Surveillance: Fed Game Plan with Dudley

He is a former New York Fed President, preceding John Williams. He writes for Bloomberg Opinion. We are honored by that, and most importantly, he has led an incredibly consistent and cogent debate of how we need to get used to higher interest rates, We need to get use to a more sustained inflation and do something about it. Bill, what do you make of the cacophony of the last and days?

Just as in an open question to a former art official, your your followers speaking, you're in the next hour, what do you make of the last ten days? Well, I would say it's really much ado about nothing, because at the end of the day, how the economy performs is going to determine how much the FEED does, and any disagreement between the market and the Feds we resolved by

the economic data. Uh. You know, what we saw on Friday is a good example that we had a very strong employment report, and the market is now repriced to basically mimic what the FET is written down in their December Summary of Economic projections. Market is now pricing in a twenty five basic point rate hike in March, in the twenty five basic point great hike and make that's what FEED officials have been promising. So we're pretty much in alignment. Now, what is the character of our disinflation?

The textbooks you studied at Berkeley would be something like, there's a sixties seventies Prevoker inflation, there is a Korean War sharp disinflation, which the Laurea Krugman wrote about just in the recent days, and then there's all discussion about the Biden stimulus, and almost back to Freedman and a monitorist dynamic. What does Dudley disinflation look like? Well, I think part of the problem is that debased and muddeled is because people have either put themselves in the transitory

camp or the non transitory camp. And the reality is we have some of both. In the transitory side, we had a lot of goods pressure inflation in the goods marketing sector of the of the economy because of the shifting composition of demand towards goods during the pandemic. That's all I'm winding now. But we still have quite a bit of pressure in services inflation. And that's one thing that policy highlighted. We need to get services inflation x

housing down. We're not gonna do that until we have more slack in the labor market, the layer markets basically the tightest layer market in memory, uh, and that that is not consistent with a tu percent inflation outturn. So the Fendries aerve needs to push the unemployer rate of generate more slack of the layer market get wage inflation down. Only once they have done that can they be confident and they're gonna get inflation back down to two percent

on a sustainable basis. What's the role of financial conditions on that process of disinflation. Well, the financial conditions are sort of the way that monetary paulic the impulse gets translated to the real economy. Right, So if the FED raises short term interest rates but nothing happens in terms of the bond market the stock market, it's not going to have much of a restraining impact. So it's really important that the rise in short term rates affects bond

prices and stock prices. That's how the FED gets grabs the real economy. We see that in the housing sector. It's it's the rise in long term interest rates, the rise and morang rates. That's really cool to off housing. That's how the FED gets gets attraction on monetary policy.

You know, I think Paul basically it's not that disturbed by the marginal easy in financial conditions to head or the last few months, because he knows that if the FED keeps going, financial conditions probably won't ease much further and the Fed words are, will actually be able to get control of things. Well, this isn't really important. Pill. Basically you're saying it doesn't really concern FED Chair J. Powell because he thinks that when they actually enact tighter

financial policy, the markets will adapt and adjust. Another word, stocks will fall and you won't get the same kind of rally that you saw in January. That's a different message than the markets taking away, which is that he doesn't care. Can you explain why you have conviction around the view that he just knows that eventually they're going to realize and they're going to see the light. I think part of the issue here is that there's a

lot of concerning about the economic album. So you know, Paul isn't really sure how much further he has to go, So he's not really sure if financial conditions are off where they're relative to where he needs them to be. What he does know, though, that is that he controls the policy rate, and so if he needs, if he needs to slowly coming down more, you can just raise policy rates higher, or you can keep them higher higher, longer, and that will tighten financial conditions and do the job.

So the fedcing control here, I mean, financial markets can think whatever they want. At the end of the day, the Fed Reserve is going to write the script based on where they take the Federal fundry build. There's a guy out in San Francisco a number of years ago who its stars in his eyes and develop our and then our ard and now we're talking about our start start. You watched the Ascent of John Williams and is great

respect within monetary economics. And now he sits in the chair you had in New York explain our start and its importance in this cacophony that we're living in right now. What we're trying to do is figure out what level of short term rates makes monterary policy restrictive. So to do that, you have to have some notion of what's neutral. You know that words, how high should not a federal fundrais be to have a neutral Montrey policy? And that's

where our start star comes in. Our star is an estimate of what the neutral interest rate is after adjusting for inflation. And our star came down in the in the last ten or fifteen years. It was running two percent prior to the Great Financial Crisis. Now it's around, you know, probably somewhere in this one percent range. But you have to have a no show where neutral is before we can think about what's tight. Right. Well, if that's the case, do we have a confidence in our

meeting demeaning monetary theory? Given the effective technology, the effective demographics, the effect of larger factors that Olivier Blanchard's writing about. Now, do we have a confidence the formulas work well? I think your pointing out the fact that there's a lot of uncertainty exactly what neutral where neutral is uh, And so the Fed Reserve is essentially trying to push Monterrey policy to us, saying that they're confident that they're at

in restrictive territory. They probably don't know how restrictive, but they're confidence that are there in restrictive territory. As long as that they're in restrictive territory, that will slow the economy and bring inflation down. Now, if it turns out that our star was much higher and a five percent fed nomenal Federal FUNDRAI wasn't enough to push Monterrey Paul into restrictive territory, the Connie Win Slow and the Federal

Reserve and ultimately have to do more. So the uncertainy about our star is translates to uncertainty about how tight does Monterrey policy have to be, how high does the federal fundraiate have to go, and how long does the Federal Reserve have to keep it there. That details perfectly into Friday's labor market report. That really shifted the narrative

for at least the bottom. But but but this really raises a question of whether it was material enough to shift your view of how high our star has to be, how high the terminal rate needs to go. Well. I think at this point the FEDS game plan is to go to what they think is restrictive and then keep

it there as long as it takes. I think, you know, if they are faced was stronger data, I think it's more likely that they extend the timing of how long monetary policy is restrictive as opposed to keep raising the rate higher and higher. Now, obviously, if the commy stays really strong, then they're gonna revise up their forecast of

what interest rate peak is necessary to slowly commy. I don't think we're there yet, but do you think that five five quarters still where they're headed, and then they're going to hang out there for a while. If the econmy stays strong after you get to five to five and a quarter, then you could see them move even further. Remember we used to talk about the improbability of a soft landing, the improbability of getting this to land in some sort of nice way, and now that's the base case.

Do you push back or do you think that it looks more and more likely that we could get some sort of immaculate disinflation or a soft landing. I think it's still unlikely. I mean, I think that it's true that we're not going to go into recession anytime soon. The economy just says too much for momentum. If you look at the Lanta Fed now a GDP now forecast, they revised it up by over a percentage point just in the last week, so they're looking for two point

one percent growth first quarter. Before it was less than one percent just on the back of last week's data, So I think the commy has quite a bit momentum. I do think the recession is likely in the medium term because the Fed has to push up an employer rate by a meaningful amount to generate that slap in the layer market. And every time the Fans pushed the unemployer rate up by more than half a percentage point, we've always ended up in recession. I just don't see

that this time is gonna be any different. Do you think that we, when we look back from historical perspective, can write the book on zero rate policies as having ended without any sort of financial accident that was material. Well, I think all the things that we did during to fix the financial system fund the Great Financial Crisis have helped a lot. I mean, the banking systems in much better shape, much more capital, much more liquidity, stress test mismanagement.

So I think the financial system system is stronger now. And that's why the Fender Reserves in some way in control of the process. Once the FED that cheese is objective, they can cut rates. And so if the e commy turns out to be weaker than the FED wants at some point, you know, six months, twelve months down the road, the Federal Reserve can cure that pretty quickly because they're gonna be a you know, they're gonna be five in terms of rates. There canna be plenty of room for

the Fed to stimulate the economy. That's why Paul, you know, said that, you know the risk of staying too tight too long is less than the risk of not doing enough, because the FAN has the ability to support the time comes hugely valuable. Dr Dudley, thank you so much. Quem Dudley, the former president of the New York Fed. Next guest home, was looking at three hundred thousand, and that was like the app he was like, and then we go five

seven set that Outliers. Andrew Hollenhorst, his chief US economists at City Group. He's really provided intellectual leadership over the last year. We had a wonderful conversation a number of weeks ago here on the terminal rate on where this fed will go. Andrew, John and Lisa want to dive into that. But what I'd like to talk to you about in the days you see, l A, you had the great joy of all the heritage U c l A of Axcel Leonovot, who is one of the bravest

economists I've ever read. He was way out front in the sixties and seventies. Some people have said he was the marine coming out of the trenches on inflation for Volker Axel Lanovo would look at the M two right now and he would just simply say, what do we have going on? What do we have with the money supply coming down? You were weaned on this at u c l A. Should we pay attention to Leonovid's M two?

Thanks very much, Tom, And you're right. I mean U c l A was a great place to go to school, and I think the message was to always take the theory seriously, but then confront the theory with reality. And I think that's what Axel would ask us to do today. UM. In terms of M two, You're right, it's coming down,

but it's coming down after being up very substantially. And I think that's what is difficult in annual analyzing this economy, that we had such big movements during the pandemic period, big increases in savings built up UM, and we're trying to figure out now as those things are moving in the opposite direction. Savings, for instance, are coming down, how much of a tailwind that's going to be for demand

and for spending and for price pressure. And going back to that Job's report, it looks like we may have more of a tail wind than we might have thought. What is your disinflation confidence look like we've got this February fourteens at report. Do you have confidence to five to four to three or Kenya? Was John mentioned in your note get somewhere in the vicinity of Chairman Paul's two percent. I think we're still the ways away from

two percent. And we have some good news on inflation, which is that goods inflation has cooled, But that's really what we're seeing in these monthly inflation prints and share Powell was trying to emphasize that, and let me just re emphasize that that a big part of what we've seen is used car prices that are coming down. Goods inflation in general that is slowed. So that's good news

on the inflation front. But if you look at those non shelter services, you look at services away from housing, those are still inflating at a rate of about four percent annualized. So it does look like maybe some of the biggest, most aggressive inflation on the good side has come off, but we still have the services inflation, and that's what's gonna be sensitive to the labor market. That's what's gonna be sensitive to a number like five thousand

plus jobs. So then why er do you think that Chair Powell isn't more aggressive, isn't taken the same kind of wyoming tone with respect to his press conference on Wednesday, With respect to that interview yesterday, I was a little bit surprised, to be honest. I think that David Rubinstein kind of set him up to make some change, make some differences from what he said last week before the

job's number versus after the job's number. I think you could tell from the body language and from reading between the lines of it that that there there is a change. Probably it's uncomfortable for a FED official to make too much out of any one monthly number, but it's not just the one monthly number. Lease If you look at the pace of job growth prior to the January reading, we're running at something close to three hundred thousand jobs

per months. So I don't think we're going to continue to print five hundred thousand jobs a month, but even three thousand would be enough to keep that unemployment rate moving down. It's already at a fifty year low. I'll go back to those days at u c l A. If you do the base macroeconomics, it's a very very tight labor market. It's hard to think that that wouldn't create wage pressure, but we are seeing wage pressure actually declined,

So what do you make of that? So that's been one of the most interesting things in the data that we have, this this really tight labor market, it's actually tightening further. And then you're right across a range of measures, we saw some softening in wages, but remember it kind of goes back to what we were talking about earlier.

This is a softening from historically rapid wage increases. We were reopening the economy all at once, every restaurant was trying to hire workers at the same time bring these workers back into the labor force. That of course is going to create a surge of wage pressure. So maybe we've come off of that surge of wage pressure against a bit and we'd come down from you know, call it five percent wage inflation to four percent wage inflation.

But with a really tight labor market, I wouldn't expect that to slow further, and if anything, the risk is that it accelerates. And after the March meeting May three June fourteen July, the school starts against Septe number twenty. Which of those meetings is the real crucible for this FED where they've really got to decide if their demand structured Phillips curve driven or not. So I think you

have a few signposts along the way. The March meeting is going to be really important because that's where Chaire Powell isn't going to be able to do what he did in the interview yesterday and kind of say, well, let's let the data take US where it does, the f O m C will have to come out and Fed officials broably will have to come out with their projections for the economy, inflation, and importantly for that terminal

policy rate. Right now they have a five to five when you looking at that jobs report, maybe if anything, it should be revised up. So we'll see where the core inflation data comes in. We think it will be a little bit stronger. UM. Where does that median dot go at the March meeting will be really important. It looks like a basis point rate hike is quite likely in March. The question is going to become May. In June, they've talked about ongoing rate hikes, probably another hike in May.

We think are gonna be hiking again in June. But this is when it might get a little bit more difficult because they're gonna have to actually navigate between a labor market that, if financial conditions tighten further, should be slowing UM an inflation that is still too high. So how are they going to navigate that tension and the reaction function. They haven't really had to do that yet. Andrew, I love reading your notes every time they come out.

I'm excited to read them, especially when everybody was convinced that we're going to go back down to two percent inflation by the end of the year and the fiend is going to be cutting rates by fifty basis points. There was frustration in your voice that I sensed of, Hey, guys, the data hasn't changed. It hasn't so often they're still

going to have to hike that much more. What has the response been, like two clients, the mood swings among investors that pushed back as this sort of a view in the market has shifted from rapid disinflation to well,

maybe not. It's interesting listen because we have this kind of stability that we're talking about from share Powell trying not to try and change too rapidly as the data come in um in any of the market, which of course is going to change very rapidly, to try to figure out where that next data print is coming in. And we had a series of three cooler core inflation prints,

we had softer wage data. So I think it makes sense that the market got a little bit more excited about these outcomes where inflation just comes down of its own accord. And I think our job here as economists is to look at all of the data and really figure out what's most likely in terms of an outcome.

And despite the slower price inflation, despite the softer wage inflation, looking through to the tight labor market, looking through to services inflation, we just weren't convinced that really anything that's slowed down in terms of an underlying pace. And well, you know, you see how it just takes one data print and all of a sudden the market is well along those same lines. Makes you wonder what happened to Jackson? Hope?

Pal doesn't it? What happened to Jackson? Hope? The data caught up with these guys are data is changed changing? Sign Andrew, Thank you? Andrew homean host that of City Joy. She is chief investment Officer Morgan Stanley Wealth Management, Lisa Shellett here knowing that things have changed. There is a yield and that means cash has Vailue. Lisa, we're talking before the show about your outside of perspectus, where you've got maybe ten percent cash whatever that movable feast is

to portfolio to portfolio. But the Morgan Stanley audience wants to hold more cash than that. Why well, look I think that there's a huge amount of uncertainty out there. I think you know that we've been cautioning against the fact that we think that this is yet another bear market rally. Uh, that if we were going to really materialize the soft landing, we would not be seeing negative earnings and year over year compares and not negative earnings

guidance and negative earnings revisions. Uh. So you know, I'm hardened that maybe our clients are are taking our cautionary view to heart. Uh, they're also embracing for the first time and you know literally uh you know, six seven eight years a livable uh fixed income yield meaning net of the expected inflation by the end of the year, which may be sub four percent, gives them a positive really yield um and they don't need to take any

duration risks. So you know, we've got folks piling into things like certificates of deposit, like money market funds, which you know, I know in many eras were not considered sexy products but are satisfactory for a lot of investors right now, Lisa, do you think that's wise to take on a product that maybe you have to think about where to deploy capital in a year or two where

yields just done at this level. Lisa, how do you how do you advocate for taking maybe a little bit more risk, maybe taking on a little bit more duration, but looking in these interest rates for a whole lot longer. Yeah. So look, I mean I think that there's an argument there. Uh. The problem is right now we've got an inverted yield curve, and so you're not really getting paid any extra yield for taking on some of that duration risk. Uh. And so what we've said to folks is, look, let's be

patient this year. Ultimately, if we get this this mythical soft landing that everyone seems to be betting on, Uh, then that yield curve is going to invert. I mean, it's going to re steep, and I should say I'm sorry, Uh, And that means you're longer. The longer unto the curve is going to give you some higher yields. And so let's stay ultrashort duration right now. Let's see how the year plays out and see if there's opportunities to kind of roll up and lock in for longer um some

of those higher yields. One of the biggest inconsistencies right now in markets And I ask this because a lot of people have been saying that bond markets are hearing what FED shared. J. Powell is saying the actual words, whereas stock markets are just hearing that he said disinflation a couple of times. Yeah, I couldn't agree more. You know, to us, the US equity market is fighting the FED big time. Um, there are some major disconnects and how

the equity market is positioning itself. We we saw, you know, a huge short covering rally. We we saw uh, you know, a low quality dimension to the rally, and now most recently, we've seen cyclicals out performing more defensive stocks. What's precarious about that, uh, is that we have almost all the cyclical linked indicators, meaning recession linked indicators, like the Index of Leading Economic Indicators, which is really plummeted. Uh. And

yet uh, it's disconnected from this cyclical out performance. So you know, I've heard the theories that people say, yes, we understand what what should have been, but we're gonna look through it. Um. I don't know how far their crystal ball goes to look through it. But history is not kind to these kind of you know, massive disconnects. At least I just wanted to finish on something that's getting a ton of attention at the moment. So bear

with me as I work through the issue. There are these things called zero day to expiry options at the index level. It's getting a ton of attention. Join a manual of bt I G or rather of evercorn now wrote about it. I've got to get used to that list of ever court. He said this this morning. He said, you had a one point five to two percent bullbear bull sequence yesterday. Why because zero DTE options trading has become an important marginal price setter. He said, this least

around lovely response to it. Look at options volumes yesterday dominated by zero and one day to expiy spy options and higher rates. Of course, this unintended consequence as people have moved down of zero percent money market funds, deposited a places where they can get four percent interest and take ten percent of their capital and trade options virtually

for free every day. Ad response to that, Lisa, look, I do think that we're in a period of time where there are some of these speculative excesses going on. Uh and you know, you know Tom mentioned that we were chatting before going on air and you know right now, this issue of excess liquidity and markets of huge piles of cash still sitting on the sideline. Uh. It is there. And while Chair Powell did not want to address the realities of the fact that over the last four months

financial conditions have massively eased. UM, he has not answered the question. The reality is we're seeing these bizarre perturbations and markets, this speculative activity, UM, Jonathan, to your point, this use of options, and this willingness to take you know, the these kind of um, you know, very high turnover strategies. UM. And to me that's an indication that um, you know,

liquidity is at play. Uh, that market stability is gonna once again raise its head as an issue that if Chair Powell doesn't want to talk about it, potentially some of the other governors actually look at the data may start bringing up Lisa, that's great. The only reason I put up with Pharaoh's he perfectly explained that options insanity we're seeing within one day, John, you perfectly explained that.

And it's so hearkens back to a time Lisa and I remember where there was actually a vailue to cash. That's really what this is about, is tob talking about the gravity is returned, and so is the idiosy that you explained a Lisa, thank you. It's great a catchp wise at LEASA shout at that of Morgan Stanley. Right now,

we're gonna rip up the script. We're very good at doing this, and we do it with a world class expert on the show of Hollywood and the rest, Michael Nathanson with us, who wrote a brilliant note on Disney a number of days ago, but we've been overcome by the news flow. He's with SVB moth At Nathanson this morning. Michael, you absolutely nailed the streaming failure that the the the

experiment would not provide profit. The Wall Street Journal reports this morning that Warner Brothers Discovery has just flat out blinked. Forget about all the happy talk. You've been to those those dogg and ponies where they talk about we're all going to merge together, and they said, no, they're gonna keep Discoveries separate. Why are they Why are they renigging on everything of the last year's plans, Because Tom, there's no overlap between HBO content and Discovery content right there is.

We've done a time to work on this. There literally is no overlap, maybe temperance out of the market and junified, So putting discovery content on HBO doesn't move the needle, right, So they having a niche service and discovery, plus they don't want to lose it by merging with HBO, and I want to drive any new value at HBO. So that strategy is not going to work. And we always question, you know, it's just such a hodgepodge of content that

it's best to keep it separate. But doesn't It doesn't solve any of the problems, which is that linear is declining rapidly and there's not a big enough solution to upset that decline of linear economics streaming, what is discovering? What is the time urgency for a company? Was Debtor for that matter, the time urgency for the many streamers John knows them better than me that don't have critical scale.

What's the immediacy here? In two thousand twenty three, Yeah, we've labeled this the third act of streaming UM and we think the next one or two years. Your conversations today about the cost of money will affect this. We look at the balance sheets of these companies in a cash generation. Shocking actually how little cash they produce, even all Disney. So they have to use the next one

or two years to consolidate, slowdown content, spend, race pricing. Right, they need to change the you know, the dimension of their business quickly. So I think it's one or two years and that's the third act. Right, things will happen change and to the benefit. I've never said this before to Netflix. Netflix will now right off into the sunset victorious because they've come through this and now they generate cash in the balance sheet. It's not as bad as

everyone else's balance sheet. So that's that's pretty good. Let's talk about what you expect from Disney after the bell today with their report earnings, you talk about consolidation, and you see that some of their biggest non forced errors included the acquisition of twenty century Fox, bidding on cricket in India and other sports that were non primary for ESPN. I'm sure that would be a controversial call on your part. What kinds of consolidation or closures or layoffs are you

expecting from Bob Biker's Disney. Well, Lisa, I'm not thinking any numbers today, you know, like I think they're still gonna work through a plan to give us cost savings. But the real question is they changed their vision of Disney plus. If you go back to the first investor day, they had a smaller vision llion subs, and then during the middle of the pandemic, about a year later in December twenty, they gave you a much grander vision of

over subs. That's got to be ramped back, right, So I'm expecting a more sober outlook on the addressable market here as part of that revisit of what the opportunity is. I'm expecting a reduction of the long term spending they need to do to get there. Right. So it's to me an honest discussion which wasn't being had the past twelve months, about how much you need to spend in streaming and isn't the business big enough at this point

in time to start trying to drive better profitability? Right, So I'm looking for a toad shift on investment spending when it comes to streaming, not actual numbers yet least so just to build on that. For years we were talking about content is king. You're willing to borrow whatever kind of money you need to invest in whatever kind

of production you need to. And now we're seeing, you know, one production of a major franchise after another, whether it's Bond, whether it's whatever you want to do, and that's really the main output. What is the new mantra after content is king? Well, it's platform is king, so you send me up. Well for that, right, you have to have

a scale platform, inscrution platform. You need to get the chrotical mass of enough people with a minimum out of churn, and then I'm not sure our content is king anymore. There's a lot of average content that's sticky just because you have this um you know, scaled base where people come in every day to take a look at something. Right, So you need to scale. At this point there are three or full scale company and white content is longer king.

There's there's too much content, so there's too many platforms and at some point you need to ratchet that back. Maybe content be king in the future. Right now it's it's platform scale. I get some desperation out there, Michael, which frankly, you've you've spearheaded research on where Disney has taken the first episode of Mandalorian. They're gonna put it out on cable or whatever they're gonna do. But the bottom line, do your enthusiasm about Netflix is editorial is

Mandalorian is not Wednesday. That's the heart of the matter. It's still about making hits that John Farrell will watch at night, right right, But Tommy, you also need to scale it right, and you basically need We've been saying this for years. Netflix has this constant, you know, shooting model where the basic putting shot tungle every day. The media industries don't have the model like that. They pick their franchises, they build them, they let them out slowly.

Netflix has a model it's really hard to replicate. I don't think it's a great model, as you know. I've said that for years. But these companies can't get there because their balance sheets are true restrictive. They can't. They can't produce seventeen billion dollars a year of streaming content with a continual you know, release schedule every day of a new binge titles. It's not a model that they can get to. Michael, how do we get revenue for

some of these streaming industries. Is it through just pay for a subscription or is this going to start to be more of an adver tiesment driven model. Yeah, it's going to be a bit of return to what they had. You'll see people using windows, so people go back to putting movies in theaters. Shockingly enough, Doctor raised prices, which just happened last month with Disney and Netflix or Disney

race prices. You have an ad here, but I think you're going to see, um, everyone started driving higher and higher revenues through pricing and advertising and then also using windowing to try to offload the cost of the content and older window right. So this experiment to put everything at once and streaming the way the Warners did it and Disney has done it has to be reversed. And that's what you got here. Yeah, Michael, can we get you in the studio? Signed? Yeah with model totally great.

I would love to hear good for one in your seeing that happened, Michael. Thank you, Michael, Thank you, Michael. Nice gotten the Spy Run. Subscribe to the Bloomberg Surveillance podcast on Apple, Spotify and anywhere else you get your podcasts. Listen live every weekday starting at seven am Easter. I'm Bloomberg dot Com, the I Heart Radio app tune in, and the Bloomberg Business app. You can watch us live. I'm Bloomberg Television and always on the Bloomberg Terminal. Thanks

for listening. I'm Tom Keane, and this is Bloomberg