Jay Powell is pivoting into an inflation problem

Hello, I’m Andrew Whiffin, stand-in for Chris Giles today. We work together on Monetary Policy Radar, where we try to figure out what central bankers are thinking and the path they will dictate for interest rates.

With the Federal Reserve’s September decision capturing the market’s attention, I will offer a few thoughts on why if the central bank cuts as expected, it is unlikely to charge into another period of rapid easing. Then I look at recent data that might be a sign of the more structural upward pressure on US prices.

But first up is Fed voting member Lisa Cook, who is reportedly being fired by US President Donald Trump following allegations of mortgage fraud. Cook has refused to step down and a legal battle over the “for cause” framework that Trump cited in her termination letter is shaping up. Cook said: “President Trump purported to fire me ‘for cause’ when no cause exists under the law, and he has no authority to do so”.

This raises the possibility of another Trump pick joining Stephen Miran on the Fed’s board. It could also threaten a potential constitutional clash if the president’s dovish appointees ever find themselves outvoted by “inferior officers”, the hawkish heads of the regional Fed banks who have not been signed off by the Senate and Trump.

If you want to know what will happen next, read this MPR explainer.

Powell pivots into rising inflation

Speaking at Jackson Hole Symposium, Fed chair Jay Powell hinted again that the Fed would cut interest rates in September, stating that “the baseline outlook and the shifting balance of risks may warrant adjusting our policy stance”.

Powell already indicated at July’s rate meeting that higher unemployment was a prerequisite for a cut. July’s employment report later delivered as much, along with big downward revisions to jobs growth in the summer.

In our capacity as rate forecasters, we now expect the Fed to cut in September. But we do still expect inflation worries to temper appetites for rapid easing. Tariff-related inflation is one thing, which Chris has covered in detail here; inflation from immigration policies deserves some attention, too.

Powell’s speech was otherwise quite hawkish. It included the following near the top: “Changes in trade and immigration policies are affecting both demand and supply. In this environment, distinguishing cyclical developments from trend, or structural, developments is difficult.”

Tariffs might prove to be transitory, as per the Fed’s base case. Other unknowns are changes in the jobs market and the impact of immigration policies on labour supply. One question is: how much of the downgrade to jobs growth this summer was a function of supply and not demand?

The US foreign-born labour force has fallen by about 900,000 people since April. The participation rate is down too, presumably over fears of government enforcement.

This could be exactly the kind of structural change to the economy the Fed is worried about, and one which lower rates could make worse. Back in February, Goldman Sachs identified agriculture and construction as two sectors most at risk from lower immigration. This might already be showing up in the latest data.

Upon publishing July’s producer price data, a measure of wholesale prices, the Bureau of Labor Statistics said: “Forty per cent of the broad-based increase [in prices for final demand goods] in July can be attributed to the index for final demand food.”

One-quarter of the increase was down to fresh and dry vegetables, which rose by 39 per cent from June. This measure is very volatile, but it was still the biggest increase since early 2022.

The producer price index for final demand food tracks prices of goods at the factory gate. It rose by 4.2 per cent year on year in July. Consumer price inflation for food has also risen this year and was 2.9 per cent in July. The chart below shows CPI for food against factory-gate food inflation. They correlate most strongly with a five-month lead.

Higher import costs for fruit and vegetables thanks to tariffs are another possible explanation, albeit an indirect one in the PPI measure. But given reliance on foreign workers in the food manufacturing sector, rising labour costs are likely.

Food inflation, recently described as “salient” by the Bank of England, needs special attention from central bankers. Not only does food have an outsized impact on inflation expectations, the Fed has said food inflation has the best predictive value for headline CPI.

US food prices have already been facing the same broad-based cost pressures pushing up consumer prices across the world. A labour crunch would compound them, and is another reason why we think the Fed will proceed cautiously when it starts easing again.

A September fall

Goings-on in the depths of US money markets risk stealing the limelight from September’s rate decision.

September 15, two days before the Fed meeting, could be a crunch point. That day is special because quarterly tax payments and bill coupon settlements could drain $200bn of central bank reserves in a single day, and push reserves below $3tn for the first time since 2020. 

“In a sense we will be heading into uncharted territory in September since reserves will fall to levels not seen this cycle on a sustained basis,” says Samuel Earl, vice-president at Barclays.

A quick reminder that reserves are the most liquid for central bank money. And in the past when they have become “scarce”, things in the US financial system have started to break.

US government funding is at the core of the issue as the administration rebuilds the Treasury General Account, the government’s current account. The TGA receives funds either when the government sells a bond or bill, or when taxes are paid. Money leaves when the government has to pay bills, such as wages or debt repayments. 

Having run down the account this year because of limits imposed by the debt ceiling, the Treasury is now topping it back up to about $900bn (which the “big, beautiful bill” and the debt ceiling extension made possible). But this also acts as a drain on the fixed levels of broader central bank reserves.

The question is whether this takes us into the realm of “scarce” or whether reserves remain “ample”, the level the Fed is aiming for. This contrasts with “abundant”, the artificially high level of reserves in place during quantitative easing eras.

The problem is that no one really knows when reserves move from ample to scarce, and in the past we have only found out when something has gone wrong.

We appear to still be some way off. But we know the Fed is concerned because of the slowdown in quantitative tightening earlier this year.

Today reserves are around the $3.3tn mark, down from about $3.6tn at the beginning of 2024. Barclays’ Earl, who prefers to think of reserves as a proportion of bank assets, predicts they will move to around $2.9tn by the end of September, or “above the 11 per cent level we think is the sweet spot of reserves under the Fed’s ample reserves framework”.

What I’ve been reading and watching

A chart that matters

Could the Fed surprise us by holding rates in September? It’s possible, but highly unlikely. The central bank rarely goes against the consensus. And when it has in recent years, the surprise has been one of magnitude rather than direction.

The chart below is from academics working at the San Francisco Fed who measure the so-called “information surprise”, which is a function of what interest rate futures do in the half-hour after the Fed puts out its rate decision statement.

It tells us that in the past hawkish information surprises have generally meant good news for the economy, signalling stronger growth and inflation.

With the Fed likely to start cutting again in the face of rising inflation, a return of hawkish surprises seems likeliest to me. This time, though, that might not mean the economy will do better.

Central Banks is edited by Harvey Nriapia