In testimony to Congress this week, Jay Powell, chairman of the Federal Reserve, quashed any doubts that the US central bank was gearing up to cut interest rates this month in a bid to protect the economy from mounting risks around the world.
But Mr Powell’s dovish commentary on Wednesday and Thursday has elevated concerns about the merits of the Fed’s strategy and raised new questions about whether the US central bank plans to cut rates by only 25 basis points or will be forced into pursuing more aggressive stimulus efforts over the coming months.
As he faced lawmakers in both the House of Representatives and the Senate, Mr Powell stressed the darker features of the US economic picture, including persistently low inflation and potentially negative spillovers from a gloomy international environment.
At the same time, the Fed chairman played down brighter news such as last month’s strong labour market performance, as well as the recent tariff truce sealed by Donald Trump, the US president, and Xi Jinping, his Chinese counterpart, at the G20 summit in Japan. He suggested the US central bank was ready to take preventive action sooner rather than later, cheering financial markets and driving equity indices to record highs.
“We see the economy as being in a good place, and we are committed to using our tools to keeping it there,” Mr Powell said.
But if the Fed chairman can draw comfort from the market reaction, he is nonetheless knee-deep into the relatively uncharted waters of easing monetary policy to nip possible economic damage in the bud rather than to tackle a slump.
The first challenge that Mr Powell will have to contend with is that investors are betting heavily on Fed easing, so the central bank risks a backlash if it does not deliver the rate cuts that are expected.
According to future prices compiled by Bloomberg data, the probability of a 25bp reduction in rates this month is 78 per cent, while the chance of a 50bp cut this month is 23 per cent. Traders reckon the Fed will follow July’s cut with at least one more by year-end.
Ethan Harris, head of global economics at Bank of America Merrill Lynch, said Wednesday’s hearing was Mr Powell’s “best opportunity” to give the Fed some flexibility to refrain from easing, or delay rate cuts, but he did the opposite. “You’re in a position where if you don’t cut you’re disappointing markets,” Mr Harris said.
Ward McCarthy, chief financial economist at Jefferies, wrote in a note to clients: “It is not remotely clear to us what rate cuts will accomplish aside from temporarily sating market expectations and quieting the White House Twitter account. After getting a taste of lower rates, both will want more.”
Mr Powell laid out the case for monetary easing by highlighting some softness in indicators such as business fixed investment and persistently low inflation. But mostly, he stressed the impact of uncertainty stemming from trade tensions, weak global growth, the possibility that the US Congress fails to raise the debt ceiling, and a no-deal Brexit.
Fed officials seem to have converged around the idea that by cutting rates early, they could create a protective buffer for the US economy against such shocks. However, monetary policy actions based on an assessment of risks rather than hard data are unusual for the US central bank.
A strong reading on consumer inflation released on Thursday, with core prices rising by 0.3 per cent last month, was unlikely to steer Mr Powell off the easing path, even though Michael Feroli, an economist at JPMorgan, said it would discourage a 50 basis point cut this month.
Sonal Desai, chief investment officer at Franklin Templeton Fixed Income Group, said Mr Powell was being too cavalier about the pitfalls involved in further easing.
“The Fed is acting like there is absolutely no cost to buying insurance with rate cuts when there is,” Ms Desai said. “You can create distortions in financial markets, and when I see equity markets at record highs in the face of what the Fed is telling us about a worrying economic backdrop, there is something messed up here.”
Complicating Mr Powell’s task is that he is trying to engineer a rate cut while Mr Trump is pushing the central bank to slash rates to juice the economy and lend him a hand in the trade war with China.
Mr Powell has asserted the Fed’s independence, but it could be hard for the central bank to avoid the perception that it has given in to White House demands if it strays too far from the data in cutting rates. On Wednesday Democratic lawmakers urged Mr Powell not to “submit” to the “pressure tactics” from the US president.
If the economy slows sharply in the coming months, Mr Powell’s confidence in ploughing ahead with monetary easing is likely to be seen as prescient, but otherwise he and the Fed may struggle to defend it.