Powell Warns of Two-Sided Risk
Powell, in his Semiannual Monetary Policy Report to the Congress, warned about the two-sided risk facing monetary policy. “We know that reducing policy restraint too soon or too much could stall or even reverse the progress we have seen on inflation. At the same time, in light of the progress made both in lowering inflation and in cooling the labor market over the past two years, elevated inflation is not the only risk we face. Reducing policy restraint too late or too little could unduly weaken economic activity and employment.” This means the Fed's first cut could come in reaction to 1) more evidence that inflation is sustainably falling towards the 2% target, or 2) the spike in the unemployment rate and a recession. Until recently, we were facing only one-sided risk - elevated and sticky inflation well above the Fed's 2% target. With each inflation report that showed a continued disinflation, or the fall in annual inflation rate, the market was cheering the prospects of a soft-landing, or even a no landing. A soft-landing scenario assumed that the inflation would fall enough for the Fed to start lowering interest rates - before the labor market weakens and before the recession hits. The soft-landing crowd was looking at the unemployment rate to stay at 4% or below - this is in fact what the Fed predicted in the Summary of the Economic Projections. This scenario supported the bull market from October 2022 to current. Unfortunately, the labor market has already weakened past the 4% unemployment rate, with the recent reading of 4.1% for June. More importantly, the leading indicators are pointing to a continued weakening of the labor market. We are facing the risk of a recession and the risk of elevated inflation at the same time - that's the two-sided risk. When describing the labor market, Powell stated: “The unemployment rate has moved higher but was still at a low level of 4.1 percent in June.” The clear implication is that the Fed is still willing to tolerate the unemployment rate at 4.1%, and will not cut pre-emptively until the unemployment rate spikes even higher. That's a problem because based on the Sahm rule, the recession is usually triggered when the unemployment rate increases by 0.5% above the cyclical low point (3.5% during the recent cycle). The current Sahm Indicator is at 0.43% based on three-month averages, so another month at 4.1 or higher will officially trigger the recession warning. Here is some data from the household survey (which reports the unemployment rate): The number of unemployed people increased by 814K over the last 12 months. The number of people who work full-time has decreased by 1.5M over the last 12 months. Both numbers are consistent with a recession. Yet, these numbers are not sufficiently weak to bring inflation down to the 2% target. And keep in mind: the S&P 500 (SP500) is facing possible recession amidst bubble-like valuations: PE ratio over 24, Shiller PE ratio over 36, and the Buffett indicator at the highest level in history.
