Colby Smith is the US economics editor for the Financial Times, Steven Kelly is the Associate Director of Research at the Yale Program on Financial Stability, and Gerard DiPippo is the Senior Geoeconomics Analyst at Bloomberg. For this special year-end episode of Macro Musings, Colby, Steven, and Gerard join David to talk about the major surprises, themes, and underreported as well as overreported stories of the past year. They also discuss their prediction outcomes throughout 2023, the economic and political landscape ahead for 2024, and a lot more.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Our guests today on this special New Year's episode are Colby Smith, Steven Kelly, and Gerard DiPippo. Colby, Steven, and Gerard join us to discuss the highlights of 2023 and what we can expect looking forward in 2024. Colby, Steven, and Gerard, welcome back to the show.
Steven Kelly: Great to be here.
Colby Smith: Thanks for having us.
Beckworth: Now, I should say to Colby, welcome to the show for the first time. Gerard and Steven have been on before, but this is your first time. It's long overdue, so welcome, and of course, you are the Fed Beat reporter for the Financial Times, so welcome to the show.
Smith: Thank you for having me.
Beckworth: And I understand that you are doing your part for the US economy. You're adding to the future of labor supply, labor force in the US economy. Is that right?
Smith: Yes, absolutely. In a couple weeks' time, if it all goes according to plan, so hoping to do what I can to help rebalance labor demand and supply and help the Fed out.
Beckworth: I tell you, a true economic patriot, there you go. Okay, so I'm delighted to have you three on because you each bring a unique perspective and angle to our discussion today. Colby, you cover the Fed and issues surrounding that. Steven, you're a financial stability expert. Gerard, you're the international man. And so, you all cover areas, and sometimes it overlaps, and you know something about each other's area as well, so I'm looking forward to our interaction. We're going to take a look back at 2023, mostly, and then spend some time thinking about 2024. Let's start with our first question, and we'll go Colby, Steven, and Gerard. Colby, what was the biggest surprise of 2023 for you?
The Biggest Surprises of 2023
Smith: I've got to say, it had to be that third quarter GDP print where we saw the economy gaining, at an annualized pace, above 5%. That was the kind of growth that I think was well in excess of what was expected at this point, when you have the Fed funds rate at a 22-year high, and you think back to the way in which we know how tight monetary policy affects an economy. And so, that definitely, I think, was quite striking in a way, and it was obviously predicated on this much stronger labor market than I think anyone expected.
Smith: And I think if you told people that in December 2023, we'd be looking at a 3.7% unemployment rate, with fed funds as high as it is, I think that they would think that you were quite crazy. That, to me, really sticks out, and it's completely reshaped, I think, the whole narrative around a soft landing for the US economy, which is going to be a big theme in 2024.
Beckworth: Okay, Steven, what about you?
Kelly: Mine follows directly from that. Even Powell's tone a year ago about a soft landing, it was like, "Well, we're going to try." Now you have Yellen doing the victory lap tour saying, "Of course we were going to have a soft landing." Three rate hikes after $300 billion of bank failures, two rate hikes after $500 billion of bank failures, it's just a really resilient economy. We're a year out from that infamous Bloomberg headline that 100% of forecasters were forecasting a recession or whatever, so that has to be the surprise of the year.
Beckworth: Alright, Gerard?
Gerard DiPippo: The first thing on my list was the so-called “Balloongate” when the Chinese spy balloon flew over the US and derailed US-China relations for maybe six to nine months. The second thing was, and this is a little bit cheating, but AI. Technically, the hype with ChatGPT started at the very end of 2022, but actually, I checked the Google trends, and it didn't really peak until, really, May. This was the year when the world is speculating and sort of grappling with what AI actually means in practice.
DiPippo: The third thing would be the Chinese economy and the consumption recovery that never happened. Many people expected it to, but it did not. On the more national security side, there was a specific event, which was, in late August, Huawei announced a new cell phone, the Mate Pro 60, which had a semiconductor, a chip, that theoretically should have been prevented, from US export controls. And they actually announced this during Secretary Raimondo's trip to China. I think that sent shockwaves through the sort of national security apparatus and figuring out, are these things working? What do we do next?
DiPippo: Then finally, and this is probably the most dramatic and obvious, was the Hamas attack on Israel, which had a whole bunch of spillover effects, which we can get into. And then I would just say two quick honorable mentions, which might have been sort of generally under-emphasized. The first was the US-Japan-Korea summit, which President Biden had organized at Camp David, which, in a historical perspective, was actually a big deal. Then the final one would be, in my view, European resiliency in the face of its energy crisis, where, I think, they basically did better than I was expecting.
Beckworth: Okay, so there's a lot there. Let me circle back and ask a few follow-up questions. Colby, there's no recession this year. That was a big surprise for most of us, as you said, and an even bigger surprise, as you mentioned, the third quarter, this surge in growth. Why did we get it so wrong? What's the story behind our missed call in 2023? As Steven said, 100% of forecasters were expecting a recession.
Smith: I think in a lot of ways it has to do with the historical precedent. We'd never seen, or we had very few examples of inflation coming down by the magnitude that was going to be required, given the initial shock, without there being a more substantive pullback in economic activity, in higher unemployment, anything like that. It just really defied the economic models and relationships that we know to be true. And I think that there was just a hesitancy amongst policymakers who had erred on the side of missing the inflation surge on the way up to be too optimistic, I guess, as it was coming down about what that outcome would really look like.
Smith: They didn't want to be wrong, basically, in both directions. And so, I think that it led people to having a more pessimistic bent than otherwise would have been the case. I also think it's just an acknowledgement of the fact that in the post-pandemic era, labor market dynamics were just different than they were before. We had a degree of labor hoarding. We've seen supply take a while to catch up to demand, but now it's here. And so all of these things, I think, really challenged the narrative that was in place.
Smith: It just really wrong-footed economists again and again, and not just on the street, but also at the Fed as well. If you look back to all of the various economic projections that we got over the course of the year, it's remarkable. I think if you look back to December and March, and I guess March was around the banking crisis, the expectation was growth of half a percentage point for 2023, and that really just didn't play out.
Beckworth: Yes, some deep soul-searching is going on among all of us. Phillips curve thinking, how do we have this soft landing without creating any collateral damage in the labor market? So, a lot of soul-searching going on, but I want to go back to this point you mentioned about trying to avoid two wrong calls coming in and then coming out of the pandemic, and we end up doing it. By trying to avoid making a second bad call, we end up making a bad call by predicting a recession. Steven, one thing that I was curious about for this past year in your area, and that is the banking turmoil in the spring of this year. Was that a surprise to most observers, or did they see that coming with interest rate risk and the surge in interest rates?
Kelly: The issue of interest rate risk wasn't a surprise. I think that was an issue that was known, but was discounted. It's not inherently problematic for a bank to have unrealized losses, because remember, those marks are assuming that the asset is funded with, essentially, the Treasury curve, and banks fund way cheaper. They fund with deposits. There's still tons of profit even in an unrealized loss security for banks, but you’ve got to hold onto your deposits. And so, that was really news, I think, to a lot of investors, was the natural erosion due to the Fed and due to the state of the macro economy, particularly in the innovation sector of deposits. It just hit everybody in that sphere much quicker than was expected.
Beckworth: And to be fair to everyone, all of us weren't expecting rates to go up as fast as they did, even the Federal Reserve. Colby, you mentioned the SEPs. They were forecasting low rates well into the year and then they shot up. It's understandable that some people got those forecasts wrong. Gerard, circling back to you and China, one of the things that's happened is that the economy's done relatively weak, lackluster growth and people were expecting this robust bounce out of the strict COVID lockdown. Is any of that tied to the developments that you mentioned, the balloon incident or anything else going on, or is it just deeper structural problems in the Chinese economy?
DiPippo: The bigger theme is probably weak sentiment, and that's true for consumers and for investors. I think some of the external events, including US-China tensions, maybe made that worse at the margin. But if I had to pick one factor, it's probably the property sector in China, which was and is the most important sector for the overall economy. It's deflating from something like 25% of GDP a few years ago, when you factor in all the inputs and outputs, to maybe something about 18% now, and it still has ways to go to get to some international average.
DiPippo: When it does that, it's essentially deflating the savings of households, because households in China primarily invest in their housing, not so much stocks and bonds. It also affects collateral, which, it's a huge part of collateral for lending, but also for the assets that local governments use to issue debt. Then finally, there's just direct macro impact which is that it's causing unemployment, particularly for construction workers and others, steel factories, whatever, and it's really hitting all of that at once. At the same time, the Chinese fiscal system was at its limits after the COVID shock. And so, I think those things have compounded to result in the lack of so-called revenge spending and the consumption recovery that never was.
Beckworth: Gerard, did the Fed’s ‘higher for longer’ rates, did it have a bearing internationally? Because that was one of the concerns, that the Fed does monetary policy, it transmits to the rest of the world. It strikes me that it wasn't as consequential, but maybe I've missed something. Was there a big effect from the Fed's high rate policy in 2023, globally?
DiPippo: The macro thing would be that the dollar has been strong the whole year. A lot of dollar debt, especially in the developing world, that's been an issue. I suspect if you actually went back and looked at what people were saying about a year ago, things in reality may be not as bad as they would've expected or would've forecasted. That said, I think that the impacts in developing economies are maybe offset by the fact that COVID is over, more or less. These are economies that just got slammed through various channels, and I think that maybe has mitigated some of those problems.
Beckworth: One surprise I'll mention before we go into the major themes, and that is something that just happened yesterday. We are recording this on December 14th, and yesterday we had an amazing change in forecast in the Summary of Economic Projections of interest rates. Everyone's revising down their interest rate forecast for next year, which is pretty surprising, and I'm going to come back to that later. But let's talk about major themes. Could you summarize what's happened, what you just described, in terms of themes or topics? Colby, we'll start with you again.
The Major Themes of 2023
Smith: Just taking a step back in terms of Fed thinking, I think, that came to characterize the year more so than I think people thought, was this whole need to balance risks. As Steve mentioned, you had the financial stability concerns early on in the year. That was not something that the Fed was having to grapple with as it was also trying to fight inflation by raising interest rates. Then we had this period of time where they were rolling out emergency facilities to make sure that they weren't causing financial dysfunction, and not also having to reverse course on what they needed to do to get to price stability and maintaining full employment and things like that.
Smith: And so, that was the first balancing act that I think was a major theme of the year, and then that slowly transitioned, I think, to a balancing act between the upside and downside risks to inflation, and then, in turn, the labor market. That's, I think, where the Fed is at the current moment, where they see the balance of those risks as being more in equilibrium with one another. Whereas last year, for instance, they were much more concerned about doing too little to quell inflation, and having there be a situation where consumer price growth was just running at a too elevated of a level, and then they would have to then do more in the end to get it under control. Now it seems like there's just this bigger emphasis on making sure that they don't overcorrect here, wait too long to cut interest rates, push more people into unemployment than is necessary when you have inflation trending lower anyways.
Beckworth: Alright, Steven?
Kelly: I think a big theme of the year was non-banks. We have sort of had a structural shift towards the so-called shadow banking sector, really in advance of March. The March banking crisis obviously accelerates that, and then you get things like Basel III Endgame requiring more capital and the banking system, pushing more end activity outside the banking system. The other thing is just interest rates, which make every asset a higher credit risk at some point. The example that I like to share is that BMO Harris sold a portfolio of assets to private credit and then funded that sale, gave them a loan, to buy those assets.
Kelly: That is banks retranching themselves in this economy into a more senior place where banks are more comfortable. We saw the hedge fund basis trade peak, so it's the year of the non-banks and we'll see where that goes. Obviously, it's got regulators nervous and it's got banks pushing back against new regulations saying, "Look, you're going to lose sight of all of these risks if you keep letting all these non-bank players do this activity."
Beckworth: Let me just echo your point on the interest rate risk. That was the theme I saw this year, not just in financial firms, banks, but also the central banks themselves. Around the advanced economy worlds, we saw them take hits on their balance sheets. They lost both market value of their assets they hold, but also, net income was negative for many of them because of interest rate costs going up unexpectedly. So, interest rate risk, this new awakening and this new awareness that we have to take it seriously, we're so used to a low interest rate world, so this was a shock to many. Alright, Gerard?
DiPippo: Mine is probably the bleakest, although it actually does relate to the interest rate story, and the theme is war and the defense industrial base. In 2023, we, of course, had a continuation of the Ukraine-Russia war. We now have a new war since October, essentially between Israel and Hamas. We have an under-reported war in Sudan, which is actually quite large. We've had border clashes and incursions with Azerbaijan and Armenia, and we have the recent threats of Venezuela invading Guyana, although I don't think they're actually going to do that.
DiPippo: Where it overlaps with the interest rate story is that, I think there's a growing recognition in the US that our post-Cold War peace dividend and drastically reduced defense industrial base is just not up to snuff. It can't produce enough munitions, even basic things like 155 millimeter shells, which is essentially World War II level technology. It's not enough to meet current demands, let alone if there are further conflicts. And this is happening at a time, as you say, with rates being higher, therefore the budgetary trade-offs for the US are getting starker than they were, say, three or four years ago.
Beckworth: I'm probably looking ahead to an answer you're going to give later, but does this imply that defense spending is going to get a bigger share of GDP going forward?
DiPippo: I think, for many countries like Japan and many in Europe, that is certainly the case. For the United States, I think that is debatable. Maybe there will be a slight increase, particularly, for example, if President Biden's supplemental package that he wants for mostly Ukraine has passed. But I think that the US is already spending about 3%, 3.5% of GDP, and also, as you know, nominal GDP matters, right? Our nominal growth rates are high as well. People, when they talk about defense budgets, generally get fixated on the nominal value, so they end up deflating the overall spending level. So, I'm not sure, but I think globally speaking, yes, I suspect there will be more defense expenditures.
Beckworth: But not necessarily in the US, because if you look at a time series chart of defense spending as a percentage of GDP, it comes down, it's leveled out around 3% as you said, but it won't budge back up.
DiPippo: So, I think there's a much broader question, and I think part of the 2024 election, to get ahead of ourselves, is going to hinge on this and at least might determine it, which is the US polity, so to speak, deciding, what is America's role in the world and what are we prepared to pay for it?
Beckworth: Okay, fair enough. Alright, let's turn to another question. What do you think was the most underreported but important story in 2023? Colby?
The Most Underreported, Important Stories of 2023
Smith: We were talking a little bit about labor supply at the top of this, but I actually think that is probably one of the things that stands out to me. I remember talking to John Williams, the president of the New York Fed, back in July, and even then, after we had seen some uptick in labor supply and the labor force participation rate in all of these monthly jobs reports, he was skeptical about the possibility that there could be more help from the supply side in terms of rebalancing labor demand and supply and getting inflation under control.
Smith: I think, basically, since then, and over the course of the year, all of the trends have really defied that to a certain extent. You're seeing working mothers come back to the labor force. You're seeing men aged 55 to 64 coming back. Immigration has picked up. Census data shows a huge uptick during the Biden administration to a record high on the immigration front. So, that's just really helped to change the trajectory of the labor market and what's possible in an environment when rates are so high. And, we've heard from Chair Powell as recently as the latest Fed meeting that, as much help that they can get from the supply side, that the better off they are in terms of this soft landing outcome that everyone wants to see.
Beckworth: Alright, Steven?
Kelly: At the risk of stating the obvious, I'm going to say that Colby neither underreported or overreported anything this year. But, I think one of the more underreported aspects of the banking crisis in March was the SVB Bridge Bank. Listeners may recall, when the FDIC didn't sell SVB that first weekend it failed, it ran it as a bridge bank for about two weeks before it ultimately sold most of it to First Citizens. In that two weeks, not only did the FDIC guarantee everybody who was a depositor at SVB at the time of its failure, they were guaranteeing that bridge bank for all new deposits.
Kelly: That's really not how guarantees in crises are supposed to work because, in theory, you'll get a flood of money in. For that two weeks, the SVB Bridge Bank was effectively JP Morgan. It was Fed accounts, and it continued to bleed money. It continued to bleed employees. So, It's certainly an interesting case study in the value of a bank, but it's also really interesting that the FDIC said, "Yes, any new money, we’ll guarantee." So, SVB was going out to its customers saying, "Hey, we have unlimited deposit insurance. We are the safest place in America for your money."
Beckworth: Steven, the new facility that the Fed created— maybe Colby, you can chime in as well— during this banking turmoil in the spring, if I remember correctly, it took in collateral at 100%, or at face value, right? There were no discounts, and that back then was a big deal. This is the first time that the Fed has done this. Usually there's some haircut or discount. Some people on Twitter were like, "This has redefined central banking. This is the Rubicon we've passed." Was that an underreported development or is it something we just did, and we've moved on and [it’s] not a big deal now?
Smith: I think it was the crux of why the response was seen as so credible at the time. I remember reporting on that whole… that Thursday to Sunday stretch, and that entire weekend, everyone was waiting for the announcement of the rescue package to come. And there were… every twist and turn imaginable, the failed attempts to find a buyer for SVB, bids were still being called in, I guess, throughout the weekend. Then when that looked like it was fizzling, it was a matter of time before we knew we were going to be hearing from the Fed, Treasury, and others on this.
Smith: And it dropped, I remember, at like six o'clock or so that evening. It being a facility based around par value, I think, was what made it something that was able to instill the confidence that authorities needed before markets opened on that Monday. So maybe, in hindsight, that was not necessary, but it's the same way that we saw, with those COVID facilities, they’d rather err on doing way too much in those moments than underdoing it, because that just means that they have to step in more forcefully later.
Kelly: It's sort of unique, and we're not supposed to really have financial crises because of interest rate risk in this way, right? It's sort of a unique crisis and a unique response. It's also just for Treasuries, at least thus far, it's just for safe assets. It also fits weirdly into this discussion that underlies a lot of what the Fed does with standing repo and who they have their eligible counterparties being, which is like, "Are you protecting the Treasury market? What do you want Treasuries to be? Do you want them to be liquid? Do you want them to be zero risk?"
Kelly: But yes, typically, it's one thing to go in with no haircut and buy an asset at fair value. We've seen the Fed do this in crises, and it just says, "Okay, assets have gone too far, prices are overcorrecting, we're drawing a line under this fire sale." But they sort of really went the other direction and said, "We'll lend against par value, which is more than they're worth." They didn't buy at par value. When they buy at par value, that's the Rubicon, I think, because they really just termed out these losses. They lent at 5%, yes, it was against par value, but eventually, it's going to go back to the bank, and they're going to pay 5% for the year.
Smith: I also think that if you want to talk about crossing Rubicons as well, you have got to go back to the COVID facilities that I was talking about. At that point, they were doing corporate bonds, munis, I mean, they stepped into different asset classes well beyond the Treasury market. And that, to me, was the moment in time where you realized how powerful the Fed can make itself if it really needed to be, to shore up financial markets and prevent a bigger downturn of any kind. That, to me, felt more significant than, I think, the post-SVB aftermath.
Beckworth: Well, kind of an ongoing discussion we are having on this podcast is whether those COVID facilities are something unique to like a wartime development, something extreme, or do they reflect the fact that the global dollar system continues to grow, and the Fed has to step in? It may not be a public health catastrophe or a war, it might just be a financial crisis like in 2008, and the Fed has to step in. Otherwise, the entire global dollar system crashes, so interesting question.
Kelly: David, I'll just add, too, the other sort of unique thing, and this has been a trend really since COVID across the world, is central bank intervention like we saw during COVID, in general, despite healthy banks. The Fed is supposed to come after the banks, and it goes back to this discussion of bank capital and, really, how flexible it is. After 2008, we kind of said, "Okay, we don't want banks to just soak up all of the risk and have it all get dumped back on the banks, and then the banks blow up." But prior to that, it sort of worked, right? The banks sort of pick up the marginal risk, they write a floor under the markets, and now it's, "When are the central banks going to do it?" Corporate bonds are blowing up. The commodities market is blowing up. Where are the central banks? Even though we have solvent banks and totally healthy banks, which is a weird world to be in.
Beckworth: Alright, Gerard, what was the most underreported but important story in 2023?
DiPippo: I would say that it was a theme with some discrete events under it. The theme is the idea that there could be geopolitical events that no one actually intends, which then can because massive implications. So, Balloongate was a good example of this, right? No one intended, in a sense, for that to derail US-China relations, but it did for six months. The discrete events that I've observed, which they've been covered, but maybe not as much… or maybe not as much as people should appreciate that they matter for risk, is the increasingly aggressive military actions in the South China Sea and some Chinese military actions around Taiwan.
DiPippo: I say this because I think there is, beyond a non-negligible risk, I'd say a moderate risk, that there could be a collision, say, between a US or Taiwanese fighter jet with a Taiwanese or with a Chinese plane, which actually happened in 2001, almost happened a few times this year. If that thing happened, which no one would actually intend, it's going to suck up much of the diplomatic bandwidth on both sides of the Pacific. And if it's anything like the 2001 crisis, where a Chinese fighter collided with a US P-3, and they ended up essentially holding American airmen prisoner for a while, that's going to be much harder to resolve now. And I think it could be an event that no one plans for, but it's more of like a gray rhino. But there are more specific activities over the past year that suggest that the probability of that happening is rising quite a bit.
Beckworth: Gerard, what about the increased use of financial sanctions by the US government? We saw it during the invasion of Ukraine by Russia, and even recently, we’ve seen more people getting targeted. That has come under a lot of discussion recently as well. Where does that stand internationally and in the US?
DiPippo: I would've said that last year, 2022, was the year of, let's say, sanctions’ enthusiasm and 2023 is the year of realizing their limits. I think the general narrative is that they have accomplished less economically than people might've thought [in] the early days of Russia's invasion of Ukraine, so, say, February, March of 2022. The US does continue to impose sanctions, but they're more to sort of plug holes, so to speak, and the EU is doing this as well. The clear difference in the discourse this year compared to last year is that, basically, no one expects the sanctions to win the war.
DiPippo: I think, early on, some people were too enthusiastic about that. Part of that is a matter of choice. It's that the US and the EU don't really want to go all that hard on Russia relative to, say, Iran, because they don't want to stop Russia from exporting hydrocarbons, which would be very disruptive to the global economy, particularly in a coming election year, but nonetheless, those limits exist, and I think the Russian economy has certainly done better in weathering those sanctions than people would've expected about a year ago. And so, I think it's deflating expectations with what sanctions can actually accomplish.
Beckworth: That definitely would be the case if we were to go to war with China. We couldn't do the same type of financial sanctions to China that we did to Russia. It's simply because we're so connected, or if we did, it'd be very painful and very clear to the US public.
DiPippo: My answer might sound a little convoluted, but I think if there were a war, the war itself would be the sanctions and the sanctions would be moot. I think if there actually were a conflict, and I wrote a piece on this previously when I was at CSIS, it's still on the website called, *Sunk Costs,* basically saying that if you game out the scenarios, it's only really plausible that the US would go hard in the Russia level sanctions domain with China if a conflict were either happening or about to occur, and in which case it would be too late. Yes, I think they would actually use them, but it wouldn't really matter at that point.
Beckworth: Fair enough. I'll throw my one story in the mix here for the sake of time and then we'll move on. But I think that what I mentioned earlier about central bank balance sheets bleeding, actually negative income earnings on central bank balance sheets around the advanced economies, I think is an underreported story, and maybe I'm projecting here because I definitely have a certain view on this. I prefer smaller central bank balance sheets, as Steven knows, but there's been a number of articles, people talking about it.
Beckworth: Claudio Borio from the BIS had a speech recently called, *Getting up From the Floor,* talking about a floor system. There was an article in Central Banking, actually, that Steven sent me, discussing the future of operating system frameworks and just the fact that we are now more aware that large balance sheets do have a cost. It is one thing to run big balance sheets in advanced economies when rates were really low and we didn't have much interest rate risk, but now we're very aware of that and there's both the actual fiscal cost to large central bank balance sheets and there's also a political economy cost, the appearance that something's wrong.
Beckworth: And I think maybe those might manifest themselves more going forward or maybe I'm just projecting and hoping they will, because I would love to return to a smaller balance sheet framework, a corridor operating system, or maybe even a tiered one, somewhere between a floor and a corridor. Okay, I'll stop there on my underreported story of the year. Let's move on to the flip of that and let's talk about what was the most overreported, but relatively unimportant story in 2023. Colby?
The Most Overreported Stories of 2023
Smith: I struggled with this one because there's always some value, I think, in looking at certain dynamics, and having to write all these stories, you never want to think of over-egging something, but one of the things that I think probably got a bit more attention than was warranted was in the post-debt ceiling saga back in May and June. There was just a raft of articles about the difficulty that markets were going to have in absorbing all of the Treasury bill supply that was going to come on the market as Treasury refilled their coffers and rebuilt their cash balance once a deal was actually made. People were saying that this could offset the Fed's QT program. We could see equities plummet.
Smith: There's going to be funding stress to the degree that we saw back in the 2019 repo crisis. And that really just did not play out in any capacity. We've seen yields really plummet from those levels, obviously [with] fluctuations in between. We had the overnight RRP balance, which is at the New York Fed… yes, that number has come down in terms of the amount being stashed there overnight, but there's this buffer that has transformed how and when funding stress can rear its head. So, that to me is something that stuck out as a fear that never really transpired.
Beckworth: I like it. It's related to central bank balance sheets. Steven?
Kelly: I think something that got a little too much attention was the idea that bank runs are really different now because of Twitter and because of mobile apps, particularly because the bank runs we saw were obviously about uninsured deposits and the uninsured deposits just disappeared in two days and everybody says, "It's because you can do it so fast on your phone and because people were talking on Twitter." But an uninsured deposit is $251,000 and more. These are massive accounts. In practice, there are hundreds of millions, billions. First of all, those apps have like $2,500 limits most of the time, but even if they don't, this is not a retail phenomenon. Twitter and phone apps are retail phenomena. The corporate treasurers aren't using their app to do withdrawals. I think that's just a discontinuity that never got squared at all.
DiPippo: Steven, do you think, though, that social media, particularly with SVB, didn't matter in terms of accelerating how quickly the actions occurred? I guess it was definitely present in the bank runs before Twitter, but I think the issue was-- It was Peter Thiel or something, someone tweeted whatever he was saying and that sort of was the initial spark.
Kelly: I would push back that it was the initial spark. I think we observed a lot of talking on Twitter for sure, but that's just what we observed. It was clear that the bank run was already on, and for that kind of stuff to work, the run has to already be on. Bill Ackman's always on Twitter saying something. There's always short sellers saying something, and from what we know from on-the-ground reporting, it all happened over messaging and stuff way before it hit Twitter, and we observed it on Twitter and drew a line of causality that I don't think is there. We can't observe Bloomberg chats where this stuff normally happens, which is as soon as a hedge fund pulls out of a bank, the whole street knows, right? It's really just that we made that connection because we could see it more than that was actually the causality.
Beckworth: Steven, you're crushing me. I thought my Twitter engagements were important, but I guess they're not.
Kelly: It's got to be comforting that you won't cause a bank run with Twitter.
Beckworth: True, true. No blood on my hands. Okay, Gerard, what about you?
DiPippo: Sticking with more of the geopolitical theme, and with Colby's caveat that these are things that certainly deserved to be covered, but for me it was the Xi-Biden meeting at APEC in November. Not that it's not important, but I think a lot of the commentary was exaggerating the possible outcomes to suggest there's more pathways than there actually were. I think a broader theme is that people often confuse the tactical for the strategic. It might be something that, in a broad sense, matters, but actually if you think, what were the actual outcomes that would've come from this? A lot of this stuff is already essentially pre-negotiated before they actually sit down as leaders. It's pretty narrow and the outcomes are mostly that the US and China have agreed to talk with a few small deliverables which may or may not happen, such like on fentanyl. And so I think that was a bit overhyped.
Beckworth: My one story that I'll throw into the mix here is the talk about the dollar’s decline, the dollar dominance fall. Now some of this was in 2022, as Gerard mentioned, but there's a lot of it in 2023. Sometimes you'd see these really disturbing graphs of how the Chinese yuan share of, say, SWIFT has doubled in size. Then you pull back and you realize it's gone from like 2% to 4% and the dollar is up there at still just monumental levels, 40%, 50%. In fact, I checked recently, the Euro had gone down, its share of SWIFT transactions. The dollar had gone up. And most indicators indicate that it’s still relatively stable, [but] on the margins there's some change taking place. But Gerard, is that your impression, too, on that?
DiPippo: I think there's a narrative disconnect. There are some sort of, let's say, dollar absolutists who will say, on either side, that the dollar will remain dominant or it's going to be unseated. Obviously, the latter is not plausible. The dollar is going to remain the primary currency in almost any scenario you can imagine. But then there's a more nuanced position, which is that, are we seeing signs incrementally that dollar usage is being reduced?
DiPippo: And a point I would make that I think is actually under-emphasized, and by the time this podcast is out, I would have already published a note on Bloomberg about this, the Chinese are settling a lot more of their trade in RMB than they were before the Russian invasion. At the end of 2021, about 15% of China's trade was settled in RMB, that’s with the rest of the world. As of Q3 of this year, that's 27%, and It's just basically straight up. And only about 27% of that increase, by our estimates, is Russia. So, it’s not just Russia, it's a whole bunch of countries, mostly in Asia, that are looking to switch to RMB with the world's leading trading power, which is China.
DiPippo: Now, this is a long-term process. I'm not saying the dollar's gone, but I think it's certainly plausible over the next few years, depending on geopolitical winds, that the countries that are interested in having these types of transactions, let's say like Saudi Arabia and others, could push that figure, on the upper end, up to maybe half of China's trade with the world, which does not fully insulate them from sanctions, obviously, and also their counterparties would still be in the dollar network. But there is a trend that I think is being underappreciated, which is, I think, largely driven by geopolitics.
Beckworth: Okay, fair enough. Alright, let's move on to our next question where we get to eat some humble pie, and that is, are there any calls you got right or wrong in 2023?
Predictions in 2023: Right or Wrong?
Smith: I can start. Thankfully, I don't have to make any calls, so I can just report everyone else's wrong calls.
Beckworth: Fantastic, yes.
Smith: I would say that the recession call was definitely, first and foremost for me, just this complete underestimation of the US consumer and their resilience. With unemployment as low as it was, that definitely stuck out to me. But I’d also say that there were two others that were somewhat similar, just in terms of the inflation trajectory. The first, I think, was when we did see those very strong growth figures. There was this whole summer panic about the fact that this was going to reignite inflation pressures, that the Fed was going to have to wholesale raise interest rates more than anyone imagined. It was somewhat of the basis, I think, for the embrace of the “higher for longer” narrative that we heard at the September FOMC. And there was just this notion that maybe housing was rebounded, we're way past the peak drag in terms of past rate rises, and we just haven't really seen that play out ever since we got those July inflation figures. We've seen a bumpy, but somewhat steady decline in inflation, and that looks set to continue to a certain extent.
Smith: And to that same point, I think one of the things that people were concerned about that also has important fruit is the oil supply cuts from Russia and Saudi Arabia. I think that the initial gut reaction for everyone there was, “oh, supply side constraints, that's going to mean we're going to get an energy price resurgence, there goes the whole disinflationary process.” That also hasn't borne out because we've seen global economic demand declining enough to offset any increase that otherwise would have been the case, I think.
Beckworth: Okay, so there's a lot of humble pie being eaten out there by all of the people who called for a recession this year. I probably would put myself in that camp, so I'm serving up a nice slice right over here. Alright, Steven, what's up with you? What's your story?
Kelly: So, for wrong calls, we had an office party earlier in the year, and I gave a speech, and I toasted to the end of financial instability forever, and I think that was on March 3rd. I didn't expect it to age perfectly, but I didn't expect to be proven wrong within about five days, so that was definitely humble pie. On the right side of the ledger, and thank God I got this right because I said it about 50 places, including here on this podcast, which was that there really wasn't a vector of contagion from the March banking panic to Wall Street. Every bank that we ended up being worried about or ended up having to be resolved, we had their names on a list right away in March. We started worrying about them then, and we never added a new bank.
Kelly: That being said, as time went on, I flipped into having to push from the other side where folks were writing about this like it was over, and that vulnerability wasn't still out there. I talked about earlier how there was sort of an innovation economy recession, and that's what left those particular banks especially vulnerable. That's what really sparked with those banks who had the vulnerability built in from interest rate risk, but other banks had that vulnerability. They didn't have those sparks. So, to the extent we were worried about a recession or commercial real estate, that sort of risk re-sparking that vulnerability, which is still out there. So, now I'm on the other side of that, of just reminding people like, hey, that vulnerability is still in the system.
Beckworth: But when you made that call, you were fairly alone, right? There weren't many other people making that call, so you took a bold stand and were proven correct.
Kelly: Yes, a lot of the questions at that point were really, "Are there any brothers that this reminds you of, maybe Lehman or so, or otherwise?" It was that, and it was really like, "No, this really isn't that."
Beckworth: Okay, Gerard, what about you?
DiPippo: I would say, this wasn't really a discreet call I made, but I think it's what I believed, and it's probably what the consensus was, which was disappointed. It was that Ukraine's offensive against Russia did not go nearly as well as a lot of people, myself included, hoped it would, and that has longer term implications, including the balance of forces gradually shifting in Russia's favor, which is going to be an issue going into 2024. Something I would argue that I got right is that, in the beginning of June, I published a piece in the China Leadership Monitor explaining what's happening in the Chinese economy. It's aged pretty well in terms of setting out what the issues were. I maybe should have been a little more pessimistic in my tone, although I was trying to give the Chinese government the benefit of the doubt, but I think that one is held up.
Beckworth: Gerard, let me throw in, since you brought up the Chinese economy, the recent debate between Adam Posen and Michael Pettis. I think Adam Posen takes the view that it's the leadership, it's the people directing China, and then Michael Pettis is taking more [the view that] it's the deeper structural forces that have led to the weak recovery in China. Where would you come down on that debate?
DiPippo: I think they both have a point. I think Posen's point is more sort of deeply political, that it's a Leninist system that is inevitably going to fail. Maybe I'm oversimplifying, but that's sort of the gist of it. Pettis focuses very much on structural imbalances in savings and investment and current account and that kind of stuff, and inadequate consumption. They're both not wrong, but I actually think there might be some missing the forest for the trees going on where it's possible that the Chinese economy will start to stabilize over the next few years. I think if I had to pick on one thing, I would say it's just the real estate sector. If not for that deflating, which initially was a government policy, it was a choice, I think they would not have been having that same debate. I don't think any of that is actually inevitable, nor is it the case that the Chinese government is necessarily going to make mistakes.
DiPippo: I also think that Pettis's argument that China is chronically under-consuming is, from an accounting perspective, maybe right, although it's not really clear that the data shows what he says it shows, but it's not as predictive as he would have suggested. In fact, he could have, and in fact, did make that call repeatedly over the past decade or so. And so, to me, I focus more on the specific issues, which are mostly relating to the property sector and government debt.
Beckworth: Okay, very interesting. Well, I will mention just one wrong call I made, and this was me losing my religion on safe assets. I, for the longest time, have been an advocate of the fact that there's this shortage of safe assets. As a result, R-star and interest rates are going to be low. And I promoted it on the podcast for five or six years. Then this year, I began to lose my religion. I began to see higher rates. I thought, well, maybe we have finally reached a point where R-star is higher, where the fundamentals have shifted, even though deep down in my heart, I knew we still had the demographic problem in the world. We still had low growth. Then regulations, post-great financial crisis, all of those things should lead to a low equilibrium or R-star rate.
Beckworth: The only thing substantial that I would throw on the other side of the scale would be the prospects for ongoing large budget deficits going forward. That could push it up. But, lo and behold, here we are. We went from like a 5% 10-year Treasury rate to 3.9%. That's quite a drop in a month or two. And I was looking before the show today, and we are now at a place where if we use that 10-year measure and look at the real one, the TIPS, real 10-year Treasury is at 1.7%. Most forecasts for real growth over the next year are between 1.8% and 2%. So guess what? R is now below G again. We're back in that camp. Now, again, this may be temporary. By the time the show comes out, things may have reversed themselves. But I think I gave up a little too soon on believing in the safe asset shortage story. So, I'll be interested to see how this unfolds in 2024, and let's use that as a segue. What will happen in 2024? Colby, what is your outlook?
Breaking Down Outlooks for 2024
Smith: If you would have asked me two days ago, I would have said something very different in terms of Fed rate cuts. I think heading into the final meeting of the year, the message that we were getting from Fed officials and Chair Powell was the fact that it was way too premature to be talking about the end of the rate-raising campaign, even though no one really thought that they were going to go follow through with that, and then in turn, it was too early to talk about cuts.
Smith: And in the final meeting of the year, all of that somewhat changed to a certain extent, in that the Fed was just a lot more willing to embrace the idea that it had done what it needed to do here and it could transition to that next phase of the policy debate. So, that's really, I think, upended people's expectations about how quickly we turn to cuts next year. One caveat, I'd say, that has come up in my conversations is that if we get this raft of looser financial conditions, that could actually prolong the pivot towards cuts, because it just means there's less restraint on households and businesses in the coming months or so as markets have repriced.
Smith: That being said, clearly, inflation is on a downward trajectory. If the Fed is as committed to the soft landing outcome as they seem to be, it could very well mean that we're going to see lower borrowing costs earlier, and by a larger magnitude next year than otherwise would be the case. But that's going to be the major debate, I think, in central bank land.
Beckworth: So, Colby, a less serious question… did team transitory win?
Smith: So, I've heard every iteration of this where people have rebranded transitory to being 'long transitory.' So, it just all took a lot longer but ended up being true. That seems a little bit rich to me when you have fed funds over 5%, frankly. So, I think that's probably the death knell of the transitory argument to a certain extent, because obviously the Fed had to take action in order for this to come to pass. But there are more whiffs of truth to it than I think were the case when it was being totally panned back in '21.
Beckworth: So, the original team transitory has a big loss, but the new team transitory can arguably have a win. Alright, Steven, what about you?
Kelly: I alluded to one theme earlier, which is just the growth in private credit, the growth in nonbank credit. This will continue to be a big theme in 2024, especially as, like I said, bank regulations come down the pike. I'm not convinced that this is really a major financial stability risk, but that's going to be the conversation. Private credit alone is $1.6 trillion right now. All of the projections are for it to triple by 2030. It's a big market, and we should think and care about it. That'll be a continued theme as banks continue to sell assets and de-risk.
Kelly: The other big one, I think, will just be… possibly, we'll get conversations about inflation risk. Colby was alluding to this. The inflation is really on a downward glide path, the macroeconomists are really forecasting a return to… kind of in the Fed's vicinity. The risk is something like a Ukraine-type spike where it puts the Fed in an awkward position where there is a supply shock or something else that they can't look through, something persistent, and then they have to raise rates more, and then you go back and you start to worry about the banks again. You start to worry about commercial real estate again. So, that conversation, anytime we see a bump in inflation, will get into that discussion of, "Oh, is it coming back?” Whatever the reverse of a double dip is, double spiking in inflation, that, I think, will be lingering for 2024.
Smith: That's why I think— sorry, if I could just jump in— the pivot was so surprising, because I think that that risk hasn't gone away by any stretch. If anything, you could point to a multitude of things that could actually present that outcome for the Fed. But, the one thing I'd say is, I think, because they're so decisively past the hiking part of this cycle, that maybe the lever that they're going to more likely pull is just pushing back cuts as late as possible rather than restarting hikes again, because that would be a real acknowledgment of a mistake, I think, in some capacity. Whereas, at this point, they can stretch the length of time between the cuts as long as they need, and they don't look like they erred in some way.
Beckworth: Alright, Gerard, what about you?
DiPippo: I think that a big theme for 2024 is going to be the elections and an anti-incumbent revolt that is already underway, just because election cycles have an abnormally high number of leadership elections that would cover 43% of the world's population and 44% of its GDP. That includes India on the population side and, of course, the US on the GDP side. For smaller economies, the one I'm watching is in Taiwan. They're having their election in January, and it matters because whether the incumbent party wins or loses, I think we have pretty immediate implications for cross trade relations, which could have some other spillovers.
DiPippo: On the US side, in general, I think markets are underweighting the probability that Trump is going to win. It's clear that most incumbents are losing across the world. It's not just populists. Matt Yglesias had a piece about this. It's not just one party or the other, it’s that whoever is in charge is getting deposed, and that to me suggests that there's more evidence that things are maybe heading in a direction that a lot of people don't want to believe. And in general, another risk related to that, overlapping with AI, is the degree of disinformation and misinformation we might be seeing on TikTok and other platforms, using deep fakes, et cetera, which are obviously just getting much, much better, and that might have bearing on those elections.
Beckworth: Well, [it’s a] very sobering thought that we might be in a place next year where the Fed will be under pressure, once again, from Trump to do things that he wants. That could be a whole other conversation, what will the Fed look like in '24, '25 if, indeed, Trump is president? And I will just throw this out there for my consideration for this next year, and this is something near and dear to my heart, as probably all of you know, and that is the Fed's framework review coming up in '24, I think the second half, and then going into '25. And in the grand scheme of things, relative to Gerard's big important points, this is probably pretty small, but it's near and dear to my heart, because this is an opportunity to reevaluate the Fed's framework, the flexible average inflation targeting framework. It'll be interesting to see what they do, if anything.
Beckworth: I think it is, probably, pretty important that inflation continues to come down if they're going to have a serious conversation. I can't imagine them talking about changing the framework dramatically if inflation is still pretty high, above target. I think it's actually great news to see inflation coming down, rates coming down, some sense of normalization so they can go into that conversation. And Colby, I guess I'll ask you since you cover them so closely, have you heard any rumblings, or musings, or any considerations about the framework review yet?
Smith: So the questions that come up, I think, most frequently with that… it's all about flexible average inflation targeting, but then also, how committed is the Fed to 2% inflation? Thankfully, they haven't had to really entertain that whole debate, because inflation has come down without there being this substantive uptick in unemployment. But if we are in a situation next year where the 'last mile' of getting inflation down to 2% does prove to be more difficult than this first phase of the disinflation process, then I think there will be more credible questions about how tied are they to 2%, in a way. Would they accept 2.3%, even though, in that average targeting framework, they've been well above 2% for so long because of the extent of the inflation spike, post-COVID? How willing are they to sacrifice the labor market in that kind of environment?
Smith: But right now, that kind of conversation is completely and totally toxic to them. It doesn't serve them well at all, and so they avoid it at all costs. And the other element of the framework— and other central banks, I think, are engaging with this a little bit more directly— is what was behind the forecasting failures, post-COVID, as well. I think that some officials have dabbled with where they got things wrong and what, in hindsight, they would have done differently, but I think the review might be a good time to also delve into that kind of conversation.
Beckworth: Well, I'm hoping for the best, because I want them to think about nominal GDP targeting, which I know is kind of far off and ambitious. But, with that, our time is up. Our guests today have been Colby Smith, Steven Kelly, and Gerard DiPippo. Thank you all for being a part of the show, and Happy New Years to you.
Smith: Thank you.
Kelly: Thank you.
DiPippo: Thank you.