Odd Lots - Lots More With Neil Dutta on a Looming Fed Policy Error

Episode Date: June 28, 2024

Neil Dutta, the top economist over at Renaissance Macro, has generally been sunny and optimistic about the economy over the last four years or so. But now he's warning of a possible mistake by the Federal Reserve. In his view, the central bank is waiting too long to get confirmation that inflation is coming back to target. Meanwhile, unemployment is starting to creep up in a meaningful way. As he sees it, if you're still worried about upside risk to inflation at this point, you need to have a theory about where that inflation is going to come from — and it's really hard to come up with an answer for that right now, given the general downward momentum in hiring and the overall economy. In this episode of Lots More, we catch up with Neil to talk about the risk that the Fed will blow the soft landing.See omnystudio.com/listener for privacy information.

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Barges. This is an after-school special. I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Where's the best squid ink posten? These are the important questions. Is it robots taking over the world? No, I think that like in a couple of years, the AI will do a really good job of making the oddlots podcast. And people are saying, I don't really need to listen to Joe and Tracy anymore.

We do have... Cha-ching? The perfect guest. You're listening to Lots More, where we catch up with friends about what's going on. right now. Because even when the odd lots is over, there's always lots more. And we really do have the perfect guest. I think it's kind of weird to be worried about like some sort of recession or policy error on a day when like the market is basically at all time highs. Don't you think that's a little strange? No. Really? I feel like normally we have these conversations about like something's

going bad and like the market's down like 15%. Yeah, but the market's not that prescient all the time. And I mean, as we've been discussing on the podcast, a lot of that, you look at what's going on in the S&P 500, like a huge portion of that is just driven by a handful of companies. Well, this is definitely true. The market is definitely not prescient all the time, but normally chatter follows the market. Yeah, that's true. But more and more people are talking about some sort of recession or policy mistake by the Fed where they don't cut soon enough. Yes, this is definitely true. So we have seen a little bit of softening in the labor market. We've seen inflation start to come down, and there's a lot of discussion about how durable that trend actually is. And yet, if you look at,

especially Fed speak, if you look at Fed speak, they seem very hawkish. I generally would agree. So here's the weird thing. Here's the thing that really freaks me out, which is that one of our friends of the pod, Neil Dotto, who has been like really, you know, sunny. and is always smiling and it's like always slaying the bear is a little nervous. Neil, why are you nervous? That freaks me out that you're anxious. Well, I just think it's important to look at the realized data, right? You know, everyone's looking at, you know, what's the outlook?

And if they cut once, is that going to reignite the entire economy and inflation? I mean, let's just look at the realized data, the information as it's been coming in. I don't think forecasting is particularly useful when all the Fed does all day long is talking about how uncertain everything is. So just focus on what's actually happened. And what we know about what's actually happened is that the unemployment rate has jumped 60 basis points from its low point.

It's rising at about 30 basis points every five months. If you look at what's happened so far this year, which puts it on track to go up to 4.4% by year's end. That's higher than where the Fed believes it's going to stay. And core inflation, after, a bumpy first quarter, that, by the way, is still edging lower. It's likely that in May, over the last year, core inflation would have run two and a half percent. So when you think about like a rules-based framework, you know, I think it's important to sort of just acknowledge

that across a variety of monetary policy rules, it all suggests that a less restrictive stance of policies required. And, you know, I mean, obviously back during the post-GFC era, right, I mean, there was all this talk about, well, we don't want to run policy based on like a computer, you know, what's the point of having it, right? Like, you know, you need to have some judgment. Well, if you're always uncertain about everything and you can't actually think and you don't want, and you don't want to actually apply any judgment, maybe you should go to the rules. And the rules are basically telling you one thing, which is cut and do it relatively soon. Yeah, in my mind, it feels like at this point, you could essentially do like an insurance cut, right?

Like the momentum is kind of in your favor. And yet it seems like FOMC officials, at least looking at some of the recent Fed speak, they're really worried about this idea that like there's going to be a long tail in inflation. And if they're not really, really going up against it, it's going to be the 1970s all over again. Yeah, I don't, I don't really buy it. I mean, in the 1970s, they took real interest rates negative. Right? No one's talking about doing something like that right now. I mean, I think what I'm talking about or advocating for is that it's important to start a recalibration of policy. If they wait long enough, maybe they will have to go more. But the idea is to do a little bit now so you don't have to do more later and sort of stabilize economic

conditions at the moment. I think what's important is that there's really not much of a right tail risk to the economy. I mean, I would agree with Joe in the sense that I'm not going to light my hair on fire over recession risk, but it's just important to note the areas of the economy that have been kind of responsible for some of the slowing that we've seen this year. It's housing and consumption. Okay. I mean, if you look at nominal retail sales and food services spending so far this year, it's actually basically where it was. in December. So it's been flat for five months. And then when you look at new home sales, they've generally been slowing. If you look at new homes sold that haven't yet been started,

it suggests that we're going to see continued weakness in residential construction spending over the summer. So it's not just about the economy slowing. It is, but it's really about the areas from where that slowing is coming. And so I think it's important to just keep that in the back of your mind. And, And it's just, to me, it's balance of risks. Like, what is the risk for the unemployment rate? Like, tell me the downside story for unemployment. Like, why does the labor market retighten at this point?

It's really hard to come up with it. And same thing, with respect to inflation, like, what's the upside scenario for inflation? So I think this sort of idea that they're just going to be a slave to the high frequency data and, oh, just another few more months and we'll get there. It's kind of ridiculous when you don't have like a fundamental story for why that risk is really worth paying attention to. I thought it was really revealing, you know, I think at the last press conference, Jerome Powell was talking about import prices. He's like, well, you know, import prices rose, and we can't really understand why. And then literally like 24 hours later, the import price number comes out,

and it was a complete dud, like it fell substantially. And why would you worry about import prices if the dollar is strengthening? I mean, how do import prices work? I mean, you know, sometimes it's important to kind of stick with first principles. And so, I don't know. I mean, I just, they never really had a good explanation for why Q1 was so firm in the first place. And they're sort of a slave to the high frequency data. And, you know, I just think that you have to have like a fundamental framework in place. And the way to sort of frame this to the markets is, look, labor markets are an important driver of inflation in the way we think about the world. And the lay, the inflationary impulse from the labor market is basically zero. We've, we've trimmed excess labor demand. And

and as is evidenced by job openings, which is a series that they've been paying so much attention to. And if you look at unit labor costs over the last year, they're running under 1%. So where is the inflation going to come from? That supports a recalibration of monetary policy. And we can take by meeting my approach. If that's what I would say,

but, you know, Joe, as you know, I don't have a PhD. I'm not at the Fed. So, you know. I don't have a PhD. Tracy, do you have a PhD? No, of course not. I have a postgraduate diploma. I like the way you pose this question, which is that it's understandable in the abstract to say, you know, it's understandable in the abstract to say, oh, you know, their risk to both sides.

But the onus does seem to be on the sort of hawks to say, okay, like, if we're going to get a reemergence of inflation, where's it coming from? Because the story about labor markets and so forth was kind of a compelling story for years, except now we do have this pretty clear labor market. slowing really across a range of a range of indicators. Here's my question, though, like, all right, so they want to see a little more data. They want to see a little more disinflation. How much risk is there if, like, okay, they don't do July. They probably won't, like, September, maybe November. Like, does it really matter, like, if, you know, whether it's September or November?

I think November might matter. Yeah, but, like, like, when it does it really get away from them if they, like, put it off a couple more meetings? I mean, the risks certainly build. You know, I mean, you know, I'm not going to say that the difference between July and September means the economy rolls over hard or not, but I definitely think the risks certainly build, the more they see, the more evidence they see inflation is slowing and the more intransigence they sow in responding to it, the more the risk built for the economy. Because remember,

I mean, today's inflation data represents yesterday's monetary policy. So what do we know about inflation. We know that inflation's already been slowing, and we know that monetary policy hasn't been changing. So a good first-pass estimation is that inflation will continue to slow. So in that respect, they're going to be passively tightening policy by doing nothing. So in my mind, that means that the risks continue to build. So you're talking about an economy that's only growing, you know, it's growing at about 2%. Okay, fine. But the pressure we're continue to build. And you look at the labor market, I mean, this is something, a point that you brought up before, the only reason the labor markets look as good as they do is because the layoff rate is really, really low. It's not like the

rate of hiring has perked up or anything. The rate of hiring remains low. So if companies are getting now to a point where they're feeling a little bit more cautious on the outlook, a very modest increase in the layoff rate will generate much weaker growth in employment. Right. And to me, the fact that the Fed has been leaning in heart to this sort of positive supply story, that just adds to it, right? Because at that point, you know, any weakness in employment growth will imply that much weaker demand. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and

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on Apple, Spotify, or anywhere you listen. Neil, you mentioned the idea of companies getting a little bit more cautious just then. I was overjoyed to see in one of your most recent notes, not just a mention, but an entire rendering of the beverage curve, which is something that has been kind of like a hot topic in recent years. It's basically the relationship between job openings

and unemployment. And for a while, lots of people were looking at the beverage curve as sort of like the key to whether or not we would have a soft landing. But it was really interesting. You were arguing that looking at the beverage curve, it seems like you could have an even larger increase in unemployment if things start to turn for the worst. Can you talk to us about that? Yeah, sure. So as you mentioned, the beverage curve basically relates changes in the job vacancy rate to unemployment. And, you know, for the better part of the last year, we've been you know, sort of the labor markets have been operating on sort of the vertical part of the of the beverage curve, right? So you can trim job openings or labor demand. I mean, job

openings are a proxy for excess labor demand. You can trim excess labor demand without seeing much of an increase in the unemployment rate. And that's more or less what we've seen for the better part of the last year. But if you look at where the latest points are kind of lining up, it looks like they've, you know, we're basically, we've normalized. So in other words, any first the deterioration in labor demand from this point will imply, you know, higher unemployment. We're no longer on that vertical part of the curve. And so that's what I'm concerned about. And I think the risk is, you know, unemployment never just goes up a little bit, right? I mean, it's, it's either up, you know, a lot or not at all. So we've kind of been, what we've seen in the last year has been

somewhat a historical in the sense that we've seen a fairly notable increase in the unemployment rate and we haven't seen recession. But I mean, how far do you really want to push that experiment? Particularly when broader measures of labor utilization suggest that if anything, the U3 unemployment rate at the margin is probably overstating the degree of health in the labor market. I mean, if you look at things like the quits rate, they're actually lower today than they were right before the pandemic. That's, of course, true for the hires rate as well. well. You know, as I mentioned, I talked about unit labor costs, but the fact that labor turnover is so low and the quits rate's been coming down, that would suggest that there's not really much

wage pressure out there. I mean, if anything, it's more likely at this point that firms are holding their workers flat relative to last year, more so than changing their pay, you know, for moving their payout, rather. And so, you know, that again, I mean, so where is the inflation coming from. If the labor markets are not consistent with an inflationary impulse, and the Fed believes that they're running a very, very hawkish policy, they should be much more concerned about potential downside risk to growth than upside risk to inflation. And what do we know about growth? We know that growth is slowing relative to where it was last year in two important sectors, housing and consumption. Tracy, can I say something that bothers me a little bit?

Sure. You know, I... Now I'm nervous. No, no, it's not that bad. But so listening to, like, the Fed officials, I'm trying to think, I don't want to express an opinion here because I don't do that. But can I just say people, so there seems to be, and Neil described the state of the labor market as the hiring rate is down.

So if you're looking for a job, your odds of getting a job have declined. But we haven't really had a layoff cycle. And so there seems to be like some comfort with this dynamic that's like, okay, like, this is softening. but like people who don't have a job in looking for a job, just because they're not recent layoffs, like they count too. No, for real, you know?

No, it seems to be like this view. It's like, oh, well, it's okay because it's just that the hiring rate is down, but at least we aren't seeing like layoffs. It's like,

yeah, I'm glad we're not seeing mass layoffs. But also if the people who are looking for a job are finding it harder and harder, that's not good either. No, of course not. I mean,

the housing inventory thing works, right, guys? I mean, you don't have, right? I mean, it's just basically it's taking longer for the excess housing

inventory here. And in the process, that's driving up inventory. It's the same thing with unemployment, right? Like, if you lose your job, at any given month, people are losing the job, it's taking those people longer amounts of time to find a job, right? So over time, you continue to, like, right? It's like a bathtub model of unemployment. Yeah. No, I get how it works. I'm just saying, like, they count two. You should make a T-shirt, Joe, that says they count two. They count two. Actually, this reminds me. So one thing I was thinking about is like so much of the labor market tightness was driven by the services sector in recent years. And, you know, we saw the displacement of workers there and then it took a while to get people back. And then there was a ton of pent up demand and everyone wanted to go out to restaurants again or go on vacations or whatever. I do feel like potentially the peak of that is over, which kind of begs the question of, well, if you're not going to get additional tightness in the services market, then where does it come from? I don't think it's going to come from like AI investment and everyone suddenly becomes a chat GPT prompter or something like that. To that point, if you look at average hourly earnings in retail trade and leisure and hospitality, they've slowed precipitously over the last year. I mean, those are the two industries,

those two sort of service industries that got so much attention during the COVID pandemic because, you know, sort of a proxy for kind of low-end service work, you know, these are the people with hyper, pensions to spend, but their wage growth has been slowing over the last year. So again, I mean, where is the inflation coming from? I just keep coming back to this point. Like, where is the inflation coming from? You know, people may, you know, you can point to oil or something. I mean, I just don't really, that's not really a broad increase in prices.

Ultimately, the labor markets are an important driver for how the Fed thinks about inflation, rightly or wrongly. But right now, unit labor costs are basically zero. So, you know, I think that there's room for prices to keep coming down. Obviously, in private and in public and in every statement that any member of the Fed has ever said, with kind of one exception, but I'm not going to say what this. Wait. Okay. I'm going to ask you afterwards. They'll say politics just does completely not matter. You know, it's not our job. It's like

time things around the election. Nonetheless, Neil, do you think the reality of the calendar right now. There's a July meeting, there's a September meeting, and then there's a meeting that's literally two days after the election or something like that.

Does the timing of the calendar, do you think it's affecting how the Fed is thinking about the timing? No. Okay. Because I think that it's sort of you're damned if you do, damned if you don't, right?

Let's say that they don't want to respond to the calendar, right? Let's say that they want to hold off on cutting because they're worried about doing something that looks political ahead of the election.

Okay? That in and of itself is political. Yeah. Okay. Right? Because what are the chances that, okay, we should, I mean, this inflation data are slow and we should probably get on with it, but we're not going to. In the process, the economy is weakening as a result of that.

Then you have a new president that just gets, that comes into office or just wins the election. And then boom, you start the easing cycle with a 50 basis point move. Right. Like, how does that look? Yeah. So it's sort of, I just think that you just focus on the data, do what you think is right. I do think that there's precedent for the Fed moving in advance of an election. I mean, there's this nonsensical talking point around Wall Street about how, you know,

never has the Fed cut interest rates in a September meeting before an election. Well, okay, Bernanke launched open-ended QE in September of 2012. I mean, like, it's like one of these things where it's like, yes, I guess that's technically true, but also irrelevant because we were never taking rates negative. So instead, they launched an open-ended asset purchase program. I mean, is that enough? So I think the Fed has shown that it's willing to do things at politically sensitive moments. You know, I mean, many of the people that are talking about how the Fed's political have also been the ones talking about long and variable lags, right, for the better part of the last, you know, 18 months. And if the Fed does something in September, like, how does that help Biden in any

meaningful way in November. Neil, I'm going to ask you to do our job for us, but Joe and I are supposed to go to Jackson Hole in August. On the off chance that we run into Jerome Powell hiking through the woods or something like that, what should we ask him? Tell him that he should be cutting through the woods. Just tell him to cut. I would ask him if the unemployment rate rose two-tenths of 1% in 2023 with the real economy

growing 3%, why would it stay flat for the next two quarters with the economy slowing? Oh, this is the SEP, right? The dots. Yeah. How does that work? Explain it to me. Oh, man. Like, that would be one question I would ask him. I think Powell's going to be running away from us in the woods. And I would also ask him, does he think that inflation is a lagging indicator? Like Ben Bernanke.

Yes. Rent, that seems like one source of firmness. friend Connor has been pointing out, Connorson, has been pointing out that if you look at some of the apartment reads, those are actually doing pretty well. And there are signs affirming. There was a story in the journal, I think, last night or this morning, we're recording this on the 26th. Talk about how the investors are sort of bullish because the supply constraining effect of the rate hikes, there's going to be sort of minimal new supply coming online. And so that creates upward pressure on rent in the long term. That is one area that people, we have not seen the

slowing that people would like. If you're asking the question, where does the inflation come from? Could it come from shelter in some measure or another? I think it ultimately boils down to the labor market, Joe. I mean, I don't like to get. I mean, I think, frankly, the REITs stories is essentially like an interest rate play, to be perfectly honest with you. Okay. Right. I mean, REITs are rallying. Why are REITs rallying? Why are REITs rallying? Because interest rates have come down. And that's like, reads are thought of like, you know, like an income substitute, right? So I think that's, that's largely what's going on. It's just it's a derivative. of lower interest rates and the Fed expectations.

But I ultimately think what drives rents is how people pay for those rents, which is wages and salaries. So you have to tell me why wage and salary income accelerates. I mean, like if you get into a situation where, you know, shelter costs are quite sticky, but people are seeing their income slow down, that just means they're going to have to cut back in other areas, which will then drive the prices for those things down. So I just, I think that's part of the issue with this kind of bottoms up approach. I kind of like to look at it sort of more of a top-down perspective.

Tracy, have you gotten the $5 McDonald's meal yet? No, I haven't. Are you going to? I mean, I guess. Wait, what's in it? Have you not seen it? No, I haven't. It actually looks pretty legit.

You can get a small fries, a Coke or a drink, and like a chicken sandwich for five bucks. Oh, I don't like the chicken sandwich. No, or there's something else. I think there's two options. I think it might only be chicken. I only see what the McDonald's app chooses to show me nowadays, and it hasn't shown me the cheaper meal, unfortunately. Neil, will you try it?

Do you, is that fit into a fasting regime? You know, they're not in my diet, Joe. You know that. Okay, I just make sure. But if Subway brings back their $5 foot longs, I might go for it. All right. I like the idea that the Fed needs to cut when Subway brings back its $5 footlongs. That general mill story today was interesting.

I mean, if they're focusing on trying to boost volumes, like there's only one way that can happen. Right. Volume, it's price now. Volume over price, yeah. Fet's got a cut. Lots more is produced by Carmen Rodriguez and Dashel Bennett with help from Moses Ondam and Kil Brooks.

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