Reputation is a big deal to the Fed – It just got blown away

Outlook

This week we get Germany IFO today, US durables and consumer confidence tomorrow (plus the Atlanta Fed GDPNow), Nvidia earnings on Wednesday, Tokyo CPI on Thursday, and US core CPI and German CPI on Friday. We can’t remember ever before naming an equity name earnings report as an FX market-moving factor.

The abrupt switch by the Fed to a dovish stance from what the majority of economists (and FOMC voting members) expected is a game-changer. Because it’s not normal and reasonable, we wonder whether the initial effect—sell dollars, buy equities—has any lasting meaning. When we get a Shock like this, the usual response afterwards is a pullback. As though everyone is saying “Really? It can’t be. There must be a trick.”

Powell’s hint that the Fed will indeed consider a rate cut at the Sept FOMC got an exaggerated reaction everywhere, with equities soaring, yields falling back and, as we worried, the dollar losing its shine. We had given this outcome a low probability, so ate crow on Friday.

We were hardly alone. Plenty of commentators point out that inflation has been above target for years and employment is okay. To switch priorities to employment doesn’t make data-sense and in worse, to assume that the tariff inflation effect will be a one-time thing is unrealistic. Needless to say, the conspiracy crowd wonders if Powell didn’t just chicken out to Trump’s incessant demands for rate cuts. To blame prior inflation analysis by the Fed’s mighty economist teams is not nice, nor fair.

However, we can criticize the economists for being wrong about supply-chain inflation being transitory. This time we get to blame Powell for accepting that tariff-induced inflation will be transitory. For one thing, it fails to acknowledge greed-flation—merchants raising prices just because they can. You have to wonder if Trump will take on price controls, something he hinted at in the campaign when he claimed he would tame inflation.

Maybe Powell really believes what he said, but there will always be some who view Powell as blindsided by Trump, making him the classic lame duck, which finally became clear with the board member resignation (Kugler) and got a final nail in the form of charging Fed Cook with fraud. It doesn’t matter whether fraud was committed—that’s not the point, The point is to emasculate Powell.

Whatever the Powell reasoning, the flip-flop in policy stance is disruptive and speaks volumes about the adequacy of “communications policy” and “transparency.” Reputation is a big deal to the Fed. It just got blown away.

Maybe there is a sneaky hidden message here—once Trump lackeys take over the Fed, which is surely going to happen, don’t trust it. After all, you couldn’t trust us, and we are Boy Scouts.

There’s another strategic outcome potentially in store, too. It depends on the votes. Maybe Powell can get the votes for September, but there are two more meetings and he may have the votes for a hold at them. We don’t know how devious Mr. Powell may be. He’s certainly no patsy.

And as Reuters reports, while the big names agree to the idea of a Sept cut. BoA is not convinced. “Analysts at Bank of America, though, are sticking to their call for the Fed to keep rates unchanged next month, although they acknowledge risks have shifted towards a cut. ’We see a risk that the Fed could make a policy error by cutting just as activity rebounds, with inflation headed to 3%," they said in a note.” One possible implication—PCE inflation this Friday and the newest payrolls (9/15) to be released before the Sept policy meeting,. Powell could get rescued by the data,.

We do confess that after getting the message, the rest of Powell’s comments made little sense. The analysts and commentators had to throw in their own data and interpretations afterwards to maintain Powell’s credibility. Bloomberg has charts going back to 2022, as the post-pandemic boost was soaring, to make the case. Granted, the next payrolls number is likely to be on the soft side. To be fair, Bloomberg does write “Recent data have shown inflation has stalled above the Fed’s 2% goal, with some measures indicating that price pressures may be spilling over to products and services not directly impacted by tariffs. Meantime, while hiring has slowed significantly over the summer, other labor market indicators, like the low level of unemployment, paint a more stable picture.”

At Jackson Hole, a smart remark from a Peterson Institute senior fellow: “If a cut does come and reflects slower US growth, that probably means slower growth for them given the size of the US,” referring to the eurozone and other economies. Does that not mean more rate cuts there? 

Forecast

We always expect a pullback after a Shock as traders consider what comes next. We can still get seriously negative inflation data and an absence of negative employment data, so the Sept rate cut may be a done deal but there are two other Fed meetings before yearend, Oct 29 and Dec 10. And it’s not even clear Sept is a done deal—a hefty 25% in the CME FedWatch betting parlor still think rates stay the same. And that’s up from 14.8% a week ago.

The verdict is not in on whether it was a losing battle for politicizing the Fed. 

We wrote Friday that if a dovish Powell would be dollar-negative because it implies the inflation premium being built into yields can be relaxed. “To the extent the dollar depends on yields, we could see the dollar pushback come to a screeching halt today. Get out of Dodge.” That was good advice at the time but what do we do next?

Alas, we need to look to the bond gang. We can’t expect the curve to shift much, and probably not invert—because growth is still pretty good. But will they start to price in the inflation premium as they “should?”

Then there is the comparison of the change in yield vis-à-vis the Bund. The US  2-year edge over the Bund is down under 175 bp at the lowest since April. The 10-year spread is down over 17 bp in the month to 150.5 bp. But the Kshitij chart indicates the euro is already overbought vs. the 2—year spread.

Food for thought: We are worried about two currencies, the CAD and the yen. Canada reports Q2 GDP on Friday. The Bloomberg survey shows a 0.5% contraction, or perhaps 0.7%. This is almost a sure thing because on the monthly basis, April and May each had -0.1%.

Second is the yen. There is no way a firmer yen is justified given over-target inflation and a stubborn central bank that will not be raising rates until after the new year, out of fear of the tariff effect, presumably. Logic points to an effort to return to 150 while the trendline itself is pointing toward a return to 142.70 (July 1). We get an inflation report this week but it’s not expected to have any effect. This is not good management.

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