During this keynote address, the Moody's chief economist will share his views on the country's macroeconomic picture.
Transcripts :
Announcer (
00:09):
All right ladies and gentlemen, here we are for our last session of the day. We have Jira McGuire from Moody's managing Director. She is going to be welcoming in our Zoom attendee tonight, our presentation for the keynote speaker. So let us give Jira our attention. Thank you.
Jira McGuire (
00:35):
So, hi, I am good afternoon. I am Jira McGuire. I am an associate managing director at Moody's Investor Service in the Texas office and we really appreciate you coming to hear our keynote speaker today. Dr. Zandi is our chief economist and a managing director at Moody's Analytics and we had a few technical challenges beforehand, so we're going to look at his picture and hear his voice and go through some slides together. But if you are not familiar with Dr. Zandi, he really focuses on macroeconomics and financial markets and public policy and testifies and helps businesses and policy makers understand the economic environment we are in and we're welcoming them back this year for the second year in a row. So thank you for joining us and we will get started.
Dr. Mark Zandi (
01:34):
Thanks Jira, it is good to be with you. I apologize for not being there and for all the drama, but I appreciate the opportunity. Just for sake of disclosure, I am also on the board of directors of MGIC, which is a publicly traded mortgage insurer. I am surprised you invited me back. I can not remember what I said last year. Hopefully I got more than half right. So thank you for the opportunity to come back again, I am going to speak for 20 minutes. Mike talk has four parts to it. Part one is just a quick assessment of where things stand and I think it is fair to say the economy is still struggling with the still very high inflation in high interest rates and we will talk a little bit about that. Then we will quickly turn to the outlook. My horizon is the next 12,18 months. I think it is fair to say under any scenario it is going to be a bit of a struggle, but I will make the case in part two for an economy that is able to avoid an outright recession.
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02:49)I think that is the most likely scenario and we will talk about the reasons why, but then in part three, turn to the risks and why recession is such a serious threat to the economy. And then finally in part four, I will turn to a couple of indicators that I think would be important to watch to gauge which scenario is unfolding: the no recession scenario, my baseline or the darker recession scenario. So with that you can turn to the first slide and you should see the treasury yield curve. And I will have to say that the consensus view I think at this point among economists, policymakers, CEO's, is that we will suffer some kind of recession in the next 12,18 months. Mild recession, short recession, but a recession. And the reason for this view is history. If you go back historically and look at periods when the economy is grappling with uncomfortably high inflation and the Federal Reserve is responding to that by raising interest rates aggressively, that invariably results in an economy that goes into an economic downturn.
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04:14)Very difficult for the Federal Reserve to kind of thread the needle between raising rates high enough, fast enough to slow the economy's growth to get inflation back in but not raise rates too high, too fast and undermine economic activity. The other reason for the consensus is the many of the leading indicators point to recession and that is the point of the chart with the yield curve, the difference between the 10-year treasury yield and the three month treasury me the federal funds rate target the Fed, the short term interest rate, the Federal reserve controls, I am showing you data monthly back into the seventies. The last data point is for the month of March. And you can see every time the funds rate rises above the 10 year, the so-called treasury yield curve inverts that line. In the chart goes negative recession follows, not too soon thereafter, recessions are denoted in the chart by the red shaded bars.
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05:19)I am not going to go into the intuition behind this or the logic behind it. I will say, and here is a bit of an advertisement. I have a podcast, I might have mentioned this to you last year called Inside Economics. I think you need to be a little nerdy to fully appreciate it. But I sense this group is on the nerdy side and I mean that as a compliment. And I had Cam Harvey Campbell, Harvey Duke finance professor, not long ago, and he popularized the yield curve as a leading indicator of recession. It was the basis of his PhD thesis a couple decades ago. And an interesting conversation with him. He talked about how foolproof the relationship is between an inversion of the curve and a recession. Six out of six he said in the last six recessions. But then I asked him, well what does the inversion mean this go round?
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06:14)And he is, he said, to my surprise, there will be no recession. This go around this time is different. So anyway, I am not going to go through why he says that, but that is a bit of a teaser. If you are really interested you can go listen to inside economics, but nonetheless, when the curve inverts, you have to take that seriously as a recession. Okay, let us turn to the outlook. And let me begin with a bit of optimism. As I mentioned earlier, I do think there is a better than even probability and I do not want to be pollyannaish here. I mean recession risks are high, but I do think there is a better and even probability that the economy can navigate through without a full-blown economic downturn. So my kind of baseline most likely scenario is not a recession, what I call a slow session. And you can see that in part two of the deck, a slow session is an economy that is not going anywhere fast.
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07:15)So the popular description of not recession is soft landing. But that does not resonate with me. I do not think what we are going to experience here over the next 12,18 months is going to feel like a soft landing. it is going to feel uncomfortable. So slow session, let me give you two reasons for optimism and here you can go to the next slide on inflation E2, my optimism is the expectation that inflation is going to come back down to the federal reserve's inflation target in a reasonably graceful way. And that is what I am shown in that chart. That is a consumer price inflation CPI inflation year over year, quarterly Q1 2019 through the end of 2024. You can see where history ends, the forecast begins as the shaded part of the chart. Got another data point today, very encouraging in that top line CPI inflation is now down to 5%.
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08:15)It peaked at nine back last June. It is now five and I do think it is going to continue to head south here over the next 12, 18 months or so. There are three phases to the slowdown. Phase one, we are in the middle of the net, we are towards the end of now. And that is the slowdown related to an easing of supply chain problems. We are going back to the pandemic and a winding down of the fallout of the Russian War on Ukraine on energy prices and food prices. Food and energy prices have come back in as the effects of the war have begun to fade. There is still a bit more to go here. One positive development over the next few months should be a fall in vehicle prices. We should get a lot more production coming out of Japan and Germany in the next few months as the auto sectors in those countries are able to ramp things up as their supply chain issues are winding down.
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09:23)Now that China is on the other side of its covid restrictions and again the Russian invasion is no longer disrupting, at least not to the same degree production in Ukraine, that is key to the automakers in Europe. And so we should see some decline in new vehicle prices in the next few months. Phase two, it goes to the cost of housing services. That is a big part of CPI over a third of the index and that has been growing very strongly, a reflection of very strong rent growth a year ago. And the good news is that we have seen a very significant increase in multi-family construction as the supply chain issues and labor market issues related to the pandemic wind down and demand for rental units has weakened given the high previously surge rent and now high rents. And so vacancy rates are starting to rise and that is, that is good news from an inflation perspective because rents are now flat to down and that is going to be reflected in much slow growth in the cost of housing services as we make our way into the second half of the year.
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10:31)And then the third phase will be later this year into next. And that goes to the cost of non housing services, mostly labor intensive activities like healthcare and hospitality, personal services. That goes to the expectation that the job market will continue to soften. We will see some increase in unemployment wage growth will come in and that will allow service companies to kind of reign in their price increases and we should get inflation back to target. If that path holds reasonable soil for inflation, then I think we're pretty close if not at the end of the federal reserves rate hikes, maybe one more rate hike when they meet again in early May, put the funds rate target just over 5%. But I think that would be the end of it because they will be satisfied with the path given that we can weaken in the economy and of course given the stress that have been evident in the banking system and the financial system more.
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11:33)One more reason for optimism before I move on and that is in the next slide is consumers are hanging tough. Consumers continue to drive the economic train, they are the firewall between recession and no recession of course they are doing quite well in terms of jobs and unemployment being so three and a half percent. We actually are starting to see real wage growth turn positive again, real wage growth being wage growth, less inflation. So that is very encouraging. And as you can see in the chart, there is still a lot of so-called excess savings that savings that consumer above which consumers did in the pandemic above which they would have done if there had been no pandemic. So this is on top of what they would have typically done. A lot of the excess saving is now with high income households, we were sheltering in place and could not spend during the pandemic.
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12:27)And of course they are the, there is key to consumer spending because that is where the bulk of the spending occurs. In fact, the folks just as to give you a sense of that, the folks in the top 10% of the income distribution account for almost half of all the consumer spending in the country. Stock prices are down, housing values have kind of rolled over here. But despite that, there is still stock prices. Stock values and housing values are still well above what they were pre pandemic. So I do not think people are feeling like they have lost a lot of wealth. So I expect consumers to hang in there not to spend with an abandon. I do not expect that, but I do expect them to do their part, continue to contribute as they historically have done. And if they are able to do that as I anticipate, then the economy should be able to avoid risk.
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13:17)But obviously this gets to the risks and let us turn to part three of the conversation. Recession risks are high less than even, but nonetheless uncomfortably high over the next 12 to 18 months. And if you turn to the next slide, which is a risk matrix, this encapsulates the various threats to the economy here in the near term. Let me just describe this matrix to you. The X-axis to horizontal axis represents the loss, the economic loss, the cost if the risk were to occurs in my mind is kind of like a present value of economic loss. So it accounts for the timing of the loss as well. So for example, you can see climate change, it is in the southwest part of the chart, not that climate isn't a big deal when it comes to the economy, it is economic implications, but that is going to play out over a long period of time.
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14:11)It is less threatening here and now and certainly over the next 12 to 18 months. That is why it is, it is where it is in the matrix. The Y axis to vertical axis represents the probability of that risk, obviously a subjective assessment. So you really want to focus in on the northeast part of the chart and you can see that all the way in the northeast is the potential for federal reserve misstep. And I do think this is the biggest threat to the expansion. And this goes to my earlier point about threading the needle. That is not easy to do and the Federal Reserve is in a very difficult spot. I am expecting that they will be able to pull this off, but very possible that they do not get this quite right. They could for example, continue to raise rates here in the near term focused on inflation push rates closer to six, better fund rate, closer to 6% as opposed to five.
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15:16)And at that point I suspect that would break something else in the financial system, in the economy would go into recession. Conversely, they could pause here and that could be a turn out to be a mistake. Inflation becomes more entrenched and they ultimately have to raise rates even more aggressively just later in the year or in early 2024 to combat the higher, more persistent inflation and that will push the economy into recession. So for the Fed to get this right is difficult and obviously a risk. The other risk that you will see very quickly is the bank credit crunch. And this goes to the banking crisis that has unfolded here over the past several weeks. Now the crisis is over. I do, I believe there will be. I would not be surprised if there are a few more bank failures, but they will be small bank failures and the federal government has made it clear that it will step in to backstop all of the depositors in the bank.
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16:14)So I think the crisis is over in the sense that there will no longer be any more significant runs on the bank, no deposit runs if that is the case, that is good news, but there will still be fallout from the failures that occurred in the hit to the banking system, particularly smaller mid-size banks are still under a lot of pressure with the deposits and are now pulling back very aggressively on their lending standards and underwriting. And you can see that in the next slide. That slide shows you some data from a senior loan officer survey that the Federal Reserve conducts every quarter. They ask senior loan officers are they tightening, underwriting or easing it? And what is shown in the chart is the difference between the two. It is a so-called diffusion index. So if it is positive, that means the net percent of respondents are tightening underwriting.
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17:17)You can see I am showing you data back in history for three different types of lending, CNI lending, that is commercial industrial lending. That is lending done by banks to businesses, credit cards and commercial real estate loans, CRE loans. And the data I am showing you is even before the crisis, the bank banking system was already tightening down on underwriting as pressure was starting to build, they were having all kinds of asset liability management issues, deposits were already under pressure and as a result they were starting to pull back on lending. But now they are sure to tighten down even more aggressively and that will mean much weaker lending growth, weaker credit, and of course that will have impacts on consumers and businesses on the broader economy. In my baseline optimism, I think the hit to the economy should be manageable, but a lot of risk around that very difficult to gauge and the credit crunch could be much more severe and its impact on the economy much more significant.
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18:19)Okay, let me now end with part four and you turn to the next slide and talk about two indicators. I would watch to gauge which scenario is going to unfold here. The first, and this is shown in the slide that is showing you consumer confidence as measured by the survey conducted by the conference board. It is a monthly survey and I am showing you a lot of history. At the end of the day, a recession is a loss of faith. Consumers lose faith and pull back on their spend spending, they think they are going to lose their job, they pull back on their spending and it is a loss of faith by businesses who can not sell whatever it is that they produce and begin pulling back on their payrolls and laying off workers. And you get into a self-reinforcing negative cycle that is a recession, it is a loss of faith.
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19:13)The conference board measure of consumer confidence is a pretty good barometer of the phase of households. And when that falls sharply in a short period of time, you can see 20 points in a three month period. Historically that means that consumers are panicking, running into the bunker and have stopped spending and a recession will ensue. And typically that recession ensues about six months after the collapse in competence. Takes a bit of time for that to feed through in terms of spending and overall economic activity. Good news, the conference board survey is sitting around a hundred that is equal to its long run historical average and no indication yet that it is falling. It is very stable, goes to the strength of the labor market and that suggests that at least for the moment, at least for the next six months, the economy should remain recession free. But watch that carefully.
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20:15)And then the final indicator I want to call out in the last slide, I want to show the next slide. And this goes to my Moody's roots, it goes to the corporate bond market and it is the COR high yield corporate BO bond spread. It is the difference between the yield on high yield corporate debt, junk corporate debt below investment grade corporate debt, and 10 risk free tenure treasury yield. Historically, I am showing you a lot of history monthly back into the nineties when the junk market was put on the planet. The average good news here, the average spread historically is about 5% or 500 basis points and that is roughly where it is today despite the banking crisis. And it does not appear to be heading north. And you will see the rule of thumb in the chart whenever it rises above 750 basis 0.7 0.5%, that is an indication that the investors are losing faith that they are going to get paid on time, the economy's going into recession. But that is not the case today. Another good indicator to what? Consistent with my baseline, but nonetheless very kind of a tenuous situation. So with that, I took my 20 minutes I think on the nose. I will stop and I'll turn the conversation back to you, Jira and the group.
Jira McGuire (
21:38):
Okay. So thanks Dr. Zandi. Does anyone in the room have questions? Going to, hopefully he will be able to hear you if we get a mic to you. I know we are standing in between you and wine, but does anybody have any questions while we are moving around? I think we have some questions in the room.
Audience 1 (
22:01):
Check. My question is, at what point or in your opinion does the Fed unwind the backend of the curve and correct itself?
Jira McGuire (
22:19):
Mark, can you hear the question?
Dr. Mark Zandi (
22:19):
You mean in terms of the qu? Yeah, I did. It came loud and clear. Just to clarify, are you asking about when will the balance sheet normalize? When will it get back to something that is more consistent with the kind his typical historical norms, the qt, the quantitative tightening? Yes. Is that the question?
Audience 1 (
22:39):
Yes it is.
Dr. Mark Zandi (
22:41):
Yeah. Okay. Well right now the Fed is allowing its balance sheet to run off through maturation and prepayment. Not a whole lot of prepayment obviously on the mortgage security. So it is all maturation and it is about 190 billion hundred billion a month. So if they continue to maintain that pace, it would take, right now they are a balance sheet, I am speaking from memory, but it is about eight and a half trillion on the balance sheet. They probably want to get it down to 5 trillion. So that is 3.5 trillion, that is 35 months. That is probably going to take about three years for them to get it back to something that would be consistent with long run historical norms. And they want reserves that are consistent with the way they are managing the federal funds rate and short term interest rates now. So they need ample reserves of about five. So my sense is it will take them about three years to get that back in.
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23:51)I would be very, the bar for them actually accelerating the process and selling securities is very high. You would have to have runaway growth and inflation for them to want to do something like that be very disruptive. And particularly in the mortgage market, there are not a lot of marginal new additional marginal buyers in that market. And that is one reason why mortgage spreads are so wide. So I do not think they want to do that. And of course the bar for them to stop the QT is also very high. And we saw that here in the banking crisis mean despite the crisis, despite setting up a credit facility to help the system with the liquidity needs during this crisis, they continue to QT at the same time cause so very kind of incongruous kind of policy. But that was intended to send a signal that they are very intent on getting that balance sheet back down in a timely, reasonably timely way. So the bar for them to sell securities or to stop the QT very, very high. So I think they will stick to maturation. It could be a little faster than three years if rates were to come in and we saw some prepaids on the mbs, but I would not count on that. The coupon on a standing mortgage is about three and a half percent. So right for that to get pretty low I think to get a significant refinancing wave. So I think it is going to take about three years for them to get that balance sheet back.
Jira McGuire (
25:35):
Thank you. let us see, do we have any other questions in the room? I can not see very well, but any other questions? Dr. Zandi? I had a question for you. This is Jira. Last year you talked about landing the plane and it really was dependent upon what the Fed was going to do with raising rates and of course we saw a lot of rate raising. Was that in hindsight now, do you think the Fed was doing a good job, they have done more, should they have done less?
Dr. Mark Zandi (
26:16):
Well, I think they have done a reasonably good job up to this point in time. I mean they obviously got it wrong A year ago, a little over a year ago when the economy was strong, lots of jobs, unemployment was falling rapidly and inflation picked up significantly, particularly around the Russian invasion of Ukraine. And when oil prices, it got into inflation expectations and the wage structure and inflation kind of metastasized across the economy and they missed that. Now I do not want to be not fair to be too critical because that is grappling with some very massive supply side shocks, the pandemic and the Russian invasion and also trying to adjust to fiscal policy. We had some very significant fiscal support provided to the economy through the pandemic, all the way up through the American rescue plane in March of 21. So the Fed had a lot to navigate around and to adjust to.
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27:26)So I think it is unfair to be critical, but clearly they got it wrong, certainly in hindsight. And then they had to play catch up and I think they played catch up. Well, I mean here we are, a year later, the economy is struggling a bit. The financial system is shuttering, but at the end of the day the unemployment rate's 3.5%, we are creating a lot of jobs and inflation is moderating. It is coming in so hard to be critical of that at this point, it is getting difficult again because, going back to threading the needle they need, they got to be very careful now not to push rates too high, too fast and push the economy into recession. So I think it will see what they do here. But if they end their rate hikes now or maybe one more time in May, and that is the end of it, I would say they, I would give them pretty good grades for what they did.
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28:32)I would give them a solid B, maybe a minus for what they did if they pull this off. But if they keep on tightening, in my view, that would be an error that would likely push us into recession. And I do not think they need to do that. I think they can get inflation down in a reasonably timely way with the rate hikes they've put in place, particularly in the context of the extraordinary pressure of the financial system is under and continues to be under. So we will have to see how this script is still being written here. J Jira, well it is too early to give the Fed a grade, but I am hopeful that they will pause within their rate here relatively soon. And if they do, I think we should see that slow session or that soft landing that economists call it and not a recession. And they should get high grades for that.
Jira McGuire (
29:28):
Okay, great. Thank you. Any other questions? Okay, well thank you and I hope you get home safely.
Dr. Mark Zandi (
29:37):
Oh, thank you. I appreciate the opportunity. Take care. Bye everyone.
