Powell prepares to launch historic interest rate cut
Jay Powell is widely expected to announce a historic interest rate cut this week as an insurance policy for the US economy against a weakening global outlook and rising trade tensions.
If the Federal Reserve chairman follows through with the move, it would be the first US rate cut since the aftermath of the financial crisis — and it would represent a remarkable reversal from the tightening cycle that Mr Powell pursued last year.
Swap contracts imply that investors have priced in a more than 80 per cent chance of a 25 basis point cut at the US Federal Reserve’s monetary policy meeting on Wednesday, with nearly 20 per cent likelihood of a larger cut.
This comes despite the fact that the US economy is experiencing its longest-running growth streak since at least 1854, enjoys near-record low unemployment and record-high equity markets.
Behind the move lie four pivots in emphasis and thinking among Fed officials, each of which have contributed to the central bank’s change of direction.
When Mr Powell signalled that the Fed was pausing its tightening cycle earlier this year, the bank stressed that its posture was one of patience. Any future change in policy would be dictated by incoming data — if it turned out to be stronger than expected, the Fed might return to increasing rates, while if economic indicators weakened it might resort to cuts.
Since then there have been some signs of a slowdown, with second-quarter growth coming in at 2.1 per cent, a big drop compared to 3.1 per cent in the first quarter.
The GDP showed substantial softness in business investment. But other parts of the economy are holding up. Consumption remains strong, as is the labour market which experienced solid employment growth in June.
What has changed is that the Fed’s evaluation of the risks to the economy is weighing more heavily than it did before. As a result it is set to act pre-emptively because of fears of the impact that trade tensions could have, rather than as a reaction to the actual fallout.
US officials have always framed their thinking on trouble in the global economy — and markets — in terms of its spillover effects.
They could analyse and model the risks of contagion from problems in the rest of world, and make a determination as to the likely impact on the US economy. But there was always a sense that the US could operate as a distinct ecosystem.
By contrast, at a speech in Paris earlier this month, in his last public remarks before the upcoming FOMC meeting, Mr Powell showed that he is perhaps more attuned than his predecessors to the importance of “global factors”.
Even though the US economy may look healthy at the moment, the world is less so, and the US could be vulnerable to infection, he warned.
“Monetary policy in one country can influence economic and financial conditions in others through financial markets, trade, and confidence channels,” he said. “Pursuing our domestic mandates in this new world requires that we understand the anticipated effects of these interconnections and incorporate them into our policy decision-making.”
The first clear signal that Mr Powell was entertaining a rate cut came in early June, during a low point for US trade policy. Talks with China had fallen apart, leading to a rapid and acrimonious escalation in tariffs and bilateral tensions, while US president Donald Trump had threatened to slap sweeping tariffs on Mexican products.
Fed officials were never comfortable with Mr Trump’s trade policies, but things had looked rosier just a few weeks earlier when the US and China were on the verge of a deal. Then between May and June there was so much disruption on trade that Fed officials grew increasingly concerned that the uncertainty was here to stay.
The Fed’s so-called Beige Book revealed that as the trade tensions escalated, the central bank’s business contacts began to complain with greater frequency and central bankers expressed their worries more openly.
And the truce between Mr Trump and Xi Jinping, the Chinese president, at the Osaka G20 meeting — and the deal on immigration reached with Mexico — have failed to persuade the US central bank that trade policy will calm anytime soon.
In addition to the external environment, there is also a domestic factor which is preoccupying policymakers.
Last year, Mr Powell and other Fed officials assumed that wages would pick up as the US economy barrelled towards full employment, feeding through to higher prices and inflation. This dynamic would be the trigger for rate rises.
But it did not turn out that way. The traditional relationship between prices and joblessness has all but broken down. Mr Powell told Congress this month that it was strong 50 years ago, but had become “weaker and weaker and weaker”.
The result, he said, was that wages were “not responding” to the expansion.
“We don’t have any basis or any evidence for calling this a hot labour market,” he said. “To call something hot we need to see some heat.”
Last November, Mr Powell launched a review of the Fed’s policy framework, and changes to the way officials look at inflation rose quickly up the agenda.
A rate cut this week would be the first fruit of that shift in thinking — indicating an acceptance by the Fed that there is more slack in the jobs market than mainstream economists had hitherto believed.