Powell speaks, sending a major signal

Author: Fan Zhiqing

On Monday, U.S. Federal Reserve Chair Jerome Powell appeared at a Harvard University panel discussion and delivered a speech. He stated that the Federal Open Market Committee (FOMC) can take a wait-and-see approach regarding the impact of the U.S.-Iran conflict on the economy and inflation, and noted that policymakers often “temporarily ignore” shocks such as rising oil prices.

Latest currency market pricing shows that traders’ expectations for Fed rate hikes this year have cooled.

“There’s an obvious trade-off between the two major goals”

“We believe the current policy stance is in a favorable position to wait and see how things develop.” Powell said during a Q&A session in Harvard’s macroeconomics course.

His remarks seemed to reassure financial markets. Recently, market expectations for the Fed to raise interest rates to curb inflation have been rising; however, after Powell’s speech, expectations for rate hikes have diminished.

As the U.S.-Iran conflict enters its fifth week and the average U.S. gasoline price rises to about $4 per gallon, Powell acknowledged that the Fed faces a potential conflict between full employment and price stability. “The labor market has downside risks, which means low interest rates should be maintained; but inflation has upside risks, which suggests perhaps low rates should not be maintained.” Powell said, “There is an obvious trade-off between the two major goals.”

However, he also stated that the Fed currently does not need to take action, despite policymakers closely monitoring signs of worsening inflation expectations—potential signals that policy responses may be needed. “In the long run, inflation expectations seem firmly anchored.” Powell said, emphasizing that the public must not develop high inflation expectations. Research shows that if Americans start to expect higher inflation, prices will rise substantially.

Powell analyzed that over the past roughly five years, inflation has remained above the Fed’s 2% target, resulting from a series of shocks: the strong demand and supply constraints following the reopening from COVID-19 lockdowns; and the recent, what he called, “much smaller” tariff shocks. “We are now facing an energy shock: no one knows how big its impact will be. It’s too early to draw conclusions.” Powell said.

Earlier this month, after a two-day policy meeting, the Fed kept the overnight benchmark interest rate unchanged in the 3.50%-3.75% range. At the post-meeting press conference, Powell said he hopes to see inflation driven by tariffs in goods prices decline before considering rate cuts.

The Fed chair downplayed concerns that private credit defaults could evolve into a crisis similar to 2008 in subsequent communications. “What we’re seeing is a market adjustment happening; of course, some will incur losses. But it doesn’t seem to have the conditions to develop into a broader systemic risk,” Powell said.

Policy outlook

On Monday, international oil prices continued to rise, with U.S. WTI crude futures surging over 3%, closing above $100 per barrel for the first time since July 2022. Since the conflict erupted on February 28, both major benchmark oil prices have soared nearly 60%.

Regional tensions remain high, with the Strait of Hormuz, responsible for about a quarter of global seaborne oil trade, nearly closed for nearly a month with no signs of reopening soon. Saxo Bank’s commodities strategist Ole Hansen stated in a report: “A key development is that ‘waterborne oil inventories’ are running out. Most tankers that left the Gulf region before the escalation have completed their voyages and unloaded. With limited new supply entering the market, the initial buffer that suppressed oil prices is rapidly disappearing.”

This week’s U.S. employment report will be a key economic indicator. February non-farm payrolls unexpectedly declined by 92k. Concerns about worsening labor market conditions previously prompted the Fed to cut rates last year. If employment deteriorates further, the Fed will face a dilemma. Current inflation levels are already above the Fed’s target, and soaring energy prices further hinder rate cuts.

According to a summary by Yicai, several recent Fed policymakers tend to downplay labor market risks while emphasizing inflation risks. Anna Paulson, president of the Federal Reserve Bank of Philadelphia, told researchers at a Fed seminar in San Francisco last Friday that she worries about rising oil and fertilizer prices caused by the Strait of Hormuz closure, which could quickly and persistently push up inflation expectations.

Market sentiment has shifted to favor the Fed’s hawkish stance. Investors have already priced in all foreseeable rate cuts, with the probability of a rate hike this year once rising to nearly 40%, but after Powell’s latest speech, the probability has fallen below 10%. However, if upcoming data confirm the resilience of the U.S. economy and sticky inflation, markets may reprice a 25 basis point hike.

Bob Schwartz, senior economist at Oxford Economics, told Yicai that the conflict between the U.S., Israel, and Iran casts a shadow over the economic outlook, with the situation potentially escalating from mild to severe oil shocks. “Our baseline forecast is that the economy will continue to expand, even as consumers face major pressures from rising energy prices and depleted savings buffers. But if oil prices stay above $140 per barrel for a long time, it could push the U.S. economy into recession.”

Scott Anderson, chief U.S. economist at BMO Capital Markets, wrote in a report to Yicai that “we are more concerned about the inflationary impact of this shock… prices are continuing to rise, which will undoubtedly start to influence behaviors and decisions across the board, not just among consumers but also among businesses.”

In contrast, Krishna Guhar, vice chairman of independent research firm Evercore ISI, told clients that the Fed might cut rates for various reasons—either because inflation data improves or because the labor market weakens. “We believe the hurdle for rate hikes is high, especially considering Kevin Waugh will take over as Fed Chair in May,” he said.