iFlow > Short Thoughts
Published on Tuesdays, Short Thoughts offers perspectives on US funding markets, short-term Treasuries, bank reserves and deposits, and the Federal Reserve's policy and facilities.
John Velis
Time to Read: 6 minutes
EXHIBIT #1: SLIGHTLY MORE DOVISH POLICY PATH EXPECTED
Source: BNY Markets, Bloomberg
Fed Chair Powell’s speech at Jackson Hole opens the door to a Sept. 17 rate cut, but, while we agree with market pricing that it strongly implies easing next month, our reading of the speech doesn’t suggest an overtly dovish tone. Indeed, he acknowledged that the economic situation may become “challenging” for monetary policy. We choose to frame our reaction to Powell’s final speech at the annual Economic Policy Symposium around its implications for the short-, medium-, and long-term and will discuss each one in turn.
To be circumspect, the only real nod toward a rate cut appeared near the conclusion of the address’s first section: “Nonetheless, with policy in restrictive territory, the baseline outlook and the shifting balance of risks may warrant adjusting our policy stance.” Markets interpreted this to mean a rate cut is coming. Probabilities for a Sept. 17 reduction in the federal funds rate (by 25bp) topped out at 94% just after the Powell speech began and settled the day at 81%.
With downside risk to the labor market now present alongside upside risk to inflation, Powell implied that rates are “modestly” restrictive and indicated that adjusting the policy stance was possible and — in our view, along with the market’s — almost a done deal for the next meeting. Interestingly, probabilities for future rate cuts did also increase, but the swaps curve is only moderately more inverted after the speech. From a total of 47bp in cuts through the end of the year priced in before the speech, the market only added 7bp (to 54) more in expected rate reductions afterwards. To be sure, it is now pricing in two full cuts, but not much more than that.
Past September, we don’t think the Fed is sold on additional rate cuts as a sure thing. Our view comes both from our reading of the inflation/tariff process, as well as our reading of the Chair’s speech. We — and it seems Powell as well — remain concerned about a pickup in inflation in the fall months, just as markets expect rate cuts to continue. We laid our argument out in a previous Short Thoughts (see here).
As for the labor market, Powell described a “curious” balance between supply and demand. Supply is likely falling due to changes in immigration policy and a general slowdown in labor participation across the economy. At the same time, demand is slowing due to cyclical forces and policy changes that affect aggregate demand in the economy, which Powell noted is slowing. It may be that the “breakeven” number of jobs required for the labor market to stay in balance is far lower than even a year ago, and the jobs situation can remain in the balance for some time. This is not an overtly dovish argument from Powell to our mind.
Inflation, on the other hand, clearly is on Powell’s mind, and he claims that “a reasonable base case is that the effects will be relatively short lived — a one-time shift in the price level.” However, he conceded that “one time” doesn’t necessarily mean “all at once” and acknowledges that the adjustment process (i.e., rising prices) may be prolonged. This is a nod to the argument that a central bank may be able to look beyond price increases from one-time policy shocks and keep rates focused on the other side of the dual mandate.
But then, he says that “it is also possible, however, that the upward pressure on prices from tariffs could spur a more lasting inflation dynamic.” This is our concern. Prices may rise steadily and slowly, but noticeably. We have a hard time envisioning potential core inflation at or above 3% and rising, while the Fed continues to cut rates. Powell suggested that inflation expectations could “move up.” This would, to us, require a central bank response, and that response could be holding off on further rate rises while this process continues. Indeed, this could be what Powell is hinting at when he concludes his inflation comments thusly: “Of course, we cannot take the stability of inflation expectations for granted. Come what may, we will not allow a one-time increase in the price level to become an ongoing inflation problem.” Exhibit #2 shows a chart of market-implied (swaps) inflation expectations for the 1y and 2y horizons.
EXHIBIT #2: SHORT-TERM INFLATION EXPECTATIONS HAVE PLATEAUED SINCE APRIL
Source: BNY Markets, Bloomberg
We therefore believe that the immediate takes on this speech focused on the hint of a September easing and not on its declared concern on and steadfastness towards inflation. We think the speech was mildly hawkish, in fact. Yes, a September cut is likely, but at this juncture, we don’t expect the guidance accompanying the move to necessarily imply more cuts thereafter, pending inflation developments.
The final two-thirds of the Jackson Hole speech featured Chair Powell describing the evolution of, and the recent changes to, the Fed’s Monetary Policy Framework, which has recently undergone a year-long review. The last Framework Review, introduced in August 2020 in the dark shadow of COVID, was criticized for being ill-suited to the inflation that appeared in subsequent years and its adaptation of Flexible Average Inflation Targeting (FAIT) deemed irrelevant in a post-COVID world.
FAIT suggested that after years of inflation running below the 2% target of the central bank, the Fed could afford to let inflation run above 2% for a while as a “catchup” to below-target inflation in the 2010s. This of course proved not workable after the inflation of the early 2020s and is no longer a feature of the new Framework, which instead returns to a more traditional approach of a symmetric 2% inflation target.
The new Framework also defines maximum employment as “the highest level of employment that can be achieved on a sustained basis in a context of price stability.” This switch could lend itself to being interpreted as being dovish, in that it suggests employment goals are more important than price goals. However, we think it could also mean that inflation from tight labor markets will not be tolerated and could hint at stingier monetary policy ahead.
Inflation expectations need to be anchored over the long run for this new Framework to succeed, the Chair concluded: “We believe that our commitment to this target is a key factor helping keep longer-term inflation expectations well anchored.” Exhibit #3 shows the term structure of market-implied inflation expectations derived from examining the spread between inflation-protected Treasury notes and those that pay a nominal yield. Such “breakeven” inflation is elevated for earlier years but converges toward longer-term levels in the latter years of the term structure. However, we still are concerned, as we discussed above, with the recent rise in 1y and 2y inflation swaps.
EXHIBIT #3: INVERTED TERM STRUCTURE FOR BREAKEVENS
Source: BNY Markets, Bloomberg
What does this imply for the potentially “challenging” situation that could endure later this year if jobs markets weaken further but inflation continues to rise? This is described as a period in when the employment and inflation objectives are “not complimentary.” In that case, Powell declared the Fed would take a “balanced approach” and “take into account the extent of departures from our goals and the potentially different time horizons over which each is projected to return to a level consistent with our dual mandate.” This is not precise, although it does acknowledge that it’s likely the Fed will confront this circumstance. It is also a phrase Powell has said quite a few times this year. In reality, we think it means that the Fed doesn’t yet know what it will do after September.
