 2022 to start the anti-inflation journey, this JH speech had a more relaxed tone of a winner; compared to the detailed breakdown of inflation in 2023, this JH speech focused entirely on the labor market, as if switching from a single goal (fighting inflation) from 2022-2023 to another single goal (full employment).

The two most impactful sentences in the entire speech are both related to the labor market.

The first sentence is "We will do everything we can to support a strong labor market as we make further progress toward price stability".

The second sentence is "We do not seek or welcome further cooling in labor market conditions".

This easily brings to mind the classic statement of ECB President Draghi during the Eurozone debt crisis - "whatever it takes". Powell's "do everything we can" and the "disgust" for further cooling in labor market conditions also convey the Fed's clearer intention to support economic growth.

Why did Powell shift from the balanced stance at the July FOMC to the most dovish speech to date within just one month?

Powell's speech downplayed the importance of inflation and emphasized the impact of supply-driven factors. He believes that pandemic-related supply-demand distortions, especially the severe impact on energy and commodity markets, are important drivers of high inflation; at the same time, wage growth also brings certain inflationary pressures.

However, with supply being restored to a level relatively matching total demand, the U.S. inflation problem should be resolved. Currently, the U.S. goods and labor markets are in a more balanced state, so there is no need for more restrictive demand-side policies.

Although inflation may be more turbulent in further returning to the 2% level (or may not return to 2%), at least the trend over the past few months has given the Fed one less reason not to act

With inflation stable, Powell's speech shifted to concerns about the continued rise in the unemployment rate and the possibility of crossing the inflection point.

The first concern comes from the first forum paper at this year's Jackson Hole meeting (Powell's speech also referenced this paper), mainly deriving from the Beveridge Curve that "the inflection point of accelerated deterioration in the unemployment rate is around 4.42%," which is close to the latest U.S. unemployment rate of 4.3%. Considering the time lag of monetary policy transmission, the window for interest rate cuts is approaching.

The second concern is that the Fed's estimate of the unemployment rate remains cautious. Powell's speech compared the current labor market conditions to pre-pandemic levels, with the tightness of the labor market (V/U ratio) lower than in 2019, and both the employment rate and quit rate lower than in 2018 and 2019 (actually at new lows since 2014 excluding the pandemic period); this means that the Fed's tolerance for the unemployment rate is also at a level similar to 2019.

In the latest unemployment rate estimates released at the June FOMC meeting, the upper limit estimate for 2024 is 4.4%, and the July unemployment rate is already close to this level (4.3%), hence the Fed has the logic for action.

However, there are two reasons that may affect the speed of Fed action.

First, a large part of the July unemployment rate is driven by temporary unemployment, which can be attributed to the impact of hurricanes; however, temporary increases in unemployment have also occurred in previous pre-recession cycles, making it difficult to distinguish the true driving force.

This means that the August non-farm unemployment rate will be crucial for the rate cut in September: if the unemployment rate declines or remains stable, proving that hurricanes are a larger short-term driving factor, the Fed can more calmly cut rates in small increments; but if it mirrors the pre-recession cycle, the possibility of a significant rate cut by the Fed cannot be ruled out.

Second, immigration factors have raised the level of the unemployment rate (also a reason why the "Sam Rule" may fail). The current unemployment rate for foreign-born individuals in the U.S. is 4.7% (July 2024), significantly higher than the 3.0% level in the same period in 2019, while the unemployment rate for native-born individuals does not differ much (4.5% in July 2024, 4.2% in July 2019). With supply driving up, the Fed's tolerance for higher unemployment rates may also increase.

What Powell didn't say is equally important.

First, Powell did not elaborate on the magnitude, pace, and endpoint of the rate cuts in the short term (September), nor did he provide any interpretation on the 2% inflation target or the structural process of de-inflation.

Second, Powell did not mention the recent hot phrase "gradual rate cuts" used by Fed officials, indicating that the Fed will still follow a "data-dependent" approach. Once the rate-cut cycle begins, it will be difficult to rely on data trends and will have to return to interpreting individual data points, leading to greater volatility.

Third, Powell did not delve into the risks of inflation rebound and the demand-side impact of inflation after monetary policy easing. For example, whether real wages in the U.S. will improve further with faster inflation decline, thereby driving higher demand; and how to understand the demand-side impact of the external wealth effect brought about by the rise in U.S. stocks and real estate prices.

If rate cuts do stimulate the U.S. economy, these unmentioned demand-side factors may increase concerns about the sustainability and predictability of Fed monetary policy.

From the market perspective, the full expectation of a rate cut in September and a 75bp rate cut expectation for the year after the July FOMC meeting has already fully taken into account Powell's intentions. After his speech, the market further converged towards the expectation of a 100bp rate cut for the year, without paying much attention to the risk of economic stimulus from rate cuts leading to inflation rebound.

Powell did not react to the expectation of a 100bp rate cut for the year, nor did he attempt to suppress bets on such a magnitude of rate cuts. Maintaining an open attitude towards any magnitude and path implies that he actually confirmed what no one dared to say directly: the Fed is starting to worry about economic growth.

However, against the backdrop of recent good economic data, this shift seems somewhat abrupt.

Author: Song Xuetao (S1110517090003), Zhong Tian, Source: Xuetao Macro Notes (ID: gh_5f81fe86a5dd), Wall Street News columnist, Original title: "Powell's Dovish Turn"