Economy

Powell May Detail Carpet for New Era of Higher Rates Later This Week

By Yasin Ebrahim

President Jerome Powell is poised to provide new insights on monetary policy later this week. While many do not anticipate the Fed chair’s comments to echo last year’s caution about potential economic "pain," there are concerns that he may suggest the possibility of higher long-term interest rates.

Goldman Sachs notes that while Chair Powell’s delivery may lack the same ominous tone as last year, the overarching message will still emphasize the importance of "seeing the job through." For the Federal Reserve, this likely translates to an economy experiencing below-trend growth and a noticeable, sustainable decline in inflation.

However, accomplishing the goal of controlling inflation may necessitate an adjustment in the Fed’s long-term or neutral interest rate—defined as the rate that neither stimulates nor restrains economic growth. This could signal a steeper trajectory for rates moving forward.

Morgan Stanley points out that any change in perspective regarding the neutral rate deserves careful consideration, as it would alter expectations for the policy rate and affect the broader yield curve.

Bond Markets Respond to Anticipation of Higher Neutral Rates

In anticipation of Powell’s remarks, the bond market is not waiting idly; it appears to be bracing for a more hawkish monetary policy, characterized by sustained higher rates, as the likelihood of early-year rate cuts diminishes.

On Monday, the bond yield reached its highest point since 2007, driven by anxiety that Powell might set the stage for a higher neutral rate.

In June, policymakers projected a median neutral interest rate of 2.5%, suggesting a real interest rate—often referred to as r or "r-star"—of 0.5% after accounting for the Fed’s 2% inflation target. Morgan Stanley elaborated that if the policy rate exceeds r, it exerts a cooling effect on the economy; conversely, if it falls below r*, it stimulates economic activity.

This real neutral rate has remained unchanged since 2019. Given the resilience of the economy after Covid, which appears less sensitive to interest rates, there are calls for a higher neutral rate to steer policy into a restrictive zone that could help temper growth and inflation.

"The household sector is in great shape with substantial excess savings and a favorable employment backdrop, making the economy less sensitive to interest rates, especially as it hasn’t been borrowing heavily for investment," noted Phillip Colmar, a global strategist at MRB Partners.

"This is not a credit-driven cycle, so a higher cost of capital is necessary to restrain the economy," he added.

Powell Expected to Caution Rate Cut Advocates While Acknowledging Progress on Inflation

Recent data, including a robust inflation report for July showcasing consumer resilience, suggest limited grounds for Powell to adopt a more dovish stance at the upcoming symposium, according to MUFG.

Though the number of advocates for immediate rate cuts—referred to as "pivoteers"—is diminishing, Powell will likely underscore positive developments when he speaks on Friday morning.

In contrast to last year, when the Fed chair warned that rising interest rates would lead to consumer "pain," Goldman Sachs asserts that the current environment appears significantly more reassuring, making a "soft landing" seem more feasible than at any point over the past year.

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