All eyes were on Jackson Hole, where Fed Chairman Jerome Powell delivered his much-anticipated annual speech in the business world. Powell’s words signaled a new direction for the coming months: lower rates, after 2 years of monetary austerity. Such a move could send markets to new highs!
An unexpected soft landing
Contrary to the pessimistic forecasts of two years ago, The American economy appears to have achieved what many considered impossible: a “soft landing.”
In August 2022, Powell had warned that the fight against inflation would be “painful” for households and businesses, foreshadowing a difficult period. However, the reality turned out to be quite different.
Inflation, which had reached worrying heights, has gradually decreased without the economy falling into recession.
The unemployment rate remains historically low at 3.5%, while economic growth remained above trend.
This result, described as “happy” by many economists, nevertheless raises fundamental questions about the mechanisms that allowed this disinflation without a major slowdown.
The Fed now faces a delicate dilemma: How to calibrate its monetary policy to keep inflation close to its 2% target without risking an excessive cooling of the economy?
A prolonged landing for the Fed
According to some analysts, the American economy has reached what they call “inflation target » in June 2023, when the monthly growth rate of the Core PCE price index fell to 2.09% at an annual rate.
Since then, the economy has continued its soft landing, which has now lasted 14 months.
However, due to the long and variable lags in the transmission of monetary policy to the real economy, Estimated to last around fifteen months, the effects of the Fed's current decisions will not be fully felt until much later.
This reality poses a major challenge for Fed policymakers.
The Fed faces a dilemma
A monetary policy is said to be “neutral” when interest rates set by the central bank are at a level that neither stimulates nor hinders the economy. In other words:
- A restrictive policy (high rates) slows down the economy
- An accommodative policy (low rates) stimulates the economy
- A neutral policy keeps the economy in balance
The “neutral rate” is the interest rate that neither accelerates nor slows down economic growth.
In the current environment, the Fed has raised rates to combat inflation, adopting a restrictive policy. The idea is that even if the Fed starts to lower rates, It will take time before these rates reach the neutral level, that is, the level that no longer slows down the economy.
If the central bank begins cutting interest rates in September at a rate of 0.5 percentage points per quarter, and the true short-term neutral real rate is 1.5%, We would have to wait until July 2025 for monetary policy to be truly neutral, and October 2026 for this neutrality to be fully reflected in the economy.
This prospect of a potentially restrictive monetary policy 40 months after the start of the soft landing raises legitimate concerns.
Some economists believe this delay is odd and suboptimal.
The Fed and the Lessons of History
Throughout his tenure, Powell has often drawn on the lessons of history to guide monetary policy, whether great inflation of the 1960s or of the Volcker disinflation of the 1980s.
In his 2018 speech, he stressed the importance of being open-minded about how the structure of the economy might evolve, citing examples where the Fed either underestimated (in the 1960s) or overestimated (in the 1990s) inflationary risks.
Traditionally, there is an inverse relationship between inflation and unemployment, known as the Phillips curve. When unemployment is low, wages tend to rise, which can lead to higher inflation.Conversely, a higher unemployment rate can help control inflation.
Today, the central question is: whether the Fed has “done enough” to bring inflation back to 2% sustainably.
If so, any further rise in unemployment would have a social cost without any real benefit in terms of price stability.
However, it is impossible to answer this question with certainty, which puts Powell in a delicate position as he prepares to guide the easing cycle.
The Fed Was Right About Transitory Inflation
In 2021, Powell called inflation “transitory”a claim that had been widely criticized as inflation continued to rise.
In hindsight, it appears that The Fed was right about the temporary nature of inflation, although it underestimated the time horizon.
This experience highlights the difficulty of accurately predicting inflationary dynamics and recalls the importance of a flexible and responsive approach to monetary policy.
Towards a rate cut in September
Several major challenges loom for the Fed in the coming months:
First, Powell took a major step by declaring at Jackson Hole that “the time has come for a monetary policy adjustment.” This announcement puts the economy on track for 2% inflation, without, however, declaring victory prematurely. Its communication aims to anchor long-term inflation expectations and reassure the markets.as evidenced by the positive reaction of the American stock markets following his speech.
Although Powell has clearly opened the door to a rate cut, He did not give any indication of the extent of this drop. Analysts are mostly counting on a first decrease of 0.25 percentage points in September, but some are considering a more aggressive cut 0.50 pointt.
The decision will depend on the assessment of the relative risks of inflation and economic slowdown.
The Fed faces major challenges
The Fed must continue to juggle its two statutory objectives: price stability and full employment. Powell reaffirmed his support for American employment, saying: “We will do everything in our power to support a strong jobs market.”
Powell's speech marks the beginning of a new era for US monetary policy, moving from a period of aggressive tightening to a more nuanced phase.
Despite the apparent optimism of the stock markets, which continue to reach new highs, Powell and his team must remain vigilant against the risk of a sharp correction.
The Fed will need to integrate the lessons of this inflationary period into its long-term policy framework and potentially develop new tools to address future challenges.
International implications
The Fed's decisions have repercussions far beyond America's borders.
Many emerging economies, in particular, are sensitive to fluctuations in US interest rates. Too rapid an easing could cause capital outflows from these countrieswhile a prolonged maintenance of high rates could slow down their economic growth.
Indeed, when US rates fall, investments in the United States become less attractive. Investors then look for higher returns elsewhere, often in emerging economies. However, if this easing is too rapid, it could cause a sudden outflow of capital from emerging economies.
In this context, international coordination of monetary policies, although difficult to implement, could become increasingly important.
Powell will likely have to address this international dimension in his thinking, given the central role of the dollar in the global economy.
Jerome Powell’s speech at Jackson Hole marks a turning point in US monetary policy, signalling the end of tightening and the beginning of an easing phase. This shift reflects the Fed’s confidence in returning inflation to 2%, while acknowledging persistent economic challenges. The Fed will now have to strike a delicate balance between price stability and supporting employment, in an uncertain economic environment.
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