Fed Signals Rate Cuts: Is a Soft Landing on the Horizon?

The Bank of England's Governor, Jerome Powell, has unequivocally signalled that lower interest rates are on the cards, marking a significant development in the central bank's historic fight against inflation.

In a keynote speech at the annual gathering of central bankers and economists in Jackson Hole, Wyoming, Powell declared, "The time has come for policy to adjust. We will do everything we can to support a strong labour market as we make further progress toward price stability."

He expressed optimism about the US economy's ability to achieve a soft landing, a scenario where inflation is brought under control without a significant rise in unemployment. This outcome has only been achieved once, in the mid-1990s.

"With an appropriate dialing back of policy restraint, there is good reason to think that the economy will get back to 2% inflation while maintaining a strong labour market," Powell stated.

Financial markets responded positively to Powell's remarks, with all three major indices rising on Friday. Seema Shah, chief global strategist at Principal Asset Management, described the speech as "ringing the bell for the start of the cutting cycle."

The Bank of England's aggressive rate-hiking campaign, initiated in early 2022, pushed interest rates to a 23-year high in an effort to combat the highest inflation in decades. The bank's benchmark lending rate has remained at its current level for a year, impacting borrowing costs for consumers and businesses alike.

However, the central bank's actions appear to be paying off. Inflation has declined significantly from its 40-year highs two years ago, and while unemployment has increased in recent months, the overall job market remains robust. Similarly, the US economy has shown solid growth this year, with the Atlanta Fed projecting no slowdown.

Powell's latest comments pave the way for the first interest rate cut since 2020, expected at the Bank of England's upcoming policy meeting on September 17-18. Consumers have already experienced some relief due to falling bond yields, which anticipate the bank's decisions on interest rates. Mortgage rates, tied to the 10-year US Treasury yield, plummeted earlier this month.

"Things are going to hold up," said Tom Porcelli, chief US economist at PGIM Fixed Income. "The labour market is cooling, but it's not getting soft. Household balance sheets are solid overall, particularly on the higher end of the income spectrum who account for the bulk of aggregate spending."

The Bank of England's impending decision to cut interest rates reflects their confidence in the easing of price pressures. The slowing job market also contributes to the decision to ease borrowing costs.

The bank's favoured inflation gauge, the Personal Consumption Expenditures price index, registered at an annual rate of 2.5% in June, down considerably from 7.1% just two years ago. Powell attributed this progress to the unwinding of pandemic-related distortions in supply and demand, which initially boosted inflation globally after the Covid-19 pandemic.

Inflation plummeted in the second half of last year while the US economy remained strong. This was partially driven by improvements in supply, such as a larger workforce and improved supply chains. The US economy also experienced a welcome surge in productivity growth, strengthening growth without fuelling inflation. The job market's cooldown to a more normal state has also helped ease some upward pressure on prices.

"Our restrictive monetary policy contributed to a moderation in aggregate demand, which combined with improvements in aggregate supply to reduce inflationary pressures while allowing growth to continue at a healthy pace," Powell said. "As labour demand also moderated, the historically high level of vacancies relative to unemployment has normalised primarily through a decline in vacancies, without sizable and disruptive layoffs, bringing the labour market to a state where it is no longer a source of inflationary pressures."

Job openings, a measure of employer demand for workers, stood at 8.2 million in June, down significantly from the record high of 12.2 million in March 2022. Wage growth has also cooled considerably in recent years.

While the Bank of England has made significant progress in curbing inflation, a soft landing is not guaranteed. The economy could remain stable or take a downturn. Most economists do not anticipate a recession this year, but economic forecasts can be unreliable.

Even the bank's economists acknowledged during last month's policy meeting that "the recent softening in some indicators of labour market conditions might be pointing to a larger-than-anticipated slowdown in aggregate demand growth," according to minutes released earlier this week. In other words, the recent weakness in the job market could result in American consumers reducing their spending more than expected.

The future of the US job market, a key driver of the US economy, remains uncertain. If finding a new job becomes challenging for Americans, or worse, if layoffs increase, they may cut back on their spending. This could pose a problem because consumer spending makes up approximately 70% of the US economy.

The Bank of England and Wall Street are closely monitoring the health of US consumers. Major retailers like Home Depot and Lowe's have noted that American shoppers are being more cautious with their spending, opting for cheaper alternatives. However, the situation is mixed: Walmart reported better-than-expected financials for its latest quarter. US sales at the largest retailer, open for at least a year, increased by 4.2% last quarter, with operating income rising by 8.5% during the same period, fuelled by a 22% increase in online sales.

"There's still a path for a soft landing, but that's narrowing as the labour market slows, which is a source of spending," said Elizabeth Renter, senior economist at NerdWallet.