Special Encore: For Better or Warsh

0:00Andrew Sheets:In case you missed it, today we're bringing you a special Encore release of a recent episode. We'll be back tomorrow with a brand new episode. Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.

0:13Seth Carpenter:And I'm Seth Carpenter. Morgan Stanley is Global Chief Economist and Head of Macro Research.

0:17Andrew Sheets:And today on the podcast, a further discussion of a new Fed chair and the challenges they may face. It's Friday, February 6th at 1 p.m. in New York. Seth, it's great to be here talking with you. And I really want to continue a conversation that listeners have been hearing on this podcast over this week about a new nominee to chair the Federal Reserve, Kevin Warsh. And you are the perfect person to talk about this, not just because you lead our economic research and our macro research, but you've also worked at the Fed. You've seen the inner workings of this organization and what a new Fed chair is going to have to deal with.

0:56Andrew Sheets:So maybe just for some broad framing, when you saw this announcement come out, what were some of the first things to go through your mind?

1:04Seth Carpenter:I will say first and foremost, Kevin Warsh's name was one of the names that had regularly come up when the White House was providing names of people they were considering in lots of news cycles. So I think the first thing that's critically important from my perspective is not a shock, right? Sort of a known quantity. Second, when we think about these really important positions, there's a whole range of possible outcomes. And I would have said that of the four names that were sort of in the final set of four that we kept hearing about in the news, you know, some differences here and there across them.

1:39Seth Carpenter:But none of them was substantially outside of what I would think of as mainstream thinking. Nothing excessively unorthodox at all like that. So I think in that regard as well, I think it should keep anybody from jumping to any big conclusions that there's a huge change that's imminent. I think the other thing that's really important is the monetary policy of the Federal Reserve really is made by a committee, a Federal Open Market Committee. And committee matters in these cases. The Fed has been under lots of scrutiny, under lots of pressure, depending on how you want to put it. And so as a result, there's a lot of discussion within the institution about their independence, making sure they stick very scrupulously to their congressionally given mandate of stable prices for employment.

2:25Seth Carpenter:And so what does that mean in practice? That means in practice to get a substantially different outcome from what the committee would have done otherwise. So the market is pricing – what's the market pricing for the funds rate at the end of this year? About 3.2 percent, something like that? Think about that, yeah. Yeah. So that's a reasonable forecast. It's not too far away from our house view. For us to end up with a policy rate that's substantially away from that, call it one percentage point, two percentage points away from that, I just don't see that as likely to happen because the committee can be led, can be swayed by the chair, but not to the tune of one or two percentage points.

3:00Seth Carpenter:And so I think for all those reasons, there wasn't that much surprise. And there wasn't, for me, a big reason to fully reevaluate where we think the Fed's going.

3:09Andrew Sheets:So let me actually dig into that a little bit more because I know our listeners tune in every day to hear a lot about government meetings. But this is a case where that really matters because I think there can sometimes be a misperception around the power of this position. And it's both one of the most public important positions in the world of finance. And yet, as you mentioned, it is overseeing a committee where the majority matters. And so can you take us just a little bit inside those discussions? I mean, how does the Fed chair interact with their colleagues? How do they try to convince them and persuade them to take a particular course of action?

3:42Seth Carpenter:Great question. And you're right. I sort of spent a bunch of time there at the Fed. I started when Greenspan was chair. I worked under the Bernanke Fed. And of course, for the end of that, Janet Yellen was the vice chair. So I've worked with her. Jay Powell was on the committee the whole time. So the cast of characters, quite familiar. And the process is important. So I would say a few things. The chair convenes the meetings. The chair creates the agenda for the meeting. The chair directs the staff on what the policy documents are that the committee is going to get. So there's a huge amount of influence, let's say, there.

4:15Seth Carpenter:But in order to actually get a specific outcome, there really is a vote. And we only have to look back a couple weeks to the last FOMC meeting when there were two dissents against the policy decision. So dissents are not super common. They don't happen at every single meeting, but they're not unheard of by any stretch of the imagination either. And if we go back over the past few years, lots going on with inflation and how the economy was going was uncertain. Chair Powell took some dissents. If we go back to the financial crisis, Chair Bernanke took a bunch of dissents. If we go back even further through time, Paul Volcker, when he was there trying to staunch the flow of the high inflation of the 1970s, faced a lot of resistance within his committee and reportedly threatened to quit if he couldn't get his way and had to be very aggressive in trying to bring the committee along.

5:05Seth Carpenter:So the chair has to find a way to bring the committee along with the plan that the chair wants to execute. Lots of tools at their disposal, but not endless power or influence. Does that make sense?

5:18Andrew Sheets:That makes complete sense. So maybe my final question, Seth, is this is a tough job. This is a tough job in the best - You mean your job and my job or? Not at all. The chair of the Fed. And it seems especially tricky now. You know, inflation is above the Fed's target. Interest rates are still elevated. You know, certainly mortgage rates are still higher than a lot of Americans are used to over the last several years. And asset prices are high. You know, the valuation of the equity market is high. The level of credit spreads is tight. So you could say, well, financial conditions are already quite easy, which can create some complications.

5:55Andrew Sheets:I am sure Kevin Warsh is receiving lots of advice from lots of different angles. But if you think about what you've seen from the Fed over the years, what would be your advice to a new Fed chair and to navigate some of these challenges?

6:09Seth Carpenter:I think first and foremost, you are absolutely right. This is a tough job in the best of times, and we are in some of the most difficult and difficult to understand macroeconomic times right now. So you noted interest rates being high, mortgage rates being high. There's very much an eye of the beholder phenomenon going on here. Now, you're younger than I am. The first mortgage I had was 8.5%. I bought a house in 2000 or something like that. So by those standards, mortgage rates are actually quite low. So it really comes down to a little bit of what you're used to. And I think that fact translates into lots of other places.

6:45So inflation is now much higher than the committee's target.

6:49Seth Carpenter:Call it 3 % inflation and core inflation on PCE rather than 2 % inflation target. Now, on the one hand, that's clearly missing their target. And the Fed has been missing their target for years now. And we know that tariffs are pushing up inflation, at least for consumer goods. And Chair Powell and this committee have said they get that. they think that inflation will be temporary. And so they're going to look through that inflation. So again, there's a lot of judgment going on here. The labor market is quite weak. We don't have the latest month's worth of job market data because of the government shutdown that'll be delayed by a few days.

7:25Seth Carpenter:But we know that at the end of last year, nonfarm payrolls were running well below 50 ,000. Under most circumstances, you would say that is a clear indication of a super week economy. But if we look at aggregate spending data, GDP, private domestic final purchases, consumer spending, CapEx spending, it's actually pretty solid right now. And so again, that sense of judgment, what's the signal you're going to look for? That's very, very difficult right now. And that's part of what the chair is going to have to do to try to bring the committee together in order to come to a decision. So one intellectually coherent argument is the main way you could get strong aggregate demand, strong spending numbers, strong GDP numbers, but with pretty tepid labor force growth is if productivity is running higher.

8:17Seth Carpenter:And if productivity is going higher because of AI, for example, over time you could easily expect that to be disinflationary. And if it's disinflationary, then you can cut interest rates now, not worry as much as you would normally about high inflation. So the result could be a lower path for policy rates. So that's one version of the argument that I suspect you're going to hear. On the other hand, inflation is high and it's been high for years. So what does that mean? Well, history suggests that if inflation stays too high for too long, inflation psychology starts to change. The way businesses start to set their own prices can get a little bit loosey-goosey.

8:57Seth Carpenter:They might not have to worry as much about consumers being as picky because everybody's got used to these price changes. Consumers might become less picky because, well, they're kind of sick of shopping around. They might be more willing to accept those higher prices and that's how things snowball. And so I do think that the new chair is going to face a particularly difficult situation in leading a committee in particularly challenging times. But I've gone on for a long, long time there. And one of the things that I love about getting to talk to you, Andrew, is the fact that You also talk to lots of investors all around the world.

9:29Seth Carpenter:You're based in London. And so when the topic of the new Fed chair comes up, what are the questions that you're getting from clients?

9:37Andrew Sheets:So I think that there are a few questions that stand out. I mean, I think a dominant question among investors was around the stability of the U.S. dollar. And so you could say a good development on the back of Kevin Warsh's nomination is that the market response to that has been the price action you would associate with more stability. You've seen the dollar rise. You've seen precious metals prices fall. You've seen equity markets and credit spreads be very stable. So I think so far everything in the market reaction is to the point that you raised, consistent with this still being orthodox policy.

10:12Andrew Sheets:Every Fed chair is different, but still more similar than different. Now, I think where it gets more divergent and client opinions is just what are we going to see from the Fed? Are we going to see a real big change in policy? And I think that this is where there are very different views of Kevin Warsh from investors, some who say, well, he's in the past talked about fighting inflation more aggressively, which would imply tighter policy. And he's also talked more recently about the productivity gains from AI and how that might support lower interest rates. So I think that there's going to be a lot of interest when he starts to speak publicly, when we see testimony in front of the Senate.

10:54Andrew Sheets:I think the other, the final piece, which I think, again, people do not have as fully formed an opinion on yet, is how does he lead the Fed if the data is unexpected? And, you know, you mentioned inflation and, you know, Morgan Stanley has this forecast that, well, owner's equivalent rent, a really key part of inflation, might be a little bit higher than expected, which might be a distortion coming off of the government shutdown and impacts on data. But there's some real uncertainty about the inflation path over the near term. And so in short, I think investors are going to give the benefit of the doubt for now.

11:29Andrew Sheets:I think they're going to lean more into this idea that it will be generally consistent with the Fed easing policy over time for now, generally consistent with a steeper curve for now. But I think there's a lot we're going to find out over the next couple of weeks and months.

11:43Seth Carpenter:Yeah, I agree with you. Andrew, I have to say, I'm glad you're here in New York. It's always great to sit down and talk to you. Let's do it again before too long. Absolutely.

11:52Andrew Sheets:Seth, thanks for taking the time to talk. And to our audience, thank you, as always, for your time. If you find Thoughts of the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today. The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.