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Transcript
Marc P. Seidner, CIO Non-traditional Strategies: Hello, and thank you for joining. I’m Marc Seidner, chief investment officer of Non-traditional Strategies at PIMCO. It is my pleasure to be joined by Dr. Ben Bernanke. Both a colleague and a friend. He’s former chair of the US Federal Reserve and deftly steered the economy and the central bank through the Great Recession and the global financial crisis. He is a senior advisor to PIMCO and chairs our global advisory board.
Investors are hoping for more stability in interest rates in 2024. Today, we’ll explore if and how that can happen.
Ben, let’s start with financial conditions. It’s been a volatile couple of months, actually three or four months, in financial markets. A pretty steep increase in interest rates in September and October, with ten-year Treasury notes touching 5% and then a pretty rapid decline in interest rates in November and so far in December.
Can you tell us or talk through your broad reading on financial conditions now, particularly given the historically significant policy tightening that we’ve seen over the last 18-24 months?
Dr. Ben Bernanke, Former Fed Chairman and Senior Advisor to PIMCO: Sure, Marc. The Federal Reserve would say that conditions are relatively tight, given that the federal funds rate has been increased by 500 basis points in a relatively rapid succession. Given that federal funds rate and longer-term interest rates are higher than inflation so that real interest rates are high, and you could look at some sectors like the mortgage sector and see pretty constrained conditions.
But if you look at other indicators, it’s a little bit more of a mixed story. You know, we’ve seen bond prices go up. We’ve seen the stock prices go up recently. If you look at indicators like the Chicago Fed’s National Financial Conditions Index, you find that overall, taking into account all financial assets, the dollar and other things, that financial conditions are actually a bit easier than the historical average.
So, there’s a little bit of a contradiction there. I think the Fed would argue that the tightening conditions relative to ’21 and the current level will be sufficient to continue the slowing of the economy, which has already begun and which they feel they need to get inflation back to target.
Seidner: The Federal Reserve updated its summary of economic projections for the path of interest rates and for the economy. They revised down slightly for 2024 their expectation for inflation. They revised down slightly their expectation for GDP growth. And there was a meaningful reduction in expectations for where policy will land towards the end of 2024.
How should market participants interpret the latest projections?
Bernanke: People who follow the Fed look often at the so-called dot plot, which records the individual projections of the participants in the FOMC as to where they think the federal funds rate, the policy rate ought to go over the next couple of years. And the dot plot this time showed first that the most participants are, essentially all participants, think that a further increase in rates is pretty much off the table.
And they saw three cuts during 2024, which is more than they had previously expected, and suggests that they are really open to the idea to begin to cut rates. This is based on a view which is also very positive. Their summary of economic projections includes their forecasts for the economy, and they see both inflation coming down to target by the end of next year, early 2025, and an unemployment rate that doesn’t go above 4.1.
So that’s what we call a soft landing. And that’s something that there’s a lot of skepticism, whether the Fed could pull that off. But at least for the moment, participants at the FOMC think that that’s going to happen. This pivot, or change in view, which has been driven by good inflation data in recent months.
I do want to give a few caveats. First, the dot plot and the forecasts are done by individual participants in the FOMC without, it’s not part of the of the meeting. It’s not an official pronouncement of the FOMC.
Secondly, there was an awful lot of disagreement. If you looked at the dot plot, while the median suggested three cuts in 2024, the range of possibilities, according to participants, was quite wide, suggesting there’s a lot of uncertainty and disagreement about how rate policy was going to evolve.
And the final point to make is that, of course these projections are all contingent on the data. So, if we come to a situation where the inflation data takes a bad turn or the economy looks like a three accelerating, you could see a significant change and presumably a tightening of financial conditions.
Seidner: Ben, as you know, from your interactions with PIMCO’s Investment Committee, we tend to build portfolios across a wide range of scenarios without banking on one particular outcome or another. That said, we’ve had a pretty optimistic outlook for the bond market, particularly given valuation and the rise in rates in recent months.
Right now, many areas of financial markets are pretty confident in rate cuts in 2024 by not just the Federal Reserve but by global central banks.
Can you talk a little bit about why and what tools the Fed will be using to ascertain when the timing might be right and what order of magnitude might be appropriate for policy reduction in 2024?
Bernanke: The Federal Reserve is very focused on getting inflation, and they target a particular index called PCE inflation, not the CPI. They’re very focused on getting that back to their 2% target. And things are moving very decidedly in the right direction. So that’s good. Then why would they stop tightening?
Well, first, if they were convinced that inflation was on a path that was going to get to 2%, and they evaluate different components of inflation – just to give one example, rents are a very big share of inflation in terms of the basket that is used to measure inflation. And there’s a very good expectation that rent statistics will begin to come down over the next few months, given that new leases that are being signed across the country are showing actual declines in rent in many cities.
So they believe that inflation will be coming down, and it’s already to some extent built in. So why cut? Well, one reason would be that we don’t need as tight a policy anymore, that we don’t want to unnecessarily slow the economy. Secondly, you don’t wait, as Jay Powell has emphasized a number of times, you don’t want to wait until you get to 2% to begin to cut because policy works with a lag.
And if you did that, you would end up with inflation undershooting the 2% target. So you’ve got to move in advance of inflation reaching 2%. And a third reason, which has been emphasized recently by Governor Waller, is that as inflation falls, given the interest rate, given the nominal interest rate, the real interest rate sort of passively increases – that is, given the novel interest rate, falling inflation means that inflation is falling relative to the interest rate.
It makes the real cost of money higher. So just to avoid that problem by passive tightening, you would want to cut. So all of these factors lean in the direction of cutting as long as inflation is moving in the right direction. Now, why would you delay cutting?
Just a couple of reasons to mention. One is that while it looks like the economy is slowing, there’s always the possibility that, you know, it could begin to accelerate. And so, what the Fed is looking for is an economy which is growing a bit below its long-run potential growth rate.
And so, you don’t want to overstimulate the economy when you get things on a good track. Another reason is that the data month to month can be very noisy. And the Fed has already had a few head fakes where they thought inflation was coming down. And then the data the next month or revision of the data showed that progress was not as great as they expected.
So I think they’ll be patient. I would think that the market view that cuts will come as soon as March. Personally, I would go a little later than that, but it’s a very, very hard thing to judge.
Seidner: Can the economy remain resilient in 2024? I suppose one of the surprises of 2023 has been that inflation has moderated to the extent that it has without an increase in the unemployment rate or without a decline really in economic activity. Do we need areas like the labor market to weaken, or the housing market to weaken, to get inflation back to the 2% inflation target or effectively be able to navigate that last mile from two point something to 2.0?
Bernanke: So, there’s really two questions there. One is, do we need a recession to get inflation down? And then the second question is, will we, in fact, have a recession going forward? And let me talk about the first one. Do we need a recession? The answer is, no. And the reason is that disinflation is not your grandfather’s inflation. This is not like many inflations in the post-war period that were driven by overheated demand.
Instead, inflation, this time, as the Fed has recognized and its economists generally recognize, has a very substantial supply-side component to it. That includes, for example, the big increases in energy prices and food prices. That came about first because of the reopening of the global economy after the pandemic and then secondly because of the Russia-Ukraine war, which added further pressure on commodity prices.
So those commodity prices going up first, obviously directly add to inflation, but they also indirectly add to inflation by raising inflation expectations. People see gas prices go up. So they say, well, I need a higher wage. And by raising costs, you know, transportation prices go up when fuel prices go up, for example. So that was one important supply element.
Second one was the famous supply chain problem. During the pandemic, people switched their spending very much from services. Instead of going to the gym, they switched to goods. They bought a treadmill at home. And so this big switch, very substantial switch from services to goods, put pressure on the ability of firms to deliver those goods. And that pressure was made even worse by the famous supply chain problems.
So prices of cars and other durable goods shot up and contributed very much to the inflation. And finally, and this was something perhaps that should have been better anticipated as the pandemic ended, people didn’t come right back to work besides working from home, and they just didn’t get reemployed. And participation rates were low and there was a shortage of workers.
And that, too, was putting pressure on wages and prices. And what’s been happening is that all of these things have been reversing. Energy prices have come down recently. Food prices have flattened out. The supply chains are in much better shape. We got much better participation in labor market. All these supply-side improvements have contributed to lower inflation. It’s not to say there aren’t demand-side factors, there are, but the improvement of on the supply side, it gives you sort of a painless disinflation.
It doesn’t involve a slowing economy. In fact, it probably adds to economic growth. So that it’s still true that the Fed will have to slow the economy somewhat because there are still demand-side pressures arising, for example, from fiscal and monetary policy at the end of the pandemic and other factors and the labor market is still quite tight, but they’ve already made a lot of progress in slowing the labor market.
The second question, briefly, is, will we, in fact, anyway have a recession. That’s a little harder to say. We have had some slowing. We have had a Fed tightening. It’s very hard to calibrate exactly how big that effect is. There are other forces that we can anticipate. My sense is that will either have a very mild recession or no recession at all.
So, in either case, I would call that a soft landing. My confidence is based on the fact that consumers are in great shape, relatively speaking, financially, and that’s supporting their consumer spending along with strong labor income. So we’re only seeing a very moderate decline in sectoral cyclically sensitive sectors like construction and manufacturing. So I would guess that we will not see a serious recession.
It’s possible that there’ll be a technical recession with a modest increase in unemployment, but that would probably require new shocks that are not yet on the horizon.
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