Richard Clarida on This Tricky Moment for the Federal Reserve

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1:25Hello and welcome to another episode of the All Lots podcast. I'm Tracy Allaway. And I'm Joe Weisenthal. Joe, I feel like it's fair to say there are a lot of weird things that have been going on lately. You know what the weirdest was for me recently? Go on. Having the Fed meeting on a Thursday. Oh, yeah. That threw me off for that entire week. I thought you were going to say the weird thing was having a Fed meeting two days after the election. But no, you're right. I was really confused just the fact that it was on a Thursday at all, setting aside the fact that it was an extraordinarily busy week, which was just last week.

2:00I didn't realize how much of my sense of normality was, in fact, influenced by having the Fed do something on a Wednesday. But anyway. That threw me, too. So we just had a Fed meeting. We are recording this on November 12th, and clearly this is an interesting moment for the central bank. Totally. I saw a tweet today. I don't remember who it was from, so I can't give proper credit. Or maybe it was a sell side note. I don't know. Just words that I saw on my screen at some point. But I think what made this interesting is this moment, or maybe it was a tomb doing note, whatever. It was this moment where the Fed is still clearly in the sort of short term data dependency.

2:41Are we going to see further progress on realized inflation and so forth? Watching the data, plenty of missed signals there. Meanwhile, the market is very seemingly focused on the medium term and thinking a lot about Trump and the new fiscal and macro policies that will emerge under this administration. And I thought that was a really good way to frame it, which is that right now there's two different time frames that people are in and people are trying to resolve the two. And it makes for some very interesting times in macro, to say the least. Yeah. And I have to say, like, I do not envy policymakers on the FOMC at the moment because they have been emphasizing the data dependency, as you said.

3:21But there is all that uncertainty about how the Trump administration is going to unfold and what its economic policies will actually look like. It seems really difficult to me to have to react to that from a monetary policy perspective. So basically, there are a lot of questions, lots to talk about. And who better to ask these questions of than a former Fed person? So we are going to be speaking with Richard Clarida, the former Fed vice chair, now economic advisor at PIMCO, and a professor of economics at Columbia. Richard, thank you so much for coming on All Thoughts. I'm glad to be on the show.

3:58Big fan. Oh, thank you. So first of all, you know, last week, the FOMC meeting on a Thursday, I got to ask, when you watch those, are you sort of watching them like wistfully wishing you were there? Or are you thinking like, oh, gosh, this is really tough now? Well, it can be tough. Yeah, I was certainly involved during my four years there in thinking about and prepping for the press conferences. But yeah, I watch them as a Fed watcher now, And the chair has become quite polished and experienced in navigating what can be sometimes some choppy waters. By the way, Tracy, you didn't say it, but I believe Rich is the perfect guest.

4:35Oh, I'm sorry. No, I just want to establish that I believe in this moment we are talking to the perfect guest. And then listeners are like, why didn't you call Rich the perfect guest? So I just want to make sure that both - It was truly an oversight on my part. Truly both Tracy and I consider you to be the perfect guest. So we had that 50 basis point cut in September. Then we had the quarter point the week of the election. As I'm looking at the warp function on the terminal, expectation is for there's 65 percent chance of a cut in December. So not a slam dunk, but that still seems to be the expectation.

5:06What do you give us as a Fed watcher your current read on the crosswinds that the Fed is going? Let's start with the short term still, because then we can get into the term. The crosswinds that are happening right now as the Fed looks for the near term path of policy. Well, they've made some judgments. One, they judge that policy is restrictive, that they've done enough. And so they cut rates. They recalibrated. I think that was the term the chair used in September. Important to note, they've begun to cut rates even though inflation is still somewhat above target. Some of your listeners may wonder why.

5:38And the answer is monetary policy operates with lags. And so if they had waited to cut rates until inflation fell all the way to two, then they might have overdone it. So I do think it made sense to get the process started. I do take them at their word. They're not on a preset path. The committee is united, a unanimous decision to cut rates. And I think importantly, and I'm sure we'll get to this later, you know, the chair's made very clear that he and the committee are not going to be making policy decisions in 2024 based upon what might happen in 2025. And so I think it's important to clarify that.

6:15I think they are data dependent. But my sense is that the probabilities that you quoted seem pretty sensible to me, not a slam dunk, but I think more likely than not that we get a rate cut in December. So just on this point, how do you square the proverbial lags in monetary policy with the desire to not be reacting to an incoming administration where policies are not necessarily clear at the moment? it's a great point luckily we have a lot of historical examples because as you know we have presidential elections every four years and the fed as an institution and the staff have a lot of experience and one of the things i learned is especially in the u.s system unlike say the uk system where you present a budget and here there's a whole set of negotiations and so i do think that the chair gave a good insight into the process that that they'll follow which is that over time They'll learn about the contours of the plans for policy than what gets enacted.

7:15I do think it is a good point. I think initial conditions here are quite relevant. And so in particular, with inflation running close to target, if a bit above, I think the general playbook they usually follow makes sense. There is a risk that if they don't start moving now, then for certain scenarios, it's too late. But I think given where inflation is, they're making the correct call. So I don't know if economics is really a science or not, but if it is a science, I feel like economists are cursed to never have the pure experiments in the real world that they would like to see. And I'm thinking about that specifically since September, since mid-September, early October, we got that 50 basis point cut.

7:59Since then, rates at the long end in particular have been rising. Unfortunately, from a pure scientific experiment, that is around the same time that Donald Trump's odds in the polls also started rising. Therefore, it's a little tough to tease out how much of this is, OK, we're going to have more reflationary policies in the next administration, which we can get to, versus, you know what? The economy is stronger than we thought. Neutral is stronger than we thought. And the terminal rate is not going to be as low as we thought simply due to existing economic conditions. When you look at that rise in the long end, the higher terminal rate and so forth, how do you try to disambiguate the two?

8:40And what signal, if any, do you read in post-September market activity? Great question. And I think, you know, the simple answer would be you look at all the above, but I think we can make a couple of informed observations. The first, and if I were back on my old Fed job, I'd be looking at this is measures of longer-term inflation expectations, either in the TIPS market or surveys. And those are very well behaved. Secondly, we also have had some pretty strong macro data, big revisions to GDP, which in some ways really change in important ways the assessment of where the economy is right now. We got a very soft labor market report, but I think the markets in the Fed are inclined to look through that given the storm and other related consequences of that.

9:27A term perhaps you've used on your show before is also look at the term premium. How much of this move in yields is essentially bond investors saying, I want to get paid more in terms of a higher yield, given what may happen to fiscal policy or growth. And I think all of the above has been going on. It's been some move in term premium, some stronger data, backward looking data, and probably some repricing of the path for the economy given the election. I would point out that at this stage, I think you want to distinguish between a phenomenon where by knowing the election victor, I think we know something about the contours of, for example, tax policy.

10:07It's more likely that the 2017 Trump tax cuts are going to get extended more or less intact. And that probably would not have been the outcome if we'd had an opposite election outcome. So I think in this early stage, it's hard to determine how much of this is a repricing of the level of markets versus a new trend, because I think both could be going on. I feel like I should just mention, again, we're recording this on November 12th, and there is something happening tomorrow that might have a bearing on this conversation, which is we're going to get the latest CPI reading. When it comes to inflation, obviously there has been improvement on this front, but in the most recent FOMC meeting, Powell was emphasizing, you know, really making the point that he expects this to be a sort of bumpy path going forward.

10:57When a Fed chair is saying something like that, should we assume that the risk is to the upside on prices? I don't think so. I don't think that's the message he was trying to convey. I take him at his word that it is a bumpy path. Maybe I'll put something back into that conversation that sort of fell out of favor. There was a lot of talk a year ago about the last mile being tough to navigate. And I would point out that, you know, if you look at inflation on a 12-month basis, in December of last year, inflation fell to 2.9, the Fed's preferred measure on the core PCE. And that was a big moment.

11:32That was the first time in almost three years inflation was 2 point something. It's very likely that this year inflation will end on a 12-month basis anyway at around 2.8 or 2.9. So at least by that metric, you know, this is a year when we've not move backwards, but you could argue that progress on inflation at minimum has been slow. And so the way I take the conversation from the chair and other members of the Fed is they have a view that disinflation will continue, but they're also open to the risk that it may stall. I don't think necessarily it means inflation is going to go up to frightening levels, but progress could stall.

12:10And I think that they're very attuned and attentive to evidence in the data on that.

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13:10Giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform. All while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting. EasyCater, your business tool for food. To learn more, visit easycater.com slash podcast. So as you mentioned, you know, there's a confluence of factors. One of the things that may explain why the market has repriced its terminal rate or the depth of the rate cut cycle this time. And you mentioned that we had some hot we got that strong jobs report. There was a positive GDP revisions that make it look like the economy is in a higher state.

13:53The one thing that's been bandied about for years now is this idea that post pandemic, like so-called R star is higher. I don't know what it is, whether it is higher or not. But if it is higher, what's different? Suppose it is higher. What has changed in your view that would explain a higher neutral rate of interest? Good point. I think a couple of factors. First of all, why was our star believed to be pretty low in the decade before the pandemic? Maybe a bit of an anecdote. There was also uncertainty about our star in 2018 when I arrived at the Fed. A range of views, I think, from the funds rate, maybe two and a half up to three and a half.

14:33In that cycle, the Powell Fed sort of found out where neutral was because when we got the funds rate to two and a half, the economy was in a pretty good place. In fact, if anything, inflation began to slow. So it is true that you don't know precisely, but you can sort of have a sense if you're in the right ballpark. So why might it have gone up? Well, there are some positive reasons and maybe some more negative reasons. The positive reason is our stars thought to be related to growth. So if potential growth is higher, either because of innovation or AI or list your favorite contributor. That could push up our star.

15:06It could also reflect demand for capital. We have had some evidence, at least in certain sectors, of expanded capital spending. We went through a decade when capital spending was weak. On the other side of the ledger, a lot of the factors that were keeping our star pretty low have not really changed. Demographic factors have not really moved. And if anything, saving has been moving up. So I think they will find it in this cycle as we did in the last cycle by looking at the data and as they get close, you know, rethinking that. Could government spending be a contributor given that deficits as a share of GDP are very high given where the unemployment rate and resource utilization generally are?

15:48Certainly. And here, maybe if I could be a little wonkish for your listeners. Never worry about that. Never worry. I wrote a recent essay in the FT on this topic. Here, I do think you want to distinguish between the neutral rate that the Fed focuses on, which is really the front end of the yield curve. So where's the funds rate going to end up when inflation gets to target? And right now the Fed thinks that number is around 3%. If you ask me the question, where are bond yields going to end up? My own view, and I think the PIMCO view is higher than we saw in the decade before the pandemic. So in other words, we think the front end of the curve may not be all that higher, but long rates could be higher because the curve will be steeper.

16:29In other words, markets will adjust not so much because the Fed has to do something different, but because the yield curve will be steeper. It was very flat in the decade before the pandemic. For example, in 2018, when we got the funds rate up to two and a half, 10-year treasury yields were three. And so for the reasons you mentioned, deficits and debt, probably in a world with higher longer yields than we saw in the decade before the pandemic. Since we're on the topic of higher long-term yields, one of the things we've been speaking about on the show recently is mortgage rates. And even though the Fed has been cutting, those haven't really gone down, partly because they are influenced by longer-term treasury yields, and those are going up.

17:14Given that affecting the cost of housing or the mortgage rate is supposed to be a primary tool in which a central bank actually influences the real economy. Does that pose a problem at all for the central bank? I think it's a reality for the central bank because for the most part, although the Fed has been very active in supporting the mortgage market through the QE programs, its mortgage portfolio is running off. And if anything, Tracy, they've indicated that may well continue even when they stop QT in general. And you are correct. Mortgages will tend, yields will tend to move closely, not so much with the funds rate, but the longer end of the yield curve.

17:56I would say it's more of a reality as they think about the appropriate stance of policy. They will need to factor that in to what they project they need to do to achieve their inflation and employment target. So I think in the Fed's thinking, it's just a reality of the way the financial markets work, and that may call them to adjust policy in one way or another in the future. There was a famous paper that came out saying on the subject of housing called Housing is the Business Cycle. And one of the things that was interesting was that during 2022, when the mortgage rates really started to rocket higher, we did get this freeze in the housing market.

18:36We didn't see a plunge in home prices, but we really saw, yeah, the market sort of came to a freeze. And there still is a lot of diminished activity and we still see fewer housing starts and we still don't see a lot of sales and all this stuff. Do you think the relationship has changed in some way between the housing market and the broader macroeconomy? Great question, because, you know, you look at I've been doing this now for four decades. So you look at business cycle history and there are some common features and then there are always some surprises. And in particular, in this cycle, one One thing that has been different is the fact that so many folks in the years before the Fed raised rates were able to lock in low rate mortgages that you've had less mobility.

19:18People are less likely to move even if they want to simply because if they sell their house, they then got to get a mortgage at a much higher rate. Now, this phenomenon is always evident in the data because people can lock in low rates and then rates move up. But what's different in this cycle is the magnitude of the gap between the spot mortgage rate and the rate that millions and tens of millions of people locked in. So I think in that respect, this is a different cycle. And it's been a factor that's been supporting house prices, even though the Fed's been raising rates dramatically. Typically, you would not have seen that in the past.

19:52Just related to this topic, the Fed has been talking a lot about how it's necessary to, I guess, ease up on the restrictiveness of monetary policy and therefore cut rates. And I'm always a little bit confused because when I look at financial conditions on the Bloomberg, they look pretty easy to me. And, you know, obviously this has happened post the FOMC meeting. But we have, for instance, junk bond spreads getting pretty close to historic lows, equity markets obviously at a record. Where's the restrictiveness actually showing up? Great point. And I look at the same screens that you both do as well.

20:32The Fed, the Board of Governors actually about a year ago or so developed its own index of financial conditions. And that also shows conditions, you know, trending in an easier direction. The chair got a question or two on this and the press conference last week. And I'm paraphrasing, but his answer was more along the lines of they try not to get up in high frequency, you know, day to day or week to week moves. But they do want to look at longer run trends. I would argue, even if you look at longer run trends now, conditions are certainly moving in an easier direction. Now, that's OK. But it's also important, I think, as the Fed communicates through press conferences and speeches, that they clarify what they are looking at.

21:16Because sometimes Fed officials will talk about the funds rate being restrictive relative to inflation in history. And that's true. But the conversation, I think, also needs to acknowledge what we're looking at in different parts of the markets. Now, again, inflation is on the path down to 2%. So an easing of conditions relative to, say, 2022 when they're very restrictive is not necessarily a problem. But it certainly, I think, needs to be a factor in the outlook. I'm going to ask a sort of I think it would be a variation on Tracy's question. And it came up in also a recent episode we did with Chicago Fed President Austin Goolsbee.

21:52When you look at the progress that we've made on inflation since it peaked, given that many financial indices have surged, given that the unemployment rate is still only 4.1 percent, what's your story for it? And what's your story for the connection between the move up in short-term interest rates by the Fed and how that fed through to lower realized inflation? Well, you know, in my youth, we used to call it the$64 ,000 question, maybe the$64 billion question. Inflation has hypothetical questions. Globally, the$64 trillion question. The good news is relative to real time, and I can tell you as a Fed official in 2021, we had so many conflicting signals.

22:39But with the benefit of hindsight and also looking across the globe, I think some pretty clear patterns help to account for this. I should also confess that I was a charter member of Team Transitory. This is where people come up. Odd lots is confession time for all of them. I'm a child member of Team Transitory. And obviously, it took a while for inflation to get back to two point something. A couple of things. First of all, in retrospect, a lot of the surge in inflation in the U.S. and globally was driven by supply disruptions. It turned out to be more timely and costly to reopen the global economy than it was to shut it down.

23:23Secondly, in the US, there was a lot of demand support that was flooding the system. The Fed went all in without apology in 2020. We had$6 trillion of fiscal support in 12 months. And so from Econ 101, if the demand curve shifts right and the supply curve shifts left, you're going to get a move up in prices. And that's what we got. But there was a lot of uncertainty when the Palfe started hiking in 2022 about would they succeed? What would it take to get inflation down? And I think we're all pleased that, in fact, inflation has come down pretty close to target without a real disruption in the economy.

24:01And I think that's due to some of the supply shocks reversing here and abroad. And it's also due to the fact that the Palfe did raise rates aggressively. They re-anchored inflation expectations. So I think if I can editorialize a bit here, I think we're in a world where unlike on your show, we're going to have 30 or 40 minutes. A lot of economics commentary takes place on Twitter and 140 characters. And there are a lot of topics in economics and finance that are really you can't do justice to in a tweet. And I think this is one of them. So some folks look at this and they say, well, it has to be supply or it has to be demand or it has to be monetary policy.

24:39And in fact, it was really an all of the above in response to a once in a century shock. And it was also a global phenomenon as well. And so I think that's the received wisdom now. It was not obvious two or three years ago. I feel like this is my chance to ask you what Powell's burner account on Twitter actually is. But it's probably a long shot. OK, so speaking of like the overall macro picture and the story that we tell ourselves, Richmond Fed President Tom Barkin was just speaking and he sort of laid out two opposing paths for the economy going forward. And one is a pretty optimistic path where election uncertainty is behind us.

25:24And so companies feel more confident in terms of hiring and investment. And so everything stays very pleasant and the economy keeps going strong. And then the downside scenario is that as price is cool, companies feel more pressure to cut costs in order to either maintain or boost their margins. And that's when you start getting a labor market that is weakening, you know, even further than some of the softness that we've seen in recent months. What's your sort of scenario analysis for, let's say, 2025? Well, thank you for introducing scenarios because that's also quite important. So I do think the baseline, what I call the baseline scenario, which is the most likely outcome, is the one the Fed has more or less and really most Wall Street economists and forecasters have sketched out.