Lots More With Neil Dutta on a Looming Fed Policy Error

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1:03should we start yes i'm not sending that's all right okay thanks jeff i need the emotional comfort of being signed into my bloomberg terminal i did a deadlift one two three

1:24barges this is an after school special except i've decided i'm gonna base my entire personality going forward on campaigning for a strategic pork reserve in the U.S.? Where's the best squid ink pasta? These are the important questions. Is it robots taking over the world? No, I think that like in a couple of years, the AI will do a really good job of making the Odd Lots podcast. And people will say, I don't really need to listen to Joe and Tracy anymore. We do have... Cha-ching. The perfect guest. You're listening to Lots More, where we catch up with friends about what's going on right now. Because even when the odd lots is over, there's always lots more.

2:01And we really do have the perfect guest.

2:06I think it's kind of weird to be worried about like some sort of recession or policy error on a day when like the market is basically at all time highs. Don't you think that's a little strange? No. Really? I feel like normally we have these conversations about like something's going bad and like the market's down like 15%. Yeah, but the market's not that prescient all the time. And I mean, as we've been discussing on the podcast, a lot of that, you look at what's going on in the S &P 500, like a huge portion of that is just driven by a handful of companies. Well, this is definitely true. The market is definitely not prescient all the time, but normally chatter follows the market.

2:48Yeah, that's true. But more and more people are talking about some sort of a recession or policy mistake by the Fed where they don't cut soon enough. Yes, this is definitely true. So we have seen a little bit of softening in the labor market. We've seen inflation start to come down. And there's a lot of discussion about how durable that trend actually is. And yet, if you look at especially Fed speak, if you look at Fed speak, they seem very hawkish. I generally would agree. So here's the weird thing. Here's the thing that really freaks me out, which is that one of our friends of the pod, Neil Dutto, who has been like really, you know, sunny and is always smiling and is like always slaying the bears, is a little nervous.

3:33Neil, why are you nervous? That freaks me out that you're anxious. Well, I just think it's important to look at the realized data, right? You know, everyone's looking at, you know, what's the outlook and if they cut once, is that going to reignite the entire economy and inflation? I mean, let's just look at the realized data, the information as it's been coming in. I don't think forecasting is particularly useful when all the Fed does all day long is talking about how uncertain everything is. So just focus on what's actually happened. And what we know about what's actually happened is that the unemployment rate has jumped 60 basis points from its low point.

4:10It's rising at about 30 basis points every five months, if you look at what's happened so far this year, which puts it on track to go up to 4.4 % by year's end. That's higher than where the Fed believes it's going to stay. And core inflation, after a bumpy first quarter, that, by the way, is still edging lower. It's likely that in May, over the last year, core inflation would have run 2.5%. So when you think about like a rules-based framework, you know, I think it's important to sort of just acknowledge that across a variety of monetary policy rules, it all suggests that a less restrictive stance of policy is required.

4:56And, you know, I mean, obviously back during the post-GFC era, right, I mean, there was all this talk about, well, we don't want to run policy based on like a computer, you know, what's the point of having it, right? Like, you know, you need to have some judgment. Well, if you're always uncertain about everything and you can't actually think and you don't want to actually apply any judgment, maybe you should go to the rules. And the rules are basically telling you one thing, which is cut and do it relatively soon. Yeah, in my mind, it feels like at this point you could essentially do like an insurance cut, right?

5:31Like the momentum is kind of in your favor. And yet it seems like FOMC officials, at least looking at some of the recent Fed speak, they're really worried about this idea that like there's going to be a long tail in inflation. And if they're not really, really going up against it, it's going to be the 1970s all over again. Yeah, I don't really buy it. I mean, in the 1970s, they took real interest rates negative. No one's talking about doing something like that right now. I mean, I think what I'm talking about or advocating for is that it's important to start a recalibration of policy. If they wait long enough, maybe they will have to go more.

6:10But the idea is to do a little bit now so you don't have to do more later and sort of stabilize economic conditions at the moment. I think what's important is that there's really not much of a right tail risk to the economy. I mean, I would agree with Joe in the sense that I'm not going to light my hair on fire over recession risk. But it's just important to note the areas of the economy that have been kind of responsible for some of the slowing that we've seen this year. It's housing. And consumption. OK, I mean, if you look at nominal retail sales and food services spending so far this year, it's actually basically where it was in December.

6:51So it's been flat for five months. And then when you look at new home sales, they've generally been slowing. If you look at new homes sold that haven't yet been started, it suggests that we're going to see continued weakness in residential construction spending over the summer. So it's not just about the economy slowing, it is, but it's really about the areas from where that slowing is coming. And so I think it's important to just keep that in the back of your mind. And it's just, to me, it's balance of risks. Like, what is the risk for the unemployment rate? Like, tell me the downside story for unemployment.

7:28Like, why does the labor market retighten at this point? It's really hard to come up with it. And same thing, with respect to inflation, like, what's the upside scenario for inflation? So I think this sort of idea that they're just going to be a slave to the high frequency data and, oh, just another few more months and we'll get there. It's kind of ridiculous when you don't have like a fundamental story for why that risk is really worth paying attention to. I thought it was really revealing. You know, I think at the last press conference, Jerome Powell was talking about import prices. He's like, well, you know, import prices rose and we can't really understand why.

8:01And then literally like 24 hours later, the import price number comes out and it was a complete dud. Like it fell substantially. And why would you worry about import prices if the dollar is strengthening? I mean, how do you how do import prices work? I mean, you know, it's just sometimes it's important to kind of stick with first principles. And so I don't know. I mean, I just they never really had a good explanation for why Q1 was so firm in the first place. And they're sort of a slave to the high frequency data. And, you know, I just think that you have to have like a fundamental framework in place.

8:33And the way to sort of frame this to the markets is, look, labor markets are an important driver of inflation in the way we think about the world. And the inflationary impulse from the labor market is basically zero. We've trimmed excess labor demand, as is evidenced by job openings, which is a series that they've been paying so much attention to. And if you look at the unit labor costs over the last year, they're running under one percent. So where is the inflation going to come from? That supports a recalibration of monetary policy. And we can take it by meaning by approach. If that's what I would say, but, you know, Joe, as you know, I don't have a PhD.

9:10I'm not at the Fed. So, you know. I don't have a PhD. Tracy, do you have a PhD? No, of course not. I have a postgraduate diploma. I like the way you pose this question, which is that it's understandable in the abstract to say, you know, it's understandable in the abstract to say, oh, you know, there are risks to both sides. But the onus does seem to be on the sort of hawks to say, OK, like if we're going to get a reemergence of inflation, where's it coming from? Because the story about labor markets and so forth was kind of a compelling story for years, except now we do have this pretty clear labor market slowing really across a range of a range of indicators.

9:50Here's my question, though, like, all right, so they want to see a little more data. They want to see a little more disinflation. How much risk is there if like, OK, they don't do July. They probably won't like September, maybe November. Like, does it really matter? Like if, you know, whether it's September or November. I think November might matter. Yeah. But like when I think does it really get away from them if they like put it off a few a couple more meetings? I mean, the risks certainly build. You know, I mean, you know, I'm not going to say that the difference between July and September means the economy rolls over hard or not.

10:25But I definitely think the risks certainly build the more they see, the more evidence they see inflation is slowing and the more intransigence they sow in responding to it, the more the risks build for the economy. Because remember, I mean, today's inflation data represents yesterday's monetary policy. So what do we know about inflation? We know that inflation's already been slowing, and we know that monetary policy hasn't been changing. So a good first pass estimation is that inflation will continue to slow. So in that respect, they're going to be passively tightening policy by doing nothing.

11:01So in my mind, that means that the risks continue to build. So you're talking about an economy that's only growing, you know, it's growing at about 2%. Okay, fine. But the pressure will continue to build. And you look at the labor market. I mean, this is something, a point that you brought up before. The only reason the labor markets look as good as they do is because the layoff rate is really, really low. It's not like the rate of hiring has perked up or anything. The rate of hiring remains low. So if companies are getting now to a point where they're feeling a little bit more cautious on the outlook, a very modest increase in the layoff rate will generate much weaker growth in employment.

11:40Right. And to me, the fact that the Fed has been leaning in hard to this sort of positive supply story, that just adds to it, right? Because at that point, you know, any weakness in employment growth will imply that much weaker demand.

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12:46Hey guys, it's Erin Andrews from Calm Down with Erin and Carissa. So when the pressure's on, you remember the people who helped you get this far, whose knowledge guided you and whose care kept you grounded. For me, it was my dad, my mentor, who believed in me when I was just getting started in journalism. A real-life example that showed me when you work with someone who knows a lot and cares even more, you're unstoppable. At Truist, that's exactly how they approach banking. Truist, leaders in banking, unwavering in care. See what knowledge and care can do for you at Truist.com slash unstoppable.

13:21Truist, member FDIC, leading based on top 10 commercial bank. Neil, you mentioned the idea of companies getting a little bit more cautious just then. I was overjoyed to see in one of your most recent notes, not just a mention, but an entire rendering of the beverage curve, which is something that has been kind of like a hot topic in recent years. It's basically the relationship between job openings and unemployment. And for a while, lots of people were looking at the beverage curve as sort of like the key to whether or not we would have a soft landing. But it was really interesting. You were arguing that looking at the beverage curve, it seems like you could have an even larger increase in unemployment if things start to turn for the worse.

14:06Can you talk to us about that? Yeah, sure. So as you mentioned, the beverage curve basically relates changes in the job vacancy rate to unemployment. And, you know, for the better part of the last year, we've been, you know, sort of the labor markets have been operating on sort of the vertical part of the of the beverage curve. Right. So you can trim job openings or labor demand. I mean, job openings are a proxy for excess labor demand. You can trim excess labor demand without seeing much of an increase in the unemployment rate. And that's more or less what we've seen for the better part of the last year.

14:37But if you look at where the latest points are kind of lining up, it looks like they've, you know, we're basically we've normalized. So in other words, any further deterioration in labor demand from this point will imply, you know, higher unemployment. We're no longer on that vertical part of the curve. And so that's what I'm concerned about. And I think the risk is, you know, unemployment never just goes up a little bit. Right. I mean, it's either up a lot or not at all. So we've kind of been, what we've seen in the last year has been somewhat ahistorical in the sense that we've seen a fairly notable increase in the unemployment rate and we haven't seen recession.

15:21But I mean, how far do you really want to push that experiment, particularly when broader measures of labor utilization suggest that if anything, the U3 unemployment rate at the margin is probably overstating the degree of health in the labor market. I mean, if you look at things like the quits rate, they're actually lower today than they were right before the pandemic. That's, of course, true for the hires rate as well. You know, as I mentioned, I talked about unit labor costs, but the fact that labor turnover is so low and the quits rate's been coming down, that would suggest that there's not really much wage pressure out there.

15:54I mean, if anything, it's more likely at this point that firms are holding their workers flat relative to last year, more so than changing their pay, moving their pay up, rather. And so that again, I mean, so where is the inflation coming from? If the labor markets are not consistent with an inflationary impulse, and the Fed believes that they're running a very, very hawkish policy, they should be much more concerned about potential downside risk to growth than upside risk to inflation. And what do we know about growth? We know that growth is slowing relative to where it was last year in two important sectors, housing and consumption.

16:32Tracy, can I say something that bothers me a little bit? Sure. You know, I... Now I'm nervous. No, no, it's not that bad. But so listening to like the Fed officials, I'm trying to think, I don't want to express an opinion here because I don't do that. But can I just say people, so there seems to be, and Neil described the state of the labor market as the hiring rate is down. So if you're looking for a job, your odds of getting a job have declined. But we haven't really had a layoff cycle. And so there seems to be like some comfort with this dynamic that it's like, OK, like this is softening. But like people who don't have a job and looking for a job just because they're not recent layoffs, like they count, too.

17:14No, for real. You know, there seems to be like this view. It's like, oh, well, it's OK because it's just that the hiring rate is down. But at least we aren't seeing like layoffs. It's like, yeah, I'm glad we're not seeing mass layoffs. but also if the people who are looking for a job are finding it harder and harder that's not good either no of course not i mean inventory thing works right guys i mean you don't have right i mean it's just basically it's taking longer for the excess housing and then the process that's driving up inventory is the same thing with with unemployment right like if you lose your job at any given month people are losing the job it's taking those people longer amounts of time to find find a job right so over time you continue to like right it's like a bathtub model of unemployment Yeah.

17:53No, I get how it works. I'm just saying like they count too. You should make a T-shirt, Joe, that says they count too. They count too. Actually, this reminds me. So one thing I was thinking about is like so much of the labor market tightness was driven by the services sector in recent years. And, you know, we saw the displacement of workers there and then it took a while to get people back. And then there was a ton of pent up demand and everyone wanted to go out to restaurants again or go on vacations or whatever. I do feel like potentially the peak of that is over, which kind of begs the question of, well, if you're not going to get additional tightness in the services market, then where does it come from?

18:31I don't think it's going to come from like AI investment and everyone suddenly becomes a chat GPT prompter or something like that. To that point, if you look at average hourly earnings in retail trade and leisure and hospitality, they've slowed precipitously over the last year. I mean, those are the two industries, those two sort of service industries that got so much attention during the COVID pandemic because, you know, sort of a proxy for kind of low end service work. You know, these are the people with high propensity to suspend. But their wage growth has been slowing over the last year. So, again, I mean, where is the inflation coming from?

19:10I just keep coming back to this point. Like, where is the inflation coming from? You know, people may, you know, you can point to oil or something. I mean, I just don't really that's not really a broad increase in prices. Ultimately, the labor markets are an important driver for how the Fed thinks about inflation, rightly or wrongly. But right now, unit labor costs are basically zero. So, you know, I think that there's room for prices to keep coming down. Obviously, in private and in public and in every statement that any member of the Fed has ever said, with kind of one exception, but I'm not going to say what it is.

19:47Wait. OK, I'm going to ask you afterwards. They'll they'll say politics just does completely not matter. You know, it's not our job to like time things around the election. Nonetheless, Neil, do you think the reality of the calendar right now we have there's a July meeting, there's a September meeting and then there's a meeting that's literally two days after the election or something like that? Does the timing of the calendar, do you think it's affecting how the Fed is thinking about the timing? No. OK, because I think that it's sort of you're damned if you do it. damned if you don't, right? Let's say that they don't want to respond to the calendar, right?

20:22Like, let's say that they want to hold off on cutting because they're worried about doing something that looks political ahead of the election, okay? That in and of itself is political, okay? Right? Because what are the chances that, okay, we should, I mean, this inflation data is slow and we should probably get on with it, but we're not going to. In the process, the economy is weakening as a result of that. Then you have a new president that just gets that comes into office or just wins the election. And then, boom, you start the easing cycle with a 50 basis point move. Right. Like, how does that look?

21:00Yeah. So it's sort of I just think that you just focus on the data, do what you think is right. I do think that there's precedent for the Fed moving in advance of an election. I mean, there's this nonsensical talking point around Wall Street about how, you know, never has the Fed cut interest rates in a September meeting before an election. Well, OK, Bernanke launched open ended QE in September of 2012. I mean, like it's like one of these things where it's like, yes, I guess that's technically true, but also irrelevant because we were never taking rates negative. So they so instead they launched an open ended asset purchase program.

21:34I mean, is that enough? So I think the Fed has shown that it's willing to do things at politically sensitive moments. You know, I mean, many of the people that are talking about how the Fed's political have also been the ones talking about long and variable lags, right, for the better part of the last, you know, 18 months. And if the Fed does something in September, like, how does that help Biden in any meaningful way in November? Neil, I'm going to ask you to do our job for us. But Joe and I are supposed to go to Jackson Hole in August. On the off chance that we run into Jerome Powell hiking through the woods or something like that, what should we ask him?

22:13Tell him that he should be cutting through the woods. Just tell him to cut. I would ask him if the unemployment rate rose two tenths of one percent in 2023 with the real economy growing three percent, why would it stay flat for the next two quarters with the economy slowing? Oh, this is the SEP, right? The dots. Yeah. How does that work? Explain it to me. Oh, man. Like, that would be one question I would ask him. I think Powell's going to be running away from us in the woods. And I would also ask him, does he think that inflation is a lagging indicator? Like Ben Bernanke does. Rent, that seems like one source of firmness.

22:55And our friend Connor has been pointing out, Connor has been pointing out that if you look at some of the apartment reads, Those are actually doing pretty well. And there are signs affirming. There was a story in the journal, I think last night or this morning, we're recording this on the 26th, talking about how the investors are sort of bullish because the supply constraining effect of the rate hikes, there's going to be sort of minimal new supply coming online. And so that creates upward pressure on rent in the long term. That is one area that people, we have not seen the slowing that people would like.

23:26If you're asking the question, where does the inflation come from? Could it come from shelter in some measure or another? I think it ultimately boils down to the labor market, Joe. I mean, I don't like to, I mean, I think frankly, the REITs story is essentially like an interest rate play to be perfectly honest with you. Right. I mean, REITs are rallying. Why are REITs rallying? REITs are rallying because interest rates have come down and that's like REITs are thought of like, you know, like an income substitute. Right. So it's, I think that's, that's largely what's going on. It's just, it's a derivative of, of lower interest rates and the Fed expectations.

23:58But I ultimately think what drives rents is how people pay for those rents, which is wages and salaries. So you have to tell me why wage and salary income accelerates. I mean, like if you get into a situation where, you know, shelter costs are quite sticky, but people are seeing their income slow down, that just means they're going to have to cut back on other areas, which will then drive the prices for those things down. So I just I think that's part of the issue with this kind of bottoms-up approach, I kind of like to look at it sort of more of a top-down perspective.