"The Time Has Come for Policy to Adjust"

Last week Fed Chair Jerome Powell made his long-awaited remarks at the Fed's annual Jackson Hole Economic Symposium, where he solidified a policy rate cut at next month's FOMC meeting. In his remarks, Powell all but declared "mission accomplished" on taming inflation, while acknowledging the weakness in labor markets:?

"Our restrictive monetary policy helped restore balance between aggregate supply and demand, easing inflationary pressures and ensuring that inflation expectations remained well anchored. Inflation is now much closer to our objective, with prices having risen 2.5% over the past 12 months. After a pause earlier this year, progress toward our 2% objective has resumed. My confidence has grown that inflation is on a sustainable path back to 2%."?

"Today, the labor market has cooled considerably from its formerly overheated state. The unemployment rate began to rise over a year ago and is now at 4.3% — still low by historical standards, but almost a full percentage point above its level in early 2023. Most of that increase has come over the past six months. So far, rising unemployment has not been the result of elevated layoffs, as is typically the case in an economic downturn. Rather, the increase mainly reflects a substantial increase in the supply of workers and a slowdown from the previously frantic pace of hiring. Even so, the cooling in labor market conditions is unmistakable."?

If it wasn't clear before that the Fed's objective has now shifted to supporting the labor market from taming inflation, Powell was explicit with his words:??

"We do not seek or welcome further cooling in labor market conditions."?

Markets were prepared to parse his remarks for clues as to the next rate cut. In terms of timing, Powell gave a clear answer, while the number of cuts will depend on incoming data.??

"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."??

Markets responded to the dovish speech with a classic easing of financial conditions: rates fell, the yield curve steepened, credit spreads tightened, and equities rose.?With only three FOMC meetings remaining in 2024, interest rate markets continue to price in 100 basis points of cuts, which means that there must be a 50-basis-point rate cut at either the September, November, or December FOMC meetings.??

We believe that given current economic data, a 50-basis-point rate cut seems too aggressive; however, the distribution of outcomes for bond yields remains skewed to the downside, especially given more labor market data expected over the coming months coupled with the Fed's sensitivity to labor deterioration. Powell's dovish tone lowered the bar for the Fed to cut 50 basis points at a meeting if labor data surprises to the downside.?

Last week also saw a large revision to the Quarterly Census of Employment and Wages (QCEW) over?the 12 months ending March 31, 2024. The Bureau of Labor Statistics estimated that nonfarm payrolls should be revised lower by 818,000 jobs over that period, which means that jobs grew by only 178,000 per month rather than by 246,000 per month. Still a healthy pace, but a large downgrade, nonetheless.??

Why was the revision so large? The monthly estimates of payroll growth are derived from Current Population Survey (CPS) data, which are estimated from about 60,000 households. The QCEW draws upon reports from 10 million establishments, which makes it a more detailed account.?The downward revision was the largest outside of 2009, during the heart of the Great Financial Crisis. While there will be revisions to this number until it’s finalized in February 2025, the size of the downward revision suggests that the job market was not as strong as previously thought.?

Recent developments point to a slowing labor market, which is a key focus for the Fed, as a deterioration of the labor market could cause a negative feedback loop that results in an economic recession. Current economic readings aren’t pointing to an imminent recession, but the economy is showing signs of cooling and Powell all but guaranteed that the FOMC will ease policy at the September meeting. Fixed income remains favorable in this backdrop,?not only to provide total return but also as a risk diversifier, as the correlation of bonds versus equities turns negative when the Fed shifts its stance from inflation fighting to growth preservation.?

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