On Friday, August 26th, the Federal Reserve held its annual retreat in Jackson Hole, Wyoming. It has grown into an international event with quite an audience—and policy-important speeches.
Jerome Powell, the chairman of the Federal Reserve, presented his view of the U.S. economy and his assessment of where monetary policy should go. It was a highly anticipated speech: since refusing to cut its policy-setting federal funds rate in June, the Fed has been pressured by analysts and commentators to make a cut at its meeting in September.
Until that point, Powell had refused to give any hints of where he stood on the issue. Other Fed policymakers have dropped hints of a coming rate cut, but it was not until Powell spelled it out in Jackson Hole that it became clear that a rate cut is coming. The only question now is by how much the federal funds rate will drop—0.25% or 0.5%.
I am leaning toward the bigger cut. I don’t want the Fed to cut by that much: after basically two decades of inordinately low interest rates, we have created financial and structural economic imbalances in both Europe and America that the respective central banks need to correct. That can only be done by returning us to more long-term normal interest rates around 5-6%.
Unfortunately, that is not happening. For three reasons, a rate cut of 0.5% is more likely than a cut half as big:
- Powell’s openness about a coming rate cut,
- The strong pressure from other market actors for a rate cut, and
- The recent adjustment by the market for U.S. debt in anticipation of the rate cut.
As noticed by Paul Kiernan with the Wall Street Journal, Chairman Powell deliberately avoided certain words in his speech,
like “gradual” and “methodical” that some colleagues in recent days had used to describe their expectation for a series of traditional quarter-point rate cuts. In doing so, Powell’s silence kept the door open to larger rate cuts
Kiernan’s observation is good. He cautions that the size of the cut will depend on what labor-market data look like when the Federal Open Market Committee meets to make its decision. I put less emphasis on the labor market than Kiernan does—we got negative data on business investments earlier in the summer that should be a stronger argument for a rate cut than the present state of the labor market.
That is not to say the unemployment rate is unimportant. Powell mentioned it in his speech, noting that the share of the workforce that is involuntarily without a job has increased in the last year. He was not overly dramatic about it, noting that the cause is not a surge in layoffs but a slowdown in hiring while labor supply keeps growing.
It is important to know which unemployment numbers to look at. Practically all analysts use seasonally adjusted figures, and those are the ones that the Fed itself refers to. However, if we want to know the ‘real’ strength of the economy, we should look at the seasonally unadjusted unemployment rate. It is as close as we can get to reality.
From April to July, this unemployment rate increased from 3.5 percent to 4.5 percent. There is nothing alarming about this per se: let us remember that it is not adjusted for seasons. Last year, the same numbers were 3.1 percent and 3.8 percent, respectively. Therefore, the key figure for the Fed will be the unemployment rate for August: if the economy is operating normally, we can expect unemployment in August to be the same as in July, or lower.
If it comes in higher, even a little bit, I would expect the Fed to weigh it as yet another reason for a larger rate cut.
If it goes that far, the Fed will be following the same route as the European Central Bank, which made a small rate cut in June. Another rate cut is likely at its policy meeting on September 12. Normally, the Fed leads the ECB, but the macroeconomic conditions in Europe and America are so different today that the ECB found it necessary to move forward with a rate cut even though it could take months before the Fed did the same.
While visiting the event in Wyoming, Martins Kazaks, the governor of the Latvian central bank and a member of the ECB’s monetary policy team, explained that he favors two more rate cuts this year, with the door open for one of them in September.
The problem for the ECB, as for the Federal Reserve, is that inflation still has not returned to the long-term 2% rate that both central banks use as their benchmark. As Figure 1 shows, the drop in inflation that happened in 2023—when both central banks tightened their monetary policy—has come to an end while inflation is at or slightly above 3% in America and 2.5-3% in the euro zone.
Figure 1
I do not expect the U.S. inflation rate to fall to 2% any time soon, even if the economy cools off a bit. It would take a significant recession to make that happen. The reason is traceable back to the artificial economic shutdown during the 2020 pandemic: due to government-forced closedowns, many small businesses had to close their doors permanently. In many consumer markets, this led to a strengthening of the dominant market position that large retailers already had; with weaker competition, those retailers have been able to increase their profit margins without risking a loss in sales.
Since competition takes time to come back, the higher profit margins will continue to translate into higher inflation—even as the economy cools off a bit. Therefore, neither the Fed nor the ECB can use the 2% benchmark with the same rigor as before, unless they purposely shift their monetary policies toward permanently higher interest rates.
So long as that does not happen, both central banks will remain under pressure to cut rates more in the near future. In the case of the ECB, these rate cuts will fly increasingly in the face of higher-than-2% inflation across the euro zone. Table 1 reports the annual inflation rates, month by month, since January 2023. Inflation rates that exceed the ECB’s 2% long-term target are marked with red.
Table 1
Currently, only five euro-zone countries meet the 2% inflation target. As of July, six countries had an inflation rate in excess of 3%, and only two were in the 2-2.5% interval.
This is not a currency area on its way back to 2% inflation. It is a currency area where weak GDP growth and a sluggish labor market are living side by side with persistently high inflation. For this reason, at some point the ECB—and later the Fed—will have to admit that it cannot pursue the 2% target anymore.
