Deep Dive
Shownotes Transcript
Welcome to Inside Economics. I'm Mark Zandi, the Chief Economist of Moody's Analytics, and I'm here with my good friend and colleague, Chris Dridis. Chris? Hey, Mark. We're in person. We are. Side by side. I feel like the moments. How did that happen? You know those two moments? Awkwardly side by side.
Did you notice, Marissa, when he set his chair higher than my chair so I looked, you know, it was a classic power move. It was. Yeah, he's trying to. People on YouTube can see this. Yeah, look at that. He's got his snozz right up on the camera. Look at that. That's pretty prominent. I've never seen it up close. It's a little overwhelming. All right.
No, you're very dapper. I'm so glad I'm not there. Yeah, everyone knows how much I think you're very dapper. Well, thank you. I didn't mean anything about your nose. I take it back. I take it back. Anyway, Marissa, good to see you. You're out there. It's nice to see you. Very nice to see you. And we've got Martin. Martin Worm, how are you?
I am good. I'm in Germany. It's getting dark. Ah, I was wondering about that. Yeah, it's not, the sun has not faded on the West Coast. I'm on the other side of the world for once. Where in Germany are you? I'm in Munich. That's where I'm from, actually. Ah, very good. Very good. I love Munich. A great city. It's a fun town, for sure. Did you actually grow up in Munich?
I grew up in Munich. I was here until I was in my early 20s and I spent five years in Wisconsin. And then ever since then, first the West Coast, then Moody's, now back to the West Coast. Oh, that explains a lot. The whole Wisconsin thing. You went from Munich to Wisconsin? Yeah, I spent five years in Wisconsin, but it was grad school. So, you know, I mean, what are you going to do? You're going to spend all your time in the library. They can't really say I'm a Wisconsin expert. I wouldn't claim that.
Well, that explains your Midwestern German accent. That's right. I'm a love for bread and beer and cheese. There you go. Well, good. We have a little bit of housekeeping. We had a contest back a couple of podcasts ago. Tell us, what was it? We had a, so we name our episodes, obviously. So we named an episode, The Final Countdown. It's The Final Countdown.
And in the episode blurb, we asked if anyone knew the meaning of this title. And we had a couple of winners, right? We had William Black, a former Moody's employee. William was a consumer credit, as I recall. He's deep into consumer credit. He was, right? I think he has credit cards. Yeah, he has his own podcast series. As good as ours?
pretty good it's pretty good pretty good okay i got to listen he guessed it and you remember what why we named it the the final countdown no i can't remember why well yeah we had trouble naming it yeah and the episode was about europe uh-huh everyone knows the band europe saying oh that's right that's right there you go marissa did you know that yes i did
The logic was clear, Mark. It was very clear. We also had another winner, but we don't know who it is. Someone responded on Spotify, apparently. Oh, the winner, by the way, gets a cowbell. Yes. So William Black is going to get a cowbell.
And the person who responded on Spotify also got it, but didn't leave any kind of identification. Well, the person I Sarah sent me the person's username. I'm probably going to butcher this pronunciation, but it's like Zuchelkowski. Oh, OK. Is the last name. So if that's you and you're listening, send in. You could send us an email. Help economy at Moody's dot com and we'll send you a cowbell, too.
Cool. Okay. Very good. Well, that's the housekeeping. Well, on the business, unless you guys have something else you want to talk about before we move on to business. Always something to talk about. Yeah. Let's get to it. Let's get down to business. Well, this was an action-packed week. A lot of data came out, and we want to talk about that. GDP growth.
for the fourth quarter and then we got a data dump. This is Friday. What's today's date? January 31st and the data dump of PCE consumer expenditures, PCE deflator, PCE deflator. I said that twice. I don't know why I did that. Income, personal income. And also the Fed met this week. The Federal Reserve met, kept rates unchanged. And we invited Martin to come on. Martin, have you been on the podcast before?
I've been a couple of times. Last time I want to say was maybe three months ago, four months. Probably centered around another Fed meeting, I would guess. Yes, it's usually interest rates and all the stuff that my students love when I used to teach them. Yeah, because you're all things Fed for us. That's right. So a lot of money stuff, a lot of banking stuff. Monetary policy, right. Yeah.
Martin, I don't know. Have we ever asked you to give us a little bit of your body? You kind of said, I was born in Munich. I left in the early 20s. I went to Madison, got my PhD. Then what? What happened after that?
Yeah, so I grew up in Germany, Munich here. I graduated high school and went to university to study business because I didn't know what else to do. I don't want that much detail, Martin. I mean, come on, man. Yeah. I already got you up to high school and now you're going back to what I had for lunch in the fourth grade. Come on.
- Well, in any case, long story short, I ended up studying actually in Milwaukee, not Madison. And I ended up in economics, sort of out of business because I didn't love business. Then I taught for a few years on the West Coast and then I applied for Moody's and here I am. - Oh, very good. - My background has always been money and financial stuff. I graduated during the financial crisis and I felt that was a good topic for that era and it's certainly well since. - Where did you teach, Martin?
I taught at a very small liberal arts college in the Pacific Northwest that you probably wouldn't know. It's called Pacific Lutheran University. Very cool. Very cool. We're very lucky to have you and you do a great job following the Fed for us and helping out with that. Very lucky to be here. Yeah. Before we get into the Fed, let's talk about the data. And maybe, Marissa, can I turn to you?
And just an open-ended question, because again, there was a data dump this week. Yeah, there's a lot. Just riff, what would you say? Well, we got fourth quarter GDP. Okay. Right? So that came in at 2.3%.
annualized over the quarter that was down from 3.1% in the third quarter. And this was a little bit weaker than we were anticipating it to be, but still a pretty solid reading. It was led by consumers again. So consumption rose 2.8% and that was an acceleration over what we've seen for any of the prior year. Actually, it was the strongest consumption reading that we've had in quite some time.
Non-residential investment fell. It detracted from GDP. This is fixed investment, so this is not housing, right? Housing added a little bit to GDP, where it had detracted in the previous quarter. Inventories were a negative. We know that the change in inventories can swing wildly from quarter to quarter, right? This quarter, inventories detracted from growth.
Net exports, it was almost a wash. It was up 0.04 percentage points that it added to growth. Government consumption added to growth, but this was really consumer-led growth.
Anything else you want to know about? Yeah, there's a couple of things. The GDP implicit price deflator rose to 2.2 percent, up from 1.9 percent in the third quarter. Yeah, a couple of questions, a couple of things kind of bothering me about the because it was, as you say, softer than expecting closer to three came in closer to two. And the big difference was inventories. They were down significantly.
They subtracted almost a percentage point. That's the real difference between what we expected and what we got. And what's surprising to me is given the tariffs that we all anticipate, I would have thought that we'd see an inventory build, that importers would bring in product before the tariffs had built inventory. But that's not what happened here.
No, no. And net exports were positive too, right? And we've been hearing this narrative that you said in anticipation of the tariffs that we have this surge in imports going on to build up ahead of the tariffs. And it doesn't, we don't really see that, at least in this release. Now, this is the first release of fourth quarter GDP. So we'll get two subsequent revisions to this. So we'll have to see what happens there. But you're right. I was a little surprised by that as well.
Yeah, the one, correct me if I'm wrong, but the one place where the anticipation of tariffs might have shown up in the report is the strong increases in consumer spending on durables. That's true. That's right. I mean, much of what we consume is imports, right? So you'll see that in consumption as well. Yeah. I was attributing more of that to the hurricanes or to the rebuilding efforts. People have to replace a car, they have to
Oh, okay. I don't know. Maybe. That actually makes more sense because they'd be consistent with no other effects of the tariffs. Right. Right. So that's interesting. So they're really, as you say, this is the first print. Maybe things look a little different after we get the revisions. But at this point, it doesn't feel like the tariffs had any kind of meaningful or major impact on the data, on the GDP data, which-
A little surprising. Yeah, right? Okay. The other thing I find interesting is that for all the hand-wringing about the housing market and all the issues there, housing is a plus, not a minus. It's a small plus, but it's still a plus. How do you square that circle? Well, I mean, I wonder if that could also be
be rebuilding or something after these hurricanes. There was a note in the release that the hurricanes may have impacted the data.
but they don't quantify what that impact is. I mean, there's certainly a lot of destruction of homes and vehicles and that sort of thing, right? But there's also rebuilding happening. So they do kind of caution that some of this could be impacted by those hurricanes without quantifying what that impact is. And again, I think that's where when we get revisions, we'll probably have a better sense of what that impact might be. Right. Okay. And then the one other kind of anomalous thing or thing that just...
struck me was the decline in investment spending on equipment. I think it was equipment, right? Did you notice that? It was down. And maybe that's, I keep going back to the tariffs, but the uncertainty might have an impact on investment spending. But I just found that a little odd. Did you notice that? Yeah. I mean, could be. And this is also, yeah, I wonder how much of the tariff
anticipatory spending would be happening, would have been happening back in the fall, right? I mean, we had the election was in early November. So we had the run up to the election. Now it's very clear that there are going to be tariffs. It's more of a certainty now than there may have been back then. We may actually get tariff policy here in the next
month or two in the first quarter. Actually, this weekend. That's right. February 1st, right, was the, yeah. So the timing is a little strange, right? Because the anticipation and the actual tariffs are going to straddle these quarters here. So yeah, we'll see. Well, let me ask you this. Do you think abstracting from the vagaries of this data, the ups and downs and all arounds,
that underlying GDP growth is closer to three coming into 2025 or closer to two coming into 2025? I, I kind of feel like it's like two and a half, a little bit North of two and a half, somewhere between two and a half and three. Yeah. I mean, I still see pretty strong consumer spending, which is fueling all of this. And yeah,
Sort of the wealth effect, I think, is playing a big role here. I mean, we've seen very strong equity abstracting from bad days here and there. We've seen really strong equity prices. We've seen housing, which is more data that we got this week, holding up. So I feel like it's on pretty solid ground still. Chris, you same way? Yeah, I'd agree. I think there's a lot of momentum still coming into this year.
but some slowing some slowing yeah definitely some headwinds but right well the consumer is right hanging in top we got the spending data as well good yeah martin did you want to uh opine here too do you have a view on all this on the on the gdp numbers because i know you look at all this data very closely in the context of what it might mean for fed policy
Yeah, broadly, I mean, I agree with that. It's the Fed's assessment coming in out of 2024 was over 2%. That was the precise figure that Powell said. And clearly, we're way north of that. So things might look a little slower, but we are still, the economy is still solid. Same in hiring, same in GDP, even if the fourth quarter is a little slower.
Okay. All right. Yeah, it feels like to me, excluding the inventory swing, it's over three, right? Over three. So it feels like it's, to me, it feels...
I'm not going to argue with you too much. You said two and a half to three. It was closer to three to me than two and a half. Than two and a half, if we're splitting hairs. Oh, and we should say that for the whole year, 2024, now that we have this fourth quarter, the year came in at 2.8% and 2023 was 2.9%. So pretty much the same, right? Just down a tick.
Which is pretty close to the economy's potential because maybe even a little south of the potential, right? Because the unemployment rate kind of notched higher here through the year. So we were, a year ago, we were below 4%. Now we're above 4%. Yeah, again, I'm splitting hairs, but nonetheless. So the economy's potential, that rate of growth, the economy can post with,
that will create enough jobs to maintain stable unemployment, you know, it feels like that, again, another good year there, both in terms of the actual output, the actual GDP and the potential GDP. Okay. What about the data we got this morning? I haven't had, Chris and I are here, you know, talking, you know,
about the moody stuff and we haven't had a chance to look at the data uh not that that's a bad thing it's good good to talk about movie stuff every once in a while absolutely yeah someone's got to do some planning so that's what we're doing but um uh what was the data dump like today well i i guess the big one of the big ones is that we got the pce deflator right
So that rose 0.3% over the month, up from 0.1% in November. The year-on-year PCE growth also rose from 2.4% in November to 2.6% in December. Core growth year-over-year stayed the same. So that's at 2.8%.
So still elevated, right? Still above the Fed's 2% target. Well above the Fed's 2% target, right? We're looking at 2.6% on headline core. And if we look at some of the details of that, durable goods prices fell. That's something we've been seeing for a while, right? Weakness in goods.
prices while service prices actually accelerated a bit. So the housing and utilities component of the PCE ticked higher from 0.2% to 0.3% over the month.
And actually, month on month, core PCE rose as well. So it went from 0.1% in November to 0.2% in December. So still kind of showing what we've seen in other measures of inflation, right? Not linear downward in inflation here at all, definitely hanging up there a bit and basically hanging up there on services and housing. Okay. Chris Martin, anything on that data that you want to point out?
Martin? Yeah. It's a little higher than what the Fed had anticipated for the month, but also it's within the range of what is broadly expected. It doesn't hit the number exactly. It reflects the sort of volatility we've seen over the past few months. Yeah. Markets like it. I was looking at the stock market. There's a lot of green, at least last time I looked. Bond markets seem to be okay with it. I think it was in consensus, right? Consensus. Yeah. Okay. So bottom line, Marissa, the economy...
based on the data we got this week, fine, it's doing okay. - Yeah, it's doing okay. I mean, we got some labor market readings, we got the employment cost index. - Oh, what did that say? - It also goes to inflation. - Tell me about the ECI. - So this was also for the fourth quarter, this is a quarterly reading, right?
Total compensation ticked a little bit higher over the quarter. So went from 0.8% in Q3 to 0.9% in Q4. If you just isolate that to wages, that also ticked higher. So benefits steady, wages a little bit higher. Year over year,
ECI wages went from 3.9 down to 3.8, so down just a tenth of a percentage point year over year on wages. So a little bit of progress, but again, just kind of slow progress. But we're solidly under 4% year over year on wages in the ECI, which is
Kind of a big victory if you look at the history of where we were just, you know, a couple years ago on wage growth. It's extremely high. So everything's sort of moving in a better direction, it seems, but very, very slowly. Like this last leg of this fight is going to be arduous, I think, in terms of inflation. Yeah. Yeah. I think it's going to be really hard. And then, of course...
although i do think uh there will be some as we move into 20 now that we start getting 2025 day this is 2024 day of december this is still 20 end of last year that's right there's base effects that are going to start helping us out here i think so even if there is no improvement on a year-over-year base actual improvement in inflation we're going to see some improvement in the measured year-over-year growth rates just because
Last year at the beginning of the year, you saw these big jumps, spikes in prices, probably measurement related issues, so-called calendar year effects that juice prices up. And so that should help out here. But it feels like the data is really down the strike zone, down the fairway, in the middle of the strike zone, it feels pretty good.
Both of those. Yeah, we also got we got income, we got spending, we got and those are, again, like pretty solid. Both readings on those was pretty solid. Jobless claims had ticked higher two weeks ago. Right. They fell back again to an extremely low level.
So yeah, everything looks still very solid. Yep. Okay. Okay. So what I want to do now is take all this that we've learned about the economy, the data we got and put that, uh,
in the context of what the Federal Reserve decided to do this week. And by the way, if it's okay with you guys, because we're a little short on, we don't have as much time today because Chris and I are actually doing some work here, you know, Moody's work. Right. What does that imply about what me and Martin are doing? You know, you can take it however you want to take it. But we've got to cut this podcast a little bit short. So we're not going to do the game. We might take a few listener questions depending on how
you know, loquacious Martin is with regard to the Fed. You know, we might have some time for that, but we want to turn, I want to turn to the Fed now. And Martin, did you, I think you had a chance to, I've been traveling a lot this week, so I didn't have a chance to really listen in to Jay Powell, chair of the Fed's press conference after the meeting this week, but maybe you can just give us a rundown. What did the Fed do?
Anything about the statement that they released with their decision and what you learned from the press conference? The FOMC met this week and decided to leave the policy rate unchanged at a target range of 4.25 to 4.5 percent for the federal funds rate. It was the first meeting over the last 40 in which the Fed did not cut rates. That had broadly been expected based on previous signaling.
When you look at the statement and when you listen to the press conference, the primary motivation is what we just talked about is the fact that inflation is still slightly elevated. It's not dramatic like it was two years ago, but the Fed is not at target yet and it remains stable.
committed to reaching a target, which means monetary policy needs to remain sufficiently restrictive, in the words of the chairman. And at the same time, the economy is doing quite well. That is also the Fed's assessment. So the Fed is adopting more a wait-and-see approach. It's going to process incoming data as it has the last quarter, as in the last years.
Once they feel ready to lower interest rates, once they feel that inflation has consistently been back to target, then they may normalize. That is the official language. There's been some language changes in the statement, but I don't think they're particularly meaningful. Mostly it's been language cleanup. The message is roughly the same as it happened before.
What is the other aspect in the room, and that's not in the official language, but it came up during the press conference, is, of course, that we have a new administration. The administration has ambitious plans along four dimensions of policy. That is immigration, that is tariffs, that is deregulation, and that is fiscal policy, spending and taxation. And there is a general sense that many of these policies could act more inflationary going forward.
This is something that the Fed is aware of, but because there's uncertainty what these plans will really exactly look like, it's going to take the Fed some time to process that. And it's in some sense a bridge they'll cross when they get there. So if by summer we see a little bit more of an uptick in inflation, if GDP slows down, the Fed is going to adjust the stance of monetary policy around that. That in a nutshell is the meeting. There were a lot of political questions, which I'm not going to go into. It's like, did the president call? These kind of things.
He did not, for the record. I'm curious. He did not. I mean, that's at least, Powell said he did not get a call. Well, okay. That's interesting. Actually, all the political stuff is the interesting stuff. It is. Yeah. You sure? You don't want to tell us about that? Well, I can repeat what Powell said to this, which is basically enough him. Okay. He's very good at fielding questions that he wants to answer and not answering the ones he doesn't want to answer. Yeah.
And of course, the Fed has a tradition to try and not to comment on political statements. They try to make the decisions based on what the data has to say. Now, in reality, of course, that's interwoven. You can't really separate that entirely. But in communications, they tend to focus on the data. And that was broadly the vibe I got from this meeting and from previous meetings as well. Okay. Well, I want to talk about the decision by the Fed to
pause in terms of its rate normalization or interest rate cuts. And it feels like, and I think markets are on board with the idea that the Fed's not going to be cutting rates anytime soon for lots of reasons. And I'd like to go through each of those reasons and get your sense of it and what it implies about future rate cutting or what policy will be down the road. Economists, when they think about the Fed and the appropriate
Fed policy, interest rate policy, they use what's called a reaction function. It's, you know, basically here are the things that the Fed looks at when making a decision around interest rate policy. Number one is the economy at full employment, you know, and right now we're at a 4% unemployment rate. That's pretty close to full employment. So that feels like that's neither here nor there in terms of, you know, interest rate policy.
The second is inflation. And here, inflation is still, as we said, a bit elevated. It's 2.8 on the measure they look at, the core PCE measure. And that's well above 2, moving in the right direction, but not quite there. So that would suggest, all else being equal, that I wouldn't be cutting interest rates. Certainly may raise rates, but certainly not cut interest rates.
Third is inflation expectations, what people think about inflation in the future. And that goes to what inflation will be in the future. That feels like that's OK. It's kind of consistent with where the Fed would want it. So that's neither here nor there in terms of monetary policy. And then there's financial conditions. And what that means is the Fed moves the federal funds rate
but it really is that change in the funds rate and all its effects on the financial market, stock prices, credit spreads, long-term interest rates, lending conditions that ultimately drive economic activity. So financial conditions are so-called tight,
the transmission of the interest rate, you know, through of the federal funds rate, the rate the Fed controls over to the real economy is restricted. And if the financial conditions are easy, then more of the effect gets amplified through to the economy.
Did I cover it? Oh, international conditions. That's kind of a sidebar. The Fed also looks at the value of the dollar and financial global conditions in terms of setting policy. And the dollar is strong, which would suggest that that has some latitude to ease. And I guess the final thing I'll throw into the mix, and then I'll stop and ask if you think I got the frame right and how you're thinking about it, is...
The so-called equilibrium rate, that is the federal funds rate that is consistent with policy, interest rate policy, neither supporting or restraining economic growth. And there's a lot of debate about that, but because you can't, it's not written in a book somewhere or in a computer data bank, it's inferred by what's going on in the economy, feels like that that's higher than it has been historically.
But the question is, you know, is it close to the four and a quarter percent, four and a half percent where the federal funds rate target is today? So I just said a lot. Is that what do you think of that framework for thinking about things that consistent the way with the way you think about it?
Yes, it hits all the components. The way we can go through it is two ways. We can talk about all these factors you mentioned initially, or we can start with the polymer brain. So I would do it one way or the other, whichever you prefer. Okay, and I should say one other thing I should mention that isn't in the kind of the classic way of thinking about the reaction function, but it's there, and it's obvious in the current context, is the level of confidence that
that the Fed has in each of these things. So if there's a lot of uncertainty with regard to, say, tariffs and immigration policy and fiscal policy, all those things, that makes it less likely that the Fed will change policy because they're uncertain. They don't know. So that's another dimension to it. But let's take each one of these pieces of the puzzle in turn. And let's go to the equilibrium rate first, because that's the one that I had the most difficulty with.
How do you think about that? Maybe you can describe it in your own words and how we should be thinking about it. What do you think the equilibrium rate is today? Yeah, so the equilibrium rate is
So generally speaking, the way you would define it in a textbook is the interest rate that prevails in the economy. If the economy is in perfect equilibrium, there is no output gap. GDP is exactly equal to potential. Unemployment is equal to its long-term trend. Inflation is equal to target. And that's, in a sense, how it's defined.
What determines that rate in the long term has nothing to do with monetary policy. It's a function of the economy. And broadly speaking, it's very closely related to potential GDP growth in the sense that if, for instance, I am a lender, I give Mark you a loan for a million, you open up a new firm, Moody's 2.0, something like that.
You build that firm, it produces a certain amount of revenue. Mark Zandi.inc is what I would call it. Mark Zandi.inc, that's right. Whatever that additional output is, that is what you can pay me back as interest. And in the overall economy, what we produce more from one year to the next in trend is potential growth. So interest rates over longer periods of time are very closely related to potential GDP.
There's a lot more theory around this, but this is sort of the nutshell. If potential GDP growth is higher, the long-term trend rate is higher. If potential GDP growth is lower, it's going to be lower. That's the first thing around this. Can I say, can I ask, okay, so nominal potential GDP growth now, I would say, is four and a quarter, four and a half percent. You know, that's 2% inflation plus...
two or two and a quarter, two and a half percent real GDP growth. That's the nominal potential growth economy. So you're saying not that the federal funds rate
Are you saying that the federal funds rate equilibrium is? No, that's not what I'm saying. Okay. The federal funds rate is one interest rate is related to all other interest rates. Okay. So in theory, if there were just one interest rate that affects the average maturity of loans, that is in a sense what the longer term. Okay. So what you're saying is like the five-year treasury bond or the seven-year treasury bond, because that's kind of- Whichever one it is. Whatever it is, that's what should be four and a quarter or four and a half.
That's right. And then the federal fund rate is related to that through some maturity spread because it's a shorter maturity. But in principle, if potential growth is higher, the neutral rate is higher. If potential growth is lower, the neutral rate is lower as well. Okay, got it. And the reason why I'm saying this is because it anchors to the stuff. The Fed does not set it. That's the important takeaway from here. It depends on how the economy is performing. Yeah.
Now, in practice, what happens is we go through the business cycle. So we see periods of inflation. What that means is the economy is not at equilibrium. It's overheating. And the Fed needs to respond to that by adjusting the stance of monetary policy. And that's what a reaction function more or less prescribes. If, for instance, it is higher and the Fed will have to keep the actual policy rate above whatever the neutral rate is.
If you're in recession, if the economy is performing below potential, the Fed will lower the policy sense below what the neutral rate is to stimulate demand. That's the general idea. This is where monetary policy is. Does that make sense? It does. And going back to the equilibrium rate in this reaction function,
In my thinking, the equilibrium rate is not written in stone. It is not. In part because potential growth rate of the economy moves.
But also, and it can move in the near term. Like in the last couple of years, we've gotten higher potential growth because labor force growth has been strong given the strong immigration. Therefore, the equilibrium rate would be higher, you're saying. That's right. But in the long run, abstracting from the surge in immigration, potential growth rate will settle in between four or four and a half percent. And in the long run, that would be the equilibrium rate that would prevail. But the other factor that I...
have come back to often in the context of the current period is that the economy is less interest rate sensitive because households and businesses have done a really good job, did a really good job locking in the previously record low interest rates before the Fed started jacking up rates in 2022. So if you go in the teeth of the pandemic,
recession, rates collapsed, Fed put the funds rate at zero, people refied, businesses refied, they locked in. And so that makes the economy less rate sensitive as the Fed has tightened. And that pushes up the equilibrium rate, at least for a while. Is that right with that? Yes. I was actually just going to say that. You were? Okay.
And sometimes, I mean, the way that Jerome Powell will phrase this, and he's asked this question now and then, is that we don't really know what the equilibrium rate is. We know whether the Fed basically hit the policy right relative based on its works. So the Fed is increasing the policy rate by some amount. If inflation had picked up, then policy would not have been restricted enough, even though the policy rate increased.
So to some degree, when the Fed raised interest rates to 5%, the economy slowed a little bit. We see this in interest rate sensitivities like the housing sector, for instance. But it did not slow nearly as much as pretty much anyone expected in 2022. And so when we went into this tightening cycle, we expected the equilibrium interest rate to be something like 2.5%, 3%.
the Fed hikes all the way to 5%, and you see a relatively small impact on economic output, that is consistent with what you just said, is consistent with the observation that the near-term equilibrium rate is actually higher than, say, 3%, closer to 4%, maybe 4.5%. And right now, the federal funds rate target is 4.25%, 4.5%. It's down a percentage point from where it was back late last year. So they've lowered interest rates.
They paused here at four and a quarter, four and a half. Do you think that's the current equilibrium federal funds rate target? I mean, again, it's not written in stone. And over time, that probably will come in, come down. Right now, is your sense that it's around four and a quarter, four and a half percent? Or within spin? It feels close to it. What our model producer actually looked it up. We have a model equation in there. That's around 4.3%. Some estimates are a little bit lower.
Powell was asked that question, too. He feels, and this reflects some of the FOMC, but not all of the FOMC, that we're still a little bit above the equilibrium rate.
But if you want a range in between what the Fed is saying and what we are estimating and some other outlets, I would say it's maybe between 3.75 to 4.25. Okay. That is sort of the estimate I'm seeing. Kind of in the ballpark. Okay. So that would suggest that all else being equal, if the funds rate target currently is close to...
the equilibrium rate, all else being equal, I hold firm. A reason to pause. Right? Yes. And that's right. I mean, your official line is inflation is still slightly elevated. We are still slightly restrictive. That is the official term. Slightly restrictive.
but we're getting very close to what neutral looks like in short right okay and so now i'm going down the react i'm looking at the rest of the reaction function if i look at the the strength of the economy the labor market you mentioned the gdp uh the so-called oppo gap or the difference between unemployment and full unemployment that's consistent with we're there so that has no impact on interest rates
Inflation. Yeah, what's happening, inflation a little bit in terms of the labor market, the sense of the Fed is that labor markets are roughly in balance. So there is no big concern about unemployment at this point. There is no big concern about wage growth on the Fed side. It's still that small piece of inflation. Right. So that... And so...
the actual inflation, as we said, is a little bit above target. So that's one reason why you would want to keep the funds rate a little bit above that equilibrium. And it feels like that's where we are. Then there's financial conditions. Now here, it's a melange of stuff, stock prices, credit spreads, bank lending standards, fixed mortgage rates, so forth and so on. How do you think about financial conditions? Are they
All else being equal, are you for higher rates, lower rates or no change in rates? So the answer of how I think about financial conditions is broadly saying broad. Right. So it's not one of these particular things. It's not the stock price. It's not interest rates per se.
The stock price itself, I think we've talked about this before, stock price valuation looks very frothy. The S&P has done very well over the past couple of years, way ahead of GDP growth. If you look at price multiples, price earnings ratios, they start to resemble periods like the early phases of the dot-com loss that are fairly highly valued.
And there is a sense that that may correct going forward. Powell was asked whether that is a big factor for the Fed. And when it comes to stock prices alone, the Fed will usually punt a little bit. Stock prices are volatile. They don't affect everyone. The Fed looks at this much more holistically. There's data sense what's happening in bonds market, what's happening in the household side, how much can households absorb a shock, how much can banks absorb the shock.
And it is true that certain valuations look a little frothy, stock prices, 10-year yields, treasury yields have increased. We can talk about that in a second, too. But at the same time, you have a financial system that is much better capitalized than it was, say, in 2005. Banks have much bigger buffers. So even if there is a bit of a correction, the Fed is not too concerned that that could really cause a widespread decline. So financial conditions are not so tight that the Fed feels they're choking off the expansion at this point.
Yeah, it feels like to me, I mean, stock prices would say financial conditions are rip-roaring easy, but the 10-year treasury yield and the fixed mortgage rate would suggest, oh, no, they're tight. And you kind of take all these things together. It feels like kind of a wash. It's hard to conclude one way or the other. I think the word I would use, too, it's mixed, but there is really nothing here that suggests – it's not really setting off my alarm bells at this point. Okay, okay.
And as I said, it's not just asset prices. It's also the question of do banks have buffers to deal with this? Do households have buffers to deal with this? And if you compare that to, say, the early 2010s, household debt is a lot lower, debt service is a lot lower. So there is more capacity to deal with tighter financial conditions than in the past. Okay, so you mix all this up, you consider all the elements that go into the reaction function,
What does it say to the Fed on hold? Feels like. For now, I think it says on hold in the near term. We talked about what the current data is suggesting early on. We have reasons to believe that inflation is going to improve. We don't have strong reasons to believe that economic fundamentals say until May are going to decelerate a lot. So I think at that point, if you're in the Fed's shoes, you kind of hold and see what happens on the inflation side.
And then, of course, because there's policy changes, things will get reshuffled in the second half of the year. There's a lot of uncertainty about what the policies will look like. So it's difficult to say at this point how exactly it's going to shake things up. Right. That's in some sense, it's a data problem. You heard that conversation. I mean, would you take umbrage with any aspect of that? No, I think that's the...
Good summary. I think it's the right move to certainly pause at this point. There is, you know, the elephant in the room, of course, is the policy. You have tariffs, deportations, tax policy. Right. So given that all that uncertainty again, best move is. I mean, it almost feels like even if you didn't have the uncertainty,
You'd pause. You'd pause. Now with the uncertainty. All the more reason to pause. And the other thing about the uncertainty is it's related most immediately this year to tariffs and immigration policy. And those policies will, all else being equal, raise inflation.
And we can growth, right? Yeah. So you're at the Fed, which is it? If it's adding to inflation, then that means I raise interest rates. If it's hurting growth, that means I lower interest rates. But I have no idea which one wins, which one wins. So therefore, I go I go on hold until I get clarity around the policy, what the fallout is and which is predominant. Is it the inflation or is it the growth? That's right. Yeah.
Right. Does that sound right to you? Yeah, that sounds right. And Paul was actually asked this question regarding heightened uncertainty. And what he'll say is in this scenario, what pretty much any central banker will say is like, this is a transitory problem whenever you have a new administration coming in. Policies change. Usually the changes are, in a sense, marginal. I mean, they have impacts, but you don't go from 3% growth easily to, say, a really deep recession. That's not what policy really does.
You have to process what the policies are. You have to get a sense of how they affect data. And once you know that, then you can start acting. And later in the year, they will know that. They just don't know as of today because we haven't seen it yet. Well, you think they'll know that given. I'm not sure. You hope. Sure. You hope we know something more than we know today, I assume. Marissa, what do you think? Are you on board with all this or would you push back on anything or highlight anything else?
No, I mean, I think I'm increasingly more in the camp of if they do anything over the course of the next six to nine months, it might be that they raise rates. It,
It's really hard to argue why they would be lowering rates at this point, given everything. The labor market is solid. The rest of the economy looks solid. They're not worried about that. Inflation is still above their target. And the outlook for inflation, if anything, is that there's some upside risk to it. So pausing seems like the right thing to do now. And barring any collapse in the labor market, which I don't really see where that would come from out of the blue,
it seems like being on pause and watching inflation is what they need to do. So I don't see why they would lower at this point. Right. Okay. In our baseline forecast that we all work on and put together every month, that's kind of in the middle of the distribution of possible outcomes. We have the Fed on hold until the September 2025 meeting. They cut a quarter point at that meeting, then again in December, and then
under the idea that the equilibrium rate will start migrating lower in 2026, they cut rates a quarter point each quarter until we get back down to 3% by the end of the year. That's our estimate of the equilibrium rate in the long run, you know, abstracting from the vagaries of the business cycle and sensitivity of the economy to interest rates and all those kinds of things. Martin, does that, I know you're, you are key to making that forecast, but
So I'm asking you to comment on some degree on your own forecast, but what do you think? Is that comfortable with that? And if it's wrong, in which direction would it be wrong?
So I'm comfortable with that based on our assumptions surrounding inflation and surrounding GDP growth. So it's contingent on that. We do, in fact, have inflation tick up. We actually still have it accelerating by September. So I think it peaks in early 2026 as an outcome of tariffs and migration policies. But at the same time, and Mark alluded to that earlier, we also have GDP slowing down.
And in a sense, because as GDP comes down, the neutral stance comes down as well in the near term. So we're moving away from these 3.75% to 4.25% that we mentioned earlier, closer towards 3.5% and eventually to 3%. And for the Fed to remain neutral, that alone implies a rate cut.
So it's not so much the inflation side itself. It's more that if the neutral rate really comes down slowly, if the Fed keeps the rate where it is, monetary policy will become more restrictive automatically. That's just by the virtue of the underlying, what defines the neutral rent state, stands changing over time.
That said, which way could it be wrong? So there's two things. So in the near term, inflation is going to decelerate, I think, most likely. That's what we see. The core drivers, shelter is falling. Base effects. Pretty much anything base effect. So this is a scenario in which inflation is going to look at target for a couple of months until March. If labor markets start to look a little bit wonky, the Fed might have an inclination to cut in March still.
I don't think it's particularly likely. If they don't cut in March, the window is going to close because at some point, inflation is bound to pick up. At that point, they're not going to cut. The longer the wait, the less likely it becomes for something. Because you're saying it's going to pick up because of the tariffs and the- That's right. That's exactly right. Right. So they've got a window here before the tariffs and immigration policy kicks into gear, right?
that they might be able to move another notch down in rates. That's right. That's the risk. That's a potential outcome, right? One of many. Potential outcome, yeah. Right. And markets go back and forth between essentially that outcome and our baseline. So when a good batch of economic data releases, markets expect an earlier cut in early summer
When bad information is released, it moves back. Recently, markets, Fed funds, futures markets have swung more towards the later summer into the fall. So there is less of a perception that the Fed is really going to cut still, partially in mind with the fact that inflation might pick up later on.
The other outcome is we don't know what the actual inflation effects are going to be. So when we're talking about deportations, there is an extreme estimates that I can put out there, which is we export, we deport 11 million people, 5 million of them workers. If that were to happen, it's not likely, but if that were to happen, it will potentially act much more inflationary. And at that point, the Fed is not going to cut later in the fall or potentially might increase rates.
But that depends on the extent of what these policies are going to be. And at this point, it's just difficult to say how that's really going to play out. Okay, got it. It sounded like, Marissa, if you took the baseline, and I asked the same question, if the baseline is wrong,
What would be the forecast? It sounds like you're saying rates would be higher, not lower. They're going to go up, not down. Yeah, I mean, I think there's a possibility that we don't get two cuts this year. Maybe we get one. Right. Or none, depending on- I think there is. I agree. We have discussed it at the point, but given what our current outlook for inflation and GDP looks like, that's where we ended. We will learn more about what will actually happen, and based on that, we'll have to adjust the outlook.
all right first what if we're wrong which way would it go i'd agree that no cuts no cuts so that would be my gut feeling but i think the baseline that we have is a reasonable approach it's just low confidence i think that's what we're saying here right uncertainty right
Yeah, I mean, I think our baseline is good just because I can see both sides. Yeah, there's too much uncertainty to change it. If I can say it's equally probable the rates could be higher and lower, then it feels like the baseline is right. You know, it feels like that. But I can make a case, you know, if you go back to Trump won when he imposed tariffs, it actually...
forced the Fed to start cutting interest. They waited a while and then they started cutting interest rates because the inflationary effects were small relative to the growth effects. The growth effects were pretty significant. By 2019, the economy was really weakening. Manufacturing and agriculture was in recession because of the tariffs and retaliation by the Chinese on the agricultural products that we sent to China.
So if that's a good case study, that would argue, you know, maybe even lower rates towards the end of the year going into next. Those tariffs are pretty targeted though, right? Now we're talking about the broad base. So then more inflation yourself. Yeah, more inflation. But let's see, who knows? This is a negotiation tactic as well. Right.
Okay. Okay. Anything else on the Fed, Martin? Did I, you know, I was pretty prescribed in the way I framed it, and I don't want to box you in. Is there something that we should be thinking about that we didn't talk about before?
Nothing with regards to current politics. I mean, we could talk about independence, but that's a tail risk. The sort of question, does the Fed get captured? We don't really, I mean, because Trump at some point before he was elected suggested that he might want to have a say in interest rate decisions. The Fed is, of course, institutionally sheltered from the administration. And Jerome Powell has made it pretty clear that he's not going to be easily convinced to listen to any politician.
Although he's gone in March of 2026, isn't he? He's gone in March of 2026, but the FOMC has seven members. And then, sorry, the FOMC has 12 members. There's seven governors and the rest are district bank presidents. There's only two of the governors that are going to be replaced in the coming years. So that's Jerome Powell, most likely. And the other one is Adriana Kugler, who took over Leonard Brayman's seat. So it's difficult to capture the Fed in conventional ways.
You could try to get to Congress and change the law. You could try to go the legal route. But all of this seems really difficult to do in the end for what? Because you want the federal funds rate to be a quarter point lower. I'm not entirely convinced that that's really a likely outcome. It's possible. Right. That's a good point about Fed independence, though. Although I always get confused about that. I mean, I know President Trump wants lower rates, but...
if he's pushing the Fed to lower rates more aggressively than the economic data would suggest is appropriate, if he's not using the same reaction function as we all are using, the markets are using,
All that happens is it drives up long-term interest rates, right? That's right. And your treasury yield rises, fixed mortgage rates rise, corporate borrowing. So, and that's where the action is in terms of the impact on the economy anyway, right? It's not really that, I mean, funds rate matters, but what really matters is the longer term interest rates.
Yeah, that's the thing. I mean, I don't 100% understand the argument. You could do something like this. You cut the interest rate more than what the data suggests. What's going to happen is it's going to push up inflation expectations that drives up to 10-year. And effectively, you have the same outcome. So as I said, I don't really see it. There is a risk that there could be an attempt to…
cut independence of the central bank that mostly in longer-term terms would result in higher inflation. What it would do politically is not entirely clear tonight, to be perfectly honest. Right. Okay. So I'm confused as well. Anything on Fed independence, Chris or Marissa, that you want to point out? No, so far, we haven't seen any real threats. Yeah, I mean, Powell was asked directly during his press conference if, you know, Trump did not, President Trump did not like that the Fed held interest rates higher
where they are, was very vocal about it and said that he would demand lower interest rates. And he was asked directly, did you hear directly from President Trump? And he said, no, I've had no contact with him. So and he won't answer any questions really about about the president. Yeah. Although President Trump, when he was speaking to the World Economic Forum in Davos, was, you know,
Pretty strident. Yeah, that's when he said he would demand lower interest rates from the Fed, right? But again, it doesn't really matter because bond markets are not controlled by the Fed. Right. So the outcome is it makes a minuscule difference. I have a question that is also a little... I'm trying to digest that comment, but go ahead. Go ahead. Yeah, yeah, yeah. Go ahead.
I have a question that's also a listener question. What about the Fed's balance sheet and the fact that it is QTing now? I mean, how much of an effect do you think that's having on long rates? Very little. If any. Very little. So there are estimates around it that can get academic, but I'll keep it short.
So the first thing to be clear what QE and QT is, after the financial crisis, the Fed started buying long-term assets, particularly treasuries, because the policy rate had been zero. And in some sense, that's an attempt to lower longer-term rates to stimulate the economy. Over the past few years, the Fed has reduced its asset size, its asset holdings, in part because...
Less to really reduce rates, to increase rates, but more because the Fed doesn't really want to absorb all this outstanding treasury debt. That is something that markets should do. It's not really the function of the central bank. So in some sense, that's a part of normalization.
But to be clear, QT is not QE in reverse. When the Fed bought assets, it bought long-term assets. In QT, the Fed is not selling assets. The only thing the Fed is doing is it's letting assets mature. And the assets that are maturing are short-term assets. That's a one-year bond, for instance. It's not a 10-year bond. And as a consequence of that, when you look at the composition of the Fed's balance sheet, the overall amount is smaller.
But it is now a much larger share of long-term bonds in there than there was before the Fed ever started QE. And as a consequence of that, whatever rate effect there is from the Fed buying these assets is larger than of the Fed rolling them off now during QT. There are estimates that academics have produced at the margin that comes down for about a percent of GDP, which is in the trillions, that rolls up shares of four or five basis points of the long-term rate.
So the effects are very small in terms of just the Fed reducing its balance sheet. - Well, Martin, we make our own estimates, right? I mean, we have the estimate of the impact of QE, QT on long-term rates. I think it's for every percentage point, and you correct me if I'm wrong, you know the modeling better than I, but every percentage point change in the amount of Fed assets to GDP
results in a couple basis point change in the 10-year yield. That's right. That's right. That's right. But that's an interesting point. You're saying the QT is mostly going to affect the short end, shorter term interest rates, because that's what's actually maturing. Yes, that's right. Was the long end. Okay. Interesting. I mean, there is a secondary question. As public debt grows in the future, if the Fed is not buying this additional debt, somebody else has to buy it. Right. And that would presumably be households, investment firms, and so forth.
These agents are much more interest sensitive. That will make demand more volatile. That has a potential to push rates up. But we are not really there yet. We're really talking about the current run of QT. Yeah, I'd push back on that comment that it's not having much of an impact. I mean, I think in the current context, because there's no net buyers of treasuries. The Japanese are not that anxious because they can get an interest rate with no currency risk on their own debt.
You know, the Chinese are exiting for obvious reasons. The banks are cautious because of what happened to them in their bond portfolios a couple of years ago. All you have left is the hedge funds. Right. So you're replacing the Fed with hedge funds. Price insensitive, price, Uber price sensitive. That feels like that's a that's a meaningful impact on long term interest rates.
Yeah, sure. But I mean, to be clear, the Fed and foreign central banks are still holding about a third of outstanding debt. At one point, it was closer to 60%.
That's going to change going forward more and more and more. And so this is why I'm saying we're coming off a run of QTE that's reducing the foot imprint as the treasury is expected to borrow more, which it is under really all projections. The share that is held by central bank is going to fall. And then it's going to become increasingly a problem. Got it. Okay. Well, guys, I think we need to cut this short because Chris and I have to go do some work.
you know, some Moody's work. That sounds very important. It's important. It's very important what we got to do here. So we're going to go off and do that. And unless anyone has anything pressing to say, Chris, Marissa, no, Martin, thanks for joining us. That was very insightful. Happy to. Yep. We're going to call this a podcast. Thank you to your listener. We'll talk to you next week. Take care now.