Is Fed policy working?

0:05Pushkin. It was almost exactly two years ago this month that the Federal Reserve Reserve started increasing interest rates. But inflation is still above the Fed's target and appears to be rising rather than falling. Today on the show, is Fed policy working? This is Unhedged, the FT podcast about markets and finance. I am Rob Armstrong, and I am joined here at Unhedged World Headquarters in New York City by Kate Duguid, who is our expert on all things bond market, treasury, Belgium. She grew up in Belgium, listeners. So she's a woman of all trades. Hello. Kate, let's talk about the Fed meeting yesterday, the statement in the press conference.

1:04What did you take from that? So the Fed yesterday signaled that interest rates are going to remain higher for longer. The FOMC or Powell specifically said that there had been a lack of further progress. That was the key phrase, lack of progress. It brought me back to my report cards as a child. I doubt it. Come on. You'd be surprised. Don't you have a PhD? I did. I was a late bloomer. I was a late bloomer. Anyway, so lack of progress was the headline. On 2 % inflation or towards 2 % inflation. Yeah. And we're broadly, we're at three and maybe going the wrong direction. So it's not actually a lack of progress, right?

1:45It's that we actually have gotten worse. Things have gotten worse, right? In terms of inflation. Yes. In the past three months. Right. Maybe it's not a huge move, but it is, the lines seem to be going in the wrong direction. Do we have a diagnosis for why that's happening? People have attributed it to housing, right? That's the stickiest part of things. Yes. I mean, in headlines, certainly we've had some stuff with oil, which has driven things, but who cares about that? Yeah, we only care about core inflation. That is inflation without food and energy. There was at least one question in that press conference that suggested the Fed itself was part of the problem.

2:19Somebody stuck up their hand and said, Mr. Powell, aren't loosening financial conditions contributing to the strong growth that is fueling inflation? And I think what that reporter was referring to was the fact that back in December, the Fed came out and said, oh, we think we're at the peak for the cycle and the next move is going to be down and et cetera. And that got markets so excited that that itself was inflationary. Yeah. How do you like that theory? I like that theory. You know, if you take a look at the financial conditions index, certainly financial conditions have gotten a lot looser since October, but the moves have not been like huge.

2:57Yes. Right. Like we've actually been kind of stable in the past couple of weeks. I don't know. There's been a little bit of variability there, but I'm not sure. I would say that the thing on financial conditions is just I mean, it's all driven by stock prices. Yes. We should maybe back up for listeners, actually. Financial conditions index is basically how easy is it to get and move around money? Yeah. Yeah. So it's like stock prices, credit conditions, how easy it is to borrow. For companies. For companies. For companies. Specifically. Right. So generally, when there's optimism in the air, financial conditions loosen because if you need funding, if you're raising equity, whatever, it's like free play time.

3:42People want to give you money. Yeah. Right. And so the question is, did the Fed, by broadly signaling a few months ago that the next move was lower rates, kind of release these animal spirits in some way? On the one hand, you could argue that they did, right? Because you've seen a bit of a move in this financial conditions index, which should describe pretty broadly how easy it is for a company to borrow money. But rather than just looking at borrowing rates, these financial conditions indices really include a lot of stock. Like a lot of it is made up by stock prices. And the ease with which companies can borrow has actually not changed that dramatically.

4:21Yeah. But there has been a real rally in stocks on this expectation that rates will be cut. Yeah. And that's starting to peter out now. So maybe the problem is solving itself. Is the index. Yeah. Let me ask you a really dumb question, Kate. Yeah. If the problem is that inflation is going the wrong direction. Yeah. And the Fed's central tool for fighting inflation is increasing interest rates. Why don't they increase interest rates? It seemed like yesterday, J. Paul was at pains to say the committee was not going to do that. And I didn't quite get that. I think that the Fed's greatest tool is not actually interest rates, but is credibility.

5:07Right. It's the market trusting that the Fed can rein in inflation or the market can bolster employment if the conditions weren't. Yes. And that's why the Fed. Right. Like part of the question is also like, why not cut rates now? And that's because like the Fed doesn't like to change directions abruptly. Yes. The Fed likes to be very, very, very steady. And they really tell us way ahead of time what they're going to do. I guess Paul said there's two reasons. I like this pronunciation of Powell's name. Okay. It's Powell. Rhymes with towel. Powell. Okay. I guess Powell said yesterday a couple of things about why he thinks they don't need to.

5:53He thinks - Which you're not convinced by. Which I'm not convinced by. The labor market continues to soften. Yeah. And he thinks housing inflation is going to go down. Regular listeners will remember one of our many discussions of how the way rent inflation is measured in the official indexes lags behind actual changes in markets rents. without going into the details. That hasn't happened this time. Powell thinks it's going to happen. He's keeping the faith. Right. Well, what he said was that rent inflation on new leases is coming down. And so that's not yet showing up in official measures. But it will.

6:33And it will. Yeah. So that's the argument. Yeah. I'm not sure. Why are you not sure? Well, house prices are going up. I'm wondering if by the time the new leases that were signed recently at non-inflationary levels, by the time that happens, I'm wondering if the housing market in general and the rent market in specific will have heated up again. Yeah. It was going to be a lag too far, as it were. I wanted to ask you something else, Kate, which is something changed about quantitative tightening yesterday. Yes. That I struggled slightly to understand. And part of the reason you're on the show is so you can explain it to me and get it through my thick head.

7:16So we've been talking about interest rates. The Fed has another tool at its disposal, which is buying bonds. Another monetary policy tool at its disposal. Quantitative easing, which is what they engaged in at the start of COVID, is where the central bank tries to increase the amount of liquidity in its financial system. And that's typically by buying a bunch of bonds. So they're taking bonds in and putting cash out there. Right. So now there's more cash sloshing around. So it means that banks can lend more money, right? Got it. They buy a bunch of bonds from big banks. Banks can lend more or invest more.

7:53We've been moving in the opposite direction. for a little while now. The Fed has been doing something called quantitative tightening, which is where they shrink the size of their balance sheet. They're not actively selling bonds, but they're letting bonds sort of roll off their balance sheet and mature. So this is sucking cash out of the system. Yes. Yes. It's hard the sucking cash in versus out, but it's sucking cash out of the system in the sense that private investors have to buy a lot more bonds. Yes. Right? Right. Right. Now, third step. What they announced yesterday is that they're going to slow the process of quantitative tightening.

8:30Right. They're not quite moving to quantitative easing. It's not like they're buying bonds. Yeah. But they're slowing the pace at which they are shrinking their balance sheet. If inflation is a problem, why would they do a thing like that? You know, it's an open question. I think one of the things that happened is they did quantitative tightening too quickly back in 2019. Yeah. And they caused a repo crisis. Ah. Right? And they're really, really, really worried about repeating that. Yeah. And so they, I think that's the reason why they're doing this. They don't want to suck too much cash out of the system and cause problems for banks.

9:07I think that's probably the main reason that they are engaged in this quantitative tightening. Lori Logan, the Dallas Fed president, has also said that the reason that they're slowing down quantitative tightening is so that they can actually do it for longer, so that they won't run into a crisis like that, right? That they're still trying to shrink the size of their balance sheet, but they just want to do it at a slower pace and so that they can actually reach their target. They want to go fast by going slow, as the phrase goes. Gradually, gradually, then we don't get tired. Nobody freaks out.

9:37Exactly. But I think the bottom line here is that private investors are going to have slightly fewer bonds to absorb. And that means that rates could come down a little bit. Not interest rates, but that bond yields could come down and bond prices could go up. That could send stocks slightly higher. Yes. We also know that mortgage rates are based on the 10 year treasury yield, right? Or are tied to it. So does that mean that if mortgage rates come down? Yeah, that's that's upward pressure. That's upward pressure on houses. That's upward pressure on rents. So it's a pretty delicate balancing act.

10:16Yeah. For the Fed. Yeah. Here. Speaking of delicate balancing acts. One of the questions that was put to Powell yesterday is, Mr. Powell, you may have noticed there's an election coming up in November. Is it harder for you to cut rates in the shadow as the shadow of the election grows longer and deeper? And he was like, no way we don't think about that kind of thing. Like, of course they think about it, right? In being apolitical, they have to think about it, right? They have to think about what would seem political. Right. Right. So you think it's harder for them to cut rates in the meetings in the fall before the election hits?

10:55Without seeming political? Yeah. Yeah. I think it will be difficult for the Fed to cut interest rates this year if they don't cut in July. We have a meeting in September. They could potentially cut then, but we are getting very close to the election. Yeah, you're right on top of the election. And they're afraid that if they do cut, they look like they're pulling for Biden? Yeah. Is that the... Yeah. I would say so. And the next meeting after that is November 7th, which is two days after the election. So if the new president or the same president hasn't fired them all at that point, then they'll have a choice to make that.

11:27All right. So summing up, inflation is not doing what the Fed wants, but the Fed wants to proceed very deliberately. It's not going to run around hiking rates and panicking because of one quarter's worth of bad data. but the situation is serious and they got some hard choices ahead. I think so. It's funny, though, because we always say, like, the Fed's not going to panic based on one month's data. And now it's like the Fed's not going to panic based on one quarter's data. And it's like, how far can we stretch that? All right. On that note, Unhedged is not going to panic. We'll be right back with Long Short.

12:13Welcome back. This is Long Short, that portion of the show where we go long things we like and we go short things we don't like. Kate, I have a short. Yeah. Tell me about your short. Starbucks. Yeah. As close followers of the stock market will have noticed, Starbucks shares took a beating yesterday after the company announced that it had a lousy first quarter in which something like 7 % less people came into its U.S. stores. The company complained about weather. They said the economy was getting worse, et cetera, et cetera. I think slash hope that the country is just getting over$7 cups of coffee.

12:58No way. No way. You think Starbucks is eternal? No, I think people are now buying$9 cups of coffee. Yes. So they're being priced out of the market by even more expensive coffee. Some segments. But you have a point to make about not the wealthiest consumers. It's clear in this economy that people at the lower end of the spectrum and specifically people who have more debt than they have assets. Right. In a raising right environment, that hurts. Right. When your debts get more expensive and you don't have the asset growth to offset that. So that explains why poor consumers are pulling back and you might see bad results at a McDonald's.

13:40But when it starts happening at Starbucks, then you're like, wow, maybe the affluent middle classes are starting to feel the pain. I'm not sure that it's true. I think we're all just getting sick of Starbucks coffee. But perhaps this is a fantasy of mine. I don't I don't happen to love their coffee. OK. Yeah, it's pretty bad. It's kind of burnt. Yeah. But you mentioned I think you mentioned the Jane Frazier comment, the Citigroup CEO. Yeah. A K-shaped economy. Yeah. Yeah, which you say is not evident like a K-shaped economy is not evidence of a weak economy. Yeah, because there's so much of American spending comes from the upper end of the spectrum.

14:20This is not the situation any of us want. This is just the unpleasant fact of the matter. Most of the consumer economy is driven by the affluent, the middle class, upper middle class, upper class. and the number of people suffering at the bottom isn't enough to really affect the aggregate numbers. I wish the world wasn't like that, but it is. Do you have a long or short for me? I do. I have a long. I have a long. I'm long Civil War. I'm not sure. Are we talking about the movie or the reality? The reality. I'm not sure how much money I'm going to throw behind this. Yes. But I know somebody who is throwing some money behind this.

14:59Tell me. And that is former Bridgewater CEO, Bridgewater founder, Ray Dalio. Yes. So we know civil war has been on everybody's minds, I think, for not just since January 6th, but I think it's sort of like entered the mainstream a little bit. And as you mentioned, there's this film that's been sort of number one at the box office. I was at my mother-in-law's house last week and she was watching a lot of MSNBC. The Trump trial is, you know, like people are thinking about this. Political polarization in the United States has been on the rise. for decades. Anyways, I was speaking to Ray Dalio a couple of weeks ago who said that he figures there's about a 35 to 40 percent chance that the U.S.

15:39enters a civil war in the next five years. Whoa. Okay. That's heavy stuff. Right. It's a big thing. And this isn't necessarily the sort of civil war where people pick up their guns and shoot each other. I think he's imagining like an exaggeration of the political polarization we've already seen, right, which is people moving out of states where they feel sort of like they're not politically aligned. Right. So it's it's conservatives from New York moving to South Carolina and liberals from Arizona moving to California. Exactly. Oregon or something. Exactly. Yeah. Which like is going to happen as states around the country begin to have different laws.

16:15Right. We're seeing this on abortion. We're seeing this on, you know, on a variety of things that. And so you're a doomer on this. You think it could happen. You think it's not out of the bounds of all imagination that something like this could happen? If we bring it back to market stuff for a second. Yeah. What have we seen happen multiple times a year, every year for the past like two decades, right? It's like a fight over, with some exceptions, but it's a fight over the debt ceiling. Yeah. Right? We have political parties who cannot agree on. Yes. The basics of how a federal system should work.

16:52Exactly. and on the sort of most basic kind of spending. And it has led to credit downgrades. It's led to sort of big warnings from U.S. officials. It has led to S &P, Moody's. All these guys are sort of freaking out about this. And so I think that we're seeing it in some ways already, in ways that raise credit risk for treasury bonds, which should be... So there actually is an investable theme in what Dalio says. Yeah, yeah. Yeah. Well, you heard it here, folks. I think Americans are changing their preferences for coffee. Kate thinks we're going to war. That's the spectrum of opinion you get on this podcast.

17:34Thanks for listening this week. We'll be back in your feeds very soon. Unhedged is produced by Jake Harper and edited by Bryant Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn, and Natalie Sadler An extra special thanks to Anthony Pohl for writing the 12-volume novel series A Dance to the Music of Time FT Premium subscribers can get the Unhedged newsletter for free A 30-day free trial is available to everyone else Just go to ft.com slash unhedged offer I'm Rob Armstrong, thanks for listening

18:25Porkchips