00:00I feel like if we had this conversation a few weeks ago, it would be a little bit different
00:03about where we thought rates are going. Right now, at least if you look at the Bloomberg
00:07terminal, about a 50 percent chance right now for a rate hike in September is what traders
00:13are betting on. And now you have a lot of economists saying that even if we get that
00:17hike in September, it might not be the only one. Why?
00:19Well, I think this is a very interesting question. And some of that is to do with the data and
00:24the volatility in the inflation prints, the fact that we haven't had that much progress
00:28on inflation over the last five years. But a lot of it has also to do with some
00:35misunderstanding or lack of clarity in terms of the Fed reaction function under the new
00:40Fed chair, Kevin Warsh. And so what has happened since the weekend is that now we have a bit
00:45more visibility. We don't have forward guidance. And I think it's clear that he's not going
00:50to go down that path. But we have some guidance with regards to his reaction function.
00:55And I think the market is reading a lot into his statement that financial conditions are
01:01actually not that tight, that 2 percent inflation is still the goal. And we haven't seen sufficient
01:08progress in bringing inflation down, even with the last two reports that have trended lower
01:14and and showed some progress. But he indicated on Friday that that's not enough yet.
01:19When you look at the market reaction to what he said, do you think the market got the right
01:24message? I feel that they did. The thing is, Warsh did his reaction function. He did not communicate
01:32that very well between the June and the July Fed meeting. I think he made a mistake to say that
01:38financial conditions have tightened and therefore the market is doing the work for us. And so the
01:43market needed to see this reassessment and this recommitment to price stability and to the 2 percent
01:50inflation target. And now I feel they have the right signal. Now, what's important between now
01:57and the September FOMC meeting, we have two data reports. We have CPI and we have payroll data.
02:03The decision in September remains data dependent. But the hurdle, I think, has become quite different
02:10than it was before Friday. What's the balance between those two, that labor market report coming this
02:15Friday, a CPI report in the in the days ahead after that? I mean, there are a lot of people
02:21that came
02:21out of that speech at Jackson Hole and said that this isn't a Fed that sounds like it's, you know,
02:27following a dual mandate. It looks like at least for the short term, there is one mandate, and that is
02:32bring inflation back down to that 2 percent target. Is that how you read it? I think that's a great
02:36question. And I do agree with you. So what we heard on Friday is let's look at what's happened with
02:43wages and the labor market. Well, the labor market is in full employment and wage growth is
02:48decelerating. But words very clearly said, I'm not taking signal from that. Wages are not a good
02:54predictor of forward inflation. What I'm looking at is the breadth of inflation. We have 54 percent of the
03:01PCE basket that has been above 3 percent for quite some time. That's the kind of breadth that he seems
03:07to be
03:08uncomfortable with. So I think the reaction function is biased towards inflation right now. And the Fed
03:14is acting like a single mandate central bank, at least temporarily. As an economist, though,
03:19do you believe that with regards to the idea that wages aren't necessarily the best gauge to follow?
03:26I wouldn't agree with that assessment. I would say that wages are not a risk to the inflation outlook
03:32right now because productivity growth has been quite resilient. And so that explains part of the
03:37wage growth that we've seen in recent quarters. And as long as the economy is becoming more productive,
03:43even higher rates of wage inflation are not necessarily inflationary. So I don't agree with
03:48Warsh's statement that wages don't matter for the outlook for inflation. But I do think that wages are not
03:54an upside risk to inflation going forward. Does the U.S. unemployment rate, does that matter as much?
04:00Is that a proper signal or is it maybe a missed signal? The labor market in the U.S. has
04:05been buffeted
04:06by many structural forces in recent years. And I think those ongoing structural forces are driving
04:12the unemployment rate. That's why it's been very important to look at the labor market in its entirety
04:18and to look at hiring rates and vacancy rates as well as the unemployment rate. Because when I look at
04:23the unemployment rate now, it is true that it's lower, but a lot of that is being driven by labor
04:28supply
04:29in demographics, aging population, slower migrant flows. It's not necessarily a sign of a tight
04:36labor market. So then you go to wages and wages are moderate. Then you go to the vacancy rate,
04:42which is low, going to pre-pandemic levels. You look at hiring rates. They're not very elevated.
04:47So we don't have a hot labor market right now. You mentioned productivity. And I am curious how
04:52productivity gains sort of address the inflation situation. And I assume those productivity gains
04:59are coming partly from some of this AI adoption, if you will, and implementation.
05:05Yes. And I think we need to look at productivity over a long period of time. In the near term,
05:10we'll have the easy productivity gains. The way we measure it is output per worker, GDP per worker.
05:17And so when you're not hiring a lot in the economy, but output or GDP is increasing because you are
05:23investing a lot and capex growth is high, then you'll have a mechanical improvement in productivity
05:28growth. But then over the medium to long run, what will matter is total factor productivity and
05:33the interaction of this new technology, AI with labor. And I think those gains are still ahead of us.
05:40So I'm actually quite optimistic about the outlook for US productivity. Stronger productivity
05:46growth also means we can look forward to higher GDP growth, both real and nominal without it
05:53necessarily being inflationary. So when I'm looking at the outlook for next year and beyond,
05:58I'm quite positive that we'll be able to bring inflation down to 2%, even without interest rates
06:04being too restrictive because of this productivity gains. But with regards to how AI feeds into that,
06:10I mean, some people are saying that AI itself is inflationary. It may be disinflationary
06:13at some point. You don't buy into that. I don't. I think this kind of debate doesn't fully take
06:20account for all the effects of AI in the economy. So this debate that in the short run, AI will
06:26be
06:27inflationary is looking at specific CPI components like software, like computers. And it's true,
06:33those are increasing, but they are a small part of the basket. However, this debate is ignoring
06:39completely the effect of AI on the labor market. The fact that we have this labor enhancing technology,
06:45the fact that workers maybe don't feel so confident to switch jobs right now or to ask for higher wage
06:51increases. I think that has an effect on inflation on the other side. Now, it's much harder to quantify it.
06:59But if I had to bet on one outcome, I would say that the disinflationary effect of AI will be
07:04much larger,
07:05both in the near and medium term. With regards to some of the structural issues in the economy,
07:10there's been a lot of focus on the U.S. deficit, its debt load, and more importantly, how the Treasury
07:17is managing that. Does that sort of work in conflict with maybe what we think Kevin Walsh wants to do
07:24with regards to both his communication and his desire to get inflation back down to that 2% target?
07:29So I would say that given the reaction of the long end of the U.S. Treasury curve over the
07:34last
07:35two, three months, the three are very, very closely related. And what we notice every time Walsh comes
07:42out with a message that is tough on inflation, that emphasizes Fed credibility, we see the long end
07:49yields coming down, term premia suppressing. So I think those three things are very closely together.
07:55And trying to achieve lower yields by cutting interest rates can, in fact, be counterproductive,
08:03as we've seen many times when the long end moves higher.
08:07And just real quickly here, I mean, as somebody with fixed income as part of their umbrella,
08:12are you anticipating we're going to see more volatility on rates in the secondary market,
08:16given the presumed less guidance we're going to get out of Kevin Walsh?
08:20I think this is a period of huge uncertainty. So the answer would be yes, for many reasons.
08:25No forward guidance. The data has been more volatile. We're at cross-currents in the labor market,
08:31in inflation. And so all of these things are going to lead to more volatility.
08:36That's why it's exciting to be in an actively managed fund.
08:39That's why it's fine.
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