Why Fed Will Raise Rates Next Year ft. Adam Posen

[00:00:06] Adam

For a variety of reasons, not just officials who can’t, but markets don’t seem to be pricing in, properly, the inflationary effects of these policies or the inflationary effects of the fiscal policy. So, I think by a year from now, the Fed is going to be raising rates with a very high level of confidence.

[00:00:32] Intro

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:27] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is the series that I not only find incredibly interesting, as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game-changing issues, and hopefully dig out nuances in their work through meaningful conversations. Please enjoy today’s episode hosted by Alan Dunne.

[00:02:12] Alan

Thanks for that introduction, Niels. Today, I’m joined by Adam Posen. Adam is President of the Peterson Institute for International Economics. He has had a long and distinguished career as an economist. Over his career, he has contributed to research and public policy issues on monetary and fiscal policy, focusing on central bank independence and inflation targeting. He’s also written around the challenges of European integration and macroeconomic policy.

He has been a consultant to numerous US government and international agencies including the Fed and the Bundesbank, and between 2009 and 2012 he was an external voting member of the Bank of England. He is also the co-author of the 1999 book on inflation targeting and these days is a frequent commentator on macro issues. Adam, delighted to have you with us. How are you today?

[00:03:02] Adam

Great, Alan. Thank you for having me on.

[00:03:04] Alan

So we always like to ask our guests first of all how they got involved in their respective fields. So what got you started as an economist and interested in policy?

[00:03:15] Adam

In a strange, nerdy way, I was always interested in international policy and thought I would end up at the juncture of research and policy, but I was originally more of a foreign policy and national security person. I happened to be coming out of undergraduate when the Berlin Wall came down and that got me shifted into being an economist in pretty short order.

[00:03:44] Alan

Interesting. Well, that’s very interesting timing. It coincides with a very big structural trend that the global economy went through in that period, so I think we might pick up on that. But one thing I wanted to kick off with today was you wrote a piece in the Financial Times recently called “The Curious Case of Central Bank Convergence”, where you talk about how monetary policy reactions are very similar across the US and Europe despite some fundamental differences in their economies. My reading of it, you very much highlighted the recent episode as further evidence of the success of inflation targeting. Is that fair to say?

[00:04:24] Adam

Yeah, it is. But I want to emphasize that it was a surprise to me, the evidence, because I always, coming from a political economy background, actually, more than my distinguished co-authors, Bernanke, Mishkin and Laubach, I had less faith that independent central banks with inflation targets alone was enough.

Because if you look back at the ’80s and early ’90s, you had very costly disinflation like Volcker, like Thatcher, on and on, which were not consistent with the idea that credibility and transparency were all that matter. But it turns out, when I try to look fairly back at the last few years, it looks very much in line with the theory, frankly, that Bernanke, Laubach, Mishkin, and I and others talked about, which is if you have a credible long-term anchor for expectations, with an independent central bank transparently, you can ease in the short term and get it back.

Now, again, I think if the Fed hadn’t committed to raising a lot when it did, and ideally, even a little earlier, we might be singing a very different tune. But ex-post, it turns out, it looks like the expectations channel for monetary transmission works.

[00:05:47] Alan

Okay. There is a view in the market in particular, at least from some commentators I read, that maybe central bankers got a little bit lucky in the episode. Obviously, we had an energy spike. Oil prices and European energy prices spiked up, we came back. We had goods prices spiking in relation to COVID, but then it normalized. So some commentators are suggesting, I guess, as a variant of transitory that things would have normalized anyway. Sounds like you wouldn’t necessarily agree with that.

[00:06:15] Adam

No. I think you’ve got to have a reason why it comes back. Because even if we say (and this is why I talked about the idea that the central banks were all on the same page sort of, and similar outcomes being a surprise), that huge difference in energy consumption and energy market structure in the US versus Europe versus UK; the huge differences in labor markets, not so much US, UK, but versus some parts of Europe; the huge difference in exposure to imported food as well as imported energy; the size of the government, all of these things are very big. So even if you were team transitory, or as you say, the markets now see it, it should still be surprising to you that yeah, sure, things start coming down when the shock starts coming down, but the fact that such different transmissions, such different economic structures, didn’t have differing effects needs an explanation. Because just straightforwardly, it may have been the same global price shock in food and energy or in supply chains, but the share of that in the consumption basket, the share of that in CPI or in HICP is very different.

So that’s why I end up, with good reason and a bit of surprise, thinking, well, it really was monetary policy, because otherwise there’s nothing that’s similar across countries.

[00:07:42] Alan

Okay. You touched on how maybe central bankers might have been a bit faster to tighten. You talk about, in your piece, on this central bank convergence, I think you call it the end of history moment for central banking in the sense that there seems to be no alternative now. But that’s not to say inflation targeting isn’t without its critics, certainly around financial stability issues.

Looking back at that post-COVID era, I’m talking about 2021 when monetary policy remained fairly easy, with the benefit of hindsight, do you think that was a mistake? Were, in that whole period, maybe even back to 2019, central banks too keen to try and push inflation up towards 2% and did that have adverse economic impacts down the line?

[00:08:36] Adam

I view the mistakes as being made mostly in 2021 and the first half of 2022. I think it was entirely reasonable for central banks facing a global pandemic, which was not something they expected or were prepared for, to worry about both short and long-run damage. Short-run just how much disruption there would be to the economy, and long run, as Fed Chair Jay Powell said repeatedly, worrying about scarring in the labor market.

But once things turned around, and that was clear in Europe very quickly because Europe, UK, even Japan did a good job of deciding we’re going to keep programs in place to try to limit the burst in unemployment, to try to limit the pain from the energy price hikes. In the US case, when unemployment shot up noticeably but came right back down, then somebody said okay, phew, we dodged a bullet. This is where we’re lucky. Let’s pivot.

You had, in the US in particular, but in other places to a lesser degree, fiscal policy going on and being expansionary even after the legitimate emergency needs during COVID, the legitimate worries. Again, once it became clear, you want to be able to turn around. Central banks can turn around policy much faster and budget policy, they should have been even more willing to turn around.

But I don’t think it was the inflation targeting regime. I think it was some wishful thinking, particularly at the Fed, and some blindness responding to fiscal policy, which I think, as we may discuss, sets up a further mistake that seems to be on the horizon.

[00:10:23] Alan

The point about financial instability and inflation targeting is something that comes back from time to time, but was there, maybe immediately prior to the financial crisis.

[00:10:33] Adam

Yeah, but it’s a garbage point. Just fundamentally, we had financial instability obviously before the global financial crisis, and it was clearly attributable to deregulation and poor supervision. I was there at the Bank of England while we were cleaning it up. You can’t tell me it was loose monetary policy, especially since the Bank of England, before I got there, had been tightening.

Similarly, the financial instability we saw with Silicon Valley Bank and the other midsize banks that blew up a year and a half ago in the US, there is an obvious smoking gun that they were given the special carveout under congressional pressure with the Vice Chair, the then Vice Chair of the Fed’s blessing, and totally lousy supervision. The rest of the system, which had better supervision and capital provision and liquidity provision since the financial crisis, did not suffer any knock-on effects. So no matter how many times people say this, it’s false.

[00:11:35] Alan

So from your perspective, macro prudential policies can address that point.

[00:11:39] Adam

Not macro prudential policies, micro prudential policies.

[00:11:42] Alan

Okay, micro, sorry.

[00:11:44] Adam

No, it matters. It’s a distinction. What I’m saying is make sure banks have enough capital, make sure they have enough leverage, make sure you’re following their books, make sure you’re monitoring them and enforcing. That’s micro prudential. Macro prudential is this nonsense that central banks can, in a judgmental way, fluctuate the amount of capital or liquidity over time, and that I’m not a huge fan of.

[00:12:06] Alan

Okay. So you touched on coming out of undergrad years in ’89, Berlin Wall coming down. You wrote the book with Bernanke and co-authors in, I think, 1999 or so. So this whole period we’ve had for inflation targeting has had that favorable period of disinflation, that kind of global trend, and we’ve had a particular set of circumstances in the global economy.

We had Gary Gerstle on the podcast recently. He’s written his book about the end of the neoliberal order, but that period was all around neoliberalism, free markets, disinflation. Do you think that was a more easier period? Did central bankers have a tailwind behind them, and might we see a more challenging period going forward from an inflation targeting perspective, do you think?

[00:12:52] Adam

Yes, I do. In fact, I started warning about that shortly before I went on the Bank of England committee a dozen years ago. we have a couple of things going on that are going to make it harder. Partly, it’s what you said, that we went through a period where there was, just through some combination of good fortune and some structural developments, a lot of things dampening down on inflation, but more importantly, dampening down on inflation volatility.

We just got lucky. There weren’t energy shocks, there weren’t pandemics, there weren’t wars. Sadly, for climate reasons and geopolitical reasons, we should expect there are going to be more shocks, more energy and food price shocks, more wars, sadly, more migration, all kinds of things. Those are real things. All the central banks have tried to do is manage the second round price effects of real things. So yeah, it is going to be more challenging for the foreseeable future, which is 5 to 10 years.

[00:12:53] Alan

I guess linked to that is maybe the political support or the political dimension. Is that something that could waver? From the perspective of in this cycle, we never had a situation where the central banks, at least with the Fed, where they had to maintain tight monetary policy in the face of weak conditions. So they obviously tightened policy, growth was still solid, it’s still solid now.

So they’ve never really had to face a trade-off between, okay, do we keep policy tight here now to get inflation down even though the economy is weakening. Do you think if they had that dilemma to face would you still have the political support of monetary policy?

[00:14:38] Adam

Well, the only way to judge that is where they will need to do it ex-ante. Remember, the Fed and the ECB and the Bank of England and some other central banks, all in late second half of 2022 through the first part of 2023, were raising rates when the overwhelming bulk of forecasts were for recession. So, they were willing to do it.

Now, again, ex-post, I and a few colleagues, like Karen Dynan at Peterson, said we didn’t expect recession. But the central banks certainly thought there was a high-risk of recession and they were still willing to do it.

I think if anything the political situation awful as it is in the US, in Europe, in the UK, for central banks isn’t worse because what we’ve seen is how much people in high-income economies really still hate even low levels of inflation.

Even after years of low target inflation, it turns out the public is asymmetric, in the economist jargon. They hate overshooting inflation more than they hate undershooting the target. The second thing is, as we’ve seen in Turkey and India, as we’ve seen in Europe, even very nationalist politicians in the end seem to decide, well, messing with the central bank is probably not a good idea.

Now, presidential candidate and former President Donald Trump, in the US, is threatening to mess with central bank independence in the US if he is elected. As a couple of colleagues of mine, former officials, David Wilcox and Maurice Obstfeld have written, that’s pretty dangerous.

So, the US, because there is such a direct potential attack on the rule of law trying to increase the power of the president if Trump gets back in, there I think there’s an issue. But I don’t view that as politics in the sense that there’s mass pressure or opposition to the central bank. That’s the views of Donald Trump.

[00:16:51] Alan

Just in relation to a couple of other topics around inflation targeting and the construction of that. I suppose one of the things we’ve heard more recently, and it often surfaces in times like this, is that the case for increasing the actual inflation target. Going back maybe 10 years or so, we already had this from Olivier Blanchard suggesting maybe 4% was a better lever.

Obviously, arguably, maybe now is not the best timing. But with the benefit of hindsight, you wrote the book in 1999. If you were writing today, would the target be any different or would there be anything about the construct of the inflation targeting approach that would be different?

[00:17:51] Adam

Speaking just for myself, because I know a couple of senior co-authors disagree, but speaking for myself, I think one of the things we got wrong in the book was we talked about the idea that targets should be varied not frequently, but the inflation target should be subject to change over time as the structure of the economy changes, the nature of shocks change, as we learn things.

Obviously, if you vary it every few minutes, you’re going to lose all credibility. But the idea that with parliamentary or legislative assent, you can vary it every several years was in the book. We didn’t foresee something that probably people in markets may have already seen, which was announcing inflation target is kind of like announcing an exchange rate peg. Once you announce it, it’s very hard to decide to change it.

New Zealand tweaked theirs, the Bank of England tweaked their definition. But that headline number, even if there seems to be good reason to vary it, people are very reluctant. Because just like when you’re on an exchange rate peg, you’re worried it hurts your credibility, you’re worried it looks bad. So before this most recent inflation, I was aligned with Blanchard, another colleague of ours Joseph Gagnon was on this, a number of us including Jason Furman, were out there saying, okay, given the zero lower bound problems we saw during the last recession and crisis, given the way labor markets work, given how much we’ve been undershooting the target, probably a 4% or at least a 3% target would be better. I still think, on the economic merits, that’s true.

It’s also partly an operational issue in the sense that, essentially, you have a choice right now of they’re going to run the target, keep it officially at 2% in the major central banks, but they’re going to overshoot it for a few years. I don’t know why that’s better per se than raising the target if you’re just going to accept that you’re going to be averaging higher for a while.

But again, I’ve got to come back to what I just said a minute ago, Alan. I am struck by how much the public in high income democratic societies, let alone middle-income countries, hate even small amounts of inflation. That became clear and you have to respect the society. So I am not as convinced of the merits of changing the target as I once was.

[00:20:04] Alan

In your book, you have a whole series of case studies, and one of them is around Bundesbank and how they used to maybe change their target on a one-year horizon but have begun to structure a longer-term target. Is that a model that that might work? Does it create issues?

[00:20:20] Adam

I’m actually proud of that. The late Thomas Laubach and I wrote that chapter and most of the case studies. But anyway, that chapter in particular we worked on. I think it was important, not just academically for policy and markets, to point out that here, supposedly the very, very Germanic anti-inflation Bundesbank, which indeed it was, was credible and kept inflation lower than everybody else but was still quite flexible.

In that same chapter, we discussed the Swiss National Bank which similarly ended up with very low inflation compared to others in the ’70s, ’80s, early ’90s. It was harder, of course, because it’s a smaller, more open economy than Germany. Similarly, they were flexible. They varied their targets over time. So, again, from an optimal economy setting point of view, there is a case for doing that.

But going back to the Op-Ed I just wrote, which is sort of my take on lessons from the recent events, in the end it looks like these fine differences in central bank targets and communications actually don’t seem to matter very much. So we spent a lot of time looking at the details of that. There are a lot of other economists, both academics and at central banks, who between the mid ’90s when we started writing and now have done work with central bank communications, niceties of central bank legal structures, central bank committee structures, central bank targets. Again, it’s all nice, but it doesn’t seem to really matter very much in the smaller aspects.

Basically, you have a low inflation target, you’re transparent in talking about it, you’re independent enough, you can pursue it on an operational basis. That’s it. All the other stuff doesn’t seem to matter very much.

[00:22:17] Alan

Within that, the key is that anchors expectations. Is that right?

[00:22:20] Adam

Yeah. Which of course is somewhat circular. That goes to why I was skeptical. So, my co-authors were pleasantly surprised, because how do we know the expectations are accurate while inflation stays down? Why is inflation staying up? Because the expectations are anchoring. We do have, in government bond markets, particularly in places where there are index government bonds, or five-year five-year forwards you can play with, we do have some measures of what seemed to be long-term inflation expectations.

You do have surveys that are done both by independent organizations and the central banks that also give you some sense of long-term expectations. Most of these are not great on levels, but if they show a sustained change in one direction or the other, they seem to have information. So, I don’t want to oversell it. You can, in some proximate way, track the anchoring of expectations. But there is a little bit of, you’re chasing your tail.

Ben Bernanke and the monetary theorist Mike Woodford did a very important paper, after our book came out but while the inflation targeting debate was still alive, about the idea that you could end up, as economists say, with multiple equilibria if the central bank too closely chases the market expectations. You end up potentially creating uncertainty.

[00:23:52] Alan

You touched on being transparent around it, and I think related to that is communications as well. Over the course of that 30, 40 years that you’ve been an economist, a huge change in the communications approach. Even in the ’94 tightening cycle I think, they just announced the rate hike. They didn’t even, or maybe it did. Now we’ve got over guidance at every meeting and every line is assessed.

I saw Stanley Druckenmiller, a well-known hedge fund manager, saying that the Fed should stop forward guidance. It’s just creating more confusion. On the back of I think maybe the May FOMC and certainly the December FOMC, do you think it’s important or is it going too far? I’m wondering, from the perspective of how that forward guidance influences financial conditions, which could then have an impact on the economic outlook, you’re in this trying to assess the second and third-order impact of any communication, does that complicate things or do you still think forward guidance is a positive thing?

[00:25:07] Adam

Well, I never thought forward guidance was a positive thing. In 2012 as, I left the Bank of England, I gave a talk at the Fed’s Jackson Hole conference at which I said forward guidance is stupid, and I stand by that. Communication more broadly, in the sense that if you know where you’re going or you know what you’re looking at to decide where you’re going, you should tell people is about issues.

The reason I’m harsher on forward guidance (and then I’ll get to the Druckenmiller point) is because forward guidance is the idea that your statements, very specific statements, about the path of policy can influence outcomes. It is a tool in and of itself. It got coined during the crisis when it seemed like monetary policy was pushing on a string either because you couldn’t cut rates anymore or because QE didn’t seem to be that effective outside of a crisis situation.

But it becomes what you and Stan Druckenmiller and others have talked about. It becomes the sort of chasing the tail. It seems like central banks, the Fed, they were both I think subject to this, are getting a little too caught up in not surprising markets and meeting expectations. That’s a level of fine-tuning that doesn’t make any sense from a public policy point of view. Especially since there’s going to be noise in the sense of there’s going to be variation in the actual economic outcomes, in the price developments that you just can’t control, and you don’t want to react to it.

So, I do think there has been a problem. Again, I think in the Fed’s case in particular, for a while at the Bank of England less notably, where there’s just been too much fine-tuned communication confused with this, additional confusion with this message of so-called data dependence. Again, the problem isn’t so much saying we react to data and here’s the data we react to, or we intend to do this policy tract. The problem is saying, A, we don’t want to surprise anybody.

You may not take the light with surprising people the way say BOJ Governor Kuroda did when he announced a negative rate after telling everyone he would never do a negative rate. That’s bad. But it’s also not a first-order of concern. If I get suddenly new data that really profoundly changes my view of the economy, I’m going to change whether or not it’s a crisis.

So anyway, sorry to sound vague, but it really is a matter of degree. I think the central banks have gotten too much in the habit of micro-managing and worrying too much about what current financial market expectations are. We saw this with the whole process over the last year, year and a half, where the Fed accelerates rate hikes and all kinds of people in the market say, Oh, they’re not going to do that.

Various people like me, said, no, they’ll do that, just listen. And then they did that. Then there was, Oh, they’re going to cut 17 times in 2023, and various people like me said, No, listen to what they’re actually saying, they’re not going to do that, which they didn’t do. At some point, you just have to not be that concerned about day-to-day things.

Now, this is the Top Traders podcast. So, for traders, the upshot, in my view, when I advise investors, is generally you take the opposite side of any bets that move a lot due to central bank communication because they’re usually going to be an overreaction. I think, in particular with the Fed of late, Chair Powell just seems to, whenever he makes a statement, he’s correcting to the dovish or the hawkish side from what his last statement was.

So on a more than intraday basis, I would basically say that if there was a large move due to a statement, I would take the other side of that bet. I similarly think that was true for the Bank of England, the ECB less so.

[00:29:53] Alan

Just on the question of the impact on markets and then financial conditions, one of the I suppose curiosities of the last number of years is obviously, different people have said the stance of monetary policy is tight or not depending on what you’re looking at. Obviously, nominal rates went up high and quickly. But there’s a suggestion, there’s this debate on are they above neutral are not.

At the same time, real rates have gone higher because inflation has come down, and then financial conditions have fluctuated depending on what equity markets have done in credit markets. So as a policymaker, somebody who’s sat at a table at the Bank of England as far as your discussions, which of these is more important? Is it nominal rates, real rates, financial conditions, changes in rates, or all of the above?

[00:30:45] Adam

I feel strongly the two are much more important than the other two. I feel that financial conditions, even though as you say they’re highly variable, and then changes in rates are the most important indicators. I feel that both level of both nominal rates and real rates on the Fed side, or on the Bank of England side, the instrument rate in the short end are vastly overrated. You can see this right now.

So finally, we’re getting a little bit of slowing in the residential construction market in the US. But usually in all past Fed tightening cycles, at least since the war, a 500 basis point rise in Fed funds rate would have completely cratered the housing market. So that tells you there’s a lot of other things that go into this than just the rate.

We had six months ago a number of Fed officials, including the New York Fed President John Williams saying very explicitly, Oh, inflation is coming down, therefore, the real rate of interest is going up. People like me, in this case, I was more in the minority, but I was right, said that’s not a sufficient statistic for credit conditions. We’re looking at a world where spreads on junk bonds over investment grade bonds, or corporates over government bonds, or even the duration spread, the yield curve, all have not moved very much for a given fit thing.

So how are you saying you have this mythical real interest rate, but it doesn’t describe what’s going on in the economy? I remember fighting this issue, as you said, when I was inside at the central bank and there were discussions, and one of the Fed governors at the time through the crisis said, well, the great thing about monetary policy not moving the short-term interest rate is it gets in all the cracks.

My response was, that’s exactly wrong. The whole point of this crisis is that financial markets are segmented during a crisis, things get worse, so the segmentation gets even harder. So the short-term Fed funds rate is contributing to part of the credit conditions, but it doesn’t get in all the cracks.

Now that we have, especially in the US, but throughout the advanced economies, non-bank financial intermediaries playing such a large role in non-financial credit, we have large international capital flows. We have very large moves in savings behavior in the US, in China, to a lesser degree, in some other countries. The idea that this one interest rate is a sufficient statistic strikes me as very mistaken.

Again, that doesn’t solve the problem, because as you say, you can create a financial conditions index of whatever construct and you have things, day-to-day movements in Nvidia at some level affect credit easing, and that’s not accurate either. But it’s closer to accurate, in my view, that it’s the changes in these interest rates and what that says about the effectiveness and path of monetary policy, and then the overall credit conditions that matter.

[00:34:24] Alan

So putting that in the context of current markets, obviously, we’re in the midst of a big run-up in equity prices. Credit spreads are tight. I haven’t looked at financial conditions indices lately, but obviously, short-term rates have been sticky around 5%. So that is an offsetting factor. But certainly, they haven’t been tightening anymore, and obviously have eased since last October.

[00:34:48] Adam

Again, whatever definition of financial conditions you want to look at, and there have been various ones, they all suggest that A, we’re less than the most tight we were in this cycle, less restrictive; B, that for the given Fed funds rate increase, we seem to be less restrictive than we’d been in the past. On many of them, it would seem to indicate we actually have pretty loose financial conditions.

[00:35:18] Alan

There is still a view around the lags of monetary policy. I guess maybe you’ve answered it already, but the view being that you bring with rates to 5%, 5.5%, okay, things don’t crack immediately. But over time, because of the lag, they will. You seem to be saying you don’t buy that.

[00:35:37] Adam

Yeah. I don’t. If you go back to roughly February/March 2023, there were a bunch of people saying that. Some of the notable investment banks like Goldman Sachs was talking about that, some of the Fed officials were talking about that. A wide range of people were talking about that. The reason I date it to then is because then came Silicon Valley Bank and First Republic Bank, and people got distracted. But at that time, everyone was very intent on this idea it’s just lags, it’s just going to get bigger.

When we run out of so-called excess savings, then things might crash. I kept saying I don’t think that’s right because that would imply zero forward-looking behavior on the part of markets, which zero is extreme and I don’t think that’s right. That would imply that, for some reason that nobody has specified, the effect of interest rates on housing construction in the US for example was much more lagged than it ever had been, and there was no good explanation for that.

And then in general, it was just this insistence that somehow lags were going to be much longer in this situation even though we had visible evidence again of not terribly tight credit spreads. It just didn’t make any sense to me. And I think this has been proven out. So yeah, there’s some tightening effect and some of it takes time.

To be talking about tightening that was done in the second half of 2022 still barely having an effect in middle of 2024 when the Fed started tightening and all the central banks started tightening in early 2022. You need an argument for why the lags were so much longer in this case, which nobody had ex-ante.

Again, the only argument that made any sense would be with the consumer sector, the so-called excess savings. But as Karen Dynan and I both argued starting in 2021, the excess savings argument was kind of a misnomer, because that assumed there was some hard fix that savings rates had to go back to, in the US at least, exactly where they were in 2019, which was a multi-year high. Again, that was a reasonable assumption, but there was no reason to think that that was a fixed point.

If anything, the fact that people accumulated so much savings during the COVID years, and the US government and other governments were actually, and I think appropriately, generous in supporting people in the worst of COVID, should have given people more confidence they didn’t need to save as much in a precautionary fashion as they used to. Now, again, I can’t prove that it was one possible outcome.

But the idea that everyone had faith that somehow… And I just saw a Bloomberg reporter retweet a chart from the Fed San Francisco about running out of excess savings, and it was always seen as a very small decrease in the rate of consumption. It may not be ideal either for households or the economy as a whole, but there’s no reason the US can’t have low savings rates again for several years, and there’s intuitive reason why they might.

Sorry to go on so long, but it’s just these statements come out and I don’t think people really think them through. They have a surface initial plausibility, but if you want to trade and think on the basis of macro trends, you’ve got to think it through a little more.

[00:39:35] Alan

Everybody obviously points to Milton Friedman’s famous line of long and variable, so it’s kind of an easy one to defend.

[00:39:41] Adam

Well, I’m thinking reciting out-of-date scripture isn’t a good analysis point for investing.

[00:39:51] Alan

One of the other things that you get when you get an economic scenario like this that’s unusual or has surprised people is then theories like, actually, the Fed needs to cut rates to slow the economy down because higher rates are benefiting wealthy savers, etc., and higher rates are not working because of that.

Obviously, you get structural changes in the economy that the percentage of baby boomers might rise over time. But do you think that’s plausible, or do you take that argument seriously?

[00:40:23] Adam

I think taking it seriously in the limited sense that the structure of the economy, as you just said Alan, has some effect on what we would call the monetary transmission mechanism. So if you’re trying to forecast specifically the lags and the impact on different sectors in the economy, household behavior by income decile or something, Those things happen.

I think the ECB just came out with a working paper, I think today, some publication, in which they talk about the fact that the effects of quantitative tightening vary across countries over time depending on who’s doing the savings. So there is something there. But I want you to think about they’re overdoing it where people switch sides. There was a point at which during quantitative easing, I and the others on the MPC in the UK and on all the other central banks would get attacked, “You’re cutting rates. You’re quantitative easing. All you’re doing is blowing up acid bubbles which are unfair to small savers. You should raise rates.”

Now you’re quoting people who are saying, “Well, by raising rates, all you’re doing is helping the rich people, now you should cut rates.” Many of these are the same people who are saying these things. So, again, if you want to drill down and think about specific structural aspects of the economy, that’s worthwhile, but the people who make these grandiose directional claims generally contradict themselves and are contradicted by the facts in a short manner of time.

It is roughly the same people who were saying we were totally unfair to small savers and helping rich people by quantitative easing and low rates, and now they’re turned around saying we’re totally unfair helping rich people and hurting people by having high rates. Well, it can’t be both. The answer is the real mistake a central bank can make is having the monetary policy rates out of whack with the state of the economy.

[00:42:39] Alan

I suppose, in general, having been inside central bank policymaking forums, is the level of research at that level of granularity, the Fed obviously has a model of the economy, but is it based on more general relationships of consumption decline?

[00:42:57] Adam

It’s very, eclectic is a little too strong, but it is a multiplicity of views. So what happens is the Fed does have a baseline model. It’s called FRB US, Federal Reserve Board Model of the US. Just like the Bank of England has a central model, the ECB has a central model. These models are used for two things. They provide a baseline forecast, and they are used for what are called policy experiments, which are not literally policy experiments but you run simulations, if we did this policy, what would happen.

But all of them, in all central banks, even PhD economist labor is cheap compared to the value of getting a central bank decision right. So you can have 300, 400 economists and you assign a dozen of them to looking at micro data about savings behavior, how it varies across the income distribution depending on this, that, and the other. So then you try to bring those things together. That’s why there isn’t a mechanistic policy world.

There are a lot of reasons why not, but in the good world, that’s why there isn’t a simple mechanistic policy world, because if the committees are doing what they’re supposed to do, and making use of the staff in the way they should, you’re having this ongoing discussion, okay, here’s the baseline. Here’s new research or updated research looking at this development. Here are some anomalies in the data. Let’s try and make it all fit together and decide what makes sense.

So sorry, if you’re doing it right, it’s messy. At the Bank of England where I was, there are these things called the agents (I shouldn’t say things), people who have regional assignments and their job is to talk to businesses and households and institutions in their region and report on that. The Federal Reserve has a different thing. Now it is called the Beige Book, which is each Federal Reserve district collects a lot of anecdotes from businesses and workers about what’s going on in the economy.

Again, it doesn’t fit directly into your model, but sometimes it can be very revealing. So the example that the former governor Mervyn King used to give about the utility of the agents, which I think was entirely valid, the agents saw the surge in migrant workers in the UK before it showed up in the national data in the early 2000s, and how this was having a disinflationary effect.

It was reducing labor supply constraints, it was reducing wage pressures, it was increasing growth. That fed into decisions made at the Bank of England in the early 2000s that, in retrospect, I think were right, but which were difficult ex-ante, were based on the national level data and some of the standard models, it looked like they were getting more inflationary. But because they had this hint in a consistent, interesting way from the agents, they knew that. They said, okay, let’s risk going easier for little longer because it looks like we’re getting positive labor supply.

A great example of a similar sort of thing is Al Greenspan in the mid ‘90s. Of all the things that justified his title Maestro, what really was the right thing that he did was roughly around 1996, he figured out (which again, couldn’t be proven ex-ante but was right ex-post) that the economy in the US and some other places, but mostly the US, was becoming much more efficient, productivity was gaining, information technology was having an effect. Before it was showing up even in micro data, he figured it out. Partly, it was the Beige Books, partly it was his own network.

Thinking very hard, he looked at different kinds of data than the model did. There are economists who worked at the Fed at that time who have stories about him sending them off to chase what’s the weight of the economy. And it’s like, what the hell’s the weight of the economy? They don’t track that. We don’t even know what it means.

At that time, very distinguished academic background policymakers, including Janet Yellen who was on the board, who later of course became Fed Chair and is now Treasury Secretary, and Alan Blinder, who is a very distinguished Princeton professor who went on to become Vice Chair, got it wrong. Even though they were progressives, they were out there arguing against him in 1996, ‘97, saying we have to raise rates, ’98. We have to raise rates because we don’t see this yet.

So anyway, just to say, and Alan Blinder has made this point very well, just to say you need some kind of model to have some kind of consistent base to structure the discussion so you don’t just opine off the top of your head. But if you’re doing it right, you’re still taking into account these qualitative, anecdotal, as well as where you start at this point, Alan. Research on different deciles of the economy behave differently.

[00:48:13] Alan

You talked to a lot of different factors there. Taking all of that together, where do you see things now from an economic perspective? We’ve had maybe a little bit of softening in the data from the real economy in the last month or so. So what’s your take?

[00:48:34] Adam

Well, let me put it in terms of the US economy. I can also talk about the UK or the Euro area for Ireland if you want, but let me put it in terms of the US economy. In my view, Alan, there are four major things come together, all of which you masterfully took us through even if I blathered on. First is the Fed is not as tight as they think they are. So even though the economy is softening, it’s not very accommodative and I don’t expect any sharp downturn.

Second, that fiscal policy in the US, notwithstanding what the election may lead to a split Congress, is likely to continue to be stimulative, at least compared to the baseline assumptions people are making, and possibly be much more stimulative coming in 2025. There’s going to be defense spending, there’s going to be infrastructure spending, there’s going to be industrial policy spending, irrespective of what happens in Congress, and that’s 50% of government budget, and possibly big tax cuts and other things.

Third, we arguably are at the start of the information technology jump. That’s a whole other topic we can go into. Jay Powell said they’d like to Greenspan in 1996 and say this is coming, but we don’t know yet. It’s probably going to take a little longer, but that’s there. Fourth, and this is something I work on a lot in my day job at the Peterson Institute, anti-trade, anti-migrant policies in the US are already inflationary and contractionary.

Under Biden 2, they’re likely to get a little worse, and under Trump 2, they will get enormously worse. That’s going to be inflationary. If you do the anti-migration policies, including deportations, that’s going to be contractionary, so you get stagflation. As I sort of said a few minutes ago, for a variety of reasons, not just officials who can’t markets don’t seem to be pricing in properly the inflationary effects of these policies or the inflationary effects of the fiscal policy.

So I think by a year from now, the Fed is going to be raising rates with a very high level of confidence.

[00:49:31] Alan

Interesting. We’ve talked to a number of those factors. Obviously, fiscal policy is very important as you say, and that’s been the thing that’s probably surprised a lot of economists, deficits of 6% and 7% when the economy is full employment. Barry Eichengreen was speaking at Jackson Hole last year talking about debt and deficits and saying they’re here to stay basically because political issues and the way you get it down is either austerity, which is no winner these days, or growth, which could be linked to productivity as you say, or higher inflation.

The point that people in the macro world always say is the central banks or governments are going to let inflation go higher to deflate away the debt. Does that ever come up in the conversation in central bank world?

[00:51:56] Adam

It does not come up in central bank conversations in high-income democracies. I know people insist it must be true. But the fact is, if you do the algebra, it takes an awful lot of inflation to make a material change to the debt. So the net debt over GDP picture in the US didn’t go up quite as much one-for-one as large deficits would have told you they would given the high inflation we had in 2020, 2021, 2022, but it still went up a lot.

You have to really get a lot of inflation to move the needle on that. Generally, you then lose it back, at least some of it, on interest rates. Similarly on productivity growth. We published a volume on this a couple of years ago. Productivity growth is great for real incomes, it’s great for the economy, but it’s not necessarily that helpful to debt sustainability for governments, because generally, your long-term interest rate, your real rate goes up one for one roughly with an improvement in productivity trend because the cost of capital reflects the rewards to capital. If the average reward to capital is going up because productivity is going up, you pay a higher interest rate.

[00:53:21] Alan

So G and R are both going up.

[00:53:23] Adam

G and R go up roughly. You probably get a little more on G than you do on R. So like with inflation, it helps, but it doesn’t take away the problem. My colleague Jason Furman, in various places recently, has made this point that even if we do get meaningful improvements in growth in the US, whether it’s in productivity or something else, that’s not enough to really get you back on a good fiscal path. You have to raise rates or you have to do massive cuts in spending.

[00:53:54] Alan

So how do you see that playing out? Do you see a possible fiscal crisis at some point in the next number of years?

[00:54:02] Adam

There are two answers to that. The first one is, if there is a fiscal crisis in the next few years, it is likely going to be completely due to political breakdown in the US not due to market forces. That doesn’t mean it’s not going to happen and it wouldn’t hurt. It both very much could happen and will hurt. But it will be driven by radical behavior if Trump and the majority Republicans sold one of the Houses of Congress or public violence or divisiveness in an extreme way that leads to a breakdown of government.

Happily, I’m not expert to put a number on that. Sadly, I think that’s a very real possibility. So you could get a fiscal crisis in the US for that, but it’s not going to have anything to do with the numbers. It’s going to be just because markets wake up and say, Oh, we’ve always given the US a pass, because we’ve always assumed if push comes to shove, they could cut spending and raise taxes enough to get things under control ,which at intervals the Congress not. If that faith goes away, that’s when you have fiscal crisis.

[00:55:17] Alan

Maybe a fiscal crisis is too strong a word. But what we saw maybe last summer going into October, yields going up to 5%.

[00:55:27] Adam

That is fair. So I think it is entirely reasonable. It’s part of the reason I’ve been saying, along with Larry Summers and some other folks, that R star, which again, is a non-measurable concept, the long run average 10-year bond rate on treasuries, the real 10-year bond rate on treasuries if the economy is at its growth path is going to be higher for the next couple of years, and a big piece of that is fiscal.

Now, if you look at the CBOE numbers, the national budget officers, the watchdog in the US, they estimate every persistent percentage point increase in debt to GDP is only worth a couple of basis points. So, over time, it just keeps going up, but it doesn’t go up by that much.

There are other ways to think about this that would suggest that it’s probably not that linear, that crowding out but also fears of misallocation of money, and as people realize that you’re spending more on interest payments as a share of government outlays than you used to versus useful things, or at least politically popular things, I think interest rates go up more.

When you’re in this zone, again, there’s no magic number. It’s not when you’re over 100%, therefore, bad things happen. But when you’re in this zone of large peacetime deficits, large non-pandemic deficits, the response to markets will be a little harsher. So again, not to mince words, a crisis, no, barring political breakdown, but economic pressures, a sustained higher interest rate on US government bonds, which then filters through to the rest of the world, yes.

One more thing which I’ll throw in is the US and the Chinese governments are both putting up barriers and discouragements to capital flowing out of China into the US. That was another thing that was keeping down interest rates, as Ben Bernanke spoke about the savings glut in the famous speech early in his chairmanship.

Some economists say don’t worry about that. They can try to put up barriers, but then the money just goes to Abu Dhabi, or Singapore, or Zurich, and then gets rerouted, or Dublin and then gets rerouted into the US. I think the kinds of things the US and China are doing actually do have some traction.

So, we potentially end up with a world, in my view, where that further increases US interest rates because there’s just simply a smaller supply of savings they’re drawing on to fund a larger supply of treasuries. It drives down domestic Chinese interest rates because they’re getting lower returns on capital because they’re not as diversified and money-strapped there.

But on net, for the world economy, the US interest rate, even if the Chinese economy is large in financial circles, the US interest rates are much more important. So we end up with higher rates for longer.

[00:58:45] Alan

Obviously, we’ve had the Treasury tactically issuing more bills to circumvent that. How sustainable is that?

[00:58:53] Adam

That I don’t like. I’m sure I’ve offended a bunch of markets people with my remarks on this call and I’ll just further reinforce that. I remember several years ago, a lot of people, including in markets, were saying the Treasury, if Austria can issue 100-year bond, why the hell isn’t the US Treasury issuing? I completely agreed with that. I didn’t understand why the US Treasury wasn’t going way out on duration issuance, given how low rates were.

People on the TBAC, the Treasury Borrowing Advisory Committee, which has a lot of serious market people at the time said no, no, no, no, that’s an illusion, that’s not the way to go, that will disrupt markets when you have issuance across the curve. I didn’t get it. I didn’t get it. But what the US Treasury is doing now strikes me as even worse. So it’s bad to forego the opportunity to finance a lot of good stuff at low rates.

It’s even worse, when you’ve got temporarily very high rates, why you would try to issue in short term as much as possible. There I do see the disruption to markets potentially, so I don’t get it.

[01:00:12] Alan

Okay. Final word briefly. Productivity, is AI going to change the world in the short term or not?

[01:00:20] Adam

I honestly don’t know, but I am reluctantly becoming a productivity bull. I do this as a macro forecaster, so not pretending to know anything about technology. I think there are two things that we’ve seen that are necessary but not sufficient for general-purpose technologies to take hold.

One is, and we’ve seen this with railroads, we saw this in the ’90s with fiber optic cable and the internet, one is, you need to see labor hoarding. You need to see in a disaggregated way lots of employers adding or retaining workers that, on current GDP forecasts, they don’t seem to need because they know something’s near, and we’ve seen that news. The other thing you need is crowding in of investment in a particular way, not just that we have lots of investment in Nvidia or in Chat GPT or whatever. But that huge amounts of investment go in because nobody knows who’s going to win the competition.

They know that at some point 5, 10 years down the road, there’s going to be a dominant company, but nobody knows which one it’s going to be. So everybody invests hoping they get the right one. There are signs, it’s harder to document, but there are signs of that going on. So to me, these two things are early warning indicators that we are having a positive productivity shift.

If you combine that with the stories of experts who you’ve spoken to about what generative AI can do, then I’m persuaded it’s coming. Is it coming in the next six months? Probably not. Is it coming in less than five years? Probably.

[01:02:03] Alan

Good stuff. Thank you very much, Adam. This has been a tremendous conversation. Thanks very much for doing this today. So make sure to follow Adam’s work because as you can tell from today’s conversation, we’re living in a truly global macro driven world. So from all of us here at Top Traders Unplugged, thanks for tuning in. We’ll be back to see a bit more content.

[01:02:21] Ending

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