Chairman Powell Signals Progress on Inflation, But More Data Needed Before Fed Actions
During his recent testimony before the Senate, Federal Reserve Chairman Jerome Powell emphasized that “considerable progress” has been made in taming inflation, but he cautioned that more data is required to be confident in achieving the 2% inflation target. This cautious stance is not surprising, as Powell aims to temper bullish investor sentiment. However, with the Fed’s preferred inflation measure already falling from 7.1% to 2.6%, many wonder how much more evidence is needed when leading indicators point toward further disinflation.
Market Expectations for Rate Cuts
Despite Powell’s cautious tone, markets have not been shaken. Stocks and bonds have gradually priced in the beginning of a rate-cut cycle expected to start no later than September, increasing the odds of a soft landing for the U.S. economy. Powell reassured that the Fed would make policy decisions on a “meeting-by-meeting” basis, keeping the door open for a rate cut at any upcoming meeting, including the one at the end of this month. While a July rate cut would be prudent, Powell is unlikely to act unless market expectations align, which currently anticipate two rate cuts this year, starting in September.
Off-Base Economic Projections
One point Powell did not address is how outdated the Fed’s recent economic projections have become. Just one month ago, Fed officials raised their forecast for the core inflation rate at year-end from 2.6% to 2.8% and adjusted their target for the Fed funds rate from 4.6% to 5.1%, without changing their unemployment or economic growth projections. However, the core Personal Consumption Expenditures (PCE) price index has already fallen to the Fed’s year-end target of 2.6%. The unemployment rate has risen above the year-end target to 4.1%, and economic growth appears unlikely to meet the Fed’s 2.1% expectation. The Atlanta Fed’s GDPNow model forecasts a second-quarter growth rate of just 1.5%, following a first-quarter rate of 1.6%.
Anticipated Adjustments in September
These discrepancies suggest significant adjustments are needed in the Fed’s quarterly projections at the September meeting. It is likely that Fed officials will raise their unemployment rate forecast and lower their economic growth outlook. This would necessitate a lower year-end inflation target and a reduced Fed funds rate. While Powell avoided discussing these points during his Senate testimony, markets are already pricing in the likelihood of three quarter-point rate cuts by year-end—a probability that has more than doubled from 10% to 24% recently. This expectation is expected to rise in the coming weeks, improving the chances of a soft economic landing later this year.
Economic Weakness and Policy Implications
Recent economic data underscore the urgency for the Fed to act. Construction spending fell by 0.1% in May, and the ISM manufacturing index dropped to 48.5 in June, marking three consecutive months of contraction. Despite some improvements in new orders and employment activity as reported by the S&P Global PMI, overall economic growth remains weak. The labor market is also showing signs of fatigue, with the three-month average of monthly payrolls falling to 177,000, the lowest in three years, and rising weekly and continuing claims.
Conclusion
Chairman Powell’s acknowledgment of progress in controlling inflation, combined with weaker economic data, suggests the need for the Fed to begin easing monetary policy soon. While Powell may not have provided specific details during his testimony, the market’s anticipation of rate cuts starting in September reflects a growing consensus that the Fed must act to sustain economic growth and achieve a soft landing. The coming months will be crucial as the Fed adjusts its policy to navigate the delicate balance between inflation control and economic expansion.
