Weekly Economic Trends and Indicators

For the last two weeks, we have considered the risk of recession in the U.S. as well as the effect of recent economic developments on the Quad Cities area. This week, we wrap up that series with a discussion of the latest comments from Fed Chair Jerome Powell. These comments nicely encapsulate many of the themes we have covered over the last several months. The main story is that the long-anticipated interest rate cuts are almost certainly coming in September. Behind that headline, however, is the fascinating story of how we got to this point.

The story begins with the post-COVID monetary and fiscal stimulus that cause inflation to rise to levels not seen since the late ‘70s and early ‘80s. Bringing inflation under control in the '80s caused a serious recession, and that experience reinforced the view that controlling runaway inflation will cause a recession as a general rule. However, another view developed in the intervening years that held that bringing inflation under control need not cause a recession if inflation expectations are well-anchored (which they were not back in the '70s).

That is not to say that labor markets are unaffected by Fed policy. The post-COVID labor market was, by any estimation, unsustainably tight. Everyone acknowledged that higher interest rates would slow the labor market, but views differed on how much slowing would occur. An important part of the Fed’s messaging strategy was to signal that they were willing to tolerate some slack in the labor market. This was seen as a commitment mechanism. A Fed that is willing to accept labor market slack is a Fed that is serious about inflation. Everything we have learned about inflation expectations in the last 40 years tells us that the credibility of the Fed is absolutely vital to keeping inflation expectations well-anchored.

At the Fed’s Jackson Hole symposium on Friday, Chair Powell reminded his audience that two years ago he warned that “addressing inflation could bring some pain in the form of higher unemployment and slower growth.” Even so, Powell and the Fed signaled their commitment to bringing inflation down. That commitment was the key to anchoring expectations.

Powell went on to say on Friday that the “stability of longer-run inflation expectations since the 2000s had not been tested by a burst of high inflation.” Yet inflation expectations did hold. The yield on the 10-year Treasury never broke the 5% level. As a result, inflation has continued to trend downward with only a modest increase in unemployment—for the time being, at least. The credibility built up over decades appears to have paid off.

It was the success of the last two years that led Powell to lead off his speech by saying, “It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions” (emphasis mine).

This is a significant change in policy direction that acknowledges that the balance of risks has tilted more toward labor market weakness. As Powell said, “The time has come for policy to adjust.” This is the unequivocally strong signal that the rate cuts are on the way at the next meeting. It is also a message that the Fed does not expect that a slightly less restrictive monetary policy will cause inflation to re-ignite, at least not to the levels of a year or two ago.

Hopefully, the rate cuts will not be too late to prevent additional softness in the labor market. Regardless, the events of the last two years are vindication for those who believe in the power of well-anchored inflation expectations to break the negative relationship between inflation and unemployment.

Next week: Housing market update