Inflation is too high, and the Federal Reserve has started on an aggressive hiking path in order to tame it. But will these hikes really accomplish anything? After all, the Fed can't print more oil or housing. So what is the central bank's real goal here? On this episode we speak with Edward Harrison, a senior reporter on the Bloomberg markets team, and the author of the 'The Everything Risk' newsletter. He explains how the Fed sees the challenge at hand, what rate hikes are supposed to do, and the odds of it all actually working out as planned. Transcripts have been lightly edited for clarity.
Points of interest in the pod:
What are interest rate hikes supposed to do? — 05:11
Why is the Fed raising rates ‘expeditiously’ ? — 09:04
How do higher rates translate into lower demand? — 11:24
What hikes mean for stocks and other financial assets — 14:11
The link between higher rates and unemployment — 17:28
Is a softish landing possible? What does history tell us? — 22:59
On the health of the health of the US consumer — 27:06
The possibility of the Fed backtracking on hikes — 32:20
Political considerations for the Fed — 35:52
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Joe Weisenthal: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway: (00:15)
And I'm Tracy Alloway.
Joe: (00:17)
Tracy. We know a couple of things about the economy right now. We know that inflation is high, it's way too hot for the Fed and the general public and that the Fed, as of the moment, plans to hike aggressively over the next several meetings in order to bring down inflation. I don't think we actually know much more than that.
Tracy: (00:39)
Yeah. I think there are a lot of open questions on what exactly... well, what impact are hikes actually going to have on the economy? How do interest rate hikes actually work to slow down price levels? And of course, there's this big open question about whether or not we should be targeting demand when supply seems to be more of an issue. But the other thing we don't really know is how does the Fed react once the impact or the effects of those hikes start working their way through the economy? What level of inflation is acceptable? Does it have to go back to 2%? Is the Fed willing to, I don't know, accept slightly higher levels of inflation in order to preserve, I guess, functioning financial markets and things like that.
Joe: (01:26)
Or expansion, like the question of, okay. Would the Fed be happy with three and a half inflation three and a half percent inflation if it means it doesn't push us into a recession? That strikes me as like an interesting question.
Tracy: (01:41)
It feels like, and I know we've been saying this for two years now, but it feels like we are actually in a different type of economic cycle. And so there are a lot of open questions swirling around exactly what that looks like and how potentially it ends.
Joe: (01:55)
Yes. So I think there's this view that okay, maybe inflation is expected to come down significantly, but it's unlikely to get back down to target by the end of the year. And so then the question is like, well, how hard does the Fed push for those last one or 2%? Or does it ease off a little bit? But then also again, and it's a question that never really comes up, which is, can the Fed articulate how rate hikes, how they tame inflation. We have this idea, you hike rates [and] inflation in theory goes down, and I think the Fed is getting a little bit more explicit about this. It's like, yeah, well maybe there's going to be some pain. Maybe unemployment is going to rise. But again, most parts of the economy aren't really rate sensitive. Housing is obviously the big one, maybe autos. And so the connection between rate hikes and actually getting inflation to target, at least to me, I think there's still some ambiguity.
Tracy: (02:48)
Yeah. And I mean, I think most of the people at the Fed would readily admit that, and they're still talking about it and trying to work their way through it as well.
Joe: (02:56)
So it's a weird time. And I think that, you know, right. There's all these questions about what is the Fed's goal? How does it accomplish them? What is it really trying to achieve? What does success look like. So we're going to talk about that today. And we are going to be speaking to one of our colleagues at Bloomberg, one of the sharpest people here, great writer, and someone that we've been fans of for years before he even came to Bloomberg. So it's a real treat that he's a colleague, we're going to be speaking with Ed Harrison. He's a senior editor on the markets team and he will answer, he will tell us all the answers to these questions.
Tracy: (03:29)
He has the answers!
Joe: (03:31)
He’s going to give us the answers. Ed, thank you so much for coming on Odd Lots.
Ed: (03:34)
Well, thank you for having me. And I hope I have some of the answers.
Joe: (03:37)
How long have you been our colleague now at Bloomberg?
Ed: (03:39)
It’s coming up on a year, actually next month it will be one year.
Joe: (03:43)
So I don't want to like sidetrack because this is not the topic of the conversation, although maybe we could get into it, but you know, I've been reading your blog and your newsletter Credit Writedowns for years, probably like coming out a decade. And I was thinking, I was actually talking to someone about it the other day, and you know, this sort of like indispensable source during the euro crisis, Italian spreads are widening again. Like there’s a little bit of tension in Europe again, isn't there.
Ed: (04:08)
Yeah. I mean, there are all sorts of weird externalities that happened when, I mean, because the way I remember the Euro crisis anyway was Dubai World. I remember Dubai World…
Joe: (04:19)
November, 2009.
Ed: (04:20)
That was the event that kicked off people questioning sovereign debt and bizarrely, then it moved straight to Europe.
Joe: (04:30)
From Dubai to Greece.
Ed: (04:32)
Right. It's almost like a butterfly effect.
Tracy: (04:36)
This is bringing back euro crisis flashbacks. So I'm going to bring us back to firmly to…
Joe: (04:41)
Okay, because we could have a whole conversation on that too.
Tracy: (04:42)
Yeah. Just talk about the ECB for 30 minutes.
Joe: (04:46)
And Ed speaks seven languages. So he's actually, anyway, let's go back to…
Tracy: (04:50)
Talk about the ECB in Portuguese and Greek? No, let's talk about inflation and the economy in the US and try to focus it a little bit. So maybe just to begin with the really broad question that Joe was kind of hinting at in the intro, but what exactly are interest rate hikes supposed to do in the current situation?
Ed: (05:11)
I think that they're basically supposed to, from what I understand the Fed saying, is bring supply and demand into balance. And ultimately when they say that, what they're saying essentially is that if the supply is limited, then we're going to limit the demand. We're going to bring demand down to the limited level that supply is. So they're essentially creating the preconditions for a recession. Now, if they bring the demand down to a level, think of it in sort of like a Goldilocks, or actually I think it's the too hot, too cold porridge. What was that?
Joe: (05:50)
No, that's Goldilocks. That’s where that comes from.
Ed: (05:52)
That they're thinking, okay, we'll bring it down, demand down, but not so far down that we have a recession. Powell has started to dance around that issue. And I think he is mirroring something that I heard Loretta Mester, who's the Cleveland Fed president, say, she mentioned to Mike McKee, one of our colleagues, that maybe we'll get another quarter or two of negative growth to go along with the Q1 negative growth that we had. Mike McKee was like, that sounds kind of like a recession. And she was like, no, no, maybe not. And so now the new code word is ‘softish’
Joe: (06:31)
Soft-ish.
Tracy: (06:31)
Instead of soft landing, softish
Ed: (06:35)
So what does that mean? I think what it means to me is what the Fed is effectively doing is they're telling you that a mild recession is not a problem.
Joe: (06:48)
And to some extent, I mean, look, I don't think the Fed wants a recession clearly. Like all things being equal, it would clearly prefer growth to recession, but there is something about that signaling. It seems like it's an expression of seriousness when the Fed is telling us that it might be willing to tolerate a recession if that's what it takes to bring down demand to a level such that we’re back in balance and don't have this high inflation anymore, it's sort of indicating a seriousness about the degree to which it'll undertake its task.
Ed: (07:24)
Definitely. And so I think then the other question for us is, what are their hopes and dreams and what are their prognostications about what's likely to occur? You know, is the Fed, unlike what Bill Dudley's saying, actually pulling its punches. Is the Fed not giving us the full story? Maybe the Fed actually believes that softish is the base case, right? Why don't you go out and say that, but they're not saying that. What they're saying is we're hoping that we can get this down and the economy keeps growing, but more and more financial markets are pricing themselves as if that is more likely to be the case.
Tracy: (08:07)
So there's another thing that I think we take for granted at this point in time and I think it should be discussed a lot more and that is the pace of the hiking cycle. So we just saw 50 basis points at the last decision. And I think the Fed’s talking about doing 50 basis points at the next decision, and it seems like they are moving -- and they've used this specific word -- but they're moving quickly and expeditiously and it feels like there's really a sense of urgency. But on the other hand, they will also openly talk about the economy is already slowing. We think that inflation is currently peaking. So I guess my question is like, why that urgency? What exactly are they worried about here? Is it inflation expectations becoming unmoored? Is it some sort of wage price spiral or is it something really simple, like credibility. They have to come in and convince people that they are serious about prices.
Ed: (09:04)
Yeah, I think it's all of that. And you know, there are three words that I've been listening to that I find very interesting in the way that they talk about it. Expeditiously is one of the words, cadence is another word. And then there's that softish word. I think that when you combine the three of them together, what it says is that they want to front load, meaning that they want to do it at a specific cadence, 50 basis points and then have the optionality after that to be able to do whatever they need. You know, Loretta Mester, who I mentioned before, I find her talking points very beneficial. They're very much on point in terms of, you know, what the Fed is looking to do. And she talked about the optionality question. And so that's what front loading is supposed to do. It's supposed to say, if we, at the time that we start hiking hike more aggressively in the beginning, then we have the option to go zero.
We have the option to go 25. We have the option to go 50. We have more optionality that way. And given the fact that our policy acts with a lag, then that's beneficial because the stuff that we did three or four months ago, we’ll start to see that filter into the system. And then we might even be able to completely miss a meeting. We might be able to go 25 at that meeting. We might be able to speed it up, but by front loading, by going at this specific cadence, this 50 basis points cadence, we're giving ourselves more optionality rather than less.
Joe: (10:51)
I want to actually go back to the first question because there's another component of it. When we talk about what is the Fed trying to do by raising rates. And as you say, it's trying to bring supply and demand into balance and in a supply-constrained environment, it means bringing demand down, but there's another step, which is what is the transmission mechanism between higher rates and bringing demand down? How do you think it works? Or how does the Fed think it works mechanically, they hike 25 in March. They hike 50 in May. We’re probably going to get another, how do these higher rates translate into lower demand?
Ed: (11:24)
Yeah, I mean, and that is the tricky question. I mean, that's the $64,000 question because there are a lot of different thoughts about that.
Joe: (11:32)
It's so wild that like, this is the primary tool that we have in the developed world to manage inflation, which economists consider basically to be the top test. And that actually, we don't really know or have like a clear, succinct answer from anyone, about how that works. But anyway, what's the thinking generally on how this works?
Ed: (11:51)
Well, let me throw a curve ball into the conversation. Because I, you know, every once in a while I get a chance to talk to Warren Moesler, the godfather of MMT. And as controversial as some of the things he says are, the thing that I find the most interesting in the controversy is his concept that when the Fed hikes rates they're actually adding interest income to the private sector. So literally yesterday I was walking down the street and I got an email, it was from my savings account. The savings account said your interest rate is going up. It's going up from like almost nil to a little bit more than nil. But that amount that it went up…
Joe: (12:34)
You go out and buy a new TV?
Ed: (12:36)
You know, that potentially could add to aggregate demand. So when we talk about interest rates going up, only working against the economy, it's not entirely true. When you look at the, the mechanisms through…
Joe: (12:52)
How does the Fed see it? What's sort of like the mainstream trip view of the transmission mechanism?
Ed: (12:56)
Yeah. So I think the mainstream view of the transmission mechanism is mostly about financial conditions tightening. And, you know, there are two things in particular that I would think of one is mortgages and interest rates for businesses. And then the other is of discount rates. So you think about stocks and bonds going down because interest rates are going up, that's financial conditions tightening. But also when you think about mortgage rates going up, when you think about bond yields going up, that's also financial conditions tightening. And the biggest tricky point for the Fed is that the United States is an economy, especially in the household sector, that is leveraged to fixed-rate mortgages. You know, in the UK, when you raise interest rates immediately everyone's mortgages go up relatively quickly. In the United States, there's been a massive refi boom that has been stopped out now. And so there are a lot of people who are at very, very low 30-year mortgage rates. And so increasing interest rates just a little bit, you know, 50 basis points, a hundred basis points may not be enough to have a tightening of conditions in that market.
Tracy: (14:11)
That is interesting. Does that mean that they have to pull other levers or they have to wait for other components of financial conditions to start tightening and, you know, things like asset prices will feed into that?
Ed: (14:22)
Right. So, I mean, they're looking at an aggregate picture and so they have to, if they want the feed-through mechanism to work, then they might have to do more or get more from one of those other areas. And obviously the more of that you get, the greater the chance for discontinuity, where you get sort of liquidity problems, where you get crises and things of that nature.
Tracy: (14:45)
Yeah. So this is what I was sort of alluding to in the intro about market functioning, but it does feel like we are in this environment. You know, things are unclear at the best of times. And no one seems to know how inflation actually works or how interest rates actually work to tame inflation, and then add in this unusual situation, post-Covid, where we have supply issues. We have things just being very different to how they were before, and it feels like that there's a potential here for something to go wrong or for something to break or for the Fed to overdo it in some way. So how do you think they're thinking about and trying to manage that particular risk?
Ed: (15:28)
You know, that is a very good question because it's not clear that they have a specific strategy on that. The thing that I found most interesting from the Fed recently is that some of the speakers and I think actually most of the speakers that I've heard, including the most hawkish speaker, mentioned the tightening of financial conditions. And I think that the terminology that Jim Bullard, who is the St Louis Fed president and who is one of the more openly hawkish members, the terminology he used was ‘quite a bit,’ or, you know, ‘a lot.’ So to me, that's sort of a messaging that, it sort of undercuts this whole thing, that we are moving expeditiously. And we'll, you know, we want a softish i.e. potentially mild recession landing, but at the same time, it tells you that they're looking at financial conditions. So they won't let things unravel is I think what the messaging is. I mean that's the best they can do.
Joe: (16:27)
So this is something Tracy and I were actually just talking about this at lunch. And, you know, stock trading is really hard and I could never do it professionally. And I'm glad that's not my job, but, you know, stocks are financial conditions or, you know, when stocks go up that represents a loosening of financial conditions. When they go down, in some sense, the Fed basically said by saying that A), we want to defeat inflation by tightening policy and B) our policy works through tightening financial conditions. In some sense, the Fed sort of told you that they were going to make stocks go down.
Ed: (17:04)
Right. And, you know, I think it's interesting because the number of former Fed officials and people in the know who have been telling the Fed and Bill Dudley in particular, that by the way, if stocks aren't going down, you're really not tightening financial conditions. I think it's interesting because clearly they're listening to what Bill Dudley has to say.
Joe: (17:28)
Well, and then the other follow-on that's striking is I think if you look at like corporate behavior, you could see a pretty clear link between a falling stock market and hiring, decisions to pull back on hiring. And so we know that the most intense selling in the stock market is a lot of these high-flying tech stocks. And one after another, you're reading these memos, like we're putting on a hiring freeze because investors want to see free cash flow. They don't want us to spend a lot. And so to the extent that the goal for the Fed is to have this softish landing and to sap demand, and one way you sap demand is by weakening the labor market, maybe increasing unemployment, you can draw a pretty straight line between they've tightened, they've hit stocks and the companies whose stocks have fallen are slowing hiring.
Ed: (18:21)
Right. And so unemployment, I think bill Dudley at one point during the last business cycle when he was a Fed official, you know, New York Fed president. Yeah. He mentioned something about too low unemployment, low, low unemployment. And I think he said too low unemployment. So, you know, mentally this whole Phillips Curve thinking, which is what that's representative of, says that you need to throw people out of work and that's going, and that's ultimately how demand gets slowed down. So when we think about the transmission mechanism, ultimately it's about people losing their jobs, which is difficult just on a human level to think about -- that's our transmission mechanism.
Tracy: (19:05)
So one thing I was reading just before I came in here, there's a big paper published by the Bank for International Settlements. Actually, I think they called it a book and it is very long. And it's all about inequality in recent years. The fact that inequality's been going up and what it means for central banks and the contention there is that inequality actually makes monetary policy less effective because, you know, a lot of people, sort of the wealthiest percentile, or the wealthiest chunk of the population are insulated from things like mortgage rates going up -- to your point earlier. So I guess my question is, is there a better way to try to bring supply and demand into balance than a pure blunt interest rate hike?
Ed: (19:51)
Yeah. And to me, that question automatically makes you think about fiscal and monetary policy and some of the debates that you might have about what you should do and where there is a quasi-fiscal monetary policy where the line gets drawn, etc. And I think what we've seen is that the Fed believes, and it's probably true, that these other substitute policies like quantitative easing are squishy. They're not as easy to deal with. And there are externalities like we saw with the repo crisis in 2019 that they wish to avoid. So quantitative tightening is seen as an adjunct to the primary tool. So I think they're in between a rock and a hard place in terms of coming up with other mechanisms. Regulatory, certainly, but you know, this hard blunt instrument really is what they have. And then you ask yourself what else can be done from a policy perspective? And that obviously begs the fiscal question. I think what we're seeing, especially with the degree of in the United States, at least wrangling, discord, that if you want things to get done because you're behind the curve or because inflation is moving quickly, it's very difficult to think that fiscal is a replacement for monetary policy. And I think that one of the reasons that we've been leaning on monetary policy -- and these are unelected officials obviously -- is because they can get it done very quickly.
Joe: (21:25)
Well, and if we sort of accept, and I don't know that we necessarily should, but if we sort of accept this premise that people need to be thrown out of work in order to bring supply and demand into balance, I guess on some level politicians, maybe like getting to outsource that to, you know, unelected officials at the Federal Reserve rather than having to make a policy decision that would have that effect.
Ed: (21:53)
Yeah. I think that, you know, we would need a complete rework of our political policy making institutions and not just in the United States, but I would say generally speaking in Western or in industrialized economies.
Joe: (22:10)
So where do you stand and what does history tell us about this prospect of either the soft or the softish landing? Because there's some view of it's like, this is a fantasy. It never happens every time they go into one of these hiking cycles, especially with inflation as high as it is [at] 8%. So they have a lot of work to do to bring into target. And so the argument is there is no historical precedent for this much of an inflation collapse without a recession, without a meaningful increase in the unemployment rate to my mind, the only counter argument is, yeah, maybe there's no historical precedent for that. There's also no historical precedent really for a pandemic and this sort of extremely strange business cycle or this cycle that we've seen over the last two years. But in your reading of history is the softish landing possible?
Ed: (22:59)
I would say that's not my base case. Okay, I'll give you two things that I'm looking at. 1994, which some of the Fed officials point to and the seventies. So with regard to ‘94, one of the reasons that we look at that is because that was a softish landing, not just softish, it was soft in the sense that, you know, you had a 14% correction in the Nasdaq at that particular juncture. Interest rates went up, people were thrown out of work. You know, the financial condition adjustment that we've seen thus far is commensurate with that particular period. It would be nice if that were the analog. There are multiple problems with that analog, however. One of the problems that you mentioned is that inflation's much higher now.
Second problem is because inflation's much higher we have to be more aggressive or at least the Fed believes that it has to be more aggressive. In 1994, there was never any back to back rate hikes of more than 25 basis points. The last time that there were back to back rate hikes greater than 25 basis points was 1989. And those were the last two before a recession. And now the Fed's talking about back to back to back 50 basis point rate hikes, plus the potential for more after that. So that's a differential in terms of the adjustment process, which is much greater than ‘94. And then the last thing going back to, the inflation question, when you look at the Fed funds rate and the real rate of inflation that people experience. So when you think about real rates, rather than, you know, inflation-protected securities, TIPs, look at Fed funds minus CPI. And what you find is that in order to break the back of inflation, you had Fed funds above CPI materially for a continuous period of time in the early eighties. We're nowhere close to that.
Joe: (25:01)
So that would be rates at like 10% or 11% these days.
Tracy: (25:03)
I can't even imagine.
Ed: (25:05)
Yeah, exactly. And, you know, I'm actually, I was writing a piece right before this, about the seventies in that regard. You know, if you look at the seventies, early seventies before the oil shock, we had Fed funds above CPI as inflation was going up, but then the oil shock hit and the Fed relented. They allowed the Fed funds to fall below the CPI and then inflation kept on going down. But it dipped only to 5.9% before it started going up again. And then that's when Volcker came in and really went to town.
Tracy: (25:43)
Can I say something weird? You know, people talk about low interest rates and easy money, but when I hear like 10% Fed funds rate, and I think like, oh, just put money in a bank account and get 10% back. Like, that seems like the really easy money to me, but I guess obviously you'd be losing a lot on inflation and that's the whole point of having higher interest rates.
Joe: (26:03)
And you might not have an income in an environment like that.
Tracy: (26:08)
But setting that aside, 10% sounds great. Ok. On a serious note, so I feel like -- to the recession point -- one of the things that has happened most recently is we've also seen some questions swirling around the health of the US consumer, and this was supposed to be the thing that was really underpinning the expansion. Consumers were resilient. Now we've seen consumer sentiment readings for the past few months that have come in quite poorly. And then more recently we've seen some major, major retailers start to warn on the profit forecast. So Target and Walmart were the big names. Most recently, we're recording this on May 19th, I should add. What is going on there. And is that an early sign of the economy slowing or an early sign that perhaps we've misinterpreted an inventory build as underlying economic strength and maybe we're hiking too fast?
Ed: (27:06)
Yeah. I, my view on that is that the markets are looking forward and they're looking forward to concerns about the consumer and those concerns are in the future. And that the data that we've seen thus far do not show the consumer melting at this point in time. So first on consumer sentiment, I think that in the last two recessions, what we saw is there's no correlation between consumer sentiment and the actual consumer spending.
Tracy: (27:39)
Right. Because sentiment's been low for a while, but spending keeps going.
Joe: (27:42)
Yeah. So we just got April data. It was fantastic, it was great, really solid.
Ed: (27:46)
I don't know what economists use consumer sentiment for, from a predictive tool, but I'm very skeptical about that tool as a, you know, foreshadowing of weakening consumer demand. Then the second thing, when you look at Target and Walmart in particular, I was looking at Target just the other day when it came out, comparable store sales were up 3% versus expectations for like zero point something percent, 0.3 or 0.5, I think it was. So they beat on a top line basis. Their problem was that the margins were cut in half. And obviously since your stock is based upon your net income, you know, the free cash flow, that's a problem for the stock, but it's not a problem for consumer spending.
Joe: (28:35)
Right. It was really interesting reading the Target earnings call because it was strange. I mean, so Target came out with their quarterly report and then the stock proceeded to plunge, it had its worse day since 1987. But as you say, the top line was okay. And they actually said like, demand is fine. And people keep coming to the stores and traffic is good. It was basically, their costs are going up. And they really misread apparently the shift in consumption, which we all knew was coming. And so everyone's been talking for like probably at least a year and a half. It's like, at some point we're going to switch back from household durable goods to services and they really misread the timing. And now they have this huge inventory pile. But it was interesting how they kind of said like, but actually the health of the consumer is okay.
Ed: (29:19)
Right. And so in the context of a 25% correction and the worst day since 1987, it tells you that, you know, it tells you something about the sentiment of the markets and the jitteriness, it doesn't tell you anything about actual consumer demand. The thing that they said that worried me the most was the point that you said, they used to be very good at reading consumer demand. But the pandemic and supply chain shortages has wrought havoc on their ability to forecast. And I think that this is the hidden problem from an inflationary perspective, because when you have one of the best companies in terms of being able to do that, having those problems, then the question becomes A) how long does that last? And B) why are they having those problems? I think one of the reasons that they're having the problems is because we are in a new era, that era is not the previous era, which was the just in time inventory era. We're in an era where supply chains are less just in time inventory builds. And then by the time you realize that you've not gotten it right, then suddenly you have to purge those inventories and demand has moved to somewhere else. That's much more akin to the period that we had pre-China integration into the global system. That's more like, you know, the 1970s, the 1980s, the 1990s. And now we're going back to that.
Joe: (31:03)
So if we go back to the soft landing question, you pointed out like history is not very encouraging on this front, but I guess, you know, to me, I can think of like a few counter reasons. And one is, look, we're not in a business cycle, classically. The recession that we saw in spring of 2020 was not like a true recession, it was an exogenous shock. We bounced back very quickly. The recovery was not a normal expansion. And I think if you listen to Fed officials, even Powell, there's, you know, the 8.5% inflation that we see today, there's some chunk of it that would still be characterized as transitory factors, right. Things related to supply chain pressures, the sort of things we used to talk about on this podcast a year ago, you know, cars and chips and all that. And then there was something else, like some sort of like underlying pressure. And I guess the sort of optimistic argument is that a big chunk of that 8.5% is still things that we would call transitory that will normalize when all the effects of the pandemic are gone. How do you think about that question? Like, how do you weight, why do you think we have 8.5% inflation right now? Like how do you sort of like, weight the different drivers of it?
Ed: (32:20)
Yeah. And I think it's a great question, but I don't know anymore than anyone else obviously, but that's another, you know, $64,000 question in terms of should we wait? Where's our terminal rate in terms of how we think about this? Because let's say, let’s disaggregate the 8.3%. Okay. And say that 4% of that is temporary, 4.3% of that is remaining. We're going to bring demand down to the supply level. And so that 4.3% will fall to 2% over time. That's one way to look at it. What does that mean in terms of the terminal rate? It means three rate hikes up to 2% and then say 25 basis point hikes until you get to say 3.5%. By the time you get to 3.5%, actually the Fed funds rate is above or about the same as the CPI.
So that's a very benign scenario. A less benign scenario is one in which only say 2% of that is actually supply chain-related. And that you bring demand down, you bring it down to say where the CPI is at five and a half percent. And then you said that your terminal rate is three and a half percent. You cause a recession with inflation still at five. And it ticks down to say three and a half percent, but then it starts to go up again, because at that point, the economy is reaccelerating. So you you've miscalculated. I would say that that's what happened in the seventies, is that they miscalculated how much in ‘74, ‘75, they needed to deal with the inflation problem.
Tracy: (34:14)
Hmm. So what's your estimate for how long it could take to get to a point where the Fed would have to reassess what it's doing? Like, what is the sort of make or break timeframe?
Ed: (34:26)
I think you're looking at the beginning of 2023, when they will be able to see what the discrepancy, sort of in the March timeframe, by that time you can get to the Fed funds forward terminal rate of 350. So Fed funds forwards say the Fed will get to 350 by March of 2023. If you're at that level and the CPI is 5%, then you have a question as to do you want to stop there? Do you want to continue to go higher? What are financial conditions? And what's the state of the economy at that particular juncture, because those are the three variables that you're playing with. And, you know, that leaves the Fed less room, obviously, to operate if two of those things are problematic as opposed to one.
Tracy: (35:21)
So the other thing that I think is worth thinking about as we discuss the timing of all of this and the pace or the cadence, as the Fed has put, is political considerations. And of course the Federal Reserve is supposed to be an independent body. They're not supposed to care about politics, but in practice, I suspect that it may play some sort of role or it would at least be at the back of their minds that later this year we're going to have an election.
Ed: (35:52)
Yeah. And, you know, you asked at the top of the show about consideration, you didn't mention the politics at the top. But I suspect that that could play a role. I mean, here's the question, is it preferable to hike 50, 50, 50, and then ease into other rate hikes well before a midterm, a contentious midterm election? Or would you rather be going, you know, 50 basis points at a time in a November and December FOMC? And I think that, you know, it's preferable to do the first as opposed to the latter. I look at the speech that Jerome Powell gave at the beginning of the last FOMC meeting as highly unusual and a representation of the level of political pressure that he must be under. Because when you speak to the American people, ‘I want to speak directly to the American people,’ he said. To me, that's a sign that he feels political pressure to speak to the American people.
And so, as apolitical as the Fed would like to be, the reality is that they are a creature of Washington. They're in Washington and they work at the behest of Congress. You know, my sense is that by the time September comes around. And that's when people are going to be on the campaign course, the economy will have decelerated, meaning that right now, we're not seeing full-on deceleration. The consumer's still holding up, but by September we will see some deceleration. And then the calculus from a political perspective is, do we want you to go on inflation or do we want you to go on growth?
Tracy: (37:31)
Yeah. Then we're back to having these discussions again about unemployment versus price stability.
Ed: (37:40)
Because you know, the jobless claims that came out just today…
Joe: (37:44)
We're ticking up.
Ed: (37:45)
Yes. I mean that number is historically no low number, but…
Joe: (37:50)
So it seems like the bull case just on labor is, so since the middle of March, weekly initial jobless claims have clearly been ticking up. There's clearly clearly an uptrend. But the absolute levels are low. So I feel like there is this hope and maybe it sort of relates to the softish landing again, you know, I remember like the early two thousands people used to talk about the jobless recovery, right. So we had the recession after Dotcom Crash and after 9/11, and then the economy started growing again, but it was not producing a ton of jobs. And I feel like the hope is that we have sort of like the unemploymentless recession, whatever the opposite of a jobless recovery is. that basically there is some way to slow down the economy, but that we're starting in such a good position and that there's so much labor demand. And that there's so much like room to slow that we can actually have a slowdown without a meaningful rise in the unemployment rate. That feels like that's the bull scenario and you hear people talking about that. I don't know if it's possible though.
Ed: (39:01)
It does sound like people are talking about that. And I think that the missing piece is the participation rate. That they're saying essentially that the pandemic is still having a residual effect on the participation rate. And even if we get an uptick in jobless claims and things of that nature, there's still lots of people who are on the sidelines. And as long as we get the softish landing, as soon as we start to reaccelerate, those people will come back into the workforce and all will be well. I'm not going to comment on that, but I will say that the political situation is going to be quite different if that doesn't come to pass. If between now, you know, May and say September, when the Fed is going to have to decide, are they going to go for the fourth 50 [basis point hike]? You have a considerable uptick in either unemployment or slow down in the economy. Then the political calculus changes tremendously
Joe: (40:01)
Before we go. There's one other question that I want to ask about, which is this year, of course, and, you know, everyone talks about it, is the two sort of unexpected, again, fresh exogenous shocks. There's of course Russia's invasion of Ukraine, which has various destabilizing effects. It has effects on energy and so forth. And then the extremely hard lockdowns in China, which are creating new supply chain stress. How does the Fed incorporate, you know, the effects of them. You know, they don't reflect underlying conditions, but they're real. And they've pushed gasoline prices up. And again, we heard, Cisco earnings. They said that they're having real supply chain issues out of China again. How do these sort of outside shocks that are outside of the cycle affect the Fed’s thinking at this point?
Ed: (40:54)
I would think that it gives them more impetus to front load in order to have greater optionality on the backside, you know, the quicker they can get these hikes in there, the quicker they can come to say that we're at the neutral rate, we've gotten to a level that we feel is justifiable over the long term. And then, whatever shock hits the economy, they can then deal with that shock at that time, without having to worry about, you know, being at a level that's lower than the neutral rate. I mean, the worst thing for them would be that the shock happens when interest rates are at 1%, then their hands are tied. Then you have to start thinking about reversing quantitative tightening, right? All these kinds of things. That's going to be a very difficult situation.
Joe: (41:38)
Ed Harrison, it’s so great to have you on finally. And that was a great chat and I genuinely feel I have a better understanding of like how the Fed and how we should be thinking about the Fed's challenge through the rest of the year after that. So thanks for coming on Odd Lots.
Tracy: (41:53)
Yeah, I really enjoyed it. And you're writing a new newsletter at Bloomberg, right?
Ed: (41:57)
Oh yeah, that's right. Good. Tracy, you are very good. ‘The Everything Risk.’ And if I could give it a plug, what I would say is that it's about the concept that we are now – post-Great Financial Crisis -- living in a world in which there are risks that are embedded in the system in ways that we can't understand. And I think that we're seeing that. This whole discussion was a manifestation of a risk that I, as a, you know, hardcore deflationist, would've told you didn't exist two years ago, and yet here it is.
Joe: (42:32)
Yeah, no, absolutely. And I think like, you know, we're all sort of figuring out, is this a true… What I'll say is this, the 2010s are starting to feel like a long time ago. You know, at one point, i was like, oh, I kind of thought it's like, oh, we just normalize… But that is starting to feel like a long, that economy that we had in 2019, 2019 feels like a long time ago to me.
Tracy: (42:57)
But it's also just kind of crazy that we spent like a decade worried about why inflation was under target. And doing a lot of stuff to try to get it up. And then suddenly it's like, oh, inflation's up? Oops. A little bit too much.
Ed: (43:12)
Yeah. Who would ever have thought that we’d want to go back to the days of secular stagnation?
Tracy: (43:17)
Yeah, exactly. Like this makes secular stagnation look good.
Joe: (43:20)
Yeah. I miss 2018 and 2019 when the big issues were, are we going to teach coal miners to code? And what are we going to do about truck drivers when AI robots, you know, those were like the big problems back then. That seems like ancient history. Anyway, thank you so much Ed for coming on.
I have to say Tracy, hearing Ed talk about the sort of histories, the poor prospects of a soft landing, at least based on history were not encouraging. I sort of got a little bit more pessimistic at that part.
Tracy: (44:09)
Yeah. I mean, I think the overarching thing that comes through on that conversation is just how difficult it is to balance everything that's going on. And as we discussed, you know, interest rate hikes aren't necessarily the best tool for an environment where supply is more of the issue than demand. And then the other thing that I was thinking, and I'm going to repeat it again, but it seems like so many of our problems at the moment stem from the unusualness of the situation. And the fact that we don't really have, I know we reach for historical analogies and parallels like the 1970s, but actually there isn't a really good example of this happening. Maybe like post 1918 Spanish Flu kind of thing, but…
Joe: (44:55)
And honestly, that actually to me is like the optimistic thing where it's like, okay, in the past we had to get Fed funds up above inflation in order to bring it down, which means that, you know, we're nowhere close to enough. The optimistic case is yes, but this is not like any of those scenarios, there is still a large residual transitory effect. I'm still sort of, I'm pretty sympathetic to that view and that for natural reasons, things will roll over, but we have no idea. And you know what else we have no idea about? You know, I'm thinking back to some of the episodes we did in summer of 2020 even before inflation started picking up, like right in the middle it's like, we would like ask people…
Tracy: (45:36)
Ask central bankers…
Joe: (45:36)
Central bankers, like what causes inflation and we'd get like, ‘no idea.’ No one had any good answers back then. And we don't really know what caused inflation if we’re being honest. And now we have inflation, but it's still not obvious for me that even now, that we actually know why.
Tracy: (45:51)
I would like to see -- this is slightly off topic -- but I would like to see an anthropological look at yeah. At inflation or like a sociology look at inflation, like look at it from the perspective of the people who are making the decisions to raise prices and why they're doing it.
Joe: (46:08)
Yeah. Let's get a manager from like Proctor & Gamble on and talk to about how they…
Tracy: (46:15)
Yeah, forget the central bankers.
Joe: (46:17)
They'll just blame the person they're buying the commodities from. So then we gotta talk to the commodity person and so on.
Tracy: (46:22)
Okay. Well,
Joe: (46:23)
Let's do a series on that.
Tracy: (46:23)
All right. We just got an idea for, you know, an infinite number of episodes. Shall we leave it there?
Joe: (46:30)
Let's leave it there.
You can follow Ed Harrison on Twitter at @edwardnh.