Surveillance: Fed Day with Lacker

by a gentleman from the Richmond Fed. Jeffrey Lacker, came out at University Wisconsin, Madison and had to step into maybe the biggest shoes and biggest cultural moment in Fed America, and that was all of the heritage and the conservative ethos of the Richmond Fed. Dr Lacker joins us this morning, the former Richmond FED president, Jeff Just a perfect time

to speak to you as well. If I walked down my hallway at home and I threw half my books out, Jeff, because I'm blind, like years ago, I kept all the textbooks. There's man Que, there's Abel Bernanke, there's CARLN. Saski's there's all these great books, including what you studied in one on one at Wisconsin. Is any of this Fed moment, this theory, this framework, is any of this fed process

in the textbooks. I think so. I think that the empirical record of the Federal Reserve over the last a hundred years or more that they've been around shows repeated instances of them pivoting from a concern about promoting demand and growth to a concern about trying to fight inflation. UM. Their record is UM not that great. I think less than half of the time have they done it without successfully, that is, reduced inflation without successfully without pushing the UM

economy into a recession by overdoing it. It's hard to do because the lags involved. And they've set out a course for themselves this year, and they've they've got a tough job this year for sure. Are they going to move forward and do you have confidence they can move forward and recalibrate and adjust with stability or do you suggest there is instability risk. I think they're threading a needle UM. I think they have to tighten UM rapidly

enough to ease demand and ease inflation. UM cooler and inflation. But I think that they UM are going to be mindful of not going too fast and pushing the economy into the recession. I think they're all going to be mindful of Psalms rule. This is this impure, amazingly consistent vehicle regularity that the unemployment rate never rises more than five tenths of a percentage point without rising two or three percentage points. So you know, without the economy to

begin to inflate into a recession. So they're gonna be They're going to be on egg shells this year. Jeff, what would it take to slow things down? I just want to understand that from your perspective, because clearly that number is shifted in the last ten years and shifted quite a lot. And clearly it's different with inflation at

seven percent compared to say inflation down it. So what do you think it would take, um, So they have to get the real rate positive, perhaps to one or two percent, and if they got inflation down to two percent, that would take obviously three or four percent nominal rate on the Fed Funds rate. Don't have to get there overnight, can get there in a year or two, but to

lay out the expectations so that markets understand it. That's about where the Fed Funds rate is likely to be at the end of three I think that's what it's going to take that's well north of where the dolt pot is. As you know, I wonder, Jeff, how you would think that the bannet sheet reduction would play into that as well as that's something that complements that effort,

something that replaces it, What would it mean? And so I've been in the camp for a while of thinking that the balance sheet is kind of small beer relative to funds rates um increases. So I don't think the balance I think they ought to roll off the balance sheet, and they ought to get about it rapidly and soon. But I don't think that that's the major determined the stance of montery right policy right now sort of a

marginal pact um. So, um, yeah, I think they need to, um, you know, focus on the funds rate and getting that going. Do you think, Jeff, that FED chair j Powell has been a good communicator through all this, you know, yeah, given the handy has been dealt in terms of what

to communicate by the committee. Yeah, But I think, um, there's got to be a lot of my former colleagues, um on the FED I feel bad for who are looking back at the last year and feeling as if the FED didn't play its hand very well that Jeff no no, I apologize for how to off, but can you elaborate on which aspects, which moves they made that you think in retrospect were big mistakes and sort of

site two or three things. First, they they hamstrung themselves by placing them under this tactical constraint of UM, giving the market a huge amount of notice before they started tapering. So Powell said, you know, we're not even talking about talking about tapering. Well, that means you got to talk

about it, and then so on. I think that delayed their reaction, and they felt compelled to go through this steady march of releasing discussions in the minutes before they started tapering, and they put on their themselves the constraint that they were going to raise rates until they stopped UM, that they stopped purchases. So I think that set them back materially. And I think you can see, like around August and September they realized they needed to start raising rates.

They could have done it in October November, but they were on this sort of tapering thing. The second, because continue, Jeff, continue, sure. The second Well, the second thing is the way they think about maximum employment. I mean they think of it the way as three point five percent unemployment and labor force participation rate backup to trend. And I think that caused them to misinterpret inflation in the first half of last year. I think they assumed, well, we must there's

a lot of slack in the economy. It can't be um, you know, a persistent inflation search And they were wrong because maximum employment last year was about where it was about where actual employment was. We got to maximum employment MAXI employment various over time. It depends on all sorts of develop continue economy. I don't think they take it on board. Jeff, this is a delicate question because we speak to all these people with immense, immense respect. But

I'm suggested Laquers never heard me say this. Krugman and lacquer are on the same page that we've got to go back to a much more traditional economics. And Jeff, for you, that's Wisconsin nine economics, which is one of the leading departments in the world at the time. Is the is the regret of the Fed looking at John Williams Richard Claire that one of the founders of ds GE that the Feds getting to Mathey and they've got

to get more conceptual about the real economy. So this idea about maximum employment varying over the cycle, I mean, that's been around a while. There's been some new empirical work on it by Robert Hall and Marianna Goodly Act, But I don't think of that as as a new idea. What I think they ought to go back to is before the last framework revision. I think the last framework

was a mistake. It essentially took preemptive rate increases off the table, and I think, in hindsight last year would have been the ideal time UH to engage in that in the second half of the year, nudge, nudge the rate up a bit, just to hedge your bets about whether inflations persistent in transitory rather than putting all your eggs in the transitory basket. But I think that the framework that took preemptive rises a rate increases off the table,

I think that was a big mistake. So Jeff, just finally, is this a failure of expost monetary policy? After all that effort to shift in that direction, you're saying gets failed and we should go back to what we used to do. I don't think that the new framework was

a constructive step forward. I think that people took for granted the price stability we had from on, and I don't think they appreciated the extent to which, you know, small preemptive moves were really going to established the credibility of the fact. Jeff, this is this is fiery language. Can they catch up and be preemptive at two pm this afternoon? I think, Um, I think they can. And it's going to play out over a couple of meetings,

but I think, um, you know they're there. At the next meeting, they'll release Summari economic projections that will have dot a new dot uh, and that's an opportunity for them to spell out that, you know, they anticipate a more aggressive UM path. I think they could be more realistic in that in that some reveection on the actions about their inflation forecast. I don't think two point six

percent is at all plausible at this point. I think inflation is likely to be four percent or north of that is that calendar year, UM, and I think they can spell out the extent to which they're gonna how they're gonna respond incoming data. Are they gonna discount blips one way or another. Are they gonna get on top of um inflation and and move the great path up if inflation comes in stronger than expected the first half of the year. Jeffrey Laca, formerly of the Richmond Fed,

Jeff fantastic to catch up with you, Bob Michael. He is chief investment Officer and ahead of Global Fixed Income, Currency and Commodities of JP Morgan John. That means he's senior vice president Headaches and Estimates for all of JP Morgan John. Why don't you kick it off? I think that makes he's busier than you and I. We're going to talk about a football lights above, So let's start with this one. Why do you want to sit in cash in this market with this backdrop? Well, I think

there are a number of things going on. First, let me say I think the Fed has played this month perfectly and given all the chaos, that may seem to be a conundrum to a lot of people, but think about it. Uh, they got last year wrong. Inflation got away from them. They walked in this year, they admitted they got it wrong, went out there all the f O m C members talked about all their tools were in play, then went into their quiet period and let

us in the market hash it out. So they come into the day's meeting knowing what the median expectations are March liftoff for rate hikes, q E n's in Mar and some conversation about q T at the end of the year. They didn't have that information two weeks ago, so they are now playing it, I think very smartly. My concern is those things won't be enough the inflation genius out of the bottle. They're going to try to thread the needle and go with the market consensus. I

think we heard them from Waller. They don't want to surprise the markets. They got enough for this meeting, but we think down the road they're going to have to accelerate a number of things, including rate hikes. We think they're going to have to go to every meeting twenty five basis points and QT. We hope that's the Jackson whole conversation that may be pulled forward, and then you

have to watch the caps. Let's get into it before we get to the caps on banant reduction, it's really really important, really nuance, we need to spend some time

on that. You're looking at potentially at a hike at every single meeting balance sheet reduction that could come earlier, maybe totally in one point five trilli and through the end it's twenty And you think that's what it's going to take to get inflation down, Bob, What does the market look like if they deliver everything you just said, John, You have to understand, central banks broke a thirty year

promise to us. They told us the one mistake they would never make is to let inflation get away from them, and it has in every part of the world, in every economy. And now you listen to the Fed at the start of this month, they're back on their heels and they've got to fight ahead of them because inflation is getting entrenched. It's in the price of shelter, it's it's an employment They've got a couple of tough months

ahead to look at inflation data. So we think that the inflation battle is much bigger than either they're estimating or admitting. So yes, they should bring forward those fights, John. If they do for rate hikes this year, a year from now, we're looking at a one percent FED funds rate deflate that by the inflation that's going on today, that's minus six a lot of people actually buy into the transitory idea at least that this will be a

passing surgeon inflation. That's actually the market expectation if you look at FED funds futures, if you look at some of those forward indicators in terms of break even rates, what's the market getting wrong? What data points should traders be looking at to confirm the view that you put out there. They've been brainwashed by the last twenty years that inflation never goes higher than two two and a

half percent. So I agree, it's all transitory. Things will slow down, Inflation will come down, But where will the economy slow down to? Still above trent? You've already closed the output gap, so you've got that inflationary pressure working as well. We're inflation. Will inflation slowed down to two and a half percent? I don't think so. I think

over three percent. And by the way, the oil shocks in the seventies those proved to be transitory too, but it took an awful lot of central bank ammunition to contain them. Can they stay on a measured dialogue, a measured cadence, a measured set of speeches, or do they say as you just stated, Bob we're gonna move up for rate hikes, but along the way, we're going to monitor and adjust and change if we have to. Why

can't they say that? Well, I think they will, but I think today's meeting would be a lost opportunity if they just did that, because the next couple of months of inflation data are going to put them back on their heels again before it starts to slow down. So I'll give you that. So why not do something? Why not at least come in today and say, you know what, we've put out the schedule of large scale asset purchases to five fifteen, that's the last one, and then that

a month early. That's kind of halfway priced into the market. Go with the four rate hikes, but leave the option anality there um to to go to every meeting. Fifth, I've heard a lot of discussion about fifty basis points at a conversation with client yesterday. UM, and I think fifty basis points is pretty destructive. That reminds me of the end of the tightening regime. But can we just finished on the technical stuff because you did mention it

and I promised you some time on it. The banas sheet reduction that a lot of people expect now it's about one point five trillion from the middle of this year to the back end of twenty three. As you know on the Banish at the moment there's a ton of tea bills. But you mentioned the word caps. How do you think they managed the roll off well? When they were doing quantitative tightening previously they had caps at

at fifty billion per month. We think that's a good starting point, but ultimately they should go to a billion in caps because the balance sheet is is a lot bigger and they actually don't belong in meddling in the markets to the extent that they have. They don't belong owning as much of the mortgage market and the treasury market as they have. That should be left to free market participants like myself to price, not to the Fed. Not in a recovery. But Michael, conviction trade right now?

What is it? So my conviction? There's there's been a lot of repricing in the market, um, but I'm still a seller of rallies. Can I also just ask I heard that Bill Dudley is going to be on later. I think the question you have to ask him is he brought financial conditions in disease to the FED, which is really a private markets concept. Of course us in the markets love them, but is that really something that

belongs at the Fed? Is that how they missed inflation because they were too concerned about people like me throwing our toys out of the baby carriage? And a question for Tom, Tom, I know you around when vulcar raised rates from five to can you imagine I was there? Also? Can you imagine if if he looked at financial conditions indicators? What do you think he would have said and done?

I think this really important question. This goes back to the landmark work of Michael Rosenberg, a Bloomberg folks who put together it's wonderful indusseries. I agree with you, Bob, it's been. It's been a new certitude with these indusseries that doesn't work in crisis or pivot points. And I love Bill Dudley, I've known him for years. Brilliant. She slipped that one in. That's goods. She's running the interview too, now, Bob, do you want a final comment? And you're beloved Liverpool

as well. They're coming, They're coming on strong and I'd be proud for them to have the David Ortie's number fly during their next match. Okay, Bob Michael, thank you sir, it's going to catch up my as a ways, JP Morgan Asset Management's Bob Michael, I'm fixing, come now quickly. Maryland Watson joins ahead of Global Fundamental Fixing Come strategy at black Rock. What would your own power due to

your bonds space this afternoon? Well, I think that he's going to try to convey a very very measured approach um as you as you just noticed, I mean, the market has been extremely volatile over the past few days. I think it maybe got a bit of ahead of itself in terms of what some market commentators are expecting

in terms of great rises and quantat to tightening. But I think they're going to basically try to outline a very measured path in terms of first of all ending QUEWI, which should be in March, and then potentially we could see also a lift off in March. There is some speculation around whether they might start to signal when quantitative

tightening might start to happen. I think that's maybe a little bit premature for today, but I think certainly as well they're going to acknowledge that you know, the employment levels are maybe consistent with maximum employment in the economy, Inflation remain is very high, so there is a need to continue to withdraw this very very loose munty policy, to withdraw the stimulus and start to move towards normalization. What does black Rock as a general statement doing with duration,

I mean, is it is it a micro analysis? Are you looking at first second derivative analysis of duration? What are you doing on the X axis? Yes, so in terms of duration, obviously we are starting to go a bit closer to home in terms of um the interest rate sensitivity around our portfolios. So for example, where we had been short or underweight in the treasury, for example,

we are now a little bit closer to neutral. I think at this stage, given the uncertainty in the market, given the uncertainty around the path of growth, that we do expect growth to remain you know, robust and strong, but there are increasing headwinds at the moment. There is, as you mentioned, more certainty around issues with Ukraine. There are more uncertainty has just given the slowdowns in various areas,

given on chron and different aspects. So I do think that in terms of duration we are a little bit closer to home and we are keeping it relatively like right right, John, and important research this morning always out of Hong Kong with Mr Major. I thought it was a real clarification of that camp, like Steve Englander as well. Let's look at the major note right now. It's real simple. The conventional wisdom is that changing patterns of Central bank

bond by means yields will go up. We beg to differ. Can't get clearer than that, John, The complex interactions, et cetera. The q T teaser is not solved by just looking at one side. Let's get into the q T t so a little bit more Man. I spoke to Bob Bob Miller of black Rock, a good friend of colleague if yours and Rick Rada recently, and they've talked about

the importance of that balant sheep reduction. Deutsche Bank coming out with huge numbers one trillion for twenty three five and sixty billion for the back end of this year, does that necessarily mean high yields? That's what Steve Majores getting into for HSBC is the translation. That's simple. No,

it doesn't necessarily mean particularly higher yields. I think as you do start to see the you know, the balance production, whether it begins um, you know, in the second half of this year or you know, and progresses into three or beyond UM. I think Steven Major is right and that you do see it's more complex than that, because on the one hand, you do have obviously the market is already pricing um, you know, maybe overpricing the level of interest rates that this year it's pricing in four

hikes that might be a little bit excessive. I think also when you get into q T as well, then that we might actually start to see that we've seen the back end. Actually it's almost inverted if you look at the twenties and thirties a part of the curve as well. So I don't think it necessarily means HIW you or they do think it's a lot more nuance.

I completely agree. And taking a look at that nuances the yield curve and how much do you think that the market is overpriced or underpriced projections for longer term growth at this point, Yes, the projections for longer term growth. I mean we do have and continue to have a pretty positive view on growth going forward and notwithstanding that,

you know, the headwinds and stunty that we see. So I think at the momentum projections around growth they have been revised down by their meth and various different organizations, but we actually think that they are you know, it does remain on a picture of bus path, and so we think it's pretty fair in terms of what either the the you know, the dots are projecting or you know, what the market projecting as well. We think that the growth will remain picture of us and what's in there

of black Rock. Marilyn as always, thank you very much right now helping us. Bruce Chasman, chief Economists, had a global economic research at JP Morgan. Bruce, I want to go back to the foundational mandate here, which is economic growth and the ability to create jobs. You mentioned in your note a hiccup of activity. How hiccup E is the hiccup right now? Um, we think it's pretty sharp

as you move into the new year. We're looking for the U s economy to post a seven percent gain in Q four and and something the low close to one percent in the first quarter of the year. So that's a pretty dramatic downward move. I think you're gonna see a big drop in consumption in December when we get the report later this week, and I think January

is going to be a pretty weak month. The hope, though, of course, is that O Macron hits hard, it hits fast, but it also leaves fast, and that we're moving out towards the end of the quarter. We're starting to see this reverse get get Earth momentum ab if we go from seven to one or whatever the number is for always pretty good at this to three digits. But Bruce, if we execute that deceleration, how does a central bank react other than to say we need to wait for

the next round of data. Well, I think generally the FED has made the decision that it's pretty far behind the curve. I think it's also made the decision that it's looking at the economy very much the way I just described, which is gonna get it's going to get hit by something pretty sharp, but it's going to also be pretty short lived. We think by the time you get to the March meeting, the FED will be able to see signs that that slowdown is starting to turn around.

And that's I think can abort. Reason why is we go to this meeting. We don't think the FED is going to lose its optionality about what it does in March. It's gonna tell us it's scheduled to start hiking in March, but it's gonna not give us a sense of how fast that basis at this point in time. Bruce, you said something in your research that really stuck out to me that there is a risk you think it's about one and four that the FED completely stops buying bonds,

buying any assets by February. I assume this to me, not even reinvesting, allowing the balance sheet to really shrink much more quickly. What does that look like in terms of economic ramifications and the reasoning behind it. Well, I think there's a risk that they stop, that they move the tapering forward one month and they end the purchases. I don't think that they're gonna uh start winding down the balance sheet as we move into March. And I think the the issue here is how strong the signal

do they want to send. They know they're behind the curve, do they really need to keep going here? I say it's one in four in the sense that they haven't guided us towards that and actually doing that would be a stronger signal that they're going to get more aggressive here. And as I said, I think at this point they still want to keep their optionality, recognizing that they're gonna

start raising rates in March, and that's still two months away. Bruce, how do you view the balance sheet in terms of a policy tool? I mean some people are trying to game out how many rate hikes. It's equivalent to what's your view on how the Fed is using this? Well? I think how the Fed is going to use it is easy. How it's going to impact financial conditions is complicated. I think the Fed is gonna say we need to

get going. We need to get going faster, both because we want to adjust financial conditions and also because the balance sheet has been so bloated. Uh we. As I said, I think we're gonna put it on a pace that the caps are going to be set um at at when it gets to the peak at a hundred billion or so a month. But and I think the important thing here is that's gonna put it on an automatic pilot, which is to say they are gonna let the balance

sheet run off. They're gonna watch how both the balance sheet and rate moves affect financial conditions, but it's going to be the rate movements that are gonna adjust if they're surprised that they either get too little or too much response in terms of what um we're seeing in terms of financial conditions and and their their goals on

hitting inflation and and growth. Bruce your shop and I'm gonna go back eight years, if not ten years, led by Michael Faroli, lead with an analysis of what the terminal rate of various economic indicators were, which was just stunning in folks. To cut to the chase, the vision of a potential g d P in the vicinity of two percent or even lower. Recalibrate right now the correct terminal inflation rate? Is it above four percent? Which is frightening?

Is it? And an Adam post in three sent where you suggest we need a new level of inflation or do we go back to something on the edge of Feroli, Well, I guess there's two issues here, terminal inflation and where the Fed needs to go on rates to to make sure we we kind of stay it in that zone. I would start with the idea that the FEDS tolerance level for inflation is probably in the two to three

percent range. And I think what they're gonna do is set policy uh to kind of be comfortable that inflation stays above two. But if they feel like it's moving above three on a sustained basis going forward, then they're gonna get more aggressive. What is the FED going to need to do? I think their view of neutral right now is two and a half. Um. I think it's gonna be hard to contain inflation just getting to two

and a half. And I think, actually, even though I think the supply side of the economy looks weak right now, I think the ability to generate credit is much stronger than it was earlier. I think we're gonna see you're in and feel a need to have higher interest rates to get the same amount of restraint. And I we think our perceptions of our star over time, you're actually

gonna gonna tilt up. So I would I would suggest the Fed ultimately is going to have to get well above what it currently perceives as neutral at two and a half before this cycle is over. Are they measured? Are they a green span measure shop? As your own apologist ripping and page out of green Span one on one, Um, Well, I think we're not going to get that message today. Certainly, green Span and both yell And at the starts of the previous cycles in fifteen and oh four said they're

going to move in a measured gradual way. I don't think the FED is going to guarantee that at all, and I think there's a very reasonable chance that, um, we start to feel like green Span ninety four in terms of the way the FED begins to adjust here if we can't get inflation down and the economy is as we're expecting, rebounding pretty strongly into the middle part

of the year. Bruce, based on a recent experience with the sell off that we've seen the correction in US equities, how high do you think tenure yields now can get before something breaks Well, I, first of all, I would just emphasize the equity market correction if it continued, could

be a problem. But there's a very big difference when equity markets are correcting because people are repricing the FED, and equity markets are correcting because we have an overhanging housing or we have an economy that has got problems otherwise. So I do think you can see equity markets correct without it doing undue damage or even really driving the FED to change it's um its path. Um our view is the tenure yiels are going to end the year

two and a quarter. You know, one of the issues on the balance sheet is the balance sheet will clearly put duration in the market and put upward pressure on on rates, but it's also gonna change people's perceptions of how fast and how far the Fed's going to go. And I think there's an attention here which is not at all clear. I'm comfortable with our forecast we get above two percent, but we don't see a real spiking

and tenure yields as we go through the year. Bruce, wonderful as always, Bruce Cassman, that of ja Q Morgan. Thank you said. This is the Bloomberg Surveillance Podcast. Thanks for listening. Join us live weekdays from seven to ten am Eastern on Bloomberg Radio and on Bloomberg Television each day from six to nine am for insight from the best in economics, finance, investment, and international relations. And subscribe to the Surveillance podcast on Apple podcast, SoundCloud, Bloomberg dot com,

and of course on the terminal. I'm Tom Keene and this is Bloomberg,