Powell opens the door to rate cuts: employment downside risks are significant

In his final public speech on economics and monetary policy before the Federal Reserve's meeting quiet period at the end of this month, Fed Chairman Powell hinted at the continued deterioration of the US labor market and, despite the government shutdown impacting economic outlook, maintained the possibility of a rate cut this month. He also said the Fed may halt its quantitative tightening (QT) program, shrinking its balance sheet, in the coming months.

In his prepared remarks, Powell, who was attending this year's annual meeting of the National Association for Business Economics (NABE), stated that the outlook for US employment and inflation has not changed significantly in the nearly one month since last month's Fed meeting. He said that although the release of some important economic data was delayed due to the U.S. federal government shutdown, "based on the data available to us, it is fair to say that the outlook for employment and inflation does not appear to have changed much since our September meeting four weeks ago." Powell then pointed out that data before the government shutdown suggested that economic growth may have been slightly more solid than expected. The unemployment rate remained low in August, and wage growth slowed sharply, which may be partly due to slower labor force growth caused by reduced immigration and a decline in the labor force participation rate. "In this less dynamic and somewhat slack labor market, downside risks to employment appear to have increased." In his remarks, Powell reiterated that the increased downside risks to employment and the Fed's shifting assessment of the balance of risks facing its employment and inflation goals led to the September rate cut. To address the tension between these dual objectives, "there is no risk-free policy path." He noted that available data and surveys continue to suggest that "higher commodity prices primarily reflect tariffs, rather than broader inflationary pressures." During the Q&A session, when asked whether tariffs would have a slow and persistent impact on inflation, Powell acknowledged that tariffs were a risk but noted that there were "considerable" downside risks to the labor market. The labor market is slightly undersupplied. Powell said the Fed is trying to balance the risks of its actions in achieving its dual mandate of employment and inflation. Cutting interest rates too quickly could "leave the inflation mandate unfulfilled," while cutting rates too slowly could lead to "severe losses in the job market." He reiterated that the interest rate path is not risk-free, saying: "There is indeed no risk-free path now, as (inflation) appears to be continuing its slow rise... and the labor market now presents considerable downside risks. Both the supply and demand for labor have fallen sharply." Powell said that despite the weakness in the labor market, economic data has "surprised to the upside." Powell repeatedly noted the slow pace of hiring on Tuesday and suggested the employment rate could fall further. "A further decline in job openings is now likely to be reflected in the unemployment rate," he said. "After a period of freefall, I think you'll eventually get to a point where the unemployment rate starts to rise." Powell did not provide a specific number for what he believes is the break-even point for job growth, the baseline level that keeps the unemployment rate stable. He said the unemployment rate has clearly "come down significantly." He called the fact that the unemployment rate has barely budged amidst slowing job growth "very remarkable." Nick Timiraos, a journalist known as the "New Fed News Service," wrote that Powell is keeping the Fed on track for another rate cut. He hinted that a rate cut this month could be possible due to a weak job market, despite inflation concerns. Economist Chris G. Collins commented that Powell's statement that the outlook had not changed significantly since the September meeting was a statement that he was upholding the forecast of two more rate cuts this year, announced after the September meeting. However, he did not send a strong signal of a rate cut this month, instead noting that "the growth trajectory of economic activity may be slightly stronger than expected." Reserves are ample, there are signs of tightening liquidity, and cautious action will be taken to avoid a "taper tantrum." Powell predicts that the Fed may stop shrinking its balance sheet in the coming months. In his speech, he stated that the Fed's long-standing plan is to stop when reserves rise slightly above the level the Fed judges to be adequate. "We could approach that level in the coming months, and we are closely monitoring various indicators to inform this decision." Powell acknowledged signs of a gradual tightening of liquidity, but noted that the Fed's "plans indicate they will take a cautious approach to avoid a monetary market strain similar to that seen in September 2019." Commentators believe Powell was referring to the need to avoid the "taper tantrum" market volatility associated with the reduction of quantitative easing. In September 2019, a cash crunch erupted in US short-term funding markets, sending overnight repo rates soaring to 10%. The Federal Reserve was forced to launch overnight repo operations for the first time in a decade, injecting massive amounts of funds into the money market. Mainstream research believes the September 2019 repo crisis was a sporadic event caused by tight liquidity. The primary culprit is a shortage of excess reserves, compounded by tax payment dates, massive Treasury bond issuance, and the significant reserve requirements imposed on major banks due to intraday liquidity regulations. During the question-and-answer session, Powell stated that indicators monitored by the Fed suggest that reserves in the banking system remain "ample," but that with rising repo rates, money market conditions have shown some signs of tightening. Failure to pay interest on reserves would result in a loss of interest rate control, potentially causing greater market disruption. This year, some lawmakers have criticized and questioned the Fed's interest payments on commercial bank reserves. In his speech on Tuesday, Powell defended the central bank's reserve mechanism, stating that it is highly effective and well-functioning. He warned that if the Fed were deprived of the ability to pay interest on reserves, it would lose control of interest rates, potentially causing even greater market disruption. Commentators believe Powell's speech was clearly intended to address criticism from Treasury Secretary Benson and other Republicans. The speech addressed questions about the Fed's MBS purchases, including suggestions that the purchases should be better explained and whether interest should be paid on reserves. Powell later suggested that the Fed might need to end its bond purchases sooner, after 2020. On Tuesday, Powell mentioned that the Fed was considering adjusting its asset composition to increase its holdings of short-term assets. Collins commented that increasing holdings of short-term assets, such as short-term bonds, is not a new idea. Some investors believe that if the U.S. Treasury issues more short-term bonds and the Fed purchases a significant portion of them, it would amount to a form of hidden quantitative easing, as this would lower the overall weighted average interest rate on outstanding Treasury bonds. However, Collins noted that the Treasury's issuance of more short-term bonds would not necessarily flatten the yield curve. The primary driver of the U.S. Treasury yield curve remains policy expectations, not changes in net supply. Other indicators cannot replace official data. Asked about the rise in gold prices, during the Q&A session, Powell stated that due to the government shutdown, which resulted in missing data such as the non-farm payroll report, everyone is looking at the same employment data—released by the private sector. He highlighted state-level employment data and the ADP employment report, known as the "mini-non-farm payroll report," while stating that none of these data can replace the gold standard of official statistics. Speaking of alternative data, Powell stated that some indicators can supplement official government statistics, but cannot replace them. He noted that accurately interpreting prices is particularly difficult in the absence of government reports. Asked about rising gold prices, Powell said, "I'm not going to comment on any particular asset price." Asked about the impact of artificial intelligence (AI), Powell quoted Nobel laureate economist Robert Solow on how new technologies will affect productivity: "You see computers everywhere, but not in productivity statistics." He added, "That might be one thing." Powell said Fed officials keep a low profile and stay out of politics. "We don't get into arguments with anybody. That can quickly become political." The Fed's sole goal is to do a good job for the public. However, he added, "Don't strive for perfection. These are urgent decisions that have to be made in real time." Powell said the Fed wouldn't comment on immigration policy, but he noted that such policies under the Trump administration have been tougher than many expected. He said labor force growth and immigration have fallen sharply, which could lead to a reduction in the workforce. But we're only beginning to see the effects of these policies.