From Fighting Inflation to Preventing Recession: Monetary Policy Changes Direction | Economy

Japanese research missions SLIM and the American module Odysseus That same year, they showed how difficult it is to land softly on the moon. The term “space race” was adopted by the Federal Reserve to describe how to rein in inflation without triggering a recession that would send unemployment soaring. That’s almost as hard to do in an economy as it is on the moon. It has been Fed President Jerome Powell’s goal for more than two years. Now that inflation has fallen, there are concerns that the spacecraft will run out of fuel. That means a change in the monetary policy cycle, as this weekend’s Jackson Hole symposium confirmed. Powell will soon follow the path chosen by his counterparts at the European Central Bank (ECB) and the Bank of England: lower rates.

“The time has come,” the head of the U.S. central bank said on Friday, marking a turning point. It’s almost a commitment that he will lower the price of money at his meeting on Sept. 18. The historic Bundesbank president Karl Otto Poehl said that inflation was like toothpaste: once it came out of the tube, it was very difficult to put it back in. Three years later, Powell believes he has almost achieved his goal. “My confidence has increased that inflation is returning to a sustainable level of 2%,” he said on Friday.

The symposium analyzed the extraordinary nature of the latest global inflation phase, in which demand distorted by stimulus programs and savings accumulated after the lockdowns was faced with a supply squeeze due to supply chain bottlenecks and the war in Ukraine, among other factors. Around the world, this phase, which has proven to be much less transitory than central banks initially expected, appears to be behind us.

With the notable exception of the Bank of Japan (where rates are rising), the world’s major central banks appear set to cut the cost of money. Despite some internal disagreements, the ECB appears ready to cut rates again in September, according to statements from some of its board members in Jackson Hole. Finn Olli Rehn assured that the process of deflation in the eurozone is “underway” while “the growth outlook in Europe, especially in the manufacturing sector, is quite moderate”. “This strengthens the case for cutting rates in September,” he concluded. Mário Centeno, governor of the Bank of Portugal, said it was an “easy” decision given the inflation and growth data, although his Austrian counterpart Robert Holzmann expressed doubts and assured that the cut was not a “foregone conclusion”.

For his part, Andrew Bailey, the governor of the Bank of England, expressed “cautious optimism that inflation expectations are better anchored” in his speech at the symposium. Although he cautioned that it was “too early to claim victory,” his words suggested that he would also continue to cut rates, as he did earlier this month for the first time in three and a half years, cutting them by a quarter point to 5%. Central banks in Canada, New Zealand and China are also easing monetary policy after succeeding in containing prices.

Lessons Learned

During this period of high inflation, Powell often recalled what had happened to Arthur Burns, the Federal Reserve chairman in the 1970s. He had been tolerant of inflation, and it had entrenched itself in the U.S. economy for a decade. It was his successor, Paul Volcker, who had reined in prices with aggressive rate hikes, leading to a recession. Powell, a fan of the latter, was willing to pay the price.

Two years ago, also in Jackson Hole, he said it would probably be necessary to inflict “some pain” on families and businesses, but that he would not abandon his efforts to control inflation and that until the job was done, “he would continue to do so.” (Keep up the good work, keep up the good work, (that’s the title of Volcker’s autobiography). Last year, at the same symposium, he took out his hawk’s claws again, predicting higher rates for a longer period. Now “the time has come.”

The US Congress gave the Federal Reserve a dual mandate to pursue price stability and full employment, unlike the ECB, which, at least in theory, only aims for the former. After three years of high employment and inflation concerns, Powell is now changing direction. “The risks to inflation have receded. And the risks to employment have increased,” he said. Inflation fell below 3% for the first time since March 2021, and unemployment has risen almost one point in a year to 4.3%, although it remains at historically low levels.

“Our main takeaway from Federal Reserve Chairman Jerome Powell’s speech in Jackson Hole is that the central bank will not tolerate further weakness in the labor market,” analysts at Oxford Economics wrote. “This dovish stance provides a relatively clear underpinning for the labor market and increases the chances of more aggressive monetary easing,” they added.

Gradual reduction

Barring a negative surprise in employment data in the coming weeks, Fed members are leaning toward a measured approach to rate cuts that would include a 0.25-point cut in September, followed by more in November and December. Boston Fed President Susan Collins said she expects a “gradual and methodical pace” of cuts, and Philadelphia Fed President Patrick Harker said the same: “I think a slow and methodical approach to cutting is the right way to go.”

Powell, however, did not use the word “gradual,” but instead emphasized the “ample room” he has to respond to a weakening labor market, while leaving the door open for a more aggressive response: “We will do everything we can to support a strong labor force as we continue to move toward price stability,” he said Friday. “The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of an unwelcome further weakening in labor market conditions,” he added.

“It’s going to depend on what the next data says,” Atlanta Fed President Raphael Bostic said Friday. “We’re going to have to make a bigger move” if unemployment continues to rise, he added in a statement seen by Bloomberg. The market is giving a 76% chance of a 0.25-point cut and a 24% chance of a 0.50-point cut, according to CME’s FedWatch tool. At the Fed’s September meeting, members will also release a new set of economic forecasts and indicate where they expect the policy rate to be at the end of each year through 2026.

The United States has so far avoided the recession that many thought was inevitable, and Powell remains confident that rate cuts will help prevent one: “With appropriate monetary easing, there is a strong case for thinking that the economy could return to inflation levels of 2%, with the labor market remaining strong,” he said on Friday. Across the pond, the governor of the Bank of England chimed in: “It seems to me that the economic costs of reducing persistent inflation – the costs in terms of lost output and rising unemployment – ​​could be lower than they have been in the past. “That is consistent with a process of persistent deflation, and more consistent with a soft landing than a recession-induced process,” he said in Jackson Hole.

Time will tell whether central banks will manage to avoid a recession or will be too late. Philipp Wächter, chief economist at the Natixis-linked Ostrum AM, points to the first point: “Intervene early, even if GDP and consumption data do not yet show patterns consistent with a recession. “The role of central banks is to prevent the situation from getting out of control,”

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