The Federal Open Market Committee started its hiking cycle in March and everyone expects another increase when it meets May 3-4. With uncertainty about how much the FOMC will raise interest rates at the meeting, Steve Skancke, chief economic adviser at Keel Point and former White House and Treasury Department staff member, will discuss the May decision and the panel’s next steps in fighting inflation.
Transcription:
Gary Siegel: (
Welcome everyone. Thank you for joining our Bond Buyer Leaders event. I'm your host Bond Buyer managing editor, Gary Siegel. Today. We're going to discuss yesterday's Federal Open Market Committee meeting with my guest, Steve Skancke chief economic advisor at Keel Point. Steve, welcome and thank you for joining us.
Steve Skancke: (
Thank you, Gary. It's always great to be here with you.
Gary Siegel: (
The Fed yesterday, as expected, raised rates by 50 basis points, they said that there will be some more 50 basis point hikes, and they also announced plans to reduce their balance sheet. Was there anything in the statement or Fed Chair Powell's press conference that surprised you or grabbed your attention?
Steve Skancke: (
Well, there certainly was Gary, for the first time, at the beginning of the meeting Chair Powell opened up by saying, the following: before I get into the details of today's meeting. I'd like to take this opportunity to speak directly to the American people, and at that point he went on to say inflation is too high.The Fed is determined to bring it down, and it's the Fed's problem, to solve, implying that the fed will do whatever it takes to stop prices rising so fast. When he was questioned about that, because to be honest, it was a little unusual, he pointed out that, well, indeed the Federal Reserve works for the people and that's who they seek to serve and that he wanted to assure them that they recognized that it was a problem and that they were on it. I think that's a helpful beginning, it did take me aback when I heard him start that way.
Gary Siegel: (
I think it took everyone aback because usually Fed chairs, don't speak to the American people.
Steve Skancke: (
The, the other thing that was, that was sort of interesting Gary, is that he used the opportunity to, to preannounce as you mentioned a moment ago, two more rate increases of a half percent each. He just said that these are on the table signaling that's where they're headed. He's generally been more reserved in the past so as not to get out in front of where the committee is likely to go. But I think it clearly is a recognition that they feel they are behind the curve and they need to move more aggressively to catch up not only to stem the rising prices, but also to provide confidence that they're on it and that they recognize that data has changed and they need to reflect that not only in what they do, but also in their messaging,
Gary Siegel: (
There has been some speculation that part of the reason that the Fed was behind the curve and didn't move sooner was because there was uncertainty about the leadership. President Biden was a little bit slow in picking his next chair, which turned out to be Chair Powell and the other leaders on the team. Do you feel that this played a role in their being behind the curve or were they behind the curve anyway and people are just looking for excuses?
Steve Skancke: (
Well, I think they were behind the curve, Gary and Chair Powell pointed out that he thought and the committee thought that they had been in sync with the data and that then in the fall, in November, they could see that the data had changed sufficiently, that they needed to chart a new course. Unfortunately that was right when the nominations were being discussed and we all recall that there was a lot being said about that, and a good bit of controversy as to why the president would reappoint Powell when there were others that could be appointed in his place. It always puts the incumbent a little bit at a disadvantage. I think Powell was trying to do the right thing, but at the same point he couldn't look like he was campaigning for the job. And so looking back though, I don't think it was necessarily their intent. I think it did get a little bit more behind the curve
Gary Siegel: (
And in some ways they painted themselves into a corner because they said that they weren't going to raise rates until they cut off purchasing assets. And they said that wouldn't be for a while. I forget the exact words they used, but they weren't even thinking about thinking about raising rates...
Steve Skancke: (
That's that's right, Gary. They painted themselves into a corner in a couple of different ways, where they just said, you know, the threshold is not hearing about more inflation. It's not hearing about an improvement in the employment situation. It's actually seeing it, it's having the evidence it's sitting and watching it go by and of course by the time they're watching it go by, inflation was really taking off. Now employment was, new job creation was behaving in a good way. And so that was helpful to them, but to your point, they were waiting and watching for the evidence to pass before their eyes, before they even addressed the issue of qualitative tightening or increasing the policy rate. That might have made sense in a normal circumstance, but with the way accelerating inflation turned out complicated, obviously by a whole host of things,
Steve Skancke: (
they were really, really playing catch up. CPI was five and a half percent in December. And when you drill down on it, it was seven and a half percent increase in product prices, only two and a half percent increase in services. And we had the Omicron variant showing up, well in early December it was still the Delta variant. And then we had a pause and then Omicron came and, I think they were quite nervous and tentative about how much of that was COVID-related, how much of it was transitory, even though they weren't using that term anymore. But basically a misalignment of supply and demand and, where purchases were being made and then all of a sudden, it just popped up with these, breathtaking rates, and there they were.
Gary Siegel: (
Let's talk about inflation for a minute. There's still quite a difference of opinion about when inflation is going to calm down and whether it's peaked. We were talking before the audience arrived about next week's CPI projections, which right now the estimates I see are two tenths of a percent on the headline number and four tenths on the core. Where do you see inflation going? When do you see it calming down?
Steve Skancke: (
Well, Gary, we actually had good news on the personal consumption expenditure index that was out last Friday. As we know, that's what the Fed tries to pay more attention to. And it actually ticked down by a 10th of a percent. That certainly falls within the range of data discrepancy. But, it was down from 5.3 to 5.2% core. And, that was a good indicator. We also expect, as you have just pointed out that headline because energy prices have come down, also should be, more well behaved in the data coming out next week than what it was last month. Core seems to be up just a little bit from where it was in March and that may again be a data anomaly.
Steve Skancke: (
It may be a reflection on some of this coursing through the economy, the higher energy prices coursing through the economy that just haven't settled out yet. I'm hesitant to say that we've reached the peak, but it's hard to see anything except some extraordinary external event that's going to drive core inflation, significantly higher at this point. And with the variability in commodity prices, energy in particular, we could actually see now the beginning of the decline. But I guess bottom line, I think we're at or near the top and should expect to see some flattening out with a decline to follow.
Gary Siegel: (
So if we're topping out on inflation and the Fed is just beginning to raise rates, it's raised 75 basis points, and it's talking about another full point in the next two meetings, and we know that monetary policy works with a lag, why are they moving so quickly? Is this the right move?
Steve Skancke: (
Yes, I believe it's the right move, Gary, for these reasons. One is they've been very effective at telegraphing, what they're gonna do, and that has been included in market expectations and planning certainly by businesses, some by consumers, but, certainly reflected in markets. Markets understand where they're going and so they're starting to get some of that effect already. They, aren't happy with inflation at 5.2 or five or four and a half or, or four or three and a half. They, they wanna get that down. They're also very uncomfortable with the difference between job vacancies and the number of people who are unemployed. So an unemployment rate of 3.6%, which is itself historically low. So you've got, you've got 6 million unemployed looking for work. You've got 11 and a half million job vacancies, and they don't wanna see wage inflation get worked into the system in a serious way.
Steve Skancke: (
And of course, the way to do that is to raise the interest rates until consumer spending eases up, business hiring eases up. And so job vacancies continue to move in the direction of 6 million unemployed and that we also see labor force participation start to move up a little bit as well to close that gap between vacancies and the unemployed. Obviously it also affects consumer spending, vonsumer investment in new homes as mortgage rates go up and those are all the things that the Fed is looking at with raising their policy rate, which of course then bleeds into the other rates that have the effect of slowing down demand. As you and I know the Fed can't really do anything to affect supply, so they've gotta deal on the demand side and the best they can do to tamp down demand is to reduce or make it more expensive to borrow, to have consumer debt credit card debt, mortgage debt, for businesses to be borrowing, to continue to go out, to look, to hire people and, spend to try to bring that back closer to an equilibrium level.
Gary Siegel: (
Well, considering that many employers say they're having trouble finding employees, Steve, do you think that there's a possibility that they won't stop hiring if the economy slows down because they'll view this as an opportunity to get the employees, they haven't been able to get the past six, 12 months?
Steve Skancke: (
Well, I do think, Gary, that they will continue to hire as they're able, but I think the pace of hiring, the demand for employees, will go down. The Federal Reserve and in fact, Chair Powell talked about it in his press conference yesterday. They talk about a neutral rate of fed funds or a neutral rate of interest, at which the demand is not increasing and it's not decreasing. And when asked about, well, what did you think that neutral rate was, he said basically that it's somewhere between two and 3%. We might imply two and a half to 3%. So when they have the, rates that you just outlined a moment ago, up 25 bps already, another half percent yesterday, two more at a half percent, that that puts 'em up, one and three quarters.
Steve Skancke: (
And then if they just do another quarter for each of the, the next three meetings there, they are up two and a half percent and they're in the sweet spot of what they think is the neutral rate, where they ought to see, albeit with the lag that you pointed out, they ought to be able to see a slowing in the demand for business spending, and in new employees. It's not to say that they're not gonna be opportunistic in hiring people that they want to get. You know, the other factor in this is COVID. I know we can talk about that a little bit further later in the context of some of the other things, but, you know, there's still 2 million parents who are not working they're out of the labor force because they haven't had reliable, dependable, affordable childcare. Kids all of a sudden school is closed for a week, or school is closed for two days because someone tested positive for COVID, that obviously the Fed has no control over that, but as that tends to normalize more and more, and we move away from this phenomenon of shutting down schools, because a child has tested positive those parents will be better able confidently to go back into the labor force. That'll make a huge difference in meeting that pent-up demand for employees.
Gary Siegel: (
Well, they thought that that would happen last September, given that vaccines are available and it didn't happen. What are the chances of that happening next September? How, do they measure COVID's demise or waning?
Steve Skancke: (
Well, I think there's a couple of phenomenon that we are observing. One is there's certainly a realization that we cannot eliminate it completely. I don't think anyone in the United States has thought that we're gonna go to the China model where they just tolerate no COVID infections at all. And hey'll do whatever it takes to prevent that. There's a new study out, or several studies about the impact of shutting schools because of COVID and the impact that that has had on children with no material protection or benefit to their health. And so my impression is that we're, that we're crossing that bridge, or we've crossed it already, that we're gonna react differently to what happens with COVID particularly among younger people.
Steve Skancke: (
And that doesn't mean that, something couldn't happen that changes that equation, but just looking at where schools have migrated daycares have migrated, where we've gone on the issue of not having to wear masks on airplanes or in airports, and the almost indifference in the White House. If you remember President Biden's comment when he was asked about it was almost well, whatever. And I think that's a typical reflection of where the federal government is, and also where a lot of the state and local governments are obviously. There's still pockets of restrictiveness, but those seem to be easing up more and more, and so long as parents can have confidence that when they take their child to school, that the child will be able to stay there and not be sent home because of COVID that'll be a game changer for the 2 million parents who are out of the labor force.
Steve Skancke: (
Another question is, will it be a game changer for the baby boomer generation that took early retirement which could also have an impact, that was 1.2 million. You can't expect that all of them come back, or even that all of the 2 million parents that are out of the labor force temporarily all will come back. But, but out of the 3.2, if you got half, Gary, 1.6 million, that's a big dent in the, gap between, 6 million unemployed and 11 and a half million jobs, that would make a big difference in labor markets, in wages and generally in inflation.
Gary Siegel: (
Let's talk about the other thing that the Fed said yesterday, Steve, they said they were going to reduce their balance sheet starting June 1st, any surprise in the numbers, and how much of the reduction will equal, how many basis points of tightening?
Steve Skancke: (
Sure. The second question first. How much reduction in their balance sheet affects an equivalent increase in their interest rate? Chair Powell said that it's a little bit amorphous and a little bit hard to pin down, but they, that said, they believe that what they have done, which is sort of once it's fully implemented, or once it's fully going beginning in September, that'll be equivalent to about 50 basis point another 50 basis point increase in the fed funds rate. It's interesting the way the they've set it up. They have not set it up so that they're gonna sell anything on their balance sheet. They're going to use principle payments to let it go down 47 and a half billion a month, up to 47 billion and a half per month, beginning on June 1.
Steve Skancke: (
And then beginning on September 1, three months later, up to 95 billion a month. Well, the 35 billion of that is in the mortgage-backed securities is a cap that they're likely not to reach. When you look at what's on their balance sheet and the likely amounts of monthly principle payments, that's for the most part, not gonna exceed 20 billion a month. And, so rather than it being a 95 billion a month, when fully operational, it's more likely to be in the range of 80. I thought it would be between 90 and a hundred. Maybe it will get to that point at some time, but, just looking forward to the balance of the year 47 billion and a half per month for June, July and August, and then for September through the end of the year, probably around 80. Part of that is signaling what the Fed is doing in soaking up some of the liquidity in the system, which will also have an impact on Treasury interest rates, and mortgage interest rates.
Steve Skancke: (
But part of it is, is also just a signal that they are pulling back some of the things that they had done, quite rightly, when COVID hit in March of 2020.
Gary Siegel: (
So that now that we've discussed everything the Fed did, let's turn to the more important and difficult question of will the Fed need to go to restrictive policy in order to control inflation
Steve Skancke: (
That's probably the $64 million question as to whether they can get by with what they've announced. Certainly their hope is that they can. They would like to engineer a soft or softish, as Chairman Powell says, landing for this, that is to get the inflation rate on a trajectory back toward 2% per annum sometime in 2023, 2024, without putting the economy into a recession. The fundamentals of the economy continue to be strong. That's good news, consumer balance sheets, corporate balance sheets, liquidity in the system, general fiscal stimulus, although we'll be in surplus this quarter, but for the fiscal year,, we'll have a deficit, which, provides fiscal stimulus. And so the hope is that those things will be enough.
Steve Skancke: (
But there was a question raised in the press conference about what former Chairman Paul Volcker had to do to bring inflation down in 1981, and that was to slam on the brakes hard, and it put us into a recession, a steep dive, hit the bottom state, rebound and Chair Powell said that the FOMC is ready to do that if necessary, but, their expectation and their hope was that that would not be necessary. When I visit with my colleagues at Keel Point, our clients, we see a lot of positive indicators that should prevent that from having to happen. But, we are still early in the game, just seeing the CPI number next week will be really helpful to see if there's positive movement in the right direction. If there is, that reduces the probability of harsher, more restrictive measures. If it's moving in the wrong direction in a big way, or if there's something else that's happening externally to what the Fed can control that is, or likely will drive inflation up, that makes it very hard for them to be very patient for very long.
Gary Siegel: (
So the negative GDP reading for the first quarter can be ignored because the economy is fundamentally strong?
Steve Skancke: (
We should never ignore it, Gary, because it is important data, but, it's probably as much COVID-related on the negative side as it is anything else. Net exports were down 3.2% in GDP and a normalization of retail inventories was also another 0.8% drag on first quarter GDP. When you look at just the raw export and import numbers, it was like all the ships that were off the coast of Long Beach finally landed and got unloaded and booked into the national income accounts and lo and behold, we had this massive increase in imports at the same time. We were not able to get our exports out. So that explains the big negative number. Can't ignore it, but we can explain it and understand it on the other side of it, the sales to private buyers was up 3.7%.
Steve Skancke: (
That was consumer spending was up and I'm just trying to see if I had those numbers here, but I don't, it was both consumer spending and business capital expenditures on technology, productivity-enhancing, labor-saving, training for their labor force. And the thing about that, and obviously raising interest rates will tamp that down a little bit, that's the goal of it, but businesses don't spend on technology and labor productivity enhancement, if they're thinking about terminating those workers, I mean, they're spending because they need to make their employees more productive, more productivity allows them to pay higher wages without having to experience higher unit labor costs. All of that is positive. Now, clearly we wanna see what happens in the second quarter, but just think of the COVID impact of that massive import number with moderated exports.
Steve Skancke: (
Those things just have to work through the system. It takes time. At Keel Point we're obviously paying attention to it, but we're not worried about it. Our base case for GDP growth in 2021 is that it'll be positive, probably more in the range of one to one and half percent, but not negative. In other words, no recession in, 2022. We'll see what it looks like in 2023. And that goes back to a point that you made earlier, Gary, about there being a lag with monetary policy. So they could raise their fed funds rate, their policy rate to two and a half percent or two and three quarters percent this year. The big part of that, especially at the tail end, has an impact in 2023. And that's where we're gonna see whether the landing is a hard landing or a soft landing.
Gary Siegel: (
I'm going to turn to the audience questions now, because we have several in. One person asks, how do you explain yesterday's reaction with equities surging and today's reaction where rates are spiking and equities are plummeting?
Steve Skancke: (
Gary. It's what I sometimes call extrapolation fever. The markets were factoring in a three quarters percent increase to be announced yesterday. There was a positive probability that the Fed was gonna do that. And that was gonna set the tone for what came next. While there was a general sense that that isn't the way that they were going, there was certainly that fear. And when the Fed didn't do that and Powell actually said 75 basis points is not even on the table, we're not even thinking about that huge, positive reaction to the markets, Powell validated and confirmed what market expectations were and the markets provided a relief rally. You start thinking about that overnight and what it looks like and all the things that he said, and what does it really mean?
Steve Skancke: (
And, you know, maybe they went out and celebrated last night, Gary, I don't know, but there certainly was a hangover today that showed up in markets, and, what caused it, my guess is that, and you and I both watched the press conference, carefully is that when you parse through all the things that he said, like, and we mentioned this a few moments ago, we'll do what it takes. Paul Volker did what it takes. He did the right thing. We will do the right thing. If we need to have restrictive measures to get inflation knocked back to where we wanna do that, we will do that. Well, you know, I think that hung in the air and had an impact about them thinking that forward. That certainly would be one thing. The fact that he talked about the neutral rate, we're gonna raise interest rates to the point that businesses stop looking to hire new employees, and exactly what does that mean? Well, he wants to damp down the demand that businesses have for spending on other things that they've been spending on, being out there with 11 and a half million job vacancies.
Steve Skancke: (
Okay. So, you hear that and you hear the talk about the neutral rate, and then you start thinking about it. Well, what does it mean? Okay. If we've got a huge demand for new employees and we're doing all of this spending and the chair of the Fed has just said that they've decided that they're gonna take action to tamp that down, to damp that down. I think you woke up this morning and had concern about what it meant for you and your business and your investment portfolio. And is this a time to go to cash, go to the sidelines, wait and see how this plays out.
Steve Skancke: (
It's an understandable reaction. Is it the action that we're gonna see tomorrow again? I don't know. I try not to predict what the market is gonna do day-to-day. At Keel Point, we find that that just isn't helpful either to ourselves or to our clients, but, with corporate balance sheets and earnings and consumer balance sheets, where they are, it's very possible that the market could get oversold quickly. And then you see a different reaction. You see a different rebound in the markets as folks figure out exactly what this means and how this actually plays out through the economy.
Gary Siegel: (
So our next question, Steve, is what percentage of inflation is due to supply side issues, which the Fed cannot control?
Steve Skancke: (
Gary? I think it's probably in the category of 50%. It's hard to know exactly when we see what's not getting produced and coming out of China, when we see what's not getting offloaded from ships, when we see U.S. auto production is stalled because of an insufficient chip supply. And you just sort of go down the list on those things very quickly as what we saw in December consumers were trying to spend on products, and products weren't there. Products had been there in the past would have been there, but for COVID shutdowns, particularly overseas, labor supply would have been there but for COVID restrictions. And so ask yourself, is it because people are actually trying to spend more? Yes, there's a little bit of that. Pent up consumer demand, strong consumer balance sheets, low interest rates, demand for housing in a shortage situation. But it is that supply was disrupted, both on the import side and on the domestic production side because of the unavailability of raw materials and intermediate goods and services that typically we import to finish out in our production line.
Steve Skancke: (
So, as I say, hard to know. Rough guess, reasonable guess is sort of 50% of it, the Fed can't control. So they've gotta focus on what they can control.
Gary Siegel: (
The next question is, do you think the Fed will provide, provide a backstop this time if the market continues to plunge as rates rise?
Steve Skancke: (
I don't think so, Gary, I think the old notion of a Fed put is off the table right now.The Fed gets wealth effect and all of those things, and it has no intent to punish equity holders or bond buyers, but at the same time, that's not its primary, one of its top two mandates and with equity markets in particular having performed so well over the last three years, the Fed would be hard pressed to address even a hint that they had provided a backstop to equity markets or bond markets for that matter too.
Gary Siegel: (
Next question is, in your opinion, how much did the second fiscal stimulus contribute to the current inflation level?
Steve Skancke: (
It was a big contributor, Gary, and it did what it was supposed to do. It shored up consumer balance sheets. It kept companies afloat, but what it didn't do as much as it might have been expected to do was really to preserve the production mechanism in the United States to be able to deliver the goods and services when they were, anew on demand as COVID abated. So 1.9 trillion coming into the economy gave a lot of people and then of course the childcare tax credits gave a lot of people, an opportunity not to have to go back to work, reducing the supply of labor against huge job vacancies. It provided the ability for consumers to be buying homes that hadn't been able to buy homes, allowing them to buy homes and helping to buy homes is a great thing, but it exacerbates the home supply shortage and was contributing to a driving up in those prices.
Steve Skancke: (
So bottom line, it was a huge contributor. It was a big stimulus, and regrettably, some of the money that got put out there and got spent, didn't do even some of the supply sustaining things that it was supposed to do. Good example is, money that was sent out to state and local governments that was supposed to be used in schools and the educational system. It got spent on things that didn't pay to add teachers or some of the other things that would've been more helpful in the environment that we're in right now.
Gary Siegel: (
I think we have time for one last question. One of our listeners wants to know, are you suggesting the Fed will sell mortgage-backed securities in the fall?
Steve Skancke: (
Not at all, Gary. What they've said is that they will allow principle payments without rolling those over on their balance sheet principle payments beginning June 1 at 17 and a half billion a month and beginning September 1 at 35 billion a month. But I also mentioned that the principle payments that are likely to be coming back to the Fed, beginning in September, or really beginning in June, but in any month, are more likely to max out at 20 billion a month. So a higher limit of 35 billion a month, beginning in September doesn't mean that they're gonna have that much in mortgage-backed securities coming off their balance sheet. And the Fed has said that they're not going to be selling these securities, only to allow principle repayments to reduce their balance sheet until it reaches a level that, as yet undefined, where they think they wanna maintain it. And we'll see what that means as we, as we go along. Certainly the Fed is mindful of mortgage, interest rates and those markets, and pay attention to that. When they look at inflation, they look at labor, which are their two primary mandates,
Gary Siegel: (
Well, I want to thank you, Steve. I could have talked to you for another 45 minutes.
Steve Skancke: (
Same here
Gary Siegel: (
Unfortunately have work to do. So thank you. And thanks to our audience for joining us today. This was very informative. Steve, always a pleasure.
Steve Skancke: (
Pleasure to talk. Thanks, Gary. It's always good to be with you. And it's great talking through these issues. They're so important to the public, to each of us, to our clients at Keel Point to your readership. So I'm glad that you asked me to be part of having this discussion. Thank you very much.
