As the US Federal Reserve mulls a forthcoming interest rate cut,
our Head of Corporate Credit Research and Global Chief Economist
discuss how it is balancing inflationary risks with risks to
growth.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley.
Seth Carpenter: And I'm Seth Carpenter,
Morgan Stanley’s Global Chief Economist.
Andrew Sheets: And today on the podcast,
we'll be discussing the Federal Reserve, whether its policy is
behind the curve and what's next.
It's Thursday, August 29th at 2pm in London.
Seth Carpenter: And it's 9am in New York.
Andrew Sheets: Seth, it's always great to
talk to you. But that's especially true right now. The Federal
Reserve has been front and center in the markets debate over the
last month; and I think investors have honestly really gone back
and forth about whether interest rates are in line or out of line
with the economy. And I was hoping to cover a few big questions
about Fed policy that have been coming up with our clients and
how you think the Fed thinks about them.
And I think this timing is also great because the Federal Reserve
has recently had a major policy conference in Jackson Hole,
Wyoming where you often see the Fed talking about some of its
longer-term views and we can get your latest takeaways from that.
Seth Carpenter: Yeah, that sounds great,
Andrew. Clearly these are some of the key topics in markets right
now.
Andrew Sheets: Perfect. So, let's dive
right into it. I think one of the debates investors have been
having -- one of the uncertainties -- is that the Fed has been
describing the risk to their outlook as balanced between the risk
to growth and risk to inflation. And yet, I think for investors,
the view over the last month or two is these risks aren't
balanced; that inflation seems well under control and is coming
down rapidly. And yet growth looks kind of weak and might be more
of a risk going forward.
So why do you think the Fed has had this framing? And do you
think this framing is still correct in the aftermath of Jackson
Hole?
Seth Carpenter: My personal view is that
what we got out of Jackson hole was not a watershed moment. It
was not a change in view. It was an evolution, a continuation in
how the Fed's been thinking about things. But let me unpack a few
things here.
First, markets tend to look at recent data and try to look
forward, try to look around the corner, try to extrapolate what's
going on. You know as well as I do that just a couple weeks ago,
everyone in markets was wondering are we already in recession or
not -- and now that view has come back. The Fed, in contrast,
tends to be a bit more inertial in their thinking. Their thoughts
evolve more slowly, they wait to collect more data before they
have a view. So, part of the difference in mindset between the
Fed and markets is that difference in frequency with which
updates are made.
I'd say the other point that's critical here is the starting
point. So, the two risks: risks to inflation, risks to growth. We
remember the inflation data we're getting in Q1. That surprised
us, surprised the market, and it surprised the Fed to the upside.
And the question really did have to come into the Fed's mind --
have we hit a patch where inflation is just stubbornly sticky to
the upside, and it's going to take a lot more cost to bring that
inflation down. So those risks were clearly much bigger in the
Fed’s mind than what was going on with growth.
Because coming out of last year and for the first half of this
year, not only would the Fed have said that the US economy is
doing just fine; they would have said growth is actually too fast
to be consistent with the long run, potential growth of the US
economy. Or reaching their 2 per cent inflation target on a
sustained basis. So, as we got through this year, inflation data
got better and better and better, and that risk diminished.
Now, as you pointed out, the risk on growth started to rise a
little bit. We went from clearly growing too fast by some metrics
to now some questions -- are we softened so much that we're now
in the sweet spot? Or is there a risk that we're slowing too much
and going into recession?
But that's the sense in which there's balance. We went from far
higher risks on inflation. Those have come down to, you know,
much more nuanced risks on inflation and some rising risk from a
really strong starting point on growth.
Andrew Sheets: So, Seth, that kind of leads
to my second question that we've been getting from investors,
which is, you know, some form of the following. Even if these
risks between inflation and growth are balanced, isn't Fed policy
very restrictive? The Fed funds rate is still relatively high,
relative to where the Fed thinks the rate will average over the
long run. How do you think the Fed thinks about the
restrictiveness of current policy? And how does that relate to
what you expect going forward?
Seth Carpenter: So first, and we've heard
this from some of the Fed speakers, there's a range of views on
how restrictive policy is. But I think all of them would say
policy is at least to some degree restrictive right now. Some
thinking it's very restrictive. Some thinking only modestly.
But when they talk about the restrictiveness of policy in the
context of the balance of these risks, they're thinking about the
risks -- not just where we are right now and where policy is
right now; but given how they're thinking about the evolution of
policy over the next year or two. And remember, they all think
they're going to be cutting rates this year and all through next
year.
Then the question is, over that time horizon with policy easing,
do we think the risks are still balanced? And I think that's the
sense in which they're using the balance of risks. And so, they
do think policy is restrictive.
They would also say that if policy weren't restrictive, [there
would] probably be higher risks to inflation because that's part
of what's bringing inflation out of the system is the restrictive
stance of policy. But as they ease policy over time, that is part
of what is balancing the risks between the two.
Andrew Sheets: And that actually leads
nicely to the third question that we've been getting a lot of,
which is again related to investor concerns -- that maybe policy
is moving out of line with the economy. And that's some form of
the following: that by even just staying on hold, by not doing
anything, keeping the Fed funds rate constant, as inflation comes
down, that rate becomes higher relative to inflation. The real
policy rate rises. And so that represents more restrictive
monetary policy at the very moment, when some of the growth data
seems to be decelerating, which would seem to be suboptimal.
So, do you think that's the Fed's intention? Do you think that's
a fair framing of kind of the real policy rate and that it's
getting more restrictive? And again, how do you think the Fed is
thinking about those dynamics as they unfold?
Seth Carpenter: I do think that's an
important framing to think -- not just about the nominal level of
interest rates; you know where the policy rate is itself, but
that inflation adjusted rate. As you said, the real rate matters
a lot. And inside the Fed as an institution there, that's
basically how most of the people there think about it as well.
And further, I would say that very framing you put out about --
as inflation falls, will policy become more restrictive if no
adjustment is made? We've heard over the past couple of years,
Federal Reserve policymakers make exactly that same framing.
So, it's clearly a relevant question. It's clearly on point right
now. My view though, as an economist, is that what's more
important than realized inflation, what prices have done over the
past 12 months. What really matters is inflation expectations,
right? Because if what we're trying to think about is -- how are
businesses thinking about their cost of capital relative to the
revenues are going to get in the future; it's not about what
policy, it's not about what inflation did in the past. It's what
they expect in the future.
And I have to say, from my perspective, inflation expectations
have already fallen. So, all of this passive tightening that
you're describing, it's already baked in. It's already part of
why, in my view, you know, the economy is starting to slow down.
So, it's a relevant question; but I'm personally less convinced
that the fall in inflation we've seen over the past couple of
months is really doing that much to tighten the stance of policy.
Andrew Sheets: So, Seth, you know, bringing
this all together, both your answers to these questions that are
at the forefront of investors' minds, what we heard at the
Jackson Hole Policy Conference and what we've heard from the
latest FOMC minutes -- what does Morgan Stanley Economics think
the Fed's policy path going forward is going to be?
Seth Carpenter: Yeah. So, you know, it's
funny. I always have to separate in my brain what I think should
happen with policy -- and that used to be my job. But now we're
talking about what I think will happen with policy. And our view
is the Fed's about to start cutting interest rates.
The market believes that now. The Fed seems from their
communication to believe that. We've got written down a path of
25 basis point reduction in the policy rate in September, in
November, in December. So, a string of these going all the way
through to the middle of next year to really ease the stance of
policy, to get away from being extremely restrictive, to being at
best only moderately restrictive -- to try to extend this cycle.
I will say though, that if we're wrong, and if the economy is a
bit slower than we think, a 50 basis point cut has to be
possible.
And so let me turn the tables on you, Andrew, because we're
expecting that string of 25 basis point cuts, but the market is
pricing in about 100 basis points of cuts this year with only
three meetings left. So that has to imply at least one of those
meetings having a 50 basis point cut somewhere.
So, is that a good thing? Would the market see a 50 basis point
cut as the Fed catching up from being behind the curve? Or would
the market worry that a bigger cut implies a greater recession
risk that could spook risk assets?
Andrew Sheets: Yeah, Seth, I think that's a
great question because it's also one where I think views across
investors in the market genuinely diverge. So, you know, I'll
give you our view and others might have a different take.
But I think what you have is a really interesting dynamic where
kind of two things can be true. You know, on the one hand, I
think if you talk to 50 investors and ask them, you know, would
they rather for equities or credit have lower rates or higher
rates, all else equal -- I think probably 50 would tell you they
would rather have lower rates.
And yet I think if you look back at history, and you look at the
periods where the Federal Reserve has been cutting rates the most
and cutting most aggressively, those have been some of the worst
environments for credit and equities in the modern era. Things
like 2001, 2008, you know, kind of February of 2020. And I think
the reason for that is that the economic backdrop -- while the
Fed is cutting -- matters enormously for how the market
interprets it.
And so, conditions where growth is weakening rapidly, and the Fed
is cutting a lot to respond to that, are generally periods that
the market does not like. Because they see the weaker data right
now. They see the weakness that could affect earnings and credit
quality immediately. And the help from those lower rates because
policy works with lag may not arrive for six or nine or twelve
months. It's a long time to wait for the cavalry.
And so, you know, the way that we think about that is that it's
really, I think the growth environment that’s going to determine
how markets view this rate cutting balance. And I think if we see
better growth and somewhat fewer rate cuts, the base case that
you and your team at Morgan Stanley Economics have -- which is a
bit fewer cuts than the market, but growth holding up -- which we
think is a very good combination for credit. A scenario where
growth is weaker than expected and the Fed cuts more
aggressively, I think history would suggest, that's more
unfriendly and something we should be more worried about.
So, I do think the growth data remains extremely important here.
I think that's what the market will focus most on and I think
it's a very much good is good regime that I think is going to
determine how the market views cuts. And fewer is fine as long as
the data holds up.
Seth Carpenter: That make a lot of sense,
and thanks for letting me turn the tables on you and ask
questions. And for the listeners, thank you for listening. If you
enjoy this show, leave us a review wherever you listen to
podcast. And share Thoughts on the Market with a friend or a
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