Semi-annual Monetary Policy Report to the Congress

Fed Chair Jerome Powell signals a desire to recalibrate policy

• While the message in Fed Chair Powell’s semi-annual Monetary Policy Report to the Congress was largely unchanged from recent Fed communication, he inserted a key paragraph signaling his desire to start recalibrating monetary policy.
  
  
• Powell reiterated that the Federal Open Market Committee (FOMC) continues to make policy decisions on a “meeting-by-meeting” basis while acknowledging that in light of the progress made in lowering inflation and cooling the labor market over the past two years, “elevated inflation is not the only risk we face. Reducing policy restraint too late or too little could unduly weaken economic activity and employment.”
  
  
• Powell’s forward-looking perspective along with a greater focus on the two-sided risks to the outlook is welcome, albeit a little late. We maintain our view that easing in July (or even June) would have been optimal and remain concerned that some policymakers with a strong hawkish (backward-looking) bias will push back against a September cut.
  
  
• Indeed, even while Powell’s economic assessment noted the higher 4.1% unemployment rate in June and easing of headline and core personal consumption expenditures (PCE) inflation to 2.6% in May, the remarks remained excessively backward-looking. We know the economy’s performance has been remarkable. What policymakers need to evaluate is how inflation and labor market conditions will fare in the coming months.
  
  
• As we are in a presidential election year, Chair Powell again stressed the importance of Fed independence, with the reminder that, “Congress has entrusted the Federal Reserve with the operational independence that is needed to take a longer-term perspective in the pursuit of our dual mandate of maximum employment and stable prices.”

The US economy has been cooling for a few months now. It’s been a gentle slowdown. So much so that some pundits and policymakers wrongly assumed the economy and inflation were re-accelerating earlier this year.
 

It’s also an unusual slowdown that continues to be characterized by the unique value of talent post-pandemic. With business leaders having plowed so many resources into hiring, training and retaining talent, they remain reluctant to let go of their prized pool of talent.
 

Now that the normalization in job openings, hirings, quits, hours worked, wage growth, and payroll growth has materialized, real disposable income is advancing at a subdued pace of around 1%. This has led to an increasingly visible cooldown in consumer spending growth. Lower income, younger and more indebted families are the first to exercise more prudence with their outlays, but the longer rates and costs remain elevated, the more a greater share of households will constrain their spending.
 

Could these trends turn into something worse? That’s certainly a risk. We’re navigating uncharted waters when it comes to the post-pandemic labor market. And, unfortunately, several Fed policymakers are once again behind the curve – focused on backward-looking data and maintaining an outdated and hawkish inflation bias.
 

The main risks to the economy are that: (1) businesses suddenly turn more conservative and start reducing payrolls to cut costs (the traditional pre-pandemic approach that leads to a self-fulfilling recession); and (2) that overly hawkish Fed policymakers that are out of touch with the two-sided risks to the outlook delay the onset of monetary policy recalibration leading to a sudden tightening of financial conditions.
 

There wasn’t much market reaction to Powell’s testimony today before the Senate with stocks largely unchanged and odds of a September rate cut rising marginally to 75%. The yield on two-year government notes is hovering around 4.64% with investors pricing two 25 basis points (bps) Fed rate cuts this year. The odds of a July rate cut are around 5%. Powell will again testify before the House of Representatives tomorrow.