The powerless Federal Reserve, forced to take a strong stance by Powell

Recently, at an event held by the Chicago Economic Club, Powell delivered a hawkish "triple": greater focus on inflation (and its expectations) in the short term; no Fed Put; the Fed will continue to maintain its independence. His sharp criticism of fiscal issues was filled with "sarcasm" towards the White House—addressing the unsustainable government debt problem requires focusing on mandatory spending (including Social Security, Medicare, etc.), rather than "playing small tricks" on discretionary spending or relying on the Fed's monetary policy.

While Trump remains obsessed with stirring and transforming the global economic and trade landscape, Powell seems to have gradually made a certain determination to act as a "Paul Volcker" in the final days of his tenure as Fed Chair. "Fearful at the shore, I speak of fear; sighing in the lonely ocean, I lament my loneliness." This scene seems to be filled with a certain tragic personal heroism.

Indeed, while Powell's statements may reflect a cautious desire to preserve his "reputation," the Fed's decisions are not solely determined by the Chair's persona, and the issue of economic inequality cannot be resolved merely through simple monetary policy. What we care more about are the motivations and constraints behind these appearances, as well as the conditions required to trigger Fed easing.

We will analyze from the following three perspectives:

First, of course, is the inflation and its expectations that Powell repeatedly emphasizes. Behind this are both the painful lessons of "three strikes" and the unknown impacts of tariff increases, but perhaps most importantly, Trump's 2.0 tariff policy has rendered the dollar, the "automatic stabilizer," currently ineffective. In other words, the Fed may find itself powerless to "turn the tide" and "support the collapsing building" in the current situation.

In managing inflation, Powell has already been "bitten by the snake" at least twice. Once was in 2021 when he judged that the inflation caused by supply shocks was merely "temporary," leading the Fed to delay tightening, which indirectly resulted in 2022 becoming the fastest rate hike cycle in history. This has also made Powell concerned about whether the price shocks from tariffs are merely "temporary."

The other instance was in September 2024 when, with inflation not yet back to policy targets, he unexpectedly cut rates by 50 basis points, which was followed by an unexpected rebound in inflation, drawing skepticism from various parties.

In fact, regarding this latter instance, I believe there may have been a misunderstanding of Powell. During recent roadshows, clients often ask me a question: the pressure of maturing debt this year is only now being recognized by the market; doesn't the Fed, as the monetary authority, have any contingency plans? The author believes that there may be some preparation, but plans cannot keep up with changes. The tariff policy expectations brought about by Trump's election have led the U.S. to start "grabbing imports," which has "inflated" the quality of demand. At the same time, the financial market's trading on expectations of an "overheating" policy mix (see "Stagflation is the baseline scenario, gold is the 'version answer'"), combined with the seasonal strengthening of data during the original Christmas peak season, has prevented Powell from finding an excuse to further lower market financing costs from November last year to March this year. When the high interest rates of the second quarter met the peak of expirations (see "The liquidity crisis that has arrived as scheduled - written at the time of the U.S. stock, bond, and currency triple kill"), the probability that the Federal Reserve is now "too late to mend the fold" is rapidly increasing.

The impact of tariffs on inflation has two important factors: one is the importance of imports in consumption, and the other is the adjustment role of exchange rates.

For the former, according to the Federal Reserve's statistics, imports account for about 10% of core consumption among U.S. residents (excluding food and energy, i.e., core PCE), with pharmaceuticals, automobiles, and clothing being the most affected parts. From a country perspective, China, the European Union, Mexico, and Canada are the largest sources of import impact.

As for the latter—the change in the fundamental nature of the dollar may be the new factor that troubles Powell. In the traditional global financial trade system dominated by the dollar, the classic Risk_Off chain is: tariff shocks as a global risk event → dollar appreciation → limiting inflation and its expectations. The dollar is an important stabilizing factor, as seen during the trade frictions from 2018 to 2019—dollar appreciation not only limited the transmission of inflation but also controlled inflation expectations.

Currently, this fundamental attribute of the dollar is shaken. The weakening of the global tariff on the dollar system and the resulting outflow of foreign capital have made the dollar's risk attributes stronger in the short term, seemingly losing its stabilizing function. A depreciation of the dollar would then become an amplifier of imported inflation.

Once exchange rate issues are considered, the Federal Reserve's monetary policy will also be constrained by other countries, as the differences in monetary policy rhythms between Europe, Japan, and the U.S. are an important pricing factor for exchange rates. For example, when will the Bank of Japan raise interest rates, in May, July, or September? Will the European Central Bank and the Bank of England also gradually slow down or even pause interest rate cuts?

Secondly, there is the issue of asset prices. Is there really no Fed Put? Perhaps it's not that there isn't one, but the threshold is relatively high; the U.S. Treasury market is more important than the U.S. stock market because while equity prices can rebound after a drop, once the credit foundation of U.S. Treasuries is lost, it is very difficult to recover. From the perspective of policy tools, expanding the balance sheet to release liquidity is easy, but getting the Federal Reserve to cut interest rates is much more difficult.

Recently, although the U.S. Treasury market has been turbulent, it may not yet be sufficient to justify the Fed's easing. Especially in the current complex domestic and international environment, the justification needs to be more substantial:

1. In terms of absolute fluctuations, the rise in U.S. Treasury yields after the announcement of reciprocal tariffs over the past 10 years was once comparable to that in March 2020, but it also saw a significant decline without Fed intervention;

2. In terms of volatility, the current situation can be compared to 2023, but the market pressure is far less than in March 2020, not to mention 2008 and 2020. Therefore, it is difficult to force the Fed into a "big move" of easing, and the surge in U.S. Treasury rates and sudden increase in bond market pressure in October 2023 only led the Fed to decide to completely stop raising rates. Compared to March 2023, there is a lack of iconic financial institution failures like SVB (which led the Fed to begin a phased expansion of the balance sheet to inject liquidity).

Finally, the effects of monetary policy need to be considered in the long term. To take a step back, can the effect of the Fed cutting interest rates really be immediate? Not necessarily. The main issue lies in the time lag of policy transmission and the changes in the asset-liability situation of households and enterprises. The time lag is easy to understand; it takes time from the rate cut to actually reducing the cost of liabilities in the real economy.

The asset-liability situation of the private sector: "Your honey is another's poison." It is well known that after 2020, the asset-liability situation of U.S. households and enterprises improved significantly, with liabilities repaid by the over-expansion of fiscal policy, and the expansion of assets was even more pronounced: the stock market is one aspect, and the amount of U.S. Treasuries held directly or indirectly by households also increased significantly, exceeding $13 trillion (2024), accounting for over 50% of the total U.S. Treasury market, reaching a peak since the 21st century.

After the Fed began its rate hike cycle in 2022, a very interesting situation emerged—despite the Fed accelerating rate hikes, the proportion of net interest expenses for enterprises actually decreased abnormally. In addition to the fact that rate hikes suppressed financing demand, another possible explanation is that the large amount of U.S. Treasuries or money market instruments held by households and enterprises made the income from assets more sensitive to rising interest rates than the increased costs on the liability side.

This also means that once the Fed conducts significant and rapid rate cuts, this process is likely to reverse. The income from assets will decline significantly, and we have already explained in our report "Liquidity Shock in the U.S. in Q2" that the cost of corporate liabilities will rise significantly due to refinancing at maturity, and rate cuts may instead lead to an increase in net interest expenses (as a proportion) (the reduction in received interest may exceed the reduction in debt costs)

Therefore, the Federal Reserve is unlikely to ease monetary policy easily, which may not only be due to willingness but also due to a sense of "helplessness." In summary, under the changes of Trump 2.0 and the post-pandemic era, the transmission path of interest rate cuts has undergone significant changes—if interest rates are cut further, it may lead to a depreciation of the dollar, exacerbating the vicious cycle of inflation; at the same time, it may also cause net interest expenses for the private sector to rise in the short term, leading to further weakening of demand. Therefore, the Federal Reserve may need some more "significant" conditions to restart interest rate cuts:

The dollar stabilizes, and the narrative of de-dollarization fades, which requires the White House to reduce policy uncertainty and for the economic and trade diplomatic relations between major countries/economies to gradually become more orderly.

Other major non-U.S. economies' monetary policies further ease marginally. This can constrain the Federal Reserve's monetary policy in terms of exchange rates.

Or more severe risk events may occur. For example, liquidity risks in the U.S. Treasury market + significant financial institution defaults, or rising debt costs impacting enterprises and the real economy, leading to a noticeable increase in unemployment rates and an economic recession. After all, in the early 1980s, during Paul Volcker's tenure as Federal Reserve Chairman, the U.S. economy experienced two recessions within three years.

The above conditions largely depend on the external environment. Until the dust settles, Powell will have to continue playing his role as the "lone hero" who is unafraid of power. Because if the market realizes that the Fed's easing is not merely a matter of willingness but also of capability, the edifice of dollar hegemony will collapse more quickly.

Authors: Lin Yan, Shao Xiang, Source: Chuan Yue Global Macro, Original Title: "The Helpless Fed and the Forced Strong Powell (Minsheng Macro Lin Yan, Shao Xiang)"

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