Goldman's Jan Hatzius Believes the Hard Part Is Over

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1:15Hello, and welcome to another episode of the Odd Lots podcast. I'm Jill Weisenthal. And I'm Tracy Alloway. Tracy, I would say the last few weeks, in a very real way, I would say optimism over the soft landing scenario or at least the end of the rate hikes has become like deeply conventional wisdom, I think. I would agree with that, although I think it sort of started in the summer. We saw some inklings of it then. But you're right. It really seems to have crystallized in recent weeks. And, of course, the irony is that going into 2023, the consensus was really for recession. We had a number of people who were talking about the outlook for the economy this year and how bad it might be.

1:59And then going into 2024, it seems like we've completely flipped around. So the hills are alive with the sound of soft landings. Yeah. And I think you're right. Obviously, 2023 has broken a lot of people's brains. probably a broader theme, which is that the entire COVID cycle, people have been looking at it through the lens of a traditional business cycle or macro cycle. And it feels like a lot of that just hasn't worked, starting from probably the fast rebound in late 2020. Oh, totally. So I feel like the indicator that everyone was looking at in sort of late 2022, early 2023 was the yield curve, the inverted yield curve.

2:38And there was this discussion about, you know, this is the traditional harbinger of a recession, but maybe things are different this time for a variety of reasons. And then this year, you know, fast forward to November, sort of late October of 2023. It feels like the other indicator that everyone is starting to talk about or was starting to talk about is the SOM rule. So the idea that, you know, one measure of unemployment, the moving average has been moving up. And traditionally, this indicates an upcoming recession because unemployment increases non-linearly in every business cycle. And supposedly, this was a hard and fast rule.

3:15But as we discussed with Claudia on one of our episodes of Lots More, again, maybe things are different this time. I do think it's important that you bring that up because it does feel like the labor market situation is kind of the fly in the ointment of the soft landing scenario, which is that there's clearly some kind of softening, I guess I would say, in the labor market. It's the question, how far does that go? When will the Fed have to cut? Should the Fed be taking out some sort of insurance cut sooner rather than later to forestall a downturn? All big macro questions. We are nowhere near the end of understanding this macro cycle.

3:51And I think we got to get a better handle on it. The good news about this macro cycle is I feel like 20 years from now, 50 years from now, there will still be studies coming out about exactly what just happened. Unambiguously. I am confident on that. All right. Well, we do literally have the perfect guest to help us understand this moment in macro, what happened in 2023, what we should be looking forward to in 2024. I'm thrilled to welcome back onto the show Jan Hatsias. We've had him on a few times. Jan Hatsias, chief economist at Goldman Sachs. Jan, thank you so much for coming into the studio and coming on Odd Lots.

4:26It's great to be back with you, Joe and Tracy. Always wonderful to be here. Thank you so much. You put out a recent note, and what I really loved about it is that, you know, there's this cliche that many markets journalists, maybe even Tracy and myself at times have used, where it's like, blah, blah, blah happens. Now here comes the hard part. It's just one of those things that people love to say. It's this trope, all the easy money has been made. Now here's the hard part. Inflation has gone down here. Here's the hard part. You actually said the opposite. You said actually coming up next, there's quite a bit of disinflation in store and that this stage of further declines in inflation should be the fairly easy part, that we've passed the hard part of fighting inflation.

5:05Let's start there. What gives you confidence that actually, regardless of what happens, there's more disinflation in the pipe? You're right. The title of our annual outlook report, which we published a couple of weeks ago, is The Hard Part Is Over. And the reason why I think the hard part is over is that we have a proof of concept that we can bring down inflation and rebalance the labor market without having to crush the economy and put the economy into a recession. And I think we've seen that very clearly in 2023. We've seen it in the U.S., but we've seen it much more broadly across G10 economies and EM economies that saw a big surge in inflation in 2021.

5:53Inflation has come down. if you take an average of all of these economies that saw a large and unwanted inflation surge across DM and EM, went to 6%. Core inflation in 2022 was 6%. It's come back down to about 3 % on a sequential annualized basis without any deterioration in the labor market across these economies. Yeah, in some places, you've seen some increases in the unemployment rate. We have seen some increase in the U.S. In others, you've seen some decline, but the average actually has been basically flat. And to me, that's very, very telling. Wait, can I ask you something specifically about the U.S.

6:36economy? Because I was reading another Goldman publication, you know, this one, in addition to the outlook that Joe just mentioned, this was sort of a Q &A between you and someone internal at Goldman. And they asked you about long and variable lags in monetary policy. And you sort of suggested that you don't really think that's a thing. So my question is, how do you square the idea that the hard part is over, that there's more disinflation coming, with the idea that monetary policy, maybe the long and variable lags aspect of it is over-egged? Is it just a matter of degree? It's like the majority of disinflation has happened, and now we're going to see little bits and pieces?

7:18Well, on inflation, I think we will see additional declines in a few areas. One that's, I think, very clear is housing, rent inflation and onus equivalent rent inflation is very likely to come down further. It's still running at about 6 % on a, again, sequential annualized basis. And just looking at alternative rent indicators and where they've been running and continue to run, we would expect that to get back down to the 3 % to 4 % range by the end of next year. In the core CPI, rent and owners equivalent rent has a 40 % weight. In the core PCE index, it still has a 17 % weight. So these are pretty significant reasons for expecting further deceleration.

8:10We've also seen a lot of labor market rebalancing. Job openings have come down substantially. The quit rate has gone back to where it was in February 2020. That is still feeding through to the wage numbers. And I think that's another source of disinflation. And then there is still some disinflation to come on the core goods side. So in that sense, I think the lagged effects of what's already happened are indeed important. Where I don't agree with the sort of maybe cliche of long and variable lags is if I think about the gap between a monetary policy shock and the maximum impact on the growth rate of GDP, which for me on the growth side is really the most important question.

8:56How long does it take until I see the maximum impact on growth. We think that's only about two quarters, which means that since the Fed was most aggressive in tightening policy, starting at the June 2022 FOMC meeting, the biggest impact occurred really in late 2022, early 2023. So it's quite important to think about what question you're asking. There are long lags in terms of the impact on inflation. There are even some pretty long lags in terms of the impact of monetary policy on the level of GDP. But as a forecaster, what I care most about is the maximum impact on the growth rate. Because if I have a non-recession forecast, and we've already gotten through the biggest hit from the tightening without the economy having entered a recession, now we're still seeing some negative impulses.

9:51That's not going to worry me that much because we've already survived the biggest hit. Yeah. And since you mentioned the non-recession call, I feel that we have to mention, Joe, that the last time we had Yan on was in August, I think, of 2022 in an episode titled The Narrow Path to Avoid a Hard Landing, basically laying out a lot of the soft landing scenario that seems to be coming to fruition. So, yeah, if we've been able to see all of this realized disinflation, probably more to come, without too much damage to the labor market, you know, the story goes the Fed hikes rates, it slows demand, people lose their jobs, prices compress.

10:32We didn't get the massive job losses. How do you even think about the link between the rate hikes that we've seen and the disinflation we've seen? Are they connected? Is it the kind of thing where it's not entirely clear? What has been the Fed's role in slowing down inflation? I think they're connected in the sense that the economy grew more slowly than it otherwise would have done. If the Fed had not tightened policy, we would have seen stronger growth and higher inflation. But I think the primary reason for why this cycle looks so different, which, by the way, was the title of our outlook report a year ago, this cycle is different, is that a lot of what we've seen— I feel publishing that because I feel every time I say this time might be different, I get really nervous because like there's going to be dozens, probably hundreds of people online who are like, it's never different this time.

11:26But if you're not a little nervous, then you're probably not taking enough risk as a forecaster because you're never going to be certain. So I felt that that was our core view. And so I put it out there as the, you know, as the title of the report. But of course, there's always a risk that you're wrong about these things and end up with egg on your face. But what I was going to say is that I think the cycle is very different because, as you said in the opening part, the core dynamic of this cycle really going back to the spring of 2020 has been COVID and its aftermath and all the imbalances that emerged either directly because of the pandemic or because of policy responses.

12:12Then, of course, we've also had geopolitical shocks, the Russia-Ukraine war in particular. But for me, it's really COVID and the recovery from COVID that makes this cycle so different.

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13:48HR, and more. No more app overload. No more juggling logins. Just one seamless system that makes work easier. And the best part? Odoo replaces multiple expensive platforms for a fraction of the cost. It's built to grow with your business, whether you are just starting out or already scaling up. Plus, it's easy to use, customizable, and designed to streamline every process. So you can focus on what really matters, running your business. Thousands of businesses have made the switch. So why not you? Try Odoo for free at odoo.com. That's O-D-O-O dot com. So I mentioned the SOM rule in the intro, and I think that's been getting a lot of attention recently because it's been getting closer to triggering.

14:32I think the rule itself is something like if the three-month average of the unemployment rate, this is U3, is half a percentage point more or above its low in the prior 12 months, then the economy is in the early stages of a recession. And the current value is something like 0.33, something like that. I didn't realize that Goldman has a similar rule. Apparently, it's a 0.35 percentage point increase, again, in the three-month, I think, moving average of the U3 unemployment rate. How much attention are you paying to your own rule in the current context of a softening labor market? Is it a similar idea to what Claudia was telling us that, again, maybe it's different this time?

15:17She's got to chill. Yeah, there are different ways of characterizing the data. It's a time series that goes back to the aftermath of World War II. And it's certainly true, however exactly you want to define it, that significant increases in the unemployment rate have historically coincided with a recession in the United States. This is a historical fact. Now, again, if this cycle is very different from past cycles, maybe that historical fact is not as relevant as it would be under other circumstances. I'd also note that we're only talking about 12 or 13 business cycles here, and it's not a huge sample.

16:02And lastly, I would say if you go outside the United States, you also find that big increases in the unemployment rate have some predictive value, but the rule in quotation marks doesn't work as well as it does in the US. So when I take all of these things together, where do I come out? I would say significant changes in the unemployment rate is certainly something I would pay attention to, but I wouldn't elevate it to the status of something that tells you you now have to switch to a recession forecast if you do see a significant increase. I'd also note a few other things just about this particular episode.

16:42Other labor market indicators have continued to be pretty strong. Payroll growth over the six months in which the unemployment rate has been going up has, I think, totaled 1.2 million or something on that order. The household survey employment numbers adjusted to the definitions of the payroll survey have shown a similar increase. Initial jobless claims remain quite low, not consistent really with a major layoff cycle. And so I take all of these things together and I would say I'm still pretty comfortable that the labor market is doing fine. When would you be concerned? And I guess the reason I ask is partly because this might determine when the hiking cycle, which everyone basically thinks it turns into a cutting cycle.

17:30At what point would you be concerned such that, OK, the Fed is going to need to move and maybe take out some insurance to forestall a deeper downturn? I think it's always going to be a combination of indicators. So I don't think I would want to necessarily draw a line in the sand. But if we were to see much more pervasive signs of labor market deterioration with, you know, jumps in initial claims and declines in payroll growth to something clearly below the replacement rate. So let's say in the 50 ,000 range or, you know, moving closer to zero and you get increases in the unemployment rate, that probably would be a reason to take out insurance.

18:13And, you know, it's not limited to those indicators, obviously, but if you get a combination of those indicators, I think it would be time to cut rates on the back of that. That doesn't happen in our forecast. Our forecast has payrolls still growing above 100 ,000 a month. And we have the unemployment rate going sort of broadly sideways, if not even a little bit lower over the next year. And in that kind of environment, I wouldn't expect early cuts. I think it'll still be a while before the Fed does cut. But of course, one really important point now, and that's very different from a year ago, is that they can cut.

18:53They have the ability to respond to any weakening, foreseen or unforeseen, by taking out insurance. And that's a really important reason for me why I think the risk of recession is significantly lower than it was coming into this year. A year ago, we had a 12-month recession probability of 35%. Now we have a 12-month recession probability of 15%. And a lot of the delta is the Fed's ability to respond to weaker numbers. I definitely want to ask you about more responses to slowing growth, including potentially on the fiscal side. But on the topic of the labor market, so one of the other things we've seen recently in terms of a slight softening of the data has been job openings starting to come down.

19:45And on the one hand, people worry that this is a sign that the economy is slowing. But on the other hand, this could be interpreted as sort of good news if you look back at the beverage curve debate and the idea that the relationship between unemployment and job openings had somehow structurally shifted during the pandemic. When you're looking at openings now, A, how much stock do you put in that data, first of all, because this is another big controversy? But B, what are openings telling you right now? So I think it's very important to distinguish between good softening in the labor market and bad softening in the labor market.

20:24So the labor market was clearly out of balance, overheated. We had a jobs workers gap, job openings minus unemployed workers. That was by far the highest level on record. a difference of 6 million, a ratio of something like 2 to 1. And that clearly had to be addressed in order to be on a path to non-inflationary growth and wage growth that's consistent with something like 2 % inflation over time. So the decline in job openings that we've seen over the last year and a half or so, I think is very much a good thing because it puts us on a more sustainable footing. Where are we now? We've seen a drop in this jobs workers gap from 6 million to about sort of 2 to 3 million, depending on which measure of job openings you use.

21:20And I would put some weight on the jolts, the official Labor Department data. I'd also put some weight on the link up data, some weight on the Indeed data. And that maybe answers the question about reliability a bit. I do think these indicators are challenging and the JOLTS series suffers from quite a low response rate and has been quite noisy. But if you combine it with other indicators, I would put some weight on it. And I think it's telling us a broadly reasonable story that the labor market's still strong in terms of the amount of job openings out there, but it's less overheated and it's closer to normal, although still not back to where it was before the pandemic.

22:04You mentioned the response rate on the survey coming down, and that just reminded me of something else that sort of falls into this time might be different category. And that is that we have seen the response rates on a variety of economic surveys really come down quite dramatically in recent years. And there is this ongoing discussion of whether or not that might be clouding the economic picture. So, for instance, if you look at something like a consumer sentiment survey, you know, if these aren't the actual stats, I'm just making them up for illustrative purposes. But if 50 percent of those asked are now responding to the survey versus 80 percent 10 years ago, you could imagine that maybe the people responding to the survey are, you know, maybe they feel a little bit unrepresentative, unrepresentative.

22:52Maybe they feel a little bit more strongly about certain aspects of the direction of the economy, whatever. Is that on your radar? And are you taking that into account at all? Is it causing problems for economists at this point in time? Or are you still sort of using a lot of the soft data, the survey-based data, the same as you used to? I'd say you have to be aware of issues with economic data in a variety of areas. One thing that we actually have done over the last couple of years is probably put more weight on hard data than on soft data. And we are, I would say, pretty concerned about not just because of response rates and things like that, but just for sentiment effect about the idea that sentiment effects can sort of overstate a weakening of the economy.

23:44I think we've had a couple of instances in 2023 when the sentiment-based indicators deteriorated a lot. And then even within, for example, business surveys, something like general business confidence was significantly weaker than questions that asked about orders or production or employment, which in turn was weaker than what the hard indicators were saying. And we have, in those instances, repeatedly put more weight on the hard indicators. And I think so far that's turned out to be the right choice. I want to go back to something you said in the first answer, which is that we have gotten this proof of concept of significant disinflation and relatively mild, if not non-existent labor market weakening, especially if you look across G10 countries.

24:31There has been some, you know, obviously the unemployment rate in the U.S. has ticked higher, but globally, it's pretty remarkable. Does this tell us something about the degree to which economists understand the inflation process? Is there still more questions that ask? Or do economists understand inflation except in weird business cycles that relate to pandemics? I think it is telling us that in this cycle, there was a common global factor that has really dominated everything else, and that's COVID. That's my main takeaway. Obviously, there were quite a lot of differences in terms of policy responses across countries, and that has had its effect here and there.

25:15But the dominant issue that has faced the global economy over the last, you know, three and a half to four years has been COVID and the recovery from COVID, And betting on effectively convergence between different places in terms of the inflation experience, I think has been the right approach so far. I'll give you an example. The European, both Euro area and UK inflation data until recently looked significantly higher than what we were seeing in the US and Canada and maybe some of the EEM countries. And what I just outlined suggested we really should be putting weight on convergence. And indeed, both the UK and Europe is now seeing significantly friendlier inflation numbers.

26:02I want to press on this point because, again, up until recently, when inflation really did start coming down in Europe and the UK, there was an argument out there that maybe the U.S. had outperformed because of the fiscal response in 2020 and beyond, which was absolutely massive on a sort of relative historic basis. How much weight do you place on the fiscal aspect of this at this moment in time? And then also going into 2024, there is this open question about whether or not the U.S. will have the same fiscal capacity to keep on spending or maybe do some sort of emergency stimulus if needed. So how are you thinking about that aspect of it beyond the monetary side of things?

26:46I think there are a lot of separate questions here. One is the size of the U.S. fiscal response and then the impact of that on 2020, 2021 GDP. Clearly, the U.S. did a lot and that did have a significant impact on growth at that point. I mean, there was a huge fiscal boost and that supported activity. And, you know, I think it was very important then. it's been much less important from a growth perspective since then. I mean, in 2022, there was a fiscal pullback, which consumers were able to spend through in part because of a lot of the excess savings. 2023, we actually don't get a significant fiscal impulse.

27:34And by fiscal impulse, I really mean basically the change in the deficit and the growth relevant changes in fiscal policy. We don't get a big impact here in 2023. It's certainly true that the U.S. federal deficit is very large, 6 to 7 percent of GDP, depending on how you adjust for some of the one-off items. But it's a very large number, especially relative to a 3.9 percent unemployment rate. This is a very different deficit from the deficit that we had in the aftermath of the 2008 crisis when we also had a large deficit, but it was the flip side of a depressed economy. And so this is more concerning because it's a structural deficit that will need to be addressed over time.

28:25I wouldn't expect it to get addressed anytime soon. I mean, 2024 is a presidential election year. Very little is likely to happen on fiscal policy. And even beyond that, the path to how we're ultimately going to address this is not clear.

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