Federal Reserve Chairman Jerome Powell has been so eager to take credit for the economy’s soft landing that he has now made it much harder to achieve. His prediction this week that the next interest rate move is likely to be down rather than up confirms his mistake. A little more restraint in recent months would have served the Fed Chairman and the economy much better.
The Marshmallow Test is a psychological experiment designed to measure delayed gratification in children. The test, developed by psychologist Walter Mischel in the early 1970s, places a child in a room with a marshmallow and offers him a choice: He can either eat the marshmallow immediately or wait a certain amount of time, usually about 15 minutes, and get a second one Marshmallow as a reward for their patience. The test became famous for its effects on self-control, willpower, and future success.
Powell faced his own version of the marshmallow test last fall. After a nearly 20% rise in price levels from the start of 2021 and the Fed’s fastest rate hike cycle in 40 years, Powell appeared to finally be getting inflation under control.
FED PRESIDENT SAYS NEXT STEP WILL LIKELY LOWER COUNTS, BUT TIMING UNCERTAIN
Core personal consumption expenditure (PCE) inflation had slowed to an annualized 2% by the third quarter of 2023 and financing conditions had tightened significantly. A soft landing and achieving the 2% inflation target seemed within reach for him. All he had to do was refrain from devouring the proverbial marshmallow of rate cuts and keep financial conditions tight for a few more quarters. Unfortunately he ate the marshmallow.
To be fair, Powell actually came under enormous political pressure to loosen monetary policy. Former Fed Chair and current U.S. Treasury Secretary Janet Yellen told CNBC last December that it would make sense for the Fed to consider lowering interest rates.
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Not to be outdone, President Biden himself has weighed in on monetary policy several times in recent months, telling an audience in Philadelphia earlier this year: “I can’t guarantee it. But I bet – you can bet – these interest rates are going to go down more because I’m betting that this little company that sets the interest rates is going to go down.
At the Federal Open Market Committee (FOMC) press conference in December, Powell shifted to a much more dovish stance, suggesting that despite the symmetrical language of the FOMC statement, the Fed was more focused on when to cut rates than when to cut them should increase despite the Fed’s own forecasts that inflation would exceed the 2% target over the next two years.
Powell’s dovish policy shift in December triggered a dramatic easing of financial conditions and set the stage for the rise in inflation we are now seeing. In fact, over the next three months, the S&P 500 rose 11% and high-yield bond spreads fell by more than 70 basis points.
The resulting wealth effects will now ensure that the pace of consumption growth remains inconsistent with a return to 2% inflation. Since December, core PCE inflation has risen back to 3.7%, and core CPI (consumer price index) has risen even more, with an annual increase of 4.5% over the past three months.
If Powell had just refrained from announcing rate cuts in December and stuck to the “higher for longer” principle, the economy could have slowed enough to allow for actual rate cuts in the coming months. No doubt the Fed will still be under enormous political pressure to do this ahead of the November election, but rate cuts are likely off the table indefinitely given high inflation.
Powell’s lack of self-discipline has consequences for distribution. While the top 20% of households have seen a huge boost in their asset portfolios as a result of Powell’s dovish turn, the bottom 50% are struggling.
With few assets and relatively higher floating rate debt, they will end up paying the cost of “higher and even longer” interest rates. According to the Federal Reserve Bank of Philadelphia, 3.5% of credit card balances are more than 30 days past due, the highest since the survey began in 2012.
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If the FOMC were serious about inflation targeting, it would reverse Powell’s December move and abandon the easing bias entirely, signaling that the next step could well be a rate hike. Powell was given plenty of opportunity to do so at his recent press conference following the FOMC meeting in May. For the time being, he remains hesitant to give up on the easing tendency. But it can only last so long if inflation continues to run so far above the Fed’s target and own forecasts.
If only he hadn’t eaten the marshmallow.
Scott Bessent is Chief Executive Officer and Chief Investment Officer of Key Square Group LP, a Connecticut-based investment partnership he founded in 2015.
Original source of the article: Fed Chairman Powell thinks interest rate cuts are too easy