This Is What The Rate Cut Cycle Could Look Like

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1:24Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway. Tracy, we're here in Jackson Hole. It's nice to be back. It's really nice to be back. So this is the second year we've come to the big Kansas City Fed Economic Policy Symposium. And I think it's fair to say, you know, we heard Powell this morning. There's a certain air of like victory, right? Yeah, the vibe has shifted. I think last year there was a little bit more, I guess, comfort with the idea of inflation coming down, at least compared to the year before. So remember, two years ago was the famous Powell speech here in Jackson Hole, where he stood up and he basically said, there's no way we're going to get inflation down without a degree of economic pain, i.e.

2:13a pickup in the unemployment rate, job losses, that sort of thing. And now fast forward two years, and he basically announced that it's time for rate cuts. And it wasn't a victory lap necessarily, but he sort of walked through how and why he thinks inflation has come down without those job losses. That's right. And of course, we've seen that tick up in the unemployment rate, not through big layoffs, however. So there's not been a major degree of cuts. But the other aspect of that is like, you know, there was some expectation that to balance the economy, achieve the inflation mandate, there would have to be some loosening of the labor market.

2:51But what he said, and I think it was the second line of the whole speech is, we don't want to see any more. We're good on. Yeah. At this point, the risks to the labor market are what we're primarily concerned with. And we do not need to see any more weakness to be confident that inflation is no longer a major risk. Yeah. So the focus has certainly shifted from upside inflation risk to downside labor market risk. But this opens up a whole new set of issues and things that we need to discuss. And I guess everyone's going to be focused on a slightly different set of economic indicators going forward.

3:27Right. So now the question is like, OK, if you accept that the primary risk for the Fed and Paula said it, so it is, is now protecting against further weakness in the labor market. What does that look like? Because, yes, we know now basically for certain that a rate cut is coming in September, but there are still all types of questions about the size of the cut, how many cuts, the sequencing, etc. etc. And from a market perspective, in particular, I would say this is actually still a very live and open question. No, absolutely. And the other thing that's happening, and we should get into this, but the Fed has said so many times that it's data dependent now.

4:02And so if you say you're data dependent and you're really focused on what's going on in the labor market, then that's like a combination for everyone to be watching that next jobs report as an indicator of whether or not we get 25 or 50 bps. Or if it comes in better than expected, maybe you don't get a rate cut at all. I don't know. I guess nothing is locked in stone. Everything is possible. Anyway, I'm very excited. We have the perfect guest today, someone that we have had on OddLots several years ago talking about similar stuff, including, I think it was the discussion about how you even ascertained the neutral rate of interest.

4:37But we are going to be talking about the question of what will this rate cut cycle look like that we're all expecting. So we are speaking with Peter Williams. He is the managing director of macro research and central bank policy at 22V Research. Previously, he had been at the IMF. He was at Evercore. He lives in Bozeman, Montana. He just sort of drove down here to meet with us, do some fly fishing here in Jackson Hole and also meet with us. So he was not in the room, but Tracy and I weren't in the room either. So we're all reading the speech. So Peter, thank you so much for coming on OddLots. It's nice to meet you here.

5:11It's nice to see you here. Nice to meet you guys. Nice to be down. We never met in person, right? Before it was just... No, first time. We got to meet on a fishing boat ramp. Not so bad. Yeah, not too bad. So you've been writing even prior to the speech this morning talking about like, okay, the rate cut cycle is clearly coming into view. How do you begin to think about the question? You know, 25, 50, both seem kind of live at this point. How do you start trying to ascertain like what this looks like? Yeah. So I think, you know, the starting point is, you know, Powell says, obviously, we're getting some cuts.

5:42They're starting soon. I would say while Tracy wants to keep every possibility open, they're going to cut in September. And realistically, in the vast majority of cases, they're also probably cutting in November and December too. I think just penciling in some degree of front loading, because when you're in a risk management mode, usually you move a little bit more aggressively than when you're in just kind of minding the base case. We were minding the base case in like 2017, 2018. Policy was slow, gradual. The last three and a half years, really since COVID hit in different ways, you've been minding the extreme tails in both directions.

6:13And now we're starting to worry more about the downside. So maybe base case from listening to the totality of Fed speak, besides just Powell, kind of still sounds like a 25. But especially if the labor market data comes in a little bit softer than expected, all eyes on the sort of August payroll print for sure, but also the jobless claims data as well, sort of accumulating over time. I think a 50 certainly seems very possible and maybe even prudent, but I'm also not the guy in the room making the decisions. Well, just on that note, are there pros and cons to 25 bps versus 50 bps? So for instance, maybe you want to be early and proactive, so you cut by 50 basis points.

6:51But on the other hand, I might imagine that there would be some investors or some people in the market who think, oh, the Fed's really worried about the labor market, and that's why they're cutting so dramatically in September. It seems like there are benefits and also downsides for each of those moves. Yeah, I think at this point with Powell saying that we're no longer really worried about inflation on the inflation expectation side or labor market driven inflation, the case for sort of not 50 to some extent, like not pretty aggressively front loading, you know, largely boils down to sort of institutional inertia.

7:23They tend to move relatively slowly unless you're in the midst of a very deep financial crisis or something like COVID. These mid-cycle adjustments, at least hopefully that's what this is, that we've had before have tended to be relatively gradual and small in nature. So you don't often get these very large drops in rates in relatively stable times. But against that is we know rates are very high. We know interest rate sensitive parts of the economy have been struggling for a year and a half or two years now. And so the case sort of against 50 feels more of like an institutional one and sort of a desire not to spook market participants.

7:56But like we all kind of see the same data. The Fed has a little bit of private data we don't see, but we see the big data. We all see the employment report. We all see claims. We all see inflation. And if you're just looking at that data, it's sort of harder to make a case that you shouldn't just front load, you know, the initial part of the rate cutting cycle. And then from there, you can kind of move into like wait and see mode or just pause, see what happens in 2025. but at least early on, pay back some of the hawkish insurance they took out in late 22 and over the course of 2023, and you can be a bit more level set.

8:25You know, every cycle is different. But what do past rate cut cycles generally say about the way the Fed approaches it? I mean, it's different because the economy more or less seems fine. There is certainly not a consensus that we're in a recession currently. We're not in a financial crisis currently. But what does history say about how rate cut cycles work? So you basically get two versions. There's a sort of mid-cycle correction, which 95, 96, 97, 98 around LTCM. And then arguably, although people might have different views, in sort of 2018, 19 as well. And those tend to be relatively moderate in sort of cumulative size, like 75, maybe 100 basis points.

9:07And then on the other hand, you have recessions. And these are basically the two varieties of rate cutting cycles we've had. And the sort of modern kind of post-Volger era of Fed central banking. And so I think even now, it feels a little bit different because compared to those prior periods, the assumptions about where interest rates should be in the long run, especially from the Fed's perspective, I think market participants probably think they're a little bit higher. But for most people, the Fed, the median still says 2.8. And we're sort of looking at a pretty large gap to that compared to a lot of those other prior mid-cycle corrections.

9:37So you're seeing a somewhat different sort of base rate on how far you might normally expect to cut. So the sample size of history is in a somewhat structurally different world. Yes. So the other thing I've been sort of thinking about, and it's kind of remarkable about the current cycle, but just a week or so ago, I think on August 13th, Bostick, for instance, was talking about how the Fed needs to see a little bit more data before it decides on rate cuts. And then fast forward to a week. It was literally 10 days later. Yeah, exactly. He was talking about the potential for a 50 basis point cut.

10:10And then today at Jackson Hole, we see Powell come out with an extremely dovish speech where he puts the emphasis on the labor market and says, we don't want to see further weakening. What happened in this sort of like two week period? Well, I think part of it is for a lot of the more hawkish committee members, you've seen better inflation data. You know, the Q1 shock looks a little bit farther in the rear of your mirror. Now you have relatively more confidence. And while we haven't gotten that much more marginal labor market data, none of it looks dramatically better. Jobless claims have been pretty well behaved the last couple of weeks.

10:43But you have these very large downside revisions to sort of trend NFP growth from April 23 to sort of March of 2024. And it just makes the economy look a little bit more like it's been in a funk for longer. And so that probably helps you reassess what your view on the medium term is. And if you're a little bit less optimistic about the steady state of where things should be headed, maybe you should be a little bit more proactive in trying to cut off some downside risks there because you have a bit less buffer in that sort of a world. Does the first move tell us something about what the second move will be?

11:13Yes. More so if it's a 50, I think. Because if you get a 50, I would say realistically, either the August employment report was pretty bad. So the direction of the economy looks worse. If you're still trying to head off something really bad from happening, you'll be more aggressive with it. Or if the August employment report was fine and they still go 50, then that tells you something about the reaction function and their desire just to be a little bit more proactively cautious in trying to get rates down. So I think there, if you see a 50 in September, realistically, you should expect that the reaction function, at least through early 2025, is going to be relatively more dovish than otherwise, whether that's because of the data itself or just the way they're seeing the world.

11:50The other thing I've been thinking about the last time or the first time we had you on Odd Lots, it was to talk about R-Star or the neutral rate. And since then, certainly this year, R-Star has kind of fallen out of favor. So I think the Bank for International Settlements came out and they were talking about it's better to base policy on observable inputs like the actual data rather than unobservable models. And I'm trying to figure out like there's so much talk about data dependency. Our star is kind of out of fashion, but is it still alive and well and sort of in the background of Jackson Hole and we're just not talking about it because it's no longer fashionable?

12:32It's certainly not the operative concern for policy, right? Like, you know, the primary motivating force at this point is like, we don't want to see the labor market fall apart. Powell told us that this morning, this is what's driving it. And, you know, our star maybe helps you inform like how restrictive your current policy stance is, but on like a quarter by quarter or meeting by meeting basis, you just know that rates are substantially higher than they were a few years ago. Looking at rate sensitive parts of the economy, you know, they've growing up and doing great. Overall economic activity has done surprisingly well over the last couple of years and suggests that R-star has probably moved up some post-COVID for sure.

13:04But you don't really want to base policy off of like a very uncertain structural variable and say like, oh, we should only cut, you know, 50 basis points because we're getting to a much higher R-star because you can only solve those sort of longer run problems a little bit in a future. But like if you accidentally create a recession, that's a very persistent problem you have to deal with for years after the fact. So it's sort of like different horizons for risk management. Silicon Valley is selling you a future where you're obsolete or worse. identical. At Palantir, they're witnessing something different and revolutionary.

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15:09Brokered services for U.S. listed registered securities, options, and bonds in a self-directed account are offered by Public Investing, Inc., member FINRA, and SIPC. Crypto trading provided by ZeroHash. Complete disclosures available at public.com slash disclosures. So we know that the sort of R-star is this sort of in economics is you can't directly observe it, but we believe theoretically exists that there is some rate that brings the economy into balance. What is the sort of economic explanation for why that changes over time? And just to add on to that, like why in 2024 do economists believe it's higher than say it was in 2018?

15:46So a lot of that, I think in the sort of post-GFC decade, you had a banking system that was having to sort of re-solidify its balance sheets. There was a lot of new regulation about the banks making them kind of de-risk. You had fiscal policy that after sort of the Obama-Ryan deal was in much more restrictive territory given where the sort of business cycle was. And you had sentiment, generally speaking, like on a corporate perspective, was just quite subdued for a long time afterwards. You'd have this massive shock. And I think a lot of these very persistent, but not necessarily permanent forces were dragging it down.

16:16You still have like longer run forces like productivity and demographics that are sort of weighing on our star. But all of this sort of persistent, but not permanent stuff has now sort of faded out, especially because the post-COVID experience was the exact opposite of all those things. It was massive fiscal policy. It was very loose financial conditions. It was an absence of spending restraint on the part of households and the government at large. So the other noteworthy change between this year's Jackson Hole and last year is last year, even though the trajectory or the momentum overall on inflation was good, it was coming down.

16:49There was a lot of talk about the idea that, well, there's always the possibility that it comes rearing back. And this could be the 1970s all over again, where it comes down dramatically and then And it spikes a little bit later on. This year, it feels like there's not much talk about that. There isn't even that much talk about inflation expectations being embedded. All of that seems to have gone in the rearview mirror. And it's all about the labor market. Do you think consideration of the return of inflation is warranted here? Should there be more discussion about the potential for inflation to come back?

17:25Over the medium term, I think, you know, post-COVID and especially, you know, drawing the contrast with the sort of like post-GFC era, you know, inflation, the trend in inflation seems like it has moved somewhat higher. Trying to pin it down seems like kind of a fraud endeavor, but it's definitely moved higher than it was, but it was sort of substantially too low after the GFC. Now it's perhaps a little bit too high, but it's not so high that it's obviously a problem for the Fed because I don't think most people notice if core PCE is 2.25 % or 2 % or 1.9 % realistically, as long as like the labor market is okay in that sort of a world.

17:55It adds a little bit of a bias towards policy over the medium term. And there have definitely been some structural shifts post-COVID that seem somewhat inflationary. But in general, at the moment, it's not really the operative concern. As we get into like 25 or 26, if the economy really reheats, that could be a problem down the road. But that's a problem for a very optimistic view of the world two plus years from now, not today. So in Q1 of this year, we did get warmer than expected data. One point that we talked about, there are a lot of people that thought the rate cutting cycle was going to start in March.

18:25And then we got that warmer than expected data to start the year. And then they had to push that back. So, okay, what if we have like another period just for whatever reason with some component or something, let's say Q4 does run on the warm side and they feel there are some, let's say questions emerge about whether they should continue the rate cut cycle in the face of this data. Let's say the jobs come in strong and suddenly things look warmer in the short term, not 2025, 2026. What are the costs for the Fed if the rate cut cycle is sort of aborted, so to speak? Or if they feel like, you know what, actually, we don't want to be cutting rates as fast because the data does not come in the way they expect.

19:10Well, if you get surprised by the data, you should respond to it. And I think fundamentally, the issue that I've had with a lot of some of the Fed speakers recently is that they're sort of premising this notion on doing the appropriate thing now about something that eventually down the future, it could maybe be a surprise. And some part of policy needs to be consistent over time. But a lot of shocks happen in the economy. It's always evolving. And I think the notion that you can't do something today for the most predominant risk, because you might get a little bit of a surprise direction a year from now or six months from now.

19:37But people really do talk about this. There's like, oh, the worst thing that would happen is they have to backtrack or something. And I'm trying to understand, okay, if that's so bad, what exactly is so bad about it? I think there's a fear that by changing your mind, maybe you, you know, elevate risk premia, you make markets a little bit less certain. I mean, we did just see massive drama in the market. Yeah. Because of like a reconsideration of what the Fed was doing. Yeah, true. Yes. I think, you know, the worst thing rather than not respond, you know, if you're worried that like you might have to change your mind, but it's much worse to not respond.

20:12I think, you know, fundamentally, like, yes, maybe it shifts you in a little bit on the margin of like, well, we should do a little bit less because it'd be a medium, the inflation story or something. But the softening in the labor market you see, Powell was very clear, like that's in the data. You can interpret it in different ways, but like the labor market is back to normal, maybe even a little bit soft. And if you're worried about that as the sort of dominant kind of breaking things risk, because, you know, presumably once recessions start, they get going pretty darn quick. That's something you really have to sort of truncate away pretty quickly and like, okay, it didn't happen.

20:42Well, okay, that's fine. You can sort to move on. It's like, you know, you buy a bunch of insurance for your house and then like the wildfire doesn't come. There are worse fates. I mean, I still think it's a pretty big shift. Post-financial crisis, it was very much about forward guidance and sort of trying to pin yields to where you wanted them. And then I think it was 2022, it moved to the data dependency, very, very short term. It does feel to me that there's a downside here to saying that we're going to react to every data point, especially when there's still big question marks over the quality of the data.

21:18And we just had that BLS revision that everyone was talking about. So I think the way you sort of robustify against that is you still have to have some sort of forward-looking view on a policy-relevant horizon. Six or 12 months out is typically when you think monetary policy can really impact the sort of top-line kind of macro data, right? So you have that sort of view, but you're updating it relatively robustly as the new data comes in. But the problem, especially over the last year and a half, is that different parts of the data have been telling you relatively different things. So you sort of have to average between them.

21:48And the more you get into like a sort of risk management driven mode, maybe you'll pay a bit more attention to the most pessimistic parts of the data. Right now, the unemployment rate, perhaps. Or, you know, if everything else holds up well, you might shift the signals you're paying attention to. If that theory you had about the unemployment rate sort of spiraling doesn't come to pass, then you'll maybe put one more weight on the activity data or the NFP data, despite the revisions it just had. It still looks OK, if not fantastic. What do you think about the efficacy of cuts? Because, OK, for a while, there was questions about, well, what is the efficacy of rate hikes?

22:19Because they didn't seem to be doing much for a while, and they certainly didn't impact the labor market as people had anticipated. And various stories, everyone has their mortgages locked in. Or yes, it affected the economy, but only in like real estate and like auto loans or, you know, much of the economy is not rate sensitive and how long are the lags, etc. So it feels like to some extent we need to have that version again for the cutting cycle and what we expected to do. So from your perspective, like let's just say the Fed goes 50 or 25 or whatever. In your view, how does that transmit to putting that floor under activity and how quickly?

22:55Yeah, I mean, some of it is just ratifying what's already priced in markets. They have pretty strong assumptions about cuts over the next year and a half or so. So to some extent, you still have to do the thing that's priced in, even though the long-term rates that people borrow it may not change that much. But I think a lot of it also has to do with a sentiment shift on the part of, we'll call them less financially sensitive firms and households, where just seeing headlines about Fed rate cuts sort of changes the tenor of your business and maybe changes some decision-making. Because this comes through in a lot of surveys to an extent that often kind of surprises you when you're reading them.