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Macrocast: A premature celebration?
Today on the Macrocast, Ylan, John, and Brendan are joined by David Wessel, Director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. The group unpacks Fed Chairman Jerome Powell's Jackson Hole speech, including Powell's takeaway that the economy’s growth could require additional Fed hikes to fight inflation.
The group also discusses the implications of the U.S.'s federal debt, including former South Carolina Gov. Nikki Haley's comments on the subject at this week's debate ,and triages the prospects for Congressional economic deals more broadly in the coming months.
Read more about David Wessel and his work at the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution.
Hello, thanks for joining today's episode of the macrocast. I'm your host, ilan Mui, and managing director at Penta. Brendan Walsh and John Fagan of Market's Policy Partners are my co-hosts, and our special guest today is David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. Many of our listeners may also remember him from his previous life as a longtime editor and columnist at the Wall Street Journal. That's how I first met you, david. Welcome to the macrocast.
Speaker 2:Good to be with you.
Speaker 1:Fantastic, all right. So full disclosure none of us right now are in Jackson Hole, where the Federal Reserve is holding its annual influential conference on monetary policy. The most powerful names and economics attend, including, of course, fed Chair Jay Powell. He delivered a speech that explicitly stated that it's the central bank's job to bring inflation down to 2%, and that it will do so. He also said the Fed is prepared to raise rates, or hold them steady, until it's confident that inflation is moving sustainably down. David, that was just from the first paragraph of his speech, so he really got straight to the point. This year.
Speaker 2:Yes, last year's Jackson Hole speech was particularly interesting, where he got right to the point and then stopped. It was a very short speech and he basically told people inflation is too high. We are going to raise interest rates to slow the economy. It's going to hurt. He said, for instance, that higher interest rates, slower growth, softer labor market will bring some pain to households and businesses.
Speaker 2:So a year later, a lot has happened. Interest rates have gone up, the Fed has raised interest rates a lot, the bond market has raised interest rates a lot, and so I think what he was saying is we now have tapped the brakes to slow the economy. We don't necessarily have to do more, but we might, and it was what insiders in central bank sometimes call a risk management speech. Before interest rates were too low and we have to raise them. Today Interest rates are high, we're slowing the economy. We're kind of being careful here. We don't want to do too much and we don't want to do too little.
Speaker 2:So he didn't. He certainly made clear that there's no interest rate cuts coming anytime soon. He said the choices between raising them more or holding them at this level for a long time. So that was clear. And finally, I thought he was very specific about what he's watching in the job market. He talked, as he has before, about not only the unemployment rate, which he pretty much says is going to have to go up, but also this measure of job vacancies, and that has come down, which is what the Fed wanted to see, and he said they're watching that carefully. If that continues to come down, that is, if businesses are hiring less readily, even if they're not laying off people, the Fed would see that as a good sign, and so it sounds like that's one place where he's very focused.
Speaker 1:John, how did markets react? I heard David say that there was no mention of rate cuts in this speech, and that's something that markets have continually been wondering if the Fed would have to resort to at some point in the relatively near future. Did Powell give markets what they want?
Speaker 3:Well, not exactly what they wanted. There was some sense that he was going to be pretty consistent with prior statements. As David said, the hire for longer mantra has been around for a while and the data dependence on next hikes, and so this is reiterating. But the message seems to be getting through progressively. So today, incrementally, the markets are pricing in a higher percentage chance.
Speaker 3:Everybody thinks that the consensus is a skip of the September meeting, but November is very much in play and that's been sort of the battleground and Fed fund futures. And now you know the odds. After this speech the odds of another hike in November are going up and you're seeing progressively further out. You know the chances of rate cuts slowly being whittled away. That's exactly what Fed chair Powell and his colleagues would like to achieve from the markets. You know you don't want a disorderly or sudden pricing in. You want a slow, gradual, bit by bit realization that the Fed is going to do what they say on this front. So you know the bond market treasuries aren't having a great day, but it's not a terrible sell off. Equities have turned lower but they've been trending lower all August. So it's a little bit hard to hang that around the neck of the Fed at this point. So you know, relatively mild reaction and sort of what if the, if the Fed had, you know, requested, dialed up a market reaction, this would probably be pretty close to what they want.
Speaker 2:Well, I think that I agree with everything you said, John, but the yield on two year and ten year treasuries did go up. So on balance, it was seen, as I think, slightly in that regard, slightly more hawkish than had been the view an hour or two before. Slightly.
Speaker 3:Yeah, I think that that incremental realization, one of the things that there was, you know markets have were sort of worried about, was whether Fed share Powell would make a statement about the longer term neutral rate. You know the R star Interested in getting your thoughts on that. David, he was pretty, he was pretty explicit on that on that front and didn't didn't give the markets a real scare there but but did say you know some made some points.
Speaker 2:Yeah, the problem here is that the notion of the neutral rate of interest, which the insiders call our star the interest rate that is thought to be the one that would prevail when we're at full employment and price stability is, as Powell has said in previous speeches, like navigating by the stars. And it's pretty easy to say that if the Fed holds interest rates below the neutral rate it's stimulating the economy and if it moves them above the neutral rate it's restraining the economy. But they don't know where our star is. Interestingly, the neutral rate of interest has been falling for some time, since the early 90s, and there's a big question now about whether it is it is going to continue to fall when we get through this episode or whether it's going to be an upward trajectory. So, for instance, larry Summers, the former Treasury Secretary, says our star is going up, which means the Fed has to hold interest rates higher.
Speaker 2:Everything else sell constant. Olivier Blanchard, the former MIT professor, says the opposite. He thinks the neutral rates going to come down. I agree with you that we didn't learn anything from Powell on that today, and that doesn't surprise me, because I think he thinks that would confuse the message His colleague at the President of the New York Fed, john Williams, is like an R star aficionado and he thinks the neutral rate is very low, which means that he thinks the Fed policy is pretty restrictive now.
Speaker 1:I think one of the other challenges in determining where the level of our stir is is one thing that Powell brought up in his speech the long and variable lags with which monetary policy acts right. We don't really know how much of the Fed's historic rate hike campaign has fed into the economy. I mean, powell said that inflation is still too high. He was very clear about that. He also acknowledged that there are some places where there could be sort of pain coming down the pike. I know, brendan, you've talked a lot about the coming changes or the coming cracks in the housing market. That's one area that Powell mentioned that they're watching super closely.
Speaker 4:Yeah, both the housing market and the commercial real estate market, which I don't believe he talked about the commercial real estate. I'm personally much more worried about the commercial real estate market than I am about the housing market. The housing market is really just an issue of shortage of housing. We've got to build more houses. Commercial real estate is that we have a lot of people don't go to the office anymore, so there's a lot of zombie office space out there.
Speaker 1:Yeah, but he also talked, I think too, about the challenges of bank lending and tightening of financial conditions on that front. Loan growth slowing, David. Where do you see the consumer and do you see the demand for loans holding up, even as consumer spending remains steady?
Speaker 2:I think you're right that he talked about the bank lending thing. I think that among his colleagues on the Federal Open Market Committee he had been more worried that the effective rate Fed rate increases would be amplified by a strong tightening of bank credit because of what happened at Silicon Valley Bank and the others. In the regulatory response I think we see signs that banks are getting more skeptical about loans. They're tightening credit conditions, though it hasn't been quite as bad as I think Powell feared. But he did say that look, when rates go up, people are less willing to borrow, and that's the way monetary policy works. That's the idea. We want to raise interest rates, making it more expensive for people to buy cars, so they buy fewer cars.
Speaker 2:It's been very hard to read the consumer in the last couple of years because the pandemic was so unusual. First we told everybody you don't spend any money on services, so people bought a lot of goods and that pushed up prices on goods. Then, as he points out, the supply constraints were substantial. People have kept spending more than I had anticipated and some of it is the labor market's been strong and some of it is that they were running down the money they saved during the COVID period, particularly the money that was pumped into checking accounts and savings accounts by the government. The San Francisco Fed has done a lot of work on this and they say that excess saving is pretty much runoff. So I think that the Fed hopes that consumer spending will slow. I think it has slowed some, but it's been more resilient than I would have anticipated, but probably in part that's because the job market has been so strong.
Speaker 1:Yeah, I thought it was interesting that Powell laid out some of the factors behind the inflation that we've seen post pandemic, and some of them may have been self-induced, such as fiscal stimulus, but he also pointed out that there were supply chain issues that we're still working through, and he pointed to the auto industry as a great example the shortage of semiconductors, the shortage of chips that folks are still dealing with now, and I think that speaks to the challenge that the Fed has faced during this period, because not all inflation came from a monetary source and some of the inflation was caused by these completely external factors. He also mentioned geopolitics that are driving up food and energy prices that the Fed has no control over, and, no matter what they do with interest rates, it may not make a difference.
Speaker 2:Well, look, the Fed can't do much to control the amount of supply in the economy. Their job is to reduce demand, so it's consistent with supply. If demand is growing faster than supply, you're going to get higher prices. I think what's interesting about where Powell's talking about the auto industry and stuff goes back to this whole thing about, is the inflation transitory. First they said it was transitory, meaning there were these supply problems and they'd be resolved and then inflation would come down. Then that got discredited because inflation proved more persistent than the transitory camp thought.
Speaker 2:But what I've heard from some people on Team Transitory is well, transitory was just a longer period of time than we implied, and so in part what he's wrestling with and we're all wrestling with is are the supply chains sufficiently resilient so that over the next year we're going to get more and more supply so we don't have to restrain demand? Or has demand been stronger than we anticipated and there's no way that supply can expand to accommodate it, in which case we do have to tighten more? And these calls were really easy when interest rates were zero and inflation was 9%. They're much harder now when inflation is coming down, when inflation expectations are pretty well anchored, when the Fed, as you point out, has already done a lot of rate increases and they don't know whether they've been fully felt. So I think what you read in Powell's speech is exactly right, like, okay, we're at the close call stage and it's kind of a cop out to say we're data dependent. That's another way of saying, like we don't know what we're going to do and so we're waiting to see how the economy evolves and then we'll lean a little bit one way or the other.
Speaker 2:And that's a very hard message to give, particularly to a market that wants to know okay, what are the probabilities of a rate increase in November? I need a point estimate.
Speaker 1:This is something we've been debating on the podcast for a couple of different episodes now and I'm curious your thoughts, david, which is all right. If we're at the point now where we're in close call territory, very, very near the end of the rate hike campaign, does one or two more hikes, even over the next let's call it three to six months, really make a difference from a macroeconomic standpoint, or is this all about signaling?
Speaker 2:Can I say both?
Speaker 1:You can say whatever you want. You can say both, and you know it raised rates another half percentage point.
Speaker 2:That means that mortgages are probably going to go up and car loans are going to go up and I'll have some marginal effect. I think the issue is but a lot of it is signaling the interest rates that really matter in the economy are these sort of long-term interest rates over the five, seven, 10-year horizon. And when the Fed keeps raising short rates, people that influences what they expect in the future. So a lot of it is how the Fed is influencing the yield curve, and they do that both by raising rates or not raising rates and by what they say. And so they're. Both things are important. No one 25 basis point rate increase makes a difference. But if the Fed starts signaling that they think they're going to be raising rates two or three more times, then that will play through the markets and longer-term rates will respond and that'll have an effect on the economy.
Speaker 1:Don, you've argued in the past that this is about proving to the markets that the Fed can be resolute and is resolute.
Speaker 3:Yeah, absolutely, and the markets have been getting the message over time.
Speaker 3:Flashback a few months and rate cuts were supposed to be starting in maybe as early as December. I mean, think about that now, and some of the reason why this has come home to roost in the markets this message higher for longer is because the economy has proven resilient and that gives the Fed the ability the ability to tighten further if they need to. And the recession risks have been relatively dialed back and even some big sell side banks are removing their calls for recession at the end of this year entirely. So it is a very different thing. But the test really will be if, as Chair Powell expects, economy, economic signals begin to soften in the back half of this year, do those rate cut expectations start migrating forward again? And that is going to be a bigger challenge when, if we do see job growth really slow down and you see the PMIs came in a little bit softer this last round and if those keep deteriorating, is the Fed going to have the same credibility for its higher for longer?
Speaker 1:I think that's going to be where the rubber really meets the road for the Fed versus the markets here, david do you think that we're coming in for that soft landing that everyone said was going to be so elusive, but maybe we're actually on that rear path.
Speaker 2:I think it's too soon to say yes to that question, but I would say in my own thinking I think it's more likely than I would have said six months ago that it's really hard to have predicted that we could bring down inflation, raise interest rates by more than 500 basis points and still have the labor market so strong. So it may be that we can pull it off. I think John's right. The forecasters have largely abandoned the talk of a recession in 2023. I think what we get when in 2024 depends some on what the Fed does. If the Fed thinks that we really need to raise rates 50 or 100 basis points more in order to slow the economy, then that will probably push us into recession. But it's been a very welcome development that the chances of a soft landing are rising.
Speaker 3:I think there's a bit of premature celebration though.
Speaker 1:One or the other. I'm going to ask you this, david, hopefully, and not putting you on the spot here, or maybe I do hope to put you on spot, but one of the other implications of a potential recession in 2024 is, of course, political. You've got a big presidential election coming up. How do you see the economy playing out in the campaign cycle?
Speaker 2:Yeah, that's a great question. The usual thinking is that what happens in the economy in the first quarter or two of a presidential election year is really important to the president and his reelection hopes. So I think the economy is an issue. When you look at what people are saying, it seems to be a lot of focus on inflation. To the extent that inflation comes down, particularly in the goods that people actually know the price of, like the price of eggs, milk and gasoline, that'll be good for Biden.
Speaker 2:Obviously, a recession in the middle of 2024 would be bad for Biden and the Democrats.
Speaker 2:Although if we end up with as sort of the pundits seem to think we're going to do a Trump-Biden race, it may be that economics is secondary to all the other stuff about the character of the country and what our stance should be towards racial healing in Ukraine and all that. I do think that if I were in the White House, if I were in the reelection campaign, I would be relieved that the economy is so strong, but I would be worried that it's going to fall apart just at the wrong time for the president and, as you know, the country is closely divided. There's going to be a handful of swing states and there'll be a handful of voters relatively small number of voters in those swing states. So if we have some bad economy times in Wisconsin and Arizona and Georgia, that could be devastating for Biden's reelection. On the other hand, it's really interesting how much Biden has not been able to raise his popularity despite an economy which, by any objective measure, is doing pretty well. It suggests that there are other things on voters' minds than unemployment and inflation.
Speaker 1:Yeah, I wonder to what degree. A bad economy is certainly not great and could dampen Biden's chances, but a strong economy may not necessarily help him. The best he can hope for is for things not to get worse.
Speaker 2:But also these things are also important in the congressional and Senate races, and I'm sure Biden is not looking forward to being reelected and having a Republican Senate and a Republican Congress, and so the economy may play in those races as well.
Speaker 1:One thing that unfortunately doesn't get enough attention, I feel like during the campaign cycle, is focus on the national debt and the impact that the Fed's rate hike campaign could have on the cost of servicing this debt for generations to come. I think that was the center committee for a responsible federal budget I always get their name wrong but they put out an estimate that said that if the CBOs the Congressional Budget Office's baseline estimate for where interest rates are going to be, if that continues to be as off as it has been, they could be off in terms of estimating our national debt by $2 trillion or more. So there's potentially a huge cost to future generations of the Fed's interest rate hike campaign now. Thank you.
Speaker 2:Yes, but it's important to remember that if interest rates go up because the economy is too strong in Fed parlance, that's probably not the end of the world, because we'll get more GDP and more revenues as well as paying more in interest. But I think what the recent increase in long-term rates particularly if it's sustained and I suspect it will be reminds us is that it's not a free lunch, that it was really easy to run up a huge debt. We took the debt to GDP ratio from 35% debt to GDP ratio before the Great Recession to 100% of debt to GDP today and we're headed towards 120% in the next 10 years and to 200% beyond that. That's not sustainable, particularly if we have to pay more to borrow, and it hurts the economy in a couple of ways. One of them is that a lot of the federal debt is held overseas, so we're working hard to pay interest and it's going to China and Japan and other high savings countries. I think what I'm intrigued by is I don't think we know yet.
Speaker 2:So there's been a lot of complacency about the federal debt. The bond market hasn't worried about it and, okay, fitch comes out with a downgrade, but it seems it was weirdly timed and there certainly hasn't been a lot of political pressure for this. I don't think you hear a lot of people coming to Washington to have a march to say we need to cut Social Security and Medicare or raise our taxes. But it could be that this is an inflection point, that the increase in interest rates, the attention to the extent to which federal spending has increased, may be the point at which it becomes politically saddened again. But for now the politicians see no urgency.
Speaker 2:So all this fight about a government shutdown and everything it's about non-defense discretionary, which is a small slice of the budget. If you want to do something about the federal debt, you need to deal with Medicare, social Security and taxes, and all of them are saying, well, we're not touching that. So we know we're on an unsustainable course. It's not urgent. It hasn't been urgent. The Treasury is still able to borrow trillions of dollars at reasonably low interest rates, particularly adjusted for inflation. But the cost has gone up and that's a reminder of what might lie ahead if we don't get our hand on this.
Speaker 3:It was interesting to hear Nikki Haley talk about that at the Republican debate. She was one of the very few. The Trump administration, as we all know, was not a fiscally conservative kind of administration and he's not running on that. That's not really anywhere in his platform, and so it was notable that she essentially chastised her own party for the free spending ways that they've had, and we've all seen that. They find their tea party costumes whenever there's a Democrat in the White House, but then they go right back in the trunk when a Republican wins. So it is. The cynicism is nothing new on Capitol Hill, but it was kind of. It was, as I said, notable to hear someone with obviously the political instincts of Nikki Haley bringing that back. I was like what is this 2012? This is the old Republican party, but she's still trying to bring that up.
Speaker 2:Good job, as I was responding to Elon's question, I actually was thinking of Nikki Haley. Is that the leading indicator? I agree with you.
Speaker 1:Yeah, I think it was Trump who also took social security and Medicare off the table during his negotiations. Trump just likes debt.
Speaker 2:He likes debt and the problem is as a private businessman, he liked debt because he never paid it back and that doesn't work so well in the federal government.
Speaker 3:It'll be interesting if there's a Biden second term. I don't think any of us expect a second Trump term to be particularly judicious on the fiscal side, but a second Biden term. Biden is an institutionalist. He's not by nature necessarily a fiscal conservative, but you could certainly look at that kind of a second half of a two-term where he's making difficult political choices. Biden doing something like having some sort of social security Medicare fix is impossible to imagine now, but flash forward into a second term it would be almost like a Nixon in China.
Speaker 2:I 100% agree. So there's going to be more and more focus. The Medicare trust fund runs dry in 2031, the Social Security Trust Fund in 2033. There's a lot of talk among the people I work with about how do we get ready for the eventual. They're going to have to do something. We have at Brookings now a colleague of mine now, wendell Primus, who's for a long time an aide to Nancy Pelosi. He's like working on all sorts of options for social security and one of the things that's really so. I think you're right, but it's going to take a huge education campaign.
Speaker 2:The last time we tackled social security was 1983. And there are very few members of Congress who were around then and the problem is much bigger now than it was in 1983. So there was it's really interesting when you read some of the oral histories of the Clinton presidency there were the stirrings of doing a deal on social security and then the Monica Lewinsky thing happened and Clinton needed the House liberal Democrats and it disappeared. But I 100% agree for you on that respect. Having a Republican Congress might actually make it more likely, because then they can both put their fingerprints on it. It would take a lot of work, not because of the substance. The substance is pretty straightforward on social security. Healthcare is very difficult but the politics have been very treacherous and getting Republicans to agree to a compromise that shaves benefits some in the future and raises taxes, maybe beyond Joe Biden's political acumen, but I wouldn't rule it out in the second term for all the reasons you said.
Speaker 1:I mean, it's hard to imagine a democratic sweep in 2024, particularly considering the number of seats that they're defending in the Senate. You could imagine a Republican sweep. That could happen, but if Biden wins to your point, david it is likely, with at least one chamber of Congress being controlled by the GOP, and so are there bipartisan wins to be had at that point, and it depends a lot on what happens.
Speaker 2:I mean, it's hard to imagine Kevin McCarthy doing a deal with Biden after the shellacky he got after the fiscal responsibility act, and I'm not sure how much longer Mitch McConnell is going to be around, given his age and his obvious health problems. So a lot of this depends on the makeup of the Congress and who the leadership is. But I think that if we're going to see action on the fiscal front, saving Social Security is a very appealing way to do it, as opposed to saying we're going to cut spending and raise taxes, even if it's actually what we're going to do with Social Security.
Speaker 1:David, I know you just dismissed the prospect of another government shutdown sometime this year. It's been political theater for the past. I've lost count of how many shutdowns I've covered at this point. More political theater is likely along the way, but do you see anything substantive happening on the fiscal front when Congress comes back from recess?
Speaker 2:No, I think we're likely to have a shutdown. I think McCarthy is trying to figure out how to avoid one. It's unfortunate, but sometimes in the past you've had a shutdown and then that led to some grand compromise on long-term budget things. I just don't see that happening this year Because the polarization and the tensions are so great.
Speaker 1:Is the shutdown, though? If it happened, would it just be that release valve for the Freedom Caucus members to say that they stood their ground after voting for the broader budget deal earlier, after passing the broader budget deal earlier. This allows them to say there was a point where we drew a line, and then, if you get past it, you can still pass it by the end of the year.
Speaker 2:Maybe. So there's a couple of issues here. One is the Freedom Caucus is drawing lines in the sand. That cannot be—I'm going to mix my metaphors here—the Freedom Caucus is asking for things that Congress can't pass. So I suspect if this ends nicely without a shutdown or a very short shutdown, then it will be that McCarthy recognizes I've got to have to pass this with Democratic votes and I'm going to lose the Freedom Caucus. So it may be that, yes, having a shutdown allows the Freedom Caucus to say we took it as far as we could. The danger in the current climate is that a shutdown of a couple of days doesn't really matter much economically. It can be painful to some government employees or people who are trying to get a passport or social security benefits, but these days nothing is predictable If it grinds on for long time weeks.
Speaker 2:It could hurt the economy and the functioning of government. I think the more, even more serious thing is it continues to erode people's confidence in the government's ability to manage our affairs. So I think it's all a question of the politics of the moment and whether McCarthy can find a way to get a majority of votes in the Senate, in the House, rather that relies on Democrats, without losing his job.
Speaker 1:So declining trust in established institutions, definitely a theme of the past few elections we've had and definitely a theme looking ahead to 2024. John and Brendan, I want to end with you guys and see if there's anything on your radar screen that you're watching or looking ahead to as we prepare for Congress to come back.
Speaker 3:Well, it's going to be an interesting week next week. We've got more purchasing managers indexes to give us an update on the global economy. China's PMIs are coming out and China has been a significant factor in the August sell-off here. The increasing credit problems, the plunging Renminbi or the efforts in Beijing to stabilize the Renminbi slide against the dollar and concerns that there is really the end of the Chinese miracle is upon us and is threatening a disorderly resolution in the property sector and other places in ways that would really shake the global economy.
Speaker 3:We've been sort of down on Chinese markets as an investment We've seen as dead money and the stimulus that is promised by Beijing never really seems to come through in the way that some still hope. But this is one to watch. They've got a lot of policy wherewithal to stave off a worst case scenario, but to be able to actually pick the economy up out of the doldrums that it's in right now, that's a big one. And of course, next week US jobs, non-farm payroll job stay. And my gosh, the summer has gone by so fast.
Speaker 4:Yeah, and we get the PCE price index, so we also get the inflation ratings and a second reading on the second quarter GDP, so it's a busy data week Awesome.
Speaker 1:Well, thank you guys. So much for the conversation. Thank you to David Wessel from the Brookings Institution that does it for us today. Again, I'm Elan Moy with PENTA. My co-hosts are John and Brendan from Market's Policy Partners. Thank you, David, for joining the pod. We hope that you all enjoyed our show. Please remember to like and subscribe to the macrocast wherever you get your podcasts. Thanks for listening.