Words have power. No one is more important to the US economy than Fed Chairman Jerome Powell.
Bloomberg Economics' Fed Sentiment Index, powered by a natural language processing algorithm based on more than 60,000 Fed headlines, showed that Powell boosted markets and helped the economy emerge from the slump in December by signaling a quicker shift to rate cuts.
So far, so good—but there's a catch. Four months on, with strong demand growth and inflation above target, Powell will be forced to make a reversal.
This began on the sidelines of the International Monetary Fund's April meeting, when he said that "it would be appropriate to give more time for restrictive policy to work" – pushing the prospect of rate cuts even further.
This is a step in the right direction. But the index showed that was only a fraction of the stimulus he unleashed by his pivot in December. This means that more needs to be done to bring inflation under control. This means there will be more hawkish rhetoric in support of the near-term upside in yields – perhaps as soon as this week's Fed meeting.
(Source: Bloomberg)
Resilience Theory
A year ago, Bloomberg Economics' view (and the consensus in the market) was that the price to control inflation would be a recession, which could begin before the end of 2023. But that was not the case.
Strong growth in the second half of 2023. Despite the fact that GDP in the first quarter fell short of expectations, sales of U.S. businesses and households rose 3.1%, indicating that the economy continues to grow strongly in early 2024.
Jason Furman, the former chairman of the White House Council of Economic Advisers, tweeted that the "bottom line" is that the GDP data "confirms that the economy is still very healthy in practice, but too hot in name."
There are three possible explanations.
The first argument, made by MMT proponents, is that higher interest rates are increasing consumer incomes. If this is correct, then the Fed's rate hikes will be a driver rather than a drag on economic growth, and the answer to high inflation is to cut rates.
This is a provocative idea and one that has aroused the interest of the market. But neither theory nor data can be supported – data shows that net interest income has been a drag on spending power.
The second possibility is that the growth potential of the United States – and the level of interest rates needed to cool inflation – has risen. Speaking in March, Cleveland Fed President Loretta Mester said: "Our neutral funds rate is likely to be higher. "If that's the case, then the Fed's 525 basis point rate hikes since March 2022 won't be enough to tame inflation. More is needed.
Theoretically, this is possible. Millions of immigrants have arrived in the U.S. over the past three years, which is expected to increase the size of the workforce. New technologies such as artificial intelligence are expected to increase productivity.
In fact, this idea is not supported by data either. It takes time for migrant workers to integrate into the labor market. Investment growth is below trend. The AI-driven surge in productivity is still more of a science fiction than a fact.
(Source: Bloomberg)
This leaves the third most plausible explanation: Powell's pivot last December.
At the press conference following the FOMC meeting last December, Powell was noticeably softer. To the surprise of the market, he admitted that the committee had discussed the conditions for a rate cut and did not have to wait for inflation to reach 2% before taking action.
The Fed hasn't changed its policy – the federal funds rate hasn't changed – but Powell's rhetoric has changed, which sends an important signal.
Ellen Meade, a professor at Duke University and a former Federal Reserve economist, was an early pioneer in using advances in data science to parse monetary policy signals. In a 2015 research paper co-authored with Miguel Acosta, she wrote: "Our analysis shows that natural language processing can eliminate false impressions and reveal hidden truths in complex communications. ”
Inspired by Mead's earlier insights, Bloomberg Economics established the Federal Reserve Sentiment Index. It is based on a natural language processing algorithm that is trained to read the headlines of Fed speeches and press conferences and rate them on a scale ranging from extremely hawkish to super dovish. After Powell's press conference, the index suddenly turned dovish – suggesting that the Fed is clearly close to cutting interest rates for the first time.
(Source: Bloomberg)
Dove shock
Powell's words are important for markets and the economy. The yield on the benchmark two-year Treasury fell to a low of 4.1% in mid-January from 4.7% the day before Powell's press conference as interest rate cuts were expected to come sooner than expected. The impact of falling borrowing costs and a resurgence in the stock market rippled through the economy and gave new impetus to economic growth.
According to models developed by economists Michael Ball and Eric Swanson at the Federal Reserve Bank of San Francisco and the University of California, Irvine, the biggest shock to the economy in the current cycle is Powell's dovish rhetoric, which is even bigger than after the collapse of Silicon Valley Bank in March 2023.
(Source: Bloomberg)
What would have happened if Powell hadn't brought the surprise of last December? It is impossible to say for sure. However, perhaps the U.S. economy is heading for a recession.
Data at the time showed that the three-month moving average unemployment rate rose to 3.8% from a low of 3.5% in early 2023, an increase of nearly 0.5 percentage points, which usually signals the start of a recession. The Federal Reserve's Beige Book confirms this bleak picture. Salary data looks strong, but census data from the U.S. Bureau of Labor Statistics suggests that the final revision, released in 2025, will be even lower.
(Source: Bloomberg)
Powell's steer happened at the perfect moment and stopped the downward spiral with enough force. Unfortunately, now there is a price to pay. Giving a new boost to growth has the same effect on inflation. It is estimated that Powell's policy pivot could lead to an increase in inflation of about 0.5 percentage points for the year.
That's why inflation data has beaten consensus expectations so far this year. In fact, much of the upside surprise came from the financial sector – the part of the economy that reacted most quickly to Fed signals. This is also the reason why core inflation is forecast to be above 3% in 2024 – up from 2.8% in March and even further above the Fed's 2% target.
Take history as a mirror
For Fed chairs, the example to avoid is Arthur Burns, who was criticized for failing to control runaway inflation in the '70s. Paul Volcker, who inherited double-digit inflation from Burns and did everything he could to get it back under control – even at the cost of a recession.
For Powell, the benefit of last December's pivot was that it put the U.S. economy on a soft landing trajectory. When he hits the growth pedal and rekindles the inflationary impulse, his reputation could be damaged.
Perhaps this is why Powell has already begun to reverse. Speaking at a panel meeting on the sidelines of the IMF meeting in April, he acknowledged that "recent data clearly do not give us any more confidence in deflation". He said the Fed could keep interest rates steady "for as long as it is needed" to bring price changes back to target levels.
The Fed index also showed a change in tone, strengthening slightly, suggesting that the first rate cut was far away. At the same time, it suggests that Powell's April showers have only extinguished a fraction of the dovish impulses he unleashed by his pivot last December.
This raises the question of whether the Fed will have to launch more hawkish surprises to tighten financial market conditions and get deflation back on track? The process will likely begin at a press conference this Wednesday.
This would repeat the pattern of early 2023, when there was a dovish pivot following the collapse of Silicon Valley Bank, followed by a hawkish reversal after the shock subsided.
Markets have adjusted their expectations for the Fed to cut interest rates this year from 160 basis points forecast at the end of 2023 to 35 basis points in late April. This makes sense – a favorable statistical effect means that inflation will fall over the summer.
(Source: Bloomberg)
Even so, the middle of the year could mark a low in core inflation, before it starts to rise again by the end of the year. Expected at this point, the Fed is likely to shy away from the July meeting. At that point, with inflation rising year over year and the presidential election approaching, the rate cut window may be closed until the end of the year.
The past few years have been a failure for forecasters. In 2021, few foresaw the arrival of a post-pandemic spike in inflation. In 2022, few expected the Fed to raise interest rates above 5%, even as prices continued to rise. At the beginning of 2023, it was widely believed that the price of bringing inflation back to reality would be a recession.
It was Powell's pivot last December that allowed the United States to pull up before a hard landing. In the coming months, a pivot could mean a hard landing – when it finally happens – more difficult and bumpy than many in the market expected.
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