Special Guest: Former Fed Vice Chair Rich Clarida gives his take on the US outlook

Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.

Avery Shenfeld: Hello everyone. Welcome to CIBC’s Eyes on the Economy podcast. I’m Avery Shenfeld, the Chief Economist at CIBC. Delighted to be joined today by Rich Clarida. For those who don’t know, Rich and I were both in the same PhD program at Harvard University. One of us went on to become an illustrious economist, a leading figure in macroeconomics, a vice-chair at the Fed, and currently a professor at Columbia, but also Managing Director and Global Advisor at PIMCO. The other one of us was me, but I’m very happy to be joined by Rich today to talk about where he sees the U.S. economy going, the response to the Fed’s recent decision, and anything else that’s top on his mind. PIMCO, as you know, is a major player. Many of our clients have money invested with them. So, interested to hear what advice Rich has been giving to PIMCO these days as well. So I’ll start off, by asking you, where do you see the U.S. economy right now? You know, how weak is it? How much of a threat is a recession that people have talked about for the last couple of years? And do you think that a recession might have been the outcome had the Fed not cut rates?

Richard Clarida: To paraphrase my former colleague and friend Jay Powell, the US economy is in a good place. It’s demonstrated remarkable resilience in the face of a very aggressive rate hike cycle. Global shocks, obviously two wars in Europe and in the Middle East. Indeed, many folks, including the Fed staff we know, thought a recession was likely in 2023. It didn’t happen. If anything, GDP growth moved about a point above a trend. I think coming into this year, it was pretty clear Fed rate hikes were done. Recession views definitely diminished. Again, the economy surprised on the upside. GDP growth was at 3% in the second quarter and is tracking around that for the third quarter. The one part of the economy that is slowing and it’s of course a very important part of the economy is the labor market. So at least if looking at the official data, payroll employment gains have downshifted pretty notably to about 100K a month. Also, there was a pretty significant downward revision to previous employment data, the unemployment rate has gone up by nine tenths, which triggered the so -called SOM rule, which in the past has always coincided with a recession. This may be the exception that proves the rule The U.S. economy is not in a recession. Now I’m confident of that. There is no indication now other than the slowing in the labor market that that is imminent. I would point out for your listeners Avery is you as you and I learned in graduate school and it’s still true recessions are hard to predict especially in the future. In any given year the unconditional likelihood of a recession in the U .S. is maybe 15 percent so over a two-year period maybe roughly 25 percent so there could be a recession but there’s really no indication now other than some of the labor market data that that is going to be an issue. But of course, the Pal Fed wants to stick the landing. They want to stick that soft landing. Inflations come down close to the 2% target. And now in their own words, they want to do everything they can to preserve a strong labor market.

Avery Shenfeld: So that’s certainly good news for us because we’ve been on the no recession camp for the last two yearsand still have our fingers crossed. 

Richard Clarida: Good for you.

Avery Shenfeld: In terms of the other side of the Fed’s mandate, the inflation mandate, can we say that inflation has been licked for good or do you still see some issues in getting down to that 2% PCE target?

Richard Clarida: I do. At the time and what was a I think a controversial position soon after I left the Fed in January of twenty two, I began to give talks and began saying in March of twenty twenty two actually that the power the the focus in this cycle was on getting inflation to two point something. And I actually meant the point something literally I felt that from the institutional credibility of the Fed and macroeconomic history, it would be a big accomplishment to get core inflation down from five and a half where it peaked to two point something. I felt that if the Fed did that, that it would begin to pivot towards looking at the employment side of the mandate. I also made the point that the Fed is not happy with 2.5, which is where we are now on core inflation. But it does feel that with the rate hikes in place and with demonstrable and impressive progress in disinflation, it’s confident enough that it can begin to remove the level of restrictive policy. So I think that that call is held up pretty well. That being said, there have been some who have dismissed the last mile thesis, which says that the progress from five to 3 or 2.9 may be more rapid than the progress from 2.9 to 2. I’m still in that last mile camp. And I think I think it holds up. Look, inflation in the summer of 2022 was five and a half. And the summer of 2024, it’s running at two and a half with a very, very strong economy and robust labor market. Basically, if you look at inflation on a year over year basis, ended the year last year. Avery on a December over December basis at 2.9 on core. And PIMCO believes that inflation this year, December over December, will end the year around 2.8 or 2.9 on core. So essentially, no progress on a year over year basis is likely. I do think there’s a ways to go. I think in particular, the labor market, has adjusted, it has come into better balance. But if you look at average hourly earnings, if you look at the employment cost index, if you look at the Atlanta Fed wage tracker, all three of those show wage inflation somewhere between a half a point and maybe a point hotter than would be consistent with the 2% inflation target. And so implicitly what the Fed is banking on is that disinflation in the labor market will continue without a rise in unemployment and we shall see. That’s maybe a more long -winded answer than you wanted, but I do think that is a risk. again, the big scheme of things, inflation at two and a half percent is not the end of the world, but the target is two. And it’s not clear that we’re going to get to 2% by the end of Jay Powell’s term.

Avery Shenfeld: Well, as long as wages for economists hold up, I think I’m okay with wage disinflation happening. In terms of what we heard from the Fed this week, it was an interesting combination because they chose the larger of the two rate cut options on their table. But at the same time, in the verbiage in the press conference in particular, the chairman seemed to talk actually for a Fed chair who just announcing a 50 basis point cut, he sort of talked a bit hawkishly, warning people not to assume that this is the new pace and other phrases like that. How do you interpret that message? What was he trying to convey there?

Richard Clarida: In Jay Powell’s own words, this was a consequential meeting, the first rate cut, in what will be a series of rate cuts. It was a very close call, so I was asked a lot in the lead up to the meeting, what is PIMCO’s call? And I always began, PIMCO’s call is that will be a close call, it was, first of all, just for your listeners, for understandable reasons, we tend to equate the Fed and the chair of the Fed, so the Greenspan Fed, the Volcker Fed, Powell Fed. But it is a committee. There are 19 folks around the table, 12 of whom vote. I won’t go into why. I won’t go through the fact that there are 50 states in the US and the state of Missouri has two Federal Reserve Banks. There’s a lot of archaic history, but anyway, there are 19 folks around the table on each of the 19 submits dots and projections But only 12 of those are voters, but what we do know from the dots Avery Is that there were nine folks who wrote down three or fewer cuts for the year there were nine folks who wrote down four or more cuts for the year And almost certainly Jay Powell broke the tie because in the end there were 10 dots that showed doing 50 at this meeting and another 50 the rest of the year. And then there were nine dots that showed doing 25 at this meeting and 50 during the rest of the year. So that was a surprising outcome. It was also surprising because the Fed and other central banks, but specifically the Fed, at least in the last 30 years or so, the Fed has usually done a good enough job in communicating that the actual. The actual policy decision on FOMC day is usually not a surprise. And what I mean by that is there is an interest rate futures market and you can look at the interest rate futures price or yield that would be relevant to what the Fed decision will be the next day. And you can then compare it to what they actually do. And usually there’s very little surprise. In other words, in most meetings, if the Fed is going to cut 50 basis points, than the day before the meeting, the futures pricing is 50 basis points. At this meeting, the futures pricing was about a 40% chance of 25 basis points and a 60% chance of 50 basis points. And that is the biggest surprise, I think, in the data going back at least 20 years. And so this was an unusual meeting. And then to get to the thrust of your question, it was also unusual because it was a dovish outcome with a somewhat hawkish message. And I think most people believe, including myself, that Powell pulled that off pretty well. So the dovish was, of course, the 50. The hawkish, and indeed he said this, you’ve got the exact quote in front of you, but I’m paraphrasing now, but he says something along the lines of, and don’t take any signal from this that this is the new plan to go 50 at each meeting. And indeed they reinforced that by only showing a total of 50 basis points for the rest of the year. So 25 in November and December. Also importantly, the dots show that the center of gravity on the committee thinks that even though there are eight meetings each year, they only see themselves cutting rates by a total of 100 basis points, which means 25 basis points every other meeting most likely. In particular, I think the term that he used in the press conference was there is quote, no rush to get to our destination. Now there’s still a gulf between market pricing and the Fed dots and precisely the Fed dots have the funds rate ending 2025 at 3.4 % and market pricing at least as of yesterday was at 2.9%. So roughly the markets have around 50 basis points more in cuts than are in the dots right now. I guess another thing that some folks pointed out which is also relevant is the Fed continues to project that the level of unemployment consistent with maximum unemployment is 4.2%. And yet they have the unemployment rate, I think going up and staying at 4.4 % in both this year and next year. And so at least indicating that the center of gravity on the committee is they’re okay to downshift to 25, even if you have it a tenth of a point or two increase in the unemployment rate, which at the margin is somewhat hawkish, right? So an alternative view would be any whiff that unemployment moves above four two would trigger a more aggressive response. So yes, that’s a long -winded answer to say, yes, you’re right. It was hawkish guidance on a dovish decision.

Avery Shenfeld: And that 4.4 seemed also to me at odds with Powell’s comment earlier that they didn’t want to see any further slack in the labor market. So now they seem to be willing to live with a bit. So where does that leave you in terms of what you think the Fed will actually end up doing? Is that three and a half sort of rate for the end of next year, do you think that’s about right? Or are you on the side of the market that thinks they’ll be more aggressive than that in the end?

Richard Clarida: I’ll get to that, but just let me emphasize that what stood out to me from the Jackson Hole remarks, the headline and all the financial press commentary was, the time has come. But a paragraph or two later in that speech, he also said we will do quote, everything we can end quote, to preserve a strong labor market. you know, and one sensible reading of everything we can is conduct policy so that we don’t project the unemployment rate ever moving above our estimate of its maximum potential level. So what do I think? Well, I think here, in order to discuss both the FAT and market pricing, it’s useful to think of three scenarios with some probability weight attached to each. So there is a soft landing scenario in which the economy evolves more or less exactly the way that the projections. So in the projections, GDP growth downshifts to 2%. And interestingly enough, it stays there each and every year, exactly 2% for the next three years. The unemployment rate rises a tenth or two, but never goes above 4.4. And then core inflation falls from 2.6 this year, which parenthetically to me seems a bit optimistic, down to 2% by sometime in 2027. And then I think if the economy actually evolves according to that forecast, then the Fed dots make sense. And in particular, 100 basis points the rest of this year, 100 basis points next year maybe 125 because one thing’s a little bit of a stretch for the 2025 projections is that they have an unemployment rate a tad above its natural level and they have inflation a tenth or two above its destination of two and yet they still have the funds rate at three and a half percent. But I think there is a scenario and put some weight on it so the legitimate soft landing scenario. But as you and I learned at Harvard, if not before, there are two sides to every distribution. You have a right down a left tail. So there’s a left tail. The left tail is the song rules right. We’re going to go into a recession. In that case, the Fed, I think, gets down to three percent much more rapidly than they projected. And potentially, if it’s a if it’s, you know, a worrisome recession moves the funds rate below neutral. you put some weight on a scenario where the funds rate gets to 3% rapidly and potenrtially below. There’s also a scenario, and this is the one I think maybe markets are putting too small a weight on There’s also a scenario in which inflation just basically stays stuck at 2.5% a year. Even though the rate cut occurred, two days ago, we’ve had a pretty material easing in financial conditions since the spring. So 10 year treasury yields are down almost 100 basis points, stocks are at an all time high, mortgage rates have come down, credit spreads are at tight levels. And that was even before the Fed began to hint that it might go 50 at this meeting. And so there is a case in which the easing of financial conditions is going to boost aggregate demand to a level that keeps the pressure on inflation, that potentially delays the rebalancing of the labor market, and in which case the Fed may be finished, or at least, next year won’t be cutting additionally simply because the economy is rubbing up. And of course, add to that scenario the possibility of yet another year of a new president coming in with big fiscal push. Under President Trump, there was a big positive fiscal impulse, certainly by 2017. President Biden came in and it was an American rescue plan. Either a President Harris or a President Trump are going to want to have their policy. Even before that, and then once you add in the possibility of fiscal boost next year, I think there’s a boost that, you know, the rate cut cycle, at least through next year, doesn’t get anywhere near 3%, not so much because the neutral rate has risen, simply because the economy is operating hot. So that’s probably more long -winded than you want to, but I do think certainly if I were still at the Fed, I’d be thinking about those scenarios, because I think each is relevant.

Avery Shenfeld: And for an investor then, it sounds like given that you’ve got that scenario where the US economy does a little better, with some weight presumably, does that make you bearish on treasuries at this point, that they’ve over discounted too much aggressiveness from the Fed next year?

Richard Clarida: I think the way that I think about the treasury market is it’s useful to distinguish between the view that you have about what’s the destination for policy when everything’s going great. So essentially the neutral rate is the rate the Fed sets when everything’s great. Inflation’s at 2%, the unemployment rate’s at 4 .2. So I, PIMCO, am still in the camp that the neutral funds rate’s around 3%. You know, that’s where the Fed is. That’s where the primary dealers are. That’s more or less where market pricing is now. But, and this is where I’m glad you’re giving me the platform to maybe educate a bit. One thing I find frustrating about Twitter, the blogosphere, and even some of the financial press is they oversimplify for the readers by talking about the interest rate. You’ve got a whole constellation. You got a whole yield curve. In particular, PIMCO, you we think a lot about the curve and not just the front end. And one of our real convictions for the next several years is that the Treasury curve is going to re -steepen. The inverted yield curve is not the new normal. You know, I remember I began PIMCO now 18 years ago when Bill Gross was still our founder and leader. And I remember attending a meeting with Bill early on when he pounded the table and he said capitalism requires a positively sloped yield curve. I don’t know about that, but certainly I do think at PIMCO, we think a lot of the required adjustment in the Treasury market is going to be as the curve steepens. so for the sake of argument, if you see the funds rate around three percent when everything’s going great, we do think we’re going to see a steeper curve than we saw in the decade before the pandemic. That doesn’t necessarily mean astronomical treasury yields, but it could mean treasury yields in the range of four to 5 % with the funds rate down around three. That’s a great situation for bond investors because they’re earning that yield. They’re also earning what is called roll down on the curve and bonds typically will provide a hedge against equity risk in a downturn. So not necessarily, much higher rates than we’ve already seen in the cycle. Remember a year ago, 10 -year treasury was at 499, and in April it was at 465. So yeah, we could see treasuries eventually move back into that range, but with front -end rates a lot lower than they have been.

Avery Shenfeld: So it’s a steeper curve, not necessarily so bullish for the long end in the near term, but down the road an opportunity to actually earn some money on those bonds. One other thing I’ll just ask you before we wrap it up is, the other reason, of course, that people do own bonds, and you touched on this, is as a hedge against bad economic times that drive equities lower. And you did talk about that scenario where the economy has a harder landing than the equity market is obviously thinking about right now. Is that another reason to sort of keep a reasonable weighting in the bond market at this point?

Richard Clarida: Oh sure, it’s something that’s both of interest academically as well as practically for investing, obviously portfolios can get complex with derivatives and currencies and all the rest. For many investors, a good starting point is you allocate some to cash, some to equities and some to bonds. A good rule of thumb for many investors is 60 -40, 60 -equity -40s bonds. And what’s important to note is about 25 years ago, in the mid to late 90s, the hedging value of quality fixed income, both in the US and Canada, began to become very attractive in the sense that when central banks like the Bank of Canada, who was a leader in inflation targeting, and the Fed, attained monetary policy credibility, that took an important element of risk out of investing in bonds. When you and I were at Harvard together in the early 80s, 10 -year treasury yields, I think, were at 18%. I’m not sure where yields were in Canada. And a lot of that was just an inflation risk premium. Nobody had any idea what the Canadian or US price level was going to be 10 years later and so bond investors say, you know, pay up since I have no idea what this is worth. Well, as central banks gain inflation credibility, a lot of that bond inflation premium is reduced or eliminated. And what that means for investors is that in a period of an economic downturn, bond prices will go up, yields will go down at the time that equity prices are going down. And so there is a hedging value to bonds that began to appear in the 90s. And that we think it went into hibernation in 2022, which was a terrible year for both equity and bond investors. And that’s understandable because 2022 was the year when inflation appeared to be out of control and central banks were behind the curve. But now that inflation has returned to target and central banks have maintained that credibility, we do think that hedging value of quality fixed income has returned and will be an important reason. In fact, we argued in one of our recent pieces that in fact, some investors may look at current valuations for bonds versus equity and maybe rethink 60 equity, 40 bonds, maybe move that more towards 50 -50.

Avery Shenfeld: Well, that’s music to my ears because I do speak to a lot of fixed income investors as well. And I want to thank you, Rich, for joining us. And thanks to PIMCO for letting you come on and speak to our clients. Thanks again to those tuning into this podcast. And hope you join us next time. In the meantime, we’ll be keeping our eyes on the economy and calling it as we see it. Thanks again, Rich.

Richard Clarida: You bet. Bye bye.

Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.

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