Morgan Stanley: Powell needs to think about this before speaking at Jackson Hole!

All attention this week will be focused on the Jackson Hole Economic Policy Symposium, with the theme of the conference being aptly titled "Reassessing the Effectiveness and Transmission of Monetary Policy." We expect Federal Reserve Chairman Powell to outline the Fed's medium-term strategy, especially as persistent anti-inflationary implications mean the Fed can focus on sustaining economic expansion while still achieving the 2% inflation target. The Federal Open Market Committee (FOMC) has signaled readiness to start cutting interest rates, but Powell may point out that even after the rate cut, policy will remain tight. In fact, a crucial topic may be distinguishing between levels and trends. Economic activity is slowing down, but not particularly weak. The job market has cooled off, but even the addition of 115,000 jobs in July is not particularly weak. The market will determine what is more important - levels or trends. The 0.8 percentage point rise in the unemployment rate is another debate between levels and trends. An increase in the unemployment rate signals an economic recession, a historical relationship that has been widely mentioned. However, I have previously written that today's labor market is very different from the past. The rise in the unemployment rate has historically been a precursor to economic recession, as it indicates not only a decrease in labor demand but also a reduction in job opportunities. However, in this economic cycle, while labor demand has undoubtedly slowed down from unsustainable rates, the layoff rate remains low. Furthermore, in past cycles, the signal sent by the unemployment rate was not clear because labor supply also decreased during economic recessions. This time, the rise in the unemployment rate is amplified by labor supply. In other words, the 4.3% unemployment rate is still a relatively low level, with much less signal of an upward trend than in the past. Past rises in the unemployment rate imply a weaker job market Credit spreads have a similar situation. Looking at the situation before the recent market volatility, credit spreads have been widening but are still far from recession levels. As discussed by the Economic and Strategic Joint Publication, the widening of credit spreads during market volatility is just a retracement from historically narrow spreads. The market remains open to issuers, and with yield compression, investment-grade (IG) and high-yield (HY) bond issuers continue to raise funds at current rate levels. The widening of credit spreads appears to be temporary. In fact, the difference in this cycle compared to previous cycles is that most defaults are due to debt restructuring caused by high costs, rather than a wave of direct bankruptcies or poor profitability. With the Fed lowering interest rates, even these "soft defaults" will not pose a significant challenge. Although the credit spread has widened, it is far below recession levels. Consumer spending (which accounts for about 70% of the U.S. economy) is another good example. U.S. consumer spending has surged well beyond its trend, so consumption levels should return to fundamentals more in line with income. Tightening monetary policy will only reinforce this trend. We believe this process is underway, as last week's retail sales report indicated that U.S. consumers remain very active. Level versus trend is a key distinction, and in fact, markets often trade on another concept, that of acceleration or deceleration. I suspect Powell's speech will at least subtly emphasize this distinction. The economy can slow from an unsustainable pace and still healthy avoid a recession. This distinction supports our view that the Fed will cut rates by 25 basis points at several consecutive meetings. Of course, both we and the Fed could be wrong. State-level data suggests that July employment data was suppressed by hurricanes, but if August data continues to decline, we expect a larger rate cut. However, such an outcome would indicate a significant change in trend. This article was written by Seth Carpenter, Chief Economist at Morgan Stanley