Chairman Powell’s much anticipated remarks took financial markets by surprise last week. Judging by the rapid price movements after his comments hit the tape, traders had been expecting less decisive steer on the direction of interest rates.
The yield on the policy-sensitive two-year US government bond fell by almost ten basis points while a widely-watched basket of consumer facing stocks jumped by more than 3%. Markets quickly moved to price in a September rate cut as almost a done deal whilst looking for two more 0.25% reductions before the end of the year.
Yet the Chair’s remarks, while dovish, were actually far more nuanced than the market reaction suggests.
As Powell put it, the current outlook – from a monetary policy point of view – is especially ‘challenging’.
In the near term, risks to inflation are tilted to the upside, and risks to employment to the downside—a challenging situation.
‘Challenging’ is best understood as typical central banker understatement; it is tricky to imagine a tougher scenario for monetary policy than rising inflationary pressure coupled with a weakening economy.
Turning to the wider economy first, Powell neatly set out the situation:
Overall, while the labor market appears to be in balance, it is a curious kind of balance that results from a marked slowing in both the supply of and demand for workers. This unusual situation suggests that downside risks to employment are rising. And if those risks materialize, they can do so quickly in the form of sharply higher layoffs and rising unemployment.
At the same time, GDP growth has slowed notably in the first half of this year to a pace of 1.2 percent, roughly half the 2.5 percent pace in 2024. The decline in growth has largely reflected a slowdown in consumer spending.
The pace of economic expansion has slowed sharply, and the risk of a major slowdown in the jobs market is clear.
But on the other hand:
The effects of tariffs on consumer prices are now clearly visible. We expect those effects to accumulate over coming months, with high uncertainty about timing and amounts. The question that matters for monetary policy is whether these price increases are likely to materially raise the risk of an ongoing inflation problem. A reasonable base case is that the effects will be relatively short lived—a one-time shift in the price level. Of course, “one-time” does not mean “all at once.” It will continue to take time for tariff increases to work their way through supply chains and distribution networks. Moreover, tariff rates continue to evolve, potentially prolonging the adjustment process.
It is also possible, however, that the upward pressure on prices from tariffs could spur a more lasting inflation dynamic, and that is a risk to be assessed and managed. One possibility is that workers, who see their real incomes decline because of higher prices, demand and get higher wages from employers, setting off adverse wage–price dynamics. Given that the labor market is not particularly tight and faces increasing downside risks, that outcome does not seem likely.
In other words, tariffs are definitely adding pressure to prices, and that is likely to continue for a while but – in the view of the Fed’s leadership – this slowly playing out change in the price level is unlikely to spark second round impacts due to the weakness of the wider jobs market.
That is the key judgement call outlined by Powell, – yes tariffs will push prices up, but a weak labor market means that workers will not be able to use faster price growth to bargain their own wages higher. In such circumstances, then the Fed feels able to prioritize the weaker jobs market and slowing economic momentum and reduce rates further towards neutral levels.
None of this, though, as Powell was keen to emphasize, should be seen as a commitment. The Fed, as ever, remains data-dependent. It is not hard to see how a strong jobs report – due before the next Fed meeting – could change the calculus.
This Jackson Hole was likely Powell’s last as Fed Chair. And while markets are currently concentrating on the short term picture and what the ‘challenging’ current environment means for interest rates between now and the end of the year, it is worth taking a moment to ponder what the Fed will look like the next time global central bankers assemble in Wyoming.
If markets were happy with Powell’s nuanced take on the immediate outlook, President Trump certainly was not. He renewed his attack on the Fed immediately after the Chairman spoke, threatening to fire Governor Lisa Cook over alleged mortgage irregularities.
What does seem likely is that in twelve months’ time the Fed’s board will have been gradually reshaped to bear more of the stamp of the current President. Such a board may not be able to display the same level-headedness in dealing with a complex economic situation. The real challenge for US monetary policy is not managing a tricky economy over the coming months, but managing even more complicated politics over the coming years.
