Chair Powell today came out a bit on the dovish side in some of his framing but the key message of cautious data dependence remains unchanged.
Overall, Powell seems to want to get an initial 50-100bps of risk management cuts taken care of. The timing of the first cut, and likely all of the initial round of cuts, will be spot inflation data dependent. After that the depth of the cutting cycle will depend on whether or not there is any appreciable sign of weakness in the labor market. Given my view on neutral being between 3-4% this cycle and much of the more cyclical part of the economy troughing and rebounding, my base case is that the Fed is fairly unlikely to cut below 4% until the next recession hits.
Powell said that the February PCE report was inline with the Fed’s expectations, which was itself somewhat reassuring after the January surprise even though Feb was still a bit hot. More broadly, he framed the second half of 2023 as unambiguously good data, January as “very high”, and February as “not as low as most of the good readings we saw in the second half of last year but it was more along the lines of what we want to see.”
Greater confidence that inflation is moving back towards target in a durable way, the necessary condition for cuts to take place if the economy is holding up, will come from “more good inflation data like we saw last year.” He went out of his way to note that the Fed does expect the inflation data to be noisy. I interpret this as Powell saying that while the Fed expects some continued upside surprises but those have to be more than balanced out by continued good data.
He continued to note that the Fed “doesn’t need to be in a hurry to cut rates,” and is in a cautious data dependent mode. Perhaps the most telling comment about Powell’s underlying reaction function was his view that, “the decision to begin to reduce rates is a very very important one because the risks are two-sided.” He later noted that the Fed the reason the Fed can afford to be “patient” in deciding to cut rates is because the “the economy is very strong.”
Overall, the Chair sounds somewhat spot data dependent in terms of making an initial cut but with a dovish underlying lean.
Powell largely reconciled all this by noting that with inflation having come down so far the Fed naturally has greater symmetry between its two mandates (inflation at 2% and maximum employment; the second one is a more dovish spin from the post-GFC era when compared to the older versions that were more focused on employment at some notion of equilibrium, and which I think remains a key part of the Fed’s framework even after the past few years). There also seems to be some weight placed, as we heard during the post-meeting press conference but not so much today, on the ambiguous risk that labor market easing starts to spiral on itself, becoming recessionary without a notable shock. Powell doesn’t think the current conditional odds of a recessionary are particularly elevated, making this concern part of a general risk management practice rather than anything the data is raising as a red or yellow flag.
The Fed will feel comfortable having somewhat restrictive policy until inflation is back at, or pretty close to, 2% but they care less about marginal inflation when it has a 2-handle and with inflation having fallen so far they are free to respond to any weakness in the labor market that may pop up in a way they were not a year or two ago.
Powell noted that he thinks it is unlikely rates will return to pre-pandemic levels and noted that “this economy doesn’t feel like it’s suffering from the current level of rates,” although some of this robustness likely stems from what the Fed tends to view as exogenous healing in the supply side of the economy. He noted that short-term rates are of course likely to come down some over the course of this cycle but seemed more open to, although still somewhat skeptical of, the idea that longer-term rates and the forward expectations for short-term rates embedded in them may not have far to fall this cycle. My read is that the Chair is behaving as though short-term neutral has increased somewhat but that plays only a modest role in setting policy.
As he is wont to do Powell used his regular refrain that, “we have to be humble… the outlook is always much more uncertain than most people think, including us.” The Fed has a base case built off some assumptions, which does inform the general bias of policy over the forecast period, but they’ll make policy in a data dependent and cautious way going forward.
