Is the Fed Driving the Economy Off a Cliff? ft. Komal Sri-Kumar

31:16That's the reason why inflation is persisting. I'm going to extend your viewers' question one further step. The Fed is acting in the current manner because they don't really have to care about the lower-income people. They're not there. They don't talk to them very much. They're not the one appealing to the Fed. And the higher-income groups are cheering them on because the risk-asset prices are rising. Stock market is doing well. Thank you, Mr. Chairman. and you, this is your reason why I'm feeling wealthier than I was a year ago. And isn't inflation going up? Is the price of milk going up and eggs going up?

31:56Hey, I have hundreds of millions of dollars of net worth. Do you think I worry about the price of milk? That is somebody else's problem. We are much better off with financial assets rising in valuation. So that, I think, is the reason why, again, the viewer asked about the common person's expectation. They are unlikely to be met in next week's meeting. Sri, here's another question, and interestingly enough, something that I was going to ask you about. This comes to us from Ben B., who wants to know, do the recent revisions to jobs data change interpretation of the overall macro environment? This is something that got a lot of buzz at the end of last month, I guess, August 21st.

32:42These numbers came out and we saw a significant downward revision in jobs data, some 800 ,000. I think a lot of folks who don't follow data as closely saw that number and said, well, gosh, I mean, if you overstated by almost a million jobs, how accurate is the data collection? Lots of questions swirling around that. How do you think about that revision to that number? Clearly, we are not putting enough resources into accurate measurement, ASH, and that really is a tragedy. How can you come forth and say that the numbers are not being revised a little bit, but we are revising them down by about 800 ,000 jobs, which is a huge amount to do that over a year?

33:30that is an issue which is very difficult for the Bureau of Labor Statistics to deal with needs to improve that failing that we don't have an alternative so do we know again because I'm hearing that even though the 800 ,000 downward move in revision is what is being done that may or may not apply to all the months going back. It may be particular months that may be in difficulty of measurement. So when you take all of that into account, it is not clear how much the revisions are. And if the revisions are themselves going to be revised again soon, and you may find out they did not overestimate the jobs by 800 ,000, but they overestimated only by pick a number, 100 ,000.

34:23So I think, one, it is awful that we have this problem to deal with, but I don't have any ready remedy because we all work with the data that we have in hand. And when they are so inaccurate, we are all in trouble. Sri, what's the challenge? What's happening over there? I've spoken to Bureau of Labor Statistics economists in the Department of Labor, and they seem as though they are obviously trying to do the right thing. I know there's been a lot of kind of conspiracy theories around this, but what's the challenge? Are they just under-resourced? Do they just not have the resources they need to do the job they want to do?

35:03I think that is the case. I don't believe in conspiracies there. I think the team is essentially apolitical in terms of their approach. They are not one party or the other party. But where the issue comes is they are under-resourced. They are probably not well-paid. And if you are very skilled, you probably will not work there. And you will try to get a job in the private sector based on the experience you got at the Bureau of Labor Statistics. So I think resources need to be devoted to improving the quality. You need quality check more frequently so that when the number comes out, they get to be as close to accurate as possible.

35:46It bothers me not only that we had the 800 ,000 revision ASH over the past year or so, but also in the last two to three months, the numbers have been revised down substantially, which again means that when the number comes out, the labor market comes out at the beginning of the month, four or five days into the new month, the market reacts that Friday quite significantly. But you may find out a month or two later that your reaction was inappropriate because the whole thing was wrong and it is being revised from, say, 100 ,000 up to 100 ,000 down. Then what do you do? The markets don't, again, react to it.

36:29The initial reaction was false positive. But that's what we have to go with. So I think, again, first of all, I don't think there's a conspiracy here. but I do think there is a lack of skill, a lack of ability. And one of the things I think about, since I think about the economy globally, my model on that is the government officials in Singapore, who, again, they are famous for the fact that they are paid extremely well in terms of comparison with the private sector, meaning that you can earn the equivalent of hundreds of thousands of U.S. dollars working in a mid-level position in the government.

37:14So what does that mean? It attracts the best labor, the highest skills to come into work. And working for the government is comparable in scale with what you can get in the private sector. But here we have a big gulf between what the government pays you compared with what you can get in the private sector. And you're not going to attract the best talent. So that, I think, is the reason for what we are going through. I mean, it's really hard to overstate the importance of these data points and the way that they get used by the Fed to determine these absolutely critical metrics for U.S. monetary policy that have just massive, massive impact throughout the economy.

37:57I mean, it really does make you kind of scratch your head. And, you know, look, I've spoken to these folks maybe a couple of times back when I was a CNBC reporter, and they always seemed incredibly diligent, like they were really focused on trying to do the right thing. But if you just don't have the resources, the data collection resources, whatever other resources you need, it is just such a, it seems like an underreported story that, man, this is really quite significant. Absolutely. It is very significant. You simply cannot overestimate the problem. The problem is very large and something needs to be done very quickly about it.

38:32And again, I haven't heard anything being done to remedy it, but we do have a big issue. Here's another question from Paul E., who wants to know, would either presidential candidate, if elected, be a positive influence on the U.S. economy? Again, the two main candidates who are there, we don't know what specifically their policies are going to be, essentially because both of them are electioneering. And tonight we have the debate coming up. We may get a little bit more clarity, but I doubt it because I think they'll be playing to the audience. And what you see from either candidate tonight is not what he or she will do as president starting next January.

39:23Now, what I think is very important for them to do, but they will not do tonight, is to explain what they are going to do with the fiscal deficit. Normally, the fiscal deficit increases during a recession, comes down during an economic recovery, and that is the Keynesian stimulus and cutback that exists. And that usually is automatic and self-correcting. Here, we have had the fiscal deficit increase both in dollar terms as well as a percentage of GDP, and that is taking place even during the U.S. economic recovery. So what's going to happen during a recession if you haven't managed to control your deficit?

40:09So that's something first that they have to do. The estimates that have been made suggest that both Kamala Harris presidency and a Donald Trump presidency are both going to contribute to much bigger fiscal deficits. So the first thing that either would have to do is to recognize that higher fiscal deficit is a danger. It is a threat. And to be able to say what steps they are going to take to bring the fiscal deficit down and make the situation more conducive to steady economic growth. That would be the first part. The second part is in terms of improvement of the labor force competitiveness on the global scale.

40:57You can't just do it by imposing tariffs, as, again, Donald Trump has said ahead of the elections. That is going to cause inflation to pick up. And that is going to cause, again, trade ruptures with both allies and competing countries. You need to find a way of improving the labor productivity improvement there rather than focus on tariffs. Those would be two major areas I would look at that the new president would have to focus on. Well, Sri, for those who don't have gray hairs like we do, there actually was a time when there were deficit hawks in American electoral system. That just seems to have disappeared.

41:42Yeah, absolutely. Go ahead. Sorry. No, no. It's just something we haven't heard. Yeah, we haven't heard that. And along with the deficit hawks, Ash, we used to have somebody who used to be called the bond vigilantes, who when the deficit increased significantly, they would sell the treasuries, make the yields go up. And that was a signal to the authorities that they were essentially, they had to do something about it. but you wonder what has happened to the bond vigilantes because the 10-year yield, as you pointed out in your chart, has come down substantially. And the two-year yield has dropped even more since the beginning of the year, so much so that in the last few days, the 2 to 10 yield curve, which had inverted for more than two years, is finally positive again.

42:36All of that suggests to me that even the two-year paper holders are essentially anticipating the Fed to be very easy in the future policy. And there is no sign of a deficit hawk showing up anywhere in the picture. Yeah, 2-10 spread has disinverted my new favorite vocabulary word of the month. It's now three basis points positive. You mentioned U.S. Treasury yields. I think we have a chart of that going from over 5.2%, I believe, at peak, trailing 12 months in, looks like, October of 2023, down to where we are right now, 363 basis points. Big, big moves in two-year yield. And there it is. There's the chart.

43:26Exactly. And the reason that has come down is because in the world today, there is, I mean, securities, there is no alternative to U.S. treasuries. We all thought Chinese renminbi-denominated bonds would become a competitor. Hardly. China is in very severe economic trouble at the moment. We thought the eurozone would come together. and Mario Draghi, the former head of the European Central Bank, made his recommendation yesterday that the ECB issue more common bonds to improve the competitiveness with respect to the United States, Japan, and China. And Germany is opposed to it. You need those to happen.

44:11If they were to do that, then European paper will become a competitor to U.S. treasuries, and then the U.S. treasury and the bond vigilantes will come out again in force to enforce discipline on the U.S. side, but you don't have it. So what is the alternative that you have today? Gold. Look at the price of gold, how much it has surged since the beginning of 2024. And that says to me that the investors are saying all central banks are, again, running amok. cutting interest rates. So we need protection against inflation. We, all of us global investors and debt holders, what we are going to do then is to switch over to gold.

45:00And that is the reason why the gold prices increased so substantially. Yeah,$2 ,500, almost$39 on my screen right now, up approximately 70 % trailing five years, big, big moves in gold. Right. And up just this year from around 2000 to over 2 ,500, all happened in calendar year 2024. Yeah, trailing 12 months up almost 31%, year to date up about 22.5%. Big. These are big moves in gold if you don't follow the gold markets. Yeah, I think there, again, going back to your deficit hawk question, Ash, I think the markets began by saying we will give the U.S. authorities a break. We don't have to switch over to gold right now.

45:51We may have a future in U.S. treasuries. We may have a future believing the U.S. fiscal authorities. What it says to me since the beginning of this year is the fact that the gold holders have given up any hope of the U.S. authorities becoming more disciplined, and they have switched over all-time high to move into gold. Times like this, we miss the great Pete Peterson. Exactly. Exactly. Here's a question that comes to us from C.H. Ed. And the question is, what are Sri's views on whether the Fed will also announce the ending of QT, quantitative tightening, in addition to the 25 basis point cut next week?

46:40Hearing that this QT ending may be a nice surprise for markets, he asks as a question. And by the way, we should just show on the screen the total assets of the Fed. Important chart for you to see visually just to get a sense of how fast, how much the Fed balance sheet has expanded since the global financial crisis of 2008. Yeah, no, that's a great chart and a great question. Again, to remind viewers where we were, on what I call Lehman Day, September 15, 2008, the Fed's balance sheet was$800 billion, roughly speaking. At the beginning of 2020, meaning just before we recognized COVID, the Fed's balance sheet had already increased to$4 trillion, five times as much.

47:38Keep in mind that Ben Bernanke told us that quantitative easing was a temporary measure. Temporary? Really? 2008 to 2020 increases five times and it's a temporary move. When am I going to go back to the old level? Never. It was temporary in the sense that it doubled again. It doubled again in two years. Went from$4 trillion to almost$9 trillion. and right now we are running at slightly over$7 trillion. Look at it another way. We used to be less than 15 % of GDP, the Fed's balance sheet, divided by the gross domestic product, but that more than doubled since then. So if you think you need to create more cash in terms of reacting to a growing economy, you have also increased the size of the central bank relative to the size of the economy.

48:39And the question is, I don't even want you to go back to$4 trillion, let alone$800 billion again, but I want you to at least go back to the early 2020 balance sheet divided by GDP ratio, which I don't think is going to happen. And that says to me that quantitative tightening is badly needed. Having said that, the figure you come to is what happened in September of 2019 when we had a money market problem, short-term interest rates surged, and the Fed immediately recalled that they went from quantitative tightening to quantitative easing overnight. And within the next three or four months, they had taken the balance sheet up to the November 2018 level.

49:34So in other words, we had lost about one year's worth of quantitative easing because that happened. Right now, the Fed is concerned still of that recurring, that happening. So when is quantitative tightening going to be stopped? I would say two possibilities rather than give a date. I would say if you have the slightest indication of a repeat of the money market problems, expect quantitative tightening to come to an end with the Federal Reserve balance sheet still somewhere in the$7 trillion level. The second is the Fed has reduced the amount of quantitative tightening over the past year. That means even though the quantitative tightening has not reached its objective, they are doing it at a much slower pace than they did before.

50:26And that also says to me that Fed is getting ready to stop it at some point, just declare victory and walk away. If you don't win a war, the best thing you can do is to declare victory so that nobody again complains about you after that. Let's just take a look at this on the screen. If we could just take a look at that chart one more time so people can visualize what you're saying there. If this is that gray bar, that very thin gray bar on the right side of your screen is the COVID recession. Obviously, it was a short but incredibly, incredibly steep recession. What we're talking about now is that little roll off that you see.

51:06Obviously, when you look at this chart from call it January of 2020, you see it at around$4 trillion. You see it maxing out at around$9 trillion. This quantitative tightening is the rolldown from that peak in July of 2022, around$9 trillion on the Fed balance sheet, down to where we are right now at around$7 trillion as of August of 2024. That's what you're seeing on that chart. Those are big numbers. enormous numbers. And as you point out, and I think one of the challenges when you talk about numbers this big is that it just, it sort of fries people's brains who don't spend their days in economics.

51:49But I think it's really important when you talk about the size of the Fed balance sheet relative to GDP, when you have a larger and larger percentage of the U.S. economy essentially existing on the balance sheet at the U.S. Federal Reserve, obviously challenges in terms of the broader economy. Yeah, very much so. By the way, I really loved your reference to Senator George Akin from Vermont, whose solution to the Vietnam quagmire at the time was just declare victory and go home. I mean, it's a dangerous thing, I guess, for a central bank to do. Yeah, it is a dangerous thing to do, but then the central bank exists to perpetuate itself.

52:31In my mind, that is the ultimate objective. So if you declare victory and you get enough people to believe that you have won, then you have another life and you can go on. One of the ways, again, that I have suggested to avoid this, we talked a lot about the Federal Reserve, ASH, and my recommendation, which again, until today has not been listened to, and I don't expect it will be listened to anytime in the near future, but I will make it anyway, that the Federal Reserve, despite what they say of being politically independent, I consider that very much a political entity. And one, essentially, even though the Fed chairman's term doesn't end at the same time as the president of the country, his or her term ends the year after.

53:23In the case of Jerome Powell, it ends in 2026. May is the end of the chairmanship of Mr. Powell. My suggestion has been that instead of the usual four-year term that you have for the Fed chairman, that you have a single six-year term and not renewable. So you are nominated as the Fed chairman for six years, not four years. And then you cannot be renominated. So you don't have to play political games in terms of policy. You are more likely to focus on inflation and employment. So that's what they ought to be doing. But that's not going to happen. Sri, how about this for a T-shirt idea? Declare victory and implement the Taylor.

54:11Absolutely. That would be a great T-shirt. The front and back of the T-shirt. And the 150 people who would buy it are all watching live. Very good. Good to hear. Sri, these conversations are always our favorites of the month. And I know that our viewers, I can see it by the flow of questions, feel the same way. We've covered, obviously, a lot of different topics here. As we come to the conclusion of this conversation, let me just ask you again, And based on the trajectory of everything you see, what are your expectations for the next six to 12 months in terms of Federal Reserve policy, in terms of the broader economy, and in terms of risk asset prices in the U.S.

54:58and abroad? Federal Reserve policy, I expect continued cuts in interest rates starting with next week. and the question is only going to be how rapidly they go, how far down do they go. Let's say now they are five and a quarter to five and a half. Let's say that they are at 535 to pick a number as today's rate. And it goes down to more like 3 % to 3.5 % in the next year and a half. That is what happens on that side. And on the risk asset prices, because of the sharp up and down of the interest rates, I do expect some kind of a credit event to take place. I've been talking about it for a while.

55:50Where does it come from? On the banking side, possibly. Again, a repeat, but this time not just smaller banks, but medium-sized, one or two medium-sized banks as well, which suffer a deposit flight. And the Fed is forced to intervene and cut interest rates in a hurry. In which case, immediately risk asset prices come down, but then they go up again. So if you were to tell me, take a photo shot today and compare it with where the risk asset prices will be a year and a half from now, I would probably say higher. But in between, you're going to have a dip, big dip, and the Federal Reserve eases, and then you go up again.

56:35Think about the change from September 2008 to March of 2009 on the S &P 500. The S &P 500 crashes after Lehman Brothers' failure, but March of 2009 was a low point, and then with the Fed stimulating, you went up again. Those would be the two expectations for interest rates, for Federal Reserve policy. The economy, there might be very well a potential for a recession. Look at what happened to the 2 to 10 yield curve, and that tells you a story. Even though it has been inverted for a long, long time, usually the inversion lasts about a year to 15 months. This time, we have lasted about two years and two months.

57:23But the more important thing to note, Ash, is when that reinverts or disinverts whatever expression you want to use and it goes positive again, that is when the recession hits. And look at 2007, 2008. It went from being negative to positive around November, December of 2007. and the National Bureau of Economic Research has told us that the Great Recession began in December of 2007. So this could be a mild one. Just watch out for that. So the steepening of the yield curve doesn't mean it is Hallelujah Day for you. It only says that following the usual pattern, this may be where the recession is happening.

58:14So if that were the case, a year and a half from now, since we are looking at that as a target date, you're probably out of a recession and you are in recovery. So interest rates much lower than where they are today. Risk assets take a big dip and then go up again. The economy, a recession, either mild or severe. But a year and a half from now, we are in recovery mode. and that would be my indication that you should go in for risk assets if you have a longer term time horizon.

58:52Really interesting. Sri, I just want to follow up on one point that you made earlier. You mentioned the words credit event. My ears pricked up when you said that. I think you were on in 2023 during the period where we had a little mini contagion, I guess, in some of the West Coast banks, Silicon Valley Bank, some of the others that are no longer with us today, Silvergate, First Republic. There was this moment where there was real anxiety about what was going to happen in the banking system. It seemed to be quelled by action from federal authorities. And then we haven't heard much about it. It hasn't seemed to be on most people's radar.

59:32You mentioned some of the, and I think it's such an important point, some of the sort of the organic shift that we're seeing in demand for commercial real estate. I, like most people, don't have an office to go into any longer. This is just the way the world works. You take the train into Midtown Manhattan and you see those office towers and you wonder about the occupancy rates in those buildings. Just talk a little bit about this point because Because the credit event risk, I think, is always the black swan that seems to be hovering on the horizon. The credit event can, in my mind anyway, I have two major candidates where it can emanate from.

1:00:14The first one, as you mentioned, and let's start off from there, commercial real estate and the fact that you have a situation with much higher interest rates compared with three years ago at the same time, as you mentioned, you and I not going to our offices and sitting at our homes and doing the work, much lower occupancy rate. So both of them come at the same time, and the real estate developers and the banks are hit from two different sources. Now, that could be one way it shows up. We did not show up in 2023 because until then, we had what is then called as the extend and pretend. The banks were able to extend it into 2024.

1:01:04They were able to tell you, I gave you a two-year loan. I'm going to make it into a four-year loan. So you didn't have to repay me after all. You can repay me after the next two or three years. Therefore, you are not in default and I don't have to declare that my loan is impaired to you. So the reason why that is failing or going to fail is that since the beginning of 2024, Ash, the number of transactions in the secondary market has increased significantly. In other words, I bought a building for$100 million in pick a date, June of 2019. So that let's say pre-COVID high. And that building I bought for$100 million, I kept thinking it'll go back to that price, but it doesn't.

1:01:56And if today I were to sell it to somebody else for$40 million, taking a 60 % hit, and some of those have happened in key cities. It has happened in Los Angeles, San Francisco, New York. These are three places where the discounts are quite large. If you sell the building at a huge discount, and many of you do that, I am holding on to a building still valued at$100 million. I can no longer extend and pretend that it is worth$100 million. dollars. The comparison I would give you is the fact that I started my career with Latin American debt in the 1979-80. And for many, many years, with the connivance of the U.S.

1:02:44Treasury and the Federal Reserve, the largest U.S. banks considered their loans to Mexico, Brazil, Argentina, all at being at par, even though those countries were not able to make interest payments. What essentially brought this whole charade to an end is the fact that there were lots of secondary market trades of the debt, and they were trading at 40 or 50 cents on the dollar, and the banks could no longer pretend that the loan to Mexico is still worth 100 cents on the dollar. That's the same phenomenon I anticipate with respect to office space in the United States, that somebody would come and bring reality into it and say, you can't value it at par, you have to value it at a discount.

1:03:37And that again causes a few institutions not to be able to take that hit. And that is where one credit even can come from. Second, related to it, the smaller and medium-sized banks are the big lenders to commercial real estate as a percentage of total assets. It's not the largest banks that are the big lenders, but the smaller banks who are the lenders. So that is where you see the problem going from commercial real estate to bank viability. And that is the second area where it's going to come from. Third, the banks believed Jerome Powell when he said inflation is transitory in 2020, 2021. So what did it tell you?

1:04:29If you bought 10-year treasuries at 2 % at the beginning of 2021, you thought that by the end of 2021, 2022, if you bought it at 1%, it is going to go down lower in yield and you're going to make a big capital gain. Instead, it went the wrong way. The yields went up, you lost a lot of money. And that is part of the problem the banks are running and the bank assets, a significant chunk are still underwater. And when they start to recognize it, and if there is another deposit flight from some institutions, that is going to cause the Fed to intervene. And that is, again, another area for a credit event to take place.

1:05:13Sri, this is such a big and important topic. There's only one thing to do. We've got to have you back to talk more about some of the underlying risks in the credit system here in the United States. Always a thought-provoking conversation, always something I know our viewers enjoy. Kamal Srikumar, thank you so much for joining us. Thank you very much, Ash. Great discussion. And I appreciate your questions. Thank you. And thank you for watching. Thanks for listening. Have a great day, everybody.

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