Federal Reserve Chairman Jerome Powell has given the green light to start cutting interest rates as job and employment growth slows.
“It’s time to adjust policy,” Powell said in a speech Friday in Jackson Hole, Wyoming, reviewing the monetary policy response to the pandemic.
“The direction is clear, and the timing and pace of rate cuts will depend on upcoming data, evolving outlook and the balance of risks,” Powell said.
Pointing to the worsening working environment, Chairman Powell said, “The labor market has cooled significantly from its previous overheated state,” but cautioned that it is still low by historical standards.
The unemployment rate rose to 4.3% in July, nearly a full percentage point above last year’s low of 3.4%.
The market currently expects the Fed to cut rates by 0.25 percentage points at its September meeting, with the CME Fed Watch forecasting algorithm giving it a 67.5 percent chance of that happening. As of Friday morning, the algorithm had given a 32.5 percent chance of a 0.5 percentage point cut.
Powell’s speech on Friday at the central bank’s annual meeting in Wyoming struck a definitive and retrospective tone, as he reflected on the state of the economy in the post-pandemic years that have confounded many policymakers.
He revisited claims made in 2021 and 2022 that inflation was a “temporary” effect of pandemic distortions and that there would probably be no need to shrink central bank balance sheets or raise interest rates, claims that proved to be largely wrong.
While Powell acknowledged that viewing inflation as temporary was misplaced, he did not entirely reject the logic of the argument, instead arguing that the economy “has taken longer than expected” to normalize.
“These factors took much longer to unwind than expected, but ultimately played a significant role in the deflation that ensued,” Powell said of the shock to commodity markets caused by supply and demand distortions related to the pandemic and various subsequent geopolitical events.
With price levels set to rise sharply through 2022 and 2023, the need to keep inflation expectations at 2% was the main driver behind the Fed’s fastest pace of monetary tightening in more than 40 years.
In his postmortem of pandemic inflation, Powell cited an emerging “consensus” that inflation stems from an “extraordinary conflict between overheated and temporarily distorted demand and constrained supply.”
This is consistent with recent work by former Fed Chairman Ben Bernanke and economist Olivier Blanchard, who found that global inflation was initially driven by commodity shocks, shortages and a decline in the labor force, and was later supported by “wage pressures from a booming labor market.”
They believe that the sharp disinflation experienced by the economy in 2023 and 2024 is due in part to “limited real wage catch-up”, which they attribute to the “disappearance of wage indexation”.
With working conditions worsening and inflation on a firm track to 2%, markets are expecting a series of rate cuts to head off a spike in unemployment that could pick up steam quickly and keep the economy from tipping into recession. Rising unemployment has already triggered a notable recession indicator known as the thumb rule.
Some economists argue that the Fed is already too late in cutting rates.
“The Fed is behind the curve and will be forced to scramble in ignorant fashion to address the fall in inflation,” UBS economist Paul Donovan wrote in an analysis Thursday. “Because of its policy lag, it will take some time for the economic benefits of this rate cut to be felt (the policy lag is exactly why ‘data dependency’ is so dangerous).”
The CME FedWatch forecasting algorithm expects the Fed to cut interest rates at its September, November and December meetings.
Updated 12:15 p.m.
