Federal Reserve Chair Jerome Powell gave the all clear for interest rate cuts to begin and sounded dovish notes about U.S. labor conditions in a Friday speech from Jackson Hole, Wyo., that looked back over the monetary response to the pandemic.
“The time has come for policy to adjust,” Powell said. “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Powell noted weaker labor conditions, saying the “labor market has cooled considerably from its formerly overheated state,” though he qualified that it is still low by historical standards.
Unemployment rose to 4.3 percent in July, nearly a full percentage point above its low point last year of 3.4 percent.
Markets currently expect the Fed to cut rates by a quarter percentage point at its September meeting, with the CME FedWatch prediction algorithm putting the odds at 67.5 percent. The algorithm put the odds of a half-point cut at 32.5 percent Friday morning.
Powell’s Friday speech from the central bank’s annual Wyoming retreat had a tone of finality and retrospection as it looked back over economic conditions in the post-pandemic years that have thrown many policymakers for a loop.
He revisited arguments made in 2021 and 2022 that inflation was going to be a “transitory” effect of pandemic distortions and likely wouldn’t require a reduction in the central bank’s balance sheet or interest rate hikes – arguments that proved to be largely mistaken.
While Powell acknowledged that the transitory characterization of inflation was off the mark, he didn’t totally throw out the logic of that argument, arguing rather that the economy took “longer than expected” to renormalize.
Regarding pandemic-related distortions to supply and demand, and subsequent shocks to commodity markets caused by various geopolitical events, Powell said that “the unwinding of these factors took much longer than expected but ultimately played a large role in the subsequent disinflation.”
The need to anchor inflation expectations at 2 percent amid the precipitous rise in price levels over 2022 and 2023 was a main driver of Fed’s tightening, which happened at the fastest pace in more than 40 years.
Powell’s post-mortem of the pandemic inflation cited an emerging “consensus” around its origins as stemming from an “extraordinary collision between overheated and temporarily distorted demand and constrained supply.”
This is consistent with recent research from former Fed Chair Ben Bernanke and economist Olivier Blanchard, who found that global inflation was caused at first by commodity shocks, shortages and reduced labor supply before being buttressed by “wage pressures from hot labor markets.”
The precipitous disinflation experienced by the economy in 2023 and 2024 was due in part to the “limited catch up of real wages,” which they attributed to the “disappearance of wage indexation.”
With labor conditions weakened and inflation now on a surer path to 2 percent, markets are now expecting a succession of rate cuts to protect against runaway unemployment, which can gain momentum quickly, and to ensure the economy does not slip into a recession. One notable recession indicator known as the Sahm rule has already been triggered by the rise in unemployment.
Some economists are arguing that the Fed is already behind the ball on rate cuts.
“The Fed is late, and is now going to have to scramble after the decline in inflation, in an undignified manner,” UBS economist Paul Donovan wrote in a Thursday analysis. “Policy operates with a lag, so the economic benefit of these cuts will take some time to come through (policy lags are why ‘data dependency’ is so dangerous).”
The CME FedWatch prediction algorithm is anticipating rate cuts from the Fed at meetings in September, November and December.
Updated at 11:48 a.m. EDT
