Paul Sweeney: A lot of investors are saying the Fed is behind the curve and will need to raise interest rates in increments of 50 basis points multiple times. What’s your view, Bill?
Bill Dudley: They are far behind the curve in terms of adjusting monetary policy. Look at where our short-term interest rates are relative to inflation. Look at where short-term interest rates are relative to how tight the labor market is. The Fed basically says we want to be at a neutral rate of interest, and they’re not even close to that. So, they’re going to go very fast this year towards neutral.
Sweeney: What is the neutral rate, Bill?
Dudley: Neutral does depend a bit on where inflation settles. If inflation was at the Fed’s 2% objective, rates would need to be up around 2.5% in terms of nominal short-term interest rates. But if inflation’s higher, neutral is higher as well. So, it’s going to be important where inflation settles out.
Sweeney: Matt, it seems that everyone has turned very hawkish, and there’s a question whether the economy is at full employment. Federal Reserve Bank of San Francisco President Mary Daly this week that it’s a very tight labor market.
Matt Winkler: I think the best way to look at this from the Fed’s perspective is if you take a look at their preferred monthly measure of inflation, which is the U.S. Personal Consumption Expenditure Core Price Index. If you juxtaposed that with the $30 trillion bond market’s expectation for inflation as shown in the breakeven rate, or yield gap between the benchmark Treasury note and Treasury Inflation-Protected Securities, or TIPS. The Fed inflation measure shows us what has already happened while the bond market shows us what is expected to come. And what we see is that between the second half of last year and today is an increase in inflation to 5.4%, the highest since 1983. Bond investors, on the other hand, see inflation at about 3%. This is a record divergence.
And I think, since Bill and I started talking about such things more than three decades ago, you also need to look at something else that’s relevant, which is the Fed’s own survey, the February Survey of Consumer Expectations, which shows consumers anticipate inflation subsiding to 3.8% in three years. Bill has said consistently that the Fed is behind the curve. So, I ask Bill what’s wrong with these pictures?
Dudley: The market is basically assuming that the Federal Reserve is ultimately going to do their job. They may have gotten a late start, but they now are moving pretty rapidly in the tightening direction. So, the market’s view is that the Federal Reserve will, in fact, get this done. I think that’s probably right.
I think the big risk, though, to the downside is that whenever the Fed has had to tighten sufficiently to push the unemployment rate up, the U.S. economy has always fallen into recession. Now, I’m not looking for recession anytime soon because monetary policy first would have to get to be tight. But I do think that the chances of the Fed pulling off a soft landing this time are very, very low at this point.
Sweeney: So, you don’t see a recession in the next 12 to 18 months?
Dudley: Probably not in the next 12 months. The U.S. economy has a lot of momentum behind it as we’re going into the opening up stage. You’ve seen the strength in payroll employment over the last few months. We also have an imbalance in a lot of areas between demand and supply, where demand exceeds supply. So even if the Fed knocks back demand a little bit, supply is going to continue to recover as supply chains are normalized. The economy has quite a bit of momentum over the next 12 months or so. So, I think there’s a recession coming. I don’t think it’s in the near-term.
Winkler: And that’s, by the way, consistent with Bloomberg’s survey of 57 economists, which shows no consensus for a recession, at least before the fourth quarter of 2023. And you can see that — we have a table that shows the average GDP forecast for each quarter. And the next eight quarters range from 2.3% to 4.5%. And even the lowest forecasts in the eight quarters that we’re talking about ranges from 0.5% to 3.2%. In other words, the worst of these scenarios that we’ve compiled doesn’t anticipate a recession.
Sweeney: And you’ve written about the strength of corporate America as well. You quoted the Business Roundtable and also the most recent earnings releases, saying that companies are looking to hire more than they ever have before.
Winkler: That’s absolutely right. If you went to the Business Roundtable, which is the 200, if you like, most prominent company CEOs. And they said they anticipated this year hiring more people than they have in, you know, the past two decades, which is saying a lot. And then, if you look at something like debt ratios of American companies, even with all the record corporate borrowing that we’ve seen, because interest rates have been so low, the debt ratios show that companies are actually very healthy. So, it’s not like we’re coming out of, if you will, the financial crisis.
Sweeney: So, Bill, it’s safe to say there will be a recession someday. But what pushes us into a recession? Even if the Fed raises rates aggressively, we’re still only rising from something close to zero. Where would you think the neutral rate is right now? Would you hazard a guess?
Dudley: Well, I think neutral today is probably, you know, around 3.5% because inflation is above the Fed’s 2 percent objective. The problem for the Fed is this: the Fed needs to make the labor market looser if it’s going to actually get control of inflation. To make the labor market looser, it has to tighten sufficiently to push the unemployment rate up. Whenever the Fed has pushed the unemployment rate up, it’s been very difficult to control by how much. Every time that has happened the U.S. economy has ultimately ended in recession.
Don’t get me wrong; the Fed’s going to try for a soft landing. And they, of course, have to do that if they’re going to try to control the inflation. The problem is, almost always they overdo it and the economy dips into recession.
Winkler: If you don’t mind, Bill, let’s go back in time. You probably have as much experience with inflation and deflation in our time as any economist. And during your leadership at the New York Fed you persistently defended quantitative easing when so many critics derided QE as irresponsibly inflationary and a debasement of the dollar.
The critics were wrong. And when Janet Yellen became Fed Chair in 2014, unemployment and the labor participation rate were still anemic. She said — and you agreed with her at that time — that the economy needed to run a little hot to get to an optimal job market. So just last Friday, we learned the U.S. gained 431,000 jobs in March, unemployment fell to 3.6%. Average hourly earnings registered a 5.6% increase from the same period last year. And the labor participation rate rose significantly. So, why is Brad DeLong wrong when he said recently that it’s time for another victory lap led by the Fed?
Dudley: Well, they deserve a victory lap in terms of generating a strong economic recovery and getting us back to full employment quickly. The problem now is that they’re behind in terms of where they need to be relative to where the labor market is. If the Fed wants the economic expansion to continue, it’s got to keep inflation under control. And to keep inflation under control they have to tighten monetary policy.
So, the problem for the Fed was that they adopted a monetary policy framework that they operationalize by saying they’re not going to even begin to lift off until we’ve actually reached 2% inflation. We’re confident inflation’s going to be above 2% in the future. And we’re confident that we’re at full employment. So we find ourselves in this unusual circumstance that, at a time when monetary policy needs to be neutral or tight, the Fed still is at a very, very accommodative monetary setting. .
Sweeney: How much of this, Matt, is about monetary policy? Because there was a such a huge fiscal impetus. When Bill says the Fed did a great job getting us back to full employment, it seems to me the $5 trillion, $6 trillion that the U.S. government spent was also helpful. And I noticed yesterday in the Esther George interview that Michael McKee did, she said the fiscal impetuous is going to wane.
Winkler: That’s definitely true. There’s been considerable discussion about to what extent did the relief act last year add to inflation. And there are plenty of economists who say, not that much. And, to credit Bill, he has been very consistent, going back at least a couple of years, in saying the Fed really needs to get on the escalator and that we are going to see higher interest rates. It’s just a question of when, but they have to get there. So, I’m not so sure it’s so much a fiscal issue here with respect to inflation. It’s more the latter coming out of this expansion and interest rates need to come up.
Sweeney: The inflation that I experience, and I’m sure many Americans experience, it’s at the gas pump. It’s at the supermarket. It’s maybe at the local deli. But a lot of that is just supply and demand in an economy, where you have a reopening economy and you have got these crazy supply chain issues that are vexing all types of industries. In that scenario, what can the Fed really do in terms of inflation?
Dudley: The problem we have with inflation now is not just about supply chain disruptions because we’ve seen the inflation pressures broaden out. If you look at, for example, the Cleveland Fed or the Dallas Fed that have measures of median CPI — trimmed mean — they basically show that the pressures are now much broader than they were earlier. So it’s not just a question of used car prices going up because there’s chip shortages that are inhibiting new car production. It’s much broader than that.
And I think the wage trend is also relevant. If you ask yourself what wage inflation rate is consistent with 2% inflation, you wouldn’t pick 5.5 to 6%; you’d pick something in the, probably, the 3 to 4% range. So, the wage trend already is higher than what’s consistent with 2%t inflation.
Winkler: What the Fed will pay attention to, as they should, is expectations. And the one variable here that is somewhat encouraging is that we are not seeing yet built into this market the expectation, like we did in the ‘70s, that everything is going to go up and our behavior is measured by that. We’re not there yet.
Sweeney: Bill, are we going to get to that spot?
Dudley: I think Matt’s exactly right. Thee positive in the outlook is that inflation expectations are still pretty-well anchored. And you could argue that’s actually a little bit of a surprise. I mean, if you sort of looked at what’s actually happened in terms of inflation and how slow the Fed has been to react, it’s quite striking that market participants, and households, and businesses still are comfortable that the Fed is ultimately going to do their job.
Sweeney: This is precisely what you’ve been writing, Matt?
Winkler: But I’ve saying that it’s kind of hard for me to accept that the Fed’s behind the curve when the Fed is data-dependent, which means that when the data changes the Fed changes. But the majority of economists say no, no, no, no, no — they’re behind the curve.
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