What was said
A great deal of the speech was given to tracing the path of inflation since the pandemic.[1] This included an explanation for the initial - incorrect - pronouncement by the Fed that inflation would be ‘transitory’ (more on this at the end of the article).
In terms of the present day, however, Powell concluded that inflation appears to be on ‘a sustainable path’ to the target level of 2%. As a result, he continued, it is time for the Fed to rebalance its focus towards its other mandate, which is to promote maximum employment.
The unemployment rate, while historically low at 4.3%, is on the rise as companies post fewer vacancies. If the Fed feels that the current interest rate is likely to harm employment, Powell made it clear that it would not hesitate to lower its policy rate accordingly. He emphasized that the central bank has ‘ample room’ to respond to such threats if they emerge.
How markets reacted
Powell left no doubt that rate cuts are likely on the horizon, stating, “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks."
While he did not provide a specific timeline, his message was clear. So far as the wider market is concerned, the question is no longer whether, but how quickly the Fed will ease the target rate.
Markets are currently predicting that rates will be at least two percentage points lower than the current level of 5.25-5.5% by the end of next year. A rate cut at the next Fed meeting on September 17 and 18 is now seen as “nailed on”, with just over a third of investors predicting a 50 bps cut.[2]
A broader perspective
In the media, all the focus is on the prospect of when and by how much rates will be slashed in the short-term. From a longer-term perspective, the most interesting question addressed in the speech was largely overlooked in the market commentary.
Namely, why did the Federal Reserve - along with the many other experts and institutions on what Powell jokingly referred to as ‘The Good Ship Transitory’ - fail to predict the inflation crisis in the first place?
The technical explanation is complex, but it boils down to the unpredictability of human psychology. Inflation is as much a question of ‘expectations’ (a mental factor - hard to predict and control) as it is about numerical, quantifiable dimensions such as the money supply and trade dynamics.
Powell’s prescription to avoid similar errors in future is simple: ‘humility’.
Investors should avoid adopting models and theories that are ultimately limited in their ability to explain the world. The map, as the saying goes, is not the territory.