We’re at a pivotal moment for the Fed. We’ve now gotten two CPI reports in a row that came in lower than expected, leading to some hopes that inflation is on the way down. But, although the Fed just hiked 50 basis points last week, officials seem unconvinced that the problem is over. So where do things stand now? When can inflation worriers start breathing easy? To learn more, we spoke to Tim Duy of SGH Macro and the University of Oregon, as well as Jon Turek, founder of JST Advisors and author of the Cheap Convexity newsletter. This transcript has been lightly edited for clarity.
Key insights from the pod:
What we learned from Powell last week — 2:30
What does restrictive policy even mean? — 5:21
Is this year just last year in reverse? — 10:47
Is an immaculate deflation even possible? 19:37
Can productivity miraculously rebound? — 24:01
Why is the market still pricing in cuts? — 31:36
What everyone should be watching for next — 38:36
---
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: (00:16)
Tracy, it's been a while since we've just sort of had a macro state-of-the-economy episode, but I think now is a very good time for it.
Tracy: (00:24)
Yeah, absolutely. So we are recording this on December 14th, literally two hours after the Fed's latest decision in which they hiked by 50 basis points. That was widely expected. But what wasn't as expected was the CPI number that we got just yesterday, which came in, I think the headline figure was 7.1%, which was lower than expected.
Joe: (00:46)
Right. So a pretty big week. I mean, the big macro story is: everyone's waiting for some clear sign of inflation deceleration. Everybody is trying to figure out, you know, ‘Is the Fed gonna pivot?’ and ‘What does pivot even mean?’ because I think pivot is a contested word. And so I would say a pretty big week because, as you say, we got an inflation report, a Fed announcement, press conference, all of that. And so I think a good moment to take stock of where we are in these stories.
Tracy: (01:16)
Right, is this a turning point in this sort of high inflation interest rate hiking cycle narrative that we've had for some time. And the fact that I've said ‘turning point’ and the fact that we're doing an episode on this means that it's probably going to amount to nothing, and I've cursed it, but you never know.
Joe: (01:31)
We keep setting ourselves up for the jinx right now, so we have all of our bases covered. But anyway, I think we should just get right into it with two of the people we most like to turn to on these big macro questions. We've spoken to them many times over the years. We're going to be speaking with two guests. Tim Duy is the Chief US Economist at SGH Macro Advisors. He’s also a Professor of Practice in Economics at the University of Oregon. And Jon Turek, the founder of JST Advisors and the author of the Cheap Convexity newsletter, which is a must-read. Tim and Jon, thank you both for coming on.
Tim Duy: (02:08)
Well, thank you for having us. Thank you.
Joe: (02:11)
Absolutely. So why don't, you know, I'll throw a question out for both of you, but like really simple. We just wrapped up Powell's press conference. Why don't you sort of give us your summary, you know, start with Tim, but both of you can go on, what did we just learn from Powell?
Tim: (02:31)
I think the main thing that, that we really learned from Powell is that they're very much committed to this idea that they need to hold rates, you know at a restrictive level for an extended period of time. And then we also know that they're closing in on what they think that level is. And what this seems to be coming down to is deliberately causing something that looks very much like a recession.
Although Powell will say that it's something in the forecast, which is interesting now because it's going to create some questions. Given this disinflationary trend we're seeing in the data, people are going to start asking, ‘well, why do you need to create a recession here?’
Tracy: (03:26)
Jon?
Jon Turek: (03:27)
Yeah, for me I took away three key things from today.
I think that one is that they are kind of transitioning from this ‘Where is terminal?’ to ‘how long to stay there?’ stage. And I think that that really was most put forward by the fact that policy seemed very open to going in 25 bip intervals starting at the February and next FOMC meeting. So that, you know, along with the commentary, the press conference doesn't make it seem like they're in the ballpark of what they deemed to be sufficiently restricted.
I think the second thing is that they are seemingly looking at this, at least ex ante, is that they want to stay around 5% Fed Funds for a while.
And then third, I think the interesting thing from the dots to me, you know, obviously one can point to an interesting 2023 core PCE number, but I think, you know, most interesting to me is that if you look at the real rates for ‘23 and ‘24 using Fed Funds and their core PCE projection, it's 160 basis points for both years.
So I think in terms of defining what sufficiently restrictive — this sort of vague, maybe dynamic term means, I think they gave you a pretty good insight into the level that they seemingly are going to be targeting that, you know, equates to inflation back at target over the medium term.
Tracy: (04:49)
So this is something that I wanted to ask both of you, but I feel like there are a lot of terms that, you know, we throw around now without really like digging into them very much. I mean, ‘transitory inflation’ was one of them from last year, and now we're talking about ‘transitory deflation,’ which is kind of amazing. But can we talk about ‘restrictive/ ? What exactly do we mean when we talk about the Fed moving to a restrictive policy. That can be for either of you.
Tim: (05:21)
Well it's unfortunate that the Fed doesn't seem to entirely know when they're going to be at restrictive, right? So how are they going to figure this out? And it's the case that they're looking for this rate that they think will create downward pressure on the labor market, sustained downward pressure labor market. And the desire is to get wage growth down in order to really reduce the inflationary pressures that they think are going to persist if unemployment stays this low. But what is that rate? You know, I think the best way to think about it is maybe like Jon was saying, that maybe it's a real rate of 160 basis points, but I don't know if we should have a lot of conviction in that number.
Jon: (06:07)
You know, I think that it is sort of this, feel your way around, you know, even in the context of the message I took away from the SEP today. You know, I think Loretta Mester actually set up a decent way of thinking about it in sort of these like broad strokes. In my notes to clients I kind of called it like the ‘Mester Roadmap.’ But it's basically this idea is that once the Fed gets to a rate that has, as Tim says, you know, sustain downward pressure on the labor market, sustainrf downward pressure on economic activity, they can basically tee off this handoff from below-trend growth to slowing wage growth to slowing inflation. And I think that is sort of the sequencing is that they're trying to achieve, and they can only really know which level is doing that in real time.
Of course, they'll have model estimates that will guide them and we'll, you know, I'm sure we'll see a Kashkari blog, you know, following this meeting on what that level looks like. But I think that, you know, broadly speaking, it's going to be very much informed by the data. And this is something that I think, you know, a takeaway from me from this meeting is that, you know, sufficiently restrictive is not, you know, it's not an absolute level. It's a dynamic level. And I think going into, you know, the next two years, staying still may actually include moving, but we can get into that later.
Joe: (07:31)
Let me back up a little bit, because setting aside the Fed, let's talk about the day before on Tuesday, we got that CPI report that Tracy mentioned in the beginning. Core CPI on a month-over-month basis came in at just 0.2%. Headline was obviously influenced a lot by the plunge and oil prices, which can only go so far, I guess, just 0.1%, Tim when you look at this report, are you optimistic? Are there reasons to be optimistic that this is the start of a sustainable trend? Or is this noise?
Tim: (08:02)
Yeah, certainly when I look at the report, I have to be sort of honest you know, the approach I was taking last year, right? Earlier this year, and, you know, when I saw those inflation numbers start to rise and I saw what I call ‘super core inflation,’ right? Core inflation minus housing and autos. You know, I really started to say, you know, we can't ignore this inflation as transitory. And I'm in kind of the same position as right now, is that we've seen a lot of improvement in that super core and narrowing of some inflationary pressures. And so it does seem to me like there has been a change. Now, whether or not that's persistent we'll find out, but I do think you kind of have to have to take the number at face value and say, yeah, there seems to be a lessening of inflationary pressures, at least in the near term here.
Tracy: (08:51)
So one of the things that Powell said today was, you know, he was talking about how there's this expectation that services inflation is going to be tough to bring down because the labor market is so strong and wage growth is still relatively high. And that's the thing that kind of feeds into overall prices. I mean, that implies that the Fed is explicitly going to be targeting a softening of the labor market, right?
Tim: (09:17)
I was thinking that this is a way you can sort of tell that the Fed is hawkish, right? Is that they're very much focused on getting inflation down, even at the cost of getting unemployment higher, you know, considerably higher. And, you know that’s definitely what they're trying to achieve here.
Tracy: (09:38)
So inflation is starting to come down, but for the past year or so, we've been told that the reason the Fed needs to be so aggressive is because they're worried about expectations becoming embedded. They're worried about a wage price spiral. But the fact that core seems to be beginning to come down, does that suggest that maybe those concerns were overblown?
Tim: (10:02)
That's going to be the question that people start to ask. If core is coming down and the Fed’s sort of backing down to this argument that we really need to get this lower level of core inflation, right? US services ex-housing down, it's going to cause some concern about, well, why is that now the measure of underlying inflation? Why should we be focused on that? And not in fact the idea that maybe we can return to a 2018, 2019 type of environment. And the Fed hasn't changed the narrative to allow that to happen yet. So I think it's going to be a question that's increasingly important as overall core inflation, if it remains low.
Jon: (10:47)
I have two things on this. What Tim said is absolutely right. I think that there are really like two reasons for why this rendition won't just be the reciprocal of the inflation-rising period of late last year and early this year. I think one — and this is why I think the Fed is so emphatic on showing us that they're going to be looking at services ex-OER, sort of this like core labor market trend — is because the Fed knows that the labor market is not a tailwind to achieving their goals, it's a headwind. So given the state of where nominal wage growth is, it's much harder to have conviction that inflation is going to settle back at 2% when nominal wage growth is 5.5%.
Whereas if we flip it to where the Fed was in late last year, early this year, it was it was becoming pretty obvious that inflation would be, even if there were transitory factors, it had this structural tailwind from a very robust labor market. So in terms of comparing then to now, it makes sense for at least like in terms of a range of outcomes, for the Fed to be more hesitant into embracing this trend of disinflation versus them accepting trend higher inflation because the labor market dynamic is feeding into one and not the other.
And I think the second thing is on inflation expectations. You know, such a big part of it, and this is something I think that Powell's been really pounding the table on really since June when they made their initial rise to 75, is that he said that above-target inflation in terms of expectations is not only about trend, but it's about level.
And then from there it's like a ticking clock in terms of its feed-through to inflation expectations. Whereas if you allow inflation to remain above target for three or four years, even though it's headed in the right direction, that level can be a nuisance in terms of inflation expectations and making sure that inflation's anchored at 2%. So, I think that, you know, there are similarities to playing that this is the reciprocal of the bullwhip in goods. It’s the reciprocal to the bullwhip in rents, but at the margin, there are more factors for the Fed to be hesitant in this full embrace of the early signs of a meaningful disinflation.
Tim: (13:14)
Right. Especially becausethey got burned on that last year too, right? So there’s always been a likelihood that the Fed was going to hold the line here for longer than, maybe market participants thought appropriate simply because they thought the risk of letting inflation get out of control. And Powell reiterated that today that inflation was too high.
Joe: (14:00)
So I want to talk more about labor. And Tim, this is a question for you. So right now the unemployment rate is 3.7%, and in the press conference, I don't think Powell specifically talked about a soft landing per se, or I don't know if you used that term, but he did seem to express some hope that we need to see some weakening of the labor market, but that maybe it could just be a little, because, you know, the labor market’s really tighten his view. There's all these unfilled job openings, there's a structural shortage of workers. So maybe we just need a little bit of tilt. What does history say? Can we just get a modest increase in the unemployment rate to like the low fours? Or if we start to see that pickup and the unemployment rate, does history say it's going to go up substantially more than that?
Tim: (14:47)
Yeah, I would say that the history is not in the Fed's favor here, that you really can't guide the unemployment rate, three tenths or five tenths of a percentage point higher, let alone 0.9% points higher. So I just don't think that this sort of soft landing idea is a likely outcome here. I would like it to be, but to me it it seems to be screaming against what we’ve seen in the past.
Joe: (15:20)
Yeah. Tracy, I'm just looking at the Fed's SEP — the summary of economic projections — and it anticipates the unemployment rate peaking at, you know, we're at 3.7% now, going to 4.6% next year and the year after that, and then going down a bit. So there's like this idea that we just get a little bit, or you know, 1% is not nothing especially the people who have lost their jobs. But you know, the story the Fed is telling is that the unemployment rate will be contained.
Tracy: (15:47)
Well, this is something else I wanted to ask about, which is, you know, we hear comments from the Fed a lot now about how monetary policy operates with a lag. And that to me seems like as big a question as the ‘transitory inflation ‘question that we were discussing, you know, a year or two ago. Like, how long is the inflation going to last? How long is it actually going to take interest rate hikes to have an effect? Do we have a good sense of that? Like the fact that we saw CPI come in less than expected yesterday, is that a sign that monetary policy is working? Is it a sign that monetary policy has the potential to overshoot and cause the recession that everyone seems to be worried about?
Jon: (16:34)
I think that broadly, the long and variable lag question is just very hard to answer. I don't think there is a clean one. I think that there is this assumption that the Fed is talking, and central banks broadly are talking about ‘long and variable lags’ in the sense of, you know, well we should slow down and then wait six months and you'll have more apparent evidence. And you have seen it across the world. I mean, the Bank of Canada has recently transitioned from saying that you can feel the monetary policy tightening and just the interest rate sensitive sectors in the economy to now the whole economy is starting to feel it. So I think conceptually it makes a lot of sense. I don't think that there's like a strong empirical approach to say, okay, you know, ‘T-9 months,’ this is when we'll start to feel the whole thing.
I think that the way the Fed is thinking about long and variable lags, and maybe I'll be more specific to the leadership, is I think the way the Fed thinks about long and variable lags is you kind of hope to engineer this handoff to pro-cyclical tightening. And what I mean by that is that basically you let the disinflation that's occurring basically raise your real effective funds rate.
And I think that the Fed is now at the point where the long and variable lags is that now you're starting to see the data at least begin to cooperate with them. There has been some softening, not a lot, but there has been some softening in the labor market. There's definitely less churn as we can see from continuing claims. JOLTS have come down a lot. The inflation data is starting to look a lot better than it did three months ago. And now I think from the Fed's long and variable lags quote unquote ‘perspective’ is it's about, you know, exerting real positive policy rates across the curve and letting that sort of serve as the new form or anchored form of tightening. More than, you know what we’ve been doing now, which is rate hikes.
Joe: (18:27)
I want to go back to the theoretical question about whether some sort of immaculate disinflation is possible or whether we can have inflation return to trend without a big jump in the unemployment rate. I mean, again, just going back to the last few weeks, so we got a pretty good November CPI report. We also had that hot wage growth number from the recent non-farm payrolls report. I mean, again, we're pulling at just a very few data points. I don't think you could tell a tremendous story from one CPI report or two CPI reports and one wage number in the non-farm payrolls report. But I don't know, it looks to me like you can have both. That you can have this period where wages are growing robustly, where the unemployment rate is low and some sort of rollover.
What would it take for the Fed, I guess my question would be, to say, you know what? Maybe it's possible, maybe we don't need to induce a recession or maybe we don't need to see much of am increase in the unemployment rate at all. What would it take for the Fed to look at, how many more of these cool CPI reports would it need to be, before maybe the Fed started believing in the possibility of a soft landing?
Tim: (19:37)
That's a question I ask myself a lot for exactly that reason, because you have seen some improvement in the inflation numbers and it seems like it's almost premature, right? We had been expecting, and the Fed had been expecting, that that improvement would really follow the labor market. And it's coming ahead of what we see as any significant loosening of labor market.
And the Fed's going to be worried — and I think rightly so — that persistently high wage growth, if not matched by sufficiently high productivity growth is over time going to lead to upward pressure on inflation, upward pressure on inflation expectations. And basically the argument that wages and and inflation are tied together in the long run.
And what we could be seeing in the short run is all the slippages that can happen. So you could think of, you know, higher wages being resolved through lower margins, right? Margin compression. I think as you said, it's really hard to make any clear decisions off of just a couple months of data. But, you know, the Fed will have a harder time selling that story going forward if inflation continues to slow, especially if, if those core services inflation numbers start to soften more, then that's going to be something that’s harder to explain.
Tracy: (21:05)
When did we start calling it immaculate disinflation?
Joe: (21:08)
I don't know, that’s a good question, who came with that?
Tracy: (21:10)
The earliest mention — I was curious because this is the second or third time I've heard it just today, but the earliest I can find is actually Matt Klein in his newsletter.
Jon: (21:20)
Oh, it sounds like a Summers thing, I feel like.
Tracy: (21:24)
You might be right. So I wanted to ask about financial conditions as well because, I mean, this is something that has come up. Neel Kashkari talked about it on this podcast talking about how he was happy to see the fall in stocks which fed into a tightening of financial conditions. And of course monetary policy is supposed to work through either loosening or tightening financial conditions.
But in recent weeks we've seen those conditions start to loosen again as bonds are rallying. Stocks have been rallying — up until today. It looks like the S&P 500 is down a bit after the Fed meeting. But John, this is for you in particular, because I know you were very, very focused on the stronger dollar over the summer and you had argued that the strong dollar would end up doing some of the Fed's work, when it comes to tightening financial condition, for it. But now that the dollar in particular is softening and financial conditions in general are loosening, does the Fed need to be concerned about that? Do they need to try to move to offset that?
Jon: (22:27)
That's a good question. I don't think so. I think that, you know, from the Fed's perspective, at least, you know, looking at it in dollar terms or US dollar terms, is it really almost was job done. I mean we can of course, you know, add in that China being effectively shut down for a lot of the years certainly helped commodity pressure come off. We can also add in that the SPR [created] a tremendous amount of relief to oil markets. But you know, I think in terms of the commodity supercycle that was being pitched, the dollar did neuter a lot of the right tail in, you know, the broader commodity complex and just looking at, you know, the Bloomberg Commodity Index, it’s off a material amount from its highs. So I think in those terms the Fed has achieved a lot.
I think, you know, thinking about the financial conditions question, and this is one I actually, you know, get a lot because we have had a non-trivial move, looking at something like the Goldman FCIs basket, you know, over the last few weeks. I think the way to think about it, and I think the way the Fed is broadly thinking about it, is that FCIs are sort of this relative term. They're relative to the spot labor market data and the spot inflation data. And if FCIs were loosening in the context of the inflation data getting worse or the employment stuff getting better, I think that would be at odds with something that the Fed is looking for. But, you know, a point that I've been making over the last few weeks, if the FCIs have sort of been quote unquote ‘earned’ in terms of a slight improvement in the labor market and a more than slight improvement in the inflation data, even though it's only the last two months, then I think that's something that, it doesn’t necessarily equal like the Fed is going to fight or it requires Powell to sound like he did at Jackson Hole.
I mean, I think a pretty telling thing for me was when Powell came out in Brookings and everyone was expecting him to, you know, beat the hammer on financial conditions, assuming that they loosened too much. He didn't. And I think that part of the reason he didn't is that this is different than it was in July and August when there wasn't really any compelling evidence that inflation was falling. We actually saw two months of .6s after, and the claims move, you know, initial claims reached 250k, went back to 210k basically over the course of a month.
And then it was more of a reaction function question, how serious is the Fed? Is the Fed willing to do what it takes? And then Powell came out at Jackson Hole and told you we're going to do what it takes. That's not really the question now. The market has full confidence that the Fed will do what it takes looking at either forward inflation swaps or break even rates. The question now is how much earned financial conditions loosening can you have? And that is, I think, data dependent. I think that's going to be the way this shakes out over the next few months.
Tracy: (25:17)
So just on this note, and this can be for either of you, by looking at the market reaction today, you know, stocks went up a bit right after the decision was announced, and they've come back down since then. But in terms of the market reaction, assuming the data starts to change and evolve and we do see sustained deflation and maybe even a little bit of weakness in the labor market, is the Fed going to be able to continue to convince the market that it is in fact hawkish? Because that seems to be what it's trying to do, right? It needs to maintain expectations, put pressure on financial conditions and things like that. But is it going to be able to do that as the data starts to change?
Tim: (26:03)
I think this gets to Jon’s point is that if the data is moving in a disinflationary direction, the market's going to go with that. Because they're going to assume that sooner or later the Fed is going to catch up to that approach. And it's really, you know, more problematic for the Fed if the market's just not getting the Fed's reaction function, right?
You know, where again, there could be some tension here is if the Fed is, excuse me, if the markets are looking at core inflation and the Fed's looking at this services ex-housing component, we would be in a space where there could be, you know, room for confusion.
But, you know I think once the data turns or the market starts to sense the data is turning, the Fed's just going to have a hard time, you know, selling that story. It cuts both ways too. If the data firms here, you know, lower prices cause consumer spending to rise, for example, in real terms, they could sort of tighten back up financial conditions.
Joe: (27:05)
Well I joked about this over the weekend, but I don't, you know, it's kind of only half a joke or half a troll about, you know, we've had this big plunge in gasoline prices and maybe because of that, maybe some of that is softening demand, I don't know. But for some people that's like a huge financial shot in the arm. That's more money left in the wallet each week. And so, you know, I think what could cause the data to firm? Maybe it's falling gasoline prices.
But Tim, I want to go back to something you said, you know, you think about, okay, what are some ways we could have like a soft landing? And one of them would be if we got some period of like catch-up productivity. And we know that productivity has been pretty bad. What's your story for why productivity has been bad, and is there a possibility that whatever, cause that could flip in some way and then we get a big spike in productivity?
Tim: (27:58)
Yeah. So productivity has to be measured as a residual, you know, of GDP growth and employment. So, you know how confident we are of that number should always be in question. But it does look like productivity has been weaker this year. And you know, I don't know that anyone has some huge great explanation for this. I think that when you kind of run the economy too hot, you run it inefficiently. And that seems to be to me what was going on.
You have a lot of churn in the labor market. Maybe you've got some new employees, some younger employees, and they're just not as efficient, you know, and they're struggling against stronger demand. So that erodes your relative productivity. So I think that's a reasonable story. And then in theory you could ease back if, if people got some breathing room on demand, right? So I think, you know, that's something that goes on.
To me, if you want a soft landing the most important thing is getting the Fed to believe that you can have a soft landing? Right now the Fed, they're saying that you can have a soft landing, but again, we can debate whether or not the rise in unemployment that they have penciled in is consistent with that outlook. And I would say no. But, you know, what I'd like to see for a soft landing is for the Fed to believe fully they just do not have to keep rates and can cut them sooner than they anticipated.
Tracy: (29:22)
Tim, I wanted to ask you about this as well. So setting aside the prospect of a soft landing, which has now been rebranded as immaculate disinflation, it feels like the big concern or fear for the Fed would be significant stagflation. So inflation combined with, you know, negative economic growth. What would they do in that scenario?
Tim: (29:47)
Powell has said the objective here would be to bring inflation back down to trend. You know, I think that if you had a real stagflationary episode, how the Fed [acted] would really be dependent upon what they thought was happening with inflation expectations. So if you had, you know, elevated inflation this year going into this — suppose elevated inflation was something we're still experiencing, and then suddenly the unemployment rate was rising, the Fed would start to think, ‘Well, you know, a higher unemployment rate should pull down these inflation numbers.’ And so the key in there would be what would what would be happening with inflation expectations?
Now if the Fed could be confident that they could focus on the employment mandate without worrying so much about the inflation mandate because they thought that was going down, then they could, you know, pursue an easier policy. But if they saw inflation expectations rising they would pursue a more aggressive policy.
Joe: (30:47)
Jon, you know, one of the things that Powell was asked about, you know, we were talking about how many more hikes, but he was asked about cuts. And there still seems to be this tension between what the Fed officials have said and what market pricing has said. And so, you know, all year the Fed is like, ‘What are you guys even talking about? We're not anywhere close to thinking about cuts.’ Or at least that's basically my summary and yet the market seems to be pricing in rate cuts and not even very far out. In fact, you have an inversion of the 3m2Y curve, which means, you know, rates in the fairly short next couple years [are] lower than they are right now or over the next three months in some way. What do you make of this divergence? Because it's been a story I think for several months, this gap between rhetoric and market pricing.
Jon: (31:36)
Right. No, it's a good point and I think that there's two parts to it. I'll talk about it in stage terms. And the first stage of this was really the middle to Q3 of this year part, where the market kept saying it’s like, okay, there are gonna be cuts in X amount of time. And I think that was really a byproduct of the market's assumption that given all of this fixed income volatility, given the rapid increases in the Federal Funds rate, that something was going to break, whether it be the labor market, whether it be a financial accident as we saw in the UK, something of that nature would break and the Fed would have to unwind some of the things that it did. And that's why we always even, you know, looking as far back as June, we always kind of assumed that cuts couldn't be more than nine to 12 months away.
And I think what is happening now, which is different than that first stage, and I think is actually a little bit more sustainable, is the Fed is basically, not officially, but you can glean into the fact that the cycle is almost over. And from the market's perspective, once the Fed conveys to the market that Powell's preference is probably for 25 in February, then the market has to trade with a percentage chance that March is a pause, a very reasonable percentage chance given what is seemingly the trend of, you know, disinflation at least through Q1.
And then from there, the waiting game, the market is always going to trade the skew that either a hard landing or soft landing will happen. And in both of those cases, the Fed isn't at 5% forever. You know, the way I've kind of looked at it is, is that there's three potentials for next year. There's the no landing, the soft landing and the hard landing. The no landing is sort of, we find ourselves in a similar world to where we are now, where inflation is not convincingly on its way back to 2%, nominal wage growth is still 5.5%. And the Fed is just kind of stuck. The soft landing is that you sort of get into this 2019 world where the immaculate disinflation does somewhat take place. And then you could see yourself, as you know, Goldman Sachs's Q4 forecast for Core PCE next year is 2.9 and the Fed could feel at 2.9, the 5.5% and change is a bit too high in terms of, you know, how restrictive policy needs to be. And that could lead to cuts. And then in the hard landing scenario, we obviously know that they cut a lot. So from the market's perspective, once you told them that there's really not that many more hikes left, maybe just 25 or 50 basis points, the market's going to lean into the skew of cuts. It's just a faction of time.
Tim: (34:16)
And there's really nothing that the Fed, I think, can do about that at a certain point.
Jon: (34:22)
I agree.
Tracy: (34:40)
So, you know, we've been focused on the Fed for obvious reasons, but Jon, I know you've been in particular looking at some other central banks and you’ve referred to the central bank of New Zealand, the Reserve Bank over there, as something of a north star in terms of the read-across to other major central banks. You know, it was one of the first to actually start hiking rates. Can you maybe talk a little bit about what we've learned from the experience of central banks ex-US?
Jon: (35:09)
Yeah, I mean I think that, you know, there've been a few interesting examples, I would say over the last few months I would say that the RBNZ sort of in both ways, either in terms of their policy trajectory has been sort of this north star, as you said. But I also think that, you know, for me sort of in like, you know, thinking about the trajectory of the cycle and what is the sort of the next phase of trading interest rates, I think the RBNZ in November was a pretty telling meeting in terms of how the market is digesting this potential inflection point in the cycle.
Because what happened at the RBNZ in November is that they accelerated their hiking pace from 50 to 75, from a place that was already restrictive. And then in their monetary policy statement and their forecasts for the economy over the next few years, they said that they see the terminal rate in New Zealand being close to 6%. So this was a very big rerate in terms of both the actual hiking, actual hikes that they did, and in terms of the hiking cycle in its totality. And the market's reaction to that, which for most of this year would've been, you know, rates at the very front of the curve ratchet higher, actually rates, you know, yields increased on the day but actually didn't make a new high relative to where they were in October and September. Even though given there was new marginal information and the RBNZ was much more hawkish than I think many market participants thought of.
So I think, you know, in terms of where using these leading arrows, but also getting a feel for sort of what the distribution is in terms of markets, I think the RBNZ was very telling in terms of how the cycle and at least the hiking cycle towards the end of the hiking cycle is going to be traded. And I think that, you know, broadly speaking, you know, central banks around the world now is that we’re going to be in this divergence period where there are central banks who are going to see very clear and obvious signs of growth deceleration, and there are going to be central banks that don't.
And I would probably put the Fed in the ‘don't’ camp, where it's not obvious to me that, you know, GDP next year is on track to run it as the Fed thinks 0.5%. You know, I think as Joe was sort of cheekily alluding to earlier is that, you know, there's some pretty decent impulse for growth given that the composition shift is getting a lot more healthier in real terms. And if you can sort of get a little bit less financial market volatility, you can maintain some decent real income growth, which we have sort of seen now since July, then I think the economy can do pretty well.
Whereas, you know, places like the UK, even Canada, places with very private debt levels relative to GDP and have a lot of floating rate mortgage exposure, you know, those places are going to feel growth in a very different way. And those central banks I think will be quicker to be like, ‘Listen, we have to be a little bit more two-way in terms of how we approach the cycle.’ So I think it's going to be, I think there are still north stars, but I think we're entering a period of pretty meaningful divergence where I think the economic performance is gonna be just very different across the world.
Joe: (38:23)
So Tim, I have one last question aimed it at you, but you know, this idea, and you sort of hinted at, which is that if we were to get more data points like the November CPI report that indicate, okay, it looks like there's a meaningful slowdown, then regardless of what happens on the labor market, the Fed might start to believe it? That something is real. But just how are you thinking about the next few months? So we don't have another decision again until February, then one in March. Ehy don't you talk us through like your sketch for how you're thinking about, you know, the first quarter of the first half of next year.
Tim: (38:59)
Right. So I’m expecting a 25 basis point rate hike at the February meeting. And then, you know, beyond that, getting to the Fed’s current terminal rate, you know, rate hikes of that magnitude in March and May, as well. And at this juncture, I'm finding it increasingly difficult to see that. First, if these inflation numbers are sticky, you know, sticky on the downside here, it's going to be much more problematic for Fed to continue raising rates. And then, you know, over that period of time we could see some labor markets softening. Now the interesting question to me now is to what extent the firming we're going to see in this data overrides any softening we're seeing in in labor markets right now?
And Jon mentioned some of the signs earlier, and if those signs stack, I mean, if we are getting job growth down to closer to a hundred thousand a month, even as the economy firms, then I think the Fed's gonna be hard pressed to keep raising rates, certainly after March. And that's the kind of setup that I'm looking for, is that we see some of this continued evidence labor markets softening that gives the Fed some room to pause. But they're going to want to be confident that that softening is going to continue. So I do think they're going to want to see the economy slowing, and it's not evident to me that that's going to happen.
Tracy: (40:33)
So this is a similar question, but directed to both of you. What's the one number or economic indicator that you're watching for signs of a soft landing that will allow the Fed to potentially ease up on rate hikes? And please don't just say inflation.
Jon: (40:52)
Well, I'll go with one. I mean, I think that, you know, I'll go with ECI [Employment Cost Index] because I think that that's the way Powell sort of categorized how he sees a soft landing at Brookings. I think the interesting thing about Brookings, and I think if you juxtapose Brookings with the SEP, is you kind of get a glean into what the Fed wants versus what the Fed feels they need to say. And I think the SEP is more a reflection of what Fed thinks they need to say in terms of commitment and credibility versus if you listen to Powell's talk at Brookings, you don't get the sense that he truly believes that he needs the unemployment rate to go to 4.6% to get inflation closer to target. And I think for the Fed, the question is gonna be at five and a half percent or close to 6% nominal wage growth, the Fed does not believe that that is consistent with 2% inflation. So to me, the Fed's chances of a soft lending will be, to me, very dependent on how the inflation data evolves post- a lot of this, you know, more transitory noise in the goods and rent side to some extent. But also, you know, what does wage growth look like in the middle of next year? And I think that will sort of set the stage, not necessarily for how long, how many more hikes there are, but how long they stay at this very elevated level of rates?
Tracy: (42:16)
Tim?
Tim: (42:17)
Yeah, I mean I don't want to repeat the same thing, but I do think the clearer evidence that, Jon's right. I mean, in theory if wages were to come down, wage growth was to decelerate, and so where could we see that other than the ECI number? So, you know, one place it could show up is, you know, and it's already declining, is the quits rate. You know, presumably when people quit a job for another job, that next job has a higher wage. And so even if you got the quits rate down, you'd probably get wage growth decelerated, and something like that could help convince the Fed that they did not need a recession. So the theme here is, you know, what does the Fed need to see to believe they don't need unemployment at4.5%, or excuse me, 4.7%? And the answer is probably, you know, wage growth would be the most likely place that we can hope to see that.
Joe: (43:19)
Jon and Tim, thank you so much for coming on the podcast. It's always great talking to you and [it’s a] particularly timely conversation to understand what I think is a pretty important moment, a pretty important week, in this story. So thank you both for coming on Odd Lots.
Jon: (43:34)
Thank you guys.
Tim: (43:35)
Thank you again for having us.
Tracy: (43:36)
Yeah, thanks so much guys. That was great.
Joe: (43:37)
Always great to talk with Jon and Tim. I mean I think that last point from Tim is sort of the key thing and it's still sort of the big question, which is, will other signs emerge that convince the Fed that there can be some sort of durable decline in inflation without a meaningful jump in unemployment? So maybe it's a decline in the quits rate, maybe it's other measures of wages, maybe it's something with job openings, etc. Maybe it's just the Employment Cost Index. But it does feel like those are the things to watch because look, as long as the unemployment rate is at 3.7%, you can't rule out the soft landing scenario.
Tracy: (44:31)
Yeah, absolutely. The other thing that I thought was interesting was the idea of the sort of discrepancy potentially between what the market's looking at versus the Fed. Because that seems like, you know, today might be kind of an example of it where the Fed came out pretty hawkish and the initial reaction at least was stocks went up, they've since gone down. But you do wonder as the data starts to change whether or not that's gonna become more of a theme and whether or not it's going to complicate some of what the Fed's trying to do here.
Joe: (45:02)
I really liked Jon's explanation of this sort of seeming, you know, speaking of market divergence, you have Fed officials saying, ‘look, we're not talking about rate cuts at all. We're not even done with the hiking cycle.’ And yet the market is priced, you know, on some level the market is pricing rate cuts before too long. And I like, you know, the sketch of the three — the no landing, the soft landing and the hard landing. And if you sort of like figure that okay, the hiking cycle is sort of maybe coming to an end probably, right? We're not that far from the final hike, maybe 25 in February and March or something like that, then at some point, you know, there is some chance — the spread — that we go into a hard landing scenario and that the Fed would have to cut.
Tracy: (45:46)
Yeah, I mean there are like these kind of weird discrepancies that are starting to emerge from the forecasts. So like, the PCE forecast I think went up, but the growth forecast went down, which seems strange. I do feel like we talked a lot about the past year as being like difficult for central banks, but I actually think next year could be even more difficult just because you have all these different moving parts and I know you were joking about gas prices putting money back into people's pockets, but it does seem that as these trends start to change and, you know, maybe services inflation is still going up, but consumer goods inflation starts to fall, there is a weird interaction that could start to happen where, you know, maybe people who work in the services industry are getting more money and so they start spending more on consumer goods again.
Joe: (46:40)
The no landing scenario, it's a real possibility.
Tracy: (46:43)
There are so many moving parts.
Joe: (46:45)
You know, I was glad that you asked that question about international central banks because I thought that was, Jon's answer about the year of divergence, you know, all the central banks have been sort of like rowing in the same direction, so to speak. This year they're all in inflation fighting mode. But again, on this point, you know, you have these other countries where the economy is super rate sensitive because so many people have adjustable rate mortgages.
And so, you know, you could imagine Canada and the UK, those economies really get hit by higher rates. But if you have this situation like just described, where actually the US consumer hangs in there pretty well because they're all getting a price cut on gasoline and there isn't really that pass-through from rates to mortgages the way there is here. And so you have weakness for the rest of the world. It also made me wonder, it's like, well does that mean the dollar's going to rise? We didn't really talk markets much, but that would sort of possibly be an implication if other central banks feel like they have to cut rates or slow them faster while the Fed is saying, ‘look, the US consumer’s doing all right.’ Anyway, all kinds of interesting possibilities for 2023 there.
Tracy: (47:46)
Well, I also think the big wild card is what China does here. Because we've seen such a huge pivot on Covid-19 restrictions. Are they going to pivot when it comes to monetary policy and fiscal stimulus as well?
Joe: (47:58)
Right. And then the question is, you know, the reopening we have, as of right now, West Texas oil [at] $77, last Friday it was around $70. So, you know, with China reopening and the gas cut, will that cause oil prices to go up? Plenty of moving parts to the macro.
Tracy: (48:16)
Yeah, I was going to say the theme of this episode is moving parts, moving parts in macro. The world is a complicated place. Shall we leave it there?
Joe: (48:23)
Let's leave it there.
You can follow Tim Duy on Twitter at @timduy and Jon Turek at @jturek18.