Weekly Economic Trends and Indicators

The financial markets stumbled last week as participants tried to digest the stream of economic data as well as the words of Federal Reserve Chair Jerome Powell at his press conference following the Federal Open Market Committee meeting last Wednesday. As expected, Powell and the Committee made no change to the fed funds rate target (the interest rate at which banks lend reserves among themselves), but they did leave the door open to future increases. While the market was expecting at least the possibility of one more increase this year, the directness of Powell’s words may have caught some market participants off-guard.

Specifically, the words that were the most jarring to the market were in Powell’s prepared remarks. He stated, “We are prepared to raise rates further if appropriate, and we intend to hold policy at a restrictive level until we are confident that inflation is moving down sustainably toward our objective.” He then went on to say, “Reducing inflation is likely to require a period of below-trend growth and some softening of labor market conditions.”

Compared to previous statements by Powell in this tightening cycle, these words are quite blunt. The market reacted accordingly, sending the 10-year bond yield to 16-year highs on Thursday. In plain English, the Fed is saying that they will be keeping rates higher and for a longer period of time. That is not what the market wanted to hear.

Juxtapose this with the anticipated strong GDP growth in the third quarter, and you see just how impactful Powell’s words were. Powell is effectively saying that the Fed will continue to hold rates higher until inflation comes back to around 2 percent—even if that causes GDP growth to slow down and unemployment to rise. Stronger growth means that it will take more interest rate hikes to slow it down. We should expect the fed funds rate to rise at least another quarter point compared to previous expectations. It will take at least that much to slow down this economy that, for the moment at least, shows few signs of slowing down.

We're saying “few signs” rather than “no signs” of slowing down, however, because there are some reasons for concern. Weakness overseas, the strong U.S. dollar, and the cumulative effect of high interest rates on business expansion plans are increasing in relevance. The potential effects of the resumption of student loan payments next month and the possibility of a government shutdown if a budget deal is not reached also loom on the horizon.

All of this brings us to the potential for “policy error.” The Fed is now signaling very strongly that it intends to keep up the rate hikes even if it slows economic growth. However, if some of these outside forces mentioned above hit the economy with greater impact than expected, it could cause that growth slowdown to be more severe than the Fed anticipates.

The key indicator to watch here will be inflation expectations. If people are sufficiently convinced that the Fed means what it said, then inflation expectations could fall. Lower inflation expectations could give the Fed some breathing room to pause, especially if the economy is noticeably slowing. Sometimes it takes tough talk from the Fed to make that happen. If it works, a soft landing is still in the picture.

For further discussion of these issues and how they impact us in the Quad Cities region, see the Chamber's Quartely Market Report released last week.

Next week: International Trade Update