The Fed Holds Steady with a Dovish Pivot

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

KATHY: You just heard Liz Ann's voice there, but actually she's not feeling well today. She's pretty much lost her voice. So my friend, colleague, and general partner in crime, Liz Ann Sonders, I hope you're feeling better soon and I'm sure you'll be back for our next podcast. But this week, I'm going to be the sole host.

It was a big week for the bond market courtesy of the Federal Reserve. At the Fed's last policy meeting of the year, the Committee left rates unchanged, but confirmed a pivot toward rate cuts sooner rather than later.

The dot plot, that's where each member of the Fed estimates where the Fed funds rate will be over the next two years, suggests that there will be three rate cuts in 2024, followed by more cuts in 2025 and '26, until the Fed funds rate is back at 2.5 percent.

Now while on the surface that wasn't too surprising, after all, we had penciled in three rate cuts for next year, but the shift or the pivot came sooner than anticipated. And Fed Chair Powell's comments were really taken as much more dovish than expected.

What surprised me is that the Fed went from a policy stance that was rather backward-looking to one that was more forward-looking. So far in this cycle, the Fed has indicated it wants to see inflation down before it will even consider shifting policy. Inflation is down, but still pretty far above the 2 percent target. But now the Fed has shifted to being more forward-looking again and willing to ease policy before actually hitting the target. Now that's a good thing.

Monetary policy is meant to be forward-looking, but it is a change from how the Fed has been communicating over the past year or so. I think that's why it took the market by surprise.

But it all comes down to the Fed's confidence that inflation is heading lower, back to its 2 percent target. We certainly agree. The signs of disinflation have been showing up in wholesale prices for goods, such as oil, import prices, which have been down for about 12 consecutive months, but also more recently at the retail level, where rents and gas prices have been coming down. We just weren't sure that the Fed saw it that way, and we're ready to act on it.

Well, needless to say this shift in policy or indication of a shift in policy from the Fed was good news to the bond market. Bond market celebrated this long-awaited pivot and yields fell sharply. Ten-year Treasury yields fell below 4 percent for the first time since August. So, it looks like happy holiday season to investors, courtesy of the Federal Reserve.

On that note, today I'm speaking with someone who has deep knowledge of how the Fed operates, and that's Dr. Julia Coronado. And I will give her credit as someone who had anticipated the Fed cutting rates sooner rather than later, and by more than the market was expecting. So, she should be on your radar as an expert to follow.

She's the president and founder of MacroPolicy Perspectives, which is an independent research provider.

She has more than a decade of experience as a financial market economist, including as chief economist for Graham Capital Management and BNP Paribas. After receiving her PhD in economics from the University of Texas at Austin, Julia worked for the Federal Reserve Board of Governors in Washington, D.C. for eight years, so she's got some great perspectives she can share about Fed policy with us. And she's currently a clinical associate professor of finance at the University of Texas at Austin, a blogger for the Rutgers Business School, on the advisory board of the Pension Research Council at the Wharton School, and the Economic Advisory Panel of the Federal Reserve Bank of New York. So, she's got great credentials, really thrilled to have her here today to just chat with me about the economy, about the markets, about Fed policy, what she's seeing, and get her perspective.

Dr. Coronado, thank you so much for coming on this podcast.

JULIA CORONADO: It's my pleasure to be here with you, Kathy.

KATHY: I'm going to launch into a couple of questions that I really have been saving for you. The first one is—as an economist, can you talk about how this business cycle, this economic cycle, is different from others? It seems like it's been really difficult to get a grip on the way the economy has performed this time around.

JULIA: So there's so many ways in which this cycle is different. I mean, we've had just a tremendous amount of disruption from the global pandemic. It was such an unprecedented event in a modern economy like we've had. We've had global pandemics before, but we've never powered down a highly interconnected modern market economy. So that very process and shutting it down, trying to turn it back on, different countries with different policies, different experiences with outbreaks, just added so much sand in the gears of the economy—so much disruption. And then just figuring out what was happening in the economy. Collecting the data was challenging. You can't go out and conduct surveys or gather information when everything is on lockdown. So the data itself got disrupted.

And then everything from seasonal patterns of economic behavior—you know, we are largely beyond the pandemic now, but in many ways our behavior has changed. Work from home is a new element. What people do and how they do it has changed back and forth. So lots of real changes, hard to map into our usual models. Lots of unexpected new dynamics that really kind of kept defying our best attempts at forecasting the economy. So lots of well-intentioned but very wrong forecasts. It was a very humbling experience as a forecaster.

KATHY: The market signals, along with the economic signals, have been way off from what we normally would anticipate in a business cycle. So it's been challenging, I'm sure, not just for economists, but for people in the markets too trying to navigate what's going on here.

JULIA: Yes, absolutely.

KATHY: I did want to ask you though, if there are areas of the economy that you're particularly worried about or some that you think are performing much better than you would have thought at this stage of the year, like what stands out right now in this cycle?

JULIA: I mean, the shining star of the cycle has been the labor market. It has just been incredibly resilient, incredibly strong. We've seen employers change their behavior, you know, the whole concept of labor hoarding where they're not so quick to flip into reductions in force and firing workers as revenue growth cools. It just really has been tremendous and underpinned the US consumer.

The leadership of the US economy is back. Last cycle, China was really the leader of the global cycle. That seems to be not happening. China is quite a laggard right now, and instead the US and its resiliency has been the leader. So that's been a big change.

The yield curve inversion has been with us for quite some time now. We didn't go into a recession camp because the job market was so strong, but lots of people, that was the modal forecast last year is that we would be in a recession, and a lot of signals and a lot of recession models pointed in that direction.

So, it has been quite unique. A lot of those relationships are disrupted, those rules of thumb, and there's lots of reasons. I mean, of course, the Fed is doing a lot to influence the yield curve with this both QE and now QT, and it adds a lot of volatility.

KATHY: So Julia, one of the places that I have noticed that this has been an unusual cycle is with credit spreads. They really have stayed low despite the fact that we've had these tremendous ups and downs in the market and in the economy. What do you make of that?

JULIA: I think in some ways I think about it as, you know, kind of lagged effects of the easing that are now offsetting some of the tightening, right? You've got household balance sheets that are really strong. There was all this excess savings. That seems to be largely gone, but credit quality actually improved through the cycle. That's pretty unique. We're starting to see delinquencies rise, but from a very low level.

So, it just gave us all of that support, all of that fiscal support that was given to consumers. They used it to stay current on their loan obligations. We've never had a recession with improving credit quality. And so we're starting from this position of strength to absorb it. So, when you ask, "what do I worry about?" I worry about the lagged effects of the easing running out and the lagged effects of the tightening kicking in.

So, a lot of people, both businesses and consumers, refinanced at the lows of interest rates. And so, they're locked into some of this very low funding costs, but that's going to roll over with time. And with time, we're going to face higher funding costs. And so, you know, we can see that in the banking sector, they're holding onto these, you know, big losses on their bond portfolios, as yet to be recognized losses on commercial real estate with a inverted yield curve to boot. So, a lot of really big challenges for the banking sector.

It's been, you know, pretty smooth sailing, relatively speaking, after the three bank failures we had earlier in the year. But I'd say that's still an area of concern for me, that, you know, the banking system is being challenged, and particularly not the big money center banks, but the mid-sized banks. Seems like the small, small banks are also doing OK in lending, but it really is that mid-tier of large regional banks that are just facing tremendous challenges.

KATHY: Yeah, it's an interesting dichotomy because it's like, well, people have jobs, they're doing OK. They had jobs, they had savings, the consumer's doing OK. But it's the lenders that got caught with the wrong loans, the wrong rate at the wrong time, and they're the ones who are struggling.

So you mentioned all the support that came from the Fed, and now the Fed's kind of taking that away. So where do you think the Fed goes from here? I mean, I think they can take a little bit of a victory lap right now that things are going kind of according to plan, right? We're getting inflation to come down, the labor market's cooling off. Things look pretty good. But where do you go in 2024 if you're Jerome Powell and company?

JULIA: Yeah, no, I mean, I would say it's even going way better than they had planned, right? I mean, I think the immaculate disinflation we've seen with no real weakening, no material weakening, just gradual cooling in the labor market, and yet a tremendous cooling and inflation, that's quite unusual, certainly better than they had hoped for. They've been very cautious to take a victory lap. They keep looking back at that mid 70s example where inflation cooled off, they cut rates, inflation reaccelerated. So, I think that the scar tissue from being behind the curve on inflation is going to be with the FOMC for a long time. They're going to be pretty reluctant to turn around and cut.

That being said, there's two scenarios I can see them cutting rates next year. One is if we do actually have a recession scare, if not an outright recession, if we actually start seeing that cooling in the labor market, which has been so gradual, turn into something more worrisome with job losses, a faster rise in the unemployment rate—that's going to be, you know, especially given the US leadership this cycle, if the US economy cracks, the global sentiment is going to turn pretty hard. So, you could have a financial market tightening that's global in scope. And you could see the Fed take action. I think the bar is higher given that they're approaching their 2% inflation target from above. So, they have to really see some deterioration before they're willing to take action. But nonetheless, they've got some scope to take action if the economy is clearly sliding into recession.

The other scenario is, again, the immaculate disinflation continues. We continue to get cooling, the economy is OK, but inflation continues to trend lower. The stated strategy is to eventually start cutting the nominal funds rate with inflation so that you keep real rates in check. That still seems to be the plan. Either of those scenarios, we could see them cutting rates.

One of the interesting interplays right now on monetary policy is between balance sheet tightening and interest rates, which the Fed is telling us that's going to be different this time, that they might keep tightening through the balance sheet, keep shrinking their balance sheet, even as they stop hiking interest rates or even start cutting interest rates. So, the active tool is short-term interest rates.

I sense a very strong desire by the FOMC to shrink the balance sheet further. And I think part of that reflects that like banks, the Fed is sitting on a lot of big losses on its portfolio. It's in a negative-income position. And of course, that doesn't really matter for the central bank, but I think that makes them uncomfortable almost from a political economy standpoint. The government is used to them remitting money to the government, not taking money out. So, I think there's a sense that they would really like to get that down as much as possible.

KATHY: Yeah, I have my concerns about that just because—and I sort of equate it to you're driving down the road and you have one foot on the gas and one on the brake, right? You're easing rates, but you're tightening through quantitative tightening. It's like, what are the unintended consequences of this kind of policy? I know, you know, they have tools to address issues that might come up. I know there's still a lot of money in the RRP, or Reverse Repurchase Program, that can be drawn down. So, I understand that they have their arms around this and they're actively looking at it, but I do wonder how we've not done this before. So how is it going to work in real life? I think that's one of the big questions, but you're right, they seem committed to this kind of strategy.

JULIA: Yeah, no, Kathy, I share your concerns. I think that there's every possibility that they do sort of a replay of 2018 where they kind of run into a wall first and then adjust their balance-sheet policy. Chair Powell has said that is not their intention, that at some point they're going to taper the pace at which they're shrinking the balance sheet. And so I would imagine maybe, at the first meeting in 2024, they'll have kind of a briefing and start talking about what that plan might look like, even if it's far off.

But yeah, I mean, who knows? There's lots of volatility in bond markets, even at the short end of the yield curve. So there's every possibility that we could have some volatility from this process moving forward.

KATHY: Yeah, I think one thing we can count on is volatility.

JULIA: Yes, agreed.

KATHY: Yeah, I did want to get your take. There's so much talk about fiscal policy right now, and deficits, and rising debt levels. And it's really sort of permeating now the atmosphere. Although, I would say it doesn't look like anything's happening, it's just a lot of talk, right?

So, I'd like to get your perspective on what that means going forward. Does that affect Fed policy? We hope it affects maybe fiscal policymakers, but how do you think this plays out or do you have some scenarios?

JULIA: So, I think one of the reasons that conversation sort of ramped up in Q3 this year was it was part of a perfect storm that sent bond yields spiking. And that perfect storm included, you know, a surprise widening in the deficit. So, the CBO had been forecasting that the deficit would be kind of in steady in that sort of 5%, 6% range of GDP for the foreseeable future, that we had narrowed very sharply from the wide deficits of the pandemic. And we were kind of in this zone where those are elevated deficits, certainly something to have a medium-term fiscal conversation about, but then we got a surprise widening. And that came from declining revenues, not increased spending. And that was surprising because the labor market's strong. So one of those features that you had touched on early in our conversation, unusual features of, of the pandemic recovery, that's reversed partly. You know, I think we're back on the CBO-projected path for the deficit. And, you know, of course, the data have come in to alleviate some of the worst fears of inflation. And we've seen some relief on bond yields.

So I think for markets that might push the conversation more to the medium-term bucket of concerns, rather than this sort of very heated, intense conversation we were having. You know, clearly in the political realm, it's a source of theater, you might even call it—dysfunction, certainly. And unfortunately, I think that's also going to be a feature of 2024. Unfortunately, it's an election year. That's just a whole other headwind from uncertainty because we're looking at some very, very different scenarios depending on who wins the election. And that level of uncertainty tends to be a headwind to decision-making firms, trying to make decision about allocating capital and planning for the future when you can't even really see beyond the tip of our nose becomes challenging.

So, I think the fiscal conversation—anything sensible over medium-term prospects is not likely to be a 2024 issue. Hopefully we get there in 2025. But we seem to be having a hard time prioritizing that.

KATHY: That's a very diplomatic way of putting it. Yes. I always envisioned—you know, the ideal is—I would love to give every member of Congress an Excel spreadsheet with assumptions, right?

JULIA: Yeah. Yeah.

KATHY: And say, "OK, you work it out. You come to a conclusion here." But of course, that's not going to happen either, so.

JULIA: When I teach MBAs, I think it's Brookings has a deficit game where you have to—you get the levers like, "OK, your job is to balance the budget," you know, here's the—and it illustrates how extraordinarily difficult it is to do without really hurting things that you care about or, you know, really raising taxes. I mean, one way or another, the choices are hard and it's a good way of illustrating that.

KATHY: So, speaking of teaching, I know you teach undergraduates, and we have a lot of listeners who are well educated. They're up on the markets, but they're always looking for things to read that gives them a good feel for what's going on in the economy at a level that's not a PhD, full of equations and things kind of thing. And I would love to get your sort of a takeaway here at the end, just—what do you encourage your students to read or people who are just interested in learning more about the economy, more about the markets, understanding how things work? You know, what is it you read? What do you encourage them to read?

JULIA: You know, I often have my students read the economic speeches that Fed policymakers give, you know, the good outlook speeches. Not the deep-in-the-weeds topical ones where they're tackling a topic they are focused on or care about, but the big economic outlook speeches from either the chair or really anybody on the FOMC. They go through the economy. They go through the labor market and inflation and specific issues that are arising of late. They talk about how they put it all together, how they're balancing risks. So, it's a great illustration. It's very timely. 

When I teach, you know, I just take one of the most recent speeches and have the students read that and it kind of pulls things together because they're talking about the data they're learning about and the relationships between policy and the economy and some of the thematic things that are happening in the economy. So, I think it's always a great way to just keep up on things. Obviously, people like you and I do that as part of our jobs, but for people that are just looking to like, "What is going on in the economy? And can I get a relatively unbiased kind of clearheaded view of what's the true picture?" Fed speeches are a great source of information.

And then they all do these kind of publications for their districts. So, depending on what district people live in—I'm in Austin. I often go and look at, for my own personal reasons, what the Texas economy update is from the Dallas Fed. Because they do a great job of pulling together local information.

KATHY: I have to say my favorite thing to read that's put out by the Fed is the comment section of the Dallas Fed's business outlook.

JULIA: Ha ha! That one gets colorful.

KATHY: I mean, like a very colorful commentary.

JULIA: Yes, yes.

KATHY: I go right to it. I enjoy it. Maybe that's a little nerdy. But you do … I think when the … we started to see some of the members of the Fed sort of lean towards, "Hey, we're on hold now, we think we've done enough." You could see a lot of that was coming from the comments from the district.

JULIA: Yes, absolutely.

KATHY: You could see there had been a shift away from, "Oh my gosh, inflation is the worst thing we're facing," to, "Oh, wait a minute, financing costs are high and things are slowing down." And so you really get a good sense from that. Yeah, I love reading that stuff.

JULIA: Yeah.

KATHY: And I always joke with people. They ask me about how a statistic is put together like CPI or something or all this inflation measure. They say, well, there's what, 300 PhD economists at the Fed and they've all written a paper on inflation?

JULIA: Ha ha!

KATHY: So, if you really want to deep dive, go ahead and have fun.

JULIA: Yeah.

KATHY: But that's a great suggestion. That's a great suggestion. OK. I will run with that.

JULIA: OK. All right. And you're right. You know, that's been a very interesting theme because we touched on how complicated and noisy the data have been. You know, we had this 5% GDP quarter almost in Q3 and yet Fed officials were like, "Yeah, but you know, that's not really what I'm hearing from my constituents." It's not a 5% economy. It feels like things are slowing more steadily than that. So that was a really interesting example of triangulating across different information sources in a world where things got so disrupted that you just have to absorb as much information as you can and do your best to average through it.

KATHY: Yeah, and I think that it's good for people to recognize that this is what the Fed is struggling with too.

JULIA: Yes, yes.

KATHY: I mean, they don't have a crystal ball. It's not magic. They're struggling to put all these pieces together as well, just like those of us in the market, and consumers out there, like, what's the next headwind I'm going to face, or what's the next tailwind I'm going to have?

JULIA: Yes. That's another big tension is you've got this job market that by every metric we would say is fabulous, you know, just downright stunningly amazing. And yet consumer sentiment is pretty gloomy. And that's been a weird thing. You know, consumers are spending. They have jobs. They're getting raises. They're getting real wage gains. But yet, there's still this sense of pessimism about the … and even not just generally, but specifically about the economy, which is just you know, I guess a reflection of some of the disruption. It's kind of an interesting open question as to why that's the case.

KATHY: Yeah, I get the sense that it's the legacy of the magnitude of the inflation…

JULIA: Yeah.

KATHY: …and then the feeling that, "Oh my gosh, the Fed has raised the rate so much that even if the price of say a car hasn't changed, the cost of buying it has changed because the financing cost has gone up." So there's this kind of feeling like, "Well, you're telling me inflation's coming down, but I feel like maybe it's going up."

JULIA: Some things are getting more expensive because of the financing costs.

KATHY: Right, right.

JULIA: That's an excellent point. Yeah.

KATHY: Yeah, so it's a lot of tension, a lot of mixed signals right now. Well, I'm just going to put you on the spot. For 2024, how many Fed rate cuts, assuming you think we're going to get some. Last question, how many do you think we'll get?

JULIA: We've got four to five penciled in. We've got more than the Fed has. We are more optimistic on the inflation outlook than the Fed's baseline. So we've got a faster cooling. We think that they probably want to see core PCE inflation below 3% before they cut. So we don't really have them starting till May or June. And then depending on how things are going, whether they do every meeting or every other meeting, I think there will be a sense that, you know, short-term rates don't need to be this high. And, you know, inflation is on its way down and you can at least start a gradual sequence of cuts. So we think that, you know, and again, this is a non-recessionary scenario where they don't need to panic. Things might not be booming, but they're not sliding off the rails. And so they can take out a little insurance, can keep the expansion on track. So I think that's not an unlikely scenario. Of course, uncertainty's high and lots of other possible scenarios are out there as well, but that's our baseline.

KATHY: Well, this has been great. Thank you so much for being here. I really enjoyed the conversation.

JULIA: It's been an absolute pleasure, Kathy. Thank you.

KATHY: Thanks for listening. I'm @KathyJones—that's Kathy with a K—on Twitter and LinkedIn. 

We have one more episode for you this month. Next week, Liz Ann will be speaking with a really interesting guest, Keith McCullough. He's a former hedge fund manager who now runs his own firm called Hedgeye. So join us next week for that discussion as well.

For important disclosures, see the show notes or Schwab.com/OnInvesting, where you can also find the transcript.