Can the Fed Dodge a Recession in 2023?

Dave:
Hi everyone. Welcome to On The Market. I’m your host, Dave Meyer, joined today by Kathy Fettke. Kathy, how are you?

Kathy:
I’m doing great and so excited for this interview. I can’t wait to hear what he has to say. Hopefully, it’s great news.

Dave:
I know. Nick is an excellent interview, and I follow him closely on Twitter. He just knows everything about the Fed. I feel like I follow it closely, and every time I read something he writes, or listen to an interview with him, I learn something new. Hopefully you all will too.

Kathy:
Yeah, the Fed is for a lot of people, something they never really heard of until this year, or didn’t know very much about. It’s still this sort of mysterious thing. What is it? Is it a government agency? Is it a private company? How does it work? What do they look at? What we do know is that whatever they decide affects all of us a lot. I think it’s important for people to start to recognize what is the Fed, who are they, what are they doing, and how is it going to affect me? We’re going to learn a lot from today’s interview.

Dave:
I wonder if you did a poll of how many Americans know who Jay Powell is in 2019 versus today, it’s probably quadrupled or more.

Kathy:
Yeah.

Dave:
I feel like no one knew who he was prior to the pandemic, and now everyone waits on his every word. He’s like the most important person in the country.

Kathy:
Or even, did people know what a Fed fund rate was? Oftentimes, reporters would get confused between what a Fed fund rate was and what a mortgage rate was, and therefore the audience was confused. Again, hopefully that clarity has been made and that there’s more insight on how we as investors and consumers are really manipulated by this thing called the Fed, and therefore we really need to understand it.

Dave:
Absolutely. Well, with that, let’s get into our interview with Nick, but first we’re going to take a quick break. Nick Timiraos, who is the chief economics correspondent for the Wall Street Journal, welcome back to On the Market.

Nick:
Thanks for having me, Dave.

Dave:
Yeah. I actually looked this up before you came back. You are our first ever guest. The first two podcasts we ever did for this show was just the panelists and the regular occurring people, and you were the first external guest we had. Thank you for helping launch our show. I think we’re like 60 or 70 episodes later and going strong. We’re super excited to have you back.

Nick:
Thank you. Thank you so much for having me back.

Dave:
All right. Well, back then it was April, so we were sort of just going, and for anyone listening who didn’t hear that, Nick is one of the most, in addition to knowing a lot of things about the economy in general, and how the government plays a role in that is, one of the most foremost experts on the Federal Reserve, and we talked a lot about that last time. You’ve also written a book, Trillion Dollar Triage, about how the US responded to the COVID pandemic economically.
Back when we had you on the first time in April, we were just at the beginning of this rate hike journey that we’ve been going on for the last eight months. I think most people who listen to this podcast have probably been following along, but could you tell us in your own words how you would summarize what’s happened with the Fed over the last, basically over the course of 2022?

Nick:
Yeah. Well, really what we’ve seen in 2022 has been the most rapid increase in interest rates in any year since the early 1980s. When I was on your program back in April, the Fed had just raised interest rates by a quarter point. Of course, inflation was very high. It would get up to 9% in June, largely because of what happened in 2021, but then also the Ukraine War that started at the beginning of 2022. The Fed was just beginning to figure out how to shift to a higher gear.
The Fed raised interest rates a half point in May, and then three quarters of a point in June, which hadn’t done since 1994. They did four of those increases in 2022, and then they stepped down to a half point rate increase last month in December. That’s where we are now. Interest rates are now slightly below four and a half percent. The Fed is suggesting they’re going to raise interest rates a few more times this year in 2023.

Kathy:
Do you think it will work? Do you think they’ll get what they want? Lower inflation to 2%?

Nick:
Yeah, that’s a great question. Will it work? The Fed seems determined here to get inflation down and we already see some signs, of course, that inflation has been coming off the boil. We can talk a little bit about why that is and where that’s coming from. When you say will it work, I think the big question everybody has for 2023 is how bad is the recession going to be if we have a recession? How do you define success in terms of getting inflation down? I think for the Fed, they are resigned to having a downturn if that’s what it requires.
Of course, everybody hopes we don’t have a recession, but if you look historically, when we’ve had inflation this high, it’s never come down without a recession. Then, of course, if you’re in the real estate industry, if you’re in the housing market right now, we’re in a deep downturn already. I think the question really is, when does it spread to other parts of the economy, to manufacturing, to goods production, and then ultimately to the labor market and higher unemployment rate? That’ll be the big question for 2023.

Kathy:
I was going to say, didn’t the Fed jump in a little late though on all of this? There’s still so much money printing. Of course, I want to tie the money printing to all the inflation. Let’s start there. Would you agree there’s a correlation?

Nick:
If the question is did the Fed get started too late? Yes. Everybody I think agrees broadly, including the Fed, and there were reasons why they were late that made some sense at the time. There was a view that inflation would be transitory, that inflation was tied to the pandemic, that if the pandemic was something that would have a beginning, a middle, and end, so would the inflation. Monetary policy textbooks say you don’t overreact to a supply shock.
If there’s a big contraction in the ability of the economy to supply goods and services, and you’ve been successful in keeping inflation at 2%, a low and stable inflation, then you have that credibility. You don’t have to react to a supply shock. What the Fed misjudged in 2021 was that it was only partly because of supply bottlenecks. It was because there was a lot of demand in the system. They also misjudged, I think, the strength of the labor market and the imbalances in the labor market. The question now, a lot of people say, “Well look, inflation’s coming down.”
The goods prices, used cars went up 40% in 2021. They thought used car prices would come down faster in 2022. They are beginning to come down now. You are seeing elements of this sort of transitory inflation from the parts of the economy that were really distorted by the pandemic. The concern now is that high inflation is going to be sustained because incomes are growing, because wages are rising, and because the labor market’s tight. If you haven’t changed your job, you’re probably not getting a raise that’s keeping up with inflation. You’re getting a four or 5% raise when inflation was six, seven, 8% last year.
The way that you beat inflation if you’re a worker is you go change your job right now, because you can get more money if you go to a different company. That’s the concern the Fed has is that even though the labor market is not what started this fire, it could provide the kindling that sustains the fire. Yes, if the Fed had started raising interest rates earlier, maybe inflation wouldn’t have been so high, though you can look at other countries around the world. Inflation is high almost everywhere, in places that did a really good job dealing with the pandemic, and in places that didn’t; in places that provided a lot of generous support, and in places that didn’t.
It’s a tough time for central bankers, because they have egg on their face from waiting too long at the end of 2021 to raise rates. They played catch up last year. When you play catch up and you go really fast, it raises the risk that you end up raising rates more than you have to, and you cause unnecessary damage.

Kathy:
Again, coming back to the modern monetary theory and this policy that you can just print money without consequences, just looking at the money supply alone, it’s 21 trillion versus, what was it just a few years ago, 15 trillion with 7 trillion flooding the market. It seems like they’re trying to mop up a flood with a wet mop. How do you pull that? Is there again, is there a correlation between all that monetary policy, all that printing and inflation?

Nick:
Well, we printed a lot of money. It’s true, but a lot of that cash wasn’t lent out. Banks actually make money by keeping those funds, they’re called reserves. They’re basically bank deposits that you keep at the Fed, and they earn money on them. They weren’t lending out that money. Some of the correlations that were really popular, if you took a high school economics course in the eighties or nineties, the growth of the money supply would cause inflation. Since 2008, the Fed has changed how they conduct monetary policy.
You could say they’ve sterilized the money supply. Banks aren’t lending out all of that money. I think the big difference in 2020 and 21 versus what we saw after the 2008 financial crisis is that you didn’t have a lot of damage to the economy after the pandemic. Households were healthy, people were out buying homes, they were spending money on cars. You had a lot of fiscal stimulus. Even though the Fed was keeping interest rates low, the big difference this time was that Washington went and handed out money to people, gave money to businesses, and that is what really added to the inflation.
The Fed in 2021 was looking at the experience of 2008 and nine and 10, 11, 12, saying, “God, we really don’t want to do that again. We don’t want to have this really long slog painful recovery, where it just takes a long time to get the economy growing again. We’re going to commit to really provide a lot of support, keep interest rates low for a long time.” What ended up happening was that the economy was just completely different. This wasn’t the last war. The Fed fought the last war. 2022 was a story of catching up, raising interest rates a lot, and trying to pop some of these bubbles that you had seen forming in 2021.

Dave:
Nick, you noted that the risk now seems to be of an overcorrection. The Fed was late in raising interest rates, and now some people at least are arguing that they are raising rates too fast for too long, and that there’s a risk of overcorrection. I understand that inflation is still really too high. 7.1% CPI is ridiculous, but it is on a downward trajectory.
I’m curious, how does the Fed in your mind view inflation, and do they look at it all equally? For example, we’ve seen some segments of the economy, prices have come down, and prices are no longer growing. Other sections, notably to this group, shelter for example, inflation remains super high. Can you tell us a little bit about how the Fed evaluates inflation data and what they care about most?

Nick:
Yeah, that’s a great question. It’s true that the risk right now, there are two risks for the Fed. One risk is that you do too much. You cause unnecessary weakness. You push the unemployment rate up above 5% or 6%, and you have a harder landing than you might need to get inflation down. The other risk is that you don’t do enough, and you kind of get off of the throat of the inflation dragon too soon, and you allow a more pernicious inflationary cycle to take hold.
If you look at the 1970s, that’s what the Fed is worried about going into this year. In the early 1970s, inflation was very high. There was a recession in 1973, 1974. The Fed raised interest rates a lot, but then as the economy weakened, they cut interest rates. Inflation fell, but it didn’t fall that much, and it re-accelerated. That’s the worry the Fed has right now is yes, they could do too much. They probably will do too much. It’s a little bit like driving a car and not finding out where you were until 15 or 20 minutes later.
You’re going to miss your exit when that’s the way that you’re driving a car, especially if you’re driving very fast, which the Fed was last year. Those are the two risks, and they see the risk of doing too much as probably the lesser risk, the risk of not doing enough, and having what they called the stop-go rate rises of the 1970s, where you never really get on top of inflation. That’s the worry. Now, on inflation, what are we seeing right now? You can look at a speech that Fed chair J Powell gave at November 30th to get a really good idea of how they’re thinking.
Just to summarize it, he broke inflation down into three buckets. The first is goods: used cars, appliances, furniture, the things that really increased in price a lot over the last two years, because of what happened in the supply chain, because we were all stuck in our homes in 2020. We were buying stuff instead of spending money on restaurants and travel and so forth.
You’re seeing the deflation or the declines in prices that the Fed was always expecting to get in 2021, they are coming through right now. You look at the last couple of inflation reports, and inflation has printed soft. It’s been in part because of energy and in part because of goods. That’s a positive story for the Fed. They see that, they want to see more of that. That’s good news.
Then the next bucket is what’s happening in the housing market and shelter. Of course, housing inflation’s measured a little bit differently. The labor department, which calculates the consumer price index, they look at rents of primary residences, and then something called owner’s equivalent rent, which is basically the imputed cost of the caring cost to rent your own house. That’s how the government measures housing inflation. Now, rents have been decelerating a lot in the last couple months. They really came off the boil in the fourth quarter.
Household formation kind of exploded coming out of the pandemic. People were moving out on their own, wanted more space, work from home, made a lot of flexibility there in terms of where you could live. People bought and rented. Of course, a lot of your listeners know, that’s now slowing, but because of the way the government calculates these inflation, these shelter inflation readings, it’s very lagged.
Even though you see new lease rents declining right now, that won’t feed through to the government inflation measures for another nine to 12 months.The Fed is basically saying, “We see that. We know it’s coming.” On two of these three inflation buckets, they’re expecting progress. That’s one of the reasons they expect inflation to fall this year to about 3% by the end of the year. In their most recent reading, it was a little bit below 6% if you look at headline inflation.
That leaves the third bucket. The third bucket is basically everything else. They call it core services, so services excluding food and energy. Then they also exclude housing since we counted that in the second bucket. For the Fed’s preferred inflation gauge, which is called the personal consumption expenditures index, that’s about a little bit more than half. The reason it’s a concern to the Fed, that they’re so focused on this core services excluding housing, is because services are very labor intensive.
If you think about a restaurant meal or a haircut, pet care, hospital visits, car repairs, a lot of what you’re paying for is labor. If wages are rising, that can provide the fuel that sustains higher inflation, even if you think you’re going to get a lot of help from goods and housing. The Fed has a forecast right now that has inflation coming down to 3% by the end of this year, from close to 6% in the fall of 22. We may get more than that if housing really weakens a lot, and we get more goods deflation, if energy prices come down more, we may get more help there. That would be great news.
The concern for the Fed is that we could have a wage price spiral, which is where paychecks and prices rise in lockstep. I haven’t been keeping up with inflation in my wage. I’m asking for higher pay. Companies have pricing power because people are spending money, they have income, income growth, they’re getting jobs, they’re changing jobs, they’re getting more pay. The worry there is that inflation settles out at a lower level, but still between, say, three and 4% or maybe even higher than that. The Fed has a 2% inflation target.
The final point here is the concern for the Fed is if you think about a calendar year effect, where the end of the year you say, “Well, prices went up this much. Wages went up a little bit less, I need more.” We had that in 2021, we had that in 2022. If you now have a third calendar year here of higher wages, but not quite keeping up with prices, then you could actually bake in a higher wage growth rate into the economy, and that wouldn’t be consistent with 2% inflation. The Fed worries a lot about that.
They worry about expectations that what people think prices are going to be in a year actually determines what prices are going to be in a year. They’re trying to prevent a change in psychology where prices continue to rise. That’s the big question this year is are wages going to slow down? If wage growth slows, then the Fed will be able to really take its foot off the break and say, “Okay, we think we’ve done enough, on top of everything we’re seeing in the housing and goods sectors.”

Kathy:
Do you see that as a possibility when there’s such a severe labor shortage, that we would see wages decline?

Nick:
The optimistic story the Fed says, you hear about this soft landing. What is a soft landing? A soft landing is inflation comes down without a recession, without a really bad recession. Powell has referred to a soft-ish landing, which is basically, yeah, we might have a couple of quarters of negative growth, a technical recession, but we can get the labor market to slow down without a big rise in the unemployment rate. How would that happen?
One way would be for companies to cut back hours, but they’re going to hoard labor because it’s been so hard for them to find employees. They’re not going to let everybody go at the first sign of weakness. They could reduce job openings. Right now, there are over 10 million job openings. There’s about 1.7 job openings for every unemployed person. It was about 1.1, 1.2 before the pandemic. There’s room in their view to bring down the number of unfilled jobs without having a huge increase in the unemployment rate. That’s kind of the positive stories.
Maybe we can do this without as much pain as you would look back over history and see what’s been required to get inflation to come down. We only have seven or eight examples of business cycles since World War II, and we don’t have any examples of something like what we had with the pandemic, where we were basically asking people not to work, to stay in their homes for the sake of the public health infrastructure. It’s a different environment perhaps, but you always do get goosebumps when you start saying things like, “Well, this time is different.” We’ll see.
I think the concern here would be that when the unemployment rate starts to go up a little bit, it goes up a lot. These things are not linear. The economists call them non-linearities. Usually, when the unemployment rate goes up by a half percentage point, it goes up by a lot more than that because every time the unemployment rate has gone up by a half percentage point, a recession has followed. The idea that the Fed can fine tune this, they talk about using their tools, but they really only have one tool. It’s a blunt instrument, as people in the real estate sector have discovered over the last year.
That’s the challenge here is you want to moderate demand for labor without a recession. You want to slow consumer spending so that companies actually have to compete again on price. They have to lower their prices. They can’t keep passing along price increases to their customers. If you look at recent earnings reports, you don’t see a lot of evidence that that’s happening. I like to look at companies like Cracker Barrel, the restaurant chain. They’re reporting lower sales growth, but higher prices. They’re passing along higher prices.
They had a lot of food inflation last year, but they’re able to pass that along right now. They’re reporting 7%, 8% wage growth. That’s probably not going to be consistent with the kind of inflation the Fed wants. You do have to wonder if at the end of the day here, the Fed, they won’t say publicly that they’re trying to cause a recession, but they’re taking steps that have almost always led to a recession.

Kathy:
Whew.

Dave:
Yeah. It certainly seems like we’re heading in that direction. That’s super interesting and something I hadn’t exactly heard about, that potential optimistic case, but I agree that it does sound like everything would have to align really well for that to happen.

Nick:
Yeah, you would need good luck. After a year where the Fed had a lot of bad luck, the war in Ukraine was just really disruptive. Huge increases in food prices, commodities, energy, and so it’s hard to predict the future. Maybe things will start to go the Fed’s way, but you have to do a lot of charitable pulling the threads there.

Dave:
Yeah. Well, we can hope. I do want to get back to this idea of the 2% inflation target. I understand that some inflation is desirable, a low level, because it stimulates the economy and gets people to spend money. Where does the 2% number come from, and why is this the magical target that the Fed is aiming for?

Nick:
Yeah, that’s a great question. The Fed formally adopted this 2% inflation target in 2012. They’ve had it for about 11 years now. They had sort of behaved. They released all the transcripts of their meetings with a five year delay. Really since the late 1990s, they had sort of behaved as if one and a half to 2% was a desirable way to ensure price stability. Congress has given really two mandates to the Fed: to maximize employment and to maintain stable prices. They haven’t defined what price stability is. The Fed beginning in the late 1990s, but again, officially in 2012, decided 2% was how they would define Congress’ price stability mandate.
2% actually began in New Zealand in the early 1990s. The Central Bank, the Reserve Bank of New Zealand was the first to adopt a specific numerical inflation target. 2% at the time, there wasn’t like some great science behind it. I don’t want to say it was completely picked randomly, but it wasn’t as if there was a lot of study that said, “Oh 2% is better than 3%.” New Zealand picked 2%. A number of other central banks followed suit. As I said, the Fed was behaving as if one and a half to 2% was a desirable amount of inflation.
Alan Greenspan in 1996, there was a big debate behind closed doors at one of the Fed meetings in 1996, where they began to talk about, “Well, how would you define price stability?” Alan Greenspan defined it as price stability is where consumers just don’t pay attention to what’s happening with inflation, where prices are low and stable enough that you don’t take it into account in your behavior or your decision making. People thought 2% was about right. The reason they didn’t pick 0%, there were some people that said, and that still say, “Why not zero?” There’s measurement error, we can’t perfectly measure inflation.
There’s a concern that if you have prices too low, you could tip into deflation, declining prices, which is actually a much more pernicious problem, harder to fix for central banks. 2% was seen as something that gave you a little bit of a buffer. It was low enough to satisfy Greenspan’s definition of prices low enough, people just ignore what’s happening with inflation. That’s sort of where we were over the last 25 years. In fact, right before the pandemic, the Fed was concerned that it had been too hard to hit 2%, that they had provided all this stimulus.
They had kept interest rates very low after the global financial crisis, and they were just struggling to get their chin up to 2%. There was a lot of discussion around monetary policy not being powerful enough in the next downturn because of some of the things you had seen in other countries, in Europe and in Japan, where they had negative interest rates, they had low inflation, and very little scope or juice to squeeze out of the fruit when the economy weakened. You couldn’t stimulate the economy.
The discussion had actually turned towards, “Well, could we see periods where we might want to have a little bit higher than 2% inflation, because that would give you more room to stimulate economic growth in a downturn?”

Kathy:
Yeah, it seems like it would be really hard to measure because say, a bag of chips, I don’t know if you’ve noticed, but the chips, there’s a lot less of them. It might be the same price maybe, but you’re getting less. Would you say that, it was about a year ago that inflation really started to rear its ugly head, and now the year over year data might look better because of that? Do you think that’ll make a difference?

Nick:
Yeah, so those are called base effects, where you’re just the denominator from a year ago, when it was very high, now it’s easier to beat the number from a year ago. Inflation first spiked March, April of 2021. There was a hope that in 2022, as you began to lap those high numbers, the year over year readings would come down. That didn’t happen, again, because there was more strength in the economy, spending began to rotate out of the goods sector into services, and you had some of the effects of the Ukraine war.
Now, we’ve had two years really of high inflation. It is true if you look at the last few months, the year over year numbers are coming down, in part because the growth rates of inflation have slowed, at least in the last two consumer price index reports. Also because inflation a year earlier was much higher. You have seen the CPI fall from 9% in June to 7.1% in November. Next week, we’ll get the December CPI where we’ll see if now we have more of a durable trend of lower inflation. The Fed will pay attention to that. They use a different index as I said before, but you don’t have to look at the 12 month trend to conclude that inflation’s getting better.
You can look, and the Fed does look, at three month annualized inflation rates, six month annualized inflation rates. If the inflation report is good on January 12th, then you’ll now have three months, at least in the CPI, of much better behaved inflation. You’ve already started to see markets get very optimistic now that the Fed might be done. Mortgage rates have fallen through December, through the latter part of November, because of this much more constructive or bullish outlook for inflation.
If you look in different securities markets, there’s a treasury inflation protected security, so kind of a market you could look at as a market-based measure of where investors think inflation will be in a year. Investors are looking at inflation coming down to two and a half percent, maybe close to 2% a year from now. The market really has bought into this idea that even though inflation rose a bunch last year, it could come down pretty quickly. The market right now probably sees inflation improving faster than the Fed does.
I think part of that’s because of this view that the Fed has over wages, and they’re concerned that it may not come down quite as fast because inflation is high in categories that don’t come down very fast. They’re called stickier prices, they’re slower to come down.

Dave:
Nick, as we head into this new year, one question I’m curious about is how long do you think the Fed wants to keep inflation? How long does it have to stay under 2% for them to adjust policy? To your point about the seventies, what seems to have happened is that they’d see inflation come down to where they thought it was better, then they would cut rates, and it would just bounce right back up.

Nick:
Right.

Dave:
It seems like the Fed this time around is inclined to get it down to a level they find acceptable, below 2%, and then hold it there for a while, to really make sure that we lock in and squeeze out and push out inflation for a while. Do you have any sense of how long that sort of rest period would have to be?

Nick:
It really depends on what’s happening in the economy. When Powell talks about these three categories, goods, shelter, and then core services excluding shelter, that third category, really just think of the labor market. I think what the Fed is beginning to say is, “All right. For so much of 2022, we told you we were very focused on inflation.” I did an interview with Powell in May in New York. At the time he said, “This is not a time for overly nuanced readings of inflation.” Now, his November 30th speech, he was allowing for more nuance in inflation.
I think what they’re doing is they’re basically saying, “Okay, we see that inflation’s coming down but we’re worried about the labor market. The labor market is too strong, it’s too tight. Wage growth is not consistent with 2% inflation.” The answer to your question, how long do they continue to raise rates? How long do they hold rates at that higher level, whether it’s a little bit below 5%, a little bit above 5%, or whether it’s closer to 6%, how long they hold there? It depends on how long it takes for them to see some softness in the labor market.
Once they see that, then I think there will be more comfort. It’s almost insurance that you’ve done enough, because now if the labor market’s softening, you don’t have to worry as much about the stop-go of the 1970s. What Powell has said, including at his last news conference in mid-December, is the Fed wouldn’t cut interest rates until they’re very confident that inflation is on a path back to 2%. There are different ways you could define that. One way you could define that would be you’ve seen now six months of inflation that’s consistent with two or two and a half percent.
They would want to see something like that. We’ve had two months. Powell has said that’s not nearly enough to be confident. I think of the Fed’s policy tightening, interest rate increases here, coming in three phases. Phase one is over. Phase one last year was moving aggressively to get to a place where you could be confident you were restricting growth, where you were removing all the stimulus that had been put into the economy. That meant moving in large 75 basis point or three quarters of a percentage point increases. They dialed down to a 50 basis point increase in December.
We’ll see whether they do 25 or 50 basis points in their meeting in early February. Phase two would be trying to find that peak rate or that terminal rate, the place where you’re going to say, “All right, we think we’ve done enough. We can stop, we can hold it here for a while.” They really don’t want to have to restart rate increases once they stop. They’ll do it if they have to, but it would be quite disruptive perhaps to markets for the Fed. Once the fed stops, everybody’s going to assume the next move will be a cut. They’re going to try to find that resting place. That’s phase two. That’s where we are right now.
Phase three will be once they’ve stopped raising interest rates, when do they cut? Usually, the Fed cuts once the economy’s going into recession, but this time could be different. We haven’t been through a period in 40 years where inflation was this high. Markets right now I think have been primed to expect that the minute the economy looks like it’s really weakening, the Fed will cut a lot. The big surprise I think this year could come when the Fed, even if they do cut, they may not cut as much as they have in the past.
Again, I think part of that has to do with what they’re seeing in the labor market, and whether some of these labor shortages are going to be more persistent. They might actually be comfortable with an unemployment rate that is closer to four and a half or 5%. Right now we’ve been below 4% for the last year or so.

Kathy:
Yeah, they seem to be pretty clear that they’re not changing course for a while, and that they’ll be holding where they are if they don’t raise. With that said, so many of our listeners are trying to figure out what to do for 2023. Do they hold onto their money? Do they get a second job? Do they invest? What’s the outlook for 2023, say, for a real estate investor?

Nick:
It’s difficult. I think that I hear a lot of people asking me, “When are mortgage rates going to get back to something with a 3% or a 4%?” I don’t know, and I don’t know if you can plan on that happening again because this isn’t just something we’re seeing in the United States. Other central banks that had very accommodative monetary policy over the last decade, the European Central Bank had negative interest rates. The Bank of Japan has been trying to hold down long-term 10 year government bonds in Japan near zero.
What happens is as these other jurisdictions, as these other countries normalize their own monetary policy, all of a sudden, the returns in those countries start to look better. If you can earn a positive interest rate in Europe, maybe you don’t have to invest in US risk assets, buy US real estate, buy US treasuries. It’s possible that in the next downturn, we do get back to very low levels. I think you don’t necessarily, I wouldn’t make that my base case.
We don’t know if we’re entering into a different inflation regime here, where if some of the forces that held inflation down over the last 25 years and made central bankers look very smart, those forces included favorable demographics, more working age people coming into the global labor market. You had in the 1990s, a billion and a half people between Eastern Europe and China that came into the labor market and that was the tailwind for inflation. You had globalization, you had these amazing supply chains that allowed people to move production overseas.
Even though that was quite harmful for US manufacturing, American consumers, when you bought shoes and clothes and furniture, you benefited in the form of lower prices. If that’s facing a headwind now, if companies are deciding, “Well, maybe we don’t want to put everything in China because we’re not sure if that’s the best thing to do anymore,” and they began to have multiple suppliers just in case inventory management replacing just in time, that all means inflationary pressures could be higher. You could have more volatility in inflation, and in the business cycle, and in interest rates.
That just makes it even harder to plan for what the future’s going to be like if some of these positive tailwinds start to reverse. Maybe they don’t, and maybe we continue to benefit from a more globalized economy and better demographics. Maybe inflation does come back, and we end up looking back at the period of 21, 22 as sort of this freakish aberration. Maybe that wouldn’t be so bad.

Kathy:
A freakish aberration sounds about right. It’s very funny because just a few years ago, there were headline stories about, “Oh, the robots are going to take everybody’s jobs, but right now we could really use a lot of robots and automation.” We’re starting to see more of that with ordering food and so forth. How positive is that outlook that we might be able to solve some of these issues with more automation?

Nick:
Yeah, it’s a good question. There’s always concerns that you’re going to displace workers when these innovations happen, but banks still employ a lot of people, even though we have ATMs. I think the one occupation that probably was rendered obsolete by automation was elevator operators. You used to have all elevator operators and you don’t anymore.
It’s possible that as you have more of these kiosk ordering, that just allows those businesses to hire people to do other things, stock shelves, help customers, but we’ll see. That’s a big wild card for the economy in the years to come.

Dave:
Nick, you mentioned this low period of inflation over the last 25 years. We’ve also been in a very low interest rate environment for the last 15 years at least. I think everyone knows during the pandemic, it went down, but even during the 2010s, we were in a pretty historically low level of interest rates.
Do you get the sense that the Fed wants to change the baseline interest rate and that the average interest rate, we’re talking about cuts and hikes and all this stuff, but do you think the average interest rate, I don’t even know, I know this is a hard forecast to make, but over the next 10 years will be probably higher than they’ve been since the Great Recession?

Nick:
You do see markets expecting that. The 10 year treasury, if you take the 10 year treasury yield as a proxy for where interest rates might be in 10 years, then yes. Markets do expect higher nominal interest rates. For the Fed, I don’t think they have an objective here that we want to get higher interest rates. When they began to raise interest rates in 2015, you did hear some people saying, “Well, gee, it would be really nice to have, they call it policy space, but basically means we’d like to be able to cut interest rates if there’s a downturn.”
When interest rates are pit near zero, you can’t do that unless you want to have negative interest rates, which are not popular at the Fed, not something that the US is eager to try out anytime soon. Yes, you did hear some of that. I think now the Fed is much more focused on meeting their mandate, which right now is getting inflation down. Even before inflation was a problem, I think their view was if you just deliver on low inflation and maximum employment, then the other things will sort themselves out.
The big worry, of course, before the pandemic hit, was that we would go into a downturn and there wouldn’t be policy space, that fiscal policy wouldn’t engage, that monetary policy would be constrained. There wouldn’t be that much room to cut interest rates. Lo and behold, as I write about in my book, March, 2020 arrives, and you had this massive response. Washington really stepped up and said, “All right, we’re going to throw everything at this.” You do have an episode there where the policy response was really strong.
I think the question now is if we go into a recession, whether it’s the early part of this year, later in the year, or maybe it doesn’t happen until 2024, but what’s that response going to look like? This time the Fed will have a lot more room to cut interest rates than it did when the pandemic hit in March, 2020. Interest rates were a little bit below 2% when the pandemic hit, but what’s going to happen on fiscal policy? Will we see the same kind of generous increase in unemployment insurance benefits, child tax credits, sending checks out to people? Maybe not.
It’s possible Congress is going to say that really, we overdid it last time, and we’re going to kind of hold the purse strings. It’s always hard to predict where these things are going to go. Every recession is different, every shock is different. When you look back at the last couple of downturns, there was always a view when the economy was slowing that, well, we could achieve a soft landing.
You can see in early 2007 Fed officials talking about, “Yeah, we think it’s possible to have a soft landing.” Of course, that didn’t happen. We had a global financial crisis. Predicting these things is always difficult, but that’s kind of how I think we see it right now.

Kathy:
What grade would you give the Fed for the last couple of years?

Nick:
I don’t do grades.

Kathy:
No grades.

Nick:
I try to maintain objectivity as best I can, and it’s not easy, but trying to form opinions, I’ll leave the grading to other people.

Kathy:
Well, you got to get that Powell interview next time, right?

Dave:
Yeah, exactly. Jay’s got to pick up the phone.

Kathy:
Yeah.

Dave:
Well, Nick, thank you so much for joining us. You are a wealth of knowledge. We really appreciate you joining us. If people want to learn more about your research and reporting, or connect with you, where should they do that?

Nick:
I’m on Twitter, @NickTimiraos, and you can follow all of my writing at the Wall Street Journal.

Dave:
All right. Well, thank you, Nick. We really appreciate it, and hopefully we’ll have you on again to learn about what the Fed’s done over the course of 2023.

Nick:
Thank you, Dave. Thank you, Kathy.

Dave:
What’d you think?

Kathy:
My head’s exploding. I can’t tell if I feel more optimistic or less. What about you?

Dave:
Yeah. I don’t know about optimism or pessimism, but it helps me understand what’s going on a little bit more. When he was breaking down the different buckets of inflation, and why they care about service inflation because it’s stickier, that actually makes a little bit more sense. Sometimes, at least over the last couple months, you see the CPI starting to go down. You see these things that point to continuing to go down.
You’re like, “Why are they still raising rates?” I’m not sure if I agree, I’m not a economist and don’t have the forecasters they have, so I don’t know what’s right at this point, but at least I can make a little bit more sense of their thinking about inflation.

Kathy:
Yeah. The part I still can’t make sense of is why they were still stimulating the housing market this year, early this year with buying mortgage backed securities, that being the second bucket, that clearly, clearly the housing market was already stimulated.

Dave:
That’s a good point.

Kathy:
Yeah, he’s not going to grade them. I won’t share my grade, but it is disappointing. People who bought this year or trying to sell this year are going to be hurt by that.

Dave:
Yeah. That is really interesting, because I can understand when he’s saying that they thought, oh, it was transitory because of a supply shock. That all makes sense, but there’s a difference between going to neutral and stimulating. It seems like if you thought inflation was transitory, you could at least just go to neutral and see how things play out. They still had their foot on the gas for a really, really long time.

Kathy:
Yeah.

Dave:
You could probably guess where Kathy and I grade things. I do think that it is encouraging. One thing I really liked tearing was that they do look at some private sector data. One thing that my fellow housing market nerds complain about and talk about a lot is how that lag he was talking about in shelter inflation, and how it doesn’t show up in government data for six to 12 months.
It is encouraging to hear that at least the people are making these decisions are looking at some of the data you and I look at, and can see that rent, not only is it not going up 7% a year like they say, it’s actually been falling since August.

Kathy:
Yeah. Hopefully they do pay attention to that.

Dave:
Yeah. Well, do you have any guesses what will happen in 2023?

Kathy:
I kind of like to call 2023 Tuesday. 2020 was Saturday and it was a little bit scary at first to go to the party, but then it took off. Then the party raged through Sunday. Then Monday is like, oh, not feeling so good. That would be 2022 is Monday. It’s like party’s over, and you’re not feeling great.
Then next year just kind of feels like Tuesday, where I do believe things will kind of stabilize. It’s like, okay, everybody pick yourself up. It’s just back to work, and hopefully a little bit closer to what 2019 felt like.

Dave:
Yeah. Yeah, that makes sense. I think we’re going to see inflation moderate in a significant way, but per Nick’s comments, we’re probably, that doesn’t mean the fed’s going to start stop raising interest rates right away or start cutting interest rates. As we’ve discussed on this show many times, the key to the housing market reaching some level of stability and predictability is mortgage rates to moderate.
Until the Fed really charts a fresh course on interest rates, I think that’s going to be hard to come by, and maybe at best by the end of 2023, but maybe more likely the beginning of 2024 at this point.

Kathy:
Yeah, listening to my gut, it would be that they’re going to slow down the rate hikes, but what they’re saying is not that. It’s like, are they bluffing? All I know is like listen to what they say because they’ve been pretty serious this year. They haven’t budged from their plans. You got to assume that they’re going to keep rates high and maybe even keep hiking. My gut says that they’ll slow it down.

Dave:
You’re not alone in that. I think a lot of Wall Street is betting that they’re bluffing, that they just don’t want people to start reinvesting and stuff anytime soon. They have to keep signaling that they’re going to keep raising rates. Only time will tell though. That was fascinating. I learned a lot. Hopefully all of you learned a lot. Now as you hear new inflation reports come out, new reports from the Fed, you have a better understanding of what exactly is going on.
Thank you all so much for listening. We will see you next time for On The Market. On The Market is created by me, Dave Meyer, and Caitlin Bennett, produced by Caitlin Bennett, editing by Joel Esparza and Onyx Media, researched by Puja Gendal, and a big thanks to the entire Bigger Pockets team. The content on the show On The Market are opinions only. All listeners should independently verify data points, opinions, and investment strategies.