Powell opens the door to interest rate cuts: Significant risks of a downturn in employment

Li Dan, Wall Street Journal

In the last public speech related to economic and monetary policy before the Federal Reserve's meeting blackout period at the end of this month, Fed Chairman Powell hinted that the U.S. labor market continues to deteriorate. Despite the government shutdown affecting the assessment of the economy, he still retains the possibility of an interest rate cut this month. He also mentioned that the Fed may stop reducing its balance sheet (tapering) in the coming months as part of its quantitative tightening (QT) actions.

In a prepared speech, Powell, who attended the National Association for Business Economics (NABE) annual meeting this year, stated that the employment and inflation outlook in the United States has not changed much over the past month since last month's Federal Reserve decision meeting. He mentioned that although some important economic data has been delayed due to the U.S. federal government shutdown,

"Based on the data we have, it is fair to say that there has not been much change in the employment and inflation outlook since our meeting in September four weeks ago."

Powell pointed out that data before the government shutdown indicate that economic growth may be slightly more robust than expected. The unemployment rate remained low in August, and wage growth has significantly slowed, which may be partly due to a decrease in immigration and a decline in labor force participation leading to a slowdown in labor growth.

"In this lackluster and somewhat weakened labor market, the downside risks to employment seem to have increased."

In his speech, Powell reiterated that due to increasing downside risks to employment, the Federal Reserve's assessment of the balance of risks to its employment and inflation targets has changed, leading to the decision to cut interest rates in September. To address the tension between the dual objectives, "there is no risk-free policy path." He noted that existing data and surveys continue to indicate that "the rise in commodity prices mainly reflects tariffs rather than broader inflationary pressures."

During the Q&A session, when asked whether tariffs would have a slow and sustained impact on inflation, Powell acknowledged that tariffs are a risk, but he pointed out that there are "considerable" downside risks in the labor market. The labor market is slightly undersupplied.

Powell said that the Federal Reserve is trying to balance the risks of actions taken to achieve its dual mandate of employment and inflation. Lowering interest rates too quickly could "result in an incomplete inflation task," while lowering rates too slowly could lead to "painful losses in the labor market." He reiterated that the path of interest rates is not without risks, stating:

"There is indeed no risk-free path at the moment, as (inflation) seems to be continuing to rise slowly... and now the labor market has shown considerable downside risks. Both the supply and demand for labor have sharply declined."

Powell said, although the labor market is weak, the economic data unexpectedly rose.

Powell pointed out several times on Tuesday that the pace of hiring is slow and that the employment rate may decline further. He said, "The number of job vacancies is currently declining further, which is likely to be reflected in the unemployment rate. After experiencing a period of straight-line decline, I believe we will eventually reach a point where the unemployment rate begins to rise."

Powell did not provide specific numbers to indicate where he believes the breakeven point for employment growth lies, which is the baseline level for maintaining a stable unemployment rate. He stated that the unemployment rate has clearly "declined significantly." He mentioned that in the context of slowing employment growth, the unemployment rate has hardly changed, which is "very remarkable."

Journalist Nick Timiraos, known as the "New Federal Reserve News Agency," stated that Powell keeps the Federal Reserve on track for another rate cut. He hinted that despite inflation concerns, a rate cut may still occur this month due to a weak job market.

Economist Chris G. Collins commented that Powell said there hasn't been much change in the outlook since the September meeting, which is consistent with the expectation of two more rate cuts this year announced after the September meeting. However, he did not send a strong signal for a rate cut this month, instead pointing out that "the growth trajectory of economic activity may be slightly stronger than expected."

Sufficient Reserves Signs indicate tightening liquidity, will act cautiously to avoid "taper tantrum"

Powell expects that the Federal Reserve may stop tapering in the coming months. In his speech, he stated that the Fed's long-standing plan is to halt actions when reserves are slightly above the level the Fed deems adequate.

"We may approach this level in the coming months, and we are closely monitoring various indicators to provide a basis for this decision."

Powell acknowledged that there are signs showing liquidity is gradually tightening, but mentioned that the Fed's plan indicates they will take cautious measures to avoid a situation like the money market tension in September 2019. Commentators believe Powell is referring to the need to avoid the market volatility from the "taper tantrum" caused by reducing QE.

In September 2019, the U.S. short-term funding market experienced a "cash crunch," with overnight repo rates soaring to 10%. The Federal Reserve was forced to initiate overnight repurchase operations for the first time in ten years, injecting massive amounts of money into the monetary market. Mainstream research suggests that the repo crisis in September 2019 was an incidental event caused by a tight liquidity environment. The primary culprits were the scarcity of excess reserves, compounded by factors such as tax payment dates, a significant amount of government bond issuance, and large banks needing to reserve substantial amounts of reserves due to intraday liquidity regulatory measures.

During the Q&A session, Powell stated that the indicators monitored by the Federal Reserve show that the reserves in the banking system remain "ample," but with the rise in repurchase rates, there are some signs of tightening in the money market.

Failure to pay the collateral interest will result in loss of interest rate control, causing greater damage to the market.

This year, some lawmakers criticized and questioned the Federal Reserve's payment of interest on reserves held by commercial banks. In a speech on Tuesday, Powell defended the important tool of the reserves mechanism, stating that the Fed's reserve system is very effective and operates well. He warned that if the Fed were deprived of the ability to pay interest on reserves, it would lose control over interest rates, causing greater disruption to the market.

Comments suggest that Powell's speech clearly responds to criticisms from U.S. Treasury Secretary Yellen and other Republicans, mentioning that some question the Fed's purchase of MBS, some believe there should be a better explanation for the bond purchases, and others question whether interest should be paid on reserves. Powell recalled that perhaps the Fed should have stopped bond purchases more quickly after 2020.

This Tuesday, Powell mentioned that the Federal Reserve is considering adjusting its asset holdings composition, increasing short-term assets.

Collins commented that increasing holdings in short-term bonds and other short-term assets is not a new idea. Some investors believe that if the U.S. Treasury increases the issuance of short-term bonds and the Federal Reserve buys a significant portion of them, it would be akin to a form of invisible QE, as this would lower the overall weighted average interest rate of the outstanding government bonds.

However, Collins pointed out that the Treasury's issuance of more short-term debt does not necessarily flatten the yield curve. The main drivers of the U.S. Treasury yield curve are still policy expectations, rather than 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 causing the absence of data such as the non-farm payroll report, everyone is looking at the same employment data — disclosed by the private sector. He emphasized state-level employment data and the ADP employment report, known as the 'little non-farm,' while indicating that these data cannot replace the gold standard that constitutes official statistical data.

Speaking about alternative data, Powell stated that some indicators can serve as a supplement to official government statistics but cannot replace these data. He pointed out that accurately interpreting prices is particularly difficult in the absence of government reports.

When asked about the rise in gold prices, Powell stated, "I will not comment on the prices of any specific asset."

When asked about the impact of artificial intelligence (AI), Powell quoted Nobel laureate Robert Solow's famous saying about how new technologies will affect productivity: "You can see computers everywhere, but not in the productivity statistics." He added, "This may be one thing."

Powell stated that Federal Reserve officials are keeping a low profile and staying away from politics. "We will not engage in back-and-forth with anyone. That would quickly become a political issue." The only goal of the Federal Reserve is to serve the public. However, he also said, "Don’t strive for perfection. These are urgent decisions that must be made in real time."

Powell stated that the Federal Reserve would not comment on immigration policy, but he noted that the Trump administration's policies in this regard are tougher than many expected. He mentioned that labor force growth and the number of entrants have sharply declined, which may lead to a reduction in the workforce. However, we are only just beginning to see the effects of these policies.