Viktor Shvets on How the Fed Has Become a Prisoner of Its Own Making

plug for our terminal here. But yes, look, it's been a weird year for the FED, right, because I mean, inflation continue at least through Q one of the year, inflation hot to then expect it, all these expectations of cuts keep getting priced out. Everyone's higher for longer. It's unclear whether the sort of simple models that we use, like, I mean, I think everyone sort of knows this. Nobody really knows how inflation works. But did everything seems to be okay, right.

get a rate hike at some point. When it comes in weaker than expected, you know, as it was doing up until fairly recently, everyone gets very excited and we get that kind of goldilocks moment inequities.

it actually does anything to bring down inflation. But beyond that, the other thing that's starting to happen is we are seeing international consequences and we've been talking about them on the Show of the Higher for a longer stance. So the dollar has been rising. I think the spot dollar index is up almost four percent so far this year, and then against specific currencies like the Japanese yen, it's

surged even more. And so we are seeing those tensions between strength in the US economy, you know, ongoing inflationary pressures, higher rates for longer, potentially kind of meet emerging markets and also developed economies in the wider world totally.

It's an interesting environment.

have published, they are the materials. So you've got a data dependency on the one side, which is basically dependency on a backward looking or at best contemporaneous numbers that you have. You also have a lot of faulty numbers, whether it is how you determine shelter expenses or ornery equivalent rent, how do you relate secondhand cup prices, how do you measure insurance policy or financial markets. But there's

also major problems with Bureau label statistics. I mean, I'm glad that they've increased or revised hours work last week, which basically showed the productivity miracle wasn't really there. So you have quite a faulty numbers both from Bureau of Labor statistics. On a labor market, you have mostly backward looking or contemporaneous numbers. In terms of inflation, and if you become data dependent, you starting to create exceptional volatility because you basically like a deer in a in alarmed

in a light. You are stuck. You are you cannot move to the left, you cannot move to the right. Now, what I think jerrem Pal is doing quite well is trying to introduce some degree of forward guidance. So essentially, what he's saying, and what he said last week is that if I think of the shelter expenses, they're not

quite as bad as the numbers look. And he's absolutely right if he talks about other service oriented numbers again, whether it's insurance or anything else, he kept emphasizing they're not as bad as what they appear, BOSS and CPI and PCEE, and he's been quite vocal that the labor market actually a lot loser than what Bureau Labor statistics highlights. But the problem is tracy. If you are a prisoner of data dependency and dots, the chances of committing a

policy error increases. And so one of the questions I struggle with whether in fact it matters if at a reserve does commit a policy error.

communication challenge for policymakers. In my own summary of economic projections, except the formal name for the dots submission, I have only modestly increased my longer run nominal neutral funds rate. Blah blah blah. This step does not provide a simple way to communicate the policy that the neutral rate might be at least temporarily elevated.

it's not researched. There is nothing in it so long as the line of sight is relatively stable thoughts are absolutely fine. As soon as you get the volatility, they are not. And I think Philipplow, who was who retired as a governor of Reserve Bank of Australia late last year put it the best way. He said, central banks will never see again inflation contained in a narrow range. Now what it basically means that this idea that you have relatively flatish outlaw and you try to manage it

on a margin, is becoming irrelevant. So for example, Federal Reserve at the end of last year, on a number of variables, they went past their mandate. In fact, they've overachieved their amendate. And if you look at what subsequent three or four months, suddenly they were ahead of their mandate. And that's what Philip Law was highlighting that from now on you're going to have a great deal of volatility

of those numbers. And I think the dots by themselves magnify that volatility rather than creating a gretic sort of clarity for market participants.

five BIPs. They should be more like fifty BIPs are above and so to me, the advantage of our era is that, first of all, we have too much capital. In other words, the idea of scarcity of capital that underlines thinks like DCF calculation or underlines most of the investment decision do not apply when you have too much capital. Now it is not evenly or fairly distributed by any means,

But there is plenty of capital. And the way you can measure it is essentially, what is the value of all your financial instruments globally against real underlying economies and what do you find? Depending how you do all balance it commitments, how you do derivatives, you could be looking five to ten times larger than the underlying economies. So

we have plenty of capital. What it basically means, no matter what Federal Reserve does, it's very hard to tighten because that capital just keeps circulating looking for diminishing returns. The second thing we have, and Bloomberg plays a great role in it, is that we have instantaneous repricing. So anybody, any word in the market, it's instantaneously gets repriced. And the third thing we have is that central banks are

rolling out policies and an incredible speed. They're not even debating what is the outcome of those policies or what are the implications of what we're doing. Usually something happens on Thursday and Friday, and by Monday it's all fixed. And so are we going to have new policies for private capital or private debt equivalent to what we have for Silicon Valley Bank? Are we going to have special policies for perity trade basis trade from some of some

of the niches in a high yield market. Of course we are so if you have too much capital, if you're repricing instantaneously, and if central banks are willing and prepared to plug the holes almost instantaneously, this is a world of no risk. In other ways, the way I put it, if the risk is everywhere, the risk is nowhere, and if the risk is nowhere, then you can explain speculation. You can explain goal price of bitcoin. You can explain why high yields will be trading at only three percent

spreads because there is no risk. And the reason central banks are doing it not because they're greedy for power anything else. There is no shadow, you know, deep state or anything like that. The reason they're doing it is because of the dangers of not doing it. If you sink of dot Com, that was only one asset price going wrong. If you think of GFC, that's really a bigger asset, but only one Today. You know, land mines are everywhere, and those land mines, each one of them,

could be bigger than the original GFC. And so the result is central banks really don't have a choice. So even if Federal Reserve does commit a policy error, which is possible, they can unwind it in split second. The way I describe it in my notes is to say, let's assume you get up, get in the morning, say oh my god, it's going to be a terrible day. By lunchtime, I know it's okay. And by evening, let's

have a dinner, and the whole thing just evaporated. Now the key question, however, to ask what price do we pay for it? And the price we pay for it is a volatility of inflation rates. Is this volatility? It is volatility of the neutral rates. In other words, the way describe it, risk does not disappear. It just migrates. So if you keep the market plus it, which is

what we're doing, risks simply migrates somewhere else. It migrates into politics, it migrates into social sphere, it migrates into geopolitics. And so we do pay a price. We do pay a price for this. But to argue that central bank is committing an error furniture must be broken is wrong. Even if they commit the error, which is possible, they can unwind it in thirty seconds.

regulating capital flow. The idea was that United States will take the money from other people and stimulate consumption, and those other people will be buying treasury bones, for example, in order to get return to lower the cost for US consumers, but also to reduce their currency and make

themselves more competitive. Now, Paul Walker was expecting that currency eventualist will recalibrate this process, but they never did because nobody ever wanted to have an appreciating currency, and so we're stuck in the world of accumulating against disparities between savings and spending. In other words, US and the UK consistently net spender, Germany, Netherlands, China career, Japan consistently net saber,

and we've never really rebalanced it properly. So one of the side effects of that was that it become easier and easier to borrow, easy and easier to bring future consumption to the present to maintain your lifestyle. It became easy and easier to multiply credit. Instead of having one instrument parasset, we can now have five instrument parasets ten in each one of those instruments can be leveraged yet again and yet again, and so all of that created

massive amount of capital. I mean, if you think of the financial stability, or they tried to calculate the overall level of financialization, they're usually behind time. They only have twenty twenty two numbers. But essentially what they were showing about five hundred trillion dollars, and that's based on the net derivatives and not including any of balance IT commitments or major ones, and so that's effectively was five times

global GDP. So that's what started. So if you were to ask one person or one time when that happened, it's really Paul Walker who created our debt and asset based culture now green spent in late eighties, or he did. He took Walker's idea and brought it to logical conclusion, and that's was a green spent put which Bernark and Yellen subsequently maintained.

to the nineteen seventies as your preferred historical analogy. You went back to the nineteen eighteen Spanish flu, which resulted in a big run up in inflation, but then a pretty rapid deflationary bust. And I'm curious, you know, here we are in twenty twenty four. Inflation is still relatively strong.

We haven't seen interest rate cuts at all, and as expected maybe back in late twenty twenty two, going into twenty twenty three, there are a lot of people who predicted we'd see cuts and recessions, and I think you might have been one of them. But have you been surprised by I guess, the stubbornness of inflation and the higher for longer scenario in the US. And how is that stacking up against that nineteen eighteen parallel.

My view, as you correctly said that as you have sort of misilocation of demanded supply curves, as we have destabilization of demanded supply curves, gradually winds down, inflation should come out. No need for recession, no need for unemployment, but there is a price we pay, and the price we pay, there will be no recovery, and there will

more or less a circular stagnation argument. Globally, some countries will grow a little bit faster than others, and that will be primarily driven by primary deficits, because overall deficits don't matter. Primary deficits doue and the US happened to have the highest deficits. US is now running about three three and a half percent of GDP primary deficits. Europe

is less than one. Japan is less than two. So if you have a higher primary deficits, you push up your neutral rates higher compared to for example, European Monetary Union or Japan. Now, this inflationary trend in the global is still continuing. Now. If you sink of G five CPI. For example, when we were here last time in sort of late twenty two early twenty three, the number was five percent. In March it was two point four. Now two point four. It's only twenty thirty BIPs higher than

it was over the previous twenty five years. But the leadership changed. If you sing up the second half of twenty three, this inflation in the US was extremely strong, but inflation in Europe, UK and Japan actually was climbing, not down. What you saw over the last four months is it inflation start breaking in the UK, start breaking at Eurozone, start breaking in Japan. This inflation got stronger in China as we progress, but in the US it's

stuck and actually gone up a bit. Now the question is whether that's something unique to United States a weather. In fact, in the second half of twenty four, we're going to relieve what we had in the second half of twenty three and the United States will join the rest of the world in a disinflationary trend. That's my base case. Now what underpins it is neutral rates and productivity. Now, my view is that neutral rate has not changed. Neutral

rate is a long term process. That's why almost all models are still showing that neutral rates in the US are fifty to one hundred basis points real, which means policy rates should be closer to three, not five and a half on that basis. But in a short term you can have a spike in those neutrals rates. Now I do sing neutral rate spike, despite the fact that

models don't show it. I think it did spike. Now the question is whether it's already coming off or whether somehow we can keep neutral rate at a much higher level. One of the key elements there is productivity. Now, I'm not a buyer that there will be any productivity improvements. In other words, labor productivity or multi factor productivity is not going to recover for at least ten years, possibly

even twenty years. Now, if you take a view that productivity is not going to drive it, then either you have to have much higher primary deficits continuing, or you have to have some other form of shocks in the system in order to drive it up. So if I'm correct that neutral rates have not changed and it's still fifty to one hundred bases points real, then it must be coming off. As it comes off, deflator comes off normenal GDP drops from In the US, it's already down

from twelve percent to five point four. As it starts dropping towards four percent. You can't keep policy rates at five and a half unless so you want to have a recession. That's the only reason to have it. So I'm still in the same camp, except as desynchronized or going back to the Reserve Bank of Australia. It's violent how it moves. Also, on more point, in the US, inflation is really in pockets. In twenty two or twenty one, even in early twenty three it was all over the place.

Right now is just in pockets. So all you need to do is to bring those pockets down to a low level.

system and it migrates elsewhere. Maybe the politics, maybe the geopolitics were obviously in a moment, and you can just see it by all the trips people in the administration take to trips to China, where there was a significant amount of anxiety about China geopolitically, military to military communication, cooling the temperature, coupled with industrial anxiety. Are they going to own the EV market for the entire world, et cetera.

Draw that line for us, maybe start there, Draw that line for us between the sort of taking out of financial risk and that migration and how that fits into the China phasis.

and seventies eighties. Could have put policies in place to consume it, but they didn't, neither have China. And so the result is they must invest at least forty two to forty three percent of GDP sink of the numbers. That's an equivalent of nine to ten trillion dollars invested every year. It's double of GDP of Japan invested every single year. Now, if you invest in that sort of money, it doesn't really matter what you invest in. You create

massive over capacities. And if you go into niches sayings like what Chi shipping calls productive forces, seeings like electric vehicles, robotics, automation, solar industry, if you go onto smaller niches, you almost automatically create three times global demand, if not more. Now, at that point they have very limited choices. Either they change their pivot, their policies, dramatically send checks to people instead of building another factory.

capacity onto other countries. But given the amounts of money involved, there is not much you can dumb on Kazakhstan that there is only UK, European Monetary Union or EU, United States, Japan. There's very few places that can take that sort of capacity. And so what's happening those countries are putting up barriers now. The reason they're putting up barriers is that China also

wants to change the world. They want to redesign everything, whether it's human rights information, whether it's the role of state versus individual, whether it's the role of state subsidies, trade rules. They want to change everything. So if China did not try to change the world, I think the extent to which the barriers would have come up would not have been as aggressive. But now China has a catch twenty two barriers will come up, which means it's

harder to sell that access capacity. You don't want to recognize the loss of the capital, and what you're trying to do is to go on a charm offensive. That's why a Chinese president is in Europe right now. From a US perspective, what US is trying to do is gradually grind China out of the Western system, but without dislocating refrigerator prices or without dislocating things that housewives are using.

And the way you do it is starting from the top, starting from the high tag, and just keep moving and slowly grinding them out, slowly retarding their gross rates at least relative to what you can do, but without triggering a real conflict. So to me, that's a cold war. You're walking at tritrop between degrading as much as you

can your opponent without triggering something really nasty. And I think, so far, to be fair, whether it's Jenet Yellen, whether it's Blinking, whether it's Sullivan, I think they've done pretty

good job of actually achieving that balance. Whether that can be maintained, however, depends extent to which Chinese economy and society perform to some extent, I mean, it also depends what happens in the US, of course, but if you just look at China, it depends on that because remember normenal GDP in China already fallen from ten percent to four now. In other words, as you create more disinflation as you saw in Japan. It is really norminal GDP

that tells you the extent of the pressure. Now, if economy and society a geared towards a double digit normal GDP, if you can't raise it, inevitably pressure starts rising. And so the question is extent to which the pressure rises. What is China's response, both in terms of in terms of geopolitics, in terms of politics, but also in terms of economic policies, and how are you going to change them?

of the world seems so glaringly obvious. When China first started talking about building up, you know, technological independence in things like semiconductors or strategically important technologies. I was under the impression that, like some of the idea there was to sell it into the domestic population so that you don't have to worry about the US suddenly cutting you off from important chips. You would have your own supply and then you could do with it what you will.

But as you've laid out, like boosting domestic consumption doesn't actually seem to be a priority right now, they still seem to be very focused on exports. So I guess I just don't get it, because to me, the problem with that strategy seems so obvious.

were thinking of value. Now, since late nineteenth century economy is abundant value. So we only look at the prices. So if you're a billionaire, you must have add value because price is telling us you have Classical economy says no, this guy just captured somebody else's value. He didn't create value. And so if you take that mindset, who is creating value? Who is destroying value? If you ask David Ricarda does

he think financial markets or capital markets value creative? The answer would have be no. The best thing you can argue, they're relocated, but they don't don't create it. Who is creating value? And so for Ricardo or Adam Smith, or even before that, the argument people who produce stuff, whether it was agriculture early on, whether it's manufacturing, whether it's technology, and so the emphasis seemed to be much more In supply,

the emphasis seemed to be much more production. The emphasis is to start to strengthen as Chi Chi Pink calls it productive forces, which is a classic Marxist argument productive versus unproductive. Strengthen them, put obstacle in front of people who you don't regard as productive, and they're incredibly suspicious of capital markets and finance.

and they will have to pivot. And we saw this COVID in late October early November twenty twenty two, that he can pivot very very quickly. That's why there was a disorderly opening after COVID. And so there is a possibility that there will be that moment when you actually will have the change. But the longer he waits, the worst it gets. And the reason is very simple. China is not Japan. Japan had an open capital account and fluctuating currency and convertible currency. So when Japan run into

the wall, they just collapse overnight. China has close capital account, currency is not convertible, central bank is not independent, actually lost all the power pretty much commercial banks are not commercial and private sector is not really private. So when you're operating behind the wall garden, you can't have Minski moments. You can't just hit the wall and collapse. But what you can do you can basically add increasing headwinds as you keep going. So if Japan operated Chinese system in

nineteen ninety, they didn't have to go down. They could have survived until ninety six or ninety seven. But the longer you go with that, the worse it gets, and so they need to recalibrate. So recalibration, which is needed. Change your policy settings quite dramatically. Number two, change your geopolitical stance quite dramatically. In a sense, stop trying to rebuild the world and change the world and change domestic politics. In other words, give a little bit of freedom for people,

both businesses and consumers and households. If there is is pivot change, you still have to pay a price. Because one of the things I highlight is capital stock. IMF calculates it. And if you think of two thousand and four, China had capital stock of I forgot like four trillion dollars. India had one in twenty twenty eight, they will have one hundred and five trillion dollars. US for example, will

have seventy seventy five India will only have six. So China absorbed over one hundred trillion dollars of depreciated capital in a couple of decades. When you absorb so much capital, which is entire world GDP, when you absorb so much capital so quickly, inevitably, you have an indigestion period. So that indigestion period will be with you even if you make a policy pivot today. But what will happen if

they do that? Risk premia will improve because China is the only market in the world, and the only acid in the world where risk premier over the last several years have gone up almost everywhere risk premier actually for.

and in some arguably quality reasons. One example would be people saying that the shell me phone now has a better camera, say than the iPhone. So that's one thing. And then the other thing is you say you credit yelling and blink in for maintaining something reasonably. Well, this attempt to degrade China, but not necessarily provoke something stronger.

What have they actually done substantively? Because I see the trips, and I see the talk and the anxiety and the you know, the ft columns about jumping and all that stuff, but I don't really understand or can't quite internalize what substantively they have accomplished.

that trade as much as possible. Try to focus on the areas that are important for you strategically, And that's what Trump started to do but very chaotically, and what Biden administration have done very systematically over the last four years now, except that China trade will get rerouted. Now, the fact that suddenly Mexico and Vietnam became major partners of the United States have very little to do with

capacity of those countries to actually produce it. It's a lot of Chinese trade gets rerouted through those places, and accept that because you're getting some of the benefit of that, including sometimes better quality law prices that consumers and businesses

in the United States can benefit from. At the same time, what you're trying to do is re establish as much contact as you possibly can, because as Defense Secretary was saying back in Singapore when Chinese refused to talk to him eighteen months ago, he said, with the Soviets, we never agreed on anything, but we talked. And the same is here. You need to maintain the lines of conversation so that you know how far you can go, where you cannot go, how far you can push, how high

you can bring it back. So what you try to avoid is a chaos. What you try to avoid just slapping stuff all over the place, trying to avoid pushing China too far and at the same time gradually, as I said, degrading it. Now there is a possibility, and it is a small possibility right now, but there is a possibility that something horrible is going to happen, either in Russia Ukraine, or something horrible might happen across down One Straits, and the whole thing will start escalating beyond

what you're trying to do. And at that point we could potentially see zeroing out even of Chinese and Hong Kong assets. You can even see US Department of Treasury arguing that they don't recognize, for example, the currency in Hong Kong dollar. Extreme you can have a very extreme outcomes which I think are not likely so long as there is no as I said, disasters occurring along the way.

is not that far from us. Talk to us a little bit about how that kind of political discontent plays out in your world, in the world of you know, investment and macro and things like that. Why is that on your radar?

parents or to their grandparents. They had verdically different views what they wanted to do, and so the younger generation anybody born sort of after sort of early eighties onwards have a very different view of the world. And the reason they have very different view of the world because they did not experience a world where jobs were plentiful, where you've gone to college, you automatically had a good job.

They found that the jobs degrade, They found the professional lives degrede They found that technology gives you many tools, but it also degrades both your pricing power and marginal pricing power. They found that politics become disoriented as that occurs. They found that democratic policies cannot solve the problem extreme polarization. So they're in the mixture of technological, financial, and political revolution. And when you have that change, that generation sinks very differently,

and eventually they become a very large cohort. And when they become a large cohort, they demanded change. Now, what Baby Boomas were asking for is not what this generation is asking for, But they're asking for change. And my view the change all the surveys that come out, the change they're asking is very much community based, is very

much community of equals, is very much governments supported. In other words, harping to their grand grandparents who lived in nineteen forties and nineteen fifties rather than to their parents and grandparents. And so usually it starts with those types of demonstration. Doesn't really matter what the excuses, whether it's the civil rights, whether it's a Cold War, whether it's Vietnam War, whether it's inequalities, whatever, that is something triggers it.

But then as they get big and bigger part of the population, they really drive the policy. So today late millenniums in Z already almost fifty percent of the population, but they are only about thirty nine percent of the adults. They only twenty five percent of the voters.

all of those policies change? And I'm thinking they're going to bring us back to nineteen fifties, that probably will be a more likely outcome rather than sort of nineteen nineties two thousands.

Thank you. I think it's a test and apparently, I guess it's probably rolled out to people in Harvard earlier. The implication is that people at Harvard became millennial before the rest of everyone else.

always great talking to Victor. I guess one of the things that strikes me is, you know, he highlighted the I guess unexpectedly loose financial conditions, and to me, it does feel like that is a key part of what's happening in markets right now, and it kind of goes back to that point I was making earlier, where I don't think anyone expected the cost of money to go up so much viz. Benchmark rates and the FED rate hikes,

while the supply of credit continues to expand. And that, to me is sort of like the key to a lot of what's going on in asset prices. Why we haven't seen that huge default cycle that people were predicting, Why we haven't necessarily seen as many layoffs as a lot of people were predicting, and things like that.

compressing effect on asset prices. You know, there's so much to pull out of that conversation and every conversation with Victor. Like I said, we could have talked for like an hour on the problem with the dots, and maybe we should do that, because it does seem like that's getting more attention to sort of being handcuffed by the dots perhaps you know, obviously, and we'll do more China episodes. But is it really possible? And I guess I have

my doubts. But what do I know, like to degrade China's cutting edge capacity in such a way that doesn't provoke actual geopolitical conflict something more mild, big questions there?