Powell’s Message From Wyoming

Job growth has slowed, while inflation has increased slightly, moving a bit further away from the Fed’s 2% target, creating a dilemma for the Fed.  So, what should they do?  The easiest path forward is to blame the tariffs for the temporary (or transitory, if I can use that adjective) rise in inflation and ease monetary policy, of course, especially with the President exerting as much pressure on Powell to lower rates as he possibly can.  As we expected, the Fed blinked.

There is a respectable case for the Fed to cut rates at its September meeting, or Powell would not have signaled such a path forward.  As he noted, hiring has slowed, although so far, only in line with the slowdown in labor force growth, which is almost certainly due to the change in U.S. immigration policy.  So, the unemployment rate has been remarkably stable at low levels, despite the slower pace of job growth.  The case for easing monetary policy is that hiring could quickly turn into outright job losses if growth slows a bit more.  The increase in consumer prices may also be a one-time pass through of higher tariffs into goods prices, as has been publicly argued by Fed Governor Waller.  It is a respectable way to view the data, but not the only way.

There is no doubt that businesses and households were unnerved by the “Liberation Day” announcement of massive tariff increases.  If you recall, the stock market swooned in response.  From its mid-February high to the bottom in early April, the S&P 500 fell more than 14%.  It is not at all surprising that firms and households placed their spending plans on pause.  Articles appeared likening the tariff hikes to the Smoot Hawley disaster of the 1930s.  Fearmongering was in full bloom.  That’s when hiring slowed.  But as it became clear President Trump was more than willing to negotiate reductions in tariffs if other countries opened their economies to U.S. exports, investors, businesses and households recognized that the worst case scenario was highly unlikely.  Uncertainty remained, since no one knew where the tariff levels would shake out.  Many negotiations are still underway, so we don’t know even now what the effective tariff rate will be.  But most everyone is now confident that the worst case scenario isn’t on the menu.  And there are benefits to be had, as companies announce plans to invest in America, just as Trump hoped.  Orders for Boeing aircraft, U.S. sourced natural gas, and other products have surged.  So, forecasts of a recession or downturn have nearly vanished.

The slowdown in hiring that unnerved the Fed may prove to be transitory.  (That same word, yet again.)  Nvidia is negotiating with China to take more of its chips.  (China prefers for national defense reasons to take fewer to make itself less dependent on the U.S. in case of conflict.)  But China is willing and needs to take more Boeing aircraft to meet its domestic needs, while such purchases do help redress the bilateral trade imbalance.  Other nations are also revving up purchases of U.S. products.  Domestic investment in the race to produce AI products and services ensures that domestic investment will remain robust.  Household finances are in excellent shape and rates have declined modestly, so home buying could improve a bit.  So, there’s a very good chance hiring improves, although the decline in immigrant labor may prove to be a serious constraint.  A highly plausible scenario is that hiring does rebound, while labor becomes scarcer, so the unemployment rate declines, and wage pressures increase.  That would set the stage for a non-transitory rise in inflation.

The Fed understands the possibilities described above, yet Powell chose to endorse a policy rate reduction to protect against the weakening economic scenario.  A rate reduction can easily be justified objectively as taking out a small bit of insurance against the risk of recession.  But it also increases the risk that inflation becomes embedded in the economy well above the Fed’s policy objective.  For good or bad, this decision to tilt towards lowering rates will help define Jay Powell’s legacy as Fed Chairman.

Whether the decision is the right one may become clear fairly quickly with the next employment report on September 5.  If the report shows more weakness, Powell’s decision will be vindicated, as will be Trump’s pressure campaign on the Fed to lower interest rates.  More rate cuts would likely follow even this year.  But if there’s a further rebound in hiring in August on top of July’s improvement, Powell and the Fed will find themselves to be in a very difficult predicament.  Having opened the door to a rate cut, it will be very hard for them to backtrack.  In that case, we might have one cut with no others to follow.

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