MNI POLICY: Fed Embraces Pause As Downside Labor Risks Abate

Federal Reserve officials appear to be settling in for what could be a longer pause in interest rate cuts after a stronger-than-expected January employment report reinforced the view that labor market risks which underpinned last year's rate reductions have receded. 

As officials wait for the effects of those cuts to play out in an economy whose prospects for this year already look fairly strong, they have increasingly coalesced around the notion that policy is well-positioned, with some officials guiding that rates could remain on hold for some time.

That means the onus is now on the data to convince policymakers, almost all of whom believe rates are close to neutral levels, to cut further. Even the minority who believe policy is still restrictive now find themselves on the back foot, and recognize that additional data showing either further improvement in inflation or additional deterioration in the labor market would be required to make the case for cuts.

In an indication of the hawkish shift, minutes to the January meeting showed several FOMC members would have supported a move to a neutral stance and a policy statement highlighting that rate hikes are as likely an option as cuts if inflation stays above target. 

It's not that the FOMC has become pollyannish about job market conditions. Even those who see things as stable acknowledge that the concentration of hiring in healthcare and downward revisions to last year's job growth present vulnerabilities. It's just that the reversal of the jobless rate from 4.6% down to 4.3% within three months seems to have removed the immediate threat of an employment downturn. 

Fed officials will be eager to see if January's strong hiring performance is repeated in the BLS's March 5 labor report, and how the recent weak job openings numbers will reconcile with hiring. There is also concern about a lack of churn and month-to-month volatility around the jobs reports, including potential revisions.

CHANGE OF GUARD 

The Fed's hawkish reversal following last year's 75 basis points in cuts suggests Jerome Powell might have already delivered his last reduction in rates as Fed chair. His term is set to end in May with President Donald Trump's nominee Kevin Warsh presumably to take over in June, though the timeline may be delayed by a pending Department of Justice investigation into Powell, which the chair has called a pretext for pushing for lower rates. 

Trump and other administration officials continue to call for lower rates, citing interest costs on the debt. That could put the central bank on yet another collision course with the president and complicate Warsh's task in garnering consensus within the institution. (See MNI POLICY: Warsh Could Reshape Fed On Rates, Communication) 

Since the January FOMC meeting, several Fed policymakers have maintained that an overall stable economy provides them room to be patient in considering additional rate adjustments. Some Fed officials have noted a higher bar for rates cuts, given the three rate cuts last year amid above-target inflation.

Warsh has signaled a preference for lower rates in the current environment but the stars might have to align for him on the data front, in order for him to be able to make a convincing case to his new colleagues. 

Federal Reserve Vice Chair Philip Jefferson has said the current policy stance should help stabilize the labor market, while allowing inflation to resume its decline toward the 2% target. Governor Lisa Cook, whom Trump is attempting to fire, emphasizes the need to see "stronger evidence that inflation is moving sustainably back down to target" after nearly five years of above-target price growth.

Officials were pleasantly surprised by a CPI report last week showing overall inflation fell to 2.4% in January from 2.7% the month before, but the Fed's preferred headline and core PCE price index rose 0.4% in December, the Commerce Department's Bureau of Economic Analysis said Friday.

Consumer inflation expectations have come down in recent months and measures of firms' year-ahead prices are below both 2% and their pre-pandemic averages. The Atlanta Fed's business inflation expectations index fell to 1.9% from 2.0% in January.

The Dallas Fed's Trimmed-mean PCE inflation measure has been 2.5% for two months through November, while the Cleveland Fed’s median PCE inflation reading hit 2.9% in November, the first time below 3% in over four years. Further sustained improvement in these measures could help Warsh make a credible case to resume cuts when he takes the helm.