The markets again are closely watching the Federal Reserve following its September rate cut. Much remains up in the air regarding monetary policy. BNP Paribas Chief U.S. Economist James Egelhof discusses the meeting and Chair Jerome Powell's press conference
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Transcription:
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Gary Siegel (00:09):
Hi, welcome to another Bond Buyer Leaders event. I'm your host Bond Buyer managing editor Gary Siegel. Today we're going to discuss the Federal Open Market Committee meeting and monetary policy. My guest is BNP Parabas Chief US Economist James Egelhof. James, welcome and thank you for joining us.
James Egelhof (00:36):
Good morning, Gary. It's great to be here. Thank you.
Gary Siegel (00:39):
So just a note to the audience, there will not be a separate question and answer period, so if you have any questions just put them in the queue and we'll get to them when we can. So James, was there anything in the post-meeting statement or Fed Chair Jerome Powell's press conference that either grabbed your attention or surprised you?
James Egelhof (01:03):
So this was a very exciting FMC meeting and let me give a little bit of context to how we see the Fed and how we've seen it for some time. Starting all the way back in November of last year, we've argued for taking President Trump's policy platform seriously and literally and for looking for tight immigration policy and elevated tariffs to impact the economy this year. As a result, we've expected a soft patch in economic growth, a period of elevated and persistent inflation and a labor market that remains in balance as we see both a cooling in labor supply due immigration policy and cooling and labor demand as well due to the transition effects and the uncertainty associated with tariffs. We've also looked for the Fed to be challenged by this on both sides of its mandate where it feared that if it stayed on hold for too long it could create a recession due to the economic uncertainty, but if it eased too quickly or too early or too deeply that it could entrench high inflation into the economy In a way somewhat reminiscent of what happened in the United States during the 1970s.
(02:06):
The Fed stayed on hold for a long time this year for nine months and then it last month in September it pivoted to easing. So for this meeting yesterday, we were looking for the second and what we expect to be or expected and continue to expect to be a sequence of rate cuts. We think those rate cuts are about two main drivers. One is the fed's desire to protect the labor market from what it perceived to be elevated downside risks associated with this cooling and labor demand. And second, in our view, an equally important concern was about diffusing the tense political relationship between the Fed and the White House, especially in light of the sensitive period coming up associated with the Fed chair transition. So we were looking for the Fed to come into yesterday announcing a further rate cut and setting up for another one to be delivered in December to further reduce rates down towards their perception of what the neutral rate is, the rate that's consistent with neither hitting the brakes nor the gas on the economy.
(03:06):
So what was most surprising about yesterday was Chair Powell's emphasis that the December meeting decision was not a foregone conclusion and his emphasis of themes in his economic discussion that would all else equal make an argument for putting rates on hold in December. Now, chair Powell in an unprecedented way seemed to be almost in dissent yesterday where he was arguing economic views that he would then simultaneously distance himself from. He would refer to views that were held by this group of people he referred to as they being the hawks on the FOMC. Powell used the word they about double the number of times he used that word in the prior meeting and he used it much more than he's used it at any other meeting this year. So he's beginning to refer to factions on the committee that he's having more difficulty bringing on board with the consensus and those factions are expressing concern about continuing to ease monetary policy from here.
(04:07):
It really surprised us to see how vocal these hawks were and how Powell delivered their message at the press conference. Those hawk's concerns are familiar to us. We see them being concerned about, as Powell argued, that the labor market is actually holding up quite well despite concerns over the summer that it was deteriorating that the neutral rate might be higher than the Fed currently thinks and that means that the Fed might be easing into an inappropriately stimulative stance if it continues with these meeting by meeting rate cuts and then inflation in this world might become entrenched in a way that the Fed might not be comfortable with or at least these hawks might not be comfortable with. So for us it was surprising to see this level of dissension and the intensity of these concerns about easing further in December. We continue to expect a rate cut in December because we think the Fed ultimately is following what we believe is an imbalanced reaction function where it continues to ease monetary policy even if the data either doesn't commit at all because of the shutdown or is relatively strong, but it eases more aggressively if the data is weakened.
(05:16):
We continue to hold that view and we think in practice in December the Fed might be faced with a set of unappetizing choices of either easing monetary policy and potentially making this period of elevated inflation last even longer or not easing monetary policy and taking the wrath of both financial markets and the president and increasing risks to the labor market. We think ultimately the Fed will choose the former course of continuing to ease. We think that's consistent with the reaction function they've laid out in the past several months, but the Fed is making it clear that there's going to be an increasingly rowdy debate about this choice in the coming weeks.
Gary Siegel (05:56):
Do the dissents have anything to do with the fact that President Trump has made it clear that Jerome Powell will not get another term as leader of the Fed?
James Egelhof (06:08):
So we saw two dissents yesterday. We saw one from Governor Muren who is arguing for more aggressive rate cut profile that was widely expected and we expect that he will continue to deliver that descent until rates are closer to 3%. There was another descent which is a bit newer from Reserve Bank President Schmidt who is arguing as we discussed a moment ago, that it's not appropriate to continue easing monetary policy. The question you asked which is very important is whether the descent from President Schmidt and also this apparent dissension from others on the committee who seem to have negotiated with Powell to deliver some of these hawkish messages at the press conference, whether that reflects a decline in chair Powell's leverage over the rest of the committee as the end of his term approaches. And it's entirely possible that as we approach at the end of Powell's term, that others on the FMC as the relationship comes to a close believe that there's more opportunity for them to assert themselves and less need for them to defer to his judgment.
(07:12):
Now the interesting is we haven't seen this type of behavior before under other recent fed chairs, so we did not see what I think you might refer to as a lame duck effect with Chair Greenspan or Chair Bernanke or Chair Yellen, but we may in fact be seeing it here and that may reflect in part the unusual political environment that we're in now that said, the intensity of these passions that are coming up on both sides of the committee both to continue to ease and to consider pausing also reflect the uncertainty of the moment, which is unique in and of itself. So we have a moment where there's no economic data coming in of note because of the government shutdown and we have widely diverging interpretations of the data we do have with some seeing the labor market flashing red and at stall speed and at risk of imminent recession and others saying the labor market is holding up okay and that the primary concern should be inflation. So we think it's a mix of both that Powell may be losing a bit of his leverage over his colleagues as his term comes to a close, but it's also the uniqueness of this moment in economic history that's driving some of this scenario.
Gary Siegel (08:20):
So you mentioned the government shut down which has halted release of most economic indicators that didn't derail this rate cut, but what impact does that have going forward with there seemingly being no end in sight to the government shutdown?
James Egelhof (08:40):
So look, we're hoping that the government shutdown ends soon and we're starting to see some encouraging indications from Washington. Both parties are meeting to discuss the prospects for reaching some kind of way forward. That said, when I talk to my clients, I definitely hear concerns from many that the government shutdown could last through Thanksgiving or beyond given the level of entrenchment of views on both sides of the political aisle on this matter. The Fed is in our view, likely to continue to cut in December even if the data does not come in because we believe that that is the most consistent with their stated objective of managing economic risks to the economy and is also consistent with what we believe is a second objective they have, which is to diffuse political tensions into this fed chair renomination process, which by the December meeting will be likely be reaching a peak.
(09:32):
That said, chair Powell yesterday delivered a bit of a contrary message where he indicated that there were different voices on the different narratives on this issue. What you do at the Fed if there's no data, there are some that argue in Chair Powell's telling that you have to, if you're driving in the fog you need to slow down. Usually when the fit chair delivers a powerful analogy like this, it reflects his thinking, it reflects something that's had a lot of influence there. Chair Powell also noted that others on the FMC have argued that if you don't have new data there's no reason to think that your perception of the economy should change and if their perception of the economy going into the shutdown was that there was a weakness in the labor market that required addressing with sequential rate cuts this year, there's no reason to think that that's changed. This debate is likely to continue to intensify and we'll likely see increasingly passionate views on it from different wings of the FMC in the coming weeks. Should the shutdown continue and we lack any other data of note going into December meeting,
Gary Siegel (10:38):
You expect another rate cut in December James and two in the first half of 2026, what would happen? Well, what could happen to change their projection?
James Egelhof (10:51):
So as I mentioned before, we think the Fed is following an imbalanced reaction function where the burden of proof to stop rate cuts is pretty high, but the burden of proof to accelerate or make larger the rate cuts is a bit lower for us. The concern that would lead them to want to pull back on further rate cuts completely is evidence that the unemployment rate is declining. We think the Fed is okay with inflation getting a bit sticky so long as the stickiness is at a level that's not too high. So we think if the Fed would be comfortable allowing inflation to run for another few years yet in the high twos or the low threes, if that is the price that has to be paid to de-risk the labor market and to de-risk the institution from political pressure in order for inflation to remain only at those levels and not accelerate, we think in the fed's lens it's necessary for the labor market to not tighten any further.
(11:48):
If the unemployment rate was for example to decline well through 4%, that would take us back to levels of tightness that we saw during the pandemic reopening where we saw goods price increases from supply chain shortages, get amplified through wages and produce a very powerful wave of inflation that the Fed view is highly undesirable and disruptive. We think the Fed is not interested in these dynamics recurring and that it would end rate cuts and consider other choices available to it if it saw evidence the labor market was actually tightening significantly through the unemployment rate. On the flip side, we think the Fed would become very unconcerned about inflation, would become very confident that inflation was a solved problem if labor market slack was to begin to accumulate more significantly if we were to see the unemployment rate rise, the tension right now that the Fed which is controlling this relatively gradual pace of rate cuts is a concern that the labor market isn't especially loose and could tighten to the point where these dynamics, these inflationary dynamics recur.
(12:49):
If we were to see evidence that the unemployment rate was spiking, those concerns would no longer be as salient and we think the Fed would be much more comfortable moving more rapidly to and through its perceived neutral rate, which they see as around 3%. So for us there is a dated dependence to policy. It's a bit skewed towards further easing if the data comes in very weak, but there is certainly a tail risk where the economy comes in strong, the data comes in strong where the easing would be slowed. Now the data that we've seen so far this month, the little we have and the data we saw just before the shutdown in September has actually been quite encouraging and is consistent with an economy that's doing well. We saw GDP revisions in September which flipped the script on the consumer, which indicated the consumer earlier was thought to be weakening, thought to be pulling back these new GDP data suggest the consumer actually has held up quite well.
(13:47):
What we've seen more recently, including couple of days ago from payroll's, data collected by the private sector from a DP indicates that the labor market might actually have been bouncing back from period of softness towards the end of last month. So this data is broadly consistent with an economy and a labor market that has remained stable, that is continuing to grow that is not accumulating significant labor slack and it increases the salience of the risk to us that labor stack actually starts to diminish. We think that is a remote tail risk but we think it's a tail risk. The Fed is watching closely and that's part of the argument in our view why the Fed is trying to open up a little bit more optionality for the December meeting and beyond because they're concerned that there's this tail risk of a labor market that tightens and becomes more prone to inflation that that risk is becoming more salient.
(14:37):
We think in addition to the risk that rate cuts are paused or pulled back, there's additional risks that rate cuts are simply delivered more slowly and this is the argument that Powell made about driving through the fog. Ordinarily in monetary policy when you're confronted with elevated uncertainty, the usual best course of action is to move a little bit more slowly and gradually so as to get a better sense through the data of the response of the economy to the actions that monetary policies to the forces that monetary policies imposing on it. So if the Fed were to be concerned for example, that it was easing too much easing into a stimulative stance where that's not appropriate, it's easier to detect that in real time if the Fed was to cut a bit more slowly. And so we think that's part of the argument that the hawks on the committee were asking Powell to make yesterday that perhaps if the data continues to not come in because of the shutdown and there remains this uncertainty about the true state of the economy and what direction it's going, that it might be better from a risk management perspective to move a little bit more slowly.
(15:44):
We don't think that view will carry the day, but it's an argument that many people on the FMC have and that they're going to continue to argue for quite passionately.
Gary Siegel (15:55):
Do you think the Fed and the bond market are on the same page?
James Egelhof (16:01):
Well they were closer to the same page now than they were a couple of days ago. So going into the FMC meeting, the market had priced the December meeting with basically complete certainty and had priced continued monetary policy easing into next year with a relatively low terminal rate or terminal rate that was below the rate that was in the FMCs projections, but we think the most important source of disagreement between the Fed and the bond market was specifically about the next meeting or two and the level of certainty that the market had put on rate cuts going in the next few meetings with the Fed. It generally doesn't want to surprise or disappoint the market on the day of an FOMC meeting. It doesn't want to come into a meeting where 25 basis points of price and deliver no rate cut. So if the Fed wants to open up the possibility to not deliver a rate cut, that communication needs to be delivered in advance.
(16:54):
That meeting needs to be repriced and so what we think we heard from Powell yesterday was that the market was a little bit too confident about December that perhaps of rate cut in December is still the base case and that's our view of course, but there's a possibility there's a risk that depending on the data flow and depending on how this debate among these increasingly rowdy factions of policymakers plays out that they might not be able or willing to deliver that rate cut. So he seemed like he wanted to open up to reduce the odds of that rate cut being delivered from a hundred percent. So as of yesterday evening it had been reduced to two thirds and that's probably closer to where PAL wants it. He probably likes it being priced in being expected, but where there's a bit of wiggle room, a bit of optionality for him to change course if that's something that he either has to do because of the internal politics of the Fed or feels appropriate to do based on where the data is coming in.
Gary Siegel (17:50):
There had been talk of the possibility of a 50 basis point rate cut at some point. Do you think that's completely off the table now? What would it take for that to be an option at some point in the next year?
James Egelhof (18:08):
We've actually felt that the 50 basis point rate cut has been on the table and we felt that for a long time. We felt that all the way back to April, shortly after Liberation Day. It's never been a central scenario for us. It's always been a risk, but our view is that if we see evidence that the unemployment rate is going to spike, then the Fed would respond very aggressively because there will be less concern about inflation and there'll be much more concern about the stability of the economy and the labor market. We think the political environment where the Fed has lost support from the White House and has also lost support in Congress further limits the fed's ability to remain hawkish in the face of a deteriorating labor market. It would likely make the Fed want to move very aggressively towards and through the neutral rate if we were to see evidence of a genuinely deteriorating labor market.
(18:56):
So for us, we could see a scenario if the data were to support it, where we saw rate cuts that were almost the mirror image of the rate hikes that we saw during the pandemic reopening where the Fed realized this monetary policy stance was not appropriate for the moment and felt the need to move in a determined and aggressive and quick way to a new policy stance now. So we don't think it's off the table. It does in our view require data. So for example, the approach that Governor Muran is proposing where he says we should recalibrate monetary policy based on a theoretical argument about where the economy might go in the future based on President Trump's policies, we don't think that that argument will carry the day at the Fed. We think it ultimately a decision to accelerate rate cuts has to be documented.
(19:43):
That has to be backed up by actual economic data that's been realized and for us the most important signpost for that is the unemployment rate. Another important signpost for that is jobless claims. We in our view need to see evidence of a shift in corporate behavior towards layoffs and towards an accumulation of labor slack. Ultimately for that to happen we need to see some kind of catalyst and we need to see some downside risk to the economy realizing from here and right now we don't see it right now, we think the labor market is relatively healthy, it's going to remain at the current level of slack and that's why we don't expect the 50 basis point rate cut in our economic baseline, but we think the risk is there and we think the Fed will be happy to provide this type of stimulus if the data is supported.
Gary Siegel (20:27):
James, are you at all?
James Egelhof (20:33):
I'm sorry you cut out there.
Gary Siegel (20:36):
I'll repeat the question. Are you concerned at all about stagflation?
James Egelhof (20:41):
So in our base case for the economy, economic growth continues to come in positively, but it's a little low historically and inflation becomes a bit entrenched at a level a bit above 2%. So we're expecting inflation to run more or less indefinitely at the high twos to low threes based on continued slow but inexorable pass through of tariffs and based on a services sector that would require an elevated unemployment rate to deflate its rate of inflation and we don't think the Fed is prepared to do that. So we expect somewhat soft growth relative to US economic history and we expect inflation that's a bit above the fed's target. So it's possible to argue that this is a sort of a mild form of stagflation. We don't usually use that word, but it meets the definition in a very mild way. Now I think when people talk about more severe stagflation like we saw in the seventies, that requires a bit more than what we've seen so far that generally requires a more profound adverse structural shock to the economy that causes growth to be very poor for a period of time and it requires a deterioration in what economists call long-term inflation expectations essentially that people lose confidence in the value of the dollar over time and because they've lost that confidence, they engage in economic behavior that causes that inflation to occur and to become repeating to become entrenched in the economy as it stands Now we don't think either of those things either this adverse productivity shock or this deterioration in long-term inflation expectations has happened.
(22:19):
Inflation expectations over the long-term have actually been reasonably steady and the person we have most to thank for that is Jay Powell and that he remained on hold for nine months this year in the face of economic data that was at times very difficult in the face of a significant equity market decline around liberation day and in the face of market pricing that at times called for emergency intermediate rate cuts by staying on hold and communicating the fed's commitment to returning inflation at least somewhere close to 2%, the Fed has drawn a line under some of these more significant deteriorations and if confidence around the value of the dollar that would've provoked more of these severe 1970s deflation scenarios. So we think that that's not in the cards right now as respects the growth potential of the economy. When I talk to my clients, I hear actually quite a bit of optimism about the growth potential of the economy and a lot of that comes from ai.
(23:13):
There is a belief that's very widespread out there now that once AI has been fully commercialized and has been adopted in the broad global business community that this will produce a significant pickup in labor productivity and will open up the door to multiple years of non-inflationary above his growth above historical trends. That is underpinning a confidence that has kept the economy out of recession this year according during these shocks and is helping us avoid some of this more pessimistic deflationary scenario that you throw out. So look, is there a risk that we have a period of above 2% inflation? Yes, we think that's possible. Is there a risk that we have a period of soft growth historically driven in part by immigration and lower growth in hours work to the economy? Yes, we see that too, but do we see this type of nonlinear dynamic that's reminiscent of the seventies? No, we don't see that right now.
Gary Siegel (24:13):
How serious do you think the Fed is about hitting the 2% inflation target? Would two and a half percent be sufficient for them?
James Egelhof (24:23):
So for us it's a question of we think they would like to return to 2% that remains their stated goal. Powell has emphasized it repeatedly in increasingly strong words including yesterday that the committee's inflation target is 2% and that the whole group of 19 policy makers is committed to returning it to 2.0%. So they have been steadfast in communicating that as their policy target. Now they have done a couple things that have suggested that their tolerance for inflation remaining above 2% for a time is there is that there is significant tolerance for it. They've done this a few ways. They've done, as Powell did yesterday, talked about a counterfactual inflation, but for tariffs like CPIX tariffs or PC inflation X tariffs, this seems to be a way to signal that tariff passed through might go on for a while potentially for years and the Fed might be comfortable declaring broad victory on inflation is saying that it's around 2%.
(25:23):
But for this factor, another approach that's been used by some policymakers, not by Powell but by others has been to talk about inflation as being within a reasonable range of 2%. Say, look, our goal is 2% and look a reasonable range or controllable range around that might be a hundred basis points and so long as we're with, if inflation is running at 2.9 or 3.0 that's close enough, that's within the range. We've also seen policymakers compare inflation to during the pandemic and say, look, yes it's still a little high but look how much progress we've made and we should be patient and look for that progress to gradually. So for us, we see policymakers as being willing to tolerate a moderate entrenchment of above 2% inflation so long as it's not too much and so long as there's some credible argument by which over the medium term inflation might be returned to 2%.
(26:17):
Now to do that is a challenge. We are in our view likely to see elevated goods inflation potentially for many years as businesses slowly but continually pass through margin pressure associated with tariffs to final demand prices. We think that they're trying to make this as imperceptible as possible to protect their market share, to protect their brands, to protect their customer relationships, especially in light of the possibility that a terrace might be moderated or eliminated even if that's many years from now potentially when Trump is out of office. But we think that process is going to continue and it means that the goods deflation that we've seen in the US for the past 25 years, essentially ever since China opened up to the world that that goods deflation is likely to be offset by continued tariff margin pressure pass through in order to address this pickup and goods inflation that we think is sticky.
(27:20):
It would be necessary to reduce services inflation, which is the other part of inflation, it's goods and services. Services inflation is driven heavily over the medium term by wage costs and in order to deflate services inflation, it would probably be necessary to push up the unemployment rate for a period of time and allow an elevated level of labor slack to do the work to bring services to inflation down. That's an extraordinarily painful choice to make because it puts people out of work actually it harms ordinary American working people and it's a tough choice to make for a public policy maker at any time, but it's particularly tough for this fed which whose policymakers tend to have come of age during an era where the service of the ordinary American working person was paramount at the central bank and also in a situation where the Fed lacks some of the political support that it might think it needs in order to run this type of unpopular policy for a sustained period of time. So for us it's easier to see a period of moderately above 2% inflation first of all because we think the Fed is willing to put up with it so long as it's moderate and secondly because we think the policy choices that would be necessary in order to bring inflation all the way back down to 2.0% on a sustained basis are really tough and it's harder to see them making those choices in the near term.
Gary Siegel (28:42):
I'm going to take some questions from the audience because we have a few that seem to be follow-ups. First one, I think you just answered this, what would it take to happen to get to 2% inflation? Is there anything you want to add to what you've just said?
James Egelhof (29:00):
Yeah, look, I think that's a great question to ask a policy maker too of is your policy stance calibrated to return inflation to 2%? We think there are a couple of legs if that was the objective that would need to be accomplished to do it. The first, which I think the Fed has been very effective at over the course of this year is to maintain confidence in expectations for that to happen and economics and expectations often create reality. So if you and I expect inflation to be 3%, you and I will engage in wage and price setting behavior that's consistent with that and that behavior actually causes inflation to run at 3%. So it's of paramount importance that the feds signal credibly to the market and to the general public that it is committed to returning inflation to 2.0% and that that's going to happen that Powell has done everything in his power from a communications perspective to pound the table, say that's what they're going to do.
(30:01):
So we think that that part of the puzzle so far has gone okay. The second is whether they are prepared to make difficult policy choices that involve putting upward pressure on the unemployment rate in order to achieve that objective. This is part of the last leg of maintaining that credibility we touched including over the short run. As I mentioned before, price stability isn't free and it can at times need to be paid for through elevated unemployment, which has significant human costs that has to be taken into account. In order for the Fed to make that choice, it has to be prepared to take accountability for that choice and it has to have enough political support from the overall government to be able to retain its independence and autonomy even while that labor market deflation is occurring. We think that the Fed has been very reticent to talk about this trade off as it stands now the Fed has actually taken the other side of it that they've focused increasingly on maintaining the labor market at a level of tightness, not about tolerating an increase in the level of slack and we think that the political support that would be required to run out the unemployment rate without a response is not currently there.
(31:14):
So to expect a, we think that those policy choices are available, that's what we required. I think the Fed has done a lot of what's necessary to draw a line under inflation and prevent it from rising too far, but to take it this last mile and take it from three to 2% is costly and we think it may be a cost they're not quite prepared to pay in the near term.
Gary Siegel (31:36):
Next question from the audience, how much of the current inflation rate do you estimate is due to tariffs?
James Egelhof (31:47):
We think a large proportion of it is due to tariffs. We continue to see wages that come in relatively strongly and that is supporting elevated inflation outside of the core services X housing. So we continue to see relative warmth in services inflation, but we think tariffs are still the main driver and over the medium term, that's where we continue to see the bulk of the above 2% inflation coming from. The risk here for the Fed is that if the labor market is allowed to tighten that, that could change and we could see an increase in services inflation due to a tight labor market. The Fed has also been concerned in recent months that signs of a price taking in the services sector evident in business surveys like the ISM services release and some signs of warmth in services inflation outside of housing. In some of the more recent inflation readings we got before the shutdown, that those send a signal that services inflation might become more entrenched and more elevated. It's still very early days to expect that to become recurring and we think the Fed, that is a trigger that would cause the Fed to become much more cautious if it was to become concerned that services inflation was becoming persistently high. But for now our view is that the bulk of elevated inflation is coming from tariffs and tariff price pass through.
Gary Siegel (33:13):
The next question we have from the audience is what is the effect of the AI data centers on inflation since these are unregulated?
James Egelhof (33:26):
So let me talk a bit about AI in general and then we'll talk a bit about the specific effects and different economic data. We think AI has kept the economy out of recession this year and it's not just about CapEx. We're actually take a more sanguine view on the sustainability of tech CapEx. We think that tech CapEx as a contribution to GDP growth has been historically normal this year Close there too. Our view though is that the AI boom has had broader economic effects in the US beyond just the CapEx contribution to growth. Also has provided a significant wealth effect to the consumer and has stimulated consumption growth over the course of the year as higher income consumers who own equities spend against those gains that they've seen in the mag seven equity stocks. Secondly, we think that the AI boom, as I mentioned at the start of this conversation, has drawn a line under broader business sentiment including outside of the artificial intelligent industry, outside of tech by convincing businesses that just over the horizon, a robust economic boom awaits one with strong growth and low inflation driven by labor savings associated with ai and that in that world one does not want to enter, excuse me, as a business into that world under invested, understaffed, under resourced, if we've seen in prior recessions and recoveries is that firms that have chosen to pull back on their capacity on their staffing going into an expansion have found that they've permanently lost share because they haven't been able to recover the staffing, haven't been able to recover the projects, haven't been able to recover the capacity in a timely fashion.
(35:09):
So we think that the overall AI story, not just CapEx, but also the consumer and their spending against their equity gains and the business community becoming more optimistic about the medium term and investing accordingly because they're convinced about this productivity boom that lies just over the horizon. We think that that has kept the economy out of recession and it's helping it continue to grow. When we talk about the AI boom, it's pretty normal for clients to ask us about risks ai, some valuations in AI are purportedly stretched. I'm an economist, I'm not an equity strategist. I think there are a lot of different views on whether the current AI equities are overpriced or underpriced. For us though, as economists, if we were to see a significant decline in sentiment, if we were to have a moment of disillusionment about AI similar to what we saw towards the end of the 1990s about the tech boom that could provoke recessionary dynamics because you would probably see a lot of these effects that I referred to reverse. You would see some of the CapEx drawdown, you would see the consumer pull back because of lower equity valuations and you would see the business community writ large reevaluate their level of medium term optimism. If there was to be less confidence that AI was going to provide this productivity bill, we think in that world the economy could actually move significantly and we think the Fed might well step in with more aggressive easing in that world.
(36:37):
We have seen some evidence, and this is to answer your question specifically, that AI is impacting electricity prices and other specific areas of inflation. We think that the AI industry has been trying to locate its assets, its data centers in places where there's available electric capacity or where there's low energy prices and those data centers may well be pushing up those energy prices. We've seen some of that in the data this country has over the past few decades suffered from challenges in permitting and other regulatory constraints to building a variety of industrial projects, but in particular energy projects, not just building the actual facility and also interconnecting it to the public electric grid. Should those challenges continue where it's challenging to build operate energy infrastructure, it's possible we will see continued sustained inflation and energy and we think that that's an issue that the administration seems to be well aware of and it's discussing solutions to in real time. So we are seeing an impact our near term economic forecast for inflation. We think AI is having a dramatic effect on the overall growth trajectory of the economy and we think it's very important to watch these public policy developments related to permitting and other regulatory reform to get a sense of where some of these more AI specific inflation stories will evolve for the medium term
Gary Siegel (38:07):
Term. So last question we have for my audience is why does the Fed cutting interest rates actually increase mortgage rates?
James Egelhof (38:19):
So we've seen mortgage rates have declined to level low, low levels relative to where they've been. So the expectations for rate cuts and for an easy accommodative monetary policy stance from the Fed have crept into mortgage finance and that's occurred gradually. It doesn't necessarily just occur on the day of an FOMC meeting because the fed's actions ultimately are anticipated. One concern the Fed has had about delivering more aggressive monetary easing is about the response of the yield curve. And so when we're talking to the bond buyer, talking about the yield curve seems especially important. The Fed has been concerned that we might see if they were to ease too aggressively dynamics that are similar to what we saw around rate cuts in the fall of 2024 where rate cuts coincided with the rise in longer term yields perhaps either associated with a pickup in long-term inflation expectations or a resurgence in confidence about growth that was reducing the risk, the flight to quality or the safe harbor premium of longer term treasury assets.
(39:27):
So the Fed has been focused on, in our view, on trying to find a moderate pace of rate cuts that allows for those rate cuts to be more seamlessly transmitted to broader financial conditions, including the long end of the treasury market. So our guests, given the fed's gradual pace and their relative success at managing long-term inflation expectations, our view is that we'll continue to see a relative stability in the yield curve and that we won't see a big hockey stick higher in the long end that would cause mortgage rates to rise sharply as I think your questionnaire is asking about. But that's a risk particularly related to concerns about the Fed's independence. So for us, the risk around a yield curve steepening, some of it is about the Fed moving to an excessively easy stance and that creating an inflationary entrenchment, but it's also about where is the Fed going as an institution over the coming years, particularly as the composition of its leadership and its personnel changes. As we move further and further into this administration, if we were to see a Fed chair, the selected who was viewed as very dovish or very political or if we were to see more transformative change to the Fed coming out of a shift in the composition of the Federal Reserve Board of Governors, that has the risk of creating a more significant yield curve steepening, but as of now there's been relative stability and that's been because of the feds relative success in maintaining stable long-term inflation expectations.
Gary Siegel (40:59):
So we have an follow up from the audience. How does AI data center inflation affect other countries globally?
James Egelhof (41:09):
So I only cover the US so I think my guess would be that you would see broadly similar conversations and dynamics abroad, but there are also different issues abroad. So I think that's a great question to ask other folks from BNP and perhaps we can bring them out to meet you, but that's from our perspective where they're seeing a tremendous AI investment in the us, particularly in regions that have underutilized power generation capacity or that have relatively low energy prices and will likely continue to see that go on as the AI boom continues and as firms that are leading this industry continue to invest in order to seize the commanding heights of what is thought to be the technological revolution of our lifetimes. I think the key thing for us in the US will be in the medium term about the ability of supply to keep up with demand and about the ability of government to find a way to allow for the permitting and interconnection of energy assets to support this investment in AI data centers and increase AI demand for compute. That's our core view on that topic.
Gary Siegel (42:24):
Do we need a more reliable measurement of inflation since no one who shops in the real world believes these 3% numbers?
James Egelhof (42:36):
Look, I think there's been a lot of concern among the clients I talked to about the quality of government economic data and we hear two lines of concern. One is that because of staffing cuts and a decline in morale at the Federal Bureau of Labor statistics that we will see data that is noisier or that suffers from methodology issues. We think that there's reason to be concerned about this. We've seen an increased use of a variety of technical descriptions to this. Were basically shortcuts that are taken by the physical agencies and the construction of these releases due to the inability of them to staff their process fully. That likely makes the data more prone to revision and perhaps a little bit less reliable as a bleeding edge leading indicator of where the economy has gone, given that some of these shortcuts might involve extrapolation from prior months from prior releases.
(43:35):
So we think that's a serious concern. We think that it's a concern both for labor data for payrolls and also a concern for inflation data like CPI. Those are both relatively labor intensive processes to collect. And the short answer is we think that these agencies are aware of the issue and if the public's concern and that solutions are probably likely only over the medium term, there has been an increased focus in MySpace and economics and trying to find alternative data sets. And we actually heard Powell speak about this at some length at the press conference yesterday where he mentioned by name a variety of alternative data vendors that he was looking at to get information about where the economy was going during the shutdown. But we are reasonably well aware he consults these vendors even during normal times as a compliment to the official data.
(44:25):
So for example, for labor data, they're well known to consume data from a DP, the private sector payroll processing firm, and Powell for example, mentioned price stats, which is a firm that provides a goods price inflation tracking data. So we think that these data sets, they're not a substitute for fixing the official data or resolving concerns about it, but they can provide some a compliment, they can provide a little bit more reassurance in the short run as we move through the need to plan out and implement a period of enhancements to the official data. Clients are also sometimes asked about the risk that data is politicized and that the data is somehow altered in some way. We don't have this concern. We think that there's enough transparency into the federal statistical agencies including the BLS, that if there was to be this type of impropriety in the collection or dissemination of data that we would be aware of it in real time. We also think the Federal Reserve is deeply familiar with the data collection and processing approach that's followed by the Bureau of Labor Statistics and that it would be transparent if it had such concerns and they haven't expressed any. So we remain broadly confident in the integrity of the US data process. We think that's an important part of the US having a reserve currency and being the world's destination for savings and capital and we expect that to continue indefinitely.
Gary Siegel (45:52):
We have two more questions from the audience. Do you have time for that because we've hit our limit?
James Egelhof (45:58):
Absolutely. I would be pleased. Okay, great.
Gary Siegel (46:01):
Okay, so one question is why is there a difference in view of retail investors and professionals on the outlook? Consumers are not scared and they continue to spend while professionals are scared about the future of the economy.
James Egelhof (46:23):
Look, I think there are, getting a read on the consumer is difficult. We look at consumer surveys and we see that the consumer appears to be pessimistic. If you look at measures like conference board or the University of Michigan, but then we see that the consumption data continues to be quite robust and we see there's this dichotomy across types of economic participants where we see sometimes the survey data and people's behavior don't entirely match. This is a period of elevated economic uncertainty and there are reasonable interpretations of data in many different directions. Here at B and p for example, we believe that the labor market is robust, that there's relatively little slack, that the decline in job creation is primarily structural related to immigration. It's not cyclical and that therefore you would not ordinarily be looking for a significant monetary policy response. Others, including many at the Fed and also competitors of ours believe that we are seeing emergent cyclical dynamics where the economy is deteriorating and robust rate cuts are required to keep it stable.
(47:38):
The data can be read in many different ways. We're confident in our view, but others are confident in theirs in the absence of any new economic data at the first order because of the shutdown that simply amplifies these types of divergent thinking. It causes people to lean into views that they've had and it reduces the possibility for them to be convinced to move from one camp to the other. So until the government reopens and we start seeing robust economic data again, we're likely to continue to see this type of disagreement and for those views to get a even more dug in a bit.
(48:14):
So I think this dynamic is going to continue. I think in terms of sentiments about markets and the economy, I think what we've seen from what I've seen from my clients is a broad sense of optimism about growth. I think we don't hear a whole lot of concerns about recession anymore. We hear a lot about AI and about when are we going to start seeing productivity gains from that and how is that going to affect the Fed and think we see a broad confidence around the consumer that the consumer, despite reporting pessimism to surveys, is continuing to spend and probably will continue to do so.
Gary Siegel (48:54):
Last question, James. Why does anyone want to support 2% or 3% annual inflation and prices when salaries are not growing at this rate? Where did the fed come up with that arbitrary target and would the Fed ever set a goal of 0% inflation?
James Egelhof (49:15):
Okay, so where does the 2% inflation target come from? So ultimately the 2% inflation target was born originally out of a framework that former chair Greenspan we talk about often, which is a level of inflation that is high enough to not provoke significant risk of deflation of people having to take wage cuts but was low enough so that it didn't become disruptive in people's thinking about the economy and about price setting. And so 2% was chosen as a number that sort of fit this high enough to not create economic frictions associated with zero but not so high that it created a feeling that prices were growing out of control. The Fed locked in this target officially in 2012 as part of a framework review, and it has stuck closely to it. There have been proposals over the years to increase it or to make it a bit more flexible, for example, by having a range around it.
(50:15):
And those proposals have been consistently passed on because they would be economically disruptive and because they lack public support. The Fed experimented a bit in 2020 with making the inflation target a bit looser by allowing for this inflation averaging over time. This framework they moved into right at the start of the pandemic. And that at this point has been regarded as not a success that that approach was regarded as perhaps causing the Fed to be late in responding to emergent inflation and as difficult to communicate to the public. So as part of their framework review that concluded back this past August, they have reverted back to a 2% point target. The challenge with going to a 0% inflation target as your questioner asked is that there's ordinarily noise around inflation. Sometimes it's a little higher than the target, sometimes it's a little lower, and also individual experiences are different.
(51:14):
So even if overall inflation and overall wage inflation, for example is around zero, some people will be getting raises and some people won't. A well-known behavioral friction with people that people don't like to take pay cuts. It's called a nominal rigidity. And so ordinarily it's easier to recalibrate wages, for example, by saying inflation is going to be 2% and you're getting a 1% raise and you're taking a 1% pay cut in real terms then to say that inflation is zero and I'm actually going to reduce your pay in dollars by 1%, that second thing happens less often. It tends to be more done through layoffs, which is more economically disruptive. So the thinking in monetary policy is that it's necessary to have a target inflation, a rate of inflation that's somewhat above zero to allow for the avoidance of these nominal rigidities to the maximum extent feasible.
Gary Siegel (52:15):
Well, that concludes our Leaders event. I would like to thank the audience for tuning in and I would like to thank BNP Parabas Chief US Economist James Egelhof for joining us and providing his insight. Thank you so much and have a great afternoon.
