The Dispatch Podcast - Inflation, Recession and the Fed

Episode Date: December 26, 2022

Inflation has driven the cost of living to a record high and most recent reports are giving mixed signals about what to expect. Declan is joined by Desmond Lachman, a senior fellow at the American Enterprise Institute, to talk about interest-rate hikes and Lachman's critiques of the Fed in what he calls "monetary policy overkill."  Show Notes: -Desmond Lachman: “The Fed is playing with fire with its continued interest-rate hikes”  -CPI Index released on Dec. 13th -The CME FedWatch Tool mentioned by Declan -Desmond Lachman’s American Enterprise Institute profile Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to the Dispatch podcast. This is Declan Garvey, editor of the Morning Dispatch. And today we have a great conversation with Desmond Lockman. He's a senior fellow at the American Enterprise Institute. We're going to talk to Desmond about macroeconomic policy, the latest inflation reports, the Federal Reserve's latest interest rate moves and kind of what we can expect going forward into 2023 as we're in this now years-long fight against inflation and potentially ending up in a recession. Desmond, thank you so much for joining the Dispatch podcast. My pleasure to be with you. Well, I want to get started. We've had kind of a banner week of economic news in the past week between the Consumer Price Index report coming out last Tuesday and then the Federal Reserve making an interest rate decision. And Chairman Jerome Powell, making, kind of letting investors and the market know where the Fed is trending towards in the coming weeks. So could you walk us

through briefly kind of your takeaways from those two announcements that came back to back? Sure. As far as the consumer prices go, that was pretty good news. You know, what occurred is that earlier this summer, we peaked inflation at around about 9.1%. The consumer numbers on last week showed that we're down to 7.1%. And that was better than expected. So it looks like clearly inflation has peaked that we're on a declining trend. Now, having said that, the Federal Reserve Chairman Jerome Powell, the following week, disabused us of any notion that the Fed is.

is finished with interest rate hikes. So he felt that we've still got quite a lot of wage pressure in the system, that unemployment is very low, and that the Fed still has work to do in terms of raising interest rates. So what they did is they raised interest rates by 50 basis points. That's lower than the 75 basis points

that they did on the previous four occasions, but it's still very, very aggressive monetary policy. Generally, one raises interest rates by 25 basis points. And even though he had raised interest rates at the fastest rate than we've seen in something like 40 years, he made it clear that interest rates were going to stay high for quite a while and that the Fed was going to raise interest rates another few times. So it looks like they're going to aim at raising interest rates to at least 5% over the next several months and keep them there until they see the clearest of indications that inflation is on a downward path.

Just to put into context, their inflation target is 2%, and we're running inflation now, even though I mentioned that it's an improvement, we're on the right path. is still 7.1%, which is way above their target, and the Fed is going to keep monthly policy breaks on until it sees clear indications that we're heading towards that 2% target. Right. And I think what we saw in terms of how the stock market reacted to that CPI report last week, massive spikes, assumptions that the Fed was going to ease off on its monetary policy tightening. It's, it is a stark disconnect from. Yes, inflation is slowing, but it's still 7.1% year over year. And that's a historical anomaly, obviously. We want to get it back down to 2%. I think the 2% target that's in the PCE index, correct? The personal consumption. So slightly different calculation than the 7.1, but obviously still far above there. We've thought that inflation had peaked before. I remember having conversations with a

back in March and April. You know, there were downward blips. Why do we think this is the real deal this time? You know, obviously it's been five straight months of deceleration. But are you convinced that it really has peaked? Oh, absolutely. That's my view is that we're going to see inflation coming down pretty rapidly in 2023. Now, part of the reason is that those prices that increased and drove up the inflation are now decreasing. So if we take one of the big items, that is U.S. housing costs, you know, imputed rents, housing costs constitute around about 30% of the consumer price index. Those prices went up, way in which they measuring them, they went up by something like 7.5%. So there alone, you've got 2.5% inflation right there. What is going to

happen in 2023? We're seeing we're right in the middle of a real housing bust. So instead of housing prices going up the 20% a year rate that we've seen the last two years, we're going to see declines in housing prices. And that alone will bring down the index quite a lot. Now, the same sort argument can be made in terms of used car prices. You know, the use car prices increased by something like 50% because there were supply chain issues and so on. That is now reversing. So we're getting something that added a lot to inflation is taking away from inflation. The same story with gasoline, the same story with building materials. So even before you look at the effect of the Fed tightening, there's good reason.

to think inflation comes down. Another thing that will bring inflation down is that we've had a very strong dollar. So it means that all of the import costs coming into this country are going to be lower. So there's very good reason to think inflation is coming down. Who shares my view is the bond market. So what we've got now is that we've got a situation where the long-term interest rates are way below short-term interest rates, and basically what the market is thinking, they disagree with Chairman Powell. They think we're heading for a pretty meaningful recession next year that will reduce prices. And that's the reason that you see the 10-year treasury rate now is 3.5%. You know, it's come down from something like 4.5% to 3.5%. And the shorter treasuries are more like 4.5%.

So this is very unusual that you get a, what economists call an inversion of the yield curve. You know, the short-term rates are above the long-term rates. That is telling you the market is screaming that we're going towards a recession, that the price pressures are coming off. And another way of looking at it is you can look at different kinds of bonds to see what is the inflation expectation that the market has. the long-time inflation expectation now is not very far from the Fed's 2% target. So inflation expectations are already very well anchored. And my fear is that what the Fed is doing is it's making the same mistake that it made in 2021, but now in reverse. So in 2021, what they did is they flooded the market with liquidity.

They bought bonds in the trillions of dollars worth. They kept interest rates at zero. They let the money supply increase by 40% in the space of two years. And the net result was we got inflation that we haven't seen since the early 1980s. We got inflation towards the 9%. Now what they're doing, in my view, is the opposite mistakes. So they've tightened monetary policy in a way that they haven't tightened in 40 years, that interest rates have gone up by something like 350, 0.3.5% in a very short space of time.

And they're not waiting to see what are the lagged effects of that. What they're doing is they're keep going, raising the interest rates. They're raising the interest rates at a time that the economy is already weakening. So they're really running this kind of policy. I can understand that what they're concerned about is they lost huge amount of credibility by letting inflation out of the box. But now they're making the opposite mistake. They're slamming on the brakes too hard and continuing to do so. What they're going to do is reduce a recession.

And I fear beyond that that the risk that they're going to do. they're taking is that they can really dislocate financial markets. You know, the financial markets were premised on the idea that interest rates would stay at zero for a long time or would be really very low. They're not used to the interest rates going this high, this quickly. So I expect to see quite a lot of stress. You know, I'm not talking just about equity prices being under pressure, but we could see real problems in credit markets, both at home and abroad, you know, because there's been a massive amount of lending at ready, very low interest rates to poor creditors who assumed that the good times were going to roll on forever.

As soon as we get the bad times, they're going to have difficulty paying the debt, and then we're going to see problems in the financial system. So I think that the Fed, in a recent article I wrote, I think the Fed, is playing with fire by just going gangbusters in trying to crush this inflation, even though they've probably done enough to bring the inflation down. But the Fed is giving us clear indications that they're not going to change until they see the inflation down. But that is really ignoring the fact that monetary policy operates with a lag. And, you know, if you keep the brakes on hard for too long, one risks really inviting a real recession. Right. And I want to key in on one aspect that

you brought up there, specific to housing, which I think is indicative of a whole host of other factors that go into these calculations. But, you know, the way that the Bureau of Labor Statistics calculates the housing component of CPI, the inflation report, it operates on a six-month rolling average because, you know, people are not, when people sign a lease, they're signing a year-long lease, it's not necessarily, you want to be able to capture what's happening over time. But if you look specifically at new lease agreements, new purchases, rents, and housing prices are falling faster than they have in, you know, at least a decade, probably much longer than that. And so you kind of have the situation where on a six-month rolling average, which, as you mentioned,

operates on a lag, the Federal Reserve sees that, you know, inflation, particularly the housing component of it, is still rising at an alarming rate. But in kind of real time, the stuff that we have that's closer to present day, it's showing drastic falling prices for rents and for housing. So in some way, I mean, this is probably why the Federal Reserve typically operates, you know, they'll raise rates a certain number of basis points and then wait and see. how the markets and kind of the economy reacts to that. But because, as you mentioned, we've had consistently, you know, 75 basis points, now 50 basis point hikes, the Federal Reserve is kind of operating and they're out ahead of the market in some way. Do you see that kind of trickling out

beyond the housing market as well? With the housing market, I fear that what the Fed is doing is it's looking in the rear view mirror rather than looking ahead. So what struck me is that the Dallas Federal Reserve came out recently with a study suggesting that housing prices could fall by as much as 20% next year. So one knows that there's a lot of downward pressure on inflation in the pipeline that we're going to see. And precisely for the reason that you mentioned, the way in which it's measured with a lag, it's going to take time before that comes into the official statistics.

But we really are seeing downward pressures. So that's a reason the Fed should really be forward-looking. But I'd say that the same sort of thing is occurring, you know, just in terms of demand being compressed and prices coming down with the automobiles. You know, anything where consumers have to buy stuff on credit and where interest rates are rising a lot, they can afford very much less in terms of what they buy. So one's going to see downward pressure that goes way beyond the housing. So my view is that there's a whole confluence of factors that are going to lead to prices coming down that I believe are rather predictable.

And it just surprises me that the Fed has become a totally data-dependent institution, you know, that they're not taking into account that their policy. operates with a lag. And what they're responding to is the actual data that they see rather than operating on a forecast of where we're headed. So all of this makes me think that the Fed is engaged in monetary policy overkill. And we're going to have an unnecessarily deep recession to meet their inflation targets. You know, and what it means is a lot of hardship. You know, a lot of people are going to be losing their jobs unnecessarily in the process. To kind of shift gears to that part of the conversation, the potential for a recession and job loss, we saw, you know, in all of these press conferences after the Federal Reserve makes

their announcement about the federal funds rate and kind of the direction for the coming month, Jerome Powell will say something along the lines of, you know, we don't want anybody to lose their jobs, but, and then fill in the blank there. It really seems in his comments last week that he's very concerned about a tight labor market, a lot of talk about inflation from goods shifting to the services sector. That's primarily through wage increases and those wage increases then being passed on to consumers. And despite seeing a lot of top line headlines of in the tech industry, in media, a lot of people are getting laid off, a lot of people are losing their jobs.

the government data on the monthly jobs report has still been fairly strong, stronger than expectations. And so how much of that is driving the Fed's kind of what you would say is overly hawkish policy is this concern that despite the record pace of these interest rate hikes, the labor market is not cooling at nearly the rate that they think it needs to. Well, just to back up that basically the Fed is right that in order to reduce wage pressure, they have to ease situation in the labor market. So what they've done, so I say what they did in 2021 was by causing the economy to overheat, they got the labor market in a position that it was unsustainably tight. Now what they've got to do is they've got to create a situation where unemployment rises

where you don't have that much pressure, you know, on wages so that, wages can come down to something that's consistent with their 2% target. That is well and good. You know, I'm suggesting that they're going overboard, you know, instead of perhaps getting unemployment up to 4.5%, they're risking unemployment exceeding that amount. Now, unemployment is like other indicators, you know, the same thing as you mentioned with the housing prices. It's a lagged indicator. You know, it's telling you what conditions were at an earlier stage. As the economy comes down, you know, for instance, like just if you take housing, you're seeing that the housing demand is falling off a cliff, but you're not seeing unemployment there yet, but as soon as the houses that have been started are completed, you're then going to be seeing the unemployment rising. So I would very much expect to see unemployment rise the early part of next year already, and, you know, certainly later on the year.

depends how the recession really unfolds, but we are going to see weakness. Powell's in a difficult position, you know, that he does have to create slack in the labor market. That's politically not an easy thing to do, but he's got himself into that situation, you know, that he caused the labor market to overheat. Now, when we're ready having to pay the price to get the inflation down. I don't see how you can do it without having, you know, some slowing of the economy. But the issue is how much slowing of the economy. You know, we wanting to get the optimal amount of slowing. We're not wanting to go in for overkill. And I'm afraid that he's going in for overkill. Something that we haven't spoken about, you know,

which is really very relevant to this discussion is that all of the Fed's tightening is occurring in a very difficult international context. So what we've got is we've got a situation where there's synchronized slowing now, where there's synchronized monetary policy tightening, where there are real problems in Europe, that Europe's economy is really coming down because you've got a Russian, gas shortages that are really crunching that economy. China is slowing because of COVID, because of a property bus, emerging markets aren't doing well. So, you know, you're really running risks in this kind of environment, you know, where you're also, as the Fed, you're determining what their interest rates are. You know, so that has to be taken into account in this mix. You know, so that's what makes for a very gloomy outlook for the United States. It would be one thing if we were

doing this in the context of the rest of the world economy doing well, but that is clearly not the case. So, you know, that's another reason, you know, that I fear that the Fed is engaging in monetary policy over killer. What I'd like to see them do is I'd like them to see them pause, you know, and take stock of what's occurring rather than just go gangbusters and wait to see something breaking in the financial system, you know, before they do their pivot to cutting interest rates? In terms of, you know, how they could potentially execute something like that, there's a great tool from CME group that kind of bakes in market expectations of future interest rate hikes right now. They see the February meeting raising in 25 basis points. That would be as

smaller than 50. In March, again, another 25 that would get us to forward. 0.75 to 5% range for the federal funds rate. How much do you think because as we've as we've discussed that you know, the Federal Reserve and Jerome Powell specifically have a credibility problem in terms of how they handled this the past two years that they are now feeling like they need to posture and say all the right things rhetorically and then maybe the policy itself can be a little bit more dovish, but as long as they're building in expectations that, you know, companies and consumers need to start acting as if it's going to get significantly tighter even into the 2023 that they might pull back as long as kind of those expectations are able to coincide.

Well, you know, certainly the way in which they affect expectations, you know, that affects the interest rates and that affects the way in which the economy reacts. You know, so if they talking up that they're going to keep raising. interest rates and the markets price that in, those are going to be the rates at which companies borrow. You know, it makes money tight and that can really cause the economy to slow. But at the same time, markets are expecting that the Fed is going to be cutting interest rates at some point, you know, before the end of next year, you know, because basically what they're doing is they're betting that we're going to have a recession and that the Fed is really going to have to reverse course.

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for a decade leading kind of into the pandemic and post-pandemic era, the Federal Reserve was engaged in something called quantitative easing, buying bonds, and kind of flooding the economy with additional liquidity. They've reversed that first by slowing the rate of those purchases and then now, I believe, engaged in quantitative tightening. Is that having nearly as much of an effect as the interest rates themselves, or is that kind of a separate phenomenon? No, that's, one really has to look at that as part of the tightening process. And that is, you know, it's good that you raise that because that is being done at a unprecedented rate. You know, so what we had is in 2021, the Fed was flooding the market with liquidity to the tune of $120 billion a month by buying these bonds. So what they were doing, which is ready, if you look at it in hindsight, it really made no sense at all, you know, that the stock market was booming, the housing market was booming and there the Fed was pumping the market with liquidity, $120 billion a month and buying mortgage-backed securities, you know, just to make sure that you had a real housing boom. Now what they're doing is precisely the reverse, that what they're doing is they rolling off these bonds when they've when they mature to the tune of $95 billion a month.

So what they're doing is they're taking out liquidity at a time that the markets are not in a good state, and that can really have a depressing effect on market prices, and what that does is that slows the economy. So this is really part and parcel. You're absolutely right. It's not just a question that the Fed is increasing short-term interest rates, policy rate by 350, 400 basis points, 4% in a very short base of time. It's what it's done is it shifted from a situation where it was flooding the market with

liquidity. Now it's draining the market with liquidity. You know, so you've got to look at that together. There's some people who have a monetarist persuasion, you know, thinking that what occurs is the economy rose very rapidly and you get inflation when the Federal Reserve prints money like crazy. What they're pointing out is that we're moving from a situation where the Fed was allowing the broad money supply to increase by 40% over a two-year period. I mean, that is, we haven't seen that in 60, 70 years. You know, something, so they're not surprised that we got inflation

at the record rates that we got it at. What they're pointing out now is that the money supply is now contracting. So instead of actually increasing by the 40% is contracting, and they're saying that's really another leading indicator that we headed for recession. Yeah, yeah. And we've spent the bulk of this conversation talking about the monetary policy side of things. I want to shift briefly to fiscal policy and then we can conclude with a little bit of forward-looking questions. But we're recording this on Wednesday. The Senate and House are

expected to advance a $1.7 trillion omnibus spending bill. Today, we've obviously wrapped up a Congress that has seen kind of record levels of outlays between the American Rescue Plan earlier in the pandemic infrastructure deal, kind of some of these bigger spending packages. how much do those play into the story of the past two years with inflation? And now that we're heading into an era of divided government where we're not expected to see nearly the amount of spending, if at all, do you expect that to contribute to kind of inflation's demise? Totally, you know, you're absolutely right that when you look at the way in which policy affects

the economy, one can't just look at monetary policy. One's really got to look at budget policy. So this is another reason why I fear that we could be headed for a real recession in that if we look at what occurred in 2021 is Biden had this $1.9 trillion American rescue plan that came on top of the $3 trillion that was in the Trump administration here. So you're talking about $5 trillion of fiscal stimulus. That was the largest budget stimulus we've had in peacetime. on ever, you know, you're talking about something like 20% of GDP or fiscal stimulus. This is massive. So what you had is you had that stimulus coinciding with monetary policy, never having been looser. So you had this combination of very loose monetary policy, very expansive fiscal policy, no surprise that the economy overheats and you get inflation at 9%. Now the risk is the

opposite is that as that spending fades, you know, as people run through their spending, we're going to have what some economists call Bill Coyote moment. You're going to really go over the cliff that you're going to go from a situation where the economy was receiving a huge amount of fiscal stimulus to one where that stimulus disappears. At the same time, their monetary policy is being tightened. You know, so that is another reason, you know, that I think the Fed is really not taking into account the risks that as soon as people have gone through their savings from what they had on the 2021 package, we go back to a more normal level of public spending. That is going to weigh on the economy as well. So, you know, I think everything is aligning up for

2023 being a rather difficult year for the U.S., not only the U.S. economy, but I'd say for the global economy as well. When you put it like that, $5 trillion in stimulus over basically one calendar year, maybe we're lucky that inflation only peaked at 9%, and it wasn't even higher than that. You know, it really is kind of astonishing, looking back on it, and obviously there were policy reasons why we wanted to pump that money out, especially early on in the pandemic, when people had to stay home and we're not working. To shift the kind of wrap up the conversation and look a little bit towards the future, could you talk through, I guess, your best case scenario, you know, is that the soft landing that people keep talking about that the Fed might be able to execute? It would be the

first time, I think, in 70 or 80 years where we're able to, the Federal Reserve would be able to bring inflation back under control after overheating without sparking a recession. And then what do you see as kind of the worst case scenario for 2023? Yeah, I think that, you know, you could make some case for a soft landing, you know, because some of the items on the inflation front are going to now play in favor of the Fed, you know, so we could see that working out rather well going forward, you know, that the Fed doesn't need to have the economy go into. that deeper recession, but that would require the Fed ready to back off from the policies that it's

got right now, and I don't see that. The worst case is that we really get the financial market crisis coming, you know, that we could get something similar to what we saw in 2008, but hopefully, you know, we're not going to head there. The first scenario sounds a lot better to me. I hope we're there. But Desmond, thank you so much for joining the podcast. I think our listeners will appreciate this explainer and kind of a look at where we are in this year's long fight now to bring down inflation. So thank you for taking the time. With Amex Platinum, access to exclusive Amex pre-sale tickets can score you a spot trackside.

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