In Tuesday’s written testimony before the Senate Banking Committee, US Federal Reserve Chair Jerome Powell hailed the disinflation progress made over the past two years toward reaching the Fed’s 2.0% inflation target. However, while the Fed Chief subtly elbowed the Fed closer to reducing its policy rate, he reiterated that the Committee requires ‘greater confidence’ that inflation is sustainably moving towards the 2.0% inflation target before lowering the target for the Fed funds rate.

You will recall inflation accelerated to the upside at the beginning of the year to +3.5% in March (year on year). Powell added that while inflation readings in Q1 this year did not provide such confidence, recent incoming data have demonstrated progress. US inflation cooled to +3.3% in the twelve months to May, clocking its lowest rate in three months, while year-on-year core inflation eased to +3.4% in May from the +3.6% reading in April.

Greater Confidence Required

Powell communicated that the Fed requires ‘more good data’ to strengthen confidence that inflation is moving towards the inflation target. This essentially helps seal the deal for a no-change at the July policy meeting and aligns with market pricing. However, the Fed Chair clarified that the central bank’s decisions are made on a meeting-by-meeting basis.

Investors will welcome the June CPI inflation report tomorrow. Expectations heading into the event indicate headline inflation will slow once again to +3.1% on a year-on-year basis from +3.3% in May, with month-on-month inflation anticipated to increase by +0.1% from May’s reading of 0.0%. Core inflation is estimated to remain unchanged at +3.4% and +0.2% for year-on-year and month-on-month measures, respectively.

Delicate Balancing Act

Powell said that ‘elevated inflation is not the only risk that we face’.

‘This is no longer an overheated economy. We now face two-sided risks. If we loosen policy too late or too little, we could hurt economic activity. If we loosen policy too much or too soon, then we could undermine the progress on inflation. So we’re very much balancing those two risks’, the Fed Chair added.

Cooling Jobs Market

Elevated inflation is clearly no longer the only risk to the US economy, with Powell acknowledging the dangers of easing policy too late could ‘unduly’ harm economic activity and the labour market. On the flip side, easing policy too quickly opens upside risks to inflation. This means that the decision to reduce the target for the Fed funds rate depends on the balance between inflation and the job market. Consequently, additional labour market softening could now be enough to see the Fed cutting rates.

The latest US Employment Situation report revealed job growth slowed from May’s downwardly revised reading of 218,000 to 206,000 in June (which bettered Bloomberg’s median estimate of 190,000). Unemployment ticked higher to 4.1% in June, rising for a third consecutive month and hitting its highest level since November 2021, with both year-on-year and month-on-month wages cooling in June.

Likely Direction?

The Fed are clearly in a balancing act right now with inflation and the job market.

Powell commented that it ‘doesn’t seem likely that the next move would be a policy increase’ in response to a question from Sen. Reed, adding that ‘as we make more progress on inflation […] we [the Fed] begin to loosen policy at the right moment’.

When asked about the timeline for rate reductions, Powell responded that he would not be ‘sending any signals about the timing of any future actions’. However, markets are leaning towards a 25-basis point rate cut in September, with 50-basis points priced in for the entire year.