Michael Darda on Inflation, Market Monetarism, and Fed Policy

The Fed may have dropped the ball during the Great Recession, but when measured against the ECB’s performance, the economic fallout could have been much worse.

Michael Darda is a chief economist and market strategist at MKM Partners. Michael is also a frequent guest on financial television and radio and is routinely quoted in The Wall Street Journal, The New York Times, Barron’s, and other financial publications. He joins the show today to talk about his work conducting macroeconomic market research as well as his views on the market itself. David and Michael also discuss his shift from supply-side economics to market monetarism, the Fed’s performance during and after the Great Recession, and the potential effects of a flattening Treasury yield curve.

Read the full episode transcript:

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: Michael, welcome to the show.

Michael Darda: Thanks, David, for having me. It's a real pleasure.

Beckworth: Well, it's a real treat to have you on because you would be probably the most prominent market monetarist who is actually a practitioner in the marketplace unlike Scott and myself. We're more academics. So it's real great to get you on here and discuss your work. I want to begin as I do with most guests and ask, how did you get into economics and tell us about your journey and share your monetarist's worldview.

Darda: Sure. My origins go back to Madison, Wisconsin, born and bred, University of Wisconsin-Whitewater graduate just to be clear, undergraduate in economics and speech communications, public relations. So I decided to do a double major in speech communications. I just had fun with it as an undergrad. I really had no idea what the career track was going to be. I thought I wanted to go into politics and public policy which led me to a series of internships and then to work in the Wisconsin state legislature straight out of college.

Darda: I worked in Republican politics in the Wisconsin state legislature and so as a college student, I was interested in different economic philosophies and supply side. I'd follow the articles of Art Laffer or Larry Kudlow or some of the other supply siders, Jude Wanniski would write for the Wall Street Journal. So I would follow them and I followed the supply side philosophy just as an eager student that wanted to learn. Well, it turned out when I was working in the legislature, this is before the advent of blogs, maybe the first blog that was out there was Jude Wanniski's blog. His company Polyconomics, which was a political consulting firm, sort of a think tank with Wall Street clients.

Darda: But he had a website where he would just put up essentially these posts like you would see on blogs today, but this is the pre-blogosphere and he started to write a lot about supply side economics and his history with it and different politicians and policies and so forth. I started to follow his writings and then participate a bit in some of the debate forms that they had. That actually led... He gave my name, he monitored what was going on in some of these forums and they were looking for a macro analyst to cover Western Europe.

Darda: Basically, somebody that they would bring in would have to understand the supply side model but then that they would train in terms of what they wanted in terms of covering different countries and policies and then writing for the client. That turned into an interview and I packed the U-Haul up from Madison, Wisconsin and the Wisconsin state legislature and left and the rest is history. After about two years, maybe a little more in legislative politics and policy, I packed my bags and moved to New Jersey and went to work for Polyconomics, think tank, run by the late Jude Wanniski, one of the original supply siders.

Beckworth: Okay. So you have your beginnings in a legislative branch in Wisconsin then you become a supply sider at a think tank, but today you're a market monetarist.

Darda: Yes.

Beckworth: You have a view that's emerged or evolved over time. So how did you go from being a supply sider to a market monetarist?

From Supply Side Economics to Market Monetarism

Darda: So this is interesting. I think it may have come up in one of your previous interviews with Lars Christensen, who maybe is the most similar to myself in terms of being a practitioner, dealing with Wall Street research clients and having a monetarist or market monetarist background. I think some of the earliest market monetarists were probably some of the supply siders that wanted to use market prices to guide the Fed. You probably remember the Manley Johnson, Robert Keleher work on using a market price approach to guide the federal reserve and Wayne Angell who was a Fed governor. I think he had an index of sensitive commodity prices.

Darda: This idea of harnessing market signals to guide monetary policy or in the case of doing research to make an interpretation of a policy shock potentially and then write about it to clients fits very closely with supply side. In the case of Polyconomics, Jude wrote a lot about gold. He was a relentless advocate for the gold standard but I'd say, most of the other supply siders were either skeptical on that score or not completely sold on it. Jude had this theory of the great depression that it was essentially triggered by the Smoot-Hawley tariff and that the gold standard didn't play an important role.

Darda: I remember just not being comfortable with that argument. We'd engage in it. I talked to him about it when I went to work there and I remember sending an email to Robert Mundell at the time because Mundell had a very different view even as an advocate of fixed exchange rates and gold, believing in that discipline. Mundell's view was that the depression was a monetary shock because of a misvaluation of the gold price and that it could have been alleviated or reversed and well, was with a devaluation.

Darda: But his view, even as an advocate of fixed exchange rates, was that you'd need to change them from time to time, not so much that no one believed they were credible, but obviously if you had what looks like a deflationary problem building up that it would need to be addressed that way. Even as someone who was learning and working with the supply side model, thinking about market prices even years before what became market monetarism, I think it was a pretty easy transition intellectually, at least, to what eventually became market monitors and what Scott Sumner and your work and a few others later on. But even working at Polyconomics, we'd watch commodity prices exchange rates.

Darda: The Johnson-Keleher book was about using the yield curve, long bond yields, and the dollar exchange rate to guide the Fed in terms of not overtightening and not over easing and they had this study of, I think, it was Sweden during the thirties using an approach and they had a much better outcome at a time of world deflation and mass unemployment. I think Lars Christensen did write about this on his blog but that was a book that had a fairly big influence on me. And so eventually when I did happen upon Scott Sumner and a few others, to me, it made a lot of sense just intuitively because it was almost part of my framework or at least I had already been working with a similar framework and trying to use market signals to infer what was happening to business cycles.

Beckworth: So Scott Sumner confirmed what you already knew or understood to be theory of markets in the world.

Darda: Yeah. Just connected the dots. And the beauty is in the simplicity. I'd left Polyconomics and then went to work at my current firm, MKM Partners, made that transition in late 2003 to help them build out a research platform. So I've been there ever since. And so going into the Great Recession and coming out of the Great Recession, I wasn't putting it together at that time as a monetary shock even though we were making that essential interpretation with credit markets and commodity prices. But Scott being able to put it together in a coherent monetary framework, really, I think was the power of what became market monetarism, just a very appealing framework for how to think about policy shocks and the business cycle. Who turned me on to Scott's website in 2010, I believe, was Kurt Schuler... I don't know if you've had him on the show, but he's a treasury economist and he's done some blogging and he's done some work with Steve Hanke.

Beckworth: Yeah, on currency boards.

Darda: Yeah. So both of them I think were on our lists when we'd send out research at my previous firm. And so Kurt said, "Hey, take a look at some of Scott's work." I think it was something to do with IOER, interest on reserves. So that's how I happened upon Scott's blog and then found you from there and some of the others and that was around 2010. Before that, I was using market price approach but it just was incoherent. It wasn't part of a tidy framework of how I think about policy.

Beckworth: I want to highlight one indicator that really turned me on to this and that was the TIPS breakeven inflation measure. So many of our listeners will know what that is, but the spread between a TIPS and a regular treasury bond, that difference is a bond market estimate of future inflation and if you look at those, you saw beginning about summer of 2008 begin to nose dive and they were nose diving all year through the next year. But what's interesting is the bond market was screaming disinflation, disinflation, maybe even some deflation, and the Fed was worried about this headline inflation number-

Darda: Exactly.

Beckworth: ... which was driven by commodity prices, wasn't even core inflation. It was commodity prices. One of the points that Scott makes had the Fed been looking at these market signals, when looking at the breakevens, it was screaming, "We're going over a cliff. Do something." And as you know, the Fed as late as September 2008 was worried about inflation and they refused to lower rates.

Darda: Yeah. I remember that time well. It's etched into my memory. We had the CPI headline inflation running up to a 17, 17 and a half year high in the middle of 2008. Having this discussion now maybe for some folks that either weren't focused on it or new to the discussion, at that point in time, going into the first six months of 2008, a recession had begun but an incredibly mild one. So mild that most of the macro data looked mixed. It didn't look strong, but there was even a debate about whether there was a recession. We know now that a mild recession started in late 2007.

Darda: The CPI running up to a 17-year high in the back of $150 oil prices was creating a bit of a panic about inflation and that panic was definitely seen now in the... We have the transcripts of those Fed meetings. Bernanke, even if he wanted to be a bit more aggressive, he had a problem as someone that wanted to govern through consensus. You had folks on the Fed literally wanting to raise rates. And so between-

Beckworth: Richard Fisher.

Darda: Yeah. Exactly. You had the ECB actually raising rates in the summer of 2008 into that commodity shock and then they made the same mistake in 2011, twice. But at that time, in 2008, there was a bit of panic about that and the Fed just... Scott makes this point over and over and Bernanke pretty much admitted it in his memoir with the funds rate being left stable from April until after Lehman failed in September. You can see the credit markets under a lot of stress. Now, the revised nominal growth statistics show a pretty pronounced slowdown at the time, maybe a little less, but with the economy slowing and headline inflation going up, that's typically a symptom of a supply side shock and the Fed really shouldn't be overreacting to that especially with a financial crisis getting worse. So by doing nothing, you end up with this drastic tightening in monetary policy.

Darda: I'm preaching to the choir here and you guys have taught me about this more than anyone else, but to communicate this to clients, it's taken me seven years and now most of the clients that have been with us, either they're just so sick of me preaching that they say they agree. But I think we're getting to a point where most of the money managers actually have a pretty good handle on this stuff now. They're reality based, right? So we didn't get the huge inflation from QE, we didn't get soaring long rates. Obviously. something went totally wrong in 2008 and so if you can come to them with a coherent framework and there's a way to potentially adjust a portfolio as a consequence, then they're all ears, whether it's monetarism, Keynesianism, or something else.

Beckworth: Well, I could talk about this for a long time. But let me switch gears to what you actually do, because this is fascinating. A lot of my guests are academics, journalists, policy makers, but you're actually in the weeds, you're in the marketplace, you're giving advice, you guys are doing your own trades here. So tell me about a day in life of a chief economist, a market strategist, what you do and then how that also relates to your clients.

A Day in the Life of a Market Economist

Darda: Absolutely. Our firm, MKM Partners, is an equity execution broker so we have a trading desk but we do not manage money and we don't do proprietary trading. We have about 12, 13 research analysts mostly focused on 10 different S&P sectors. I'm obviously on the macro side so my work focuses on the Fed, interest rates, inflation, the business cycle, and then where to position from a big picture standpoint. So if we're getting worried about growth rolling over and we think long term interest rates are probably going to be declining, then we'll be recommending a more defensive sector like utilities if conversely, we think we're emerging from a downturn than more cyclical groups. It's essentially macroeconomics and strategy-based research but focused on these big picture variables. Our clients are institutional money managers so we don't service retail clients.

Darda: I guess a good way to put it for listeners would be most of them probably have 401ks or if they're academics, then they have a pension that's managed by an endowment perhaps and those institutional money managers that are running mutual funds in a 401k or the folks making decisions for an endowment, those institutional money managers would be consumers of research, various different kinds of research, and macroeconomic research and strategy is one example of research that they would pay for. That's who essentially I'm writing for. If I go out on the road and leave the office that's who I'm interacting with. They could be a bond portfolio manager. They might be focused in one specific sector like financials.

Darda: I'm a generalist but many times I'll be in front of an audience that will say, "Okay, great, Darda, that's fine. But let's say that you have to invest in bank and financials, then tell me if your view as the long rate goes down, the yield curve flattens, then where should I be positioned?" So then I have to try to take the big picture view and say, "Okay, if I had to stay in that sector and how do the economic variables as I expect them to evolve, how does that play out for a particular sector and potentially different stocks in that sector?" I don't recommend individual equity securities but I can still take a big sector like financials and banks and say, "Okay, I think the economy's going to slow next year relative to this year. I think the curve's going to flatten a lot. I think long rates are probably going to be lower next year."

Darda: If I'm an institutional money manager, I have to invest in banks and financials then I definitely want to steer away from companies super levered to a steep yield curve. Maybe I overweight concerns that have business lines that are oriented around other things that aren't so sensitive to the level of long rates and the shape of the curve, perhaps retail investment products or something like that. I have to try to take these big picture ideas and then make them relevant to a money manager that's perhaps more focused in a microeconomic sense.

Darda: But I'll tell you the most fun part of the job for me is just talking about the Fed, monetary policy, how to think about it, how differentiate a supply side shock from a demand shock. You'll laugh as a professor and an academic yourself, but I'm literally using Economics 101 and 102, that's it, because there's a lot of confusion. Our clients are super bright people. Most of them have a lot of IQ points on me but they're busy and they don't have time to think about textbook macro and there are a lot of loopy ideas that end up floating around in the land of research.

Beckworth: Yeah, so you're there to correct that.

Darda: Yeah, that's definitely part of the job.

Beckworth: Tell me about the business model. A client, say, money market fund, they pay you a monthly fee or...

Darda: Yeah.

Beckworth: And then they have access to all your research, they can call you. How does that work? What do they get?

Darda: Yeah, exactly. The way that clients would typically pay would either be to just send a check usually. So the bigger institutions will have a fairly elaborate voting system. It's a marketplace, it's very much based on merit. Either money managers look at your research and say, "These ideas are helpful and useful and I will pay this person," or "No, I will not pay this person." They don't care what your background is or how nice it looks. If your ideas and your writing seems to be meaningful and they think it will help them, then they will pay you. Some accounts have a voting system and the votes translate into research dollars. So the more votes you accumulate, the more-

Beckworth: Interesting, huh.

Darda: ... the more you get paid by a certain client. And then that's a matter of penetrating with that institution.

Beckworth: So within a firm-

Darda: Within a firm.

Beckworth: Within a firm, the people in the firm will vote on Michael Darda's research. The more votes you get, the more [inaudible].

Darda: Exactly. And we have to compete with the bulge bracket firms. They have all kinds of resources and many more analysts than we have. But if you have a niche that you're good with, say for me, it's the credit markets and the business cycle or even in helping to incorporate market monetarism, that's different. That's not what you typically see from Wall Street macro research. If you have a differentiated product and it's proven useful, if we're trying to call turning points and we get one right once in a while, then the clients will pay and you can start to get a following going and then it just builds from there.

Darda: For example, let's say you're a money manager at financial institution, you might like my research a lot, you're voting for me but your advice is, "Well, you've got to get more people on board," and they may not be sympathetic to monetarism or any other economic philosophy. So then it's a matter of, "How can I be relevant to these other money managers as well?" Not changing your view, from money manager to money manager, but, "How can I rephrase what I'm doing in a way that makes sense and is helpful for an array of different institutional money managers?"

Darda: It's been a labor of love. I've guessed I've been at this for almost two decades now and hopefully, like anything you get better over time. For me, it was baptism by fire because I came to the first think tank as a fairly young guy in my mid-twenties and it was a small firm so I got to start interacting with institutional money managers right out of the gate. And so then you learn right away what is important and, and useful to investors and then you just try to get better at your craft over time.

Darda: I felt... Well, luckily for me, my methodology proved to be helpful going into the Great Recession because the credit markets were really on the front edge of what was happening there. People cared a lot less a few years earlier when everything was calm and stable, but then when things started to fall apart, that's really where the following that we've been able to build up for my product took off.

Beckworth: So your clients can they say, "Hey, Michael, I want you in the office at 3:00 today." Did they do that? Or is it more of a conference call or...

Darda: There's an unwritten understanding that depending on what they're paying us, if it's not very much relative to what an institutional money manager would pay, then they don't ask for a lot. If they happen to be a big client that are using our trading desk and so they're paying us maybe for multiple research resources plus trading and they're a big account for the firm, then it's like jump and how high. I'd like to talk it's 9:00 at night or 10:00. And that did happen not infrequently during the crisis, but it's been... And then maybe again in 2011…

Beckworth: I'm very interested…

Darda: But for the most part, I'm probably writing, let's say three to five research reports a week. Sometimes, I'll write every day, I'll get on a theme and if I feel compelled to right, I'll write. And so the clients don't say, "Hey, I need two notes from you a week or a month." I just know that I can't overwhelm them because they're busy. They're not going to probably read everything I write. I need a hook, something interesting, and then the writing needs to be crisp. Essentially, the notes you've seen are literally one paragraph and then probably five or 10 charts. That's what Jude taught me. He was a newspaper man so he wrote for the Wall Street Journal. Before he was on the editorial page, he was part of the what's new section where you have to boil a story down into three sentences and it's not an easy thing to do.

Darda: So when I first went to work for him, a lot of his employees had a journalist background. I'd write a piece and that would just be ripped to shreds like this isn't going to work. I had to relearn, even as somebody that had a background in writing and communications, how to write in a very simple, crisp fashion but with a hook. If you can succeed at that, then it helps you stay ahead of the game in a competitive environment because the clients within 30 seconds will know exactly what I am intending to say and then they can look at the charts or they can come back to the charts at another time.

Darda: That's a typical day would be if I'm not out on the road doing meetings or doing conference calls or I do some media stuff, radio and TV. It would essentially be the morning hours. I try to focus on updating spreadsheets and writing because my notes really tend to go out I'd say anywhere between 10:00 in the morning and maybe 2:00 in the afternoon. That's a good time. You want to hit the clients when there's a lull. All the bulge bracket research goes out 5:00 or 6:00 AM Eastern time. I try to never really publish in the morning and compete with... I'd rather be somebody comes back from a nice lunch, maybe they're feeling a little sleepy and then my goal is to not totally put them to sleep but they're ready for maybe a dose of macro strategy around the afternoon time.

Beckworth: Yeah. I've read the notes, they're great, and you're right they cut to the chase, hook them, and the graphs are always excellent. Well, that's an interesting business model. Imagine many of our listeners aren't familiar with, maybe some are, I guess I don't know who all listens to the show, but based on the guests we've had, this is definitely a unique perspective.

Darda: Sure.

Beckworth: But let's move now into your assessment of Fed policy and what's going on in the markets today. So we move away from the business model to what you actually see going on. We've touched already on 2008. So let's move beyond that and just do a reflection on the past decade since the recovery, at least.

Darda: Right.

Beckworth: What is your overall grade for Fed policy? If you could do that, and then maybe if you want to break it down into more nuanced comments [inaudible].

An Overall Grade for Fed Policy

Darda: It's a difficult question because I think if we're grading the Fed based on an idea that Scott and you and others have set, which is essentially keeping nominal GDP growth stable, doing whatever you need to do to achieve that aim, obviously, there was a big failure in 2008 and 2009. Thanks to you two and others, I think that failure is being recognized far more now than in the past. If we just look at the actual recovery it's been slow, but nominal GDP growth has been relatively able. It's been fluctuating but within a pretty steady band. So it's almost, and I think Scott Sumner has actually used the phrase, a new great moderation but the magnitude's lower now with slower growth in nominal GDP.

Darda: We've seemed to have had a productivity slowdown as well. We've got some demographic issues with slower labor force growth. So there's obviously a very big debate about what's causing that. And I'll tell you something. The clients are probably more interested in that than anything else. Every meeting I do, we get around to talking about productivity and they want to know why it's slowed. If it's just a mismeasurement, what the prospects are for a pickup. We end up talking about supply side policies and then I try to keep it fair and balanced and say, "We can talk about corporate tax cuts, but if we're going to more restrictive immigration and trade policies, those are adverse for the supply side." So maybe that's why the bond market's not so convinced we're on the precipice of a big growth breakout.

Darda: I'd say to answer the question specifically against an ideal of stable nominal GDP, we've had big failures. The ECB failed to a far greater degree than the Fed, but I think there's been a real recognition of that now so hopefully next time around, we'll probably deal with a recession at some point in our future. Hopefully, if there is a policy failure, if it can't be avoided, it will be recognized earlier on, and there'll be a more forceful reversal so you don't have the Great Recession once in a 80-year storm. Hopefully, we don't have to deal with something like that for a long period of time. That's anyone's guess.

Darda: I think policy has been in recent years much better because the labor market has been recovering. It has been slow but it's been an ongoing recovery. The U.S. avoided a double-dip recession. The Eurozone ended up in that predicament because of a second policy error. I think if we're grading on a relative basis, a curve, if you will, I think the Fed gets pretty high marks relative to the ECB. That's when I do get into debates with clients and they tell me either QE was a catastrophe or a failure, it's funny how they're both in the same sentence.

Darda: Yeah, exactly. It's either too effective or not effective at all. I use the Eurozone example because that's the most vivid because it's within this business cycle for the U.S. The ECB failed not just through an act of omission, like the Fed in, say, 2008, but an act of commission where they actively were raising short term interest rates and sending that signal at exactly the wrong time. We can see what the result was in terms of a much slower recovery, double-dip recession, far less favorable outcome for labor markets.

Darda: It's a less controversial story now I think when we were first out attacking it. In fact, I actually had the opportunity. I did a Wall Street Journal editorial piece the day before the ECB raised rates in April of 2011 and I had a chart of M1 money supply growth in the Eurozone tanking. I think it may have gone negative even before they raised rates so there was already some signs in some of the monetary indicators that things were really slowing down. I had the M1 money chart or I had the M1 money growth indicator charted with business confidence and leading by nine months and I thought, "Okay, if I can get this in the Journal, that would be great." For whatever reason, the U.S. based journal editorial team didn't find it as interesting as I did, but they put it in the European Wall Street Journal. Trichet probably read it that morning and then raised rates later that day.

Beckworth: [inaudible] he wished he had paid closer attention to what you had written.

Darda: You wouldn't know that based on his recent interviews, but...

Beckworth: Yeah, no. It's a fair point for those of us who have been critical of Fed policy. It could have been a lot worse, 1.2, it wasn't the Great Depression. They did do some things right and it is remarkable the relative stability of nominal demand growth since the bottoming out which... It's hard to draw straight lines. Nature doesn't naturally create straight lines so if we see a straight line, some human intervention and nominal GDP growth has been a fairly straight line up so give them credit where that's due. I do though want to push back on one issue and that's inflation, right? So the Fed itself has been puzzled, which is a little troubling. Federal reserve doesn't understand why inflation has been persistently below its target.

Beckworth: I've done a search, Google trends, I've searched newspaper articles, and as late as November or October 2014, you start seeing articles with the word mystery conundrum, puzzle, the burden of this missing inflation, what's going to happen. The Fed itself has acknowledged something is afoot and I know the Fed’s inflation target begins in 2012 so it's only five years or so of missing target. But if you go before that, when it was implicitly targeting near, you have a fairly long run of below 2% inflation. What is your take on that?

The Fed’s Low Inflation Puzzle

Darda: My take on that is a similar take as to why QE was not highly effective. And the reason I think is because the Fed was just too worried that it would be highly effective. Going back to all of the liquidity mechanisms in support systems that the Fed was toying around with in 2008 and 2009, Bernanke went to great lengths to say, "This is temporary. It's going to be reversed. We need to get a recovery going." So the bar was set pretty low.

Darda: The bar was not, "We want inflation around 2," and that target did come a few years later, but we're going to just open this up and we're going to go until we actually get there. Or maybe there's some forward looking bogie like the TIPS market, or it could even be other inflation surveys or so forth and they could have just said, "We're opening up the spigots until we get there." But that, at the time, would've been such a controversial maneuver that Bernanke may not have had the support on the board to actually do that. Just the act of large scale bond buying was unprecedented and scary to a lot of... As a consequence, quite scary to a lot of policy makers because they didn't...

Darda: Even with Japan's experience with QE and it not having a real big influence, the Fed seemed to still be far more concerned that once they opened up on QE that maybe we'd have a lot of trouble pulling it back. And so, as a consequence, the programs were go-stop and the stops were taking place without the Fed, achieving its goals. Initially, even on the employment side, later once employment fell enough, the Fed seemed to be sufficiently comfortable hitting that side of the mandate or getting close to it that if inflation was running under that that seemed to be okay.

Darda: I also think now more so there's this Phillips curve issue. A lot of FOMC officials and probably most of the staff, the essential framework is a slack-based Phillips curve model that drives the inflation process and everything else is secondary and tertiary and so they believe we're going to be getting back to a higher inflation rate and they are now more worried about potential overshoots. In fact, we saw that recently with some of the Fed minutes attached to the March meeting where there's much more optimism about getting to 2% and more concern about overshooting it simply as a product of the employment rate. The Phillips curve is still alive and well, at least, I think with some caveats obviously but that's the essential framework of most of the Fed staff and FOMC policy makers.

Beckworth: I had David Andolfatto on the show recently. We talked about the Phillips curve and he's much more the monetarist. Although he used money broadly to include treasury bills, it's an institutional view of money.

Darda: Right.

Beckworth: But anyways, his point was we have to move beyond the Phillips curve. But I want step back and take a point. You've stressed just a few minutes ago and I think the continued use of the Phillips curve among other things is tied to the continued embrace of this inflation target or low inflation is the norm. And as you mentioned before, that thinking made the Fed concern in 2008, made the ECB concerned in 2011-

Darda: Yeah.

Beckworth: ... and today it's making the Fed’s concerned. They use the Phillips curve to think through the dynamics, but the bigger point is they're worried about inflation taking off and yet this hasn't been a problem. In 2014, when oil prices fell in half, the Fed said, "Well, is this because of supply shock? A demand shock?" And honestly, in real time, it's hard to know. I don't think I would do any better.

Darda: Right.

Beckworth: But to me, there's something that's screaming from all of this debate, something very obvious, and that is maybe inflation targeting isn't the best approach to monetary policy. Maybe it's just too hard to do in real time.

Darda: Right.

Beckworth: Maybe you should try something like, oh, I don't know, nominal GDP targeting.

Darda: Exactly.

Beckworth: No, I know I'm preaching to the choir [inaudible] to that view.

Darda: Yeah, exactly. It's interesting. So you brought up 2014. It was an interesting test for the Fed and for then chair, Yellen. Bernanke kept telling us, "We're not on a preset course. We're not on a preset course," but it sure looked like it was a preset course as they said, "Okay, we're going to go for the taper and then we're going to halt the balance sheet. Keep it level. Start to raise short rates and then sometime in the future, we're going to start to reduce the balance sheet." The Fed was modeling out for four rate rises in 2016 and what was happening as we were going into late 2015, credit spreads soaring, a lot of stock market volatility, inflation expectations had crashed, not just crude oil, but other commodity prices had crashed.

Darda: It doesn't take a genius to take a look at that and say, "There's probably a global demand story going on here. And if the dollar soaring is part of that equation that maybe it's connected to monetary policy expectations." This is a way that I think I can end up being helpful to our clients even though I'm not an academic economist, keeping an eye on these markets and then making the correct interpretation based on what's happening. Oil was falling more forcefully than other commodities but other commodities were going down too. I think that was a sign that China was weakening. They were trying to defend their currency and so you had essentially a monetary shock hitting the global economy back in 2015 and '16. We could see that in some of these market indicators. What saved the day then I think was Fed governor Brainard, actually a friend of mine, who's-

Beckworth: Oh, really?

Darda: Yeah, a friend of mine who's... Well, I'm sorry. Brainard is not. I don't know Brainard personally, but one of my friends who's a hedge fund manager started to point out Brainard's onto something here and I think Yellen will eventually start listening to her. I was actually much more pessimistic. I thought, "No. Yellen I think is more confident in the Phillips curve and the Fed has set out this course. I think it's going to be difficult unless the macro data really start tanking on us." It turned out that he was right about that. I think Brainard pressing with those speeches focusing on-

Beckworth: I remember that, yes.

Darda: ... focusing on the dollar and financial conditions, credit markets, inflation expectations, and then just the volatility we were seeing, we were going through these rolling bouts of weakness in equity markets, weakness in credit markets. So the Fed after the first rate rise in December of 2015 paused for a year. And what happened in the interim was that these market indicators started turning around. Credit spreads peaked, I think, in February of 2016 right around the time that the stock market trough and then began a long period of compression. We didn't have the data back then because I remember debating clients and they're telling me, "See, the market's addicted to all of this QE and it's all baloney and this isn't a business cycle issue."

Darda: In fact, I think former Fed governor Warsh should've written an article for the journal saying the Fed really needs to not pay attention to these market tantrums and just carry on with the tightening. Well, now we have the data and the data show that nominal GDP growth slowed from around 5% year over year in late 2014 all the way down to two and a half percent year to year by mid 2016. We went through a five quarter profit recession. We went through a capital spending downturn. Now, a lot of this was focused in the oil patch and so forth.

Darda: But there clearly was a macroeconomic business cycle fallout from what we were seeing in financial markets. They were anticipating it as they always do. It doesn't mean that markets are always right but there was a fundamental reason and a damn good one if I may say for the Fed to pause and on those rate hikes for a year and that pause helped the equilibrium interest rate recover with more robust credit markets. When the Fed resumed the rate hikes in December 2016, they have been much more successful in being able to string together a successive series of moves without the renewed volatility and fears of a double-dip recession and that means they're...

Darda: I tell our clients, "If Fed looks like they're not doing anything, it means they're doing it right. We shouldn't be focused on it. If they're just following the so-called natural rate up, then you're not going to see these freak outs of different markets in fears of a recessional..." Instead, we'll see commentators go on the financial press and say, "See, the Fed has no influence. They just did 125 basis points of rate hikes and it didn't do anything." Right. That's what you want-

Beckworth: …compared earlier when they got ahead of the market, ahead of the recovery.

Darda: Yeah.

Beckworth: This is great to bring this period up because I wrote about this a while back that the Fed did get ahead. I think Janet Yellen becomes new Fed chair. She's got to prove something. I think it's more than just that but I think it's important to signal she's serious about inflation too and Janet Yellen and the Fed if you look over it, they were talking rate hikes almost the whole time, many more than they actually did.

Darda: Right.

Beckworth: And I think part of it is what you said they were getting ahead of themselves, getting ahead of the recovery, and Brainard was like, "Rein in. Slow down, cowboys. We need to-

Darda: Yeah, front and center.

Beckworth: ... pace ourselves."

Darda: Yellen was also fighting off this false dove affiliation. For whatever reason, very pervasive view on Wall Street that Yellen is a dove. When I'd asked our clients that would say that to me why do you think that simply because she was out front in recognizing the economy weakening, say, in late 2007. I think the transcripts from the January '08 Fed meeting showed that she recognized with the December '07 employment data that we were probably in a recession because the U-3 unemployment rate had pushed up five tenths of a percentage point from your earlier levels. And she said, "Look, men and women, that has not happened outside of recessions in the post war period and we should be more worried about that than commodity prices." She was really out front and very right in pushing for the Fed to be more aggressive then. But I would remind our clients that back in the late nineties, she was quite hawkish and in fact, there's a story in Larry Meyer's book about his time at the Fed where he and Janet Yellen cornered Alan Greenspan I think in the fall-

Beckworth: Really?

Darda: ... in the fall of 1996 because the unemployment rate I think, had fallen into the fives or something like that and these are pretty low levels for the unemployment rate in terms of the business cycle expansion of the eighties and nineties up until that point and the Phillips curve models were saying that we've got a potential issue with slack and bottlenecks and inflation could be around the corner. Greenspan had this crazy theory that productivity was picking up but it wasn't showing up in the data just yet and that crazy theory proved correct. We ended up seeing far lower unemployment rates than what was perceived as possible with quite low inflation. So Greenspan, he gets all this flack now but he was quite right about this positive supply side shock.

Darda: But the point of that story is that Yellen has historically been very committed to the labor market, cares about it, cares about the dual mandate, and if the labor market is a loose, Yellen tends to be pretty dovish. If the labor market is tight, she tends to be hawkish. That's why we had that setup going into 2015 and '16. She was quite reluctant to move off this preset course that the Fed told us they weren't on but it turned out they were. She eventually did move to the sidelines quite rightly but this interpretation of Yellen as everywhere and always a dove was totally wrong.

Beckworth: So that's interesting. She cornered Alan Greenspan, said, "Look, you got to tighten because things are looking bad based on my Phillips curve model."

Darda: Yeah, they were-

Beckworth: Interesting.

Darda: I believe this is in Larry Meyer's book and they were getting concerned. I think it was in the fall of '96 because the Fed had this period where rates were just steady and inflation was low at the time but there were a group of Fed governors that and reserve bank presidents getting concerned that unemployment was falling to a level that would start to produce a problem with inflation and it turned out not to happen and Greenspan turned out to be instinctually correct in terms of productivity picking up and the sustainable growth rate going up. Yeah, it's a fun piece of financial history and it turned out to come in very handy with Yellen's early tenure as Fed chair and this misinterpretation that she's always dovish which is totally false.

Beckworth: And that's when the dollar starts to rise. You can easily trace in my view at least that 20% plus shrinking of the dollar from 2014 to 2016. It tracks very nicely the rise in the federal fund's futures market. The market's expecting rates to go up versus the Eurozones flat or falling and if the dollar follows that up and it tied closely to the [inaudible]. But let's move on to some other interesting stuff going on. So right now we see a slight flattening of the treasury yield curve-

Darda: Yes.

Beckworth: ... and it hasn't completely inverted.

Darda: Right.

Beckworth: But it's getting closer. You've written also about a stealth liquidity drain given what the Fed’s doing, its balance sheet. So what do you see going on right now? Is the market telling us something and are we okay?

The Fed’s Stealth Liquidity Drain

Darda: I think both. I think we're okay in the sense that it's not uncommon historically for the yield curve to flatten pretty considerably in a later cycle environment and that typically means the Fed is lifting short rates in a successive fashion. For whatever reason, some folks thought, "Well, as soon as the Fed starts lifting rates and/or cutting its balance sheet, long rates are going to zoom upward." We heard that with each QE off iteration that turned out not to be the case. But if you look back at any sustained rate hiking cycle in the U.S., the yield curve tends to flatten. I don't think the flattening of the curve is a sign of potential recession at this point. But there's a big difference between flattening flat and then actually inverted.

Darda: One exercise that's fun to perform is to look back at the monthly trend of the yield curve since December of 2016 when the Fed resumed its rate hikes and if that average monthly flattening persists going forward or something close to that average monthly flattening, when would the yield curve invert? And it turns out it depends on which yield curve you're looking at, if it's bills to tens or tens to ones or something else. But basically sometime between the summer and fall of next year and maybe early 2020, depending on what version of the curve you're looking at.

Darda: You can also do this reverse engineering with the feds projections. If you look at what they're projecting in terms of Fed rate hikes and where the 10-year yield is now assuming the yield doesn't move dramatically, it may, but that's not my assumption. The Fed is telling us that they'll probably end up inverting the yield curve sometime between 2019 and 2020 which would give us a 2021 recession. I had to laugh with this last iteration of CBO projections for the next decade that came out. They're incorporating some pretty rosy effects from fiscal policy now. I think around seven-tenths of a percentage point a year for lift on growth which is pretty significant. But that is all out the window if we get an inverted yield curve sometime in the next year or so and that's usually where the CBO projections totally go awry. You're not going to forecast a recession.

Beckworth: So the Fed’s own forecast, this is a summary of economic projections-

Darda: Yeah. Basically.

Beckworth: ... they inclusively show an inverted yield curve.

Darda: Well, the Fed’s not forecast. The Fed, I guess, assumes that inflation moves up, the long rates are going to move up and so-

Beckworth: Okay.

Darda: No, it's not an intended policy. But the Fed has a long, pretty undistinguished history of telling us that an inversion was different this time when it... Carolyn Baum is a good friend of mine actually. I know you had her on the program and she's written about the yield curve a lot. But we can just look at the last three inversions. So in 2006, Bernanke was telling us that... And he had just taken over for Greenspan so there was probably some pressure on him to show, "Hey, I care about inflation. I'm not going to be a super dove." So when the yield curve inverted in the summer of 2006, his story was that this is the global savings glut. It's distorted the term and premium in the treasury market. Risk spreads are narrow."

Darda: So there you go, Darda, there's a market indicator it's telling us it's okay. But typically the curve moves before everything else and we could have probably another hour discussion on why that's the case. But in terms of an inversion and then things going wrong, that's usually the first sign that is over tightened and then you start to see it showing up in other places later. But in the year 2000, when former Fed chair Alan Greenspan inverted the yield curve, he said that fiscal surpluses were distorting the treasury market. So don't worry about the inversion. It's different this time. Tech PE is starting to level off or compress. Fiscal surplus is maybe distorting the term premium again. Turned out it wasn't different that time.

Darda: And then if you go back to the late eighties, 1989, the yield curve was inverting after the Fed was resuming tightening and leaning against the business cycle. Greenspan back then said, "Don't worry about the inversion. This is due to idiosyncrasies in the treasury market stemming from the S&L crisis," which I guess that was Greenspan-esque for the term premium again. So it wouldn't be a surprise in the next year or so if we end up with an inverted curve in the Fed saying, "No. Different this time. It's the term premium and we have global QE and..." Whatever the argument is, it'll be a different this time argument.

Darda: But I'll just say this, the San Francisco Fed recently within the last month or so put out a paper or their Fed letter looking at the tens to ones treasury spread, this is the most accurate portion of the curve in signaling and pending recessions inverting about a year ahead of time. And then they looked at a few. It's different this time arguments, term premium distortions, low natural or equilibrium interest rates and they essentially said, "We don't find compelling evidence that those things are going to matter if this spread inverts," then it is a meaningful signal. I thought, "Wow, that's a great piece of research." So I've been getting a lot of mileage out of that and client meetings.

Beckworth: I bet. The thing that strikes me about the Fed officials saying it's different this time, Bernanke, Greenspan, they're in a position where they really couldn't say anything else. Imagine you're Bernanke or Greenspan, you get up to give a talk and you say, "Well, the yield curve's inverting. Usually, that means recessions. Run for the hills."

Darda: Right.

Beckworth: They really can't. They're in a position where they could exacerbate the panic and make it worse.

Darda: Right.

Beckworth: It's almost impossible for them. Maybe the best thing for them would be not to speak about it at all.

Darda: Right.

Beckworth: But even if deep down on their heart, they think it's telling something to watch out, to be careful, they have to keep their mouth shut or reinterpret it in a more sanguine manner.

Darda: Right. Well, there is a way around it. Obviously, if they had a different target for policy and markets found that target highly credible, then you wouldn't really need to worry about that and you probably wouldn't really see inverted curves, maybe flat curves, but an inverted curve is an unusual occurrence at least in terms of U.S. financial history. I think Scott Sumner's talked about this so-called triple lag in policy where you end up with the Fed overdoing it late in a cycle because a slowdown isn't necessarily in the data, the unemployment rate is maybe leveling off but it's quite low, the labor market's tight, wages are doing okay, industrial production and retail sales are rising and the curve is flattening and then starts to invert. But it's incipient. You don't see a recession in the macro data. Maybe inflation's also elevated at least on the demand side. It will tend to follow the business cycle or nominal GDP with a lag.

Darda: So the Fed doesn't see slowdown or recession in the data and they also... So there's a lag in terms of when the data's released and then there's a lag because you get revised data. And then there's another lag on policy from the Fed not wanting to look like they're lurching from tightening to easing. They prefer to stop tightening, have a nice long pause, then maybe ease, but they don't want to look like they just tightened now they're easing a month later. What's a matter with you guys and gals? This triple lag in policy gives us what you see represented by the yield curve inverting and maybe other indicators. I'll say this for the listeners. What comes up in a lot of client meetings is in other countries you don't necessarily get the inverted curve before every recession and it is true in a very low rate environment yield curves have had a less successful history. We had a period...

Darda: I think I have 150-year yield curve chart in my deck. I'll rip it out for you. But we saw the yield curve. We can construct yield curves with railroad bonds and then call money rates even before the advent of the Fed and I'll be darned if you don't see inversions associated with recessions. But this period in the U.S. basically from the early thirties until the early fifties, the yield curve was very steep and then just relentlessly flattening and we had a few recessions in there without an inversion foreshadowing the recession. So if you're in a super low rate, fairly low growth environment, the risk is that you get a recession almost always associated with monetary tightening, but whether the curve inverts for you or not is an open question. And for me, that was always the biggest issue with the yield curve in this cycle.

Darda: I'm more confident now than I have been since the cycle started that the curve will likely invert before the next downturn simply because the Fed has so far at least successfully raised rates. What do we have? Four in a row, five in a row now after the stumble out of the gates and the markets expect the Fed to continue moving up and we're getting this flattening in the curve that's pretty relentless. They're not far away in terms of how many more hikes would do it. If they do three or four this year and then try to repeat that next year, and by the way, I won't mention any competitors but some of my competitors on Wall Street are calling for exactly that. If you're of the belief that the unemployment rate and slack are the prime movers of the inflation process, everything else is secondary then you're in the three to four camp and another three to four... That'll give us an inverted curve.

Darda: I think I'm getting more comfortable now with the idea that the curve should be an early warning signal for us if we're ending up with the Fed going too far. But in the Eurozone and Japan, we've had to look to other measures. Some of the monetary indicators have been helpful. I mentioned M1 in the Eurozone tanking before the 2011 recession and also before the '08 downturn and the Eurozone generic curve not inverting before 2011, but we had some other indicators. There are always a few that can help us even if there's a missed signal with one or several.

Beckworth: Well, with the time we have left, let me ask a follow up question related to that point and that is, are you confident with the new Fed, with the new FOMC? Or are they going to make the same mistake? You're saying we're in the position or really susceptible to inverting the yield curve again but it's not necessarily going to happen and it depends on the people. So are you comfortable with what the Fed is saying and thinking and the new faces?

Thoughts on the New Fed Regime

Darda: Not really. But I hope to change my mind. I think we don't really have enough information yet because push is going to them to shove when we have an issue and by that, when we have, let's say, an elevated CPI inflation rate with signs of slowing in nominal GDP or let's say the curve flattening further, maybe some pressure in credit markets, and at that point, the Fed’s going to have to make a decision. What is it? Is it the Phillips curve and headline CPI? Or are we going to rely maybe on some of these more forward looking signals coming out of the TIPS market which is the fact that we have had a flattening in the yield curve, some of the monetary metrics, if they're slowing down, those are out of favor now on the Fed.

Darda: I don't have a super high level of confidence that when push comes to shove, they're going to make... Because we look at history and you seem to have these repeated mistakes where the Fed goes too far and they have an argument that seems really appealing at the time and it turns out that it's actually not correct. I will say this. I try not to throw my whatever weight I have behind any particular personality. But even though I didn't agree with Yellen on everything in terms of a framework, it's a much more Keynesian Phillips curve framework, that's not really my framework, but I was sad to see her go because to me she was replaced for no other reason than politics. Why rock the boat when after a stumble with the first tightening in December of 2015 she really did a remarkable recovery from there?

Darda: If you look at all the metrics over the course of her tenure, you could actually argue that you might have had the most successful tenure of any Fed chair in terms of good stock market performance, falling unemployment rate, no recession, successful sustained tightening after an initial stumble, beginning to shrink the balance sheet. I say this to all my super hawkish Austrian clients that were never Yellen fans like, "Did you ever expect this person you thought was an Uber dove to be the Fed chair that presided over sustained rate hikes in an incipient reduction in the balance sheet that all the QE infinity folks were telling us would never ever happen?" And it's happening and it started happening under her watch.

Beckworth: That's right. That's a fair point. But what you're saying is that business cycles, they die of bad policy not of old age.

Darda: Exactly. That's the Rudi Dornbusch quote that business cycles don't die in bed of old age, they're murdered by the federal reserve. And another chart that I'll leave with you is a hundred-year history of the Fed policy rate. This is not a reasoning from a price change intellectual error but it's simply to see that every single recession over the course of the last century, we had the Fed doing some monetary tightening going into that recession. And so by definition, they had to have eclipsed the natural rate. There's one exception to that rule. The only fiscal recession I can find in the last century was the World War II demobilization of 1945. It was a six-month recession in which the Dow Jones industrial average rose about 20% and I think the unemployment rate rose from one to two. So if that's what a fiscal recession is, I'll take it any day of the week and twice on Sundays.

Beckworth: Okay. Well, our time is up. Our guest has been Michael Darda. Michael, thank you for coming on the show.

Darda: My pleasure.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.