Powell’s Insight Highlights Importance of Flexibility

Federal Reserve (Fed) Chair Jay Powell offered interesting insight on the U.S. economy and monetary policy last week.

In testimony to Congress, Powell said he was more concerned about low inflation than high inflation, a view that echoes market sentiment but runs counter to the Fed’s recent view that the U.S. economy is more prone to overheating. As shown in or LPL Chart of the Day (and examined in this week’s Bond Market Perspectives), the 1-year breakeven inflation rate has dropped to its lowest level of 2018, while longer-term breakeven rates have remained relatively unchanged this year. Breakeven rates are the difference between the yields of nominal Treasuries and yields of Treasury Inflation Protected Securities (TIPS), and they imply market expectations for inflation rates over a period of time.

“While the U.S. economy is solidly improving, wage and price inflation are running far below their expected paces,” said LPL Research Chief Investment Strategist John Lynch. “The Fed must reconcile the future course of tightening with tepid inflation.”

Fed funds futures markets are pricing in a 66% chance of at least two more rate hikes this year, and that probability has remained steady since Powell’s testimony. However, less inflation pressure would prompt the Fed to hike less (all else being equal).

Powell also said the Fed “believes that—for now—the best way forward is to keep gradually raising the federal funds rate.” Investors saw “for now” as critical, especially amid rising trade tensions. If data start to deteriorate due to tariffs or an all-out trade war, the Fed can (and likely will) adopt a slower path of rate hikes, put them on hold entirely, or even become more accommodative.

Other components of Powell’s testimony echoed the Fed’s long-standing views. Broadly, Powell indicated that the Fed remains on course to gradually raise interest rates and that the economy is strong and growing at a solid pace. While Powell’s views were largely status quo, his comments on inflation and trade tensions demonstrated the Fed’s willingness to be flexible with future tightening.

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