At Jackson Hole, Federal Reserve Chair Jerome Powell gave a hawkish speech intended to leave no ambiguity about the Fed's commitment to defeating inflation. But what does that mean in practice? How aggressively will the Fed have to hike? And how much pain will the economy endure as a result of it? On this episode of the podcast, we speak with Neel Kashkari, the President of the Minneapolis Fed. He explains his thinking and why he's become one of the most hawkish officials at the central bank. We also discuss the future of the Fed's decision making framework, the impact of student loan relief, the market and much more. Transcripts have been lightly edited for clarity.
Points of interest from the pod:
How much pain do we need to get inflation down? — 3:41
How Kashkari became a hawk — 5:17
What is the market saying? — 8:41
Should we take comfort from recent cool inflation readings? — 11:55
Did the Fed fight the last war? — 18:15
What constitutes restrictive policy — 22:47
How the Fed thinks about international developments — 31:20
The inflation impact of student loan relief — 32:36
The supply side effects of monetary policy tightening — 36:07
Why Kashkari was happy about the recent stock market selloff — 42:05
The impact of QT — 44:53
---
Joe: (00:40)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy: (00:45)
And I'm Tracy Alloway.
Joe: (00:47)
Tracy, what do you think of when you think of the Federal Reserve in August. Any sort of traditions or annual events come to mind?
Tracy: (00:57)
Jackson Hole would be the obvious one?
Joe: (01:00)
Right. We are recording this Monday, August 29th. And of course, just on Friday we had Chairman Powell's Jackson Hole speech, which I would say was very brief. And the tone was definitely hawkish.
Tracy: (01:14)
Very to the point. Yes. I mean, I think you actually wrote this in the newsletter, but it's clear that the Fed means business when it comes to fighting inflation. And the big news out of Jackson hole was that Jerome Powell is willing to stomach pain for households and businesses in order to bring prices down.
Joe: (01:31)
And the the brevity of the speech was sort of telling, because I sort of think of Jackson Hole typically as this venue for theoretical discussions about monetary policy...
Tracy: (01:42)
Right, academic papers and things.
Joe: (01:43)
And this was not an academic speech. It was saying ‘We're here to fight inflation. And that's all I feel like saying right now.’
Tracy: (01:50)
I think that's right. But you know, you mentioned August traditions. There's another August Fed tradition, isn't there?
Joe: (01:55)
There is another Fed August tradition, at least one that I think of and that is of course having Neel Kashkari, the President of the Minneapolis Fed on our podcast. This will be the third straight August. I don't know if that's actually intentional. I think it sort of always works out that way. I don't think we've purposely timed it around JacksonHole each time, but we have Neel on again.
Tracy: (02:17)
That's fantastic. There is clearly a lot to talk about and clearly things have changed since the last time we spoke to him. I mean, back then inflation was at, I think it was something like 5%, and now fast forward to the last data for July, it’s 8.5%.
Joe: (02:31)
Yeah. It's a lot higher than it was in the past. And of course over the last year we've seen this Fed pivot and this very aggressive attempt now to get inflation under control. Anyway, no more talking from us, let's get right to our guests. So Neel Kashkari thank you so much for coming back on the podcast.
Neel: (02:49)
Thanks for having me. I was looking forward to it and I'm glad our tradition is continuing.
Joe: (02:53)
I love this tradition, so let's just get right into it. So one of the lines that caught a lot of attention from Chairman Powell's speech at Jackson Hole was that these higher interest rates, this effort to fight inflation, will “bring some pain to households and businesses.” And nobody knows exactly how much, but it's clear that you and the rest of the committee are willing to do what it takes or you're saying you're willing to do what it takes to fight inflation, even if that means a labor market and an economic slowdown. In your research and analysis, do you have any estimate for where you think the labor market needs to go to? How high does unemployment need to get from your perspective, or might it need to get, in order to get inflation under control?
Neel: (03:41)
Well, it's a good question. It's a very important question. And unfortunately, the answer is we don't know. You know, this is not a labor market-driven surge of inflation. This is not the traditional story where labor market gets tight, wages climb, businesses have to pass those costs on. And then that leads to inflation.
This inflation has been driven by mostly by supply chains, by the war in Ukraine and by a lot of fiscal and monetary stimulus, putting money into people's pockets. And wages have been climbing, but they've been a lagging indicator, not a forward indicator of inflation. And so when I think about that, that tells me, it really depends on: Do we get more help on the supply chains? Do we get more help from commodity prices and as fiscal stimulus wanes, that should relieve some of the pressure. And then the labor market will have to carry less of the burden, so to speak, through monetary policy. So I don't know the answer to that because it really depends on do we get help from these other sectors?
Tracy: (04:41)
So I'm sure we're going dig into wages a bit more, but one more big picture question before we do — last year, you were on the record saying that inflation is transitory. And I think when we last spoke to you, you were talking about how the Fed shouldn't overreact to temporary inflation measures. But now fast forward to today, and you've basically transformed from the Fed's biggest dove into the biggest hawk. And you were talking at Jackson Hole about inflation now being a “blazing inferno” and things like that. What accounts for that transformation, what made you change your mind?
Neel: (05:17)
I changed my mind because the data didn't react the way I expected it to. So a year ago, when we were speaking, you know, we talked about how much fiscal stimulus was in the pipeline. We talked about workers who were probably going to return to the labor market, and it's true. The fiscal stimulus ran its course, but if you look at consumer balance sheets, generally speaking the American consumer is still doing very, very well, even relative to where they were before the pandemic.
We've seen multiple waves of Covid. We've seen some workers return. They have not returned as quickly as I had expected. And at some point, even if those things ultimately prove to be true, they're taking so long to resolve themselves that we are running the risk at the Federal Reserve of allowing inflation expectations to become unanchored. So even if in the end, when history writes the book, they might say, ‘Hey, some of these factors were in fact still transitory,’ but they're simply taking much longer than I had expected, and that I am willing to tolerate, for risk of unanchoring inflation expectations. If we were to allow that to happen, that would be very devastating to main street, to our economy, to people all across our country.
Joe: (06:25)
How do you gauge inflation expectations? Of course, there are various private surveys. There are other surveys, they don't seem to have picked up. And in fact recent measures, you know, on Friday right as Powell spoke at 10:00 a.m. Eastern, we got the latest UMich survey. It actually ticked down a little bit to 2.9% over the next five to 10 years. A) what do you look at on the inflation expectations measure? And then more broadly, what is the mechanism via which high inflation become could become entrenched? You hear this word a lot or concern about it may be entrenched. How does ‘entrenchedness’ happen?
Neel: (07:04)
Well, I'll give you a few examples. So first of all, we look at all the different measures we can, which are survey-based measures that you just mentioned as well as indicators embedded into financial markets. And they're all suggesting that ‘Hey, inflation's gonna come down fairly quickly.’ Especially if you look at the financial markets, the market seem to think inflation's gonna fall rapidly next year. And I hope they're right.
Now, part of the reason I think that all of these measures are showing a lot of confidence that inflation is going to fall is because they are looking at us and we're saying, we're on the job. We're on the case. We're not gonna let high inflation remain. So partly it's a reflection, I think, of confidence that we are going to walk the walk, you know, not just talk a big game, but we're actually gonna follow through and make sure that inflation comes down. And so that is comforting that they seem to be trusting in us, but that doesn't absolve us from needing to then follow through. It means that more than ever, we need to follow through to make sure that those expectations are vindicated.
Tracy: (08:06)
You mentioned financial market indicators. And of course, when you look at Treasury yields — and actually this was something you mentioned last year as something that you were watching which weren't necessarily implying inflation at that time. And as you mentioned, bond yields further out into next year suggests that inflation is going to come down. But how much of that is predicated on inflation coming down because of something like a recession? How do you gauge that risk? When you look at bond yields, you look at the inverted curve, things like that, a traditional recession indicator, what are they telling you?
Neel: (08:41)
Yeah, it's something I do pay a lot of attention to both the nominal yield curve and the real yield curve. They usually move together. But because of these inflation dynamics right now, there are some differences. So the last time I looked, the nominal curve had inverted. I focused mostly on the 2-10 curve. The real curve had not yet inverted, but was getting close.
Something interesting happened in July. You remember the Bank of Canada raised interest rates by a hundred basis points. And there was a lot of chatter before our prior FOMC meeting, will the FOMC raising by a hundred basis points? And the yield curve did something very interesting. The front end of the yield curve went up, as you would expect for a more hawkish expectation of monetary policy, but the back end of the real yield curve went down.
So why would the back end of the real yield curve go down? I interpreted it as markets were saying, ‘Hey, they may be more aggressive with monetary policy that may lead more quickly to some type of slowing of the economy and a more, a sooner achievement of the dual mandate goals, which would then allow them to back off.’
Now, does that technically mean it would be a recession? I don't know, but I interpreted it to mean markets thought we would more quickly achieve our dual mandate goals. And then we would be able to relax somewhat. It's an interesting data point that I pay attention to it. It's not driving my recommendations at this point, but it's something that I think is giving us some information.
Tracy: (10:02)
Since we're talking about bond markets. Can you maybe talk a little bit about Fed communication at this point and how it's evolved? Because when the Fed did that first 75 basis point hike after ruling out one just a few weeks before, we did had a bunch of bond traders who were talking about how this was the death of forward guidance. So I guess my question is, was it? Because before it felt like even though you were stressing data dependency, you would still try to avoid surprising the market.
Neel: (10:33)
Yeah. I think this notion of the death of forward guidance is premature and probably an exaggeration. What does forward guidance even mean? I see value in members of the FOMC going out and saying we are united in our commitment of getting inflation back down to our 2% goal. That means we are gonna do what we need to do to achieve that and how much we're gonna need to do. It's going to depend on what happens in a lot of the sectors of the economy or supply chains, etc., but us expressing our commitment, our united commitment to doing what we need to do to get inflation back down, that's a form of forward guidance.
Should we not articulate that? I don't agree with that at all. And so, yes, I want to say there's a lot of uncertainty about what's going to happen at the next meeting or what's going to happen by the end of the year. It's going to depend on all of these different factors. That's all true. And I think we should be honest about how much uncertainty there is about these factors and what's going to drive where monetary policy needs to go. But certainly as forward guidance, expressing our commitment to getting inflation back down, I think it's very valuable for us all to express that.
Joe: (11:55)
So you mentioned there was some discussion at the last meeting about whether the Fed, like the Bank of Canada, should go a hundred basis points. And I think you were among those who supported such a strong move to stamp out “raging inferno of inflation” that we're seeing right now. Fast forward to right now, the last couple inflation data points --and it's not a lot of data to work with — [but they] have not been that bad. We got that 0% CPI report. The PCE for July was actually a slight decline in prices sequentially. It's just one month that we've had some pauses. Does that affect your view on September, the meeting that's coming up near the end of September, and your thinking of whether 50 versus 75 basis points would be appropriate?
Neel: (12:40)
Well, as you said, Joe, it's basically one data point. You know, we've been surprised for the past year, almost every time, of inflation surprising us to the upside. So if we have one surprise somewhat to the downside, I'll happily take it, but I don't take much signal from that. You know we need to see a lot more before we get convinced of inflation is well on its way back down, or that we've seen peak inflation.
I'm not convinced of that yet. So, to me, if the inflation readings that we've gotten since the last meeting were surprising us to the upside yet again, then I think you'd probably see people talking more about ‘Hey, would they consider a hundred basis points?’ I think the fact that the chatter is 50 versus 75, you know, we've got more data to see before I would be ready to draw any conclusions from that. But my guess is we're somewhere in that range of 50 to 75 for the next meeting, based on the data that has come in.
Joe: (13:30)
This week we're getting a jobs report. Last month’s was particularly strong. In the absence of fresh inflation data, would another surprisingly strong jobs report — I mean, we got half a million new jobs last month — how would you be thinking about that? And would that push you more towards the 75 camp?
Neel: (13:51)
Well, I don't know. Certainly I want to see a strong labor market. I want to see people getting jobs. I want to see real wages going up. So that gives me more comfort that we're probably not actually in a recession right now. Obviously you've talked a lot about the first two quarters of negative GDP growth and are we in a recession? And as you know, you've talked about it a lot, typically a recession comes with a very weak labor market and a lot of layoffs. So if we continue to see strong job growth, that would give me confidence that we're not actually in a recession, even though some of the data indicates we might be. But ultimately I would be looking at wages. I would be looking at real wage growth. And ultimately I'm very focused, more than anything, on the inflation data and the inflation expectation data. So for me individually, I don't think the labor market itself is gonna be determinative of 50 versus 75, or what the subsequent reading needs to be.
Tracy: (14:43)
Actually that reminds me, you know, at Jackson Hole, you made that distinction between running the economy hot and the current situation, which you called a “blazing inferno.” Can you elaborate on that a little more? What is the difference between benign heat in the economy where you have a healthy labor market versus damaging inferno heat? How do you gauge those two? Does it just come down to the inflation expectations spiral that you described, or do you look at broader types of damage? Like, you know, people being unable to afford rent and pay off their debt and things like that?
Neel: (15:23)
Well I would say it starts with the actual inflation that American families are experiencing. So let's just go back in time a few years before the pandemic, we had 3.5% unemployment for the four or five years before the pandemic. We at the Fed kept thinking, ‘Oh, we're at maximum employment.’ And then we started raising interest rates and I objected to those, ‘cause I wasn't sure that we were actually at maximum employment and inflation was coming in under our 2% target. And then the job market, the economy kept creating jobs — much to our surprise, suggesting we were not in fact at maximum employment because inflation stayed low, and wage growth was picking up, but picking up only moderately. So in that context, we asked ourselves, is there some way we could provide more of a boost to the economy using monetary policy during times of low inflation?
And that's how we came up with our new framework that we adopted a year or so ago. And that framework is literally designed to provide more stimulus in those low inflation periods. But once you get back to a high inflation period, 2% or above, then the new framework is the old framework.
It just goes back to conducting monetary policy the way we did in the past. So in that context we were asking, how do we provide a little bit more of a boost to the economy in periods of low inflation? And that's what I would define as running the economy hot in that context. Now in contrast, where are we now? We had multi-trillion dollars of fiscal stimulus. We have supply chains that were gummed up because of Covid. We have millions of missing workers relative to what we expected. We also have a war, Russia launching war in Ukraine, which is upending commodity markets and energy markets. Those are two wildly different scenarios. And so that's why in the meeting, I was pushing back on the notion of, ‘well, this proves that it's really dangerous run economy hot.’ This is not what we were talking about a few years ago. This is a completely different situation. And while one might eventually conclude, ‘Hey, you don't wanna run an economy hot.’ At least for me, it's entirely premature to draw that conclusion right now. And in the context of what we meant about a hot economy a few years ago,
Joe: (17:29)
That's an interesting way to frame it. You know, the Flexible Average Inflation Targeting was unveiled at the August 2020 Jackson Hole. So it's two years old at this point. Was it basically an example of the Fed fighting the last war, which is a charge that's been levied at sort of the fiscal expansion, etc., that the Fed overlearned the lessons of 2008, 2009. So is FAIT fighting the last war? And in order to stay consistent with FAIT, what does that actually mean in practice? Because in theory, if you know, you're supposed to get a 2% average — we've had, you know, 8%, 9% — do we have to run sub 2% inflation for a while in order to actually fulfill that framework?
Neel: (18:15)
I mean, I think everybody always says that everybody's always guilty of fighting the last war, whether it's in economics or it's in the military. You know you have to learn from the last war and you have to make yourself stronger so that you're not vulnerable the way you were last time. And so go back in time, the big mistake in hindsight that Congress and the Fed made coming out of the ‘08, ‘09 downturn was, we were not aggressive enough collectively in supporting the economy and supporting Main Street.
And it took 10 years to put Americans back to work. That is way too slow. This time Congress said, we're going to act very aggressively in the Covid downturn. They passed big fiscal stimuli. And when most of that stimulus was passed, we had no idea when and if vaccines would be available. I was talking to the best health experts in the country and they said, we just don't know how long it's going to take.
And so it's actually a miracle of science that we have multiple, highly effective vaccines available within a year. And so the economic downturn was much shorter than had been expected at the time the stimulus was passed. And so now we've got a very strong labor market recovery. Did Congress, you know, learn the wrong lesson from ‘08, ‘09? I don't think so. I was emphatic, better to err on the side of doing too much than too little. So now we're in a position that we collectively have done too much and we need to adjust, but I don't want to go to those millions of Americans who are working today and say, ‘you know what? You shouldn't have your job. We should have been much more timid in our recovery because all of a sudden we might have been in a new regime that we didn't foresee.’
Joe: (19:50)
What does it mean to apply FAIT now, does it have to overshoot to the downside?
Neel: (19:57)
Yeah, I don't think so. I mean, we left ourselves a lot of wiggle room. You know, we don't, I've never been a subscriber of rigid monetary rules because strange things happen in the economy. And if you tie yourself to this rigid monetary rule, then you end up doing very damaging things. And so, no, I don't think so. I think that we will be able to get inflation back down over the next several years to our 2% target. And I don't think we're going to then say, well, we have to go run it 1% inflation for the next X number of years to mechanically average 2%. I think that that would be silly for us to do that.
Tracy: (20:29)
You were talking about timeframes just then and the idea of the vaccine coming out, you know, possibly quicker than a lot of people expected at the time. How are you gauging policy lags at the moment? Because this is something that the FOMC has talked a little bit about in its statement, this idea that, you know, an interest rate hike takes some time to filter into the real economy. Now that rates are higher and presumably closer to, you know, neutral — although you tell me if you don't think that's the case — does it get harder to gauge that? Do you have to start thinking more about the impact of previous policy decisions as you start to make new ones?
Neel: (21:12)
It's hard and it's complicated. We know that interest rate sectors of the economy will be affected most and most quickly, and they already are — housing being the best example of that. But we also know, you know, we study history a lot and we study what has worked in history for policy and what has not worked. And one of the biggest mistakes they made in the 1970s at the Fed is they thought that inflation was on its way down. The economy was weakening and then they backed off and then inflation flared back up again before they had finally quashed it. And so that to me is something that I'm very focused on. We can't repeat that mistake. So to deal with these lags, you're right, the lags are there. They're hard to see. They're hard to measure exactly. There's a lot of things happening in the economy.
I would be much more comfortable raising rates to some end point, you know, let's say it's 4%, let's say it's 4.5%, maybe higher, whatever we think is needed at the time. And then just sitting there and let's just press pause and wait to see how some of these underlying dynamics evolve. To me, the most costly mistake we will make is if we get fooled thinking, ‘oh, we've got inflation licked. Now let's go cut interest rates because the economy is showing signs of weakening.’ That to me, has a potential really dramatically negative effect on our credibility and on people's belief that, ‘Hey, they're just going to repeat the mistakes of the 1970s.’ And so the way to deal with the lags for me is just to get somewhere and sit there until we're really convinced that we've got inflation licked.
Tracy: (22:43)
Is 4% or 5%, is that your definition of restrictive?
Neel: (22:47)
Knowing what we know now? I mean, the challenge is so we have to look at, first of all, I think the overnight interest rate is interesting, but not that interesting. What's much more important are longer term real rates. That's what I believe drives economic activity, five-year real rates, 10-year real rates. They're positive.
Now the question is though, embedded in those real rates are market expectations for inflation expectations over the next five or 10 years, 4% to 5% is probably where I would guess right now the level of restriction needs to be given what we and what financial markets believe about inflation over the next few years. The biggest risk, not the most likely risk, but the most damaging risk is if we and financial markets are fundamentally misreading the underlying inflationary dynamics. And if markets belief that inflation is going to come quickly back down to 2% over the next couple years, if that's just wrong. Then you could see markets discovering that, we discover that, and all of a sudden we need to be in a substantially higher interest rate environment. I'm not ready to forecast that now, but I'm also not ready to rule it out.
Joe: (23:54)
So just for your forecast specifically, I think at the last dots in July, you indicated your inclination was for Fed policy to go 3.9% by the end of the year, 4.4 next year, has anything changed since your last forecast, either to the upside or downside regarding what you see as the sort of optimal trajectory of the Fed funds rate?
Neel: (24:19)
You know, sitting where I am today and there's more data to come in between now and the September meeting, nothing has really changed that would dramatically change my rate path outlook, but again, I don't wanna prejudge it. I need to look at the remaining data that comes in. And this is something that I deliberate on a lot with our research department here, as we look at different scenarios. But from the data I've seen, it doesn't imply a big change to my rate path.
Joe: (24:43)
So let me ask you a slightly bigger picture question about, you know, as you think about setting policy, you know, one of the things that we've discussed or that you've discussed with me for a long time is this idea that economists both maybe within the Fed and outside the Fed have a bad habit of sort of changing their structural outlook of the labor market after a recession. And so you have this big shock in 2008, 2009, and everybody sort of sets lower sights on what full employment actually looks like. And it turned out after 2008, 2009, that actually we could get back to old levels. We just needed more growth, there wasn't some inherent structural barrier. But it seems to be a habit of economists everywhere, the US, Europe etc. Right now, the employment to population ratio in the US is 60%. Whereas pre-crisis, February 2020, it was 61.2%. So by that measure, by that labor market measure, there hasn't been a full recovery. Do you worry that this could again be a mistake where everyone's like, ‘okay, this time it really is different. There's been a lot of boomers retiring, etc. There's a structural shift.’ But that actually is just another cyclical change, and it's gonna be a little while before normalization.
Neel: (26:02)
Yeah, it's a good question, Joe. The answer is, I don't know, back in the earlier recovery, the last recovery, people just kind of waved their hands and said ‘mismatches and structural changes.’ They couldn't point to anything. Right now, you actually can point to something which is there are a lot of people who have long Covid. There are people who continue to get sick from Covid multiple times. And even if that doesn't permanently exit them from the labor force, there are some cohorts of folks that are not in the labor force today because they're sick with Covid.
And so it's this health dimension that seems to be more real than just this people making stuff up for why the natural rate of unemployment would be higher or why the EPOP ratio would be lower. Retirements is another one that you've mentioned. There is some evidence that retirees can come back if the labor market looks attractive, you know, and the other thing is there's some new technologies that might mean that somebody who used to work 40 hours a week, they want to retire, but maybe they work 20 hours a week remotely because technology enables it. So some of the developments of the last two years could actually point in a positive direction, but it's the health elements that I think are almost unequivocally negative. And that's the one that I just need to see, we need more time to figure out.
Tracy: (27:15)
So maybe talk to us a little bit about productivity. Because it feels like wages kind of get all the attention because everyone's worried about inflation, but productivity has been trending down as well. So I'm wondering, is that something you're looking at as something that needs to go up in order for inflation to start coming down? Or how are you thinking about that aspect of it?
Neel: (27:38)
Right now for me, it's a curiosity. I mean a little bit of it’s math. We talked about earlier, Tracy, that the labor market's been hiring a lot of people creating a lot of jobs, which is good news. Well, you know, if you end up hiring a lot of people and you don't have very strong GDP growth and you put those two things together, you're going to end up with very low or even negative productivity growth. So the negative productivity growth is not really a surprise. It's just those two factors adding together. I think it'll be interesting to see what happens with GDP. Does it get revised up over time? Does it come closer to Gross Domestic Income? And then more broadly at some point these firms, you know, one theory is these firms are hoarding labor. They're just hiring a lot of people because they wanted to hire them over the last few years. And when they become available, they hire them. You know, firms can't do that for very long. They're going to have to make rational decisions. And so it should end up showing up in the labor market. And so it's something we pay attention to, the productivity data, but it's not the driver of the economy as I see it right now. But long term, it clearly is critically important.
Joe: (28:40)
I just want to ask one more question about the labor market. And again, going back to that last jobs report, you know, half a million jobs, it's not, you know, the ability of firms to hire half a million people in a month does not necessarily seem consistent with an economy that's sort of out of workers. On the other hand, other measures such as job openings and just sort of the difficulty that firms have with hiring causes people to say, ‘oh, the economy, the labor market is extremely tight.’ Do you think there could still be slack in the labor market right now, especially again, given some of these measures of employment to population or LFP or alternate measures of labor market utilization, could there still be slack?
Neel: (29:22)
I think there could be. I mean, I think it's going to be people's decisions, which as unfortunately this high inflation is really punishing families and lower income folks are the least, you know, able to bear it, so you could see people saying, ‘Hey, I didn't want to go back to work, but I need to go back to work because this is getting too expensive to put food on the table.’ And as wages climb, people are saying, ‘I need to go back to work or I'm going to go back to work.’ And so, you know, to me, ultimately, maximum employment is as many people working that is consistent with our underlying 2% inflation objective. Those two things are in my mind, tightly linked concepts. And so yes, there may still be slack, but we need to get inflation back down to 2%. And then we'll be in a position to understand is the economy in equilibrium or not.
Tracy: (30:26)
So setting aside strength in the labor market and higher inflation, which have been two of the big hallmarks of our economic situation this summer, the other thing that's been going on is the very, very strong dollar. And I'm wondering if the Fed takes into account the impact of its rate hikes, particularly, you know, a stronger currency on the rest of the world? Because at a time when places like Europe and certain emerging markets are having an energy crisis, it feels like the impact of US rate hikes and a stronger dollar could be even greater than before. And it does feel like global pressures are building even as the US economy remains relatively strong, for now. So how are you thinking about the impact of US economic policy on the rest of the world?
Neel: (31:20)
Well we pay attention to it. We have a really talented team of economists who focus on the whole global economy at the board of governors. And we've got a lot of international economists here at the Minneapolis Fed, but we pay attention to it because it's a feedback loop back to the American economy. We have to, our charge is to conduct monetary policy to optimum outcomes of our dual mandate for the US economy. And so we run these scenarios. If the dollar goes up, what does that mean for imports? What does that mean for growth around the world? And then ultimately, what does it mean for inflation and employment in America? And so we are aware of it, but we are focused on optimizing our policies based on what the outcomes are for the US economy and for the American people.
Joe: (32:04)
So you mentioned fiscal stimulus. There was quite a bit of it in 2020 and also 2021. And it's winding down, it's mostly being withdrawn. That being said, it's not entirely being withdrawn. But I think one could say that the White House's student debt relief is a form of fiscal stimulus. Are you thinking about the inflationary impact of that? And do you see that affecting the trajectory of your policy?
Neel: (32:36)
Well, you know, we analyze whatever Congress passes in terms of the fiscal environment. And then that goes into our models as an input. My guess is it's not a huge number. You know, if you look at student loan relief, as an example, generally speaking, it's pretty regressive, meaning it tends to skew towards people who are relatively better off in our economy. The lowest income Americans generally didn't go to college and don't have student loan debt, so to speak. And the more it's regressive, which is not, I don't think, a policy objective of the authors, but the more it's regressive, in a curious way, the less inflationary it is. Because those folks are less likely to spend the money on consumption. They're more likely to save the money or pay down other forms of debt. As an example, you know, I haven't studied it very carefully, my best guess is it's not a big deal one way or the other in terms of outlook for inflation in the near term. Just like the Inflation Reduction Act. I think the CBO scored it as net deficit reducing over 10 years. My guess is it's not gonna have a big effect on inflation in the near term, but we will analyze it. We will put it into our economic models. And ultimately we'll factor that in as we come up with an interest rate outlook.
Joe: (33:51)
So you mentioned the Inflation Reduction Act. It’s unlikely, and I think almost all economists agree, that it’s unlikely to really affect inflation in the short term, or perhaps even the medium term in a meaningful way. That being said, would the Fed welcome the government building out more, I guess, anti-inflationary tools such that the burden, or the job, of fighting inflation is not entirely tied to the central bank? And I remember, again post-GFC, there was a lot of talk about, you know, there were fiscal policy, fiscal expansion, that was difficult for the Fed to sort of engineer that all by itself. Would you like to see more work done on non-monetary anti-inflation tools being built out?
Neel: (34:44)
Well, absolutely. The more help we can get from other parts of the economy and potentially other parts of the government, the less we have to do. As you all know, we can only limit demand. We can't do anything on supply. And if supply comes online, then that that reduces how much we need to reduce demand to get those two things into balance. Now, it's also hard, I mean, it's hard for the fiscal authority in the short run to create more supply. It takes a long time. So actually I'm looking at the government, we’ll welcome it, but I'm also looking at the private sector. You know, private sector firms are very focused on trying to fix their supply chains to meet their customer demand, to keep their costs low. They're making some progress. From what I can tell, the progress is on even. But the more progress that they can make, the less the burden falls to the Federal Reserve. And the more likely we would be able to engineer a soft landing.
Tracy: (35:36)
Yeah. I was gonna ask about the sort of short-term pain versus long-term gain of some of these big inflation reduction measures or projects, because I can imagine a situation where, you know, if everyone starts building out capacity all at once, then that basically just ramps up demand further, right? And it seems like that would be a particularly problematic for the Federal Reserve if you're trying to reduce inflation as soon as possible.
Neel: (36:07)
Yeah. Theoretically I agree with you, Tracy. I'm not seeing much evidence of that. You know, just take the oil sector, where oil prices have been very high. There's been maybe less investment than I would've guessed going in, to try to take advantage of these high prices — in part because if you look at the futures markets, oil prices are expected to come down over the next few years. And so you could understand why investors are hesitant to pour a lot more money into more drilling more rigs example to take advantage of these high prices. And so, theoretically I agree with you, I'm not seeing much evidence of that and that would ultimately show up in higher borrowing costs, higher long-term interest rates. And those rates still are quite low relative to history.
Joe: (36:48)
Well, let me ask you the flip side, because one area in which there seems to be widespread agreement that we're in shortage of is housing. And we've seen rent prices go up quite a bit. And we all know the frustrations of the public about buying housing, the cost of housing, and yet likely in large part due to the rise in interest rates and therefore the rise mortgage rates, we're already seeing a significant cooling of home builder activity. Do you worry about the perverse effects of like, ‘okay, we want to expand the supply side.’ One of the most important areas of the supply side is a residence. And yet one of the first order effects of higher interest rates is actually to constrain production in this crucial sector.
Neel: (37:36)
I mean, it's a fair point, but I think the effects on the supply side are much slower than the effects on demand. And so our hope is that we can get demand down into some form of equilibrium with 2% inflation over the next couple years. And then we get the economy back to what we would call something like normal. And then you could really unlock the supply. The supply is just a much slower moving mechanism than it is on the demand side. So it's a fair point, but I think the timing errs towards effects on demand rather than effects on supply.
Tracy: (38:09)
Looking ahead, is there anything that would make you more comfortable with either smaller rate hikes or a slower pace? Because I think one thing that's come through this conversation is that you are very, very keen to err on the side of being too aggressive versus being too loose. So what would you need to see to give you comfort that maybe things are changing and the Fed can relax a little bit?
Neel: (38:38)
Well, I think if we continue to see inflation readings that inflation is coming down, like multiple subsequent readings, then that would probably argue for me, that we could raise interest rates more slowly, or maybe we are getting to the point where, ‘Hey, in a few more hikes, we could get to something and just sit there, pause.’ Until we really are sure that it is done. To me, you know how high we get and how fast we get there, that is less important than us not backing off. I mean, to me, the bar to actually cut interest rates, that is going to be very high. We can raise more slowly. We can sit there for longer. All of that I'm open-minded about, and the inflation data should guide us. But to me the big error that we could make — but I don't expect us to — is cutting interest rates prematurely.
Joe: (39:33)
Have you been surprised? I mean, everyone seems to be scratching their head. You guys keep coming out and saying, ‘We're not going to cut rates.’ And yet the market has had rate cuts priced in for a while. What do you attribute that disconnect to?
Neel: (39:50)
You know, I don't know. I have said publicly, I did an event at the Aspen Institute a few weeks ago, and I said the markets are not consistent with my outlook for interest rates and inflation. All I can read from that is they think we are going to achieve our dual mandate goals more quickly than I do. And then we would be in a position to cut interest rates. And I certainly hope they're right, but that's not my forecast right now.
Tracy: (40:18)
Yeah. I was actually gonna ask about financial conditions...
Joe: (40:21)
But, you know, just to quickly get on that, like achieving the dual mandate — and I think this is the key thing achieving goals — let's say, okay, inflation comes down much faster than everyone's expecting sometime in the middle of the next year, you're on 2%. The point is though, that's not a reason to cut rates.
Neel: (40:40)
No, if we achieve the goals, absolutely, that would be a reason to relax our contractionary monetary policy. I'm just surprised that markets would think that we're going to achieve that goal as quickly as they seem to. Again, I hope they're right. And we'll take that data on board if they are right. But that's, where I think the disconnect is.
Tracy: (41:00)
Is there a tension there, just going back to financial conditions, but you know, one of the things that has surprised people is that financial conditions have remained relatively loose even as the Fed hikes at the fastest pace in decades. Is there a tension between the market thinking that the Fed is going to succeed in bringing inflation down, and then not actually taking into account the impact of some of these rate hikes — like, bond yields should be higher. Stocks should be lower. We're not necessarily seeing that reflected. And so financial conditions remain relatively loose.
Neel: (41:35)
I mean, I think it goes back to something we spoke about a few moments ago, which is markets’ expectations and our expectations that inflation expectations are well anchored and that inflation's going to come down, you know, rather quickly over the next few years, if that assumption is wrong, that we share and financial markets share, even though they're more bullish than I am, if we're all collectively wrong about the underlying inflationary dynamics, when that reality is revealed and we realize it and they realize it, then you would expect to see financial markets fundamentally reset at a much tighter setting. And you'd see longer-term real yields much higher than they are today. That's not my forecast, but that's, I think what it would take to really see a dramatic tightening of financial conditions from here.
Joe: (42:20)
Chair Powell has said at press conferences, like “Look, Fed policy works through financial conditions” And financial conditions, as we just talked about is, as we just talked about, it's spreads on corporate debt. It's mortgage rates. And the stock market is a component of it. When you see the stock market rallying, as it did — and I know the stock market is not your goal by any stretch — but when you see the stock market rallying from the bottom in June to what we saw at least up until about two weeks ago, is that interpreted as working at cross purposes for your goals?
Neel: (42:55)
You know, I think so. I certainly was not excited to see the stock market rallying after our last FOMC meeting, because I know how committed we all are to getting inflation down. And I somehow think the markets were misunderstanding that, and I was actually happy to see how Chair Powell's Jackson Hole speech was received. You know, people now understand the seriousness of our commitment to getting inflation back down to 2%, but you know, it goes back — think about, we talked about real bond yields. So think long-term real yields. They're positive, you know, depending on your measure, slightly positive up to 0% plus 0.5%, maybe up to 1% by some measures over the last several months. It's kind of an intellectual exercise. If we wanted to push long real yields to plus 2% or plus 3%, could we even do that?
And the reason why we're limited in our ability to do that is because embedded in those markets are market expectations of what's going to happen to inflation over the next few years. And that's where I keep going back to. Until and unless we and markets collectively believe inflation dynamics are different, are hotter and more embedded than we understand them to be right now, I think there's a limit to how much we can drive long-term real yields higher. And so that's going to be a limit to how tight we can make broader financial conditions — until that recognition of the different inflationary dynamics becomes clear.
Tracy: (44:24)
So one thing we haven't really spoken about is the impact of quantitative tightening on inflation. And I mean, things like bond yields and asset prices. So the Fed started winding down the balance sheet or reducing the balance sheet in the summer, but it hasn't really ramped that effort up. And I think it's expected to start doing so in September, what would be the impact of that on inflation and the market as well?
Neel: (44:53)
You know, unclear. If you look at a lot of different models of how quantitative easing works, it suggests that it doesn't have a big impact. You know, Chairman Bernanke famously equipped many years ago, “QE works in practice, but not in theory.” And the way we think it works, that those models cannot capture, is really about a signaling mechanism for the future overall stance of monetary policy. And so a lot of the effects of QE or QT get priced in right away, as soon as we lay out ‘here's our plan for the balance sheet.’ So when we announced ‘here's our plan for the roll off, here's how many billion dollars a month, here's the path,’ a lot of that gets priced in right away. And that's why if you look at long-term real yields, you can see that they reversed themselves this spring really rapidly.
I mean, they climbed in the spring much faster than they fell in the spring of 2020 when we were flooding the economy with liquidity. And I think the reason that they tighten so quickly is because markets were pricing in the quantitative tightening to come, in addition to federal funds rate hikes. So it's an inexact science. I mean, I don't think a hundred percent of it gets priced in. I think some of it does actually happen over time as the balance sheet actually shrinks. But I think a lot of the action has already taken place, would be my guess.
Joe: (46:16)
Since you became the president of the Minneapolis Fed, you've been innovative in your communication — writing blog posts, Medium posts, even tweeting. And I remember, I think it might have been your first post after getting the job, and you were talking about you’re non-dogmatic and you talked about saltwater versus freshwater economics and saying, you know, you don't belong to a school. You wanna see what the data is. You want to always be reevaluating. And I think, you know, you've definitely demonstrated that by going from someone who had a reputation as being one of the biggest doves on the committee to now being up there with the biggest hawks and the most aggressive pace of hiking, what is that like? What's that been like to go from, that evolution from someone who is seen as a major dove to someone who's now seen as a major hawk.
Neel: (47:09)
You know, it's actually been been easy for me because I just look at the data with our economists here and we try to assess where the economy is and what monetary policy makes sense. You know, these labels of dove and hawk, I understand why people give them — they’re convenient shorthand — but they're really flawed. I mean, if I always were dovish, no matter what the state of the economy was, if I always said, ‘we need to keep interest rates low.’ I wouldn't be a very useful policymaker.
And so the economy changed. Now Esther George, my good friend from the Kansas City Fed, who was considered to be one of the more hawkish has now been identified as one of the more dovish in this scenario. You know, Esther is a very thoughtful, experienced policymaker. She's looking at the data, she's making her best recommendations based on how she sees the economy. And that's what all of my colleagues are trying to do. And so the labels are short hands, but they're pretty imperfect.
Joe: (48:03)
So that's interesting too about, you know, that not everyone has sort of traveled in the same direction and there are differences of views on the trajectory of inflation in the economy within the Fed. That being said, I think there is obviously, going back to last year, a fair amount of regret that the Fed misread or sort of the use of the term ‘transitory,’ perhaps waiting too long from the Fed's perspective on hiking rates. Is there anything that, you know, maybe it's the intellectual climate or sort of like different approach that you take from that, any lessons of the last year that you think the Fed should or could internalize to make better decisions, to have a better decision making process going forward?
Neel: (48:52)
You know, it's tough. It's something I think about a lot and I go back in time. So for the eight or 10 years before the pandemic hit, we struggled with inflation. That was a little too low. And as we talked about earlier, Joe and Tracy, we kept getting surprised that we thought we were at maximum employment and there were a lot more workers to come. And before the pandemic, we had a 3.5% unemployment rate and modest wage growth and low inflation. So then the pandemic hits, a lot of fiscal stimulus. And in May 2021, just over a year ago, core inflation finally ticked above 2%. And the unemployment rate was still 5.9%. So we had achieved 3.5% with no real inflation before. Now it was 5.9% at that moment. Should we have just declared, ‘oh my gosh, we're in a new regime.’ I actually don't think so.
I mean sure. Knowing what we know now, but knowing what we knew at the time, I think it's eminently sensible that we would take a few months to figure out is this really a new world, or are we going back to the old world before we adjusted our stance of policy? You know, people call us all the time with all sorts of predictions about how the world is totally different and we're totally missing something here or there. If we listen to all of them, or if we listen to all the cranks on Twitter, we would be completely paralyzed for making any decision because somebody's always predicting something one direction or another. And so to me, I think we need to be very thoughtful when we just abandon what we have recently experienced and just assuming we're in a whole new world. In this case, we are in a new world. How long is our new world gonna last? I don't know. We’ve got to see it in the data.
Joe: (50:31)
Cranks on Twitter. I have no idea what you're talking about...
Tracy: (50:33)
Avoid the cranks on Twitter.
Joe: (50:35)
I've never seen cranks on Twitter.
Neel: (50:37)
Never seen it, never.
Joe: (50:39)
Neel Kashkari President of the Minneapolis Fed, thrilled to have you back on the podcast. That was great. And we will talk to you next August.
Neel: (50:48)
All right. Thank you both. Great to be with you.
Tracy: (50:49)
Thanks Neel. That was fantastic.
Joe: (50:51)
Yeah, that was great. I feel like we packed a lot in there, Tracy,
Tracy: (51:08)
I'm trying to remember everything that we just talked about. There was a lot. I mean, okay. So I mentioned this already, but one thing that clearly comes through in that conversation is just the extent of Neel’s change from dove to hawk and the idea that he is much more comfortable with getting to a very, very restrictive level of policy and then sort of pausing as opposed to starting to cut or even slow down.
Joe: (51:34)
Right. And I think, you know, you think about the mood music or what Powell said at Jackson Hole. He was very specific about the lessons of the 1970s. And I think he said that, you know, sort of modern central bank theory was born out of that inflationary period. And there's no reason not to take the lessons of that period. And as Neel said, you know, one of the lessons from that period of the 1970s was don't declare victory on inflation too soon. Don't get comfortable. Don't just be, ‘oh, here's a month or two of we're going in the right direction. Let's ease off.’ So the bar is going to be very high before something I would say, resembling a pivot, whatever that means.
Tracy: (52:16)
Yeah, but of course with that very aggressive stance comes the question of, are they gonna overshoot? And I know we asked Neel the question about policy lags. And that seems to be possibly problematic for the Fed. And then the other thing that was interesting to me was his response on the global economy and the impact of the dollar. And he mentioned that boomerang effect and the Fed viewing the rest of the world, what's happening there, as something that can come back and impact the US. And I think that's still a big question as well. We're going into the winter. Almost everyone expects Europe to be in a recession now. It's quite clear that emerging markets are suffering from a higher dollar, tighter financial conditions, plus higher energy costs, weather-related disruptions, all of that. What is the impact gonna be on the US? And does that potentially become problematic for the Fed?
Joe: (53:12)
You know, what I found striking was Neel saying that he welcomed the market reaction to Jackson Hole. There was quite a sell off on Friday right afterwards. And there is that cliche that trader say all the time, ‘don’t fight the Fed’ And here he's saying, yeah, there's a good reason for that cliche. Because when the Fed is fighting inflation, higher stock prices don't help that goal be because monetary policy works through financial conditions. So he's kind of saying yeah, there's a good reason not to fight us.
Tracy: (53:40)
Yeah. I feel like the Fed is explicitly saying that it thinks that stocks should be lower or not explicitly, but I mean, that is the explicit conclusion from the conversation. And this is something that we've actually written about in the newsletter a number of times. And I think we said it before we had the big bear market in the summer. Like the Fed is telling you that asset prices are too high because financial conditions need to tighten.
Joe: (54:03)
Right. They talk about financial conditions. Financial conditions means something, as commonly understood, and it’s spreads and the stock market and so forth. So if the Fed is saying, we work through financial conditions and they would need financial conditions to tighten in order to defeat inflation, they're telling you something about where they think the market ought to go.
Tracy: (54:25)
Also you can disaggregate what makes up financial conditions. Mortgage rates are a lot tighter, bond yields, to some extent, you know, have gone up. It's really stocks that are the sort of odd one out here.
Joe: (54:36)
Yeah, gotta get Bitcoin down to 10,000.
Tracy: (54:40)
You know, that's a good argument for putting crypto into the Financial Conditions Index. That would be interesting.
Joe: (54:46)
One day it'll probably happen. Okay. Let's leave it there.
Tracy: (54:48)
Oh, I was going to say we also, we need to start thinking up like a tradition for the Neel Kashkari episode. I feel like we have to unbox gifts or sing carols or something,
Joe: (54:59)
Something in August
Tracy: (55:01)
Something seasonal.
Joe: (55:02)
Let's do it live next year and let's do it in a really nice location. Because I'm always super jealous of like late August in Jackson Hole. Let’s find a nice place to do it.
Tracy: (55:12)
Somewhere where we have an excuse to wear cowboy hats.
Joe: (55:16)
I love it.
Tracy: (55:16)
All right. Should we leave it there?
Joe: (55:17)
Let's leave it there.
You can follow Neel Kashkari on Twitter at @neelkashkari.