Odd Lots - Where Things Stand Now With Inflation and the Fed

Episode Date: December 19, 2022

Last week was a big one. On Tuesday, we got a CPI report that came in substantially cooler than expected. Then on Wednesday, the Fed hiked 50 basis points, which was a step down from the series of 75 basis point hikes that we had been getting at recent meetings. So where do things stand now? When will we get a proper pivot? When will the Fed feel confident that inflation has been defeated. We spoke with two macro guests: Jon Turek, founder of JST Advisors and author of the Cheap Convexity Blog, as well as Tim Duy, Chief US Economist at SGH Macro as well as a Professor of Practice in economics at the University or Oregon. They gave as their readings on inflation, the Fed, and what to watch at the start of 2023. See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthall. And I'm Tracy Allaway. 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. Yeah, absolutely. So we are recording this on December 14th. Literally two hours. 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. Right. So a pretty big week, I mean, the story, 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 going to pivot and what pivot even means? which I think 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. Right. Is this a turning point in the 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 means that – 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. 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 because we have two great guests,

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 Dewey is the chief U.S. economist at SGH macro advisors, as well as a professor of practice in economics at the University of Oregon. And John Turich, the founder, of JST advisors and the author of the cheap convexity substack, which is a must read. Tim and John, thank you both for coming on. Well, thank you for having us. Thank you, Jeff. Absolutely.

So why don't, you know, I'll throw a question out for both of you, but like really simple. We just, just as we're talking, wrapped up Powell's press conference, why do you sort of give us your summary, you know, start with Tim, but both of you can go of like, what did we just learn from Powell? Well, that's a, um, okay, so what did we learn from Paul? Uh, so no, no, you know, I think, you know, I think the main thing that that we really learn from Paul is that they are very much committed to this idea that they need to hold rates, you know, at a, at a restrictive level for it, for an extended period of time. Uh, and then we also know that they're closing in on what they think that level is.

And so, you know, what this seems to be coming down to is causing, you know, deliberately causing something that looks very much like a recession, although Paul 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, it's only going to, you know, people are going to start asking, well, why do you need to create a recession here? Right. John? Yeah, I mean, for me, I think of it, I took away three key things from today. I mean, I think that one is that they are kind of transitioning from this where is terminal to how long to stay their stage. And I think that that really was, I think, most put forward by the fact that PALS seemed very open to going in 25-b intervals starting at the February next FOMC meeting. So that, you know, along with the commentary, the press conference does make it seem like,

They're in the ballpark of what they deemed to be sufficiently restrictive. I think the second thing is that they are seemingly looking at this at least X and D is that they want to stay at 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 PC 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 PC 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 equates to inflation back and target over the medium term. 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? Like, what exactly do we mean when we talk about the Fed moving to a restrictive policy? That can be for either of you.

I'll take it. No, well, it's unfortunate that the Fed doesn't seem to entirely know when they're going to be restricted, 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 on the 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, if unemployment stays this low. But what is that rate? I think the best way to think about is maybe like John was saying,

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. Yeah. You know, I think that it is sort of this, you know, feel your way around. You know, even in the context of what I, you know, a message I took away from the SEP today, you know, I think that what I think Loretta Mester actually set up an, a decent way of thinking about it and sort of these like broad strokes.

And in my notes of 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, sustained down downward pressure on the labor market, sustained down on 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 I'm sure we'll see a Kashkari

blog 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 a, you know, It's not an absolute level. It's a dynamic level. And I think, you know, going into, you know, next two years, staying still may actually include moving. But we can get into that.

Well, let me back up a little bit because sitting aside in 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 into just 0.2%. headline obviously influenced a lot by the plunged oil prices, which can only go so far, I guess, just 0.1%. Tim, is this like, 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? Yeah, certainly when I look at the report, I have to be sort of honest to, you know, the approach I was

taking last year 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. I really started to say, you know, we can't ignore, you know, this inflation is 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 of face value. saying, yeah, there seemed to be a fewer, the lessening of inflationary pressures, at least the near term here. 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 like a soft,

of the labor market, right? I was thinking that this is a way you can sort of tell that the Fed is hawkish, right? Yeah. 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, I think, you know, that would definitely try to achieve here. 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? 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, services minus X 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 doesn't,

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. I like two things on this. I think that, like Tim said, it's absolutely right. You know, I think that there are really like two reasons for why, you know, this rendition won't just be the reciprocal of sort of the, you know, inflation rising period of, you know, late last year, early this year. I think one, and this is why I think the Fed is so emphatic on showing us,

they're going to be looking at, you know, services XOER, 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, you know, conviction that inflation is going to settle back at 2% when nominal wage growth is 5.5. Whereas we flip it to where the Fed was, you know, in late last year, early this year, it was becoming pretty obvious that, you know, inflation would be, even if there were transitory factors, it had this structural tailwind from a very robust labor market.

So, you know, in terms of comparing then to now, I think it's, 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 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, you know, on inflation expectations, you know, such a big part of it. And this is something I think that, you know, Powell's been really pounding the table on. Really, I think 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, in terms of its feet 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 is anchored at 2%. So I think that, you know, there are similarities to playing that this is the reciprocal of the bullwhip in goods.

this is the reciprocal to the bull with and 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 inflation. Especially because they got burned on that last year too. So this has always been, I think, you know, a risk is not a risk, the likelihood that the Fed was going to, you know, 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 Paul reiterated that today was just simply too high. On April 4, 23, around 2 in the morning, a man was found stabbed multiple times on a sidewalk

in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder. of Cash App. From Bloomberg Podcasts, this is Foundering, The Killing of Bob Lee, beginning April 16. 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 like Powell specifically talked about a soft landing per se. I don't know if he used that term. But he did seem to express some hope that we need to see some weakening of the land. market, but that maybe it could just be a little because the labor market's really tight in 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 is 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 in the unemployment rate, does history say it's going to go up substantially more than that? Yeah, I would say that the history is not

the Fed's favor here that you really can't guide the unemployment rate, you know, about three-tenths or five-tenths of a percentage point higher, let alone 0.9 percent points higher. So, you know, I just don't think that this sort of soft landing idea is a likely outcome here. I would like it to be. Right. But to me, it seems to be screaming against what we've seen in the past. 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, hitting four, 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, 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. 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 like a good sense of that? Like the fact that we've seen. 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, you know, cause the recession that everyone seems to be worried about? I think that, you know, 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 like talking and central banks broadly are talking about 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 in just the interest rate sense of sectors in the economy and now the whole economy is starting to feel it. So I think there's like, 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 minus nine months, this is when we'll start to feel the whole thing. I think that the way the Fed is thinking about long variable lags and maybe I'll be more specific to the leadership is I think the way the Fed thinks about long variable lags is you kind of hope to engineer this, this handoff to

pro cyclical timing. 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 this

the new form or anchored form of tightening more than, you know, now what we've been doing now, which is rate hicks. 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, you know, a 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 out of just very few data points. Like, I don't think you could tell a tremendous story from one CPA 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 an increase in the unemployment rate at all. What would it take for the Fed to look at, you know, 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 land. That's a, that's a, that's a question I ask myself a lot from exactly that reason is

you have seen some improvement in the inflation numbers and it seems like it's almost premature, right? Right, right. We had been expecting and the Fed had been expecting that that improvement would really follow the labor market. And it's coming, you know, it's coming ahead of, you know, what we see is any significant loosing of labor market. And the Fed's going to be worried and I think rightly so that, you know,

persistently high inflation, or excuse me, 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 that basically the argument that that wages 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 wage. wages being resolved through lower margins, right? Margin compression. So, you know, I think, as you said, it's really hard to make anything

any clear decisions off of just a couple of months of data. But, you know, the Fed will have, I think, a harder time selling that story going forward. Again, if inflation continues low, especially if, if those core services, inflation numbers start to soften more, then that's going to be something it's going to be harder to explain. When did we start calling it immaculate disinflation? I don't know. Who came up with that? I think like the earliest mention, I was curious because this is the like second or third

time. I've heard it just today. But the earliest I can find is actually Matt Klein in his newsletter. Oh, it sounds like a summers thing, I feel like. Yeah, it doesn't it? You might be right. So I wanted to ask about financial conditions as well because I mean, this is something that has come up.

Neil Kishkari 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 conditions 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? That's a good question. I don't think so. And I think that, you know, from the Fed's perspective, at least, you know, looking at it in dollar terms or U.S. 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 up. We can also add in that the SPR, a tremendous amount of relief to oil markets. But, you know, I think in terms of the commodity super cycle that it was being pitched,

the dollar did neuter a lot of the right tail in, you know, the broader commodity. complex and just looking at the Bloomberg Commodd Index, it's all from 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 in, you know, and looking at something like a Goldman FCI's 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 unemployment 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 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's not necessarily equals like the Fed is going to fight or you're going to, it requires Powell sound like he did at Jacksonville. 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 did it

is that this is different than it was in July and August when there wasn't really any compelling evidence that inflation was following. We actually saw two months of 0.6s after. And the claims moved from that went saw, you know, initial claims reached 250K, went back to 210 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 of Jackson, all told you, we're going to do what it takes. That's not really the question. Now, the market is full confidence that the Fed will do what it takes looking at, you know, either forward inflation swaps or break-even rates. The question now is, is how much earned financial conditions can

you loosening can you have? And that is, I think, data dependent. And I think that that's, I think that's going to be the way this shakes out over the next few months. So just on this note, and this can be for either of you, but 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, as the data, 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? I think this gets to John'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 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, you know, core inflation and the Fed's looking at this, you know, this services X housing component would be, would be more interesting in a space where there could be, you know, room for confusion.

But, you know, I think, you know, once the data turns or the market starts, since 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, lower prices cause consumer spending to rise, for example, or real terms, in real terms, they could sort of tighten back up financial conditions. Well, I joked about this over the weekend, but I don't know. You know, it's kind of only half a joke or half a troll about, you know, we've had this big plunging 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.

I mean, that's like a lot, you know, that's more monitoring. 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, you know, 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, I think, 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? Yeah.

So productivity is to measure it as residual 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 hugely 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 to, 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. And they're struggling against stronger demand. So that erodes your relative productivity. So I think that's a reasonable story. And then Derry could, you know, ease back up if people got some breathing room on demand. right. So I think 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. Right. Right now, the Fed's, I mean, 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, say no. But what I'd like to see for soft landing is for the Fed to believe, you know, fully they just do not have to keep hiking rates and could cut them sooner than they anticipated. 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?

Paul 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 depended were really 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 were still experienced. And then suddenly the unemployment, employment rate was rising, you know, the Fed would start to think, well, you know, a higher unemployment rate should pull down these inflation numbers. And so, so the key in there would be what would be happening with inflation expectations. If the Fed could be confident that they can

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. John, you know, one of the things that Paul was asked about was, you know, we're 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 have said. And so, you know, all year the Fed is like, what do you guys even talk about? We're not anywhere close to thinking about cuts, or at least that's basically my summary of like, it's like, we're not, you know,

we're nowhere close. yet the market seems to be pricing in rate cuts and not even very far out. In fact, you have an inversion of the three-month two-year curve, which means, you know, rates in the fairly short next couple of years lower than they are right now or over the next three months in some way. Like, 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. Right, right. No, it's a good point. And I think that there's, there's, there's, two parts to it. I think that the, and 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 is like, okay, there are going to 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 looking as far back as June, we always kind of assumed that cuts couldn't be more than nine to 12 months away.

Yeah. 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 a 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 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, or inflation is not convincingly on its way back to two. Nobinal 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 Goldman Sachs's Q4 forecast for, you know, C4PC 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 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 and 50 basis points, the market's going to lean into the skew of cuts as just a faction of time.

And there's really nothing that the Fed, I think, can do about that at a certain point. I agree. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets. From corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean.

We do this every weekday, then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start your day. And on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. So, you know, we've been focused on the Fed for obvious reasons. But John, I know you've been in particular looking at some other central banks.

And you 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 X U.S.? Yeah. No, I mean, I think that, you know, there have been a few interesting examples I would say. say over the last few months. I would say that the Airbnb Z 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, you know,

what is the sort of the next phase of, you know, of trading interest rates. You know, I think the Airbnb and Z in November was a pre-telling meeting in terms of how the market is digesting this potential inflection point in the cycle. Because what happened to the RV&Z 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, you know, 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 re-rate in terms of both the actual hiking, the 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 have 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's new marginal information and the Arbyn Z was much more hawkish than I think many market participants thought of. So I think, you know, in terms of where, you know, using these leading hours, but also getting a feel for sort of. what the distribution is in terms of markets, I think the Airbnb Z was very telling in terms of how the cycle, 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, you know, there are central banks,

they're going to see very clear and obvious signs of growth deceleration. And they're going to be central banks that don't. And I would probably put the Fed in the don't camp, whereas 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, you know, very high, you know, private debt levels relative to GDP and have a lot of, or intense, you know, 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, you know, how we approach the cycle. So I think it's going to be, I think there are still north side, but I think we're entering a period of pretty meaningful divergence where I think the economic performance is going to be just very different across the

world. So, Tim, I have one last question. I'll aim it at you, but you know, this idea, and you sort of hinted at it, which is that if we were to get more data points like the November or a 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. Like, just like, why 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? Right. So I'm expecting a 25 basis point rate hike. At the, the, the, the,

February meeting. And then beyond that, you know, getting to, you know, the Fed's current terminal rate involves, you know, rate hikes of that magnitude in March, March and May as well. And at this juncture, I find it increasingly difficult to see that. First, you know, if there's inflation numbers are sticking, you know, sticking on the downside here, you know, it's going to be, you know, much more problematic for the Fed to continue raising rates. And then, you know, if we, you know, over that period of time, we could see some labor market 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 labor markets right now. John mentioned some of the signs earlier.

And if those signs stick, I mean, if we are getting job growth down to, you know, sub, you know, closer to 100,000 a month, even as the economy firms, then I think the Fed's going to be hard-pressed to keep raising rates after, certainly after March. And that's, that's the kind of setup that I'm looking for is that we see some of these continued evidence of labor market softening that gives the Fed some room to, to pause. But they're going to want to be confident that that, that softening is going to continue. So I do think they're going to want to see the economy slowing. And it's, it's not evident to me that that's, that's going to happen. 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. I'll go with one. I mean, I think that, you know, I'll go with, I'll go with ECI because I think that that's the way Powell sort of categorize how he sees. a soft landing in 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 the 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 going to be at 5.5% 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 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.

Tim? Yeah, I would actually, I mean, I don't want to repeat the same thing, but I do think, you know, the clear evidence that, that, John's right. I mean, in theory, if wages were to come down, wage growth was to decelerate. And so, you know, what, where could we see that other than just the ECI number? So, you know, one place that could be somewhere shows up is, you know, and it's already declining is the quits rate. So, you know, presumably when people, you know, quit a job for another job, that the next job has a higher wage. And so even if you got the quits rate down, you'd probably, you know, get wage growth decelerated. And something like that could help convince the Fed, 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, you know, unemployment at, at 4.5% or 4, 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. John and Tim, thank you so much for coming on the podcast. It's always great talking to and 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 luck. Thank you, guys. Thank you again for having us. Yeah, thanks so much, guys. That was great. That was great. Always great to talk with John 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 on 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, et cetera. Maybe it's just the employment cost index. But it does feel like those are the things to watch. Because look, the soft landing can't be, as long as unemployment rate is at 3.7%. You can't rule out the soft landing scenario. 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.

Yeah. 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 like you do wonder as the data starts to change whether or not that's going to become more of a theme and whether or not it's going to complicate some of what the Fed's trying to do here.

I really liked John's explanation of. of this sort of seeming, you know, speaking of market divergence of 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 and 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 hard landing scenario and that the Fed would have to cut. Yeah. I mean, there are like these kind of weird discrepancies that are starting to emerge from the forecast. So like the PCE forecast, I think, went up, but like 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 like 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 like a weird interaction that could start to happen where like, you know, maybe people who work. in the services industry are getting more money. And so they start spending more on consumer goods again. The no landing scenario. It's like a real possibility.

There are so many moving parts. You know, I was glad that you asked that question about international central banks. Because I thought that was John's, you know, a year of divergence. You know, all the central banks have been sort of like rowing in the same direction, so to speak, 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 like, you know, you could imagine Canada and the UK and the economy really get hit by higher rates. But if you have

this situation, like you're, you know, you just sort of described where actually the U.S. 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 don't really talk markets much. But, but. But, you know, you have weakness. And so, But that would sort of possibly be an implication of other central banks feel like they have to cut rates or slow them faster while the Fed is saying, look, U.S. consumers are doing all right. Anyway, all kinds of interesting possibilities for 2023 there. Well, I also think the big wildcard 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? Right. And then the question is, you know, the reopening we have, as of right now, West Texas. this oil 77 last Friday, it was around 70. So we, you know, will China reopening and the gas cut, well, that caused oil prices to go up plenty of, plenty of moving parts to the macro. Yeah, I was going to say the theme of this episode is moving parts. Moving parts. The world is a complicated place. Very much so. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts podcast. I'm Tracy Alloy. You can follow me on Twitter at Tracy Allo. And I'm Joe Wisenthal. You can follow me on Twitter at the Star

follow our guests on Twitter. Tim Dewey, he's at Tim Dewey. John Turrick, he's at J. Turrick 18. Follow our producers, Carmen Rodriguez, at Carmen Armin and Dash Bennett at DashBot. And check out all of our podcasts at Bloomberg under the handle at Podcasts. And for more Oddlots content, go to Bloomberg.com slash Odlots, where we post the transcripts to the episodes, Tracy and I blog. We even have a newsletter that comes out each Friday.

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