Fed/ECB Watch: Jackson Hole Preview
It's summer and at that time of the year central bankers are traditionally heading to Jackson Hole, Wyoming, to what has become known as an unofficial Fed meeting. Markets are eagerly awaiting Powell's view on the US economy as ups and downs in US data have triggered market volatility in recent weeks. In our view the main message will be: 'no need to panic but we are ready to act'. The Fed's rate cutting cycle will start in September after more than a year at peak rates. For the ECB, Jackson Hole is an opportunity to remind markets that the inflation crisis is not over yet. It's possible to cut rates further, also for the ECB, but some degree of restriction will still be needed.
In late summer leading central bankers and academics are gathering at high altitude in Jackson Hole, Wyoming. It's the most important symposium on monetary policy of the year and more often than not it has been used to provide markets with direction. This year's symposium is titled "Reassessing the Effectiveness and Transmission of Monetary Policy". The motivation of which probably stems from the surprising resilience of the US economy to the last rate hiking cycle. With markets becoming increasingly worried about an imminent cooling - even recession calls gain traction - this year's topic matches well the market's interest. Still most focus will be on the opening remarks by Fed Chair Powell on Friday (August 23) and (to us) any ECB voices being raised.
Jackson Hole, the Fed's verbal start to the rate cutting cycle?
Most of 2024 has been characterised by a hawkish repricing of the Fed's rate cutting cycle following rapidly falling interest rates expectations in late 2023. First quarter inflation surprises were the fundamental trigger, which at its peak even brought some market participants to doubt the Fed will cut at all in 2024. The Fed itself nurtured a more conservative stance with reflecting a median of only one cut in 2024 in its June Summary of Economic Projections. After three months of softer inflation data and a labour market which shows tentative signs of cooling the market changed sides again. The market does not even settle with rate cuts by 25 basis points at each of the three remaining meetings of the year but is pushing for at least one key rate cut by 50 basis points - and this is not the most dovish pricing we have seen in recent days. Given the current pricing and the high volatility - thus uncertainty - the market will hang on Powell's every word.
So what is to expect from Powell at Jackson Hole? In spite of markets going back and forth, the Chair of the FOMC has rarely pushed against markets. Usually, Powell acknowledges that the market understands the Fed's reaction function perfectly fine and that a variation of views on the economic outlook can result in a variation of views on the key rate path. To put it in a nutshell: Powell will not let his 'data-dependency-guard' down. This, however, does not mean that his remarks will be uninformative. His view on the economy, the labour market and inflation will be in the spotlight. We expect Powell to push the door wide open for a September rate cut.
Already at the July meeting one key message the FOMC wanted to get across was that the risks towards its dual mandate of price stability and full employment became more balanced. Given that we come from an inflation crisis, this means that the FOMC is more willing to react to any adverse development on the labour market going forward. Since the July meeting we got one labour market report which came in weaker than expected (lower employment growth and higher unemployment rate) and a CPI inflation print which confirms that higher inflation momentum in Q1'24 was only a short-term bump in the disinflation trend. Thus, it is fair to assume that Powell will speak more openly about reducing the degree of monetary policy restrictiveness rather soon.
Hardly anybody doubts a September rate cut anyway. The key question rather is about the pace of the rate cutting cycle. Will it be the slow and gradual approach of minus 25 bps per quarter the FOMC projections usually indicate. Or will like the rate hiking cycle also the rate cutting cycle surprise with a much brisker pace than first imagined? In our view this will be determined by a combination of two factors. First, does the FOMC feel to have fallen behind the curve (by not cutting in July) which would open a gap between the current and the desired level of the federal funds rates? Second, will high interest rates finally bite and turn the desired soft landing into a hard landing just as the economy "prepares for landing"?
Has the Fed fallen behind the curve? We would argue, not yet! But the Fed needs to act faster than it has signalled in June of cutting key interest rates only once this year. Based on an inertial Taylor rule with the FOMC's economic outlook from June as the input, two rate cuts of 25 bps each would be the base case. Since then, inflation came in somewhat lower and the unemployment rate somewhat higher than expected, which probably puts the FOMC's base case between two and three rate cuts in 2024. This shows that given where the US economy stands today, the Fed is in no need to panic. There is nothing wrong about kicking off the rate cutting cycle with 25 bps in September. It is, however, also clear that the Fed will react data-dependently. Thus, should the labour market deteriorate more significantly the Fed will cut interest rates more aggressively. To give an example: should the unemployment rate increase towards 5% over the next couple of months, the aforementioned Taylor rule would imply 75-100 bps of rate cuts in 2024 and 150 bps more in 2025.
Thus, in the end it comes down to the question whether the US economy will cool gradually or considerably over the next couple of months. To start with, it is important to emphasize that the US economy has done remarkably well over the past couple of quarters with GDP growth above its long-term potential. Some cooling is thus only natural but will it go beyond a 'healthy' normalization? At the moment the US economy and the US consumer, in particular, looks rather solid. See our recent US Chartbook: Solid as a rock. This being said there are some warning signals. Savings rates have come down, credit card debt is on the rise, which might signal that the underlying fundamentals of the US consumer is weakening. There is one saying though: "never bet against the US consumer". Further, with interest rates easing, already in anticipation of a rate cutting cycle, the peak of monetary restriction is already behind us, which should reduce the headwind for more interest sensitive sectors. At least based on July data, third quarter GDP forecasts look solid with the GDPNow model from the Atlanta Fed signalling 2% (qoq, annualized). In our view, the US economy is about to cool but will not fall into recession. In such a scenario, the Fed can still afford to stick to a gradual path adjusting to data when needed.
Implications for the ECB
When the market starts to move on the Fed, it usually does not take long for expectations towards the ECB to be revised too. In other words, global financial markets are highly intertwined, across the Atlantic in particular. As the market is expecting a faster rate cutting cycle by the Fed, it now also expects the ECB to increase the pace. Is this valid?
ECB voices at Jackson Hole are likely to emphasize that the ECB conducts monetary policy in light of developments in the euro area not elsewhere. And in fact, economic dynamics do differ. While the market is concerned with a cooling of the US economy, the euro area economy has stagnated for many quarters. At the same time, however, the disinflation of core inflation has been lackluster over recent months. While the euro area inflation pattern shares a lot of similarities with the US data, it seems as if the critical component for disinflation, which is core services prices, is sticker in the euro area than in the US. It should, however, also be emphasized that prolonged disinflation is not without risks in the US too.
The ECB needs to manage a narrow path between keeping monetary policy restrictive enough to bring inflation back to target and keeping monetary policy not overly restrictive to avert unnecessary pain for the economy. A cautious but gradual easing of monetary policy - by rate cuts of 25 bps per quarter - seems to be the way to go for a majority of ECB Governing Council members, at least until year-end.
But do spillovers matter for the ECB? Can markets push the ECB on a different path? First, it has to be emphasized that the ECB is guided by fundamentals. But markets can have a different view on fundamentals. Small deviations in views are not problematic for the ECB and correct over time. If the market, however, feels that the ECB is falling severely behind the curve and is unwilling to back down, it can become problematic. Why? If the market thinks that the ECB is overly restrictive the economic and inflation outlook will become priced with downside risks. Thus, assets which are sensitive to the business cycle will suffer and inflation expectations will fall (below 2%) which pushes up real interest rates. Further, the euro would appreciate as the expected interest rates differential moves in favour of the euro. A stronger currency puts additional downside on the economic outlook (net exports suffer) and the inflation outlook (lower imported inflation, weaker domestic demand). In sum this means financial conditions are tightening as a result of market worries that the ECB's monetary policy stance is too tight for current conditions / the outlook. This can result in a self-fulfilling prophecy, which results in the ECB lowering key interest rates to act against tighter financial conditions. In the end, whether the ECB will deviate from its currently envisioned rates path will depend on the evolving inflation outlook for the euro area, the degree of loosening by the Fed and the risks the ECB sees in pushing too aggressively against Fed spillovers.
With our non-alarming view on the US economy, and thus the Fed, we think that the ECB is not pushed to hurry. Staying on course with quarterly rate cuts and reserving the flexibility of deviating from that path based on how data develops is a legit approach in the current environment.
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Franz ZOBL
Austria Franz joined Raiffeisen Research's Economics, Rates, FX team in 2020 primarily focusing on US monetary policy, benchmark yields and EUR/USD. Prior to joining RBI, he worked as a research economist in the financial sector. He holds a PhD from the London School of Economics and studied at the Vienna University of Economics, the University of Vienna as well as Tilburg University. He is a published author within the field of macroeconomics and has a passion for economic history.
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