Will Powell Blink When the Job Market Takes a Turn for the Worse?

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Fed Chair Jerome Powell has vowed to continue combating inflation regardless of the economic consequences. Wall Street anticipates him blinking.

As Fed officials assemble in Washington this week to raise borrowing costs for the eighth time in a row, investors expect the central bank to reverse course and begin cutting interest rates in the coming months if the labour market continues to deteriorate and inflation remains low. The Fed does not expect to start cutting rates until at least next year.

The timing is essential because the longer the Fed maintains its stranglehold on the economy, the greater the chance of a potentially disastrous recession with significant job losses.

The addition of new faces to the Fed’s seven-member board in Washington adds to the market’s expectation that the central bank will loosen up. President Joe Biden chose three new members, including Powell, and promoted Lael Brainard, who has previously advocated for moderate rate hikes, to Powell’s No. 2 post.

Some incoming Fed policymakers are economists who have long argued for broad and inclusive employment. One of them is Austan Goolsbee, a former senior economist to former President Barack Obama who recently took over as president of the Chicago Fed and attended his first central bank policy meeting this week.

“There’s a pretty strong notion that they’ll loosen sooner than they say they will,” said former Kansas City Fed President Thomas Hoenig, whose tenure included the 2008 financial crisis, when the economy shed over 700,000 jobs per month. “The temptation would be to say, ‘Well, we’re almost there, let’s relax.'”

On Wednesday, Fed officials are expected to raise rates by another quarter-point, pushing the central bank’s benchmark borrowing rate closer to its target of 5%. The goal is to bring inflation down to 2%, which is less than half of where it is now.

Fearing a repeat of the 1970s and 1980s, when the Fed eased policy only to see price increases return, the Fed wants to keep interest rates high long enough to bring inflation under control.

Investors are pricing in a more than 75% chance that interest rates would be lower in December than they were in June, according to CME FedWatch. They doubt the Fed will maintain its benchmark rate at such a punishingly high level for long, especially if inflation continues to fall and unemployment grows.

Inflation has been falling for six months in a row, prompting hopes that the price increase is coming to an end. Wage growth, a crucial driver of inflation, has slowed further, according to quarterly data on firm labour costs issued on Tuesday.

Despite the fact that consumer price increases have halted, Fed policymakers are nevertheless talking tough in order to keep borrowing costs high enough to keep inflation on its downward path. They believe wage growth will need to slow considerably further. And Fed policymakers have made it clear that fighting inflation is their top priority.

That tone might shift if economic data allow some members of the Fed’s policymaking committee to conclude that inflation is decreasing even without a significant increase in unemployment from 3.5 percent today. The Labor Department will issue January employment data on Friday, and they are expected to show a slower, but still steady, increase in job creation.

“A rising contingent on the committee will become extremely uncomfortable not decreasing [interest rates] in the second half of the year as unemployment climbs,” said Derek Tang, an economist at LH Meyer Monetary Policy Analytics, a research firm chaired by former Fed Governor Larry Meyer. “They admit that they believe [the unemployment rate] will rise into the fours. All of this is done to reduce inflation, but when the rubber meets the road, things may feel a little different.”

The Fed’s vice chair, Lael Brainard, recently suggested large profit margins as a possible rationale for companies to keep employees, especially if supply chains improve and help them save money. According to her, this means that inflation may ease more gradually without having as big of an impact on the labour market.

Meanwhile, depending on what’s driving inflation, returning it to 2% in the medium term may be impossible.

According to Goolsbee, if the Fed tries to tackle inflation caused by supply shortages rather than overspending, it risks producing a recession without really lowering prices, a situation known as “stagflation.” That deepens the risks that the central bank faces, he told CNBC last year before joining the bank.

“The Fed needs to balance some things it doesn’t normally have to balance,” Goolsbee said at the time.

Other notable regional Fed presidents, such as Boston Fed President Susan Collins, who has cycled out of a voting seat this year but is still a part of the debate at rate-setting meetings, might also make the case for a more dovish stance on the economy. Collins, then a professor at the University of Michigan, pushed for the Fed’s inflation target to be raised slightly above 2% in 2019 to give the labour market more breathing room during downturns.

Nonetheless, the final decision of the committee will be influenced by how the economy evolves. Even Fed members like Brainard and San Francisco Fed President Mary Daly, who are frequently seen as “doves” — central bankers who are more concerned with labour market harm than inflation — have remained strong in the face of price hikes.

Policymakers have emphasised that they do not expect interest rates to be decreased this year since they will need to remain high for some time to ensure that high inflation does not become ingrained in the economy. As a result, the Fed may delay raising interest rates for much longer than markets anticipate.

More dovish authorities haven’t modified their stance yet, according to Tim Duy, chief US economist at SGH Macro Advisors, “particularly considering the extent to which evidence has shifted in their favour.”

Some officials, including Minneapolis Fed President Neel Kashkari and St. Louis Fed President James Bullard, have pushed the Fed to be even more aggressive in the face of rising prices. Kashkari, who was an outlier in advocating for abnormally low rates preceding to the pandemic, has advocated for rates higher than the authorities’ consensus prediction during the current bout of inflation. This year, he and Goolsbee will both have a say on interest rates.

“I’m just wary of assuming anyone else’s priors,” Duy explained.

Meanwhile, if Brainard leaves, the conversation might alter dramatically; she is now a candidate to succeed Brian Deese as chairman of the White House National Economic Council, according to persons familiar with the matter.

“Given the working relationship she and Powell have had over several years, I think she actually has a substantial role in thought leadership and the direction things are heading,” Claudia Sahm, a former Fed senior economist, said.

Despite Brainard’s emphasis on workers, Sahm believes she will be pragmatic about how much progress is made against inflation. “Perhaps later this year, but for now, doves, hawks, and moderates are all chasing inflation.”

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