In light of the recent signs of a cooling labor market and expectations for the first interest rate cut as early as July, it seems that Federal Reserve Chair Jerome Powell’s eagerness to claim credit for achieving an economic soft landing has instead led to a much harder scenario. Powell’s prediction that the next move in interest rates is likely to be down rather than up perpetuates this error, and a little more restraint in previous months would have benefited both Powell and the economy significantly.
The Marshmallow Test, a psychological experiment designed to assess delayed gratification in children, provides an apt analogy for Powell’s situation. Following a near 20% increase in price levels from early 2021 and the fastest Fed hiking cycle in the past 40 years, Powell seemed to have successfully brought inflation under control. By Q3 2023, Core Personal Consumption Expenditures (PCE) inflation had decreased to a 2% annualized rate, and financial conditions had tightened considerably. Achieving a soft landing and reaching the 2% inflation target appeared achievable, requiring only that Powell avoid consuming the proverbial rate cut marshmallow and maintain financial conditions’ strictness for a few additional quarters. Unfortunately, Powell consumed the marshmallow.
The pressure to loosen monetary policy mounted from former Fed Chair and current US Treasury Secretary Janet Yellen, who advised considering lowering interest rates in December. President Joe Biden also weighed into monetary policy several times in recent months, urging the Fed to consider rate cuts. Powell responded to this intense political pressure by taking a notably more dovish stance during the December FOMC press conference, implying that the Fed was more concerned about timing rate cuts than increasing them despite the symmetrical language in the FOMC statement and the Fed’s own projections predicting that inflation would surpass the 2% benchmark for the next two years.
Powell’s dovish December shift sparked a significant relaxation of financial conditions, setting the stage for the current inflation surge. Indeed, the S&P 500 gained 11% over the following three months, and high-yield credit spreads dropped by more than 70 basis points. The ensuing wealth effects will continue to drive consumption development inconsistent with a return to 2% inflation. Since December, Core PCE inflation has risen to 3.7%, while Core CPI has climbed even more strongly, up 4.5% annually in the last three months.
If only Powell had maintained his resolve and avoided signaling rate cuts in December, the economy might have slowed enough to enable genuine rate cuts in the coming months. Although the Fed will undoubtedly encounter considerable political pressure to act before the November elections, rate cuts appear unlikely due to the current high inflation.
Powell’s lack of self-restraint has far-reaching ramifications. While the top 20% of households enjoy substantial gains in asset portfolios owing to Powell’s dovish turn, the bottom 50% is struggling. Given that they possess few assets but relatively higher floating-rate debts, they will ultimately bear the costs of “higher for even longer.” According to the Federal Reserve Bank of Philadelphia, credit card delinquencies currently stand at 3.5%, the highest level recorded since the study started in 2012.
The FOMC should reverse Powell’s December pivot and eliminate the easing inclination entirely, signalling that the next step could potentially be a rise. During his recent press conference after the May FOMC meeting, Powell was given ample opportunity to do so. However, for now, he continues to cling to the easing predisposition. Nevertheless, he can only remain steadfast for so long if inflation persists at such elevated levels above the target and the Fed’s own projections.
Scott Bessent, CEO and CIO of Key Square Group LP, a Connecticut-based investment partnership he established in 2015, authored the original article.
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