Tom Graff is the head of investments for Facet Wealth and has several decades leading fixed income departments. Tom joins David on Macro Musings to provide his thoughts on the recent FOMC meeting, the Q2 2022 GDP numbers and their implications for the economy, and the future path of Fed policy. Specifically, David and Tom discuss the recent GDP numbers from Q2 2022, the merits of public concerns over a recession, takeaways from the July FOMC meeting, interest rate theory and implicit forecasts of inflation, the fiscal theory of the price level, the continued importance of the Fed’s framework, and much 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: Tom, welcome to the show.
Tom Graff: Thanks for having me, David. I'm a longtime fan of the podcast, so this is really exciting to be on.
Beckworth: Well Tom, it's great to have you on the show and you're another individual I have met on Twitter. Twitter has been a really productive place for me to meet people like you and learn from people like you, people who care about issues we discuss on this show and it's great to have you as well because you come from the marketplace. I come from a more academic setting. So I get to bounce ideas off of you. And we've been doing this online for some time. So it's great to have you on. This is long overdue. Should have had you on the show several years ago, but in any event, glad to get you here. And I must say Tom, this is a bit of an experiment, we are meeting the day after the FOMC meeting and we're trying to do a quick turnaround episode. Typically, we have multiple episodes in the pipeline.
Beckworth: So this will be an experiment in getting a quick turnaround, given that the FOMC meeting in July has been so topical, such a discussed issue. And then on top of that, today, we had the GDP numbers. And so we're here to talk about that as well. GDP numbers, what do they mean for the recession and then Fed policy - what have we learned going forward, what to expect? So let's talk about the GDP numbers. There's been a lot of debate about what a recession is, what it means. And I want to ask you, what is your takeaway from the GDP numbers today, then how do you use that to think about this debate over what is a recession?
Q2 2022 GDP: Recession Risk and Other Takeaways
Graff: Well, first of all, I'm honored to be part of Macro Musings history with this quick turnaround. Okay, so what you're referring to is the GDP came out today was the second straight negative quarter for GDP, which is a traditional sort of rule of thumb for what the definition of a recession might be. Of course, your readers know, or listeners know, that formally though, a recession is declared by the NBER. And even if one were starting right now, we wouldn't know it for many months, most likely. But honestly, I think it's a little silly to say we're in a recession right now because by most measures the economy is still extremely strong, we've had some of the best job growth we've ever had in the last six months. Consumer spending is still really hot. I mean, frankly, that's why we have an inflation problem, right?
Graff: The other thing I would just point out is that the first quarter GDP being negative was quite spurious. The final demand numbers, which basically takes out some of the trade impact, was quite positive. So the only reason why it was negative was because import numbers were so high and having a really strong import is a sign of a strong economy, not a weak economy. But this quarter's a little different. This quarter, the biggest negative effect was from fixed investment, which includes home building, and equipment purchased by companies and stuff like that. And that going negative is pretty notable, right? That's probably a first order effect of the Fed tightening financial conditions, and it's interesting that's happened so quickly. Because remember, this GDP's only counting April, May, and June, and a lot of those fixed investments decisions are made over an extended period, so the fact that's turned negative so quickly is definitely notable.
This quarter, the biggest negative effect was from fixed investment, which includes home building, and equipment purchased by companies and stuff like that. And that going negative is pretty notable, right? That's probably a first order effect of the Fed tightening financial conditions, and it's interesting that's happened so quickly.
Beckworth: Yes, I have found that striking too. And as you mentioned, a little surprising because you think of monetary policy working with long and variable lags, as Milton Friedman said, but as my colleague Scott Sumner likes to say, monetary policy can also work with long and variable leads when it comes to financial conditions and in turn, these investments as you mentioned. So the Fed has tightened financial conditions and they are already having an impact on housing and construction. So I guess the takeaway is monetary policy works and has worked really quickly. That's I guess the surprising side of it, how quickly it has affected investment in housing and construction. So the numbers were negative for Q1 and Q2, even after the revisions. And I was someone who thought maybe Q1 would've been revised far up so that it was close to positive or zero at least, but that did not pan out.
Beckworth: And so it's the case that it's negative. It is worth noting though that real gross domestic income for the first quarter was actually positive. So while we still have a negative Q1 number of 1.6, the gross domestic income grew at 1.8. And what's interesting, as you know Tom, is that gross domestic income is total income earned in the economy and GDP is gross domestic product or total spending. And in theory, those two things should be equal. Total income is what's used on total spending. So in theory, they should be equaled or not. There's some kind of measurement error, but what it suggests is then that first quarter may not be as bad as the GDP number suggests and gross domestic income has had a better track record in some cases of relaying what the underlying state of the economy is. So it's just another data point that goes along with what you were mentioning in terms of employment, growth, household spending, things that seem to be relatively strong.
Beckworth: Now with all that said, the second quarter GDP numbers, as you noted, they do look more troubling. And should we have another quarter of decline in real GDP, I would then invoke the rule of thumb of two quarters a recession then. I just don't think the first quarter is a good place to start that rule of thumb. But going forward, I think it is given we are seeing weakness. So the real issue then is going forward, are we headed into recession? Will the economy weaken? Will the Fed go too far, not engineer a soft landing, but a hard one? So what are your thoughts on that, Tom?
Graff: Yeah, so Chair Powell said it yesterday in the Fed meeting that it was probably going to be necessary for the economy to slow over the next couple quarters. And more over, that that's pretty likely. So, clearly we're not going to solve the inflation problem we have without aggregate demand coming down, and aggregate demand coming down almost certainly means slower GDP growth. And I think what [Jay Powell's] thinking there in saying that a slowdown is pretty likely is that there's a lot of tailwinds that either because of Fed policy or just because the natural course of things that are probably fading now, so consumers have normalized their credit card spending over the last couple quarters, and that has probably been a big boost to spending, but now it's pretty normal, and so it's probably not going to continue to be a big tailwind. It's also probably been a decent amount of home equity withdrawal that is probably not going to keep going, particularly as interest rates have risen by a lot and home prices may not fall, but they may not keep rising in a big way. And lastly, consumers have probably spent down a fair amount of savings. And so, they built up during the pandemic when it was hard to spend on things like vacations and whatnot. And that's probably played out.
Graff: So those things are sort of the natural things that are probably just going to go away. But then you also heard, there's a lot of anecdotal evidence that companies may be slowing the pace of hiring. We saw on this GDP report, but we've also heard it from companies like Walmart and Target that maybe may built up a little too much inventory so far this year, and they're going to have to spend it down. It tends to be sign that the economy's going to slow at least temporarily. And then of course you do have the accumulative effect of monetary policy, which should be something of a slowing impact on the economy. So, I do think definitely a slower pace in the second half is quite likely than what we saw a year ago, let's say. Whether it ultimately turns recessionary or not, I think it's an elevated risk right now, but I don't know that it's for certain.
Beckworth: Okay. And that's the great point you've highlighted there that even in the absence of the Fed tightening, there had been some natural slowdown coming out of the pandemic, people spending down their balances, normalizing their behaviors. So great points. One last observation about this question about recession or not, and that is the inverted yield curve. And we'll come back to this later probably, if we have time, but it's inverted. But it didn't invert till April or until the second quarter of this year, so if you use another rule of thumb, the inverted yield curve, it would suggest the recession is ahead of us. It would be a very weird reading to have a yield curve say the recession occurred before it inverted. So I guess that'd be just another data point.
Graff: Yeah, I guess I would say on the inverted yield curve, in the old days, David, that an inversion meant that the Fed was sort of above neutral and at some point would go below neutral or at least fall back to neutral, right? And that's why the short term rates needed to be high, but long term rates were lower than short term rates. We've had sort of a weird period here where because the Fed has been so upfront about how quickly they were planning on hiking, short term yields almost immediately priced all that in. And so I think the curve flattened faster than it has in past cycles, so that might mess up the timing of the signal you're mentioning. I guess we'll find out, but it's at least a plausible outcome to me.
I think what [Jay Powell's] thinking there in saying that a slowdown is pretty likely is that there's a lot of tailwinds that either because of Fed policy or just because the natural course of things that are probably fading now, so consumers have normalized their credit card spending over the last couple quarters, and that has probably been a big boost to spending, but now it's pretty normal, and so it's probably not going to continue to be a big tailwind. It's also probably been a decent amount of home equity withdrawal that is probably not going to keep going, particularly as interest rates have risen by a lot and home prices may not fall, but they may not keep rising in a big way. And lastly, consumers have probably spent down a fair amount of savings. And so, they built up during the pandemic when it was hard to spend on things like vacations and whatnot. And that's probably played out.
Beckworth: And to be fair, the last time it inverted was right before 2018 or during 2018, and we didn't have a recession then. I guess you could argue the pandemic recession, but the link between that and the inversion is not there, so it's a very different.
Graff: Yeah. Not there.
Beckworth: Yeah, so to be fair, the yield curve's not perfect. And it's a rule of thumb, and that's what I would caution all the listeners. So is two quarters of negative growth a rule of thumb, and that's all they are. One last thing, I mentioned that was the last thing, but I lied, one more thing. As you know, I'm a big fan of following nominal GDP as a way to think about demand and spending, and some would prefer final sales, but all in nominal terms. And I just wanted to highlight, this is from the BEA report, they say current dollar GDP, or nominal GDP, increased 7.8% of the annual rate, or 465 billion dollars in the second quarter to a level of 24.85 trillion. And they mentioned in the first quarter it grew at an annualized rate at 6.6%. So if we're thinking in terms of aggregate demand, it's still pretty robust, right? It's still pretty strong. And yes, a lot of it's going directly into prices, not real growth, but that's 465 billion dollars’ worth of spending that occurred in Q2. So two things, one, it would suggest there's still activity out there. And two, the Fed has its work cut out for it still. If it wants to have that soft landing, there's a lot of aggregate demand to reign in still.
Graff: No doubt, no doubt.
Beckworth: All right, let's move to the Fed. And again, this was the original motivation, so we want to spend some time here and get your hot take, but informed take, on the FOMC yesterday. And so as listeners probably know the July FOMC the Fed raised for a second time, it's target interest rate, 75 basis points to the 2.25 to two and a half range. What was your takeaway? What questions did you have? What is your overall sense of that decision?
The July FOMC Meeting
Graff: Well, as we already said, everybody knows the economy is probably slowing, exactly how much is to be determined, but Powell acknowledged that, the market knows that, everybody is on the same page there. And I think everyone else was on the same page that this is a necessary thing in order to quell inflation. So, what the market's trying to figure out is how much more tightening is going be necessary. And moreover, how much tightening the Fed is willing to do, even in the face of a weakening economy. There's this dance that goes on between markets and central bankers, Powell knows that's what the market's thinking, right? He was even asked a question during the press conference about the fact that futures prices have some rate cuts priced in, and he attempted to downplay that, which I'll talk about in a second, but so he knows this is going.
Graff: So when he's communicating, this is kind of the way I think about it as a market participant, when he's communicating, he is sort of talking to me, as a market person he's talking to me about what he wants me to think and do as well as talking to the broader public, because he knows that by getting investors to do certain things he can change the financial conditions in ways that are important to them. So he continues to go out of his way to be as hawkish as he can be and make sure everybody knows the Fed is resolutely committed to bringing down inflation no matter what other consequences may occur. And I had mentioned a moment ago where he said, he was asked this question, and went, "Well, the market has rate cuts priced in for 2023." And he said, "I don't know about that because our dots say we're going to still be hiking." I think that's an example of where it may be true that in his mind, he says, "Well, maybe. If the economy is weak enough, we might do that. But he can't say it, because if he does, that would influence the way financial conditions evolve and that might get in the way of the policy outcomes that he's looking to do.
Graff: So as a market participant, I got to think through that. I got to sort of hear what's not being said, as well as what is being said. And so I'll just give my take on what I think was not being said, but is being thought. I think the fact that Powell more or less withdrew forward guidance – he more or less said, "look, I don't know what we're going to do in September, or November for that matter" – I think is a sign that he's less sure that having this kind of maximum hawkish position is going to continue to be either necessary or desired as we evolve over the next couple quarters. And by the way, the market took it that way. So both bonds and stocks rallied quite a bit, so meaning bond yields fell and stock prices rose quite a bit over the course of the press conference. So I think that was almost a universal thought that, "Hey, maybe not pivot so much, but maybe a downshift of pace is going on."
Beckworth: So speaking of forward guidance, you did a Twitter thread on it yesterday or the day before. But in general, what is your sense of forward guidance as a market participant?
Graff: Yeah. Look, I think it gets derided a lot actually amongst market participants. I can speak to why it's not totally unfounded, but I think we should bear in mind of how effective forward guidance has been in the last two cycles going back to the GFC. Back then, people forget, but in the beginning part of the Fed cutting rates all the way to zero in late 2008, the market didn't really believe it was going to stay that way for very long. Futures markets were pricing hikes a year or so into the future at the time, which seems silly now because now we know they didn't hike until 2015. But at the time people were like, "Well this is a weird policy that exists only for this emergency moment and when the acute emergency has passed, that's going to end."
I think the fact that Powell more or less withdrew forward guidance – he more or less said, 'look, I don't know what we're going to do in September, or November for that matter' – I think is a sign that he's less sure that having this kind of maximum hawkish position is going to continue to be either necessary or desired as we evolve over the next couple quarters.
Graff: Had that continued, had the market not realized how serious then Chair Bernanke was about keeping that maximum policy position, I don't think we would've gotten the monetary thrust that we got that ultimately helped us get out of that recession. So that was sort of initial part of this version of forward guidance that we have now. But even fast forward to today, when COVID hit and the Fed cut to zero and said, "We're going to keep it here as long as we need to." The market believed it right away because they were used to this forward guidance thing. Right? So they got the kind of boom policy outcome that they were looking for. Then more recently, we were talking a moment ago about how quickly the market priced in a large number of rate hikes, you contrast this hiking period with 1994, which was the last time they were anywhere near this aggressive, financial conditions just inched along in real time with Fed hikes in 1994.
Graff: So they didn't get to anywhere near this amount of kind of policy shift for a whole year. Whereas Powell was able to get that to happen in a couple months. So I think that's going to wind up with better outcomes this time around than would otherwise be. So there are problems with forward guidance and I think what people most often can criticize the Fed with, and I think this came up in the presser yesterday, was whether forward guidance caused them to be too slow to hike this time around. I'm not totally sure, and Powell denied that, but I actually agree with Powell in this case. I'm not totally sure that was the main culprit. I think the main culprit was they were fighting the last war, right? They were sort of worried about tightening too quickly with inflation that really up until the fall of last year did look transitory.
Graff: So I think that was more to blame just kind of the strangeness of the cycle and how inflation was playing out in the moment. I think it's fair to criticize the Fed, and Powell sort of took a mea culpa on this, it's fair to criticize the Fed that, well, maybe it could have tapered a little quicker and that would've gotten you to hiking a little quicker, but I don't know, that's a wildly different outcome, right? I don't know the inflation is totally different now. Maybe reputationally I'm sure he would rather have moved a bit quicker because it would feel a little different to regular consumers and to market participants. But I don't know that we want to totally throw out the baby with the bathwater. Now I do think at this moment it's smarter to give no guidance than it is to suggest maybe a cut would happen at some point down the road. As I said earlier, you don't want to prematurely allow the market to think you're pivoting. It'll show a lack of resolve and that's not what they want. So I totally understand why right this moment you want to pull it away, but I don't think it's going away. I think it's a useful tool for setting policy.
Beckworth: So forward guidance is effective. You're saying it empowers the Fed, in fact it gives the Fed more ammunition. They can make a little move with a big bang because they've guided people like you. In fact, they encourage people like you to do the heavy lifting for them.
Graff: They've got us trained, David. They've got us trained. We've been trained.
Beckworth: You've been trained in the school of hard knocks of forward guidance. It's never going away for sure. So one of the criticisms, I mean, of this, and I think we talked about this this week with the Ellen Meade on the podcast, is that it can lead to some misunderstanding of what the Fed intends. Maybe this is a different issue. Maybe this is a communication versus forward guidance, per se. So in 2020, early 2021 if you looked at the summary of economic projections, they had zero interest rates for three years out or more. And some people took that to be unconditional, "It's going to be this way." Even though those forecasts are conditional, they're like, "Okay, given the state of the economy, given what we think is optimal monetary policy ..." Do you get that sense that sometimes there's confusions between “this is set in stone” versus “we are very data dependent”?
There are problems with forward guidance and I think what people most often can criticize the Fed with, and I think this came up in the presser yesterday, was whether forward guidance caused them to be too slow to hike this time around. I'm not totally sure, and Powell denied that, but I actually agree with Powell in this case. I'm not totally sure that was the main culprit. I think the main culprit was they were fighting the last war, right? They were sort of worried about tightening too quickly with inflation that really up until the fall of last year did look transitory.
Graff: I think Ellen's criticism was right. That they, maybe intentionally, maybe semi-intentionally let it slip into something unconditional. Which we know it's got to always be conditional because who knows what happens? I mean, heck from '19 into '20 no one could have known that kind of pandemic shock was coming. So everything's got to be conditional at some level. I think maybe sometimes they let that part of the communication slip a bit. But look, I think market participants have to realize that, in fact it is conditional. Just look last meeting, not the one from yesterday, but the one in June where they hiked 75 basis points after explicitly guiding to 50 basis points. So clearly they are willing to break with the guidance they've given us if they feel it's necessary. I would love to live in a world where they communicated a bit more in terms of their reaction function and less in terms of, "Here's exactly what we're going to do."
Graff: I think that would achieve a lot of the benefits of forward guidance without sort of this drawback, this created unconditionality. I mean, I was a huge fan, although this only lasted a couple of months, but I was a huge fan of the Evans rule. I thought that when they were sort of withdrawing or slowly considering withdrawing policy in the kind of, as we were coming out of the GFC, I thought that was a good way of giving us a clue as to when they might just move off zero. Now you wouldn't use that same rule every time, you would use a rule that was appropriate or a guide, I guess, that was appropriate for the moment. So today's be a lot more about inflation, a lot less about unemployment. But I think things like that are pretty useful because it allows us market participants to think more in terms of the data and less in terms of just what's the Fed telling me, you know what I mean?
Beckworth: Yeah. Well, let's focus in on that point about you, the market participant, trying to read the Fed's forward guidance. You get it directly from them sometimes, but sometimes you get it from other sources. So going back to the June FOMC meeting where they had been signaling 50/50/50. Then I think it was Monday morning before the meeting, or maybe the week before, Nick Timiraos of The Wall Street Journal had an article that said they're going to go 75 or likely to go 75. Everyone said, "Okay, that's it." And it got priced in. So as the market participant, do you all follow certain reporters, you say, "Aha, he's the one that's giving information out." I mean, is that part of the work?
Graff: I mean, I don't want to dox Nick, he's a great guy.
Beckworth: He's a great guy, yes.
Graff: He's a great guy. But yeah, look, I think not only him, but Craig Torres at Bloomberg had a very similar article almost at the same time. I believe it was over the weekend, and that's awfully suspicious. So look, it's not wrong that the Fed uses the media to communicate things when they need to. I know Chair Powell might not admit this quite yet, but if you read Ben Bernanke's memoir, he says that we do this. So, this is a thing. Look, it's it is something we've got to deal with, is this a leak? Is this just Nick being a good reporter? Is this him piecing things together? Because he's plenty capable of doing that. It's something we got to deal with. For people who are short-term traders, which is not me, but for people who are short term traders, you got to act quickly. Right? So that's why you see the market lurch on these things suddenly is because you got to make snap judgements. That's just part of it, it's part of the game.
Beckworth: Another question as the market participants, you're reading the tea leaves from the Fed, from reporters who are on the Fed beat, but also the political economy of the Fed. I mean, how close of attention do you pay to that? Let me give you an example I'm thinking of, and that is like right now in the polls inflation is the number one concern for most Americans. I mean, poll after poll shows inflation has risen to the top and that has some influence then on Congress, which puts pressure on the Fed. And we see it, the Fed has got this laser like focus on inflation now where pre pandemic they had a lot of things they were looking at, inequality, wealth gaps. Their attention span was kind of broadly spread. But now it's very, very focused on inflation and I think understandably so given what Americans are feeling about it. So someone like yourself are you also looking at these kind of broader body politic movements that influence the Fed as well as the more narrow ones we've talked about already?
I think market participants have to realize that, in fact it is conditional. Just look last meeting, not the one from yesterday, but the one in June where they hiked 75 basis points after explicitly guiding to 50 basis points. So clearly they are willing to break with the guidance they've given us if they feel it's necessary. I would love to live in a world where they communicated a bit more in terms of their reaction function and less in terms of, 'Here's exactly what we're going to do.'
Graff: Yeah. The Fed is definitely a political animal, it has influences that aren't purely in GDP numbers and inflation numbers that matter to them. So exactly how that plays into their decision making I think depends on the moment. I think in this moment they're on the exact same page as what politics would want them to do, which is fight inflation. I think that's super important. I'm sure they're aware of how poorly inflation polls, how important it is on people's mind, because I think they want to be aware that if their reputation is damaged of taking this seriously with the broad public, then that will make it harder to enact policy in the future. And if the broad public creates pressure around inflation, then Congress might do some things that aren't very smart. I mean, there is not a great history of politicians trying to fight inflation. So I think all those things probably do influence them. They want to make sure the politicians here, "Hey, we're on the case. You don't need to do anything crazy over here."
Beckworth: Yes. This gets to a deeper question about what does monetary policy actually do? Again, the Ellen Meade episode we talked about this, so I encourage listeners to go back and check it out if they haven't already. But she mentioned her work on inflation, targeting central banks and how it adds credibility. The idea being that central bankers themselves can take a stand and push for inflation, if they have the independence, they can take a stand and make a difference. Whereas someone like Adam Posen, he would argue that central banks’ desire for price stability is driven by the body of politics. So it's the preferences of what the country wants. So how did Paul Volker have the ability to push through his war on inflation? Well, there are people who didn't like it, but overall it was a number one, again, issue in polls and he had the support. He's doing what was wanted and most Americans want price stability, I guess, is what you could argue here.
Beckworth: So how much degrees of freedom does the Fed actually have versus how much are they just are representation of what society wants? So I know that's kind of a deeper philosophical question than Fed watching per se. So let's move on to one other point I want to raise about the FOMC and anything else you want to add about it as well. So one thing that struck me is that Chair Powell repeatedly said, "We are committed to getting back down to 2% inflation." I mean, multiple times he said this, and I made this comment on Twitter, but I think this really underscores that the Fed is still fully 100% on board with its target and it's not giving any kind of consideration to some of the suggestions that have been made. Well, the Fed could stop at 3%. Let's just make it a 3%, an opportunistic change of targets. It seems pretty clear they're not going to settle. They're going to go all the way down to two. Is that your takeaway?
Graff: That is definitely my take. Yeah, I think if they wanted, if they had in their heart of hearts, "Oh, maybe 3% would be a better target." The pandemic would've been a great time to do it, when we were deeper into it. Now even if they wanted to, it would be pretty damaging reputationally. It would sound like you were sort of giving up on the prior goal at a time when, as you said, politically that would be disastrous. I will say you need to separate the thought of where do they want to, on inflation, end up with where they might pause rate hikes. Right? Because they may, in fact. I think they probably would stop hiking rates if inflation was rapidly falling, as it got around three, they might say, "We can pause here and see where it goes." But that is not at all a sign that they're satisfied with three, I think they would be expecting it just to keep falling. And if it didn't, they would rekindle the rate hikes.
Beckworth: Okay. Any other thoughts on the FOMC meeting? I want to move on to interest rates, but you go ahead.
Graff: The only thing I would say is, I think Powell he's still very clearly trying to tighten financial conditions. I mentioned there was that question about, well, are they going to rate cuts in 23 and 24? And he's like, "No, I think you should pay attention to the dots," is what he kept saying. If he was okay with conditions loosening up, he would've let them loosen up. But instead, he's still trying to push them tighter. So, I don't think we're going to hear a change in rhetoric anytime real soon.
The Fed is definitely a political animal, it has influences that aren't purely in GDP numbers and inflation numbers that matter to them. So exactly how that plays into their decision making I think depends on the moment. I think in this moment they're on the exact same page as what politics would want them to do, which is fight inflation. I think that's super important. I'm sure they're aware of how poorly inflation polls, how important it is on people's mind, because I think they want to be aware that if their reputation is damaged of taking this seriously with the broad public, then that will make it harder to enact policy in the future.
Beckworth: And I want to say this on his behalf, because there are many people out there who would say, "Why are you tightening? This is supply side inflation." And I think he's clearly thinking of the demand side inflation. He thinks the economy is overheated. And again, going back to those numbers, I gave for nominal GDP, 7.8% growth and annualized rate in the first quarter, 465 billion of additional spending, which is at a higher rate than the first quarter. So nominal demand, aggregate demand is still strong and robust and he still sees it. So, I'm glad he's on the job. So let me segue then Tom into interest rates, we were talking about them already. And in an observation you made, which is interesting, that the market is pricing in rate hikes through the end of the year. I think around three and a half percent, and then back down. And so, what is that telling us? Why is the market doing this and what do you think it means? And, what's the signal here?
Effect of Rate Hikes on Interest Rates
Graff: I mean, I think the signal is the market thinks that inflation is kind of fragile, that if you get just a bit above neutral, which, who knows what neutral really is? But if we say it's two and a half, which is the Fed's kind of best estimate. Three and a half would be roughly a hundred basis points over and if not that high, but that'll be all it'll take and that'll break the back of inflation. But in the course of doing that, the economy is slowing meaningfully, maybe unemployment's rising and that'll spur the Fed to cut a few times. Now I will say, you always got to remember when you're talking about what's priced in, it's an amalgamation of what lots of people think, of lots of different thoughts, that come together to make, come some kind of middle ground or consensus view.
Graff: So, what's really priced in is about a hundred base points worth of cuts over the course of 2023 and 2024, which if you took literally, would probably be kind of akin to what happened in 2019, which the Fed got a little too tight and they backed off a little bit. And the growth continued and probably had the pandemic not happened, it wouldn't have been a recession, but it might also be like, as I said, an amalgamation of maybe some people think, "Well, maybe they stop around three and a half and it hangs there." And other people think, "Well, there's going to be a bad recession, they're going to cut by a lot." And I think there's a lot of murkiness as to what happens after 2023.
Beckworth: So there's a distribution of views, but the average, the trajectory among most of them is some kind of cut going forward. So you mentioned the analogy of 2019, and I've actually been thinking about this, which analogy is a good one or a better one? You could look at 2019 yield curve inverted, the Fed was wanting to hike more, and they turned around pretty quickly and they stopped because financial conditions were tightening, they were signals, they were getting ahead of themselves. That is a nice comparison. There's also 2015, 2016. And I bring that one up, because they had talked up a bunch of rate hikes and what happened, which is very similar to today is, that ended up causing the dollar just to blow up. In terms of value, it really became more valuable. And it was also and related to the fact that the European Central Bank was doing a different type of monetary policy.
Beckworth: So, the dollar strengthened dramatically and quickly, similar to what we're seeing today, so there's a lot of talk about the dollar today, might cause a global recession or some kind of global weakening. And if that were to get severe enough, it could bleed back into the U.S. economy. And that might be something. And if you go back to 2015, 2016, that's part of the story, is they stepped back and they didn't do all the rate hikes they had talked up, because they saw the weakness coming back in from the global economy into the US. So, you could have that scenario, you could have the 2019 scenario, maybe a combination of both. Any thoughts?
Graff: Well, I think what's interesting about both those periods is that the weakness, especially 2018, appeared to be predominantly monetary in nature. Like in 2018, there weren't other problems. There wasn't some kind of misallocation of capital that needed to get fixed, or some bubble that was bursting or whatever. So could give one, some hope of a softish landing this time around, if you just said, "Well, if the only reason why the economy slows in 2023 is monetary and if, which is a big if, inflation comes down to a reasonable place, the Fed can back off hikes a couple times, maybe we can be right back to growth." Like, "Maybe it's not that bad." That's a plausible outcome to me, so I do think those two periods are pretty interesting for how quickly the economy rebounded after The Fed just backed off a bit.
Beckworth: So that suggests the Fed can be nimble, it can turn on a dime and financial conditions will respond. Going back earlier to what you said, the power of forward guidance and market participants doing the heavy lifting, whether it's tightening or easing.
Graff: But, it's all real. It's all really, that story, what's different is we've got some massive inflation problems. So if inflation isn't coming down quickly enough, I think that's how you get to the hard landing. They can't do that reversal. Maybe the only problem still is monetary, but the Fed can't do that reversal quickly, because inflation's not responding in real time. Now you mentioned a moment ago, the idea that inflation might be predominantly demand side. If that's true, then it probably is correct that inflation's kind of fragile. That all we got to do is get demand down enough and the inflation starts going away quickly. My view is that, it didn't appear that the relationship between output and demand to price, it didn't appear to be linear on the way up, so it might not be linear on the way down. In other words, it might take a small amount of demand shift to bring inflation lower. And if so, that's kind of a hopeful sign. That would mean, well, we need a little bit of a blip, but after that, the economy's probably with a good foundation.
Beckworth: Well, I hope that happens. And to be clear, I'm not certain that inflation is a majority or driven mostly by demand. I think demand is an important part, but it'd be hard for me to kind of break up 50% here, 50% there, because I think we both agree supply side stories are still at play. I guess what we need, Tom, is we need some good luck. So supply side sorts itself out, the war ends in Russia, Ukraine, and we need this non-linear effect that you just talked about. And kind of a, what's the opposite of a perfect storm, a perfect coincidence.
Graff: Perfectly sunny day.
Beckworth: Perfectly sunny day, where everything comes together. We have a soft landing, inflation comes down and we can look back and reflect on the lessons learned from this amazing period. Okay. Let's use that to segue into interest rate theory. So, what we've been talking about is the Fed’s shaping expectations and kind of a standard long term theory of interest rates. Like, what drives a 10-year treasury yield is? Well, it's the expected path of what the Fed's going to do, plus some kind of term premium, some kind of risk compensation. And, what is your theory of interest rates? When you think about that, when you're investing to, say long term treasuries, what are you thinking through as you process that?
You mentioned a moment ago, the idea that inflation might be predominantly demand side. If that's true, then it probably is correct that inflation's kind of fragile. That all we got to do is get demand down enough and the inflation starts going away quickly. My view is that, it didn't appear that the relationship between output and demand to price, it didn't appear to be linear on the way up, so it might not be linear on the way down. In other words, it might take a small amount of demand shift to bring inflation lower. And if so, that's kind of a hopeful sign.
Interest Rate Theory and Implicit Forecasts of Inflation
Graff: I mean, I do think that kind of forward rate anticipation theory, if you will, is pretty dominant. So at least, in the way and the timeframes I need to deal with, which are kind of day-by-day, week-by-week, month-by-month, I think what you see the biggest Delta in rates tends to be, because there's some Delta in the view of where the Fed's going to be. Now I do think, there's this sort of conversation of, does the Fed control interest rates or does the market set interest rates? I think it's not an either-or. A moment ago, we were just saying, Powell is trying to tell us, "No, no, we're still going to be hiking in 23, 24." And the market saying, "I don't think you will be." And so, I think the rates are primarily being set by this anticipation of where the Fed's going to be, I still think that doesn't leave the Fed in control of anything. The market is still forming its own opinion about where things are going to be.
Beckworth: Yeah. So let me share my theory with you, and then you can tell me whether it’s worth anything in the marketplace. So I think the short run theory that comes from Keynes, kind of the liquidity preference theory that says, it's a money view, it says central banks do determine interest rates in the short-term. They can literally push them up, push them down, they have that influence. But over the longer run, I buy into more of the savings investments story, kind of a fundamental story. And I say that, given that the Fed has a price stability mandate. So if the Fed cares about price stability, then over the long run, it has to respond to fundamentals. So when you said the markets say “no, you're going to cut in 2023,” the market knows the Fed has to respond to the fundamentals if it wants to fulfill its mandate. So, given that assumption, on some level, the fundamentals are determining where rates go, but it's a combination of preferences. What do you want? Price stability, full employment, as well as what drives the long run, real equilibrium interest rate.
Graff: I guess, what I would say is – and we're probably not disagreeing actually, David – but what I would say is, that's probably, the way I would think about that is like, that is what sets where like neutral policy is or where, at what point financial conditions get tight versus when are they loose. So if the Fed is trying to deviate from that savings-investment balance position, then it's maybe deleteriously influencing the pace of activity or what have you, so one way or the other. I think the literal nominal treasury rate that gets traded every day, is probably set purely by Fed expectations. What that rate means, is probably set by the conditions you're describing.
Beckworth: Okay. What about like a 20-year treasury? People trade 20-year treasuries. Are they thinking, "Well, I expect inflation to be 2% in the long run and the real treasury yield to be based on..." Is there any of that thinking that goes on?
Graff: The way I try to encourage young analysts who ask me how to think about it, is the shorter you are, the more it's directly influenced by the Fed, because we can kind of guess where the Fed's going to be over the next year or two. The longer you go, the more it's got to be, "Well, over the long run, this is the neutral rate, and this is the inflation rate and this is where it is." So I think you're right on. With a 30 year treasury, that becomes a big deal. Now I will say also, the further out you go as a practical matter, there's a preferred habitat issue that comes to force. There's a lot of investors that strongly prefer really long-term investments for liability reasons, which is why sometimes there's some funky things that happen out really long. And why I personally - as an investor, I got to be involved in all parts of the market – but as thinking about where policy is, I kind of stop paying attention after the ten-year.
Beckworth: Ten-year, is it. Okay. That's interesting, you mentioned preferred habitat, which would lend support to the notion that QE does have a real effect. I mean, the whole portfolio balance theory, so that's interesting to hear you say that. So, we have long-term interest rates. We've talked about that. I want to move to another part of interest rates and that is the implicit forecast for inflation. We can get out of treasury security. So the difference between a regular nominal treasury bond, and then a TIPS, or a treasury inflation-protected security. And I follow those, and I also know there's some problems with them, but what does the market think of them? I mean, what's your take on those type of securities?
Graff: I think you can take them seriously, but not literally. I think, like right now, for instance, if you do a forward rate on the TIPS and look at what the average inflation rate's going to be starting two years out, three years – meaning basically 24, 25 and 26, just add those three years up – it's only 2.3% or so. I think you can take that seriously. You can say, "Well, so the market thinks inflation's going to get solved." Because if you know CPI usually runs slightly above PCE, so that's about right. But I think you want to be careful taking them literally, in the sense that if they say 2.4, or 2.5 or 2.3, there's probably not much signal in that. There's a lot more messiness of, TIPS are less liquid than treasury, so that can matter particularly when there's stress, then there tends to be a bit more of a premium for the liquidity and that can get in the way of things. And then lastly, the TIPS can be really influenced by oil prices particularly because they work off headline CPI. So, if you've got a spike in oil that might not be affecting anything else. Just oil tends to be a bit more volatile than food prices, but that's also another one. But that can move tips by a lot. So I don't know that you want to get too excited if they move 10 basis points one way or the other, but I do think it's giving you a signal overall.
The way I try to encourage young analysts who ask me how to think about it, is the shorter you are, the more it's directly influenced by the Fed, because we can kind of guess where the Fed's going to be over the next year or two. The longer you go, the more it's got to be, "Well, over the long run, this is the neutral rate, and this is the inflation rate and this is where it is'... I will say also, the further out you go as a practical matter, there's a preferred habitat issue that comes to force. There's a lot of investors that strongly prefer really long-term investments for liability reasons, which is why sometimes there's some funky things that happen out really long. And why I personally - as an investor, I got to be involved in all parts of the market – but as thinking about where policy is, I kind of stop paying attention after the ten-year.
Beckworth: Well, you just answered a question I had about TIPS, which I've noticed the break even inflation does tend to move with oil prices. My theory has been what you just said, that the only reason this makes sense is because traders are looking at what's going to be the next CPI number. They know that in oil at least it may be a smaller part of the US economy as time goes on, but it's still marginally very important. It's a big changer from month to month. So is that a common understanding, common wisdom in the bond market?
Graff: I think so. I think that's been true for quite a while. So sometimes when there's a pattern that's been true for a long time, people start training algorithms to trade on them so the signal to noise effect can diminish.
Beckworth: Oh, wow. Okay. So, Tom let's switch gears to another potential influence on inflation and therefore on interest rates and that's fiscal policy. There's many different ways you could look at this and we mentioned earlier, the tailwinds are beginning to unwind and you could argue fiscal policy, the checks and such, they would've made a difference. Now they're winding down. That's one story you could tell about how fiscal policy affects inflation. Of course, my colleagues would say ah, but the Fed has the final say-so. But put that to the side. They have helicopter drops, they can make a difference. And so, do treasury people like yourself follow them? That's one channel. This other channel though, is more of the fiscal theory of the price level, and these people would say – there's a part of it that I think's true – but they would say the expected path of the US government's public finances, is it healthy? Is it getting worse? That's going to affect trend inflation. So whether the government's going to be insolvent in 50 years, or we're getting close to that, we should see inflation go up today. So I don't know if you want to take a stab at either of those stories and what you think it means for the market.
Fiscal Theory of the Price Level
Graff: Sure. This might get a little into what's the difference between how practitioners think about things and academics think about things, but I'm laser focused on factors, variables that I can show make a difference for prices. Otherwise it's not that useful to me. So I'm not going to spend a ton of time thinking about it. If you take the simplest one of the sorts of things you brought up is just simple bond supply. Are there are going to be more treasury bonds or less treasury bonds because the deficits bigger or smaller? I've never been able to make that work as an explanatory variable at all. Now they would take away my economics degree if I said supply doesn't matter. So what I think that actually says is that the demand is dominant over supply. So what's a plausible story here is that if there's a larger stock of debt, thus sort of total supply is bigger. That that's a small but persistent effect. Whereas the changes in how much I want to own treasuries are large and they're moment by moment. That's the driving force, but it's a good example where as a practitioner small, but persistent. I don't know if I've got a lot of time for that. I can't worry about that too much.
Graff: The other thing just goes to this kind of practitioner. I'm going to focus really on things that I can wrap my hands around and appear to have an effect in a predictable way. So, in this case, in terms of fiscal theory of the price level, it's hard for me to see how actors in the economy have sat around and calculated at what point the government is going to be insolvent. I don't see businesses acting that way. I don't see individuals acting that way. I don't see traders acting that way. I don't want to be overly dismissive, I just want to say that's hard for me to wrap my hands around. So, I don't know that I'm going to think about that too much, if that makes sense.
Graff: Now I'll observe that we've had a very large increase in the stock of debt since COVID, and we've had a large increase in inflation, but the timing of that certainly appeared to be related to: “when did consumers start spending that money?” And not, “when did the debt show up?” Now admittedly, there's not that much of a time gap between those two, but it sure seems to me, if we're talking about how does fiscal policy translate to inflation? It sure seems like it matters, “when does the money wind up in consumer's hands?” I mean, heck before COVID hit, what was the big debate in macro world? Which was can we even generate inflation if we wanted to? Who knows? I think we've sort of answered that question. We mail people checks. There's going to be some inflation. But it didn't appear to be based on the stock of debt at all. That just didn't seem to matter. We sure raised debt a heck of a lot after '08 too and that didn't seem to matter that much.
Beckworth: So it needed to be a helicopter drop that was permanent and given to households, consumers to spend. So let me phrase the question this way, a little bit differently. So we talked about the 30 year, the 20, the 10. I mean the 10 year, I believe today is down under 2.7%. It's had a hard time getting past three. It was there for a little bit. It keeps falling down. Which is really remarkable. You just mentioned we had a huge increase in stock of debt, about $5 trillion. If you go to the CBO, it's projecting sustained deficits going forward as far as the eye can see. Some people worry about social security, will it be funded? All these other unfunded liabilities the government's on the books for. So you have all these worries and there's some people who will say “woe is us.”
Beckworth: But man, the bond market does not seem concerned. The bond market's like “chill. In fact, we're so chill, we're only going to charge 2.8 over 10 years (or some number like that) over 30 years.” So how do we make sense of that? Does the bond market think that A, the government's going to solve this fiscal situation with reforms, taxes, cut in spending? Maybe it's a combination. But B would be, well, there's a demand for these securities. There's simply a demand for them. Even if you run these persistent deficits over the next 30 years, there's going to be people willing to buy them. That's the expectation currently. What is your understanding of how this makes sense?
Graff: I guess my best guess, look, maybe it's myopia. Maybe we're just completely out to lunch and it's all going to fall apart. But I guess my best theory is that US growth broadly, demand for dollars broadly, which extends well beyond our borders of course – and then, the fact that the US banking system and finance system writ large are really at the center of almost all global trade and finance – people don't see that changing. On your show many times people have discussed the possibility of some other currency taking over or some other financial system, crypto, or whatever taking over. Every time there seems to be even a wild card candidate, it seems to fade. So, I think there's a lot of confidence that that system is going to remain so important and that generally the US tax base is going to continue to grow into the future. That even if we can't quite see how it works out, it'll work out somehow. I think that's the best way to read that.
Beckworth: Well, that's my take as well. I think what you've said makes a lot of sense. I might put it this way, that the network effects for the dollar system are so strong and unbreakable. In fact, they reinforce themselves because there is no alternative. You go back and the more you use it, the more you're locked into it. It would take something really catastrophic to break the global dollar system at this point. That'd be my takeaway. There's simply no good alternative.
Many times people have discussed the possibility of some other currency taking over or some other financial system, crypto, or whatever taking over. Every time there seems to be even a wild card candidate, it seems to fade. So, I think there's a lot of confidence that that system is going to remain so important and that generally the US tax base is going to continue to grow into the future.
Graff: Yeah. Moreover, I think a mistake some people make, people aren't actually looking for an alternative. Most of the people, this serves the world pretty well. I know right after the Russian invasion of Ukraine was probably the most aggressive weaponization of the dollar system that we did when sanctions were put on Russia. But I actually think most of the Western world looked at that and said thank goodness this exists. Thank goodness we don't have to get out weapons and blood and solve this. That we can put pain on Russia without that. Because the alternatives was nuclear weapons. I think if anything, the dollar's role is as strong as it's ever been.
Importance of the Fed’s Framework
Beckworth: Okay. Final question before we go. As a market participant, do you really care about the framework? I mean, would you be delighted if we went to say nominal GDP level targeting? I mean, maybe you would. I don't know how you feel about nominal GDP level targeting, but let's say you do in your deepest parts of your heart. Would it make much difference though, whether they went from average inflation targeting to price level targeting or nominal GDP level targeting?
Graff: So I would care a lot. I think it was way understood when flexible inflation, average inflation targeting was announced how big a deal it was going to be. The market didn't move. Nobody cared. But obviously now we look back and like, wow, that was a big deal. So I would care a lot and actually it's a big reason why I really like keeping close tabs on what's going on in the academic world. Because it helps me sort of know what's in the zeitgeist. What are people talking about for these sorts of policy things? I try not to think too much about what the best policy would be. I try to think more about, well, why would it matter? Why would the Fed act differently if they adopted an NGDP target? I will say for my personal preference, I don't know that I have a super strong opinion about what version of levels targeting they ought to use. But I think level targeting is far superior to periodic targeting. But I also think the Fed really jealously guards its flexibility and its ability to make decisions without having rules guide them. So I think whatever they do will have some flexibility to it. So, I think there's always going to be this element of well, how are they interpreting this data even if they set it up as a different kind of target?
Beckworth: Okay. Well with that our time is up. Our guest today has been Tom Graff. Tom, thank you so much for coming on the show.
Graff: Thanks for having me.
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