In Jackson Hole, Powell Made a Pivot on Rate Cuts That Won't Be the Last

Federal Reserve Chair Jerome Powell may be taking too dovish an approach given the current stage of the U.S. economic cycle. The Fed’s dual mandate of stable prices and maximum employment has essentially been achieved: inflation is on a steady path toward the 2% target, driven by strong productivity gains, and unemployment remains low. With these successes in hand, one might question why Powell is leaning towards a more accommodative stance.

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During his recent speech at the Jackson Hole symposium in Wyoming, Powell signaled a dovish shift, assuring financial markets that further easing is likely following the expected rate cut in September. However, if the labor market continues to show strength or inflation starts to rise again, Powell may find himself needing to pivot back to a more hawkish stance.

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At Jackson Hole, Powell refrained from hedging his bets and didn’t challenge the market’s expectations for multiple rate cuts in the near future. He wasn’t more dovish than the market expected, but he also didn’t introduce any hawkish views to temper the market’s anticipation of further easing.

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Indeed, the federal-funds rate futures market reflects expectations for rate cuts totaling 100 basis points, or 1%, bringing the rate down to 4.25% by the end of the year. The market further anticipates that the federal-funds rate will drop to 3% by the end of 2025.

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Powell’s comments left little doubt that the Fed is on a path to lower interest rates. He stated, “The time has come for policy to adjust,” emphasizing that the direction of rate cuts is clear, though the exact timing and magnitude will depend on incoming data, the evolving economic outlook, and the balance of risks. For a Fed chair, this is about as dovish as it gets.

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Powell’s speech could easily have been titled “Mission Accomplished!” as he expressed confidence that inflation is on a sustainable path back to 2%. He noted, “My confidence has grown that inflation is on a sustainable path back to 2%,” adding that with a measured reduction in policy restraint, the economy is likely to achieve the 2% inflation target while maintaining a strong labor market.

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This suggests that inflation is now on autopilot, heading toward the Fed’s 2% target, and there’s no need for further concern.

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Powell’s comments also implied that the Phillips curve, which posits an inverse relationship between inflation and unemployment, may no longer be relevant. Historically, during the last seven recessions prior to the pandemic, rising unemployment was accompanied by falling inflation. However, in the current cycle, headline PCE inflation has dropped from a peak of 5.5% year over year in September 2022 to 2.6% in June, all without a recession and with only a slight uptick in unemployment from 3.4% in January 2023 to 4.3% in July.

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Powell declared that the “upside risks to inflation have diminished,” while acknowledging that “the downside risks to employment have increased.” He pointed to the recent rise in the unemployment rate to 4.3%, a full percentage point higher than its early 2023 level, but also noted that much of this increase is due to more people entering the labor force rather than layoffs.

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Powell has clearly shifted away from the Fed’s previous stance of doing whatever it takes to bring inflation down to 2%. In his speech, he pledged to “do everything we can to support a strong labor market as we make further progress toward price stability.” He also remarked, “It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor-market conditions.”

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This dovish stance raises questions. Powell’s shift seems unnecessary given that the labor market appears to have normalized post-pandemic rather than cooled due to economic weakness. The financial markets, however, seem to have fully priced in this dovish outlook, responding positively yet cautiously to Powell’s comments.

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Just a month ago, during his July 31 press conference, Powell emphasized the Fed’s commitment to maintaining a restrictive monetary policy to keep demand in line with supply and reduce inflationary pressures. He reiterated the Fed’s strong commitment to returning inflation to the 2% target to support a strong economy that benefits everyone. At that time, Powell mentioned the Fed’s dual mandate 11 times, stressing the importance of balancing both inflation and unemployment.

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Fast forward to Jackson Hole, and Powell’s tone had shifted. He mentioned the dual mandate only twice, indicating a greater focus on maintaining low unemployment rather than controlling inflation. He suggested that the balance of risks has changed, with the risks no longer in equilibrium as they were just a month earlier.

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So, what has changed since July 31 to justify Powell’s shift toward dovishness? Several key factors may have influenced his decision:

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1. Purchasing Managers Indexes (PMI): July’s manufacturing PMI, released on August 1, was weaker than expected, with all key subindexes well below 50. The non-manufacturing PMI, however, showed strength, particularly in its employment subindex.
2. Payroll Employment: July’s payroll report was weaker than expected, with downward revisions for previous months. This may have alarmed Powell, prompting him to adjust his stance.
3. Inflation: The July Consumer Price Index (CPI) showed inflation continuing to decrease, with core inflation also moderating. This supported the market’s expectation of lower rates.

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Despite these developments, the economy is performing well, with real GDP growth at 3.1% year over year and inflation on track to reach 2%. In such a scenario, it’s worth questioning the necessity of further rate cuts.

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Historically, when the Fed begins to lower interest rates, it often signals the start of a series of cuts, typically in response to credit crises leading to recessions. However, that situation has not materialized this time around.

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Given the current economic performance, some argue that the federal-funds rate might already be at the elusive neutral level, where it neither stimulates nor restricts economic growth. Powell’s decision to pivot toward a more dovish stance, despite the economy’s strong performance, raises concerns about potential market volatility if he has to adjust his stance again in response to stronger-than-expected economic data.

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