Fed: Responsible or Play Cheerleader?

Powell Should Avoid Repeating Error of Rookie Year

Jerome Powell started 2018, his first year in office as Chairman of the Federal Reserve, on a high note. Inflation in the consumer price index had accelerated from 2.2% in February when he became the Chairman, to 2.9% by mid-year despite repeated increases in the Federal Funds rate. By November, inflation was back to 1.9%. Proud of his success, Powell told investors at his press conference on December 19 to be prepared for further monetary tightening during the following year. In response, equities cratered during the final days of 2018, and the Chairman’s message abruptly changed on January 4, 2019. The Fed would be patient with monetary tightening, he assured his listeners, and the central bank actually reduced the policy rate several times during the year.

Such policy switches will sound familiar to those of us who remember 2020 - 2023 when Powell started with expectations of “transitory” inflation and lowered rates to near-zero and doubled an already bloated Fed balance sheet, before hiking rates to almost 5.5% by July 2023 when inflation did not conform to his wishes.

Before long, Powell will again be tested on whether his and his colleagues’ focus will stay on employment and prices — the Fed’s stated goals — or if the central bank would go beyond its mandate to provide a safety net to investors taking risk with their investments. The distinction is important. Expectation of a Powell Put would encourage investors to take more risk than would be prudent — a phenomenon known as “moral hazard”. We may get the first indication of the Fed’s intentions from Powell when he speaks at the annual symposium in Jackson Hole, Wyoming a couple of weeks from now.

Providing context to such concerns was the sharp fall in equity prices on Monday, prompting some market watchers to suggest that the Fed should reduce the policy rate by 25, or even 50, basis points right away rather than wait for the conclusion of the next meeting of the Federal Open Market Committee on September 18. The sharp correction in US markets was prompted by a 12.5% fall in Japanese equities at the start of the week, the index’s worst daily performance since 1987.

The call for immediate, and significant, monetary easing came despite several signs of economic strength that were discussed in the last issue of SriKonomics. Furthermore, we learned on Thursday that initial jobless claims — considered to be an early indicator of labor market strength or weakness — fell to 233,000 in the week ending August 3, down from 250,000 during the prior week. The latest figure was also lower than the consensus estimate of 240,000. Clearly, the labor market is not crying for lower interest rates even though traders losing money in equity markets have been calling for the central bank to provide support!

All this begs the question: Will Powell’s response in the coming week repeat his reaction to plummeting equity prices in the final days of 2018, or will he stand resolute in favor of protecting the central bank’s policy goals? This is more than an academic exercise. If the Fed were to ease policy despite a slowing, but still strong, economy, the ensuing rally in equities and bonds may itself prevent the achievement of lower inflation.

In the four final days of the latest market week, the various US equity indexes made up most of their decline on Monday. In the case of Treasurys, the yield on 10-year securities is approaching 4% again after reaching a low of 3.79% on Monday. But the drumbeat of those clamoring for a large rate cut has not retreated. Powell himself suggested at his press conference on July 31 that September may be a good time to initiate the first rate cut in 14 months.

His task may be made more difficult by market reaction to a 25 basis point reduction in the Federal Funds rate on September 18. If investor tantrum at the continuation of high interest rates could provoke the Fed to ease policy, what is to prevent renewed market correction if investors do not get a 50 — or even 75 — basis point reduction? Even babies know that they are more likely to get what they want the louder they cry!

All of these demands for monetary easing are coming even as inflation remains above target, and the economy shows signs of strength. The Federal Reserve Bank of Atlanta’s GDPNow estimate of overall growth in the current quarter rose from 2.5% on August 1 to 2.9% yesterday. Will Powell take all this into consideration and lead his colleagues in maintaining interest rates on September 18? Or, will he repeat his performance on January 4, 2019 and cave in to market pressures?

Just a few more weeks before we find out if we have a disciplined central bank or, instead, a cheerleader for equity markets!

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

August 10, 2024

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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