Odd Lots - Tim Duy on the Huge Challenge the Fed Now Has in 2022

Episode Date: February 14, 2022

As inflation data continues to come in hotter than expected, pressure on the Fed is ramping up big time. Traders are betting on more and more hikes, with a distinct possibility of a 50 basis point hike in March. So the question is, can the Fed hike in such a way that it tamps down inflation while not causing a recession? On this episode we speak with economist Tim Duy of SGH Macro Advisors and the University of Oregon, on the huge challenge facing the Fed this year.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon music. Oh, and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. Tracy, I was thinking outside of like crisis, like outside of like, you know, spring of 2020 and obviously the sort of like year, year and a half like, surrounding the great financial crisis. I think right now is probably maybe the most interesting time we've seen in a long time for the Fed and central banking. Yeah, absolutely. I would agree with that. I mean, we spent, you know, immediately after 2008, there was obviously a lot to digest, but then it was just years and years of basically the same thing, really low inflation.

And the central bank's kind of arguing whether or not to wind down various stimulus programs, what exits were going to look like. But now it feels like that conversation has just been ramped up, you know, times 100 because you actually do have inflation. You still have a lot of emergency liquidity lingering in the system. And the question is, what are central banks going to do about it? And can they actually navigate clamping down on price pressure? without destabilizing the entire economic recovery.

100%. Like, you know, we paid a lot of attention to the Fed and other big central banks, like, you know, for the last 10 years. But in retrospect, like it's kind of always the same story. It's like inflation is mild. It's not quite at target. Maybe it will be how low can employment go? Oh, it turns out it can go lower.

Maybe they'll try to hike a bit. Maybe it was a little premature, wait a little. It's like, it was like pretty repetitive. And right now what I think is interesting is beyond just the price pressure, like an extremely wide disagreement. And some people think, oh, it's going to fade because things are going to normalize. People worry about some sort of wage price inflationary spiral. Like lots of legitimate economists and people sort of like coming at the problem or the question in good faith can arrive at extremely different views for the next couple of years, I would say, from this starting point. Absolutely. And I think we've spoken about this before, but the thing that complicates everything is that we don't really have a historical framework or parallel to look at because we didn't experience anything like the 2020 pandemic. Well, I guess we had Spanish flu, but the crisis response wasn't quite the same. And so everyone is sort of trying to figure out what exactly is going on. And to be honest, I don't think anyone has a foolproof or bull.

bulletproof playbook just yet. Right. And also, of course, in addition to the pandemic itself, we had an extraordinary amount of fiscal stimulus this time around. We had the Fed at the summer of 2020, sort of adopting a new framework where they would intentionally allow things to overshoot. So there is a lot to unpack. It's very new. Everything is different. And we're going to, we're going to talk about how to make heads or tails of this and what's going on. Excellent. looking forward to it. So our guest has actually been on the podcast before, but a very long time ago, way back in 2016. And we just talked to him back then about the sort of the art of Fed watching. Well, now Fed watching is actually really putting it into practice these days. We're going to be speaking to Tim Dewey. He is the chief U.S. economist at S.G.H. Macro. He is also a professor of economics at the University of Oregon. I think he's had a very very

very good feel for both inflationary pressures and how the Fed would likely respond to them over the last year in his writings on Twitter and so forth. So, Tim, thank you so much for coming back on Adlotz. Well, thank you for having me. I appreciate the opportunity. Yeah, absolutely. So in retrospect, are we right, like 2015, 2016, 2017, pretty boring from a Fed perspective, at least compared to what we're doing with now. Yeah, the never-end. expansion was going to get old there pretty soon from a Fed watching perspective, that's for sure. Of course, you didn't want it to end the way it ended, unfortunately. So what is it about the current period that makes it so unusual or so interesting for

central bank watchers such as yourself? Well, it's the uncertainty. We had gone into the pandemic with a sense that we knew, right, we knew the basic economic framework that we were going to be working with, you know, for the foreseeable future. And that basic framework, you know, assumed that demand was really always and everywhere a problem in the sense of being too low. And we also thought that inflation was very, very sticky around 2%. And these were reasonable things to believe, you know, in the pre-pandemic period, because that's, that's the story that actually worked out well and seemed to be proved by the evidence, and especially

the sticky inflation part. We'd seen sticky inflation for 25 years, around 2%. You know, we went into the pandemic with really established consensus framework on how the economy worked. And the pandemic has really blown that apart, at least in the near term, because a lot of those predictions of persistently weak demand, persistently slow job growth, persistently low inflation near 2%, all of those predictions did not work out as expected in the post-pandemic era. This gets to sort of bigger picture question that I've been asking myself a lot over the last six months or a year, which is like we can list all the ways this current moment is extraordinary, right? So we're still in a public health emergency.

By many measures, we had a very intense Omicron wave. We had a delta wave before that. That's not over. There are still many disruptions. They seem to be winding down, but they're going away. But there's still many sort of interventions and masks and school issues. Then, of course, we had the massively expansion, the aggressive fiscal stimulus. And of course, the Fed, which made a decision in 2020 that they did not want to make the same mistakes they did in the past.

And they said, okay, we're going to let it overshoot this time. But my question is, why wouldn't things return to normal? Why, after the sort of pandemic ends, why wouldn't it necessarily be safe to say, okay, we're just going to go back to the sort of like the medium economy that we had pre-crisis? I think that's an excellent question. Yeah, I think, you know, particularly with respect to the inflation story, that inflation trend, the pre-pandemic, you know, trend of 2% inflation we've seen for 25 years, that was, you know, presumably a very sticky trend.

And there's a good reason to think, you know, that's a very thing. that you don't want to just sort of turn your back on a deeply established trend like that. Now, on the other hand, one idea that I play around with quite a bit is that the pre-pandemic economy was more finely balanced than we appreciated, that we essentially had just enough labor market pressure to keep downward pressure on unemployment, keep pulling people into the labor market, keep wages rising in nominal and real terms. And also, you're not not having it overheat in the sense that there were any real threats to that 2% inflation tread. That, though, might have been a more unique economy than we realized by the time we got to 2018, 2019. How much of the inflation pressures

do you see as down to supply issues, such as the various logistics problems that we've been talking about on the show over the past year or so versus demand coming from consumers, many of whom, you know, in terms of household balance sheets, seem to be in better positions than they were going into the crisis. You know, I get concerned when we try to say that, you know, things are either demand or supply related because I'm not sure that we can really tease out those factors as easily as we think we can. You know, demand and supply are like two sides of a, or

it's like a pair of scissors, right? And so both are cutting the paper. So which which blade is doing the job is hard to, in many cases, determine. I've thought that demand was a large factor here, that if we look at factors like nominal spending power on the part of consumers, that they really were spending more in nominal terms and basically stretching the ability of the economy to produce those goods and services. So I, I, I've thought that the supply angle has been overplayed and the demand angle underplayed. So that's where I sit on the subject. We look forward into the future.

I do think it still relies, depends a lot about how much consumers are able to and willing to accept. And it looks right now that they have the capacity to continue to absorb price increases. and I suspect we'll continue to do so, although maybe not at a six or seven or eight percent annualized rate as we've been, you know, as we've kind of been seeing. So we're like 10 minutes into this conversation already. And I think it's really interesting that inflation dominates the story right now. But the labor market and the sort of the other half of the feds dual mandate,

it's just been incredibly strong. And no one, I think, would have predicted sub four percent unemployment so, you know, early 2022, or I guess we're at 4% right now. My question is, in your view, was there a way to have this fast of a labor market recovery without the inflationary pressures that we've seen? Or are these inflationary pressures the inevitable byproduct of an economy that moved so fast back to normal? The rapid recovery of the labor market was certainly unexpected. And the Federal Reserve and the U.S. government dumped enormous amounts of resources into the economy on the assumption that it would not recover very quickly. And it did. Had we known really that the COVID shock

in 2020, excuse me, 2020 was going to be more like a snowstorm than a persistent source of demand, lost demand, I'm not sure that we would have dumped that. much policy stimulus into it. We'd be at a situation where the labor market did recover quickly. It's very much true that going into the pandemic, we would not have expected labor demand to rebound quite as quickly as it did. And that was really our experience in the last couple of recessions. The fact that that recovery did happen very quickly probably helped contribute to inflationary pressures when you take into account the additional stimulus. that we added onto the system.

In some ways, it comes down to me for, there's a question of, you know, was the original COVID shock like a big demand shock, like the financial crisis in 2007, 2009 era? Or was it more like a snowstorm? And you would expect a fairly rapid recovery after a snowstorm. And that's kind of what we've seen.

And I do think, you know, that the additional stimulus we put on top of that then helped contribute to the inflationary pressures we see now. How do you disaggregate the speed of that recovery from the policy response, though? Right. I think that's a great question. That would be the subject of a thousand PhD dissertations in the future. I don't know that I'm able to take a stand on that at this point. I really, this comes down to in some sense, really what kind of framework you had going into the crisis or we're adjusting that framework. I think when we started seeing the economy bounce back in the middle of 2020, it really started to strike me that there's a lot of underlying structural,

there's a lot of underlying structural recovery going on here. And we probably don't need quite the amount of stimulus as we're putting into the system. But, you know, in some sense, that was a hunch, a feel for the data more than anything else. So, Tim, you mentioned frameworks going into this. And one of the criticisms now that we've seen the return of inflation or this new inflation is that either traditional economics failed to predict this or heterodox economics, like modern monetary theory failed to predict this. And it kind of feels like everyone, everyone is criticizing everything at the moment. But do you think that's fair? Did economists, you know,

fail to see this coming? So forecasting is hard. And the underlying structure, the economy could shift. And so, you know, this is something that could hammer an economist no matter what their initial framework is. And so I try to be fairly humble in thinking about these kinds of economic developments, because I really do believe you have to be flexible to basically react in real time to what the data is telling you. And I don't know if there's really a failure of any one given sort of strand of economic thought or macroeconomic framework. It's more of what I see just a willingness to evolve from whatever your fixed position is as that incoming data arrives. Well, let's talk a little bit more about that data because I do think that, you know, even I think winter late 2020, early 2021, the COVID numbers were picking up again.

We didn't have a vaccine. There was a lot of reason to think that, oh, if we didn't get like another round of substantial fiscal. expansion. We could like have another downturn. You were like pretty, I think, pretty optimistic then. And I think, you know, starting in the summer or maybe the spring of 2021, I think you were pretty concerned that maybe the accelerating inflation wasn't just a temporary thing. It wasn't just going to be base effects. That there was something more sustained here. And that the Fed at some point would attempt to play catch up and ramp up the number of hikes sooner and faster. So what would is it that you were seeing in the data and how did you then sort of like synthesize that through

some sort of macro framework that I think at least so far has proven to be a good read on the inflationary pressure? I think the first thing is that even with that that wave in the late 2021 early, you know, that wave, excuse me, late 2020, I think even at that point we started to recognize that subsequent waves of the virus were going to have less and less of an economic impact. And so that became a critical sort of element to my thinking going forward is that we were going to continue to have COVID, that it was going to be more endemic than certainly zero COVID at that point was not really a possibility. And that we would learn to live around the pandemic. So that was what was one element. The other element that I just couldn't

shake was how tight job markets were getting. And this really speaks to the, perhaps finally balanced economy prior to the pandemic. When I saw how quickly job openings surged, you know, the fairly slow response of labor supply, and I'd say the fairly slow response of labor supply is pretty typical that we see in post-recession periods, it really started to say to me that there's a lot more pressure in this economy than, you know, I think the Fed at the point was thinking about and was probably, you know, the Fed at that point, I think, had had estimates of where full employment was going to be that were optimistic relative to what I was seeing in the labor market. So that sort of said to me, look, there's going to be a lot of pressure in this

labor market. It's going to put a lot of pressure on upward pressure on wages. That's going to be the kind of thing that can really sustain inflationary pressures over time. And I felt eventually that was something that was going to catch up to the Fed. It does feel like the Fed was very focused on this idea of, yes, jobs have rebounded. You know, the employment recovery has been stronger than expected, but we're still digging ourselves out of a COVID-related hole, I guess, and we still have further to go. Were they wrong to do that in retrospect? I think the Fed did not basically adjust their models as quickly as the data would suggest that they should.

I think that they became, although the Fed says that they think, you know, full employment to moving target, they became very much attached to the pre-pandemic economy. We all liked the pre-pandemic economy. I think 2019 would have been, you know, we would have thought 2019 was a great year if we'd been able to enjoy it because 2020 came down. it's so hard. So there was really good reason to look at that 2018, 2019 period and think that's where we need to get back to. And I think the Fed just did not, just held on to that vision for too long. And as a consequence, sort of missed the development of what I think are still substantial inflationary pressures. Even if, you know, even if they ease off,

do they ease off enough to get us back to 2% is still an open? question. I want to press you on this a little bit further because I remember like post great financial crisis, one of the criticisms then is like, oh, we can't get back to 2006, 2007, and that oh, maybe there's something structural. And it turned out it was kind of just a matter of time. And the Fed back then, I would say, and grossly sort of like underestimated for a long time, like how low the unemployment rate could get without spurring labor market pressure, which I guess again, bring me to the question, is the error of like, oh, we want to get back to some 4% unemployment, or is the error in thinking that it can happen that fast? Because we are

I mean, we just had a huge jobs number in January. We are still bringing a lot of people back into the labor market. I think we could argue that in the post-financial crisis era, the, the Fed did make an error. And I think, again, for the same reason, it became enamored with a pre, you know, a pre-financial market sort of framework, financial crisis sort of framework. And, you know, we saw right in the post-crisis era, estimates of the short run natural rate of unemployment rise, right? And we all now think, we all look back at that and say, no, that was crazy, right? That never happened. And so we sort of took that same framework and applied it to this crisis. And we didn't raise our estimates of the short-term rate of natural unemployment. And maybe we should have,

right? And so, you know, it's kind of a question, do you always get caught fighting the last war? And I think, again, I have no problem. You think it was the right thing to think of in the spring of 2020. That was our framework. And that was a reasonable framework. It was kind of just a slow adjustment to maybe that framework's not quite the right way we should be thinking about the economy in the post-pandemic era. Is there something about the Fed's structure or culture that makes it hard for them to be flexible or to pivot as the data changes? I think that institutions in general can be slow to pivot.

And you see this, I think, in any kinds of bureaucratic structures. So once you've spent 10 years developing your models in your framework, you're going to have a hard time breaking from that framework. So I think that's just a natural consequence of what happens within institutions that the Fed could not adjust as quickly as maybe they should have. When you say adjust as they should have, was there a, could we currently in February 2020 have less inflation than we have right now? Had they done something different? Like what was the moment in your view in which if they had taken a different tag, maybe started hiking earlier, et cetera, may have allowed us to be in a better situation than we are right now? Like what does that alternate scenario look like to you? Right.

And given the lags in these processes, how, you know, was by the time we did, you know, the fiscal stimulus and the monetary stimulus. And by the time we got to 2020, the end of 2021, or excuse me, at the end of 2020, the beginning of 2021, was this pretty much already baked in the cake? Really, what we're thinking about is how persistent these inflationary pressures will be going forward. So for me, a couple of things that I think that the Fed probably should have thought of differently. One is basically the asset purchases, QE. Those were really initially put in place to deal with financial market functioning. If you remember the spring of 2020, it's not clear that such emergency measures were necessary, really even past the middle of 2020, that financial markets had rebounded,

and we're functioning quite well by that point. So, you know, we did, we did years of QE that I don't, wasn't probably necessary to support the economy. Now we have to sort of think how is the Fed going to align that? The other thing that, that I think that a critical space here was the Fed, you know, from my perception, was cheerleading fiscal policy. And I think that they, they really push back or couldn't do any sort of fiscal or monetary offset, even after that last, um, black, last of fiscal stimulus we had that really, you know, gave the economy a good push in 2021. And I think that might have been a real, real error on the Fed's part is, you know, by not sort of, writing off any hope of any fiscal push or any monetary offset pretty early in the process,

also kind of set the stage in motion for, you know, the possible persistence of these inflationary pressures. I want to jump to, I guess, what the Fed should be doing now, because, you know, on the one hand, as we've been discussing, we have inflation that's been higher than expected. We've had a pretty strong recovery in the jobs market, although, you know, there are some people who say it can get even better. The recovery overall has been quite strong. But again, there are those who argue that in some ways the economy is still quite full. fragile. There's still a lot going on in the global economy with COVID and various economic pressures that could come back and impact the U.S. So taking all of that together, you know,

if you were in the Fed's place right now, what would you be doing? That's a great question. Because we're in a very, I think this is potentially really challenging time for monetary policy. because if these inflationary pressures have become embedded deeper than the Fed, Fed really believes, then you're really coming to the party too late. And you're going to have a hard time really containing these inflationary pressures without creating a recession. So, you know, I think the Fed should do a little bit more clearly what I think they're kind of positioned to do. And that's to try to get rates up to something closer to neutral as quickly as they can. So I would probably define that objective, at least right now, so that you'd be better prepared

to find that objective more clearly. So you'd be better prepared to adjust policy in the second half of this year as necessary. And that would mean, you know, I think you're starting out with, there's always a question, should you start out with 50 basis points? You know, I think optimally you'd like to be, you know, at 150 basis points by the second half of this year. And the Fed's not not positioned to do that and hasn't really primed markets to expect that kind of rate hike. That's what I would be thinking about pretty, pretty aggressively if I was the Fed. Yeah, I want to talk about this more and maybe the idea, okay,

they got there too late. You wrote something in one of your notes a couple of weeks ago that I thought was pretty provocative. And you said, you know, look, historically, when inflation is like this, the answer ends up being, it took a recession to bring it down. And so, of course, everyone hopes that you can have sort of like, you know, the so-called smooth landing where just the inflation side goes down, but employment keeps chugging along fine. That'd be great. But talk to us about, you know, the historical analogies of like, yeah, this is what it actually took to get inflation. though. Yeah, this is something that struck me. Just looking at the charts of wage growth and particularly inflation in that sort of the era not associated with two percent inflation,

that really once you sort of shifted your equilibrium, it was pretty sticky. Wage growth really stayed at, you know, whatever its pre-recession level was until you came to a recession. and the same was really true of inflation. So it really started to look in the data, to me, that changing these dynamics was actually very hard once they had become established. And it was probably going to be harder than we anticipated, especially since all of the models, I think, right now,

are calibrated on this pre-pandemic period. So, you know, when inflation never really deviates more than say, you know, core inflation never deviates more than 25 basis points away from the 2% target. In that case, you're fairly, fairly easy to see how you could guide the economy back to target without a recession. If you're, you know, 200, 400 basis points away from target, the historical data suggests, you know, you guide it back toward a lower number by inducing a recession. So that's something that's been just sticking in the back of my mind as a real risk, going into 2023, in particular in 2024, just tells me how much we're all leveraged on the idea

that inflation is going to ease by the end of this year sort of on its own accord. This might just be a question about semantics, but I'd still be curious to get your response. But if the only way historically to end inflation or avert price pressures is to have a recession and the Fed raises rates and induces a recession, can we still call that a policy error? That's a, you know, that's a good question. The policy error would have been made prior to, you know, prior to that point, right? You know, one thing I think about is, in retrospect, the Fed actually did a pretty good job in the post-grate financial crisis era. And, you know, at the time, you know, myself included, you know, criticized the Fed for maybe moving too aggressively. But, you know, but we still ended up in the

2017, 2018, 2019 economy, which I think we can all agree was really an excellent economy. We'd like to be back there. And that was managed. by essentially, you know, guidance, loose guidance on a Phillips curve. And then I would argue, you know, later in the crisis and later in the expansion, some loose guidance on the basis of, you know, not letting the yield curve invert. And that sort of slow and steady return brought us to a good outcome. And we all ended up complaining because inflation was 20 basis points below 2%. And maybe, you know, that, you know, that we should have appreciated that response more than we did at the time. So I have a really basic question, but, you know, 2% inflation target in retrospect, maybe it wasn't that bad having years of subpar below target inflation.

Like, should we should we be trying to, I mean, I know they change the inflation framework to something more flexible, the flexible average targeting stuff. But should we be aiming for something other than 2% inflation at this point in time? You know, there's a big view that we should be aiming for inflation greater than 2%. We should have picked a 3% or 4% target given our proximity to the lower bound, that maybe that would raise what we consider the neutral rate of nominal interest rates. And I do think there's some truth to that story, certainly given the current circumstances. I don't know that it's really politically possible for the Fed to target something other than 2%. I think they'd have a hard time basically creating support within Congress for a higher inflation

target, even though there's reason to think the economy could operate at 3%. Now, at the same time, I think right now monetary policy almost has to have an inflationary bias because of the proximity to the lower bound. You can't really target something less than 2%, because you can't you can't take the chance of tipping yourself into recession when you're this close to the zero bound. So, you know, this is kind of one interesting thing. I don't know if it has been, you know, properly or completely recognized is the Fed really can't sort of do average inflation targeting at 2% right now, right? They can't sort of go into the future and say, we want, we want average 2% over the next five years, average inflation of 2% over the next five years because that's going to imply some period

of less than 2% inflation and they can't do that. You know, you mentioned that the 2017, 2018, 2019 economy was pretty good. And I agree. But 2017 was eight years, no, like, you know, yeah, eight years after the crisis. And so when I think back to those years, I don't think like, oh, it's so bad that we only had 1.8% unemployment, or sorry, inflation. I think like, oh, yeah. we had like a pretty big employment shortfall for a very long time post-GFC. So when we're talking about how good of a job the Fed in retrospect did, do you think, like, does that apply to the labor side of the mandate as well?

I think, again, that's a good question is, you know, in that post-greene financial crisis period that was certainly a slow period of recovery relative to, you know, what we would have optimally expected. And I do think this sometimes gets you the question of what can you expect on a monetary policy. And I think, again, if we go back to that period of time, we all, I think, basically universally agree that we should have had more fiscal policy. And maybe that would have been the thing that would have boosted job growth. Now, it may be that neither of those things would have been, you know, as important as we'd like to think it was that, you know, for whatever structural reasons, the economy was just in a low growth mode. as we had to, you know, recover, rebuild the financial system from the, from the great financial

crisis and sort of rebuild the economy from the housing bubble. And also, I think demographics were probably in play there. You know, the boomers were aging out of the workforce and being replaced by the Gen Xers, which is a demographic hole. And so we actually have the opposite right now, where now the millennials are going to be aging into their prime working years and their home buying years. there might have been a bit of a demographic weight on the economy in that post-grade financial crisis period. Again, it's easy to criticize after the fact, but I'm not sure the Fed could have done, you know, this magic job that we all sort of thought at the time that they should be doing. So you said something interesting, and that is like, what can we expect out of monetary policy?

And I think that's like a very fair question in both directions. You mentioned, you know, a few minutes ago, okay, if we really want to crush inflation, we could probably do it by engineering a recession. But we don't want that to happen. When, you know, thinking from the Fed's perspective and they hope, okay, maybe four hikes this year, maybe five, maybe three, something like that, what is the channel via which theoretically these rate hikes do bring down inflation? Like how does it, how does a rate hike or any number of rate hikes feed through to real activity and prices?

There's this typical idea, right, of a Phillips curve where the idea of the rate hike is to raise unemployment. Essentially, there's a trade-off between unemployment and inflation. And we didn't really see that, you know, in the pre-pandemic era. We thought the Phillips curve was fairly flat. And so that was a mechanism we weren't necessarily relying on as heavily. Instead we're relying on, I think, what would be more vague. that its financial conditions, you know, tightened, that we'd see possibly monetary policy evolved through a number of different channels where it be, you know, the exchange weight would

possibly be higher and that would, you know, create, you know, a slowing of demand where firms would find themselves facing higher interest costs and that would slow their cash flow, and, you know, consequently, that would cause them to, you know, slow back or pull back-on activity. You could also think about, you know, whether this, how this is operating through home mortgages. So there's a number of channels, but clearly, you know, one way that we've always thought of this is that, you know, you're trying to find a mechanism by which to soften aggregate demand. And, you know, historically, you know, areas that has really been prominent is in consumer durables and housing. This is the challenge is that,

Can you, right, sort of make fine-tuning adjustments at the economy at this point like we became more accustomed to in the pre-pandemic era? Or are you, you know, at the verge of more major changes in policy that then do have these pretty dramatic impacts on economic activity? Thinking about financial markets. And one of the things or one of the ideas that set in after the 2008 crisis, this and the Fed's policy response was this idea of a central bank put and that the Fed would always come in when markets showed signs of wobbling and stabilize things because they didn't want to risk a tightening of financial conditions and, you know, potentially hitting the real economy.

How are we thinking about that aspect of the Fed's policy workings? Like, it's relationship with markets at the moment because we have seen. I mean, stocks fall quite a bit. But part of me feels like the Fed doesn't necessarily care, you know, if big tech valuations come down to arguably more reasonable multiples. But where I think they might start to get concerned is when something like the credit market starts to show signs of strain. So I guess the question is like, how is the Fed thinking of financial stability?

is there still a possibility here that if markets really start to get pressured, that they might sacrifice rate hikes, you know, in order to preserve them? I agree with you that it's not necessarily stock prices or big tech price or Bitcoin prices that's going to be influencing monetary policy decisions. You know, obviously, if we had a 20% drop in overnight, that would probably be something interesting. But no, it's not asset prices. I think you're right. It's a credit or market functioning. So, you know, obviously the Fed doesn't like the situations we've had where Treasury markets don't seem to be functioning properly. So that would be certainly one issue and might apply to

quantitative tightening going forward, which we really haven't talked about. The other thing is if you saw corporate debt spreads really widened, that would be, I think, a red flag for the Fed that something was going wrong. They'd like, you know, they would like credit to be a bit tighter, right? That's, you know, they want a slow activity, but they don't want those credit spends to blow out as you often see, you know, before or around a recession. And so that's where, you know, that's where I think the Fed would be much more, you know, worried that they needed to reassess what their, what their expectations were. So you mentioned quantitative tightening. And, of course, the Fed expanded its balance sheet quite a bit since March,

2020. And you hear some members, some regional Fed president sometimes talk about it's like, well, maybe we could do one or two less rate hikes in the short term, but we sort of counteract that by a more rapid wind down of the balance sheet. It's a little unclear what effect that had, highly sort of controversial. What is your view on this sort of like the, I guess, I don't know if it's a sequencing question or the impact of quantitative tightening and how they sort of like, translate to rate hikes? Like, how do you think about that question? Yeah, I think the Fed has to be really careful about how they approach that particular question because, you know, Chair Powell said, you know, in the press, most recent press conference, that there's, you know, some capacity to estimate some

tradeoffs between QT and rate hikes, but were they something you really wanted to count on? And that's, that's, you know, that's my opinion too. I'm not sure you want to start setting expectations about the path of rate hikes on the basis of what you're doing with the balance sheet. What the Fed really should think about doing is, okay, here's what our objectives for the balance sheet are. And I don't even know if we're clear on what those are yet, right? Is it about getting the size down? Is it about getting NBS down? How quickly do you want to get this down? They need to set the objectives for the balance sheet. And they should probably just let that run in autopilot on the back until there's some kind of concern from financial market functioning that they need to adjust on that front.

And then just say, that's going on. Here's what we're doing with interest rates. That's really a separate thing rather than trying to, you know, say at the front of this, oh, well, if we do this much QT, we're going to get, you know, 50 basis points less of tightening going forward. I think that's, you know, something that's just too unknown for the Fed to really commit to. I want to just go back to inflation for a little bit because I realized we didn't talk about this. And we are recording this on, what is it, February 9th and I guess CPI is coming up relatively soon. Do inflation expectations matter? And further to that, should we be differentiating between consumer versus corporate inflation expectations?

And I realize that might be maybe that's an odd question or a new question, but I've been thinking about it because I've been watching your tweets. And you've been focused a lot on what companies are actually saying about price increases. And you made the point that shareholders seem to be rewarding companies who say that they're going to raise their prices in response to cost pressures. And so I guess the question is most consumers seem to think that a lot of the inflation pressures are still transitory. and that things like used car prices are going to get better. But on the other hand, companies seem to have entirely different motivations and therefore different ways of thinking about this. So how are you thinking about expectations broadly?

So I'm not convinced that consumers right now have a good sense of really what inflation is going to be out, five years in the future or 10 years in the future. It would be amazing if they did, wouldn't it? Yeah, I think that would be really, really amazing. more likely to me is that does long-term inflation expectations adjust as short-term inflation, you know, remains sticky above those current long-form inflation numbers? You know, right now we know that short-term inflation expectations are elevated and consequently, if that continues to be met, right, if those expectations continue to be met,

then that will probably put upward pressure on inflation expectations over those long-term. So I think when the Fed, you know, looks at these long-term inflation expectation numbers as if they're really signaling some intense attitudes about long-term inflation on the part of consumers, I think that's probably misleading that those are almost certainly lagging indicators. So especially after a 25-year period of very low inflation. Now, I do think that what firms are telling us right now, so they're telling us essentially that they can raise price. and they're not getting any consumer pushback. That tells me two things, is that there's lots of nominal spending power. Also that consumers are expecting higher prices and willing to pay it because they have that nominal spending power. That suggests to me, again, sort of more of an embedded inflation dynamic than we would like to see. You know, earlier in the conversation, we talked about this idea of like, inevitably policymakers fight the last war.

And we, you know, it's obvious why that happens. But there are some elements of the current economy, even with elevated inflation, that strike me potentially like are much better than they were pre-crisis. And so we see the fastest wage growth, at least currently happening at lower income scales. It seems like there is a potential, you know, for years, Larry Summers, great stagnation, like very mediocre productivity numbers for the 10. 10 years after the great financial crisis, it seems like there's a potential here for capital expenditure to maybe kick into a higher gear. On the matter of, you know, people have been mown for

years inequality. Well, you know, it's like in a tight labor market, obviously the power shifts somewhat to workers, I mean that by definition almost, is there a potential here for the jolt that we've seen to kick us into a superior equilibrium when all of a sudden does? Right. And I think about this a lot is, you know, obviously we want to get back to at least as good place in 2018, 2019, but maybe even a better place, right? Because we'd like to see, you know, productivity be higher, right? And maybe is that requires some investment? And is that investment something we're only going to see if we run the economy hot, right? And so is there a potential here to get to a better place? And I think the answer is yes. There is that potential. And I just think it's how do you moderate the economy during that adjustment? Because I think, you know, what Chairman Paul has said has been, I think, generally correct in that if you want to, you know, maintain and extend these benefits, you need to, you know, basically have inflation under control. And if you don't get inflation under control, you know, we're going to end up with these instabilities that eventually, you know, prompt us to create a recession. So even if you're getting a jolt, can you have too much of a good thing in the short run, that you actually lose some of those long run benefits?

And I think that's the concern that the Fed should have at this juncture. Well, Tim, I mean, I think that's a great spot to leave it. And it does seem like, yeah, there are reasons to be excited, but can they get it just right? It seems like an incredible challenge for the Fed in 2022. So maybe we'll have you on. in December again of this year and we'll like, we'll see how they did with the hikes, assuming they hike. Yeah, that's great. And we'll see, you know, if inflation moderates back toward 2%, as many people expect, then the Fed is going to look brilliant because, you know, it will be near neutral

with a, you know, a pretty tight job market and inflation back to 2%. And that's, that's, you know, the optimal outcome here. All right. Well, knock on wood, I don't have any wood, but knock on wood that is the the set of conditions at the end of this year. Tim, Dewey, thank you so much for coming out. Thanks for having me. Appreciate it. Thanks, Tim. I really enjoyed that, Tracy.

I mean, I think it's clear regardless, like, this is going to be a tricky year for the Fed. Because obviously, it wants to consolidate its gains. It wants to, as to mention at the end, it wants to sort of preserve the potential for the benefits that you get from a hot economy while making the economy less hot. but also not so hot, so less hot that we're in a recession. Not so less hot. Yeah. Something like that.

Less hot, but not too less hot. Yeah, I think that's right. The other thing that stood out to me was, you know, Tim's point about how difficult it is to separate supply from demand issues at the moment. But I kind of, I sort of follow that to a different conclusion, which is I still think a lot of the demand that we're seeing is actually a result of the supply shortages. and people are, you know, just getting things when they can and sort of stalking up and seeing a bunch of other people improve their houses and do this and that and jumping in so that they're not left behind. But, I mean, it does, it does just highlight how difficult it is at the moment for for policymakers. And I know it's their job and everyone likes to criticize them. But it does seem like a particularly challenging time.

Yeah. No, I mean, I do think like the sort of. like, oh, did the massive, like, boom in demand that we saw in 2020 and 2021 turn into gluts in 2022 and 23, as you've written a lot about the sort of bullwhip effect is like, is a under discussed scenario still. Like, we don't really know, like, you know, how long it's going to go. But to your question, and you asked that important question, like, and Tim has been pointing it out, it's like, if companies are saying like, well, shareholders, we, A, we can raise prices.

Chipotle is like, yeah, we can raise the price of a burrito without hitting demand. And B, investors are rewarding us for raising the prices of a burrito without hitting demand. Then that is like a sort of like level of corporate motivation that could sustain, sustain price increases for some time. Totally. And this to me is, you know, when people are saying, oh, inflation expectations don't matter anymore. They're looking at consumers. And I kind of, I agree with that. But I really do think company inflation expectations matter quite a lot because they have the

pricing power and those are eventually going to feed into consumer expectations. So I think that's a really important point. And possibly, you know, one of the things that the Fed might have gotten right in recent years is its point about monopsony and big companies and pricing power. And we might start to see that or we might really start to see the impact of that over the next year or so. Yeah, I mean, everyone is like criticizing Elizabeth Warren and the White House for pointing out the sort of like the corporate profitability driven inflation. But, you know, you look, you know, yesterday February 8th, Chipotle earnings came out. And it's like they're doing very well and they see more pricing power and their margins are holding up well. And they're raising prices in part because they can make more money when they raise prices. And so the companies that can do that are in a position to dictate prices. are obviously doing really well. There's just like so many, there's so many moving parts to this. And I thought that was a very helpful conversation. Can I just say I've been in New York about a week and I've had Chipotle like two times now. It is so good. I missed it so much.

They didn't have Chipotle in Hong Kong. No. There's also just a broader shortage of good Mexican food. But yeah, I missed it. It's worth the price increase for me at least for now. You're one of the consumers fresh back out of American soil who is like willing to absorb any price. Price insensitive for American Mexican food. All right. Shall we leave it there? Let's leave it there. This has been another episode of the Oddlots podcast. I'm Tracy Alloway.

You can follow me on Twitter at Tracy Alloway. And I'm Jill Wisenthal. You can follow me on Twitter at the stalwart. Follow our guest, Tim Dewey on Twitter. He is at Tim Dewey. follow our producer Laura Carlson at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts at Bloomberg under the handle at podcasts.

Thanks for listening.