LIVESTREAM: A Former Fed Economist Reveals What's Really Happening, with Karsten Jeske (“Big ERN”)

26:18And why is housing inflation so expensive? It's so high because interest rates are so high. So we are almost causing the pain that people feel in terms of housing inflation, because that is the one rate of inflation where high interest rates are actually pushing the cost. Whereas everywhere else, you know, you increase interest rates, it cools down the economy, it creates disinflation, maybe not deflation, but disinflation. But in the housing sector, right, which is extremely high capital intensity and is usually financed through, well, guess what, mortgages. You create a cost factor. And so you're almost creating the inflation that you're trying to fight.

26:57And by the way, we've had the same effect just in the other direction. People in the early 2000s, which is when I was at the Fed, and people were scratching their head. Well, why is inflation so low? And we're worried about disinflation and deflation. and we're keeping the interest rate really low to help create some inflation. And we couldn't really get rid of the disinflation. And the picture was exactly the other way around, right? There, now we had the rally in the housing market, right? And if you were a big multifamily lender, you had to give basically, as I was living in Atlanta at that time, and I think they were giving something like two or three months free rent if you signed a 12-month lease.

27:37And well, guess what? But low interest rates caused a housing rally. Everybody with a pulse could get a mortgage and buy a house. And then what happens to the multifamily renters and landlords? So there was basically cooled down inflation for housing. And so then the Fed was scratching its head. Well, why is inflation so low if our interest rates are so low? And well, that was the explanation. And the same was also true for, so for example, used cars were also very, had very low inflation. Well, why was the used car inflation so low? Because everybody with 0 % interest could just go and get a new car.

28:14Why would you want to buy a used car? And then also use your home equity line of credit to get that car at a really low rate. And so in some way, there are areas of the economy where interest rates are working in the opposite way inflation-wise, where actually high inflation rates could be due to high interest rates. Yeah, and I think there are some governors and some bank presidents that understand that, and some others that are still holding on to these Phillips curve theories. And so that creates some friction. So we'll see if maybe there could be some dissents now in the other direction, where some of the hawkish governors are going to dissent against that rate cut on Wednesday.

28:56So we'll see.

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31:46The CPI data just came out and inflation has ticked up a little bit. As you mentioned, part of that might be because of high interest rates, you know, high interest rates. And that's actually an important point that I think people don't raise enough, that high interest rates do drive housing inflation. But what we've seen with the CPI data that just came out, which they've just reversed, did that contribute to the situation that we're in right now? Is that why we're here? Well, something caused the Fed to be behind the curve when we had this inflation shock. Right. So if you look at any other basically simple models for what the Fed would have done in similar situations in past events, 2021 would have been the time that you would have raised interest rates and you wouldn't have waited all the way until 2022.

32:39And I don't want to malign this flexible business there too much, but I think the bigger culprit was that people were throwing around the terms transitory versus persistent. And I think there's great confusion about what transitory versus persistent means. And because it depends on whether you look at price levels versus price increases. So in some way, every inflation shock is transitory in the sense that, well, eventually we are not going to have 10 % year-over-year inflation, right? And we're now going back down to 2%. So in terms of the rates of change, we had, say, almost 10 % or just around 10%, and now we are at maybe 3 % or just below 3%.

33:32So in that sense, it is transitory in the sense that the rates of increase are back down to the 2%. But where it is obviously very persistent is in the price level, right? Because if you look at the CPI, the level, it looks like a hockey stick, right? And then it started flattening again. And we never went down to a lower level again. And by the way, there were some goods and services where you would have gone back down to a normal level. Because there were these stories where during the height of where travel picked up again after the pandemic and everybody wanted to go to Hawaii and Alaska. And so people went to Hawaii and they were shocked that they had to pay$500 a day for a rental car.

34:16And they started renting U-Hauls to drive around as their rental car. And then the Hawaiians didn't have enough U-Hauls and stuff like that. And I remember I went to Alaska and we rented a car for a week and the regular rates at the U.S. travel agencies would have been$2 ,000. And I found one through a German agency. Wow. Which was only$1 ,200. And they wanted to see my German driver's license. So they said, without your German driver's license, because this is a special rate just for German tourists, we wouldn't have given you this car. We would have priced it twice. Wow. And I was smart enough to bring my German driver's license.

34:50So there the price went up. And then after the shock was over, I'm pretty sure I haven't checked any rates for Alaska and Hawaii recently. So definitely the level, even the level is back down again. So there you had definitely only a very transitory inflation, even in the levels. But I mean, you have to admit, in levels, in price levels, the pandemic inflation shock was 100 % permanent. We went up to about 10 % higher than it would have been otherwise. And we're still up there. And now we are basically going back to a 2 % inflation, right? So I think however you want to measure it and if you want to, and then basically they do some kind of a trimmed mean, right, where they look at the median inflation of all the different categories and they cut out the really high and the really low.

35:37So there are all sorts of ways of massaging the data. And yeah, you could argue maybe that contributed a little bit to that confusion. But I think the main confusion that haunted the Fed at that time is this transitory versus permanent. And basically, no journalist asked them, so what are you talking about? Are you talking about the level or the changes? That confusion was probably the main culprit. And probably some Fed economist came up with this concept. And I hope he didn't get fired or something over this. It's not your fault. So again, transitory versus persistent or permanent is the bigger culprit there.

36:19Okay. All right. So with all of that said, we have the latest CPI data. Inflation is still running a little too hot. So inflation is running a little too hot, and yet we're going to start lowering interest rates. What does that mean? Right. Right. So, I mean, as I said before, right, if you park a car or say a big container ship comes in, right, they lower the speed already as soon as they can see the pier or the parking lot. So I think it is justifiable in that sense that we have come down from basically almost double digit year over year inflation to so close to the target. So the question is, why isn't the interest rate already closer to its long term target?

37:02So if you think about we were at the height, we have already lowered by 100 basis points to go to maybe a neutral 3 % rate. We would have to lower definitely another amount like that and probably a little bit more. So we have only about halfway or less than halfway done the way from the peak to the long term. Whereas inflation has already gone from peak inflation, we're basically 80 or 90 % there. So why isn't the interest already 80 or 90 %? So that could be one response. And then the other response is that obviously the economy is looking a little bit shaky, right? So if you look at GDP growth, it's been, and then again, we don't want to look at just that one first quarter number.

37:52And then, by the way, we also don't want to look at only the second quarter number, because the 3.something percent bounce, part of it was bringing some of the negative growth that was basically then realized in the second quarter. But yeah, I mean, the economy is definitely expanding a little bit slower. And the labor market is, again, we've gotten that baseline revision and a relatively weak number in August. And the Fed has a dual mandate, right? It has to monitor inflation and real activity. So by all means, I think there is definitely a case to be made that we want to lower interest rates.

38:28And then, I mean, you look at some other central banks, they're already way further down on their path, right? I think the Europeans have already lowered by 200 basis points. We have lowered by only 100 basis points. They may face different inflation dynamics and different growth dynamics. It's quite rare that the Fed is so far behind the business cycle and the inflation cycle and GDP cycle. So I have been making the case that the Fed should have lowered interest. And then again, I'm not doing this for political reasons, because depending on who is in the White House, you can always almost clockwork.

39:01This senator will say we have to lower rates now. And then as another person is in power, then that same senator will say, no, we can't lower interest rates now because we're worried about central bank credibility. So I say that no matter who is in office, that the Fed is definitely behind the curve. And it goes back to some of the other points I made earlier about basically housing inflation being the main culprit. And then also the economy looking a little bit shaky. So employment definitely. And then we'll have to see what happens with the shock from tariffs. What do you make of the major jobs revisions?

39:35Employment is not as strong as we thought it was based on the initial reports that came out. We actually saw a month of negative job growth. That was June, I believe, which we only just realized as a result of the revisions. Yet, we also square that with the fact that unemployment, the unemployment rate is 4.3%. So it's still pretty close to a near historic low. And it's been there for a long time. And many people are describing the labor market as stagnant. Not a lot of people are getting fired or laid off from their jobs, but not a lot of people are getting jobs either. What do you make of the labor market overall and the big revisions that we have recently been seeing?

40:21Yeah, so just like the stock market, the labor market, because it has a growing trend, because the population is growing, it's not so much that the employment level is the problem, it's mostly the rate of change. And it could make a difference if, say, instead of growing at 100 ,000 to 150 ,000 jobs a month, it's growing at only, well, say, below 50 ,000 a month. So that definitely feels like a very stagnant labor market. There is a distinction between the unemployment rate and the payroll employment numbers because they come from two separate surveys. And you can have a very low unemployment rate because there might be people who fell out of the labor force because they haven't been looking for a certain time.

41:01So we can have very low headline number unemployment rates, but part of that is also due to low labor force participation. And then the big revision, so it goes back to this old issue. And then again, I was never involved as an economist in this particular area, in the data collection part. I was also just an end user for macroeconomic data. and interpreting the end user data is much more fun and much more exciting. And you can go on podcasts and tell your opinion on that. Or when I was working, that was much more exciting. Whereas the nitty gritty detail of putting the data together is an art or a craft, and then obviously also science.

41:44And the problem is that the payroll employment numbers come from the so-called establishment survey. That's where the Bureau of Labor Statistics keeps a sample of, I think it's probably somewhere around 100 ,000 establishments where they send a survey every month and say, how many jobs do you have? How many have you created? How many have you eliminated? You capture two factors really well with that survey process. You capture job losses and gains at existing firms. And then you also capture firms that go out of business. So imagine during a recession probably is a certain percentage or maybe not a percent.

42:20It might be less than a percent of establishments go out of business. and then they completely shut down. And then they basically go from 800 jobs to zero jobs. The one thing that you don't capture very well is new establishments, right? So if new establishments are formed, they will eventually enter the sample, right? And then the BLS is, oh, I mean, you are a new establishment. We didn't even know about you. Oh, and you were formed during a time when we didn't even know you were there. So can you give us the data of, well, how many jobs did you create over all those months that you were in existence?

42:55Oh, wonderful. So now we are going to add some more jobs. And then, of course, if the BLS never accounted for that, basically what that would mean is that the real-time estimate of jobs created would always be too low because you never capture new entrants. Right. And you would consistently underestimate the job gains. So now what the smart people and the economists and statisticians and mathematicians and maybe accountants and lawyers at the BLS said was, well, you know, we should account for that and we should already budget a little bit of job creation through new establishments. And this effect obviously is most pronounced during economic expansions.

43:38During a recession and bear market, you worry mostly about the job cuts and the job exits, the establishment exits, not so much the entrance. But during economic expansions, So the BLS has to make an adjustment. And then the question is, how much of an adjustment do we have to make? Well, we look at how big would have been the adjustment in the past when we didn't make it and we would consistently underestimate job growth. So let's add that to the numbers and then cross our fingers that over time, all these new entrants will come in. And it's possible that in this business cycle, we didn't have enough and we had less new entrants.

44:16And it looks a little bit like, you know, the BLS has some egg on their face over this. Well, so you are telling me that you are just making up and adding stuff to it. So maybe you added 2 million jobs, but in the end, it was only 1 million jobs through new entrants. And now we are missing these 1 million jobs or 933 ,000 or whatever was the number of that one year period. And it looks embarrassing. But yeah, I mean, there's obviously some reason to this madness, because in the past, we would have missed some of these new entrants. And if there are fewer entrants than we had estimated, then this is how you get these big revisions, unfortunately.

44:55Wow. Does that mean, should there be a methodological change as to how those new entrants are estimated? I mean, are there kind of fundamental weaknesses in some of the assumptions underlying that data? or was this just a kind of unfortunate run of the last few months? Well, I mean, the methodological changes should be, well, how can we find a way to capture these new entrants faster, right? Can we find, and again, I'm not involved in this. I've never been involved in this. In fact, I would be misplaced in that job, right? So my background and training in macroeconomics and finance would not be the best background to work in this capacity.

45:35So probably mostly maybe accountants and maybe different fields of economists would be in that field. But you would want to have some faster way of contacting establishments and get a print out of all the EIN numbers, out of all the EIN applications of new potential entrants into the job market and tie it to that. But I would say that the statistics behind this is probably okay. This is not like they're going to put their finger in the wind and say, okay, well, we're just going to add 100 ,000 jobs this month and think that these are the entrants. I think there are some additional mechanisms where they look at other stuff like maybe industrial production or some other data that would help them gauge, well, how many job entrants were there.

46:19So it's not just the historical average. It's not just a guess. I'm 100 % sure that this entrance data is also estimated in some way, but it's subject to some estimation error and forecast error. Or maybe somebody has to go in there and find faster ways of capturing new firms coming into the economy and grabbing them as potential serving members.

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49:39All right, so we've discussed the CPI data, the series of rate cuts that we are likely about to see, dissent in the Fed, the culture of dissent in the Fed, the labor market and the jobs report and the major downward revisions that we've seen. And we've talked about how this will affect the average person in terms of buying or selling or refinancing a home. The last thing that I want to ask about, and this is a little bit in the weeds, but you mentioned the dot plot. There are two elements, The dot plot and R-star. I think these are things that the average person has not yet heard of. Can you lay that out for the people who are listening?

50:22Yeah. So this goes back to this transparency project at the Fed. Everybody who comes to the table at the FOMC meeting, so these would be seven governors, and then there will be 12 bank presidents. So we have 12 Federal Reserve Banks in the U.S. with the 12 districts, and New York, Boston, all the way. Atlanta was in the 6th district. The biggest district by area, San Francisco, is the 12th district. They all sent their Federal Reserve Bank presidents to that meeting, and everybody gets to talk about their regional situation. But also, everybody is going to put in their estimates for important macroeconomic and financial variables.

51:05So CPI, not CPI, it's actually the PCE, which is the Personal Consumer Expenditure Price Index, GDP, and then also the Fed funds rate. And then also, I mean, not just the path of the Fed funds rate over the next few years, but then also what is the final long-term resting spot? Where should we be? By the way, why do they call that R star? Why don't they call that the Fed funds rate in 2029 or something? So the R star basically means that this is the long-term Fed funds rate if there are no other economic shocks, right? If GDP is exactly a trend and the inflation rate is exactly at the target rate, where we would be in this paradisical state where we have zero fluctuations and the Fed could be completely neutral.

51:54So that's the R star. And there's a range of different estimates of what that R star is. But right now it's about 3%. And then how to get to that R star is, so we would also see the estimate of the different voting members, so 19 of them. And again, only 12 of them are voting members because the Fed bank presidents, they are only rotating, except for the New York Fed president, he always votes. And we see the range of estimates for these different variables. And people will very keenly look at what is the, for example, end of the year dot plot for the Fed funds rate, right? because that signals to you where the Fed sees the interest rate at the end of the year.

52:36And it's a pretty good estimate for the Fed funds, right? I wouldn't quite say that the year out, the end of 2026, what the Fed predicts is the end of 2026 may not be the best forecast. I would probably still go with the Fed funds futures because there are actually some people that put some money behind it. And sometimes with the Fed, people make these forecasts and it's not thought to be as a forecast. It's more of where they hope it will be and not where they think it will be. But if we are in September already, I think when we see the dot plot for December, that will definitely signal where people will vote at least for the next three FOMC meetings.

53:20It's a hugely scrutinized output from the Fed. is a hugely scrutinized data release from the Fed. That will definitely cause some anxiety. I think there will be lots of people sitting at their screen at the release date and time, and they will click the refresh button, and they will look for, and then they want to be the first ones to download that PDF or look at that, I think it's HTML and PDF version. That will have some impact on the bond market and on the stock market too, obviously. And that reminds me of the thing I haven't asked about, the bond market. We're seeing treasury yields drop, prices rise, yields drop.

54:00As individual investors who have some bond allocations in our portfolio, how should we be thinking about our bond allocations? It depends on where you are in your life. So I always recommended young investors who are still years away from retirement, you probably, you could be 100 % stocks. There are are some people who say, yeah, well, you should be 90-10, 10 % bonds, 90 % stocks, because that's what, for example, target date funds would recommend if you're still really young and you have a lot of runway. I always view your labor income almost like a bond allocation, right? So the flows that come into your 401k plan every year, they almost feel like a bond allocation.

54:43Now, if you work in a highly risky part of the economy, right, where you're a business owner, you're a home developer or something like that, I wouldn't quite call that a bond allocation. But imagine you are a government worker, you can almost guarantee that you're going to have these flows into your 401k plan or thrift plan, which is what it's called for some, you could almost view this as a bond allocation. And the discounted value of all of these future payments is almost like a bond allocation you already have. If you're starting out, you might have several hundred thousand dollars in an implicit bond allocation and zero in a stock allocation.

55:20So you should invest very aggressively in stocks. You don't need that much in bonds. When you get closer to retirement, you should have some bond allocation. I definitely recommend right now, I mean, with bond yields still pretty decent in the 4%, the 30 years actually is still slightly above 4 % or significantly above 4%. you could definitely have some bonds in your portfolio because you, well, you face sequence of return risk, you're afraid that we have a recession right at the beginning of your retirement. And it's definitely right now, it looks as though the next recession is again going to be like one of those recessions we've had 20 years ago and 17 years ago, where you had stock market drops, but the Fed also lowers interest rates.

56:05And that's good for bonds. So bonds are going to be an excellent diversifier. So if you're worried about too much equity risk, because you're in retirement or close to retirement, you should consider some bond allocation. And it will vary depending on your specific situation. But it's definitely for very young investors, I have been very aggressive. And I actually, I was aggressive when maybe I shouldn't have been because I was working in finance. But finance is definitely my paycheck was a little bit correlated with the business cycle too. So my paycheck was a little bit like a stock too. It wasn't a pure bond.

56:41And even I was still very aggressive while accumulating. So again, yeah, I mean, your stock bond allocation absolutely has to change over the life cycle, start very aggressive towards your retirement, you go more into bonds. And then funny thing is in retirement, there are some people, myself included, you can actually go a little bit higher in your bond allocation right around your retirement date, right? Just to hedge this risk that you are retiring right at the peak of the stock market. But then you can shift out of bonds a little bit. Think of that almost like a, you could have something like a CD ladder or a tips ladder, and you phase that out.

57:19And then you go into a little bit more equity heavy later in retirement. And that actually hedges your sequence of return risk just a little bit. So I think bonds are now quite attractive. I mean, there's some people who say that the expected return in bonds is the relative to expected returns in stocks is quite attractive. So some people will say with the extra risk in equities, if you want to become something like a tactical asset allocator, I wouldn't blame you if you're a little bit heavier in bonds. I mean, it could pay off quite nicely if bond yields keep going down and say the Fed funds rate goes down to 3 % and it stays there long-term, that's definitely going to drag down some of your longer-term bond yields.

58:01And then you have this duration effect, you get your interest, there's a little bit of a roll yield if you have a constant maturity of longer-term bonds, right? Because you would constantly sell the shorter duration, constantly buy the longer duration. And normally what you sell has a little bit lower interest rate. So during the time you hold these bonds, there's a little bit of a walk down in the yield. So there's a little bit of a roll yet. And that could make up something like 0.3 % a year, depending on what kind of bond fund you're looking at. So a bond expected returns actually look pretty decent right now.

58:36And as we're recording this, S &P is at or close to the all-time high. And we have earnings ratios that are insane, almost as crazy as during the dot-com bubble. So I can see that there's a bond. Definitely, you should definitely put bonds on your radar screen if you're anywhere close to retirement or in retirement. Well, thank you for joining us. Where can people find you if they would like to learn more? Yeah, I have a blog called earlyretirementnow.com and I'm available there. You can leave a comment there. You can read my blog post. I'm also available on Twitter and the Twitter handle is on my blog.

59:15You can go to the contact info there. Thank you, Karsten, for those insights. Some of you I know saw this on Instagram as a live stream where you saw snippets of it. And now we're sharing the full audio with our podcast audience. So whether you caught it live or you're hearing it here for the first time, here are the three biggest takeaways. Key takeaway number one, the Fed's consensus culture is breaking down. This was an interesting insider story that I had never heard. So the Fed has spent decades building a culture where everyone gets on the same page before announcing decisions. Karsten shared a wild story about how consensus used to work behind the scenes.

1:00:02So the rumor is that there was one meeting where they had a meeting over the phone because it was between Fed meetings. Greenspan was the Fed chairman and they didn't have consensus. And then Greenspan basically said, OK, we're going to hang up for now because we have some technical difficulties and we're going to pick up the phone again in 30 minutes. And after 30 minutes, they reconvened the meeting and suddenly everybody was on board. Wow. And you know what happened in the 30 minutes in between, right? So he probably chewed out some people that didn't want to vote the way. That is crazy. But now the Fed's consensus culture is starting to crack and the return of dissenting votes might signal much bigger changes in how monetary policy gets made.

1:00:46So that is key takeaway number one, as well as just a really interesting story. Key takeaway number two. High interest rates are actually causing some of the inflation we're fighting. This flips conventional thinking on its head because most people assume that higher interest rates will cool down all prices. After all, when interest rates are higher, it's more expensive for employers to borrow money to grow their businesses. It's more expensive for builders to borrow money to build homes. It's more expensive to borrow money for growth and expansion. And so the idea is higher interest rates cool the economy, therefore keeping inflation in check.

1:01:28But Karsten points out that higher interest rates also drive up housing costs, which creates a bizarre situation in which the Fed's medicine, the very thing that they're doing to drive down inflation, actually increases inflation in one specific and very important spending category, which is housing. Why is housing inflation so expensive? It's so high because interest rates are so high. So we are almost causing the pain that people feel in terms of housing inflation, because that is the one rate of inflation where high interest rates are actually pushing the cost. Whereas everywhere else, you know, you increase interest rates, it cools down the economy, it creates disinflation, maybe not deflation, but disinflation.

1:02:18But in the housing sector, right, which is extremely high capital intensity and is usually financed through, well, guess what, mortgages, you create a cost factor. And so you're almost creating the inflation that you're trying to fight. And, you know, as I think about this, this works in multiple ways. So not only is it more expensive for retail homebuyers, for us, to be able to buy houses, but given that it's more expensive for builders to build, that has the effect of curtailing housing supply. And we know that the fact that housing is so unaffordable is a direct result of the supply shortage.

1:02:53So on both sides, both in terms of what it costs us as homeowners to purchase a home, as well as the amount of available supply, the amount of new construction, on both ends of that, higher interest rates drive up home prices and actually create some of the very inflation that we're trying to fight. That is key takeaway number two. Finally, key takeaway number three. The jobs numbers that you're hearing are built on educated guesses. The government just revised job creation numbers down by nearly a million jobs. And that is one of the biggest revisions in recent history. Biggest revision since 2009.

1:03:35And in 2009, we were dealing with the Great Recession when the labor market during the 2008-2009 Great Recession was changing very rapidly. there was a massive amount of economic turbulence that led to big revisions in the job numbers in 2009. And we're seeing similar sized revisions now. So while I want to be clear, job numbers get revised up and down all the time, that's very normal. But these massive recent revisions are unusually large. And so the question is, why? And Karsten helps shed some light on that. He talks about the inherent challenge of tracking new businesses in real time. The one thing that you don't capture very well is new establishments.

1:04:25So if new establishments are formed, they will eventually enter the sample. And then the BLS says, oh, I mean, you are a new establishment we didn't even know about. Oh, and you were formed during a time when we didn't even know you were there. So can you give us the data of, well, how many jobs did you create over all those months that you were in existence? Oh, wonderful. So now we are going to add some more jobs. If there are big changes being made to newly established businesses, that could help explain at least a portion of why we're seeing such major revisions. There's a much longer discussion that we could have around labor stat methodology, and that's a different discussion for a different day.

1:05:07But right now, the big takeaway is that the jobs numbers that we're hearing are educated guesses built on imperfect data. That's our show for today. Thank you so much for tuning in. If you enjoyed this, if you got value out of it, if you learned something from it, if you were as surprised by that story he told about the inner machinations of the Fed, if you were as surprised by that as I was, please share this with someone. Share it with a friend, with a colleague, with your accountant, your banker, your financial planner. Share it with your mortgage lender, or with your favorite Fed watcher. Share this with all the people in your life, because that's how you spread the message of F-I-I-R-E.

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