Gary Siegel (
Hi, and welcome to another Bond Buyer Leaders event. I'm your host Bond Buyer managing editor Gary Siegel. Today we're going to discuss yesterday's Federal Open Market Committee meeting with my guest, Steven Friedman, macro economist and managing director at MacKay Shields LLC. Steve, welcome and thank you for joining us.
Steven Friedman (
Thank you for having me today, Gary.
Gary Siegel (
So let's start by asking, was there anything in the Fed statement, the summary of economic projections or chair Jerome Powell's press conference that surprised you or grabbed your attention?
Steven Friedman (
That's a great question to start with, Gary. So let me step back and talk about the big message from the Fed yesterday. I think the real message here is that they seem to be even more concerned about inflation than they were at the time of their last set of projections in September. And as a result, they're really trying to demonstrate even more forcefully they're resolved to bring inflation back down to 2% in the years ahead. So how have they done that, they've revised higher their expectations for policy rates once again and that will in turn, according to their projections, have a more negative impact on growth and the labor market next year compared to their prior projections. So what in this surprised me? Well first I'd say that it was definitely a more hawkish message than I had anticipated. I was surprised to see the terminal rate revised up by 50 basis points, not just 25, and also that such a large contingency of policymakers see an even higher terminal rate as possible.
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What do I mean by that? So seven policymakers saw rates at the end of the next year above that median and two were below the median. So clearly the distribution of committee members' views are skewed to even higher rates than the median. So that's very, very hawkish. Second, I was surprised by the upward revisions to core inflation. The Fed seems to see significantly more inflation pressure in the economy than they did in September, and I think that's despite some building evidence of some disinflationary forces, which I think we'll discuss in a bit. And then finally, what else surprised me? I thought there were a couple of inconsistencies in the summary of economic projections. So first of all, they see a weaker economy, but more inflation. So despite the fact that they see lower growth, higher unemployment, they see higher inflation next year and that's a bit at odds with their Phillips curve framework.
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So how can I square that inconsistency? I think it has to mean that they now see a lot more inflation pressure than they did in September. So they'll be raising rates more aggressively, but even that's not enough to bring down inflation meaningfully next year. Second inconsistency that I'll mention is that they have the unemployment rate rising by almost a full percentage point and then it just sort of stops there and stays there in 2024, and I'm not sure how that would be the case, given that they still project having restrictive policy in 2024. I would think that the policy, I would think that under that set of scenarios for interest rates, you would see the unemployment rate drift higher. So overall a hawkish message more inflation concerns and perhaps some inconsistencies in the full set of projections,
Gary Siegel (
The inconsistencies, especially with inflation, is that due in part to the fact that it's so difficult to predict what's going to happen and they've been so wrong for the past year, two years, whatever?
Steven Friedman (
That's a great question. I think one thing that's sort of surprised me over the last year or two is that I don't think the Fed has actually been very nimble. Chair Powell has talked about the fact that the Fed would be nimble, but I think the evidence is to the contrary. And I think that now they're still a bit focused on all the inflationary pressures that they saw building earlier this year and even through the summer and early fall and aren't giving enough weight to some of the disinflationary forces that are building. So part of that might be because those forces, that's all about the forecast and the outlook, and this has been a committee that seems very much focused on where are the readings today as opposed to having a lot of faith in their forecasts.
Gary Siegel (
Well, the readings today seem to say that inflation is slowing down. In the past five months. CPI has been up four tenths of a percent twice. It's been up one 10th of a percent twice, and it's been unchanged once, and the last two months, CPI readings of inflation have been below expectations. So it does seem inconsistent that the Fed would raise their inflation projections now.
Steven Friedman (
Yeah, I agree. I think it it's possible that well, let me say this. I agree with you. I think that there is substantial evidence that inflation is cooling and I think by the time we get to the end of next year inflation will not only be below their current projection for next year, which is core PC inflation at, let's see, 3.5%, but I think it'll even be below what they projected in September of 3.1%. So the Fed does see inflation slowing, inflation will come down next year. They see core goods inflation moderating, some categories actually already outright deflation. They do expect shelter inflation to begin moderating as we move through next year. But I think one of the reasons they are forecasting higher inflation now than they did in September, it's because they're very much stuck on a Phillips curve framework when it comes to the service sector stripping away shelter. So they see service inflation is very much tied to the state of the labor market. The economy remains strong, the labor market remains tight. As they see it currently being the case, then they think that that service inflation shelter is going to remain very, very sticky. So it is very much a Phillips curve framework for that part of the economy and I think that's why we're seeing that upward revision to their inflation forecasts
Gary Siegel (
As long as we're discussing inflation. And you said that you think inflation will be less than projected by the Fed when do you see it reaching that 2% target?
Steven Friedman (
So I'll start with next year. I think by the end of next year we'll have core PC inflation at the end of the year down to around two and a half percent. Getting all the way back down to 2% could be challenging because we do still have some underlying issues like constrained labor labor supply. Also, there does seem to be a growing move towards onshoring of production. There are also some very powerful incentives for corporations in the Inflation Reduction Act when it comes to onshoring. So there are some factors that I think that could keep inflation firm, but I don't think it'll be too challenging to get down to 2% within their forecast horizon, especially since I do see going into a recession next year. So I wouldn't be surprised if by 2024 we're back down to around 2%.
Gary Siegel (
The SEP again had revised rates that were higher, as you said and Chairman Powell would not commit to what he thought was coming in three months. What do you expect in the S SEP three in months? Do you think they're going to again raise their projections for rates?
Steven Friedman (
That's a good question. So I think at this point the projections are, I think we're probably done with seeing upward revisions to the policy rate forecasts. The reason for that is that they themselves and I'm referring to a speech by President Bullard, who I thought did a very nice job of defining what they mean by restrictive territory and applying versions of policy rules and Taylor rules. He came up with a range of five to 7%. So I think in their view, they want to get up into that range, whether that's five or five and a quarter percent, and then stay there for a bit and see how the economy reacts. I think at the same time we are going to see more evidence of inflation moderating. So you combine those two and that tells us that it's unlikely in my mind that we would see further upward revisions to the path of policy rates in the next set of projections.
Gary Siegel (
So where does the Fed go from here? Do you see one more rate hike two more rate hikes, 75 basis points spread out somehow, where you see the terminal rate?
Steven Friedman (
Yeah, so I think the five and a quarter percent terminal rate that the Fed is now projecting, and that's for the top of the Fed funds range. I think that's pretty durable in that 17 of the 19 FMC participants projected a rate of 5% or above. So I think it would take a very, very different chain. It would take a very different type of outlook to knock the Fed off of that projection for where policy rates are going. You have to see between now and next meeting two meetings, you'd have to see very soft inflation prints and softness in the labor market become pretty evident combined. Those could lead the Fed to a lower terminal rate, but I take them at their word of getting the policy rate up to five and a quarter percent and not declaring victory early on the inflation front. I think at the end of the day, this committee they recognize the mistakes that they made in forecasting and in their reaction to inflation over the last year and a half. And they don't want to compound that by stopping tightening too soon, they would much rather risk a recession if that guarantees that inflation gets down to 2% more quickly, that's a much more acceptable risk to them than stopping too early, having a soft landing but inflation then picks back up and those are some of the lessons they learned from the 1970s and the Volcker era don't stop your focus on inflation when the economy weakens, you have to make sure the inflation genie is back in the bottle and they're going to follow through on those lessons.
Gary Siegel (
So do you expect recession or do you expect a soft landing?
Steven Friedman (
Yeah, I've been in the recession camp for some time. To me, it goes back to the fact that they are targeting a restrictive policy stance. The fact that inflation does remain high, that gives them very little flexibility to pivot in a timely manner and focus on growth risks. We also have to keep in mind that the full impact of policy tightening, we haven't even felt that yet. That comes next year given the lags with which policy works. And also I think we have to remember that the Fed is saying they want to see slower growth, they want to see a weaker labor market. That's the way that they're going to feel confident that service inflation that I talked about is going to come back down towards their 2% target. So they want to see a higher unemployment rate and the type of increase in the unemployment rate that they're projecting a rise from here of almost 1%. Historically that's always been associated with a recession. So I do see it. A recession is likely, it's my base case. I would think it would start by around the middle of next year. Why not imminently? I think there's still a good amount of excess cash built up on household balance sheets. Corporate balance sheets are healthy as well. So this timing, it does take a while to work through and impact the full economy.
Gary Siegel (
And what kind of recession are we talking about? Mild, medium, big?
Steven Friedman (
Yeah. I think there seems to be a general view that it will be a mild recession. That's a word for recession that I struggle with. If that would seem to suggest maybe the unemployment rate just goes up a couple of percentage points growth barely turns negative, and then you're sort of back to an expansion. My issue with that view is that that's not the type of recession that would give the Fed confidence that inflation would sustainably return to 2%. They actually want to see something a little bit more meaningful than that. So I do think we're looking at a situation where the unemployment rate rises from its low by about two percentage points and I'm penciling in growth next year of around negative half of a percentage point. So I would call that moderate. I don't wanna want to wordsmith too much, but I think mild, I don't think that sufficiently captures what we're likely to see. This isn't though something like 2007 and 2008, we don't have the imbalances in the economy for a very, very severe or protracted recession but I think it will be a little bit worse than markets seem to be currently forecasting. We should also keep in mind that the Fed isn't going to pivot to rate cuts anytime soon, so there won't be any quick pivot to monetary policy support. So that also tells us that the recovery could be somewhat sluggish.
Gary Siegel (
What is the yield curve telling us? It's been negative for a while now. I know a negative yield curve normally means recession is coming in 12 to 18 months. What is your read on the yield curve?
Steven Friedman (
Yeah, my yield curve read is very, very similar to that. I think big picture of the yield curve is telling us that we have a tight stance of policy too tight to maintain growth at trend. And so rates will have to be lower in the future. Now if you think a recession is coming, that's the signal you take from the yield curve. If you think a soft landing is coming, you can take a soft landing signal from the yield curve. Because if you're in the soft landing camp, you think the Fed is going to pivot in time, the curve will steepen and the economy doesn't go into recession. But yeah, to me, I think at these levels thew yield curve is sending off a very, very strong signal that we have a weak near-term growth outlook and interest rates, short-term interest rates are too high.
Gary Siegel (
After the last Fed meeting. A lot of people thought the Fed and the markets were on the same page. That doesn't appear to be the case at this point.
Steven Friedman (
Yeah, it's really interesting to see this. As I said, I thought the meeting yesterday, I didn't see a single dovish element in it. It all seemed very, very hawkish to me. And to see interest rates barely move yesterday was really interesting. And you take this back, if we look at this in September after the September meeting the Fed comes out with a new set of projections, higher interest rates, fed fund futures the LIS curve, those all moved up to reflect a terminal rate that was similar to what the Fed was saying, but as of today, the market seems skeptical that the Fed will actually get the policy rate up to five and a quarter percent. So I think rate expectations top out at around 4.8%, 4.9%, which would suggest a top of the policy rate range of just 5%. So call it a one cut difference from what the well, sorry, a one hike difference from what the Fed is suggesting.
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So how do we account for that? So I think it's in large part because the market has a different view on inflation at this point. After two soft inflation prints after poring through the data and everyone sees all these other signs of disinflation in the pipeline I think people think this is it, inflation is really starting to meaningfully soften and then that gives the Fed scope not to raise rates as much. So I think at the end of the day, this comes down to a very, very different view on inflation. With the Fed yesterday, very much focused on more inflation pressures in the economy. We need to tighten more. Yeah, markets are saying we see signs of disinflation ahead, it's starting to take hold. You don't have to over tighten.
Gary Siegel (
And the Fed is thinking we're still far from our 2% goal. Or is it something else that's leading the Fed to think there are more inflationary pressures?
Steven Friedman (
Yeah, yeah, I again, I think it does come back to the labor market. I think in their mind they're concerned that if you keep the labor market this far out of balance with the labor demand well in excess of labor supply, the wage wage gains are going to continue and those gains will be stronger than what is consistent with 2% inflation. So you are going to continue to have these inflationary pressures. I also wonder if they're a bit more focused on near-term inflation expectations. So at the long end of the curve or I should say longer horizons, inflation expectations do seem to be well anchored. But if you look at one-year forward inflation expectations from the University of Michigan survey or from the New York Fed, those are still at pretty high levels up around 4% or 5%. Now, very often short-term inflation expectations are very much influenced by recent experience and also gasoline and other energy prices. Gasoline prices are now pretty much down to where they were a year ago. So it's interesting to me that you could see short-term inflation expectations still pretty high given gasoline prices have already retraced that large spike from the spring. So I do feel like they've become a little bit more concerned about short-term inflation expectations because they're concerned that that could feed through into the wage setting process.
Gary Siegel (
Well food prices are another area where inflation is very high. A trip to the supermarket is sticker shock.
Steven Friedman (
Yep, yep, exactly. And that is likely to continue. And I think, yeah, so I think it's those sorts of observations that households make. That could be why short-term inflation expectations still seem pretty sticky at a high level.
Gary Siegel (
And for the labor market, the labor participation rate is still low. A lot of people have left the labor force. Does the Fed, or do you think that there's any chance that participation rate increases at any time in the future? Or are these people out of the market and not coming back?
Steven Friedman (
Yeah, that's a very good question and it's one that's certainly front and center for the Fed. I think it's clear from what Powell has communicated that they don't really see an improvement in labor force participation. As a result of that, in order to bring labor supply and demand back into balance, they feel like they have to hit labor demand by slowing the economy back down to this depressed level labor supply. So I think they've pretty much thrown in the towel in terms of hoping for improvement in labor supply. As for myself, I think that there are some reasons that validate their view. First of all, a lot of the decrease in labor supply has to do with early retirements. I don't see those reversing though the effect of that should lessen over time. But nonetheless, that's definitely been a factor. In addition, COVID still seems to be keeping — or illness generally — hundreds of thousands of people out of the labor force every month.
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And that's probably going to continue for a policy relevant period of time. But then another really interesting thing that's happening is that labor force participation among younger white men has been very, very low and low at a sticky level and really is far short of where it was pre-pandemic. And there's a lot of interesting research that's been done on that. I don't know if anyone has a clear conclusion, but it does seem that perhaps young men are not thrilled with the labor opportunity set in front of them whether it's the types of work or the wages. And that seems to keeping many of them on the sideline. So I don't see a huge recovery in labor force participation in the offering. And if you go into a recession, that could hurt labor force participation even further. Now, one positive news in terms of overall labor supply is that after really nosediving during the pandemic, we are seeing an increase in the foreign born pool of labor. So there does seem to be in the last six months or so, some offset coming from foreign workers coming into the country. So at least from a labor supply perspective that that's a positive.
Gary Siegel (
I'm going to make this question very general. How would you rate the Fed's performance since the beginning of the pandemic? You could look at any point from the beginning to now or start at beginning and go til now and tell me what have they done right and what have they done wrong in that time?
Steven Friedman (
Yeah, that's a great question. So if we just take their immediate policy response to the pandemic, I think you'd have to grade them very, very highly. I think they did an excellent job. I think that bazooka approach in terms of providing liquidity to markets was exactly what was needed. Not only was it large, but it was very, very timely. I thought the coordination with fiscal authorities was exactly the right message to send to the public. So their immediate policy response, I would give them an A. If we look a little farther afield since then, yeah, I think I'm much more critical. We just think about inflation. I think there are a number of forecasting errors that they made. And then even when they came around to the idea that gee this isn't as short-lived or transitory as we think they were still really slow to pivot on the policy front.
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So I think history will not judge them well in that regard. But then there's some other issues. So for example average inflation targeting in theory I don't have an issue with average inflation targeting. In fact, I thought, I think it makes sense if you say your objective is 2%, having 2% inflation on average over time. And if that means sometimes you're above and sometimes you're below, that I think is completely reasonable. The issue that I had with it is how it was implemented with this very, very aggressive forward guidance that really tied their hands. They said that they wouldn't raise rates until inflation was at 2%, going to exceed 2% in the future and you're back at full employment. So that really tied their hands in a way that I think was unfortunate. So that also made them very, very late. Now let's be clear, I don't think they could have prevented this inflation shock.
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Maybe they would've taken the peak off of it, maybe that peak would've happened a little sooner. But so much of this had to do with shifts in household spending towards goods at a time when fiscal policy gave people the money to spend on those goods. And at a time when global production and supply chains we're all snarled, so we would've had this inflation shock anyway, I think it would've peaked a little bit sooner and not such a high level. And the Fed would've just been better positioned to deal with it, which would've enhanced their credibility rather than what we have, which I think their credibility took somewhat of a hit. So I'm much happier with what they did immediately than since then. And I'll just mention one other point to this, which has implications for the future, and I kind of touched on this, is that I don't think that they've acted in a very nimble way in terms of adjusting their inflation forecast and then adjusting policy.
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And that makes me a little bit nervous about the next year or two. And I think we see it playing out in the early parts of our discussion, Gary, where we're talking about everyone else seems to be seeing these disinflationary forces building, yet the Fed still seems to be focused on the last battle of rising inflation pressure. So even today I don't think we're seeing that nimbleness. And that's always the hardest thing for central banks to do, weigh the data and make the correct decision in a timely manner. But the history of the last year and a half and even recent decisions doesn't give me a lot of optimism that they can pivot quickly and avoid a hard landing.
Gary Siegel (
So what I got from what you said was because of the average inflation target, you think the Fed waited too long to act to raise rates.
Steven Friedman (
I think for me it wasn't so much the strategy shift to that, but it was more how it was implemented in forward guidance that tied their hands and prevented them from acting in a more timely manner.
Gary Siegel (
When they implemented that policy, they were worried about not getting inflation up to 2%. And then when it soared past 2% as a result of things that they couldn't control, they were in a difficult position.
Steven Friedman (
Exactly. And I think at that point in time, I wouldn't have suggested that they should have had restrictive policy immediately. But once you start to see inflation up above 2%, you should at least be back in neutral very, very quickly so that you're well positioned to adjust if inflation doesn't come back down. And they were just far off.
Gary Siegel (
We all know that monetary policy works with lag and the Fed raised rates at every meeting including four times raising by three quarters of a point. Was that too aggressive? Was that what they needed to do because they started too late? What is your opinion on that?
Steven Friedman (
Yeah, I think it's what they needed to do because they started so late. In fact, if I think about some of the conversations we had internally at the beginning of this year I remember saying to my colleagues, Jim, they need to get the policy rate up to neutral now. They can't wait. They can't go in 50 basis point increments. So I think you could actually make an argument that they weren't aggressive enough that they really should have gotten up to neutral as soon as they realized there was an inflation issue. Or at least if once they even saw risks of a persistent inflation issue, they should have been back at neutral. So I don't think that they were overly aggressive this year. I think you could make an argument that they weren't aggressive enough in getting policy towards restrictive, into restrictive territory. So you think about the policy rate today, four and a half percent just looking at where the University of Michigan's survey was and is in terms of one-year inflation expectations, that's at 4.6%. So that tells you that the policy rate today in real terms is still zero in inflation adjusted terms. So it's really even hard to argue that currently policy is restrictive. Now of course, inflation can come down, inflation expectations should move down. So the policy stance, even if it were to stay where it was, would become more restrictive in real terms. But yeah, again, it's just hard to argue that they've been overly aggressive so far.
Gary Siegel (
So if they had raised by a point or a point and a quarter at that first meeting where they raised 75 basis points, you would've been comfortable with that?
Steven Friedman (
Yeah, I, I know it would've been a shock to markets, but I think there's something to be said in an environment where you have to reestablish your inflation-fighting credibility in shocking the markets.
Gary Siegel (
That's interesting. So we've spoken about your thoughts about rates and inflation. I think you've said that you expect GDP to be below what the Fed projected. Is that correct?
Steven Friedman (
Yep. I think their projections, I think are essentially a recession when we think about the unemployment rate and growth next year of a half a percentage point for the full year in their projections, I can mask one or two negative quarters of growth and you can still have slightly positive growth. So I think their projections are already suggestive of a recession. But yeah, I'm actually below zero for the year as a whole.
Gary Siegel (
Do you think the Fed didn't want to project negative GDP because they didn't want to say they're projecting a recession?
Steven Friedman (
I think it's really challenging for them to project a recession in advance of it happening but I think if we think about their projection for the unemployment rate and weak growth I think we see that under the surface, the projections, there is a recession there and when we hear Powell talk about that he realizes that this could be painful for many households, that word pain, that's essentially a recession. But I think not using that word now, but sort of sending strong hints, I think in their mind it can help them avoid a lot of negative public blowback including from Congress.
Gary Siegel (
So what does all this mean for the bond market? How do you see the bond market reacting going forward? If they raise rates another 75 basis points, how will that affect the bond market?
Steven Friedman (
So my view near term is that actually I think the twos-tens curve is going to invert further. I'll just look at where we are currently if you don't mind. So we have two year around four and a quarter 10 year 3.43. So call it negative 80 basis points of curve inversion. For twos, tens I think we will go to negative a hundred and that is certainly a level that sets off very, very strong alarm bells in terms of a recession. So where do we go from there? I think the market is underappreciating the Fed's resolve to get rates up above 5%. But I think the market is right in terms of projecting cuts later next year because I do think we'll see both a combination of a weaker labor market and higher unemployment and softer inflation. So that then does allow the Fed to pivot towards rate cuts towards the end of next year.
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So in that environment, maybe I'd see the 10 year by the end of next year down to three and a quarter. But if the Fed is only cutting a little bit and they're signaling that they might not cut that much into 2024, that could keep the curve relatively flat until the Fed is absolutely sure that inflation is sustainably back at 2%, then that's when they could cut further and the curve could resteepen significantly. That might be more of a 2024 story. We look be beyond treasuries. If we think about credit markets current spreads are actually fairly tight currently. I don't know where they're at at the moment, but as of the close yesterday, think about a high yield spread I think it was around the 45th percentile of its historical range. So actually below the median, yet markets seem to be increasingly expecting a recession. So I don't think credit markets are really reflecting that risk fully yet. So I do anticipate that as we get into next year, particularly in the first half of the year, we will see some very, very meaningful widening of credit spreads. But then as the year progresses as we go into recession, as we get those first hopefully green shoots of a recovery starting to build as the Fed starts to pivot and we could see spreads start to come up.
Gary Siegel (
I'm going to pivot myself and go to some audience questions brcause we seem to have a bunch of them. Can you share and expand upon a topic receiving too little or too much focus?
Steven Friedman (
Yeah, that's a very good question. I'll start with too much focus. I think this idea of a Fed pivot is getting too much focus. One because it's a confusing topic. I think for many people just stepping down the pace of rate increases and stopping raising rates is a pivot. To me, that's not a pivot to me, a pivot is when the Fed winds up doing something that's very different from what they were communicating that would be not going up to that terminal rate or cutting rates a lot sooner than they expect. And I think those are still far off. So that's why I think I, that topic's getting too much focus. In terms of too little focus, I think we need to start thinking about fiscal policy next year. And I'll mention two issues. One is the debt ceiling has to be raised and that's going to be very challenging to do with divided government.
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It will get done, but I could certainly see this coming down to an 11th hour sort of agreement like we had, we all remember unfortunately too well, when was that back in 2011 when the debt ceiling issue really came down to really the last moment. So I'm very concerned about the debt ceiling and how quickly that will get raised but then also what happens if we do go into a recession? I had said that I don't think the Fed can cut rates all that much because inflation might still be a bit elevated. So that tells us that the recovery might be somewhat sluggish. But how does fiscal policy respond to recession? I'm, I'm afraid that currently fiscal policy has fallen so far out of favor given some of the Keynesian experiments that we saw during COVID that Congress will be hesitant to use countercyclical fiscal policy and provide help to households as they typically do in a recession. I think they'll provide some, I think it's just going to be very, very limited given the recent experience with inflation and fiscal policy. That's another reason why I think this will be more than a mild recession. There's just, there won't be monetary support, there won't be a lot of fiscal support either.
Gary Siegel (
Another question is why does the market not agree with the Fed? And the person says that I believe the Fed way overstepped with rate increases. I'm just asking, that's not necessarily my position. I try to remain neutral. The person wants to know, do you agree and what will it take before the Fed recognizes the position that they may have overstepped their rate increases?
Steven Friedman (
Yeah I think again, it just comes down to the inflation outlook. I think markets are increasingly convinced that inflation really has turned a corner. It's not only peaking, but there'll be a substantial moderation going forward. So who's right here remains to be seen. I think the issue that maybe markets are underappreciating when it comes to the Fed's resolve is how focused they are in the labor market and the continued strength in the labor market. So I think for markets to be right and the Fed to stop raising rates sooner than they're signaling, it's going to require them seeing significant softening in the labor market. I'm not convinced that happens that quickly.
Gary Siegel (
We have two questions about the optimum inflation rate. One question is how did the Fed decide on 2% and there's been some chatter about the Fed raising the inflation target to 3%. In your view, is the Fed changing the target a reasonable possibility?
Steven Friedman (
So really good, really good questions. On the first part of it. Yeah, I think they knew that they wanted to target an above zero inflation rate because their concerns about what happens to debt holders in a deflationary environment. So if you're targeting inflation at zero, you go into recession, prices fall, you have deflation it makes it harder to service debts, it can make recessions more pronounced. But why 2% instead of one or 3%? I've never been convinced that settling on 2%, I think it just was something that they could all agree to, to be honest. In terms of what happens to the inflation target from here, I think prospects of them increasing it anytime soon are pretty much zero because if you were to increase it at a time when inflation is high, it looks like you, you're caving in, you're just moving the goalposts.
(
So if 2% is hard to achieve and you move it to two and a half percent, well then inflation expectations will rise. And then hitting two point a half percent becomes challenging as well. And I think they know this. So I think there could be an argument that some would make in the future that we have to go undergo this massive energy transition. Companies need to secure their supply lines and bring production back home or near to home and all that could be inflationary. So given those two significant transitions that the economy will undergo, we want those to happen. And if those are inflationary, perhaps that's an acceptable cost and the Fed shouldn't stand in the way of that. I think that's a sort of dialogue that we could see emerge, but actually having the Fed act on that I think that that's a multi-year project. And also once you start talking about raising inflation rates, Congress is going to want to get involved and that's something the Fed is always very hesitant to do.
Gary Siegel (
Next question is how many people does the Fed want to see unemployed? I guess you could give a percentage instead of the actual number if you want.
Steven Friedman (
Yeah, so that's always a challenging question. I think Powell's been asked versions of this and he has to remind people that his goal is not for people to lose their jobs. His goal is to slow the economy and bring inflation down and engineer soft landing. And if you do that, there can be pain in the short term, but it's a better outcome over the long term because you can't get back to full employment when you have a lot of inflation. That being said, I think in their view they have to get the unemployment rate up to at least 4% to bring down inflation. Then actually if you, and I say 4% because that's their estimate of a neutral rate of unemployment, that should not be inflationary. But if we think about their projections, but these really are, these policy rate projections are their thoughts on the most appropriate path of policy. So they're telling us median FOMC members saying that the most appropriate path of policy will raise the unemployment rate by almost a full percentage point. So if you think about the projections that way in terms of this is what they see as the desirable outcome to bring down inflation, that's pretty much an answer to your question. They see that they need, they see raising the unemployment rate by a full percentage point or so is appropriate policy.
Gary Siegel (
Next question. Has the yield curve been inverted since August 2019?
Steven Friedman (
No, Since 2019, no, it certainly went through a period of a positive slope in there. And so just to benchmark this, so in late 2019 we had a moderately positive slope. And then as we went further into the pandemic two stands actually had 150 basis points of steepness to it. Part of that was higher inflation expectations as the Fed were suppressing policy rates and real rates. But then once inflation really started to become more of a risk and take hold, we've seen the curve just continue to flatten and invert. So now we're down to minus 80 basis points.
Gary Siegel (
And the next question is the CEO of Starwood stated that it isn't that the Fed moved the funds rate to the level it's at, but the fact they have moved so quickly. Do you feel the market has truly felt the impact of these moves yet?
Steven Friedman (
It's really interesting because what we've actually seen, and let's put aside today, today's been a poor day for risk sentiment, but generally speaking, financial conditions have actually eased over the last two months or so, which is not what the Fed wants. But still, even with that, the tightening in financial conditions is as significant and more significant that we've seen in recent recessions. And this is exactly what the Fed wants. They,'ve felt that having fallen behind the curve on inflation, they just need to tighten policy very, very quickly and aggressively. So I think that whoever made that comment, I would agree with them that there's something very different about raising rates slowly over years versus raising them very, very significantly over a short period of time. So maybe we can think about the run up to the housing crisis. That expansion, the Fed was raising rates, they would raise rates every meeting by a quarter point or so and we got up to a level policy rate that was actually higher than where we are today. But that was a period where it remained very much of a risk on type environment. And I think part of that was because of the Fed just going in these small increments and signaling that they were going to do that. Contrast that today with the Fed raising rates so quickly and you see a very, very different reaction in terms of financial conditions.
Gary Siegel (
And the last question we have from the audience is: do you see the equity markets ever capitulating as it has done in so many previous bear markets? What the old models no longer apply?
Steven Friedman (
It's a great question and I, I've wrestled with this quite a bit. I think at the end of the day it seems to me that ahead of prior recessions you have had periods of optimism in the equity market as investors debated the prospects for a hard or soft landing. And so I think that's where we are now. So for me, I think as you go into recession, investors will just demand a higher risk premium in credit markets and inequity markets. We know that earnings will take a hit, we'll see margin compression. So in my worldview as a recession becomes more evident, we are going to see risk assets perform poorly. And I think revisiting and even going below the low that we saw this year in the S&P seems to me like a reasonable outcome to expect if you believe that there will be a recession.
Gary Siegel (
What are the biggest risks to the economy and the outlook going forward.
Steven Friedman (
So there are always the bigger risks that are really hard to get our hands around. Things like Russia the war in Ukraine, we don't know how that will play out and whether that could become a wider conflict and what's going to happen to energy prices. So there are always those sorts of events that are very, very hard to predict. Now I think what I'm concerned about relates to something that I said earlier, the supply side of the economy not just the labor supply but also the outlook for productivity growth. We go into another recession we'll see corporations pulled back on capital expenditures. And so I'm concerned that we're going to emerge from the next recession with a very, very weak supply side of the economy because of what's happening on the labor side, but also what may happen with the investment spending as well. So that's a concern I have now, there is an offset there if we are really going to see a lot more companies onshoring production or nearshoring production if we have this energy transition as well. Those are things that can help the supply side over time. But that is something that I'm concerned about that we came into COVID with a low level of trend growth. I would've put it about one and three quarters percent of potential growth. I'm not convinced to we come out of the next recession with it being any higher. And that's something that I think has been really challenging for the country as a whole in the last few decades is just how low potential growth has fallen.
Gary Siegel (
What are your clients asking? What are their biggest concerns?
Steven Friedman (
Yeah, I don't know if I would say concerns. I think the main question we get is this, I think somewhat similar to one of your participants today asked: why are risk assets kind of performing so well in this environment where increasingly people are pricing in a recession? And so that's something we've had a lot of discussions with clients about. And I do think it comes down to the fact that as you go into a recession, it's unclear that that's going to happen. There's still a contingency to think that things will be okay. And I think a lot of people are still living in this world where they expect central banks to come to the rescue and bail out investors, but when inflation is high, that just doesn't happen. So that's a question that we talked a lot to our clients about the outlook for risk assets, which we have a bearish view on. But I think generally speaking when it comes to fixed income and investing, I think a lot of our investors, they see opportunities in the year ahead because base rates are a lot higher and if we're correct and risk spreads do move wider in investment grade and in high yield, that's just going to be create an even better opportunity. So a lot short term volatility that I would expect in fixed income spread, widening markets, pricing, recession. But that does actually set up markets for some very, very good opportunities as 2023 unfolds.
Gary Siegel (
We're running a little late, but we have two last questions from the audience. Okay. When do you think the Fed will begin to lower rates and do you think they will lower them as quickly as they have raised them?
Steven Friedman (
Great questions. So I am in agreement with the market that we will see rate cuts next year because I think it'll be clear that inflation is softening and I think the labor market will be softening as well as a recession becomes evident and opens the door to rate cuts. But this is not 2007, 2008 it's not even, I don't think the 2001 recession in terms of the extent of rate cuts. I think the Fed will move it very gently. I think maybe we would see 50 basis points worth of rate cuts next year, maybe a hundred basis points the year after maybe a little bit more. But that's still leaves you with a policy rate that's above neutral. So still a restrictive policy. And this gets back to the lessons that the Fed seems very focused on from the great inflation and the Volcker years, is that you have to maintain a tight policy stance until you are absolutely sure that the inflation genie is back in the bottle. If you think about Volcker in the 1980s, he essentially kept a real policy rate in place through his entire tenure with a very, very brief exception. But now, I'm not saying that this is the 1980s because we don't have the same inflation problems, but this is the framework that the Fed is using that they need to maintain restrictive policy for an extended period of time to make sure that the inflation issue has gone away.
Gary Siegel (
And the final question, what are your forecasts for residential and commercial real estate?
Steven Friedman (
I don't think I have anything on that unfortunately that I can share off the top of my head, but I'd be happy to follow up offline on that.
Gary Siegel (
Okay. Well I think we've run out of time. I want to thank you, Steve. I want to thank those who logged in to listen and I wish everyone a good day and a pleasant week.
Steven Friedman (
Thank you for having me.
