US and EU Central Bank Chiefs Weigh Inflation and Rate Cuts Amid Looming Risks

Market participants were paying close attention to comments from Federal Reserve Chair Jerome Powell and European Central Bank President Christine Lagarde on Tuesday morning, with both central bankers addressing inflation, interest rates, and the challenges facing their respective economies.

Speaking at the ECB Forum on Central Banking in Sintra, Portugal, Powell was asked at the outset how he would characterize the Fed’s view of the U.S. economy. “We've made quite a bit of progress in bringing inflation back down to our target, while the labor market has remained strong and growth has continued,” he said. “We want that process to continue.”

“The last reading for inflation, and the one before it too, to a lesser extent, do suggest that we are getting back on a disinflationary path,” he added. “We want to be more confident that inflation is moving sustainably down towards 2% before we start the process of reducing how tight our policy is. What we'd like to see is more data like what we've been seeing recently. We'd also like to see the labor market remain strong; we said that if we saw the labor market unexpectedly weakening, that is also something that could call for a reaction.”

Powell said that the Fed want’s to know that the levels they’re seeing “are a true reading” of underlying inflation. “At the end of last year, people were saying ‘you need to declare victory, this is over,’ and then we had a quarter of inflation which was well above 3%,” he said. “We want to be more confident, and frankly, because the U.S. economy is strong and the labor market is strong, we have the ability to take our time and get this right, and that's what we're planning to do.”

When asked if this meant that they would deliver the long-awaited first interest rate cut in September, Powell laughed. “I'm not going to be landing on any specific dates here today,” he said. “We are well aware that if we go too soon, we could undo the good work that we've done in bringing down inflation, and if we go too late, we could unnecessarily undermine the recovery and the expansion. We are aware that we have two-sided risks now, more so than we did a year ago.”

“That's a big change,” he added. “Risks are coming much more into balance now.”

Powell also addressed inflation expectations in a fair amount of detail. “We don't see ourselves getting back to 2% inflation this year or next year,” the Fed Chair said. “Maybe late next year or the year after. The main thing is, we are making real progress.”

He also underlined the strong growth of the U.S. economy as a positive foundation for the central bank's work. “Many, many forecasters had a recession in 2023, which not only turned out to be wrong, in the case of the U.S., we had well in excess of 3% growth,” he said. 

Powell also discussed how the Fed’s dual mandate impacts their decision-making process at every stage of the rate cycle.

“The risk on the inflation side is that you move too quickly, inflation comes back, and we didn't really solve the problem, and we have to go back, and that would be very disruptive to the economy,” he said. “The other risk is that we wait too long, we understand that, and the labor market softens too much perhaps, and we lose the expansion. Needless to say, we don't want to do that either. We have to balance those two, and given the strength we see in the U.S. economy, we can approach that question carefully. A year or so ago, we were talking about inflation, and our framework called for us to focus on the mandate that was further from its goal. They've come back much closer into balance.”

Powell was also asked about the potential level of the long-term neutral interest rate, or R-star (R*).

“When we're sitting in the boardroom in Washington thinking about whether our policy rate is the appropriate rate for this economy right now, we're not battling over what long-run R* is, because this is a different economy, this is an economy that’s still recovering from the pandemic, and so many forces are pushing it this way in that way, and there's really not a lot of precedent, so it's a very challenging time,” he said. “The R* question is a really interesting question and that is, are we going to go back to the very low levels of the neutral rates that we had in the recovery of the global financial crisis, or are we going to go part of the way back from today's high rates to that?”

“Intuitively, most people think that we won't go back to those very low rates that we saw during the global financial crisis recovery, but we don't really know,” he said. “When we are looking at policy in the boardroom, it's how is our policy affecting today's economy, and do we think we are getting the results that we want, and by and large, we think we are. We are getting a gradually cooling economy, a gradually cooling labor market, progress on inflation, 4% unemployment, 2% growth. We are getting what we would want to have.”

Powell and ECB President Lagarde also addressed the ongoing impacts of AI on their respective economies, and how its development will impact the global economy. 

"There has to be some regulatory framework within which AI, and generative AI in particular, especially if it's in the hands of a small oligopoly of companies, is actually organized in order to protect a number of rights, and protection of citizens," Lagarde said. “The impact that AI will have on growth, on inflation, on productivity, I think is yet to be determined. I think most people would agree that it will have an impact throughout the ladder of jobs in most segments of the economy, in areas where mechanical developments have not historically affected jobs in particular, and it will require a significant amount of training and constant upscaling of people so that they can adjust to artificial intelligence, use it, and not be victims of it.”

“We at the ECB are using artificial intelligence, are trying to do it in a safe environment, without being hostage to those companies that would like to have access to the most private of our data,” she added, “so it does require a cautious management and enough control without preventing the innovation and the creativity that people can apply in the use of these tools.”

Powell also acknowledged the significant impact that artificial intelligence could have on the economy of the future. “You see this massive investment boom, you see serious people in the private sector and the public sector, there's a sense of something big coming here,” he said. “It feels like what that will be is that it will eliminate some jobs, it will create some new jobs, and the question really is, for many people, will it augment their labor and make them more productive, or will it eliminate their job? I just don't think we know that, it's too early to say.”

Powell made a point of saying that the Fed is using some forms of AI, but not others. “We are not using generative AI; we are very carefully looking at that,” he said. “Other forms, earlier forms of AI, are in fairly common use in American business, and I believe we use some of that.”

The final question put to the central bankers was what they considered to be the biggest risk to their economies. 

Powell pointed to the threat of cyberattack as the most significant risk faced by the U.S. “We know how to deal with credit risk, we know how to deal with lots of kinds of risks, market dysfunction and things like that, but we haven't really had a big successful cyber-attack on a financial market utility or a bank,” he said. “That's the kind of thing which I think is the stuff of lying awake at night.”

Lagarde said cyberattacks were the most significant risks to the ECB as well. “If you ask the financial sector, if you ask banks, typically that's a risk that they flag as one of their top-priority risks, and one which I think we need to constantly improve the level of coordination, first, second, and third line of defense, and best way to respond to those,” she said.

Lagarde added that geopolitical risks are also very much top-of-mind for the eurozone. “It's there, and it's just on the doorstep of Europe,” she said. “When you look at this horrible war against Ukraine, it's a major risk which is out there and which is hurting those on the ground and the neighboring countries in particular. 

The discussion concluded with a question about where they believe headline inflation would be 12 months from today. 

“Mid to low twos,” Powell said. “Sustainably, durably, underlying inflation between two and two and a half is what I would say would be a great outcome [for headline PCE inflation].”

“One year from now, I would say low twos,” Lagarde said. “We are at 2.5 latest reading, and bumpy on the way ahead, but low twos.”

“Fed Chair Powell's remarks at the ECB's annual Sintra forum this afternoon sounded, at the margin, just a touch more dovish than those made of late, with the Chair noting that the US economy has made "quite a bit of progress" back towards the 2% inflation target, while also flagging that the economy is back on a disinflationary path, as suggested by the May CPI and PCE reports,” said Michael Brown, Senior Research Strategist at Pepperstone. “Commentary of this ilk appears to further open the door to a September rate cut, especially with Powell also flagging the risk associated with leaving it too late to deliver the first rate reduction. A softer-than-expected jobs report on Friday, were it to come to pass, would likely further cement the case for said cut, to which markets assign a roughly 70% chance - perhaps, a touch underdone.”

“Naturally, risk sentiment has been given a lift by Powell's comments, with equity futures back into positive territory on the day; dip buyers continue to rule the roost, with the medium-run path of least resistance continuing to lead to the upside, ably assisted by the ongoing 'Fed put', and policymakers clear desire to deliver a 25bp cut - and more beyond that - sooner rather than later,” Brown added. “The dollar has also faced some modest headwinds, though remains well within recent ranges against most G10 peers, ranges that should persist for some time, given the relatively narrow divergences between DM central banks, and the synchronised disinflationary path that most major economies continue to take.”

This article originally appeared on Kitco News.