We find it difficult to reconcile Chair Powell’s recent remarks with both the signals from our models and the market’s reaction. In our view, there is a growing disconnect among these elements, and something will need to adjust going forward. Below, we outline the reasons behind this assessment.
Dovish
Powell’s Jackson Hole Speech: A Dovish Surprise
Chair Powell’s speech at Jackson Hole was notably more dovish than we had anticipated, and more accommodative than what would be implied by model-based analysis. At no point during this tightening cycle have we observed such a pronounced disconnect between the models, the Fed’s communications, our own reasoning, and market pricing. Below, we outline the key points behind this tension:
Powell stated that “the baseline outlook and the shifting balance of risks may warrant adjusting our policy stance.” We interpret this as a strong signal that a rate cut in September is effectively a foregone conclusion or at least that the bar for not cutting is very high.
Moreover, his remarks appear to open the door to a series of rate cuts, potentially continuing until the federal funds rate reaches a neutral level. In particular, his comment that “when our goals are in tension like this, our framework calls for us to balance both sides of our dual mandate” suggests to us the possibility of at least three cuts (September, October, and December) but possibly up to 6 consecutive cuts.
That said, we continue to question whether such easing would be justified in a scenario where the unemployment rate ultimately prints at 4.2% and core CPI remains elevated at 0.3%-0.4% month-over-month.
- The current FRB-US baseline incorporates only a single rate cut in 2025 (see reference here), with inflation remaining persistently elevated. Alternative Taylor rule specifications also imply limited policy easing this year. As such, it is difficult to reconcile Chair Powell’s stance with the guidance provided by inertial Taylor rules—or, more broadly, with the outputs of any of our models. For the record, these models do not incorporate political considerations or pressures.
- FRB-US model simulations (see reference here) indicate that a 100 basis point rate cut is feasible under a non-inertial Taylor rule. However, achieving such an outcome would require the economy to enter a recession.
- Chair Powell appears to view the recent rise in inflation as transitory, stating that “a reasonable base case is that the effects will be relatively short-lived—a one-time shift in the price level.” This assessment seems to rely heavily on the staff forecast and on a specific underlying assumption which, in our view, may rest on rather uncertain footing (see below for further details).
- As we review in more detail below, the updated strategy appears somewhat more hawkish on the inflation front. This stance is difficult to reconcile with Chair Powell’s recent remarks—unless he anticipates a recession or a “perfect landing” of the economy (while we are still taking off on the inflation front..). This tension is particularly evident in his reference to “balancing both sides of our dual mandate” while simultaneously signaling the possibility of imminent rate cuts. We find it challenging to align this rhetoric with the policy implications suggested by the new strategy.
Putting It All Together. In our view, the overall picture is difficult to reconcile. Based on our estimates, if the models are correct, then Chair Powell’s assessment is overly optimistic and inflation is likely to remain sticky. Conversely, if Powell is correct in anticipating a sustained disinflationary trend, then the underlying economic conditions are likely weaker than current equity market pricing suggests.
Why Powell is so relaxed about inflation? And what can go wrong?
The Fed staff made a strong assumption. While Powell was talking, a very important paper was published: “Retrospective on the Federal Reserve Board Staff’s Inflation Forecast Errors since 2019“. This paper is very important because it is written by Katia Peneva (Chief of the inflation section), Jeremy Rudd (Senior Adviser, very influential), and Daniel Villar (Principal Economist on the inflation desk).
Why Is This Paper Important? At first glance, the paper does not introduce fundamentally new concepts, as the staff framework it describes is already well known. However, one key detail stands out. On page 15, the authors note: “At the end of 2023, staff members moved back to assuming a constant rate of ULI, but at a higher level than their pre-pandemic assumption.” In other words, the staff is now assuming that underlying inflation (pi*) is constant at 2%.
Why is the pi* assumption so crucial? The assumption of a constant underlying inflation rate (pi*) is critical because it mechanically drives the model to converge inflation back to target—often relatively quickly. Without delving into technical details, this assumption was a key factor behind the staff’s misjudgments in 2021, which led them to adopt a time-varying pi* framework for a period thereafter.
In essence, this is precisely where risks can emerge again: by reintroducing a constant pi*, the staff and Powell may once more underestimate the persistence of the inflationary process.
Revised strategy
Back to pre-2020, more hawkish than AIT. Relative to pre-2020, the 2025 framework is roughly similar overall, but with two offsetting tweaks: (i) tougher on inflation expectations (hawkish), (ii) more patient about “too-low” unemployment (dovish). Net, it’s a near-return to classic flexible IT, not clearly more hawkish or dovish than pre-2020 in the round—but decidedly more hawkish than 2020 AIT because there’s no makeup/overshoot tolerance.
Table 1. Comparison of key features across Fed strategies.
Conclusion
Who is right? As noted above, there appears to be a significant disconnect between the signals from the models, Chair Powell’s stance, the assumptions underpinning the Fed staff’s forecasts, and market pricing—particularly at the long end of the yield curve. In our view, current expectations seem to reflect a scenario approaching “perfection.” If we were to make a judgmental call, we would lean toward the view that inflation is likely to prove more persistent—and ultimately higher—than currently anticipated.