Kathy Jones is managing director and chief fixed income strategist for the Schwab Center for Financial Research, and she has spent many years on Wall Street, covering bond markets and foreign exchange. Kathy joins Macro Musings to talk about the present outlook for the economy, the state of markets, and Fed policy. Specifically, David and Kathy discuss the story behind the recent economic slowdown, why equity markets are behind the recessionary curve, Kathy’s sense on QT moving forward, and 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: Kathy, welcome to the show.
Kathy Jones: Oh, thank you for having me.
Beckworth: Well, it's great to have you on. Now this is the first time we have interacted in a conversation. We've interacted on Twitter. I follow you. You've got quite the Twitter following. You have fun on there. And I learned a lot from your tweets. I mean, just today, we're recording this June 29th. You were tweeting on, at least the ones that I saw, the breakevens… Inflation is coming down. You also mentioned corporate profits. And one that was really surprising to me, I hadn't seen because I don't pay close attention to it, but real M2 growth actually has turned negative. So for those who are really worried about the money supply, it's actually contracting. So pretty interesting stuff and you are always posting neat tweets and interesting comments like that. So I appreciate your presence on Twitter and I'm delighted to have you on the show. And why don't you tell the listeners a little bit about yourself, your career journey and what you're doing now.
Jones: Well, whenever I'm asked about my career journey, I always say that I got into this business by accident. I got stumbled in by accident. So when I was young, grew up in the Chicago area and I was looking for a job in college and a friend of mine said, "Oh, you should go down to the Chicago Board of Trade. I got a buddy down there, he'll hire anybody." And so, I figured, "Well, I had a shot." And it was in the days of the open outcry auction markets in the trading pits. And I got a job as a runner at the Chicago Board of Trade running into the corn pit. And I found it just so fascinating and interesting, it was a great way to get introduced to markets. And after that, moved into the financial area, financial futures, currencies, eventually bonds and fixed income. So it was a weird pathway. I don't think… it's certainly not a way anyone else would get into the business these days.
Beckworth: And tell us about what you're doing now with Charles Schwab.
Jones: So, I'm a fixed income strategist and really what we do... So my team is a combination of things. So we are charged with investor education. And Schwab has millions and millions of clients that range from very educated, very sophisticated institutional investors, to people who are relatively new to the investing world. And so what we try to do is provide our outlook on the economy and on the bond market, and then we give guidance. So we can't give guidance for millions and millions of people, that specific, but we try to say, here's what's going on. Here's what we're looking at. Here's where we see maybe value relative to some other place. And we talk a lot about strategies and ways to implement on positions, our fixed income positions. And how to really balance portfolios. And when we go through the whole range of things from soup to nuts to try to cover the area so that people understand what's going on.
Beckworth: Sounds very fascinating. I'm curious, how do you collect your information, do your own analysis? I mean, do you wake up in the morning and open up the Financial Times, Wall Street Journal? Do you go to maybe primary sources? Do you read actual speeches of the central bank governors and central bank presidents? Walk us through how you process the data and put it all together?
Jones: The answer to that is yes. All of that. I'm a better reader of whatever's out there. I like to consume whatever information is out there. Over the years, we've got a little bit more discerning about the sources, but I do a lot of primary source reading. I do read the speeches of all the various Fed governors and presidents. I read the Beige Book word for word. I try to read the regional Fed websites that have tons of research. So I do that. And then yes, I keep up on all the other stuff, the Financial Times, the Wall Street Journal, New York Times, you name it. And then we do a lot of our own original research. So, we dig into the data and we try to find underlying things that are going on that maybe the market overall is missing.
Beckworth: What's fascinating about your work and people on the street versus my perspective… I'm more of an academic, I'm in the think tank world now. But we're thinking theoretically about reaction, functions, Taylor rules, Taylor principles, but you have skin in the game. You actually have to view this from a side. Well, what actually will make money? What's a bad decision? What's a good decision? So you're taking these same ideas, putting them to use. So it's great to chat with you. You have the skin in the game. And I'm curious since I brought this up earlier, what value does Twitter bring to your job? So I find it immensely useful. It's a way for me to connect with people like you and others, even central bankers sometimes, and people in that space. So, how do you find it useful?
Jones: Yeah, I'll have to admit at first, when they suggested that I use Twitter and other social media, I was really pretty hesitant because it just... I'm not of the generation that grew up with social media and I was hesitant about some of the things that are out there, but I agree with you. It's a great way to connect with people. I learn a lot from other strategists, as you say, other central bankers. Just general interaction with people on Twitter has really taught me a lot and guided me towards some information and some sources that I otherwise really wouldn't found probably. So, I find it immensely useful. Obviously, it's a very time consuming part of the job now. It used to be a small slice and all of a sudden, now this is how we communicate with-
Jones: ... A lot of our peers and a lot of our clients, et cetera. So, a lot more goes into it than you might think.
Beckworth: No, exactly. I have to get on to my kids, "Get off your social media, get off your phone.” “But dad, you're on Twitter." And I have to explain, "Well, this is actually part of my job. I have to engage, read, respond." And it's a very subtle argument I have got to make to my children when I tell them to get off Instagram, TikTok, things like that. But I agree. I find it immensely useful. You for example, I wouldn't have known you or had you on the show, had it not been for Twitter. And there's many stories like that I could share, go to conferences, meet people that we connect with on Twitter. So it's been great professionally. No doubt about it. All right. Well, let's tap into your knowledge, your expertise, what you do, and let's talk about the US economy. So, what is the outlook? Is the glass half full, half empty? What's your take?
Kathy’s Outlook for the US Economy
Jones: Well, I am a fixed income person. So the glass is almost always half full, half empty for me, right?
Jones: The equity folks are always the optimists and the bond folks are always the pessimists. But I'll have to say, as we've been looking at the data lately, I have to say, it looks like we're slowing down, if not skidding into recession. Looking at the PMI, the purchasing managers indices, one of the things we look at there is the difference between inventories and new orders. What we're seeing is new orders slowing down, inventories going up. That tells us that probably less production, less employment, et cetera. And just [inaudible] of housing obviously has slowed down considerably with the rising mortgage rates. Broadly speaking, financial conditions are much tighter than they were before. And depending on which measure you use into fairly like one standard deviation of tightening in a very short period of time. So I put all that together, along with where the market is pricing, what the Fed is going to do. And it tells me that the economy really is slowing down. Probably the next shoe to drop will be the employment data, will probably see slow down in hiring, fewer hours worked, things like that. Will give us a sense of whether we're actually heading to recession or just to a slow down.
Beckworth: Yeah. That's an interesting point you mentioned about the employment or the job market, because that seems to be one of the bright spots still in the economy, right? You still see a lot of job growth, job openings, things going on, but you're saying when we see weakness there, then it's like, all bets are off. We're going to be in it. And in fact today, again, it’s June 29th when we're recording this, the revised estimates for GDP came out for the past quarter and they were lowered down a bit. In fact, I think the biggest thing that was striking was the PCE or the expenditures by households was quite a bit lower than they had first estimated. I'm just curious, did today's reading alter your outlook at all or was it what you expected?
Jones: Well, I didn't expect the downward revision to be that pronounced, but it does confirm our fears that we could be heading towards a recession. Because not only were personal consumptions down, but inventories were revised up. So that combination is never a good combination for growth going forward. So, it is looking like things are really slowing down, probably faster than most people expect.
I didn't expect the downward revision to be that pronounced, but it does confirm our fears that we could be heading towards a recession. Because not only were personal consumptions down, but inventories were revised up. So that combination is never a good combination for growth going forward. So, it is looking like things are really slowing down, probably faster than most people expect.
Beckworth: So do you attribute the slow down to the tightening of the Fed policy and tightening of financial conditions or was there something already baked in? We were just over heating the economy and it was going to do this automatically? What's the story behind the slow down?
The Story Behind the Slowdown and Recession Possibilities
Jones: When I look at it, what I see is the end of the fiscal stimulus, we have the big boost in demand from the fiscal stimulus coming out of the pandemic and then that is over. So we've reversed that. It looks like from the data, although consumers still have savings. Their savings rate is down, which means it's getting eroded now that extra incremental spending is probably behind us or most of it. And then of course, the tightening of financial conditions I think is a huge one. And that really has filtered through first to the housing market, which was arguably pretty overheated. And so, that's usually the early indicator because then you don't get the mortgage refinancing, you don't get the home purchases, you don't get the HELOCs, the borrowing against the equity to spend more money. And it just feeds on itself. And that was pretty overheated. So, I think I would attribute most of it to Fed policy. And then I think the other thing is there's been a global tightening with the exception of maybe Japan and now China, but most major central banks have been raising rates and tightening policy. And I think that's contributed as well.
Beckworth: So macroeconomic policies play an important role here. So let me paint a scenario for you. Let's say the Fed... It's not going to do this, but let's say it just suddenly stopped and reversed course. So, the Fed, say it looked at commodity prices are going down, looked at your breakeven chart and said, "Hey, we got this under control." Even if they stopped, an 180 degree turn right now or at the next meeting, are we still going to have a recession? I mean, is it baked in… monetary policy works with a lag. And I say this because there is the prospect that the Fed may not tighten as many times as the market thinks it is. Things may slow down. They say they’re data dependent, we'll see. But is it inevitable, I guess, that we have to go through this or can the Fed move on a dime and be nimble?
Jones: Oh boy, I think that Fed aspires to be nimble and avoid a recession. I think it's going to be tough. I mean, maybe if they reverse course today, they could avoid it. But I think the probability of that's extremely low.
Jones: And there certainly wouldn't be enough assurance on their part, no matter what their suspicions are that they'd actually get the inflation down and inflation expectations down. So, I'm not saying it's inevitable, but I think it's going to be a really tough task for them to pull off, to make this a softish landing that Chairman Powell said, versus a recession, a lot of it's baked in and I'd be surprised if they could pull it off.
Beckworth: Today I read a tweet from someone and they say, "Expansions never die of natural, like old age. They're most always caused by some policy shift." And that's not always true. We just had the pandemic, that would've been a recession even if we hadn't all voluntarily come home from work. But the argument is policy is key here. And I think what we're hearing, what you're saying is that it's going to be playing a role here as well. So the Fed is responding to the high inflation. I think it had to do something, it's a political as much as an economic issue. Gas prices are very, very volatile. President Biden's trying to do things, but there's really… his hands are tied. There's a limited amount of what he can do meaningfully in the short run. So the Fed's stepping up and responding.
Beckworth: So, this leads to my next question. And that is why did we get here? How did we fall behind the curve? Or how did the Fed get behind the curve? Now, I guess there's an assumption I'm making in that question. And that is some of the inflation we're seeing is not just driven by the pandemic and supply side problems. Some of it is due to excess demand from fiscal stimulus, from easy monetary policy. So, I guess maybe we should start there. Do you think some of the inflation is in fact policy driven and could have been avoided, had the Fed tightened sooner?
Assessing Inflation and Interest Rates in the Present and Future
Jones: Yeah, I do. I don't usually play the Monday morning quarterback game because we're all human and we all make mistakes. And I do think that the general intention is to do a good job at the Fed, but we were seeing indications late last year or actually in the fall of last year that demand was starting to come back, that things were bouncing back quickly. And it seemed like the Fed was really hesitant to do much because they were worried about the job market and so called scarring in the labor market. And I think there was a real hesitation to move forward very quickly. They could ended QE anyway, fairly soon instead of keeping that going for so long. That would've tightened financial conditions a bit sooner. But I think they probably were fighting the last war thinking about the recovery from the great financial crisis taking so long and having such a negative impact on the job market for such a long period of time. So that's my guess as to what the thinking was. And then I think there was this belief that maybe some of the supply side shock was just temporary and would go away by itself. Clearly that wasn't the case.
Beckworth: Yes. I want to reiterate what you said. We're all human and just like FOMC officials, I too was not expecting inflation to last this long. So maybe I wasn't fighting the last war, but I had the last war in my mind. We're going to return back to that low inflation, low interest rate world. I still think we will. In fact, I'd be interesting to hear your view on that. So let's say we do get to the other side of the high inflation, all the residual issues from the pandemic. Do you think we'll go back to that low interest rate world's, safe asset shortage or secular stagnation from Larry Summers? What do you think?
Jones: Yeah, I am in the camp that we go back to slow growth and lower inflation. And I think there's not that many of us in that camp. I hear a lot of talk about how inflation's going to be sticky and it's going to be really tough to get it down. But since inflation's a rate of change phenomenon I tend to think that the rate of change is going the other direction. I don't know why it wouldn't go lower again. Even if supplies are constrained, if you get demand down enough, then I don't see why the rate of change in prices would continue to rise at such a rapid rate. But I also think the combination of things like the demographic trends, globally, suggest lower growth. I don't think we've structurally changed. I mean, there's a lot of smart economists out there, a lot of different opinions and I might be totally wrong on this, but I don't believe that we've structurally changed the economy to the point where we're going to suddenly grow at a much faster pace than we have over the past. And I do think that saving shortage is still out there. If they're smart, I think pension funds, insurance companies right now would probably be buying some long term bonds to lock in these yields. Their hurdle rates are fairly high. And if they could lock in 3% long term bonds, that would certainly get them a long way towards meeting those 5% or 6% hurdle rates they need.
I don't believe that we've structurally changed the economy to the point where we're going to suddenly grow at a much faster pace than we have over the past. And I do think that saving shortage is still out there.
Beckworth: Yeah. This reminds me of stories from the early 80's. If you bought a treasury bond back then you really did well later on as rates came down. So that's a great point. I hadn't thought about that. That might be a good investment strategy, although we're not giving investment advice out on the show, but that's a great, great point though, Kathy. I hadn't considered that. Let me go back to something you said about bond markets versus equity markets. Bond markets tend to be more pessimistic. Equity markets tend to be more optimistic. They always are like the last one to leave the party when there's a recession about the start. And if you go back and look at the yield curve and I find this very fascinating, an inverted yield curve, at least my understanding is it has pointed to recession long before the stock market has. The stock market is still growing, jubilant.
Beckworth: But the bond market long before then was like, "Hey guys, be careful." I mean, I think back to 2008. In fact, Ben Bernanke when he was chair had a speech, where he was speaking to the flattening of the yield curve. Maybe in 2006 he did his speech, but it was flattened by that point. And he said, "Don't worry. It's probably just the term premium adjusting." And all fairness to him, even if he believed otherwise, he probably couldn't say it otherwise and freak out the world. But why is it do you think that the bond market tends to get the calls right more often? And I asked this, because it's a bit of a puzzle to me because it's not like you are isolated from people in equity markets. People in equity markets can read your research and I'm sure you interact. So why do equity markets tend to be slow and behind the curve so to speak when it comes to thinking about recessions coming up?
Why Are Equity Markets Behind the Recessionary Curve?
Jones: That's a great question. I don't know that I have a great answer for you. I think the bond market is just a lot more mathematical or mechanical even. It looks forward and says, "Well, what are the cash flows that we can expect to be generated? And how do we discount that by what the Fed is doing at short term rates?" And once you do the math, there's a limit I think, unless you can look at nominal GDP suddenly growing much, much faster than anticipated or the trend, which is what it did coming out of the pandemic. But we look at it that way and we say, "Well, what can we really expect realistically going forward?" And I think the other thing the bond market tends to pick up on much more quickly is this tightening in financial conditions. So you've got the lending markets, you start to see credit tighten up a little bit. We watch those indicators really carefully. And I think in the stock market, it's more about the story, right? It's about the projections for the future that are always pretty optimistic because business people are optimistic, otherwise they wouldn't be in business. And so I think the narrative is sometimes very optimistic on the equity side. The bond market maybe is just a little bit more just about the numbers.
Beckworth: So as a fixed income strategist, what are your favorite interest rates to look at? So if you're thinking about the economy, get a sense of markets, where do you first go? Like, when you start your day, what yields are you looking at?
Jones: Well, I'm looking at the whole Treasury curve, but obviously I focus in on the 10 year yield because that's a benchmark we all follow. And then, where is it relative to two year yields and short term rates. I look at all the global yields as well, the two year and the 10 year. Those are kind of my first data check in the morning, to see if there's something going on there. When it comes to the more esoteric things, I look at the Eurodollar futures curve to see what the market's pricing in. I look at TIPS implied breakeven levels… there’s some issues with that, but I look at where inflation expectations are trending. And I tend to look at these forward rates, whether it's a CPI swap rate or the three month rate, 18 months forward. I'm just trying to get a check on the heartbeat of the market. Like, what is it expecting? What's it looking for? Is there something out of whack or is there something that stands out? That's usually what I'm looking for.
Beckworth: And I imagine you use a Bloomberg terminal to do that. You have the machine that everyone serious on Wall Street has, is the Bloomberg Terminal. So yeah, when I was back in academia, we had them in the business school, but I never had my own. So, it's always great to chat with someone who has access to that very expensive…
Jones: It's a great tool. Great tool. Yeah.
Beckworth: It is a great tool, for sure. Okay. So, we've been talking about the state of economy, the role the Fed’s playing in it. And one of the things that I see at least is the Fed is really taking more seriously, inflation. And when I say taking more seriously, I'm trying to compare to say 2019 and before. And so, prior to 2019, we had low inflation, it was taken for granted maybe one could say, and I think it presented the Fed and other central banks with a temptation to start looking into other areas, things they could do in other areas. Maybe a more intense look at full employment, inequality, climate issues, other things which I'll call luxury goods for the sake of trying to describe them.
Beckworth: I don't want to say it's abandoned them, but it's definitely put less focus on those. And it is just hardcore committed to getting inflation [down], even if it implies a recession. Now, they haven't said we're trying to create a recession, but all of their projections imply that, their Summary of Economic Projections, things that they're saying. So this new focus on inflation and even from doves, like Neel Kashkari. I mean, everyone seems to be on board with this very hawkish, "We care about inflation." Is this a new permanent phase at the Fed or is it just the moment we're in, the season we're in and we get back to that low secular stagnation world, again, we'll be back to it the way they were pre 2019?
Are Inflation Concerns in Vogue at the Fed?
Jones: Oh boy. That's a great question. Who knows who will be at the Fed if we get back there, right?
Beckworth: That's a good point. Yeah.
Jones: Will the same people be around? But I think it's funny because when I was young and starting this business, it was the Volcker years. And so, everyone now kind of wants to be Paul Volcker, the guy who slayed inflation, he's revered, he's the big hero. And I agree he was a great public servant and did what needed to be done. I think they forget that at the time he was not revered. He was not well liked at all among the business community. He was really persona non grata. And also with the politicians, obviously he was an unpopular guy. So I think though, right now, with the Fed, the dual mandate, full employment and inflation. I think we got to the low inflation, as you mentioned. And they focused on the employment end of things.
Jones: And there has been over the many, many years, the shift from labor to capital in terms of the rewards. And so I think there was probably a thought, "Well, maybe we can address the underemployment that exists in the economy." So, I think it was a reasonable thing to focus on at the time, but you can't get a stable, solid, healthy labor market when inflation's out of control. So I think that, right now, at least the moment that we're in is this Volckerist, mini Volcker moment. It's nowhere near where it was where it serves everyone's purposes to focus only on inflation, get that down and then see where we go from there. But I don't think there'll be a great temptation to focus on some of those other, as you say, luxury goods anytime soon because this episode has really been pretty dramatic and surprising to folks at the Fed. Like, clearly we were not anticipating this at all.
Beckworth: I think all of us weren't anticipating this. I mean, there's a few people who've been screaming, inflation, inflation, inflation's coming for past two decades and they finally got it right.
Jones: That's right.
Beckworth: But most people did not expect it to be this high or last this long. So speaking of Paul Volker, I've often wondered if he had been around today. If he were trying to do today what he did in the early 80's, could he have done it? I mean, with social media, with the press. I mean, I know that there was newspapers back then and the pressure was intense, but I just imagine if Twitter was around in the early 80's and he was bringing around a big recession. I mean, I've read several books about that period. And there was like a sticker that came out said, "Hang tall, Paul.” It had a noose for Paul.
Beckworth: And people sent bricks to the FOMC, some guy charged in with a sawed off shotgun. They actually didn't have security until then. So, just imagine that plus Twitter, and you wonder, do civil servants today, do they have that same resolve? It'd be really hard to do that. I mean, it's one thing to be really hawkish when everybody else or most people are demanding it from you. Inflation is the number one issue in polls, but can you do that if it wasn't such a popular thing to do? And that's a great point you bring up about Volcker, he didn't have it easy.
Jones: He sure didn't. Yeah. Yeah, I think it's a much more difficult environment as you mentioned. He didn't have to talk to people. He did have to do twice a year congressional testimony. But other than that, I can remember being young and having to watch the money supply numbers come out to try to intuit what open market operations would be, et cetera. I mean, they didn't really talk to us, the folks at the Fed. Forward guidance wasn't even a concept in those days. In fact, they didn't even release the minutes of the meetings until many years later. So, he wasn't in a position to have to give a lot of forward guidance. I don't know if that's good or bad. I think right now the Fed tries really hard to communicate. And I think that forward guidance does give them a bit of an edge because they can push the market in the direction they want. On the other hand, the political pressure from everywhere is immense, right? And it must be hard to block that out.
I can remember being young and having to watch the money supply numbers come out to try to intuit what open market operations would be, et cetera. I mean, they didn't really talk to us, the folks at the Fed. Forward guidance wasn't even a concept in those days.
Beckworth: Yeah, for sure. But that's a good point that there's a lot more information today than there was back then. So, someone in your position, a fixed income strategist, that's very useful. Although, I want to go back to something you mentioned earlier that you read all the speeches. I read many of them. I don’t have to read all of them, but you read all of them. Do you ever find with so many speeches, so many voices coming out of the FOMC, there's more noise versus signal, or do you find this signal versus noise ratio to still be worth your time? Apparently it is worth your time to keep reading it, but any thoughts on just so much coming out of the committee?
Jones: Yeah. Well, say I selectively read.
Jones: I can't say every single one. I try to read as many as I can. And there are people who I read that I think are very important because I think their roles are more significant. So if it's Lael Brainard, I'm going to read what she has to say. If it’s Powell, obviously… so, the folks at the top who really are setting the agenda. Sometimes if it’s somebody who's a consensus player who's going along, I may not find much information there. So, I do tend to skim some of them, but you will pick up on things that they're talking about, they're thinking about, research that's being done over the years. I can think of many things that Bernanke in particular would signal through his various speeches. We've got Jackson Hole coming up in August. There's going to be speeches. Sometimes they unveil some research that's been done. I remember the quantitative easing conversations that came out, a lot of it through the speeches. So, I think there can be a lot of information derived from that. It is time consuming and I will admit to not reading every word in every single speech.
Beckworth: You're human. It's good to know. Yeah. I was thinking about the Jackson Hole conference as well that's going to happen here in August. And what will Chairman Powell say? That's always such a big speech given where we are, given the moment we're in. It's going to be a very different speech than we've heard in a long time from other big changes. As you mentioned Bernanke gave some important ones. And then I'm thinking more as recently about the big switch from regular flexible inflation targeting to flexible average inflation targeting was announced there. So all these big speeches and so, what will be the big speech? I mean, maybe we're committed to fighting inflation. I don't know, but it will be interesting to see what comes out of those meetings. Well, let's move to another part of monetary policy which also has a bearing on what you do as a fixed income strategist.
Beckworth: And that is the Fed's balance sheet. So it's close to $9 trillion. They're starting to shrink it. And we've had guests on the show where we go back and forth, how consequential is QE and therefore QT going to be, going back and forth? And there's a part of me that I'll confess. I'm not sure how important it is in a big sense, other than in the midst of crisis. So when markets are melting down and the Fed does backstop things. Yeah, it's huge. But how consequential is it in normal times when markets are functioning on their own? How big of a swing does it make on yields? So there's that part of me, but then there's the other part of me that says, "Well, the plumbing of the monetary system is very sensitive." So, when the Fed does QT, that can actually cause some hiccups in the system. But I want to hear your perspective, because again, you've got skin in the game. I'm just some theorist here trying to make sense of the world. What is your sense, given you do have to get it right?
The Fed’s Balance Sheet and Quantitative Tightening
Jones: Well, we try to get right. And of course we've spent a lot of time on QE and QT because it is such an elephant in the room. And I read a number of economists and various theories, talk to various people who have theories about the consequences. First of all to me, the channel that's most important is signaling. So when we get to a point where we're in a crisis and the Fed drops the fed funds rate to zero and engages in QE, that's a real signal to the market that says, "Hey, we're here. We're going to provide as much liquidity as we can. We'll push you out on the risk spectrum so that you don't sit in cash and crunch things up."
Jones: So, I think the first thing is it just transmits the signal really fast just by announcing it. And then, obviously it has an impact on the monetary base. And so, through that actual function has an influence on the economy. Among the economists that I've talked to about it who've done a lot of work on it, including... Looking at what's on the Fed websites, et cetera. We have kind of come down to the idea that it's important in terms of rates. It's probably the equivalent… I think the way we look at it is about a 2% decline, relative to GDP in the balance sheet, is probably equivalent to about 25 basis points in tightening.
Jones: So in terms of shrinking that monetary base and having an influence, and that's obviously very approximate. But if we're at about, I think around 36% of GDP on the balance sheet, to get back to that 20%, 25%... Now that could translate into a significant amount of tightening outside of rate hikes. It's one of the reasons we think that the Fed may not have to hike rates as much as they're talking about, as much as the market is discounting, as much as the economic projection on the dot plot imply. Depending on how fast that goes, QT could substitute for some rate hikes. And I'm not sure that that's getting much attention these days.
Beckworth: Does QT need to be signaled in advance and very orderly so it's not disruptive or can they just feel their way out through the process?
Jones: Well, I think it really helps to announce [QT] and provide the signal and have it be orderly. As you mentioned before, the markets, the plumbing has been clogged up at times in the past couple of years in ways that really we haven't seen before. And so, I think they want to be really sensitive to what impact they're having. One of the issues now is the size of the Fed's mortgage-backed security holdings being such a big proportion of the market. And now, the Fed wants to get away from that and go back to a treasuries only portfolio, but the duration is extended. So how are they going to maneuver that without having huge impact on the liquidity in the mortgage-backed security market? And then it's the short end, right? How much do they have to balance off what the Treasury's issuing versus what's maturing? I think it makes a lot of sense to lay out this plan and communicate it as clearly as possible. And then, also communicate that they stand ready if the plumbing gets clogged up or there's a problem, they stand ready to adjust it or do what needs to be done to make sure the markets are functioning properly.
I think it really helps to announce [QT] and provide the signal and have it be orderly. As you mentioned before, the markets, the plumbing has been clogged up at times in the past couple of years in ways that really we haven't seen before. And so, I think they want to be really sensitive to what impact they're having.
Beckworth: So they have introduced some new facilities since the last crisis. The one I'm thinking in particular is the Standing Repo Facility. Do you think that's going to make a meaningful difference? So, if we’re shrinking the balance sheet... I mean, just looking back to 2019, they're shrinking the balance sheet and they accidentally stumbled into a point where they'd gone too far, given the taxes had been pulled out of the economy and a number of things came together for a perfect storm where they didn't have enough reserves and also played into the repo market. Let's say we're going down a path that might lead us down to something like that. Is that Standing Repo Facility going to be enough to handle it or are there other tools in place so it would be a different outcome?
SRF and Centralized Clearing as Treasury Market Fixes
Jones: Well, I'm pretty sure the Standing Repo Facility should do the job. And I also think that they're probably much more attentive to it and not as dismissive of the issue-
Jones: ... As they might have been having gone through that. There's also these open swap lines with foreign central banks. Treasury has a lot of fire power here and can be coordinated in terms of providing that liquidity that may be needed. So, I think they can pull it off without a big hiccup, but you always have to be ready to expect the unexpected.
Beckworth: In March, 2020, there was a big Treasury market meltdown. The Fed stepped in, backstopped it, took some time but it worked itself out. Was that shocking to you? I mean, did you see problems in the Treasury market ahead of time that now looking back, "Well, yes. It's not surprising." I mean, I guess one thing you could say is, "Well, this was a once in a hundred year pandemic." There's going to be pressure probably no matter what happened, but as a fixed income strategist, were you aware of these structural problems that helped contribute at least to what we saw?
Jones: Yeah. We were concerned about it going into the end of that year, that there just wasn't enough liquidity being provided. Obviously, we didn't anticipate the kind of explosion that we got. That would've required a lot more foresight than we had, but we did know that there were some problems there that needed to be addressed. I'm not too surprised it turned out the way it did. There was a tremendous scramble for liquidity. And I think that threw people off, but this is where the fixed income market always ends up, right? When all else is dying, everybody goes to short term treasuries. And they're willing to actually hold them and pay a fee, to hold them if you want safety and liquidity. So, that didn't shock me too much, but I think, clearly the magnitude of it was pretty surprising.
I'm pretty sure the Standing Repo Facility should do the job...Treasury has a lot of fire power here and can be coordinated in terms of providing that liquidity that may be needed. So, I think they can pull it off without a big hiccup, but you always have to be ready to expect the unexpected.
Beckworth: Does it concern you or should we be concerned that the Fed seemingly is becoming a more and more important player in backstopping the Treasury market? Or maybe these reforms we're talking about, the Standing Repo Facility and others, will take some of that pressure off. But it seems that the Fed has increasingly relied upon to be the backstop to the Treasury market.
Jones: I think that's a fact of life that we just have to deal with. I don't think that's going to change anytime soon, as much as maybe in theory, we don't like the idea. I don't know that we have a choice but to accept it. We're not in the same boat as say Japan where the central bank is absolutely controlling the entire yield curve… But you always hope that the market can function on its own and with as little interference as possible. So the price discovery can happen in an efficient way. But I think the reality is, in the Treasury market, the Fed's influence is going to be there for a long time.
Beckworth: So speaking of price discovery, the Fed is the biggest counterpart in the repo market. Any concern there that maybe there's less price discovery, because you have such a big footprint from the Fed?
Jones: Again, it's a fact of life right now. I don't think that's going away anytime soon. The short term rates are going to be pretty much determined by where the Fed wants them to be because of their activity in the repo market. And that's the trade off we make to make sure that there's enough liquidity to support the banking system no matter what happens. So, where would yields be without the Fed… such a heavy hand? It's anybody's guess, but I've got to say that right now, that's less a focus for me than intermediate to long term rates where there is more price discovery taking place.
The short term rates are going to be pretty much determined by where the Fed wants them to be because of their activity in the repo market. And that's the trade off we make to make sure that there's enough liquidity to support the banking system no matter what happens. So, where would yields be without the Fed...It's anybody's guess, but I've got to say that right now, that's less a focus for me than intermediate to long term rates where there is more price discovery taking place.
Beckworth: Right, right. And this goes back to what you said earlier that there are these structural forces out there that, in the long run… if the Fed cares about price stability, it has to respond to these fundamental forces and align it's... The long term path of rates with what demographics and other things would suggest. So, I share your view on that. So, the Treasury market has these challenges. We've talked about the Standing Repo Facility. There's also been some suggestions to do other things like have more centralized clearing in the Treasury market. And I think that's something that's come up a lot. Any thoughts on that as a proposal to improve the market?
Jones: Yeah. I think anything that can help with liquidity would be good. How the mechanics of it end up working out, I don't know. Anytime you make a change like that, there's the unanticipated or unexpected secondary effects, but perhaps better centralized clearing would be something that helps the function be more efficient. So, I think we can look forward to a lot of that evolution coming. We've been through a lot over the last 15 years, and I suspect that when the dust settles on this whole inflation picture, we're going to see central banks tinkering a lot with some of the mechanisms in the market to try to smooth things out and see what they can do. So, I wouldn't be surprised that we have many proposals, but I think more of a centralized market would make sense.
Beckworth: Well, let me switch gears to another area of your work that you've spent time in and that's foreign exchange markets. And look at the dollar, the dollar's done relatively well. It's been strong recently. And just more generally, what is your sense of the demand for dollars around the world? I'm a big fan of the dollar dominance literature and stuff. And it seems like every few months there's a new article that comes out and says, "Oh, the dollars days are numbered." But it seems to me at least, we have a lot of evidence that runs contrary to that. Are you seeing that as well and do you believe the dollars hold the world is still pretty strong?
We've been through a lot over the last 15 years, and I suspect that when the dust settles on this whole inflation picture, we're going to see central banks tinkering a lot with some of the mechanisms in the market to try to smooth things out and see what they can do. So, I wouldn't be surprised that we have many proposals, but I think more of a centralized market would make sense.
Is the Dollar Retaining its Global Dominance?
Jones: Yeah, it actually seems to have intensified since the last couple of years since the pandemic. So, more transactions in US dollars, more demand to hold dollars relative to say other major currencies. Will it ebb and flow? Probably over time… but I'm with you. I've been hearing this for the better part of the 40 years I've been doing it. And I have yet to see what currency will emerge to substitute for the dollar's role in the global economy. Now you can tell central banks are trying to diversify their holdings. They have more euros, they have more other currencies they're holding so that they're not entirely dependent on the US dollar at all times. But when push comes to shove, you need a market that's deep and liquid and considered safe. So if you are the foreign central bank, where are you going to put your money so that you can get it when you need it and hold its value, particularly in crunch time?
Jones: I just don't see where the alternative is going to be. People suggest the Renminbi at some stage. Well, that's great, but it's not even freely convertible right now. So we've got a ways to go there before that would be something that would even be a glimmer on the horizon. The Euro has taken up a more prominent role in terms of reserve holdings, but you have a fragmented bond market. So you don't have the same liquidity provision that you get in US treasuries. So at this stage of the game, I don't see what the alternative is. I’ve doubted over the course of my career that the dollar will lose its status as the world’s reserve currency.
Beckworth: Okay. Well, in the time we have left, I want to circle back to the Fed and ask you about the Fed's framework. So we touched on it earlier. It adopted this flexible average inflation targeting framework. And a couple questions about it… First, when it first came out, I did not read it closely. And I got it wrong. I was thinking more of an average inflation target, not a flexible average. So one of the things that I've learned over these past couple years with this framework is that it only does makeup policy from below. So, if you hit the zero lower bound, and you're below 2%, it's going to make up for that. But if you go above, no, no, no. And that was surprising to many people because they thought, "Well, now that the Fed's going way above, it's got to go back under."
Beckworth: And they're like, "No." And if you go back and look at all the documentation, it's very clear, this is an asymmetric makeup policy. So one, you must have saw that initially. I was just a little surprised. And then, I guess part of the confusion on my part was the previous flexible inflation target they had in that statement, their main document, that it's going to be a symmetric flexible inflation target. So just reasoning from that to the flexible average, I think it's understandable that many people thought it would work from both sides, but it only worked from the bottom. Am I alone in missing that upfront or is that something that was widely understood on the street?
I have yet to see what currency will emerge to substitute for the dollar's role in the global economy...when push comes to shove, you need a market that's deep and liquid and considered safe. So if you are the foreign central bank, where are you going to put your money so that you can get it when you need it and hold its value, particularly in crunch time? I just don't see where the alternative is going to be.
The Fed’s New Inflation Target
Jones: Yeah, I think it took a while for it to sink in. I don't think you were alone. I think that took a while to sink in that they were really serious about that. And I guess, when you go back and you think about it, they were so off on their inflation for so long and realized that perhaps the policy could have been easier and more flexible asymmetrically to allow employment to grow. They were addressing that era, right? And now we're in a different era entirely. So, it'll be interesting to see if they changed that, but no I'm with you. It took a little while for that to sink in and a couple of speeches to say, "Oh." But even at the time, it didn't seem like it was going to be a big issue, right? The Fed had undershot for so long and inflation was so low and so stable for so long. It seemed like, "Well, if it happens, it happens. We'll see." But I don't think anybody at the time was too concerned just because the expectation of this inflation just wasn't there.
Beckworth: Yeah, for sure. So, there were many surprises over the past few years. Inflation, the way the framework actually operates. So, going to this point you just mentioned, the Fed will be revisiting the framework… 2024, I think, and then making a decision in 2025. So what are you hearing? Do you get the sense that they're going to do any major revisions or maybe tweak on the margin or is there momentum? Let me rephrase the question. Is there an interest on Wall Street for it to be revised or tweaked in any manner?
Jones: I think there's an interest based on Wall Street and at the Fed. So, talk to some of the research folks at the Fed and they're intensely focused right now on this question of how do we get it wrong and how do we avoid getting inflation wrong again? What were our mistakes? We all on Wall Street say… we point to certain things, "Oh, well, you should have seen demand was picking up after the pandemic. You couldn't anticipate the supply side shock, but you should have realized that it was going to last a while.” I think with the way the Fed's examining it, it's really much more long term like, what kind of studies were we doing? What indicators should we have been paying attention to? How do we not repeat this?
Jones: And so, I think what we're going to see, probably not at this Jackson Hole, probably some mention of it, but I think there's intense study right now about how the Fed needs to manage going forward to avoid this kind of an episode. Because it really has shaken up a lot of people at the Fed who thought that they had it right. So, I wouldn't be surprised if the next big spade of academic papers that come out are focused on what the Fed got wrong, how to fix it, what the path going forward should be… I'm pretty sure the framework will be tweaked, if not changed ,pretty significantly.
Beckworth: Yeah. So, today Jay Powell was at a conference, and this comment made the rounds where he said that, "What we've learned is how little we know about inflation." Our ignorance-
Beckworth: ... About inflation is what's really come out of this experience. So, I actually find that reassuring since I'm a big fan of nominal GDP targeting. I don't know if you've seen me push it in past shows or on... Probably on Twitter, you've seen a lot of it on Twitter, but the thing I like about nominal GDP targeting is you don't need to understand inflation targeting like quarter to quarter over the short term, maybe even year to year. You just focus on demand. There's measurement issues and stuff there, but I would be interested to hear your view on nominal GDP targeting. Is there any discussion of that on the street or is that something that's still stuck up in the ivory towers?
Jones: Yeah, I would say it's probably more ivory tower right now than Wall Street, but that's not too surprising. Things migrate gradually-
Jones: ... To Wall Street from the academic world. But I think there's certainly a lot of us that pay attention to that. I mean, just the use of the output gap has now become a standard metric that Wall Street economists are going to look at and that people like me on the street will look at. And that's a similar notion of nominal GDP targeting. I haven't done any work on it and I haven't really seen too many people on Wall Street yet doing a lot of work on it. But I think it's an eminently sensible way to go about at least structurally thinking about maybe that's what went wrong this time around.
Beckworth: Well, you may not know this, but all guests on the podcast get a nominal GDP targeting coffee mugs. So, one will be sent to you and they're in high demand. I always get requests for them from people who are... Not on this show, but then when I get ahold of them. So, you will get one.
Beckworth: Well, with that, our time is up. Our guest today's been Kathy Jones. Kathy, thank you so much for coming on the show.
Jones: Thank you for having me.
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