Jerome Powell’s Pivot Is A Pretty Big Gamble

(Bloomberg Opinion) -- The US Federal Reserve and its chair, Jerome Powell, are betting that they can have the best of both worlds — that they’ll be able to defeat excessive inflation without forcing the economy into recession. 

I hope it goes well. Unfortunately, there’s still a significant chance it won’t.

Powell surprised markets last week with his extraordinarily dovish comments on the outlook for interest rates. He took further increases off the table and put the prospect of cuts firmly on. This was a big shift: Only two weeks earlier, he had opined that any talk of rate reductions was premature. “Higher for longer” is now in the trash bucket. Instead, officials are expecting further declines in inflation that will make earlier and more rapid rate cuts possible, even necessary.

Powell noted that the latest consumer-price report implied that the Fed’s preferred measure of inflation — the core personal consumption expenditure price index — will likely register a 3.1% year-over-year increase when the next data are released at the end of December, indicating progress toward the Fed’s 2% objective. The median expectation in the December Summary of Economic Projections is for three 25-basis-point interest-rate reductions in 2024, ending the year 50 basis points below the September projections.

The Fed might have reason to cut even more if the economy develops as projected, with slower growth, rising unemployment and declining inflation. For one, officials will have greater confidence that inflation is on a sustainable path back to 2%. Also, lower inflation automatically makes any given level of short-term rates more restrictive in real (inflation-adjusted) terms, necessitating cuts to maintain the same monetary policy stance. And as inflation subsides, the Fed can put more weight on its other mandate: maintaining maximum employment consistent with price stability. The Taylor Rule, an indicator of the appropriate monetary policy, suggests that a central bank should ease more as it draws closer to its inflation objective.

The pivot significantly lowers the risk of a recession and hard landing — in large part through its effect on markets. Fed funds futures are already pricing in a full 150 basis points of easing next year. Since the end of October, 10-year Treasury note yields have fallen by about 90 basis points, the stock market has increased by more than 10%, credit spreads have narrowed, and the dollar has weakened. The Goldman Sachs Financial Conditions Index has eased by about 100 basis points, and the firm’s economists now expect the economic impulse to be positive in 2024. The Fed’s own financial conditions index will soon tell a similar story.

Problem is, the central bank’s dovishness also increases the possibility of no landing at all — that is, overheating and persistent inflation that could undermine the Fed’s credibility, while requiring renewed tightening and a deeper recession to get things back under control.

There’s plenty that can go wrong. The slowdown in growth at the end of 2023 might reverse in 2024, as happened a year earlier. What appears to be weakness in spending could prove to be merely bad seasonal adjustment of the data. This year’s large increase in labor supply might not extend into 2024, leaving the job market too tight and wage inflation too high (as Powell noted, the current trend of 4% probably isn’t consistent with sustainable 2% inflation). Prices could accelerate again after the unwinding of transitory phenomena, such as pandemic-fueled demand for goods and supply-chain disruptions. Services inflation (excluding housing) might prove more stubborn than expected. As Powell has noted, the “last mile” in reaching the 2% inflation target should be more difficult.

Powell has repeatedly emphasized that the Fed must finish the job, ensuring inflation gets back to 2% and stays there. Yet the more weight he puts on cutting rates to avoid a recession, the greater the risk of failing to control inflation — and of markets getting a big, unpleasant surprise. One way or another, 2024 promises to be an interesting year for the economy, the Fed and financial markets.

More from Bloomberg Opinion:

• Wall Street Risks as Rates Descend the Matterhorn: John Authers
• BOE Dawdles at the Back of the Rate-Cut Pack: Marcus Ashworth
• Here’s Why Americans Aren’t Loving the Economy: Kathryn Edwards

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley, a Bloomberg Opinion columnist, served as president of the Federal Reserve Bank of New York from 2009 to 2018. He is the chair of the Bretton Woods Committee, and has been a nonexecutive director at Swiss bank UBS since 2019.

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