Making sense of the US economy and the Fed

Ali Jaffery: I really like our call. I think that that’s probably a sensible view for what the Fed is thinking and what they’re going to do then. No rate cuts eminently. So we don’t see in our view that no policy easing in the first half of 2024 and then they start say probably by the middle of the year, they start to signal that, okay, they’re more confident. 

Bipan Rai: Hello, everyone, and welcome to another edition of The XF Factor podcast. This time around, we’re going to go into a deeper dive into the U.S., especially since we’ve had some meaningful data and commentary from Fed speakers of late. And we’re going to talk to one of our premier economists who knows a thing or two about the U.S. economy, about what that means for the Federal Reserve, not just for the upcoming meeting in January, but on balance for 2024. From again, of course. Got to welcome Ali Jaffrey back to the podcast. Ali, welcome back. You know, my condolences for the Eagles. I know you’re a massive fan, as some of us league fans say up here. There’s always next year.

Ali Jaffery: Now I know what it feels like to be a Giants fan. So I feel your pain. I feel your pain. 

Bipan Rai: Right on. Right. So let’s go right into the some of the things that we saw this week and also what we heard this week. And again, you know, given his, I guess, increasingly prominent role as a bellwether for the Federal Reserve, I mean, what do you make of what your governor, Christopher Waller, said earlier this week, or is there anything that he said that stuck out to you? 

Ali Jaffery: Yeah, I think it was a good speech. I think it really reflects probably the pulse of the committee right now. There’s a lot of confusion, obviously, after the December FOMC and the fairly dovish tone that Powell struck and all the walking back from Williams and other FOMC members, I think Waller really speaks for the heart of the committee as it is now. And clearly he was, you know, pushing back on the need for imminent policy easing, which I think is sensible, but also praising the progress of inflation. So I think those are important points. And also I think he clarified the FOMC, his view on financial conditions, where Powell was asked in the presser what he thought about, you know, the easing in financial conditions. And he seemed fairly dismissive of that, and markets walked away with the sense that, you know, the Fed has kind of walked back from this important pillar that they laid out. But Waller kind of clarified that in a sensible way where he said, look, financial conditions remain restrictive. They’re about the same where they were, you know, few months prior, essentially implicitly saying that, you know, we’re looking at the long end of the curve as our main gauge of financial condition. So I think that was an important point. Another important point that he mentioned was, you know, the Fed is or that I infer from that is the Fed remains very data dependent. They say that all the time. But he laid out one important marker I don’t think is being talked about is, in February, the CPI revisions he brought up last year that when the CPI revisions came out, seasonal factors show that inflation was much higher than what they thought. So I think the Fed is waiting for that to see is a full picture of inflation that they’ve seen on CPI side. Is that how the data has come out or could there be some changes to that? So the Fed is really looking at words. How data is evolving. They’re more patient and they want to have markets and understand that their reaction function hasn’t changed as dramatically Despite that press conference from Powell.

Bipan Rai: I want to back up a little bit and talk about financial conditions in the way maybe some members view them a little bit different than maybe Waller does. But, you know, especially us on the private side and what we try to share with the Federal Reserve is talking about with respect to financial conditions. We all watch the same things. You know, we we’ve seen the dollar decline. We’ve seen lot of deals with lower and we’ve seen the equity market take off over the last couple of months. Why is Waller placing a little bit more emphasis on the long end of curve and really relying on that to say that financial conditions remain restrictive when you know some of the other, you know, markers of financial conditions would suggest otherwise.

Ali Jaffery: Likely the main reason is that the influence of the long end of the curve on activity is greatest of all of those things that you mentioned. So other measures of financial conditions, more prominent ones place a greater weight on the equity market, for example. But really that doesn’t have a strong actual weight in activity, you know, depending on how you assess the impact of changes in equity prices on GDP. So I think that’s probably the main reason why and intuitively that makes sense to me given, you know, the role of the long end of the curve influencing the mortgage market. Corporate borrowing is typically follows that for a long end of the curve, more so I think that sensible measuring financial conditions and its impulse and the impact on the economy is challenging. And you know, it’s hard to know where the high degree of precision. But my guess would be similar to Waller’s that if we’re going to put emphasis on something, it should be on that end of the curve in the U.S..

Bipan Rai: Okay, and you know something else that you mentioned that Waller spoke to was the you know, the revisions that we’ve had lowered some important bits of data, including non firms. But, you know, we’re recording this on Thursday, the day after we received a pretty strong retail sales report. And, you know, one of the notable bits from that was that the control group segment of the retail sales report suggests in the street at least forecasting it going in completely wrong and that the consumer is far more resilient. On top of that, we did get a revision higher for the prior month as well. I mean, how do you interpret that? Firstly, you know, why is it that the U.S. consumer remains so resilient and, you know, is Waller wrong with respect to what he’s thinking for in terms of key for growth going forward.

Ali Jaffery: I think the Fed has in general and Waller included, hasn’t given the strength to the consumer enough attention and we’ve seen a number of upside surprises on retail sales and consumption in general. And the Fed hasn’t given us a clear view on how they think about it rather, they mostly talk about when we see strong growth, most of which is from consumption. They’ve spoken about the strength of the supply side of the economy and attributed some of that to the underlying performance in the labor market being strong. But I think there’s something more to that kind of in the short term. One factor I think, is the strength in real wages and real income as a consequence of the labor market. Yes, remaining firm, but inflation falling quite rapidly over the past quarter and a bit. So that’s one, I think, near-term explanation that could help us understand why the momentum and consumption is strong. The big point is why the level of consumption remains so high, given all of the shocks that we’ve seen, all these various supply shocks and the dissipation, these supply shocks and the rapid changes in monetary policy. And there I think we need to kind of take several steps back and try to understand what has happened to the U.S. consumer. And I think there in my head, there are two theories. One is that there’s been some important changes in the post-pandemic environment. You know, a significant chunk of the primary labor force, according to Nick Blum and all the services that they’ve done is working from home. You know, this is not the majority, but there’s, you know, 15 to 20% of prime age workers who are working from home 2 to 3 days a week in the U.S. and they could be geographically located in some of the main cities in the U.S. and have higher weight and activity. And their consumption patterns have likely shifted. There’s also been a lot of discussion about changes in people’s work life balance and in the post-pandemic environment. And I think these things are resulting in a tilt towards more demand for durable goods. And if you just plot the level of durable goods, you’ll see that it’s incredibly resilient. And that’s not ex-ante what we would expect given not only restrictive monetary policy, but also that durable goods typically follow a lumpy cycle. You don’t need to buy a computer every quarter. You know, there’s a pull up and then there’s a pullback. And we haven’t seen any of that. And I think some of this has people staying at home more often, you know, enjoying life at home to some extent, and consuming more durable goods either to support their work needs or greater leisure needs. That’s one theory. And another theory is given that this might be the influence actually actual monetary policy, kind of a countervailing effect, that given the impact on the housing market and people are not able to afford houses because of high interest rates and constraints apply, that monetary policy is making it difficult for builders to ramp up. The household consumption budget has widened as people are more comfortable staying in their homes or renting and allocating more toward durable goods consumption. I’m not sure if these forces are outweighing, you know, the typical income and saving dynamics that emanate from the labor market. But, you know, I put some weight on the former of some post-pandemic change in preferences and habits. That’s only way for me to really reconcile the trend of online sales and durable goods in an environment where monetary policy is very restrictive. And I would hope now that the Fed, after, you know, multiple releases and more or less, I would say dismissing most of it, would give us a clue in how they’re think about it and what are the underlying drivers of consumption. Is it some of these kind of special factors that I mentioned, or do they really think it’s actually this the labor market that’s driving most of this changes in real disposable income? Explain this underlying strength in the U.S. consumer.

Bipan Rai: You know, so you mentioned several factors that are very important for the resiliency of consumer spending that we’re seeing in the United States. What does that leave us tracking in terms of Q4 GDP? I mean, we just had a Q3 numbers and it was exceptionally strong in the United States that all accounts we’re tracking north of 2% for Q4. What does the recent retail sales number alongside some of the other numbers that we’ve received tell you how the U.S. economy did in Q4 of last year? 

Ali Jaffery: Yeah. So our tracking now is a two and a half percent annualized for Q4 before retail sales. And we were around 1.9%, so just under 2%. So that’s a very strong number, especially when you’re coming off around a of 5% growth in Q3. And the handoff from this to Q1 is also going to be strong. So we’re going to have three quarters of very robust growth, well above typical estimates of potential output. I know Powell, in one of the press conferences, I also believe that was in December, mentioned that potential could have been higher on short term measure of short term potential could be higher. So but that to me doesn’t really add up. I don’t believe that US potential growth would be in and around these growth rates. That would imply either a dramatic shift in the TLI component or the TFE component. That doesn’t add up to me. So I think we’re in a period of growth being above potential and the Fed having to rely on the view of Flat Phillips curve view that is, you know, changes in Slack at this point now don’t have large implications for inflation. That might be one way to think about it, but we are definitely in a period of high growth in Q4 and likely to see some of that continue in Q1. 

Bipan Rai: If the supply side doesn’t keep pace with that inherently, doesn’t that mean we’re sort of dropping here when it comes to inflation or at least the improvement in progress that we’ve seen in the eyes of not just the Federal Reserve but other central banks as well? I mean, doesn’t that sort of shift the balance of risks going forward, at least for the next couple of months and maybe even the next couple of quarters in terms of where we see inflation dynamics playing out from here?

Ali Jaffery: I think it does. So it’s a bit of a complicated situation in the U.S. So when you look at activity, yes, clearly that looks like there’s some excess demand in the economy. And as a consequence, you should see some inflationary pressure on the should be tilted to the upside. You know, you might think like I just mentioned, that the relationship between Slack and inflation is weak. So maybe it’s not that big of a hedge, but, you know, that’s definitely pointing in that direction that you mentioned. But then when we look at the labor market, it’s painting a slightly different picture where we are seeing a rebalancing happening in the labor market. The unemployment rate has risen a bit. It’s at three seven. It was actually at three nine. It kind of pulled back a little bit, but that’s not far from estimates of the natural rate of unemployment. John Williams at the New York Fed said three seven five is kind of his estimate of you star the committee is a little bit north of that but we’re moving in the direction of getting the economy to balance and possibly a little bit into excess supply at the job vacancy rate as has coming down, we’ve seen the quits rate an important indicator of, you know, people switching jobs to take advantage of higher wages. That has normalize. So the labor force participation rate is now around where the CBO’s long run trend is. So that’s what we call the participation rate gap is now closed. So when I look at the labor market, I see the economy clearly coming into balance and I see the Fed has put more weight on this. But, you know, with the level of spending, on balance, I think even when I take that into account, yes, probably there are some upside risks from domestically induced inflation. But when I look globally, there’s other factors that mitigate against that. So we’ve seen an improvement in global supply chain disruptions based on that New York Fed index measure. Deflation in China, weaker global aggregate commodity prices. So all of that kind of mitigates against some of these possible price pressures coming from animal spirits, strong U.S. consumer appetite, whatever you want to call it. So the Fed in some way seems like in a good place where they can tolerate a bit of this. But I do think they need to understand what’s going on in the U.S. consumers mind and what’s driving that to be confident of that. 

Bipan Rai: Okay. So this is the part where I get to hold your feet to the fire. What do you think the Fed’s going to do in in a couple of weeks to deliberate?

Ali Jaffery: You know what? I really like our call. I think that that’s probably a sensible view for what the Fed is thinking and what they’re going to do, that no rate a imminently. So we don’t see in our view that no policy easing in the first half of 2024 and then they start to see probably by the middle of the year, they start to signal that, okay, they’re more confident that inflation is sustainably at their target, as they mentioned. And in the second half of the year, they start to ease you know, we right now have penciled in for cuts. And I think that’s kind of consistent with also what Waller said. Another important point that that the Fed won’t be in a rush necessarily to ease, unlike other past cycles where there have been negative shocks and they’ve been forced to ease, we, like many others, expect that the US economy will basically a soft landing that we won’t see a significant disruption to activity. That view’s fairly well confirmed after the data yesterday. So I think, you know, that’s a sensible view for what the Fed is going to go and right now I think they genuinely don’t know. They’re very data dependent, as I mentioned. But if the data comes in as we expect, and I think it’s not far from what they expect, the second half of 2024 seems like a reasonable time when they would begin. 

Bipan Rai: Okay. And do you want to delve a little bit into Canada? And what do you think that Canada is looking at right now? What our expectations are for that for this year?

Ali Jaffery: Yeah. So the bank I think is in a more complex situation. Canada hasn’t seen the favorable inflation readings like you’ve seen in the U.S. I put a lot of weight on, you know, the supply shock view. What Trevor Tomba and a coauthor from University of Calgary wrote a nice paper on that. And a lot of this is related to shelter inflation, which the bank has recognized. But I think even beyond shelter inflation, I think supply shocks have had a big role and Canadian inflation. So I think the bank is wanting to see more progress on inflation before they begin to deliberate any kind of policy easing. And I think our call is on the bank. Canada’s this is very sensible that similar to the Fed that we don’t really have any policy easing in the first half of the year, but they eased more in the second half than the Fed. I think we have penciled in about six cuts in the second half of 2024, and that’s given the view that Canada is already clearly in excess supply conditions. The labor market in Canada is around or slightly above its natural rate of unemployment and clearly activity is being held up by population growth. So the Canada economy is in a fairly weak position. It’s just that we haven’t seen inflation moderate largely because of shelter inflation. But I think the bank needs to see more progress on its preferred core measures and also some of its less preferred core measures. I think we have a good call on the bank as well. 

Bipan Rai: We should say now that what we’re thinking in terms of quantitative tightening from the Federal Reserve Central Bank, Canada, you know, at this point we have seen at least north of the border some disruption in terms of where it settles relative to target. That, of course, is a function of the fact that settlement balances that north of the border have been trading a little bit quicker than we would have expected. But again, we don’t think this is a function solely of the QT process that my colleague Ian Pollock has written a bit about this. So if you do have any questions, please feel free to reach out to us. South of the border in the United States. We think the developments, our imaginations are turning up somewhat differently. We do think that we’re getting closer and closer to the end of QT, or at least a slowing down of QT in the next couple of months that we feel is not priced in fully in some of the markets, including in the foreign exchange markets. So again, that forms the bulk of the reason why we’re expecting the US dollar to start to climb towards the second half of this year. And you know, before we get there though, of course, you hearing from Ali, understanding what’s priced into the market and that, you know, maybe the market has priced a little bit wrong. So again, you know, in the near-term, we are expecting the US dollar to appreciate before the second half, things take over, we start to see the dollar decline on a meaningful basis. Finally, Ali, before I let you go, who’s winning the Super Bowl this year?

Ali Jaffery: I hate to say it, but I think it’s the Niners, man. I hate to say it and they deserve it.

Bipan Rai: Yeah.

Ali Jaffery: Kyle Shanahan is a stud of a coach. That’s a great offense.

Bipan Rai: All right.

Ali Jaffery: I like CMC and I think the AFC is weak, man. I really do.

Bipan Rai: Well, we’ll see. And I’m sure some of our listeners that are Niners fans will be happy with that call, I’m sure. But until next time, have a good one everyone. Cheers.

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