Strategist deems Fed’s rate hike a favorable middle ground for hawks and doves – Update

Fed officials have decided to raise interest rates by 25 basis points in July. Experts continue to debate the path forward for the Fed’s interest rate cycle. BNY Mellon Investment Management Head of U.S. Macro Sonia Meskin, EY Chief Economist Gregory Daco, and George Bory, Allspring Global Investments Chief Investment Strategist for Fixed Income, join Yahoo Finance Live for a panel discussion on the Fed’s July rate hike.

Economists speculate whether cooling inflation is a strong enough sign for the Fed to pause or cut rates in the future. Daco comments the state of inflation is “still largely in the Fed’s control” as it is within range of the Fed’s inflation target. At the same time, Bory believes it is still too early for Fed officials to declare victory over inflation. Meskin emphasized the importance of cooling in services and goods inflation.

Video Transcript

AKIKO FUJITA: For more on the Fed’s decision, we have Sonia Meskin, BNY Mellon Investment Management head of US macro right with us here in studio. We’re also joined by Chief economist Gregory Daco along with George Bory, chief investment strategist at Allspring Global Investments. So Sonia, let’s start with you. You heard Jen there talking about the decision, saying the Fed essentially didn’t even acknowledge really the cooler CPI print.

We know the Fed likes to say it’s not just about one data point. But what do you make of the wording coming out of the statement today, given the latest economic data that we’ve gotten?

SONIA MESKIN: Sure. I think it’s a good– first of all, it’s a good compromise between the hawks and the doves. You did see, after the June pause, a few hawks come out and say, look, the job is not yet done. This is a good compromise between the two. I think it would have been difficult for them to strike a dovish tone just after they changed the summary of economic projections to a more hawkish– in a more hawkish direction too.

And finally, we all know that even though the headline and goods inflation are coming down, it’s really now about– just as you guys mentioned earlier, it’s about the services and service pricing is much more closely correlated to wage growth than goods or headline inflation.

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SEANA SMITH: Greg, how about you? How are you looking at this? Because we’ve talked in the past that you expected this improvement that we have seen on inflation, but the Fed’s still leaving that door open to future rate hikes and also the change here in the statement, very limited. Does this make sense to you, given some of the improvement that we have seen?

GREGORY DACO: I think it was largely expected. We were expecting to see a unanimous vote after the unanimous vote for June skip. We are also expecting to hear hawkish language coming out of the press conference from Fed Chair Powell. So I think the last thing policymakers want is markets starting to price in rate cuts by announcing that they have reached the terminal Fed funds rate. So you’ll hear a lot of conversation talking about the fact that September, even the September meeting, is still live. We think this is the final rate hike in this tightening cycle, but you’re not going to hear any trumpets announcing the end of this tightening cycle.

AKIKO FUJITA: Greg, really quickly here. In terms of core inflation, we have seen that pull back significantly if you consider we were at 9% a year ago. Yes, we’re not at the 2% target yet, but if you think about that extra 1%, the extra 2% that needs to get to 2% target, how much of that is in the Fed’s control?

GREGORY DACO: Well, I think it is still largely in the Fed’s control, because we are largely past the free lunch, the free disinflationary lunch from easing energy prices, from cooling food price inflation, cooling goods price inflation, but we are starting to see slower momentum in terms of final demand in terms of consumer spending. We’re also starting to see the effects, lagged effects, of lower housing price inflation that will feed through to CPI.

It’s going to take a little bit of time before we get back to that 2% target. The next couple of months are going to be bumpier in terms of CPI inflation, slightly tilted to the upside, but we’re going to see core inflation move into the 3% range before the end of this year and likely around 2% around the middle of next year.

SEANA SMITH: George, inflation, obviously the key variable here. The Fed seems to think it’s way too early to declare victory at this point. Do you agree with that?

GEORGE BORY: We do agree with that. As you just mentioned, inflation numbers are coming down. And you know what– our read from today’s announcement is number one, the Fed needs to preserve as much optionality as possible, and they continue to do that. They emphasize kind of data and the need to, kind of, keep an eye on things and, kind of, leave the window open, if you will, to, sort of, pivot or change between now– pretty long period between now and September 20th.

We’ll get a considerable amount of information to decide what to do next. But they do need to preserve that hawkish bias as one of the co-hosts– one of the co-speakers just mentioned, they cannot allow the market to believe that rate cuts are coming anytime soon. There’s still a considerable way to go, and we’re really into the heavy lifting phase of that sort of disinflationary trend, which is going to require sort of ongoing tightness from the Fed to keep, sort of, downward pressure on inflation. So it is much too early to declare victory.

AKIKO FUJITA: So Sonia, if we pick up on George’s point that the Fed wants to maintain optionality, yes. Potentially in the press conference, the Fed Chair is going to signal that the September meeting is still live. Do you think it’s live?

SONIA MESKIN: Yes, I do. I do. I think that the tendency towards perhaps doing an every other meeting, doing a skip rather than no pause is still there. But it really depends. I don’t think they’ve made the decision just yet. And remember that on the inflation front, there are certain almost technical factors or base effects that are going to suppress some of these individual components of the CPI for the next couple of months.

But that may actually reverse towards the fall and the Fed is aware of that. And the market seems to not be paying as much attention to this in the wake of the latest print, but the attention may return.

AKIKO FUJITA: What are those base effects?

SONIA MESKIN: Well, some of this is in real estate, for example, some of it is also about the difference between the PC and the CPI for example. The PCA is less likely to be as subdued in the next couple of months as the CPI.

SEANA SMITH: Greg, picking up on what Sonia just said, how do you think the Fed is going to look at that given the fact that we have seen maybe this wedge start to form in those two readings, and the fact that they are signaling slightly different things when it comes to getting a handle on inflation, whether or not we are?

GREGORY DACO: Well, I think the Fed is well aware of those differences. They look at a broad range of indicators when it comes to inflation. My main concern has been the backward looking excessively data dependent approach that the Fed have been adopting. I think if you adopt more of a forward looking approach, you see that the right types of developments are falling into place when it comes to the inflation trajectory towards 2%.

We’re not seeing the type of retrenchment that would signal a hard landing. We’re seeing a cooling of labor market dynamics. That cooling, that slower pace of demand should feed into more disinflationary pressures. I, again, wouldn’t be surprised to see that we have core inflation with a 3,7% reading towards the end of the year, and we are likely to move further into this lower territory over the course of 2024.

As we were saying, this is not the end of the game when it comes to tightening monetary policy, but increasingly, in this lower inflation environment, the Fed is going to be focused on real interest rates and so we’ll need less high nominal rates to keep the same types of interest rates on the real basis if inflation is indeed coming down.

AKIKO FUJITA: George, do you agree?

GEORGE BORY: We would agree as my colleague just mentioned. Real rates kind of matter quite a bit. And it is premature for the Fed to, sort of, materially change its tack. The deceleration, the pace of tightening is very consistent with end of cycle patterns. The risk is– there are always the risk of over tightening and by definition, the Fed will have to maintain kind of a tightening bias as we kind of go through the cycle.

By the time the data gives the Fed the all clear, it would be too late and so they’re going to try and fine tune this as we go into the end of the cycle. It’s a notoriously difficult task. Not impossible, just very difficult. You know, and as we mentioned, they need to keep containment on both, sort of, liquidity but also financial conditions and actually keep sort of the real rate of borrowing at a relatively elevated level to keep those inflationary pressures trending lower.

We think this is actually going to be a fairly long and drawn out process and that we’re going to be talking about this deep into next year and that this is not sort of over yet from that perspective.

SEANA SMITH: Sonia, what does all this then mean for the odds of a recession? We’ve heard Powell talk about the fact that a soft landing is still on the table at this point. He still sees a path, although it’s narrow, to a soft landing. Do you still see that as potentially likely here?

SONIA MESKIN: We do, and it’s always been one of our scenarios, and I do think the probability has increased recently and why has it? It’s because we haven’t gone into a recession yet. The consumer is actually still pretty strong. And in fact, I would somewhat disagree with one of the colleagues here in the sense that the labor market actually is quite a bit stronger than what would be consistent with 2% core inflation.

We’re having probably two to three times the monthly gains in nonfarm payrolls that would be consistent with a stable 2% core inflation over time. So we need some deceleration there certainly for inflation to continue to come down and not remain sticky above 2% in the core. Of course, this could happen over time without the labor market tipping over into recessionary territory, but you need corporate margins to also remain relatively healthy.

You need the consumer, most importantly, to keep spending, and you also need the housing market to not fall off a cliff, which so far has not happened. In fact, it’s stabilizing and we know that structurally supply is probably lagging demand. So you combine that with the relatively strong labor market and a relatively healthy consumer and I would say, yes, on the one hand, the risks of a recession are probably receding, but on the other hand, there is still an upside risk to inflation there.

AKIKO FUJITA: Sonia, you mentioned the relative strength of the labor market. And you could argue that increases to your point, this case, for a soft landing. When you look at average hourly wages, though and that has remained elevated. Why do you think it’s that sticky? And is that kind of where we’re likely to see it in the near future? Is it going to stay that elevated?

SONIA MESKIN: It’s a very good question. I do think that even across metrics, not just the average hourly earnings, you know, wages and salaries have and compensation overall, we’re getting the ECI on Friday, has stayed elevated relative to the previous cycle. Part of it, maybe not all of it, but certainly part of it is the supply demand dynamic. So we actually have a smaller supply of labor relative to demand than we did pre-COVID.

And in fact those curves actually crossed before COVID hit. So COVID could have just accelerated some of these trends. And that is a tension that hasn’t been yet resolved, at least in this cycle.

SEANA SMITH: Greg, one of the rationales for higher rates is that tight labor market. The fact that is propping up wages and the fact that we’re not going to see material improvement from here on inflation unless we do start seeing some weakening in the job market. How are you looking at that rationale and is that making less and less sense, given the fact that the labor market is still resilient at this point?

GREGORY DACO: I think we have a unique labor market. We have a labor market in which business leaders are reluctant to let go of their prized talent pool that they spent so much time hiring, training and trying to retain. So we’re not seeing the traditional types of recessionary developments where business executives lay off massively in order to cut costs. Instead they’re doing so very strategically putting in hiring freezes and you’re seeing more of a hiring correction rather than a layoff correction.

That means that the cost element is still central for business leaders. And that, in our opinion, is going to lead to some wage growth compression as we move forward. The developments are already there. When you look at the sequential momentum for wage growth, it’s actually been quite encouraging. You look at small businesses, it’s also been quite encouraging. So we think that those developments are moving in the right direction, and that even if you look at wage growth, those are very encouraging.

And I would add one more thing in terms of the inflationary dynamics on the PPI front. When you see some of the margins developments on a month to month basis, those are also very encouraging when it comes to inflation dynamics. That’s going to be the key element. The core momentum in inflation is going to be what we should be paying attention to. And that, in our opinion right now, is moving in the right direction.

There could still be surprises. Health care inflation could turn around by the end of the year. We’ve seen some stickiness in housing price inflation, but so far the developments have been moving in the right direction.

AKIKO FUJITA: We should point out we’re continuing to monitor the market reaction to all this. Pretty muted so far given the expectation that was largely baked in here of a 25 basis point rate hike. George, you’re the fixed income guy on the panel here, and I want to ask you this, because we haven’t been talking a lot about the inverted yield curve. It has remained this way. I’m looking right now where the two year yield is at 5.4%, the 10 year is at 3.8.

How do we read this as even on this panel, there’s increasing this increasing likeliness of a soft landing that maybe this recession that we’ve been talking about for a year, maybe it’s not coming, or maybe it won’t be quite as severe?

GEORGE BORY: The shape of the yield curve is one of the most powerful factors in the market. And while history would suggest that a curve as inverted as the curve is today would typically lead to a recession within say, 12 to maybe 24 months, we believe that there is a very high likelihood that an inverted yield curve does result in a recession. The difference is timing.

The yield curve doesn’t– there’s nothing magic about the shape of the curve and the actual eventuality or the moment in time when a recession occurs. We’ve just looked back over the last three or four recessions, taken an average and said it takes about 12, 18 maybe as much as 24 months before you actually see a recession. An inverted yield curve does create meaningful kind of pressure on the financial system.

It changes, economic behavior. It pulls cash and money towards the front end of the curve. So we have not given up on the predictive ability or the messaging that comes from the shape of the yield curve. What we are trying to calibrate is how long. The economy is in a very different place than in prior cycles, and there’s really two factors, one of which has to do with the balance sheet strength of many borrowers corporations as well as individuals.

We have a tremendous amount of low cost debt that was effectively attached to a whole series of assets that sort of anchors the quality of different borrowers. And so if you have, sort of– if you finance yourself fairly prudently at a very low cost, you have tremendous amount of flexibility in today’s environment. Those benefits are with us, and they will be with us for a long period of time.

And then the second component is this discussion around soft landing hard landing. Our view is we’re sort of in the midst of a soft landing. That the soft landing isn’t coming, it’s happening now. We have inflation coming down. We have growth going up. We have good wages as we just discussed. Now the Fed is trying to, sort of, fine tune its position to keep those trends in place, but we think waiting for a soft landing is you will have missed– you will have missed the opportunity.

The soft landing is now. The question is if they need to keep raising rates, does the probability of a hard landing go up? And we do think that actually is occurring. But it is, at least, 6 months out or further.

AKIKO FUJITA: Sonia Meskin, Greg Daco, and George Bory. Really appreciate all of you joining us today with your insight. Thanks so much for your time.