Background
The market is eagerly anticipating the speech from Federal Reserve Chair Jerome Powell at the Jackson Hole Symposium. We are halfway through the summer and a month from the next meeting of the Federal Open Market Committee (FOMC). Expectations are high that the committee will agree with the futures market, change direction, and begin an easing cycle. Canada has already changed course and is two cuts ahead of the Fed, and 97% certain of a third cut on September 4th. What is the destination for monetary policy?
If fiscal policy is a tool for politicians who see approval from the electorate, then monetary policy is a tool that is designed to guide economic growth to its maximum capability without triggering an acceleration of inflationary pressure. While it may not be ideally suited for the job on every occasion, monetary policy is the tool of central bankers to execute their mandate. I think about it like riding a horse (which I have done with mixed results).
Are the FOMC’s Reins Too Tight?
The economy moves with momentum and needs some guidance to shift gears or change direction. Accelerating is way more fun than slowing down, but both are required to sustain your journey. The FOMC is getting ready to ease off its grip on the reins to restrict the speed of economic growth. In 2022, the excess fiscal stimulus that was injected into the economy during COVID (and beyond) caused inflation to jump ahead of the FOMC’s acceptable range. Inflation needed to be reined into a sustainable level. Those reins remain very tight.
Inflation is the key input that many FOMC members have referenced as the impediment to cutting rates and it has moved back into the range of 2-3%. If the Fed wants inflation anchored at 2%, the data might suggest it’s close at hand. This sets the table for rate cuts. But cut to what level and over what time period? The reins are a means to communicate with a horse. If you drop off too quickly, it may be perceived as a signal to accelerate. However, easing up on the reins while maintaining a firm connection can lead to a smoother, sustainable journey.
What is the FOMC telling us?
The Fed dot plot tells us that the longer run level for Fed Funds is 2.5-3.5%; or, a solid 2% lower than the level today. The futures market suggests that the target rate will get to the middle of that range over the next 18 months. This implies that an appropriate level of real Fed Funds is 50-150 basis points over their 2% target for inflation. Canada would be similar but perhaps a notch lower due to weaker productivity levels that feed into potential growth.
The Context Matters
The last 16 years, post-GFC, have been a challenge for monetary policy. The FOMC required both quantitative easing and quantitative tightening. Meanwhile, COVID helped to re-ignite inflation. I think it is reasonable to expect lower interest rates, but I believe patience will prevail and it will take some extra time to reach the longer-run target.
The latest Canadian story is a little different. Inflation has dropped to 1.7% for the BOC Core rate, while the unemployment rate remains elevated at 6.4%. More cuts and a weaker currency seem likely at this point. The resilience of the US economy may provide the support needed for the Canadian economy to avoid recession, but lower rates and a weaker currency could help. I suspect the divergence of interest rate differentials will put some pressure on the Canadian Dollar. In turn, this could cause a breakout from its recent range against the US Dollar and cause it to weaken to levels that support economic growth.
Saddle up.
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