Our Global Head of Fixed Income Research Andrew Sheets and Global
Chief Economist Seth Carpenter unpack the inner workings of the
Federal Reserve to illustrate the challenges that Fed chair
nominee Kevin Warsh may face.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Global Head of Fixed Income Research
at Morgan Stanley.
Seth Carpenter: And I'm Seth Carpenter,
Morgan Stanley's Global Chief Economist and Head of Macro
Research.
Andrew Sheets: And today on the podcast, a
further discussion of a new Fed chair and the challenges they may
face.
It's Friday, February 6th at 1 pm in New York.
Seth, it's great to be here talking with you, and I really want
to continue a conversation that listeners have been hearing on
this podcast over this week about a new nominee to chair the
Federal Reserve: Kevin Warsh.
And you are the perfect person to talk about this, not just
because you lead our economic research and our macro research,
but you've also worked at the Fed. You've seen the inner workings
of this organization and what a new Fed chair is going to have to
deal with.
So, maybe just for some broad framing, when you saw this
announcement come out, what were some of the first things to go
through your mind?
Seth Carpenter: I will say first and
foremost, Kevin Warsh's name was one of the names that had
regularly come up when the White House was providing names of
people they were considering in lots of news cycles. So, I think
the first thing that's critically important from my perspective,
is – not a shock, right? Sort of a known quantity.
Second, when we think about these really important positions,
there's a whole range of possible outcomes. And I would've said
that of the four names that were in the final set of four that we
kept hearing about in the news a lot. You know, some differences
here and there across them, but none of them was substantially
outside of what I would think of as mainstream sort of thinking.
Nothing excessively unorthodox at all like that. So, in that
regard as well, I think it should keep anybody from jumping to
any big conclusions that there's a huge change that's
imminent.
I think the other thing that's really important is the monetary
policy of the Federal Reserve really is made by a committee. The
Federal Open Market Committee and committee matters in these
cases. The Fed has been under lots of scrutiny, under lots of
pressure, depending on how you want to put it. And so, as a
result, there's a lot of discussion within the institution about
their independence, making sure they stick very scrupulously to
their congressionally given mandate of stable prices, full
employment.
And so, what does that mean in practice? That means in practice,
to get a substantially different outcome from what the committee
would've done otherwise… So, the market is pricing; what's the
market pricing for the funds rate at the end of this year? About
3.2 percent.
Andrew Sheets: Something like that.
Yeah.
Seth Carpenter: Yeah. So that's a
reasonable forecast. It's not too far away from our house
view. For us to end up with a policy rate that's
substantially away from that – call it 1 percentage, 2 percentage
points away from that. I just don't see that as likely to happen.
Because the committee can be led, can be swayed by the chair, but
not to the tune of 1 or 2 percentage points.
And so, I think for all those reasons, there wasn't that much
surprise and there wasn't, for me, a big reason to fully
reevaluate where we think the Fed's going.
Andrew Sheets: So let me actually dig into
that a little bit more because I know our listeners tune in every
day to hear a lot about government meetings. But this is a case
where that really matters because I think there can sometimes be
a misperception around the power of this position. And it's both
one of the most public important positions in the world of
finance. And yet, as you mentioned, it is overseeing a committee
where the majority matters. And so, can you take us just a little
bit inside those discussions? I mean, how does the Fed Chair
interact with their colleagues? How do they try to convince them
and persuade them to take a particular course of action?
Seth Carpenter: Great question. And you're
right, I sort of spent a bunch of time there at the Fed. I
started when Greenspan was chair. I worked under the Bernanke
Fed. And of course, for the end of that, Janet Yellen was the
vice chair. So, I've worked with her. Jay Powell was on the
committee the whole time. So, the cast of characters quite
familiar and the process is important.
So, I would say a few things. The chair convenes the meetings;
the chair creates the agenda for the meeting. The chair directs
the staff on what the policy documents are that the committee is
going to get. So, there's a huge amount of influence, let's say,
there. But in order to actually get a specific outcome, there
really is a vote. And we only have to look back a couple weeks to
the last FOMC meeting when there were two dissents against the
policy decision.
So, dissents are not super common. They don't happen at
every single meeting, but they're not unheard of by any stretch
of the imagination either. And if we go back over the past few
years, lots going on with inflation and how the economy was going
was uncertain. Chair Powell took some dissents. If we go back to
the financial crisis Chair Bernanke took a bunch of dissents. If
we go back even further through time, Paul Volcker, when he was
there trying to staunch the flow of the high inflation of the
1970s, faced a lot of resistance within his committee. And
reportedly threatened to quit if he couldn't get his way. And had
to be very aggressive in trying to bring the committee along. So,
the chair has to find a way to bring the committee along with the
plan that the chair wants to execute. Lots of tools at their
disposal, but not endless power or influence. Does that make
sense?
Andrew Sheets: That makes complete
sense. So, maybe my final question, Seth, is this is a
tough job. This is a tough job in…
Seth Carpenter: You mean your job and my
job, or…
Andrew Sheets: [Laughs] Not at all. The
chair of the Fed. And it seems especially tricky now. You
know, inflation is above the Fed's target. Interest rates are
still elevated. You know, certainly mortgage rates are still
higher than a lot of Americans are used to over the last several
years. And asset prices are high. You know, the valuation of the
equity market is high. The level of credit spreads is
tight.
So, you could say, well, financial conditions are already quite
easy, which can create some complications. I am sure Kevin Warsh
is receiving lots of advice from lots of different angles. But,
you know, if you think about what you've seen from the Fed over
the years, what would be your advice to a new Fed chair – and to
navigate some of these challenges?
Seth Carpenter: I think first and foremost, you
are absolutely right. This is a tough job in the best of times,
and we are in some of the most difficult and difficult to
understand macroeconomic times right now. So, you noted
interest rates being high, mortgage rates being high. There's
very much an eye of the beholder phenomenon going on here. Now
you're younger than I am. The first mortgage I had. It was eight
and a half percent.
Andrew Sheets: Hmm.
Seth Carpenter: I bought a house in 2000 or
something like that. So, by those standards, mortgage rates are
actually quite low. So, it really comes down to a little bit of
what you're used to. And I think that fact translates into lots
of other places. So, inflation is now much higher than the
committee's target. Call it 3 percent inflation instead core
inflation on PCE, rather than 2 percent inflation target.
Now, on the one hand that's clearly missing their target and the
Fed has been missing their target for years. And we know that
tariffs are pushing up inflation, at least for consumer goods.
And Chair Powell and this committee have said they get that. They
think that inflation will be temporary, and so they're going to
look through that inflation. So again, there's a lot of judgment
going on here.
The labor market is quite weak.
Andrew Sheets: Hmm.
Seth Carpenter: We don't have the latest
months worth of job market data because of the government
shutdown; that'll be delayed by a few days. But we know that at
the end of last year, non-farm payrolls were running well below
50,000. Under most circumstances, you would say that is a clear
indication of a super weak economy.
But! But if we look at aggregate spending data, GDP,
private-domestic final purchases, consumer spending, CapEx
spending. It's actually pretty solid right now. And so again,
that sense of judgment; what's the signal you're going to look
for?
That's very, very difficult right now, and that's part of what
the chair is going to have to do to try to bring the committee
together, in order to come to a decision.
So, one intellectually coherent argument is – the main way you
could get strong aggregate demand, strong spending numbers,
strong GDP numbers, but with pretty tepid labor force growth is
if productivity is running higher and if productivity is going
higher because of AI, for example, over time you could easily
expect that to be disinflationary. And if it's disinflationary,
then you can cut it. Interest rates now. Not worry as much as you
would normally about high inflation. And so, the result could be
a lower path for policy rates. So that's one version of the
argument that I suspect you're going to hear.
On the other hand, inflation is high and it's been high for
years. So what does that mean? Well. History suggests that if
inflation stays too high for too long, inflation psychology
starts to change the way businesses start to set.
Andrew Sheets: Mm-hmm.
Seth Carpenter: Their own prices can get a
little bit loosey-goosey. They might not have to worry as much
about consumers being as picky because everybody's got used to
these price changes. Consumers might be become less picky
because, well, they're kind of sick of shopping
around. They might be more willing to
accept those higher prices, and that's how things
snowball. So, I do think that the new chair is going to face
a particularly difficult situation in leading a committee in
particularly challenging times.
But I've gone on for a long, long time there. And one of the
things that I love about getting to talk to you, Andrew, is the
fact that you also talked to lots of investors all around the
world. You're based in London. And so when the topic of the new
Fed chair comes up, what are the questions that you're getting
from clients?
Andrew Sheets: So, I think that there are a
few questions that stand out. I mean, I think a dominant
question among investors was around the stability of the U.S.
dollar.
And so, you could say a good development on the back of Kevin
Warsh's nomination is that the market response to that has been
the price action you would associate with more stability. You've
seen the dollar rise; you've seen precious metals prices fall.
You've seen equity markets and credit spreads be very stable. So,
I think so far everything in the market reaction is to your; to
the point that you raised, you know, consistent with this still
being orthodox policy. Every Fed chair is different, but still
more similar than different now.
I think where it gets more divergent in client opinions is just –
what are we going to see from the Fed? Are we going to see a real
big change in policy? And I think that this is where there are
very different views of Kevin Warsh from investors. Some who say,
‘Well, he's in the past talked about fighting inflation more
aggressively, which would imply tighter policy.’ And he's also
talked more recently about the productivity gains from AI and how
that might support lower interest rates.
So, I think that there's going to be a lot of interest when he
starts to speak publicly, when we see testimony in front of the
Senate. I think the other, the final piece, which I think
again, people do not have as fully formed an opinion on yet is –
how does he lead the Fed if the data is unexpected? And you know,
you mentioned inflation and, you know, Morgan Stanley has this
forecast that: Well, owner's equivalent rent, a really key part
of inflation, might be a little bit higher than expected, which
might be a distortion coming off of the government shutdown and
impacts on data. But there's some real uncertainty about the
inflation path over the near term.
And so, in short, I think investors are going to give
the benefit of the doubt. For now, I think they're going to lean
more into this idea that it will be generally consistent with the
Fed easing policy over time, for now. Generally consistent with a
steeper curve for now. But I think there's a lot we're going to
find out over the next couple of weeks and months.
Seth Carpenter: Yeah. No, I agree with
you. Andrew, I have to say, I'm glad you're here in New
York. It's always great to sit down and talk to you. Let's do it
again before too long.
Andrew Sheets: Absolutely, Seth. Thanks for
taking the time to talk. And to our audience, thank you as always
for your time. If you find Thoughts the Market useful, let us
know by leaving a review wherever you listen. And also tell a
friend or colleague about us today.
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