The Fed’s next move

0:00Hey, everybody. Welcome back to the Barclays Brief. It's great to be in the studio with Marc Giannoni. Marc's our chief U.S. economist in research. And Marc, it's your first time on the pod. Welcome. Thank you, Ronnie. Pleasure to be here. It's good timing, because if there was ever a reminder that the path for U.S. interest rates is never set in stone, this year is certainly that reminder for me. Can you take us through what the market was pricing coming into 2026 and how things have evolved since? I mean, that's very interesting. The market was expecting more than two 25 basis point rate cuts for 2026 at the beginning of this year.

0:34This was widespread expectations that inflation would moderate this year. By February, actually, there was even a narrative that took hold that labor market could deteriorate as a result of, let's say, AI replacing large numbers of workers. And so that reinforced that narrative of like rate cuts later this year. But there's not a dramatically change in early March with the war in Iran, of course. Since then, the market is expecting the Fed to remain on hold for a while. And the market is even pressing now a rate hike in early 2027. It's so interesting. Just a reminder that you've always got to be on your toes as a market participant.

1:09So we've gone from a clear expectation for a cutting cycle to something at least more ambiguous. What do you think the key drivers of interest rate policy are from here, particularly when you assess the overall state of the U.S. economy? Yeah. So on the activity front, that's going to be a key part. We'll look at the labor market as well. We'll look at the inflation. So on the activity front, GDP growth was 2 % last year. We expect it to remain at around 2 % this year. So not much change on this front. Maybe the underlying drivers are changing somewhat. But in both years, we expect a substantial boost coming from AI-related investment.

1:45That is, investment in data centers, buildup in computers and peripheral equipment, in software investment, and so on. So that contributed about 80 basis points to the 2 % growth last year, and we expect even more so this year. Separately, households have seen their real income slow over the past year quite substantially. And we think that consumer spending is therefore going to decelerate later this year. So that's something that's a fairly new development. A big reason for that is related to the labor market. So the labor market has had a very interesting evolution over the last few years. We saw, of course, lots of job gains in 22, 23, 24.

2:25But since then, really, the labor market has cooled down quite a bit, or at least the pace of job gains has moderated very substantially. What that means is that we are no longer creating as much income for households anymore in the aggregate. And therefore, consumer spending is likely to slow some. Now, even though we saw the pace of job gains diminish like that, we don't expect the unemployment rate to necessarily move up. And a big reason for that is the pace of job gains has slowed in large part because of the supply of workers having diminished. Immigration has substantially diminished in recent years.

3:00And with the aging of the population, we have a lot of people moving into retirement at this point. So we are no longer creating as many jobs as was the case before. What about the oil dynamic? That's obviously front and center. Everybody has a view on the price at the pump. How much does that play into this dynamic around real income? Yeah, that's really important. Over the last couple of months, we saw, of course, with crude oil prices moving up very sharply, we saw also gasoline prices moving up a lot. So that means that the real income of households, once you adjust for these price increases, has come down quite a bit.

3:34And I think that contributes to this decline in real income of households and therefore to the softening in consumer spending that we expect to see going forward. Now, I would say that comes on top of the dynamic I was describing before, right, where the labor market is no longer creating as many jobs and generating as much income. So both of these factors are key. Now, where oil is particularly important is on the inflation side of things. So we saw, as I alluded to, headline inflation move up very sharply in March and April. we expect it to remain elevated for much of this year with headline inflation potentially north of 4 % for much of the year.

4:13The key now is to know whether how long that war is going to last, how long our energy price is going to remain elevated and how high they could go because that's going to dictate how much pass-through we'll have to pour PC inflation. And that's where the Fed is going to be more focused on is making sure that the oil price shock that we have is not really passing through much of the core prices. I feel like the Fed always has a hard job, but it feels like they have an especially hard job right now. Welcome to the new role, Kevin. It's a good segue into a recent piece you wrote entitled, What Would It Take for the Fed to Hike?

4:47Before we talk about what it would actually take for the Fed to hike and what that path of rate hikes could look like, can you tell us a little bit about the client reaction to it? I always find information in that. Yeah, absolutely. Look, with the market pricing that we talked about before, that now expect like rate hikes. I mean, clients were particularly interested in talking about like the various conditions that could trigger that. And interestingly, I spent nearly a week in Europe and in the UK in particular talking to clients there who, you know, are particularly focused on the expectations of rate hikes here, especially - Because they feel like they really need it locally or because they feel like it will hurt their economy disproportionately given the global impulse?

5:28I think it's more that they see that the narrative around what the Bank of England is doing, what the ECB is doing is more focused on the possibility of rate hikes. And therefore, you know, when they think about the US, they look at it also through that lens. Interesting. So we're going from what was a clear cutting cycle to something that could actually become a hiking cycle. What are some of the things that you'll be most focused on in determining the signal from the noise in whether or not we end up in that hiking cycle? We would expect inflation to gradually moderate from here, right? We had elevated inflation even prior to the war starting, especially elevated in the few months before the war started due to substantial amount of pass-through from tariffs that were imposed last year.

6:12But we think that these tariffs have really come to an end and fully passed through these consumer prices. Now, the question is to what extent is inflation really moderating or is the energy prices that we have at this point that is pushing up energy prices, passing through really core goods prices? So we'll be looking at that particularly carefully going forward. And for our listeners, what are some of the key things that are readily available in the market that they should focus on to try to get ahead of whether or not the move from here is hike or cut? So I think really the picture here is predominantly affected by what's happening on the inflation side.

6:51If inflation remains really elevated, persistently so, I think the Fed will be ultimately forced to adjust its policy sense to that, especially if this triggers like an upward drift in longer run inflation expectation. So I think listeners have to pay close attention to inflation expectation measures and inflation prints as they come in. We would still expect some moderation there to take place over time so that the Fed is ultimately not necessarily forced to raise rates. I would say on the activity side, I would be looking at consumer spending. So do you actually expect the mighty U.S. consumer to start cracking?

7:27That's a tough question because we've seen over and over again. Don't bet against them. Exactly. The consumer has surprised us to the upside more than once. And that could happen once again, right? with equity prices continuing to move up, actually, despite all the news in the economy and household net worth actually increasing as a result, it's really tough to bet against the consumer. But there's one change that has happened over the past year that I think is going to affect the consumer more this year than in the past. And that is the slowing in real income growth that I was alluding to before.

7:58As a result, I do think that consumers are more likely to start paring back some of their consumption spending going forward. and we are more likely to see a slower consumer growth around like 1 % in the second half of this year than has been the case before. All right, Mark, a lot to focus on in your world. Thank you for making the time to be with us for your first time on the pod. I promise it won't be your last one and we'll see you soon. Thanks very much, Ronnie. It's been great having Mark here today. Here are some of the takeaways from our conversation from me. The path forward for interest rates in the US has shifted a lot over the past few months and whether the next move by the Fed is a cut, pause, or hike depends on several key variables, including the resilience of the U.S.

8:39consumer from a year and the path forward for inflation, which makes this a very interesting time for Kevin Warsh to begin his new role as Fed Chair. Thank you for tuning in. Please remember to hit the subscribe button wherever you listen to your podcasts, and we'd love for you to tune in again next time.