Fed Holds Rates — Inflation Back in Focus

0:00Today's number, four. That's how many years some octopus mothers will go without food while they guard their eggs from predators. Scientists have described these maternal instincts as an inspiration. However, Brooklyn Beckham believes they're doing too much. Money market's mad. If money is evil, then that building is hell. The show goes on! The folks are never watched and so, so! Welcome to Prof G Markets. I'm Ed Elson. It is January 29th. Let's check in on yesterday's market vitals. The S &P 500 hit 7 ,000 for the first time ever to start the day. Still, all three major indices ended the day flat after the Fed's interest rate decision.

0:47More on that in a minute. Meanwhile, the yield on 10-year treasuries increased. Oil climbed after President Trump warned Iran that a, quote, massive armada is ready for violence. And Tesla stock rose after hours as the company posted a better than expected fourth quarter report. However, revenue for the full year dropped the first time in company history. OK, what else is happening? The Federal Reserve is holding rates steady after three consecutive cuts last year. The central bank explained that unemployment is showing, quote, some signs of stabilization, while inflation remains, quote, somewhat elevated.

1:24In his remarks, Chair Powell said that the outlook for economic activity has, quote, clearly improved since the last meeting, and that should matter for labor demand and employment over time. Meanwhile, two governors, Stephen Myron and Christopher Waller, dissented. They voted in favor of a quarter point cut. Stocks wavered after the decision to hold, pulling back from a record high earlier in the session. OK, here to discuss this Fed decision and what it might mean for markets. was speaking with Michael Gapin, Managing Director and Chief U.S. Economist at Morgan Stanley. Michael, thank you very much for joining us on ProfG Markets.

1:59Thanks for having me on. So this Fed decision, the Fed held steady pretty much as expected. There was some dissent from Stephen Myron, from Christopher Waller. Let's just start with your initial reactions. Did anything jump out to you from this Fed meeting? Well, as you noted, the decision to stay on hold was widely expected. That was no surprise. And so I think what markets and I was looking for really was, is the Fed, have they paused or are they on pause, right? In other words, was this a hawkish hold, meaning they want to signal that they will be on hold for a long time. They don't anticipate adjusting the policy rate for a long time.

2:42or was it, hey, things look a little bit better, but we think as inflation comes down, we might ease later, right? Did they maintain an easing bias, right? So that was really the key, I think, for all of us and markets and what I was looking for. Was it a hawkish hold or a dovish hold? And I think we did get the latter. So the Fed certainly felt like the economy has gotten better. There are some signs that the labor market has stabilized. there doesn't appear to be a lot of upside risk to inflation so given that they had already moved 75 basis points or cut three times i think they felt like it was time to stop look around and see how the economy evolved what does that mean for uh rate hikes or rate cuts moving forward and what does that mean for the battle between uh donald trump and and jerome powell of course the president has been pushing for rates to come down.

3:38How does this change things, if at all? Well, I think the way that I would describe it is coming into the second half of last year, the Fed was cutting rates on concerns about the labor market. The Fed felt there were downside risks to employment. So they were labor market-based cuts. But if they've upgraded the outlook, they say activity is solid. I think that's hard to deny that. And they said the The labor market is showing signs of stabilization. So I think what that means is cuts shift to inflation-based cuts. In other words, when it's clear, if they're right, that tariffs only inject temporary upward pressure on inflation.

4:18And once that pass-through is completed, inflation starts coming back down, then the Fed can normalize its policy stance further. So I would describe it as a shift from labor market-based cuts to an outlook of inflation-based cuts. So what would mean the Fed doesn't cut is that disinflation doesn't happen. Or if inflation firms further and the labor market tightens, then maybe the Fed has to even consider rate hikes. But I think Powell made it pretty clear. He said nobody is considering, at least it's not in anyone's baseline case, that there should be rate hikes. So I think in some ways the Fed is still kind of cutting off the upper end of the policy rate distribution.

5:02and saying we're either on hold for a prolonged period or inflation will decelerate and we can move our policy rate lower. As you pointed out, the administration would clearly prefer lower interest rates. So what they want may come later. But I think the Fed sees the economy as warranting lower rates, but it may take more time to get there. If it's all about inflation now, or mostly about inflation, as you say, uh what is the fed's view of what we're seeing um with inflation right now because you know it's it's still pretty high the target is two uh we're at 2.7 although there are questions over whether that 2.7 number is accurate given the the shutdown that we had in the government so i guess the question being what does jerome powell think about inflation right now does it appear to be a real concern.

5:57I would say with each passing month, they have greater confidence that inflation will be coming down later this year. So the way that he's talking about it is, yes, there's clear evidence that tariffs are pushing goods prices higher, not meaningfully higher from the Fed's perspective, but certainly they're moving higher. And that's something to watch. But there are other goods prices which are not as exposed to tariffs. those aren't moving higher. And he said services inflation, which is mostly about domestically generated inflation, that that's decelerating. So they look at it, and I think they say outside of tariffs, it looks like inflation is decelerating towards their target.

6:42So once we get through with the pass-through, then goods prices can start to come down as well or at least stop rising. And so they have a pretty favorable outlook. So I think it's more like a matter of time for them. how quick, how long does the pass-through last? And then how quick does inflation decelerate after? But a year ago, it was almost a year ago, right? After Liberation Day, very different story, right? They were very concerned about upside risk to inflation and inflation firming well above the target. Yes. And I think as time has gone on, they've been able to see what part of inflation is linked to tariffs, what's happening there.

7:23okay, it's moving higher a little bit, but the rest of inflation still looks good. In other words, no second round effects on inflation. So I think their view is about as confident as you can get given the overall backdrop. There are some other questions I have, but I'm just interested on your perspective on that view because, you know, as an observer, if the target is 2 % and they're indicating that they're comfortable with 2.7 and yet, as I've said, you know, there are third-party sources saying the number is actually higher given the shutdown and the lack of data that we've seen after the month of October that we've seen from the BLS, I guess I'm surprised that there is a sense of comfort with that number or that that is a reason to not worry so much?

8:17I mean, it seems that the 2 % number, the target has perhaps been abandoned or at least they don't really believe that that is the true target. What would you say to that? So I think it's fair to still have concerns and I think it's right to point to the fact that we don't have the entire picture on inflation. There's probably some catch-up still to be had in the January data and certainly even into next April. That's a legacy of the shutdown and the inability of the BLS to sample prices when they need to. So there is probably some makeup effect there. So I think we shouldn't be so quick to declare victory on inflation.

9:00I generally agree with the Fed's view, but what I would say is we should really have a watchful eye. Inflation has been above or well above the Fed's 2 % target now going on five years. How long can that happen? And inflation expectations still remain stable, consistent and low. So if that market slips, if inflation slips and inflation expectations slip, getting that realigned would be costly in terms of economic output and perhaps unemployment. unemployment. So I think the Fed's right. And I think the way they would answer this question, and I will answer this question, is that's why they're keeping their policy rate at least modestly restrictive.

9:43Yes. So yes, they reduced policy rates, but they didn't get policy outright easy. They made it less restrictive. So they've left it a little restrictive, and they think that balances the pressures they're getting on inflation now versus the softness they were seeing in the labor market. Of course, we'll see if that's true. But that's the way I think they would answer it. Hey, we're not even neutral. We're not even easy. We're still restrictive on balance. And that should help guarantee that tariff pass through is transitory. Along these lines, more macro, another topic that's been making headlines this week is the the devaluation of the dollar.

10:27The dollar fell to its lowest level in four years on Tuesday. Meanwhile, the massive run-up in gold. And a lot of people, I can't tell how much of it is real, but a lot of people are talking about the debasement trade, the devaluation of the dollar, the unsustainable deficits and debts, which Jerome Powell discussed. And in concert with the massive rise in gold, it does appear that perhaps there is this kind of wholesale mistrust in U.S. currency at this point. And Powell's response to what we've seen with gold, he said, quote, we don't take a strong signal from rising gold prices, which I found interesting.

11:08I noticed a lot of people are talking about that and saying, well, maybe you should care about gold prices. I just wanted to get your views on what we've seen with gold this week and also Jerome Powell's response. Well, I think the way the Fed would view it is that we're linking dollar policy and gold policy, or at least dollar movements and gold movements together. The Fed doesn't set its policy rate to target the currency, right? So it will respond to fluctuations in the currency and what that might mean about growth and net trade or inflation. But it doesn't make dollar policy, right? Other central banks, it's different.

11:48Primarily in the emerging market world. you may actually set interest rates to help guide the currency because that generates a lot of inflation, right? The tradable sector is much more important. So I think what Powell was saying is, look, dollar policy and de facto then, if gold is representing sustainability concerns, both of those are really Treasury policy. And so we're not supposed to comment. And there's a long history of that in terms of the division between the two institutions. But that said, let's put that aside to the premise of your question. Right. There's a lot of concern out there.

12:26Let's say there's a laundry list of concerns that all end up looking like greater country risk for the United States. So whether it's concerns about an unsustainable fiscal profile, concerns about U.S. policymaking broadly and whether it's trade disconnections or geopolitical disconnections, right, there's a lot of concern about where U.S. policy is going. The rest of the world holds a tremendous amount of U.S. dollar-based assets. It's about$62 trillion that the rest of the world holds in U.S. dollar assets, whether that's direct holdings of U.S. corporates or bonds or equities or money markets.

13:13And so there's really no asset class where the rest of the world can say, well, we don't want dollar assets anymore. We're going to sell 62 trillion and move them over here, right? There is no other market to rebalance to. So what we think is happening is that means, well, I still have to hold dollar-based assets. The question is, at what price and how do I hedge them? So the dollar gets a lot of that expression, as we would say, in markets. The escape valve for pressure and concerns about U.S. policymaking, whether it's the debt profile or geopolitical or otherwise, all of that is getting reflected in the dollar.

13:54So there's a number of factors that are causing dollar volatility. And yes, usually officials, whether it's the Treasury or the Fed, will get worried about rapid movements in currency markets. And we did kind of get that this week. And we had comments by Treasury Secretary Besant today, no, we're not intervening in favor of a weaker dollar. So sometimes policymakers do have to step up to at least stabilize the situation and reduce volatility. But I would expect that these dollar concerns will be with us for some time. And to your point, concerns about debasement of fiat currencies, and therefore that may drive demand at certain points in time for things like crypto, Bitcoin, and gold.

14:38What did you make of the president's response to these concerns? I mean, he made a lot of headlines. He said, I'm not too worried about it. He said, you know, he said this comment about the dollar goes up, it goes down, it's like a yo-yo. So a lot of conclusions I think people are trying to draw out of perhaps not that meaningful words. He's just, you know, talking to a reporter. But I'd be interested to hear your response to that. I think the takeaway for a lot of people is this is a big deal. And it sounds like from what you're saying, it is a big deal. And yet the president is saying, don't worry about it.

15:13It goes up, it goes down. Well, I think it's akin to what Treasury Secretary Besson said in the sense of, hey, we're going to at least come to you in the moment. without expressing too much concern. We've got a handle on the situation. I would agree with you. I wouldn't read too much into those comments. And I would just read the totality of the administration's response to it, including what Secretary Besant said. So that said, I think what the market is concerned about is if you go all the way back to the Mar-a-Lago Accord, which was viewed as generally an expression of the administration's intent on economic and trade policy, there is a lot in that document about an overvalued currency and the negative effects that that has had on, say, U.S.

16:09manufacturing employment and the outsourcing of activity outside the U.S. So I think investors come to the table in this discussion thinking the administration wants a weaker dollar. So they're probing, is this what you want? Is this what you wanted? And so that's where I kind of think that therefore they're hypersensitive to anything that the president or the treasury secretary would say around this issue. One last question. We'll let you go. The Fed chair is, or the new Fed chair is an open question. We thought it was going to be one of the Kevins. Now it appears it's going to be Rick Reader, or at least his chances have gone up If we look at the prediction markets, he's at 46 % probability at the moment.

16:54Do you have any thoughts on who the next Fed chair might be and perhaps how much it matters? So I have a stronger view on maybe who it's not than who it will be of the remaining three. That works. I do think that the timing of the DOJ subpoena served to the Fed has certainly helped, I think, reduce the likelihood that Kevin Hassett will be the chosen one. And Trump's remarks saying, I'd prefer to keep you where you are, I think foreshadows that a bit. So maybe it was the Senate's way of saying, not this person given the risks to the institution. So that leaves Rick Reeder, Kevin Worsh, and Governor Chris Waller.

17:40I mean, Rick Reeder, to your question, he's been in financial markets for about 35 years. So he has a deep, extensive knowledge about how financial markets work. That's important, of course, because Fed policy is transmitted to the economy through financial markets. Now, some will say, oh, but, you know, Rick Reeder isn't a PhD economist. And my response to that will be, well, neither is Jerome Powell. And it's really not the job of the chair to necessarily be the best economist in the room. The job of the chair is to help build a consensus, to manage the committee, to herd the caps, and communicate to financial markets and the broader public.

18:23Rick is certainly capable of doing that. So I think whether it's Rick Reader or Kevin Warsh or Chris Waller, I think they're all capable to do the job. And I would just say recent events tell me more about who it's not going to be than who it will be. So no strong view for me. Betting markets, of course, have their view. We'll see what the president chooses. Michael Gapin, Managing Director and Chief U.S. Economist at Morgan Stanley. Michael, this was extremely informative. Thank you so much. Thank you. After the break, Meta and Microsoft report earnings. And for even more insights, you can also subscribe to my weekly newsletter at edwardelson.substack.com.

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21:52We're back with ProfG Markets. Meta and Microsoft both reported earnings and both were a beat. Microsoft's revenue increased 17 % year over year. However, Cloud growth was slightly lower than the previous quarter and investors were not impressed by that. Stock actually fell as much as 5 % after hours. Meanwhile, Meta's fourth quarter sales rose 24 % from a year earlier. The company also issued stronger than expected sales guidance for the current quarter. That sent the stock up as much as 10 % after hours. Here to help us break down these earnings, we're speaking with Gil Luria, head of technology research at DA Davidson.

22:31Gil, welcome back to Profit Markets. Thanks for having me back. We just got these earnings from Meta and Microsoft. I think we should probably start with Microsoft here, beat on the top and bottom lines, but stock is falling as much as 5 % in after hours. What did you make of the quarter? And what do you make of the market's reaction to the quarter? It was a small beat. I think the aftermarket activity is a little bit of investors being picky about Azure growth. They wanted 39 % growth and they got 38 % growth. Having said that, just a few seconds ago, they guided that next quarter will be a 37 % to 38 % growth.

23:12So I think investors will be able to relax a little bit, especially when they realize that some of the other numbers they reported, like remaining performance obligations for this year, are also up 39%, which is to say the growth of Azure this year is already in the books. So they're in very good shape. I believe that by the time investors fully digest these results, they'll realize Microsoft is still doing great. Let's not forget that 38 % compares to 32 % at Google Cloud and low 20 % at AWS and Amazon. So Microsoft is still doing the best of all the large cloud providers. And again, we now know that that's going to be the case for the rest of the year.

23:58Let's just touch on their remaining performance obligations here. up. But something that stuck out to me, 45 % of those remaining performance obligations are coming from open AI. This is something that you and I have discussed many times. Can you trust that? It seems like investors don't trust it, at least based on the initial reaction from the markets. What do you make of the fact that 45 % of the revenue to come is coming from this company that we've discussed we can't really trust. The next couple of months are going to be critical from the open AI perspective. Open AI is out in the market trying to raise capital.

24:39If they can raise the$50 billion they're aiming for, they have somewhere between$20 and$40 billion on the balance sheet. If they can raise the$50 billion, they'll be fine. And even if they raise less than that, what's different about Microsoft and the discussions we've had about Oracle or CoreWeaver AMD is that Microsoft is front of the line. any dollar that OpenAI gets, Microsoft has first claim to it. Not only is it an investor, it's also the primary compute provider to OpenAI. So even if we're in a scenario where OpenAI has to scale down significantly and may not be able to pay Oracle or CoreWeave or AMD, it'll pay its Microsoft bills.

25:23So that makes us feel better about that. But clearly it's a huge part of Azure's growth and it's the use of chat GPT. We're all using chat GPT more and that's the piece of the business that Microsoft will continue to have. The more speculative parts is if OpenAI comes back to us and raises$100 billion, then everybody's dreams can come true. Moving on to Meta, I think the thing that jumped out to me and I'd like to get your reaction is the CapEx guidance. they're guiding 115 to 135 billion dollars in capex in 2026. I guess what is striking to me last year they made that a similar announcement we're going to spend a lot of money markets didn't like it they're saying the same thing markets do like it what did you what did you make of the reaction that core meta selling ads business is doing so well investors are willing to give Mr.

26:23Zuckerberg a pass. He's still growing that ads business in the mid-20s, 24, 25%, which is remarkable at this scale. By the way, it's twice as fast as Google is growing its ad market, which tells you Meta is a significant share gainer, which just gives Mr. Zuckerberg a free pass to do whatever he wants. Right. Because let's not forget, the numbers you just talked about are pretty comparable to Microsoft. Microsoft turns around and sells that entire capacity to paying customers. Meta only uses a fraction of that capacity to make ads better and sell ads for more. The rest is just a sandbox to build new models that he's not even sure what he's going to use them for.

27:09He got asked a couple of times on the conference call, what's this even for? And he said, you know, this isn't a good time to ask me about that. Ask me about that later. People are okay with it. The growth in that ad business, what's the story there? Is that people using meta apps more? Is that more users? Is that higher CPMs on advertising? Is it all of the above? I mean, what's the story behind the more than 20 % growth in that ad business, which is already gigantic? Well, it's all of the above. They're selling double digits more ads for double digits higher prices. And to be fair to them, in terms of AI investment, it's because they're so good at AI.

27:52Our algorithms for feeding for our feed are getting so much better. And the algorithms for predicting what ads we're going to click on are so much better that they can drive that kind of remarkable growth. Again, that doesn't mean they need$125 billion of CapEx to do that. They only need a fraction of that. But they are getting so good at using AI to make our feeds more compelling, more organic content, more original content, more domestic content, more content that we find compelling, that it's helping them sell a lot more ads for a lot higher prices. Just looking at the valuations here, Microsoft trailing PE of 34, Meta trailing PE of 29, coming up on 30.

28:34Do you have any views on the valuations of these companies at this point? Does this change your view in any capacity? So Microsoft is trading at a discounted historical trading rate. It's usually trading between 25 and 35 times forward PE. Right now, as of after the market, it's around 26 times, so on the lower end. Meta tends to trade at the low 20s, which is where it's at right now. But what's interesting to know is that Google is trading in the high 20s on PE, where their historical range is more in the low 20s. And that's in spite of the two things that I pointed out. Microsoft Azure growing faster than Google Cloud.