00:00Your team revised your call for Fed rate hikes from a hold after the inflation print.
00:04What was in that data that made you change your mind, and how does the rate path look forward for
00:08you from here on out?
00:09Yeah, it wasn't so much that it was a concerning CPI report, and I would actually say it didn't change
00:14our inflation view.
00:15It was more that Fed communication had primed the market to think that any imperfect news would lead them to
00:22hike.
00:22And while the CPI report was not concerning, it was, in fairness, imperfect, with the core rounding to a 0
00:28.3.
00:28So the market predictably ran ahead, priced a 90% chance of a hike, and I think it's probably right
00:34that they would be reluctant to provoke the market reaction, the criticism, the questions about credibility from not delivering that
00:41at this point.
00:41No, I couldn't agree with you more, David, and now you have to think about the way forward, right?
00:44We have two more meetings coming up between now and year-end.
00:47What's to stop the market from rushing to price in two more hikes or even more?
00:50You know, talk to us a little bit about what the messaging needs to look like from the Fed today
00:54in order to engineer less hikes on a forward basis.
00:57Yeah, the big controversy, I think, today is will they signal additional hikes?
01:01And our best guess is no, that they won't, in part for some of the reasons that you say.
01:06I would think that they would try to gently, subtly nudge the bond market away from overly confidently pricing additional
01:14hikes.
01:15I don't think they're going to do it in the statement.
01:17That would be a little bit louder than I think they want to be.
01:20But perhaps in the press conference, Chairman Walsh could say something like, we're going to carefully assess incoming data.
01:27We're going to be looking at upcoming inflation reports, plural.
01:31We only have one before October.
01:33We're going to look at how the underlying trend evolves.
01:36All of that would signal we want to collect a bit more information before we decide what to do next.
01:41And with the midterms just around the corner from the October meeting, the market is already a little bit skeptical
01:47that that will happen.
01:48So it shouldn't be that difficult for the Fed chairman to kind of keep the market on the expectation that
01:54at least it's not obvious that they'll be hiking in October.
01:57But if you look at history, and Damian made this point earlier, a one and done is quite rare.
02:02I think that's right.
02:03And to the extent that you think you have a real problem to solve, 25 basis points is not going
02:08to do the job.
02:09I just think that it's a little bit more controversial within the committee whether or not you do have a
02:14real problem to solve.
02:15My own view would be that the economic case for a rate hike is not very strong, that we don't
02:21have a macroeconomically driven inflation problem,
02:24that the overshoot of 2% basically comes down to fading one-off things like the impact of the tariffs
02:31and the oil spike,
02:32that the last few months have already shown some signs of progress, hinting at that,
02:38and that broadly the economy is not overheated.
02:40Normally the reason you would raise rates is because the economy is overheated and you need to get the level
02:45of demand now down.
02:46I don't think that's a problem we have now.
02:48And I suspect a good number of people on the FOMC agree with that and might be hesitant to go
02:53too far,
02:54at least until they see more evidence that it's justified.
02:57David, well, the move in the 10-year note has, and I agree with you and the market agrees with
03:00you,
03:00it's not inflation break-evens that have been expanding, it's real yields, right?
03:04Now, talk to us about that move in real yields.
03:06Does that indicate to you that this is a Fed credibility issue?
03:09Is it fiscal concerns?
03:10Is it better than expected growth on a forward basis?
03:12I mean, it's all real yields to me that's driven the recent move in the 10-year.
03:16And just how far can it go?
03:18Yeah.
03:18I mean, to me, it looks like this is largely in reaction to the shift in the monetary policy conversation.
03:24Before the beginning of the war, we were thinking about cutting.
03:27Now we're talking about how far the hiking cycle is going to go.
03:30I don't think there's been a huge amount of news this year about issues like the growth outlook
03:36or the fiscal issues in the long run.
03:38I don't think we have a deep-rooted credibility problem.
03:42To me, that would mean that investors are seriously concerned about inflation staying high on its own
03:49and seriously concerned that the Fed as a committee is not going to do anything about that.
03:54I don't think either of those are true.
03:56When I talk to our clients, what's remarkable to me is actually that I don't encounter a lot of concern
04:01about inflation.
04:02And yet, here we are raising interest rates.
04:05You flag that AI investment as potentially raising the equilibrium interest rate.
04:09How big could that effect be?
04:10And do you think we're entering a world that's just really a higher for a longer era?
04:13Yeah.
04:14So, already this cycle, the Fed has raised its estimate of the longer run or neutral rate from 2.5
04:20% to 3.1%.
04:21Now, I had thought they might rethink this a little bit more substantially than that over the last year and
04:26a half,
04:27and they haven't.
04:27But I would guess that over the next year to year and a half, before they need to actually decide
04:34where do we want to stop,
04:36where do we want the funds rate to stabilize,
04:38that that longer run neutral rate in the dot plot will shift up a little bit.
04:42Part of the reason for that is very simple, that the longer the economy performs well at a higher level
04:48of interest rates,
04:49the more it would be natural to ask yourself the question,
04:51is it really so clear that we need to go a lot lower than this?
04:55Part of the reason for that, though, is also that, you know,
04:58I think other factors besides monetary policy are having an offsetting positive effect on demand.
05:05I would have thought that they might have said, well, with fiscal policy,
05:09this easy relative to historical norms,
05:12we don't need to take the funds rate all the way down to neutral.
05:15We can keep it a bit higher because the boost to demand from fiscal policy keeps demand stronger.
05:21That argument doesn't seem to have gotten much traction.
05:24It seems like the idea that there is a lot of AI investment demand,
05:27that raises the equilibrium rate.
05:29That's getting a bit more traction on the FOMC.
05:31So I suspect with another year plus to think about this,
05:34they'll wind up concluding that something a bit higher,
05:37like three and a quarter to three and a half, is the right stopping point.
05:41David, is the U.S. economy healthy?
05:43I mean, in your gut, truthfully, I mean, is what we're seeing here,
05:46is it being driven by the one half of one half of one percent in terms of growth,
05:49in terms of incremental growth?
05:51You know, talk to us a little bit about, you know,
05:52your real sense of whether or not, you know, the Fed even needs to go here.
05:57I mean, it obviously seems to me like you don't think they need to,
06:00but the numbers, from my perspective, the growth numbers keep coming in better than expected.
06:04Earnings keep expanding, you know.
06:06So, you know, at what point do you have to sort of, you know,
06:08cool the jets on the economy given the run rate here?
06:11Yeah.
06:12I certainly don't think that the economy is overheated.
06:15Broadly, I would say it's in a good place.
06:16We just got a strong retail sales report.
06:19And on the back of that, it now looks to me like the economy is growing through Q3,
06:23a bit above two percent for the year as a whole.
06:26I would put the potential growth rate of the economy at 2.3.
06:30So maybe we're a tenth or two below that,
06:32but that is a pretty small difference as these things go.
06:34The labor market also, I think, is in quite a good place.
06:38Now, there is a bit of a difference in perspective between those who are happily employed,
06:43who have very little chance of, have had very little chance of being laid off for the last five years,
06:47and those who are outside of employment looking to break in.
06:50From that perspective, it's more difficult.
06:52But an unemployment rate at 4.1 percent, I think, is right exactly where the Fed wants it to be.
06:58Wage growth is not excessive.
07:00So this is a full employment labor market that, to me, looks neither too hot nor too cold,
07:05nor particularly close to being in trouble in either direction.
07:08We have around 30 seconds here, David.
07:10So you argue that the inflation overshoot is a one-off,
07:12but with oil prices still rising and tariffs continuing to feed through the economy,
07:18what gives you the confidence that the Fed can look past those two?
07:21Sure.
07:22I do think that the increase in oil prices is kind of the hawkish risk to my expectation for today.
07:27It's possible that more FOMC participants treat this as a business-as-usual response to higher oil prices,
07:34and in that scenario, they might well anticipate doing more than one hike.
07:38Our own analysis would suggest that while higher oil prices definitely pass through to core consumer prices,
07:44the impact looks moderate and contained so far,
07:46and not as large as we saw in the spring when prices rose much more sharply.
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