The Breakdown - Hawks vs. Bulls: The Fed Clashes With Optimistic Investors

Starting point is 00:00:00 To some extent, the Fed's job has now entered a much harder phase. Inflation is clearly moderating. There is a let-up or at least some indicators, at least, in the labor data. But at the same time, financial conditions are loosening significantly, as Wall Street sees all those things as well. It's one thing to be in a position to just hike into oblivion and keep the language strong. It's another thing to try to keep everyone in line during an in-between wait-and-see-type period. Welcome back to The Breakdown with me, NLW.

Starting point is 00:00:30 It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDesk. What's going on, guys? It is Monday, January 30th, and today we are talking about the Fed's potential showdown with Wall Street later this week. Before we dive into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly down pod. All right, team, happy Monday and welcome to the first big macro week of

Starting point is 00:01:08 2023. The Fed has its Federal Open Markets Committee meeting on Tuesday and Wednesday, at which point we'll likely get our first insight into how Powell and Coe are thinking about the economy heading into this new year. So what we're going to look at today is one, how markets are thinking about that meeting and what's likely to happen, two, why there is something of a battle going on between Powell and stock investors, and three, what some other indicators suggest about the other big economic question, which is, of course, recession or not. Now, by way of background, we have been in the most aggressive monetary tightening cycle since the early 1980s. This is, of course, in large part due to the Fed's slowness in responding to rising inflation in 2021. They more or less

Starting point is 00:01:48 forced their own hand with their insistence on the narrative that has now become infamous of transitory inflation. The idea was that inflation was a byproduct of dislocations and supply demand mismatches coming out of global shutdowns around COVID-19 and that it would sort itself out. It wasn't so much that they were wrong about those supply demand mismatches being a major source of inflation. Instead, it's that they didn't appreciate how that would interact with other potential sources such as fiscal stimulus, and also that they backed themselves into a corner assuming it would just work itself out in any sort of reasonable timeline. We could do voluminous episodes on what the Fed missed. Why the dislocations they identified, for example, represented not just

Starting point is 00:02:28 short-term responses to an extraordinary circumstance, but also the acceleration of ongoing structural forces that were likely to change the equation for global inflation economics going forward. However, for our purposes today, suffice it to say that they missed it so they had to tighten and fast last year. Markets got the memo early in January 2022, when the December 2021 meeting minutes were released and discussed not only interest rate increases, but balance sheet reduction as well. In the previous pre-COVID tightening cycle following the global financial crisis, there had been a big lag between starting to raise interest rates and actually shrinking the size of the balance sheet. So, the fact that the Fed was looking to do that all in 2022 sent markets down

Starting point is 00:03:11 the path that they've never really recovered from, which is not to say that there haven't been rallies. In fact, one of the most oft-repeated micro-cycles of the past year has been markets getting out ahead of the Fed and determining that because of what they believed was an incoming recession or some other factor, Powell's hand would be forced and the Fed would have to pivot. Without fail, every time markets started to rally on some type of narrative like that last year, the Fed would trot out speakers up to and including Powell to disavow them of that notion. Markets would then retreat and then inevitably some data point would come in and validate the Fed's argument that it was way too early to even begin thinking about any sort of pivot.

Starting point is 00:03:47 Markets from there would sluff on down for a while until the whole thing began again. That said, over the last few months, there really have seemed to be some improving economic data. Inflation has continued to come down from both a headline and a core CPI perspective. Indeed, this is true even with the Fed's preferred inflation measure of the PCE. PCE inflation in December was 5% year over year, down from 5.5% in November and 6.1% in October. Removing food and fuel, PCE was 4.4% in December, down from 4.7% in November. Now, of course, simply achieving moderating inflation is not sufficient for where the Fed wants to be. John C. Williams, the president of the Federal Reserve Bank of New York, said last week,

Starting point is 00:04:28 quote, it will take some time for supply and demand to come back into proper alignment and balance, so we must keep moving. What's more, Powell and the Fed have made clear that they remain concerned with labor conditions. They view the labor market as fundamentally too tight, which both challenges the ability of rate hikes to deliver the attendant cool down in consumer demand, and also keeps elevated the risk of a wage price spiral, in which demand for workers raises wages, which companies then pass on in the form of higher prices. As he often does in advance of an FOMC meeting, the Wall Street Journal's Fed whisperer Nick Timoros wrote about which issues the Fed was likely to be focused on over the weekend. The article was titled Fed debates whether wages or low employment will drive inflation.

Starting point is 00:05:08 Easing price, wage data are at odds with concerns that the job market is too tight and the economy is operating above capacity. Now, when reading these articles, most market observers look at them in terms of both literally what is being said, as well as the broader context of what isn't being said and how what is being said has changed. So, for example, when the first line of this piece reads, stubbornly high inflation is finally easing as supply chain disruptions fade and interest rates at 15-year highs put the brakes on demand, now Federal Reserve officials have voiced unease that prices could re-accelerate because labor markets are so tight. When markets read that, participants see not only a wage price spiral-type concern, but an anticipated shift in Fed

Starting point is 00:05:48 narratives that says, yeah, yeah, we agree inflation is coming down finally, but this other issue around the labor markets is now coming into view as the big concern. Now, in this piece, Nick expands upon something he's been noting for the past several months, a division forming within the Fed, which has operated largely in lockstep behind Powell over the last year. While over the past few months, this division was characterized as between Doves and Hawks, with the Hawks nervous about stopping too soon and the Doves wanting a pause to let previous rate hikes work their way through the system. In this latest piece, the division is given even more specificity in terms of the fundamental ways in which those camps view how to look at inflation. At core, Nick says

Starting point is 00:06:24 the Doves are looking at it in terms of bottom-up numbers of prices and wages which are moderating, while Hawks look at the top-down economic performance. Quote, At issue is what's the right way to forecast inflation? A bottoms-up analysis of recent readings on prices and wages that puts more weight on pandemic-driven idiosyncrasies, or a traditional top-down analysis of how far the economy is operating above or below its normal capacity. Now, going a little further, here's how Nick Timrose describes those traditional models. Quote, the workhorse models that Fed and private sector economists use to predict inflation compare the country's total demand for goods and services with their total supply as represented

Starting point is 00:07:00 by the output gap, the difference between actual gross domestic product and potential GDP based on available capital and labor. They also lean on the Phillips curve, which predicts that wages and prices rise faster when unemployment falls below some natural, sustainable level. Interestingly, however, Timmeros is pointing out, and this is something that seems at once obvious but hasn't actually been particularly present in Fed discourse, that these models may be having their validity called into question by changing fundamentals of the economy. In other words, there is an acknowledgement here, even if haltingly, that some of the changes wrought by recent disruptions aren't likely to unwind any time soon, if ever.

Starting point is 00:07:35 which gives credence to those who think that the Fed should put less stake in those traditional top-down models and instead focus on more direct indicators. From the Timoros piece again. Since an overheated labor market is likely to show up first in wages, many officials see those as a better proxy of underlying inflation pressure. Wages reveal what employers think they can recover via prices or productivity and what workers expect given their own cost of living. Anyway, however you slice it, there is a lot of focus on labor.

Starting point is 00:08:02 And again, since the December FOMC meeting, there are a few in the end. indicators that labor demand is softening. These include declines in temporary hiring and hours worked, but it remains murky and much debated. Meanwhile, what is clear is that financial conditions have significantly loosened in the past few months. In other words, capital has been more available, which is the opposite of what one would expect to see in such an aggressive tightening cycle. And indeed, these conditions could have a big impact on the Fed's thinking. The financial conditions index is a measure taking in a number of indicators indicating the value of financial assets, interest rate levels and exchange rates. A variety of different institutions have tracked financial conditions

Starting point is 00:08:38 since the early 1980s. Since October, financial conditions have been loosening at a rapid pace to the point where conditions are now looser than when the Federal Reserve began hiking interest rates in March. These rapidly loosening financial conditions led some commentators to suggest that the Fed should shock the market with a larger than expected interest rate hike this week. In an op-ed for Bloomberg last Wednesday, Mohamed al-Earion said, quote, financial conditions have loosened significantly and, by some measures, are at levels that prevailed last March when the Fed initiated its hiking. These are strong risk management arguments in favor of another 50-point increase. That, however, is far from the consensus. At this point, a 25-bases point hike is

Starting point is 00:09:17 priced in. And yet commentators are starting to suggest that the big story this meeting may once again be Hawkesh Powell versus the markets. The last time in this hiking cycle that financial conditions got loose like this, Powell scrapped his planned speech at the Jackson Hole Conference in August and came instead with a curt eight-minute speech basically telling markets to stop getting ahead of themselves. So with that in mind, here's today's leading headline on Bloomberg. Fed's Wall Street clash set stage for Powell's hawkish message. FOMC is worried that markets may be missing its rate message. The article begins, despite 2022's slew of interest rate hikes from Chair Powell and colleagues, financial conditions are the loosest since last February, as investors bet fading inflation

Starting point is 00:09:57 will allow the central bank to soon cease raising borrowing costs and then cut them later this year. That's likely wishful thinking as far as Powell is concerned, and he has a clear incentive to push back against the trade given rising stocks and bonds, could fan the very price pressures he wants to restrain. End quote. Now, my read on the December meeting minutes released this month was that this was exactly the thing that Powell was worried about. In other words, Wall Street exuberance not just not getting the memo he was trying to send, but actively undermining it. In a few instances, this message has continued this month. Dallas Fed President Lori Logan speaking on January 18th, caution that policy could respond

Starting point is 00:10:34 if financial conditions ease further in response to a slower pace of rate increases. Quote, if that happens, we can offset the effect by gradually raising rates to a higher level than previously expected. But the markets aren't buying it. Economist Martin Adimmer and Bjorn Van Rowe say, for the Fed, with financial conditions loosening, the burden of controlling elevated inflation falls increasingly on hopes for favorable supply shocks. If that doesn't happen, our model suggests Powell and Co have more work to do to convince investors they're serious about getting inflation back to their 2% target.

Starting point is 00:11:03 End quote. Indeed, there is a gap between what the markets and the Fed think about the terminal rate. Markets are pricing in a 0.25% hike this meeting in a 0.25% increase in March, with the peak being 4.9 by May and June, falling to below 4.5% by the end of the year. The Fed's December projections had 17 of 19 officials projecting rates above 5%. So now the consensus view is starting to be that this week's meeting will be a combination of the expected 25 basis point hike, but with harsh words to go alongside it. The head of I-Share's investment strategy for the Americas at BlackRock said, the Fed will deliver a hawkish press conference. I imagine Chair Powell pushes back on the number of cuts priced in by the market

Starting point is 00:11:42 before the end of this year. The tight labor market is giving them the opportunity to do so. Markets and mayhem writes, financial conditions are looser than they were before Powell's fire and brimstone Jackson Hole speech. This isn't what the Fed wants to see. Brent Donnelly from Spectrum Market says the Fed says it'll keep financial conditions tight. The market has now called bullshit. Your move, Fed, raise or fold. Join CoinDesk's Consensus 20203, the most important conversation in crypto and Web3, happening April 26 through 28th in Austin, Texas.

Starting point is 00:12:17 Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse. Immerse yourself in all that blockchain technology has to offer creators, builders, founders, brand leaders, entrepreneurs, and more. Use code breakdown to get 15% off your pass. Visit consensus.com or check the link in the show notes. Now, this discussion of tightening financial conditions has largely taken over from the soft landing narrative, which had started to come back into focus last week. Vince Reinhart, the chief economist at Dreyfus and Mellon, who spent a quarter century as a Fed staffer, said, quote, Powell wants to write his own page in the history books as someone who, unlike Burns,

Starting point is 00:13:01 did not blink and reverse too soon, and unlike Volcker did not intentionally cause a recession. Remember, Arthur Burns was the Fed chairman in the 1970s on whose watch the Fed quit their inflation fight too soon with disastrous consequences, while Volker is, of course, the titanic figure who ripped rates to 20% in order to crash the economy, cause a recession, and tame inflation once and for all. The point that Reinhart and many others are making is that as much as Powell has invoked Volker over the last year, it's more likely that he wants the chart his own middle path, where inflation can come down without a recession being mandated. How possible is that? Well, the recession debate absolutely rages on. In an interview with Bloomberg

Starting point is 00:13:39 on Friday, Treasury Secretary Janet Yellen expressed concern over recession risk, but also hedged. She said, quote, I'm reasonably satisfied by the data that I've seen so far, but I don't want to minimize the risk of recession. I'm encouraged because I see inflation coming down. There's more talk about layoffs, but fundamentally the labor market remains quite tight. Still, you're never going to get real hot takes from an official like this, so let's turn to recession Twitter for the real state of the debate. Macro Alf wrote an excellent thread over the weekend, breaking apart each of the factors of a recession that the NBER looks at. This isn't a direct quote from his thread, but is a little bit of an expanded summary. He writes that a key driver of growth is the global credit

Starting point is 00:14:15 impulse. Put simply how much credit the banking system is injecting into global economies. This factor is particularly well correlated to corporate earnings with a nine-month lag. Unsurprisingly, global credit impulse was massively positive in late 2020. and early 2021, as government stimulated their economies and provided government-backed credit. While the steepest declines were in late 21, global credit continued falling throughout the last year, indicating that corporate earnings could fall for at least the first quarter of this year. Although global credit was not strong last year, it never dropped into negative territory, so we may not see a truly disastrous deflationary bust on account of faltering credit.

Starting point is 00:14:48 The Conference Board, a global nonprofit economic think tank, produces a leading indicator index for recession warnings that has a perfect record in predicting recessions dating back to 1974. The leading indicators at surveyed showed the global economy heading for recessionary conditions in August last year. Over the history of this index, the lead time has varied from three months to 15 months, so the most we can really say about this prediction is that a recession should be expected sometime after March. Another indicator comes from housing. A favorite saying in economics is the housing cycle is the business cycle, meaning that the housing market is a key

Starting point is 00:15:20 driver of consumer demand and overall economic health. Housing-related jobs and economic activity have been estimated somewhere in the 12 to 15% range as a share of U.S. GDP and employment. Over the last year, we've seen a rapid deterioration of the U.S. housing market, as increased mortgage rates have strangled off the availability of financing. The National Association of Home Builders' U.S. Housing Index provides a decent gauge of national house prices and typically shows a strong inverse correlation to the unemployment rate. This index has been dramatically crashing throughout the second half of last year, which would indicate that a significant rise on unemployment is coming sometime from March this year.

Starting point is 00:15:54 A final indicator is the various manufacturing indices and surveys which give us a glimpse into how goods production looks over the coming months. Several major indices entered into contraction toward the end of last year. Overall, these indicators seem to point to a recession, according to macro alf, starting sometime in the next five months. And in terms of how bad, at least for Alf, his guess is something similar to the 2001 recession. Not minor, but not a global financial crisis. Now on the flip side continues to be this labor market question. Bob Elliott, Unlimited Fund says this is your weekly reminder that the U.S. labor market remains secularly tight. Initial claims remain right around cycle lows, continuing claims stable for now.

Starting point is 00:16:33 Most of the layoffs have been in the tech space. So far, it looks like many of those folks have been absorbed back into the labor market. Of course, we will have to see whether the most recent round of tech layoffs works the same or if severance runs out. From the initial claims perspective, the economy is quite a ways from employment consistent with the recession, and even a relatively fast pace of losses would take through the end of the year to get there. Derek Thompson from the Atlantic says layoffs suck, but if you're fixated on the tech layoffs as a signal of U.S. economic strength, consider that they affect less than 0.1% of the economy. It's like predicting a house will fall down because the faucet broke. Yet still there are other indicators that some think are

Starting point is 00:17:08 looking dangerous. Eric Busmagian writes, consumer spending growth is decelerating in every major category from services to goods. The squeeze on households is becoming clear. So that's where we are. I think my big reflection is that to some extent the Fed's job has now entered a much harder phase. Inflation is clearly moderating. There is a let-up or at least some indicators at least in the labor data. But at the same time, financial conditions are loosening significantly as Wall Street sees all those things as well.

Starting point is 00:17:36 It's one thing to be in a position to just hike into oblivion and keep the language strong. It's another thing to try to keep everyone in line during an in-between wait-and-see-type period. To the extent that the right thing for the economy is raising rates a limit, little bit more and then going back into a mode of wait and see, that's the task the Fed faces. Anyways, we'll learn a lot more this week, and I'm sure there will be much to report on when that happens. Until tomorrow, guys, be safe and take care of each other. Peace.

The Breakdown - Hawks vs. Bulls: The Fed Clashes With Optimistic Investors

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