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Economist details 3 indicators the Fed should be paying attention to

MKM Partners Chief Economist & Macro Strategist Michael Darda joins the Live show to discuss how the Fed has reacted to inflation, the central bank's decision-making framework, the outlook for a recession, and why the Federal Reserve should pay attention to forward-looking indicators.

Video Transcript

- Everyone, let's take a deeper look at markets here this morning as we're 30 minutes into trade. Our next guest says that the Fed might be reactive, rather than proactive, and that the economy should brace for additional overcorrections set to hit, even sectors considered risk-off. Joining us now, we've got Michael Darda, who is the MKM Partners Chief Economist Macro Strategist here. Thanks so much for joining us here this morning, Michael.

You know, first and foremost, when you think about the Fed-- and what you've said and what you kind of have wrapped up to be the reactive nature of the Fed rather than proactive-- what is the best way that the Fed could be proactive, as they've been kind of behind the curve at this point?

MICHAEL DARDA: Yeah. Thanks for having me on. So I think the best thing they could do would be to focus on forward-looking information and leading indicators. We have a bit of a problem here with the Fed chasing backward-looking information. And so they're very focused on things like wages and rents and services inflation. Those are all very important variables, but they don't move first when economic conditions change, because many of those prices are tied to leases and contracts. So we have a big problem, that the Fed is driving the vehicle looking through their rear view mirror. And it puts us into boom cycles followed by bust cycles.

And so if we think about, how did we get into this inflation quagmire in the first place, it was because the Fed ignored a lot of forward-looking information-- telling us we were in a V-shaped rebound, that inflation was coming. Focusing on those lagging indicators gave them a false set of comfort. So you all probably remember the temporary-transitory imbroglio. And now, just the opposite is the setup, with the Fed getting aggressive here and persisting with aggressive policy, likely to take it too far and to create some economic upheaval next year.

JULIE HYMAN: Yeah. And already, some of that economic upheaval, I guess, we are seeing evidence of. We should mention, we just got mortgage rates as reported by Freddie Mac coming in above 6% for the first time since 2008. So if we look at certain lagging indicators-- you mentioned in your note wages, rents, services price inflation-- what are these forward-looking indicators then, on the flip side, that you think the Fed should be focusing on and investors should be focusing on?

MICHAEL DARDA: Sure. Well, I can give you three that have been very robust, long leading indicators of recession. One is what the setup was, which is the yield curve. So we have a yield curve inversion now that is broadening out and persisting and likely to intensify as the Fed continues with aggressive rate hikes here. Usually you see inversions about a year before a recession.

Money supply growth is now negative in inflation-adjusted terms, both narrow money that the Fed controls and broad money that the banking system controls. And so those two variables, an inverted curve and negative inflation-adjusted money growth, have been pretty robust, forward-looking recession signals in the past-- in fact, used together 10 for 10 in the last 10 recessions since the mid 1950s. Not bad.

Housing, residential real estate-- you mentioned mortgage rates-- also tends to peak about two years before recessions hit. Residential real estate is now in a tailspin. It was one of the first sectors that went into a boom with easy money and low rates, and now it's one of the first sectors that has gone into a bust. So forward-looking information is telling us that growth is going to slow pretty sharply. Inflation's likely to continue coming down. The sticky price inflation is going to take some time.

But we really don't want the Fed chasing backward-looking information here, because that just means bust that follows a boom, and then if they're still doing that, another boom. So let's have them focus on more forward-looking information and create a regime of stability in terms of inflation expectations and inflation itself.

BRIAN SOZZI: So Michael, when do you think we-- when do you think we'll see a bust?

MICHAEL DARDA: Well, we're seeing it now in residential real estate. I fear it's going to broaden to envelop the entire labor market. Probably second half of 2023 would be my guess in terms of when we start to see rises in the unemployment rate that would be recessionary.

Historically, any time the unemployment rate is lifted half a percentage point or more from where it was a year earlier, we've been in a recession or on the cusp of one. So keep your eyes on the unemployment rate. It's not a leading indicator, but it's probably the most reliable coincident indicator of a recession, meaning are you in a recession now or are you not? The first half of the year, despite those negative GDP readings, the unemployment rate was falling. Job growth was positive. That's not a recession by any logical definition. But if the unemployment rate is moving up in a persistent way, that's always been associated with recession in the past. And I think that's probably something we're going to see in 2023.

JULIE HYMAN: Michael, it doesn't seem like the Fed's listening to you when you're saying this stuff. I mean, if the Fed was paying attention to the indicators that you're talking about, would there not be a 75-- I mean, should the Fed not raise 75 basis points next week? Should it pause after that or at some point? Like, if they were doing what you're suggesting, what then would the rate increase strategy look like, or not rate increase strategy?

MICHAEL DARDA: Yeah, well, if they were looking forward instead of backward, then I think they would have limited the easing. They would not have persisted with the short rates at 0 for so long. They would have started sooner and more aggressively on the rate hikes and the balance sheet reduction so we wouldn't be in a situation now where they're going really aggressively.

JULIE HYMAN: Well, but I guess now that we're here, now what? How can they correct, if they were going to correct, for those mistakes made in the past?

MICHAEL DARDA: I wouldn't persist with 75 basis points. I would slow it down for a bit.

BRIAN SOZZI: All right, we'll leave it there. Michael Darda, MKM Partners Chief Economist and Macro Strategist, always good to see you. We'll talk to you soon.