Powell opens the door to cuts

Jerome Powell used his annual speech at the Jackson Hole Economic Symposium to signal that the Federal Reserve is preparing to cut interest rates. With the labour market cooling, the Fed chairman said plainly that the downside risks to employment now outweigh the upside risks to inflation.

The Fed has come a long way since spring. Its benchmark rate has sat at 4.25 to 4.5 per cent since December, and at the July meeting two governors, Christopher Waller and Michelle Bowman, dissented in favour of a cut. Two days later the July employment report showed only 73,000 jobs added and removed a combined 258,000 from the two previous months.

Jobs come first again

The speech ends a period in which the Fed was preoccupied with inflation above all else. Payroll growth has slowed sharply and revisions have wiped out hundreds of thousands of jobs, so the two halves of the dual mandate are back in balance. Powell accepted that tariffs still pose a risk to prices. But he argued that policy cannot stay too tight while demand for workers is weakening.

His reasoning rested on how tariffs work. A duty raises the price of the goods it hits once; it becomes persistent inflation only if workers win higher wages to compensate or if expectations of future inflation drift up. With hiring slow and unemployment at 4.2 per cent, Powell judged a wage-price spiral unlikely, and treated a one-off shift in the price level as the reasonable base case.

A simple benchmark supports the shift. Fed officials' median estimate of the longer-run neutral rate, the level that neither stimulates nor restrains the economy, is 3 per cent. A policy rate of 4.25 to 4.5 per cent is therefore well above neutral, and Powell described policy as restrictive. When unemployment is drifting up and the main inflation risk comes from a one-off tax on imports, a restrictive setting is harder to defend than it was a year ago, and a move towards neutral no longer looks like a gamble on inflation.

Powell also described an unusual feature of the jobs market. The supply of workers has slowed along with demand, largely because immigration has fallen sharply, so a slowdown in hiring has not yet produced a big rise in unemployment. That balance is fragile. If demand keeps weakening while supply is already constrained, layoffs could rise quickly, and the unemployment rate would move faster than the gentle drift of recent months suggests. Waiting for clear evidence of that would mean cutting after the damage is done.

Framework review ends

The speech also set out the result of the Fed's five-yearly review of its strategy. The committee dropped the flexible average inflation targeting adopted in 2020, under which it had promised to let inflation run above 2 per cent for a time to make up for earlier shortfalls. That approach was built for a world of too-low inflation and was overtaken by the surge of 2021 and 2022. Removing it tells markets that the Fed will not deliberately tolerate overshoots, which makes cuts easier to square with inflation still above target.

Short yields fall

Interest-rate futures quickly priced in a cut in September. Short-dated Treasury yields fell sharply, and the curve steepened as a result. The Dow Jones Industrial Average closed at a record, and small companies, which lean more heavily on floating-rate borrowing, outperformed the large ones.

The closest precedent is 2019, when Powell cut rates three times as the trade war with China dented business investment, and the economy avoided recession. A year ago, at the same symposium, he signalled the start of the current easing cycle, and the Fed cut by half a point the following month. On both occasions the signal was followed through.

Who gains from cheaper money

The distribution of gains follows the structure of debt. Small firms on floating-rate bank loans, buyers of cars and homes on credit, and highly indebted companies facing refinancing benefit first, which is why small caps outperformed. Banks gain from a steeper curve, which widens the spread between what they pay on deposits and what they earn on loans. Savers who moved into money-market funds, whose assets have grown to record levels, lose some income. The dollar weakened after the speech, which helps American exporters and emerging-market borrowers with dollar debts.

Inflation has not gone away

The strongest objection is that inflation has not finished its work. Consumer prices rose 2.7 per cent in the year to July and core prices 3.1 per cent, both above target, and tariff costs are still feeding into goods prices. Easing into rising goods inflation risks repeating the error of the 1970s, when the Fed loosened before inflation was beaten. The labour market offers Powell his defence: a jobs market this soft is unlikely to generate the wage pressure that made that decade so costly.

The political backdrop complicates the signal. President Donald Trump has demanded much deeper cuts and nominated Stephen Miran, one of his economic advisers, to the board seat vacated by Adriana Kugler, while Powell's term as chairman ends in May next year. This week he also called on governor Lisa Cook to resign over allegations about her mortgages. Framing the case entirely around employment data gives the Fed some protection against the charge that it bent to pressure.

The August employment report and consumer price figures, both due before the committee meets on 16 and 17 September, can still change the call; a strong jobs number combined with hot core inflation would make a cut harder to justify. Powell has all but promised a cut in September, and he has made clear that for now the Fed will worry more about lost jobs than about a round of tariff-driven price rises that it regards as largely theoretical.