We didn’t start the (CPI) fire…

Ali Jaffery: All of the signs are favorable to maintaining restrictive policy for longer, right? And also, let’s take a step back here and assess the Fed is not trying to stimulate the economy. Its goal is to just have a soft landing. And that means dialing back the level of restrictiveness gradually.

Bipan Rai: Hello and welcome everyone to another edition of the FX Factor podcast produced here by CIBC. My name is Bipin Rai. I am the Global Head of Foreign Exchange Strategy here at CIBC. And with me, I brought back a former guest of ours, one of our preeminent economists, Ali Jaffery, who’s going to speak a little bit about the US economy. We should start off with the US CPI print. And of course, we’re recording this on the day that we received the February CPI number. What are the bits that stuck out to you with respect to the report?

Ali Jaffery: So overall, I think it was a disappointing report for the Fed, but I don’t think it’s any reason to panic per se. So I think there are three elements here and we can kind of go by the big broad components. The first is the goods side of the basket where we saw a little bit of inflation. We’ve seen mostly deflation in core goods. This is goods excluding food and energy and for over six months now, a bit longer than that. So we saw a little bit of inflation, so 0.1% month over month increase, whereas we’ve seen this be a drag on inflation for quite some time. So that might be a little bit concerning because on one hand, we’ve known that this deflationary trend in goods is not going to last that long, and Powell has spoken about that. So there’s a concern that this might be the end of that deflationary trend. I’m not so convinced about that, but this wasn’t necessarily a great sign for the Fed there. Then on the services side, the two other big pieces are shelter and non-housing or non-shelter inflation. And there we saw shelter come down. There was a bit of noise in shelter data in January, but it’s still quite elevated. And shelter was predicted to come down much faster and much more smoothly than we’ve seen so it’s a bit concerning that shelter inflation is kind of grinding sideways at a much higher clip. And rental inflation also picked up within the shelter basket. So that wasn’t really a good sign. Now the last part, the non services part, that moderated but from a very high increase in January. So in January month over month non housing service inflation was about 0.9% and it was about 0.5% in the February data that came out today. That’s still quite elevated. This is the part of the economy that’s very sensitive to changes in the labor market. So not a lot of progress across all the main baskets of the economy. What we don’t know is what parts are being driven by demand and what parts are being driven by supply. But my sense is the Fed isn’t going to look at this and say, okay, yes, the economy needs interest rate relief right away.

Bipan Rai: So just picking up on what you said there, Ali, I mean, the slight pickup, let’s say, in goods prices, another way to read that would be that, if we are sort of cresting here in terms of the disinflationary trend, there’s more for the Fed to worry about because we’re not quite seeing that same pace of disinflation when it comes to services. if you’re Jerome Powell, you’re sitting in your chair and you’re looking at this print, what are you saying to yourself?

Ali Jaffery: I’m saying that let’s be patient. CPI inflation has been volatile in the cycle. On the goods part in particular, I don’t think there’s need to worry too much yet. There’s still a rebalancing occurring in the car market. Part of that uptick in goods prices was used car prices increased in the month. And I don’t think that’s a durable trend. I think the overall level of used car prices is still quite high and there’s a lagging relationship between the used car subindex and CPI and Manheim used car index. And there’s still a bit more to go. There’s still quite robust demand for cars because car sales have not even returned back to the pre-pandemic level. We just haven’t been able to sort out all the production shortfalls. So I think the goods sector is still going to deliver some deflation going forward, not as much as it was six months ago. And also supply chain disruptions have normalized. I know there’s been some challenges globally with some issues in the Suez Canal and other places, but I don’t think there’s a reason to worry so much about that. It will get a bit less juice there. What is a bit concerning might be is why non-service inflation isn’t coming down. And that doesn’t jive clearly with what we’re seeing in the labor market, where the labor market is rebalancing quite materially and firms still continue to feel comfortable to pass on costs. So that’s the point where if I was J. Powell, I’d be a little bit concerned. And the recipe might be, okay, let’s hold where we are and see how restrictive policy is going to feed through into the economy a bit more.

Bipan Rai: Can we touch on the labor market a little bit? Now you mentioned that things are coming into a better balance. What are you seeing there that leads you to that conclusion?

Ali Jaffery: A wide range of indicators to be honest. So first of all, if we look at the payroll data that we just saw, the key point in that for me wasn’t necessarily the headline job gains. It was the part rate, you know the participation in the economy particularly prime-edge participation continues to be very strong. We have multi-decade high in people aged 25 to 54 participating in the labor force. And there’s a lot of research that’s coming out, particularly from the CBO saying that there’s been a surge in immigration in the US that may not be fully captured in the CPS survey that underlines the household survey. And so we have this influx of people and they’re participating in the labor market. So labor supply is really robust and that’s helping us. So we’ve seen the supply of labor increase, even though the demand of labor has been has been quite strong. But even in the demand of labor, we’re not seeing it continue to accelerate. When we turn to the JOLTS data, we see job openings, you know, kind of very gradually moving down. We’re seeing measures like the quits ratio telling us from workers are less willing to hop to new job opportunities. All of these things are saying, you know, there’s a little bit less labor demand than there was at the peak, but there’s much more labor supply. And then we see it also in the wage data, across all the main wage indicators, ECI, the Atlanta Fed Wage Tracker, the average hourly earnings, and unit labor costs, the most important one arguably, all are showing that wage growth is decelerating, and unit labor costs in particular is at about a normal level. So we have strong wages, but we’ve had strong productivity growth. So the inflationary impulse from the labor market suggests down the road that this non-housing service category should experience some disinflation.

Bipan Rai: Okay, let’s tack further on to that and then really tap into the connective tissue when it comes to US activity, the labor market and so forth. We’ve got a rebalancing labor market. Certainly, your point is well taken with respect to the supply of labor increasing at the same time that other proxies for demand are starting to decline at the margin. How do you square that with activity that’s still tracking fairly strong? I believe the last I looked at the Atlanta Fed and Outcast, we’re still north of 2%. That follows a couple of cores of fairly strong growth in the US. What is the narrative link there that you would say between a rebalancing labor market and still strong activity in the US economy.

Ali Jaffery: You know, that’s a great point. I think there’s a couple of things here. One is if that population surge isn’t being fully captured, well, those are people that are also spending a lot of money. And if we’re not capturing them, maybe on the income side, we’re also not capturing them. And so that’s why you see this, you know, dip in the saving rate. But we do see when they purchase stuff because, you know, we see the receipts of the broader economy. So when you would account for that increase in population, perhaps that would also explain some of the robust spending that you’re seeing in the US economy. But I think even still, there’s other forces probably that are supporting that robust growth. The improvement in supply chains that really push goods prices down over the last half year, that disinflation has brought headline inflation and core inflation down. But that dynamic makes you have stronger real wage growth. So that’s certainly playing a role. I think also there are other more salient factors that you know, we don’t have a lot of evidence for but we kind of see it anecdotally. People’s habits may have shifted because they’re working from home more so their demand and desire for durable goods is stronger. There’s a housing shortage in the US. You know, housing is also prohibitively expensive. So people might be reallocating money away from what down payments, they’re putting off housing purchases and putting that money into consumption. So I think there’s a wide range of forces, you know, some of them emanating from increased population, but others could be more, maybe some structural shifts like this change in habits and some more related to housing that are playing a role in that strength and activity.

Bipan Rai: And so, if we talk about the strength and activity, and you mentioned this earlier, and I think this is quite important, is the fact that when it comes to non-housing related price pressures, they still get to a bait. Do you think that’s also because of the large pile of savings that have accumulated? And are we seeing any distribution of those savings that are really, pretend to us or really tell us that these are the reasons why non-housing related service prices remain elevated?

Ali Jaffery: On the excess savings, my gut is that it’s not. It depends on where you draw this trend line from what was the level of savings we had in the economy before and where you compare that to. Is that a 2015 to 2019 benchmark? Is this something more recent? And based on the work of San Francisco Fed, my hunch is that most of this has been depleted, so it’s not a major force being used to spur activity and as a result generate price pressures in these categories. What I think is something to worry about is firms desire to keep raising price in this could be their desire to test the limits about how much they can pass on costs, that their price setting behavior may be a bit different now than it was before the pandemic. That might be showing up, that might be one of the reasons why this is happening. Or it could be just that the overall level of demand in the economy still is quite strong. And we need restrictive policy rates to cool that so that they don’t feel as comfortable to pass those costs on.

Bipan Rai: I hear the story of a slowing US economy. I hear things that are very consistent at the same time activities expected to remain reasonably robust. We shouldn’t really expect a hard landing during this cycle. You know, but we look at the data. We see vacancies that are coming off, but they’re still relatively high. We see real wages that are still too firm. And we still have fiscal deficits that are quite large. Firstly, let me ask you about fiscal deficits and the role that they’ll play. I mean, we did hear from Biden earlier this week when he submitted his fiscal proposal for the next fiscal year. I mean, what’s your take on the role that fiscal deficits are playing right now when it comes to US data?

Ali Jaffery: Certainly, fiscal policy is playing some role. We’re seeing that in the investment data that was supporting a lot of non-residential construction, particularly in manufacturing. That may be related to the chipsacks and a lot of Biden’s policies. So I definitely think that there’s some element here that’s stimulative. How much is it adding? I don’t think it’s a major driver. I don’t think we’re having a major fiscal impulse. We do observe household income data, and that’s been relatively strong. But this feed through of spending to households is not showing up so much in income. So I think it’s certainly a factor, but I don’t think it’s the driving force.

Bipan Rai: What is the path to a slowdown in the US economy? I mean, we’ve hiked rates by 500 basis points, or at least the Federal Reserve has, and we’re still, by all accounts, we’re seeing an economy right now that is adjusting to higher interest rates. But the Fed will cut. We both agree there, but when it comes to where the final resting spot is, I mean, that’s still very much a target in motion. For you, what do you think that level is for interest rates? And what is, back to my original question, what is the path for a slowdown in the US economy, given that demand still remains relatively strong?

Ali Jaffery: So this is a great question. I think there’s two ways to think about it. One is actually the economy has enjoyed some major structural changes post pandemic. And what happened is we saw substantial disruptions in the pandemic. And now a lot of that is normalizing. Obviously you see that in the price data, you’re seeing the labor data. And I think we start to see that in the activity data. And the level of potential output in the US economy, so the long run trend of growth in the US economy, might be a little bit higher. So we just kind of stay where we are. I think there’s good reason to make this case, you know, for all the reasons we just talked about that activity has been very strong. And the role of interest rates in dampening demand seems much weaker in the US economy, given the structure of the mortgage market and the forward-looking nature of firms to adjust their balance sheets as we’ve seen monetary policy shocks or surprises in the outlook of the Federal Reserve. So it’s difficult to generate a significant slowdown from more restrictive monetary policy. But at the same time, monetary policy might have just much longer lags than we’ve thought, that it takes more time to feed through to the economy. And that’s one of the other channels through which we would get to this slowdown that over time, you know, the interest costs of sort to bear and firms would have to adjust, you know, the amount of labor and capital that they have and that they allocate to production. So I think that somewhere maybe between these two stories, but I think gradually I’m leaning toward the first story where the level of potential output of the U.S. economy was a bit stronger and this new wave of work that shows that population is higher also kind of supports that story because if you have a increase in population of material increases should over time support longer growth. Now your second question about where do we see the Fed going essentially. You kno, our view, which was a bit challenged today after the data, was that the Fed would start to ease in July and then cut four times this year and then probably another four times next year. It’s ending 2025 well above where at least it is penciling and now it’s long-term neutral rate. Two and a half percent is what they’ve been saying. We think that by end of 2025, there’d be about 75 basis points above that. But certainly we’re not seeing inflation cool down, at least over the last two months. So perhaps there might be fewer cuts than what we’ve penciled in 2024. And that’s what we’re going to look and assess in the data. And certainly I think the FOMC is doing that. There are no rush to ease rates. But I still think that mid-year timeframe seems sensible to begin. It’s just about the pace at which they will kind of calibrate monetary policy without the easing cycle. And they’ve been open about that. Jefferson gave a great speech drawing a parable to the 1995 cycle where the Fed was very careful and judicious, trying to act pre-emptively, but then adjusting the pace of monetary policy easing with the flow of the data. I think the case for that is growing day by day as we see very uneven data. We’re seeing hot inflation, but rebalancing in the labor market, solid activity, strong productivity, we’re seeing kind of a variety of different signals that suggest that they should move fairly slowly.

Bipan Rai: Okay, so I mean, I guess we’re arguing then potentially for a higher neutral rate in the United States then. Would you agree with that? And then second, I guess, as a follow up to that question is, I mean, if we’re talking about a higher neutral rate in the United States, should we consider other factors that might be a little bit more relevant in this day and age, including debt dynamics and the stock of overall debt by economy when we’re discussing neutral rates?

Ali Jaffery: Absolutely. I’ll start with the first one. I think clearly the neutral rate is going to be higher in the US. It’s a question of how much. And, you know, obviously certain members of the FOMC also believe that based on the dots. And that’s a question we’re still thinking about, but it’s related to the second point about the role of debt dynamics. And I think if you think the structure of debt or the term structure of debt matters a lot, which I’m really moving toward that position, then neutral could be materially higher. And we see this, the impact of how rates are impacting the economy now, I think, which is the best barometer that people are not responding to higher interest rates because they’re not affected by it. The mortgage structure has basically insulated them to a large extent. Obviously there might be some substitution happening and that’s an impact, but more generally people are not exposed to higher rates largely because they’re not adjusting their mortgages. They’re on 15 to 30 year mortgages. Now the way neutral is typically thought about is not in that lens. Neutral is thought about this global saving and global investment paradigm which is of a wide range of factors. Debt is one of them, certainly, but there’s the demand for safe assets, the investment intentions, long-term role of investment. It’s a whole variety of global factors that play into that assessment of where neutral is. I think that certainly that the role of debt, particularly debt within the domestic economy, needs to be front and center of the discussion on the restrictiveness of monetary policy. Now, economists will say, there’s different ways we can think about this. We can think about kind of a long run neutral concept, or some will call it the natural rate and then more of a short term neutral concept. And yeah, I can appreciate that those global factors will dominate in the long run, but for monetary policy, I think it’s that short run policy rate that how we judge how restrictive monetary policy is really what matters. And for that benchmark, debt dynamics certainly have to be taken into account, that assessment. And I think practically speaking, they do. When central bankers sit down, they observe the data and see where the stress is in the real economy and how that stress is affecting price pressures. And that’s divorced from the neutral rate concept. So I’m really walking away thinking that neutral is a bit misleading in terms of as a guide for medium-term monetary policies, certainly for the long term it’s a kind of a rough gauge of where you might want to be, but you adjust your speed not based on neutral but based on what you see around you and I think debt is really front and center there.

Bipan Rai: Okay, so you know for discussing the Fed view and you obviously you brought it up earlier we’ve got the Fed beginning its easing cycle in earnest at the July of FOMC and then electing to cut at each meeting thereafter bringing the total amount of cuts this year to four which equates of course to 100 basis points of easing. If I were to ask you to sort of say what the risks to that view are, are they towards additional cuts or fewer cuts for this year when it comes to the Fed? And as a second part to this question, do you think the risks are skewed towards earlier cuts from July or are they going to be pushed back most likely in your view?

Ali Jaffery: I think the risks are skewed to fewer cuts and later cuts. Clearly, the Fed is going to want to see inflation dynamics improve. If we continue to see core PC prints at 0.3 month over month, that’s going to discourage them. And they’re going to assess that we need restrictive policy at levels where they are now for longer. And they have the time. You know, they’re, as Chris Waller said, they’re in no rush. So while they’re maintaining this restrictive policy, the labor market is rebalancing, but not cracking. We saw in the payroll report, they’re running at a fairly aggressive clip, you know, 265,000 in the last three months. I know the household survey is showing a bit more weakness, but that’s more volatile and the population estimates from January also distort that picture, but overall, the labor market is not cracking. Clearly, we’ve talked about activity is fairly strong. So all of the signs are favorable to maintaining restrictive policy for longer, right? And also, let’s take a step back here and assess the Fed is not trying to stimulate the economy. Its goal is to just have a soft landing. And that means dialing back the level of restrictiveness gradually. So, they clearly have time to do that more slowly now.

Bipan Rai: Absolutely, and I would agree, Ali, that the risks for the Federal Reserve this year are for potentially later cuts and fewer cuts. And, you know, those among you that are listening that are dollar buyers should potentially look at that and look at potentially becoming a little more active a little bit sooner, if that is the case, then. Just to have something on hand when and if we get stronger US data that potentially could push the Fed to deviate a little bit from what markets are expecting and from what we’re expecting as well. Now, for those of you that are listening, Ali, of course, has roots to the Antis to the Philadelphia area and is a huge Philadelphia sports fan. Congratulations on getting Saquon Barkley. You’re still not going to win the Super Bowl next year. But I got to ask you, man, what do you feel about the Sixers for the playoffs this year in the NBA?

Ali Jaffery: You know, I think that first of all, I should say that my good old instance to you for your Giants, you know, we’ll take care of Saquon. Don’t worry about it. But my, my Sixers, I think if Joel comes back, you know, I think we have a shot at a good run. Very happy with Toronto import of Nick Nurse. I think he’s doing a great job there. Tyrese Maxey is a stud. Buddy Hill edition is great. You know, it’s just about giving enough time for Joel to come back and gel with the team. And I think the East is wide open and I think our best decision was the export of Dock Rivers to the Bucs because it takes the Bucs out. So really our only threat is the Celtics. So let’s hope for a good playoff run.

Bipan Rai: All right, you heard it from Ali Jaffrey himself. And don’t worry about it, Ali, you’re still not going to win the NBA title this year either. Thank you again for joining us on another edition of FX Factor. We’ll see you soon.

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