Federal Reserve Chairman Jerome Powell faces perhaps the toughest communications challenge of his tenure this week as investors seek clarity on the central bank's rate path following one of the longest streaks without rate changes on record.
Market pricing for Federal Reserve rate cuts has fluctuated for much of the year.
As many as four cuts were planned for this year in the first quarter amid bets on slowing growth and easing inflationary pressures.
Sticky inflation readings as well as a resilient labor market, which in turn supported stronger-than-expected GDP growth, canceled out much of that dovish stance heading into the end of the second quarter. That kept Treasury yields elevated and the dollar trading near multi-year highs against its global peers.
However, a benign CPI inflation report for June, as well as a slowdown in labor market gains and weakening consumer sentiment, have given rise to renewed bets that the Fed will implement the first in a series of quarter-point rate cuts in September.
And that sets the stage for what could be a difficult, if not impossible, challenge for Powell when he faces the media on Wednesday at 2:30 p.m. ET.
The Fed's interest rate is currently at a two-decade high of 5.25% to 5.5%. And while no changes are expected in Washington tomorrow, Powell will have to signal the need, and indeed the intention, for a rate cut in six weeks while also explaining to markets why he was unwilling to do so this week.
The Federal Reserve faces an “uncomfortable” challenge
“It's going to be a little awkward for the Fed when they try to signal that they're going to cut soon and at the same time try to explain why they're not going to cut now,” said Bryce Doty, senior vice president and portfolio manager at Sit Investment Associates.
The case for a cut, while by no means obvious, is certainly compelling: The three-month annualized rate of core personal consumption expenditures inflation, the Fed's preferred gauge, is now around 1.5%, well below its 2% threshold.
Unemployment, though low, is rising and was last estimated at 4.1%. That level could accelerate in the fall months as hiring slows and the impact of earlier Federal Reserve rate cuts chokes off credit growth.
Related: PCE inflation report cements timing of next Fed rate cut
The arguments against a September cut, however, are equally compelling: The economy grew at a much stronger-than-expected 2.8% pace last quarter, and the Atlanta Fed's GDPNow forecasting tool suggests that pace will hold firm through late July.
Recent labor market data, while softening, still suggest a tight labor market with about 8.18 million job openings during the month of June.
“So far, the Fed has managed to strike the balance that smoothes inflation without inducing a recession,” said Jason Pride, head of investment strategy and research at Glenmede.
“But if inflationary pressures continue to ease, the Fed will shift from a focus on price stability, half of its dual mandate, to a more balanced approach that considers a situation in which normalization begins to turn into deterioration due to tight monetary policy,” he warned.
Fed: Waiting for Godot
That puts the Fed in its current bind: Waiting until September increases the risk that it could fall behind in reacting to changes in jobs and inflation data, while acting now could suggest that Fed officials are seeing something in the economy that investors are not.
“A surprise rate cut this week could trigger an adverse market reaction and force investors to question why the Fed felt it necessary to cut rates earlier than expected,” said Bret Kenwell, a U.S. investment analyst at eToro. Kenwell argues that most would conclude that “the economy and labor market have deteriorated more quickly than expected.”
Related: GDP report shakes hopes for Fed soft landing
Powell himself has hinted at the nature of this dilemma. He has told investors that the balance of risks between faster inflation and a slowdown in employment is now more evenly spread, suggesting a path toward a September cut that would still need to be confirmed by upcoming data.
But Richard Ratner, senior vice president at Bel Air Investment Advisors, sees it differently, saying markets will react to the type of message he delivers at his post-decision press conference.
“In my view, inflation is no longer the problem. Growth is, and the Federal Reserve should take that into account,” Ratner said.
“As for the markets, they will react to his comments after the decision,” he added. “If (Powell) continues with his hawkish stance, it is likely that the markets will not price in a cut in September and the stock markets will plummet because confidence will be affected.”
Recovery cuts?
However, Sit Investment Associates' Doty sees any market pullback from a hawkish Fed message as a buying opportunity, arguing that “the longer and slower it takes the Fed to cut interest rates, the more it will need to do afterward to 'catch up' as households continue to struggle.”
Right now, markets appear to be hedging that exact bet: CME Group's FedWatch is now pricing in three rate cuts between now and the end of the year, with the federal funds rate falling to 4.625% at the close of the December meeting.
Related: Former Fed official changes his mind on what's next for interest rates
If the Fed's first rate cut comes in September, as expected, that would mean the longest period between the most recent increase, in July 2023, and the next reduction.
Accelerating that pace in the final two meetings of the year would also certainly fit into the recovery theory, although the Fed is not alone in changing its recent tone.
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Goldman Sachs, which just two months ago was forecasting no change in the federal funds rate until 2025, now expects at least two cuts between now and the end of the year.
“There's no question that there are some changes in consumer behavior, and the cumulative impact of what has been kind of a long-term inflationary pressure, while moderating, is having an effect on consumer habits,” Chief Executive David Solomon told CNBC on Tuesday.
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