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Fed: 'Some pain in labor markets' may be required to lower inflation, economist says

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Michael Gapen, Bank of America Head of U.S. Economics, joins Yahoo Finance Live to discuss inflation climbing during a period of declining GDP, labor market impacts, consumer spending, and the Fed's rate hike cycle.

Video Transcript

- Well, are we headed towards a recession? That's the question on everybody's mind. A new Bank of America note is forecasting a mild one as we settle into the second half of 2022. We have one of the authors of that note, Michael Gapen, Bank of America head of US economics, here to tell us about this data that he's seeing. So thank you for joining us. Now, you're predicting a mild recession. Tell us about some of the indicators that are giving you that outcome.

MICHAEL GAPEN: Well, first of all, thank you for having me on. So I think it starts with we are seeing some weakness in incoming data. We could easily dismiss the negative GDP print in Q1 as payback from Q4 and kind of idiosyncratic volatility around trade and inventories. But it does look to us like final demand is slowing in the second quarter. Some of that's an inflation tax, this surge in inflation and how it's eating into real spending.

But real spending was negative in May. We think it will be negative again in June. And whereas final demand was strong in the first quarter, it seems to be softening. On top of that, we have tighter financial conditions, which are affecting other parts of the economy, including housing and business spending and so forth. And we certainly have a Fed that seems to be leaning against further strength in the economy. It actively wants to slow things down.

So we see a number of forces that say, yes, in general conditions are pretty solid right now in US labor markets and the overall economy. But we think that that will be changing over time. We did put a mild recession into the forecast. I think in maybe around the fourth quarter of this year we could see that deterioration. But, yes, we feel like some pain in labor markets is going to be required in order for the Fed to bring inflation lower. And that's different than we were thinking previously.

- Some are pointing to Atlanta Fed numbers about the GDP decline suggesting we're already in a recession. What do you make of that?

MICHAEL GAPEN: So our tracking estimate for the second quarter is actually pretty much in line with where the Atlanta Fed number is. So, yes, that would say yes. According to the back of the envelope two quarter negative decline in GDP reading of a technical recession, it would check that box. But would it fit the NBER definition of a recession? No. The NBER looks at a broader base set of indicators, including what's happening in the labor market. So I don't think we are officially in a recession now.

We think those indicators may be more in play later this year into the fourth quarter. So I'd say right now, no. There's obviously a lot of noise in the data. And GDP declines two quarters in a row will get people nervous, of course. But, no, probably it doesn't fit the NBER definition of a recession. But that just could be labeling, if you know what I mean, that it doesn't feel all that great in some cases and consumer sentiment is weak. There's been a lot of talk about a recession anyway. But, yes, I'd say more consistent with that later this year, not currently.

- Well, we certainly have heard the Fed change its tone when it comes to their response to high inflation. They've gotten a little bit more aggressive. What do you expect to hear from Powell in just two weeks.

MICHAEL GAPEN: I think you're going to hear a pretty similar message to what you heard last time, which is we need to take more forceful action. We can't rule out that there will be a recession. If you recall, they took language out of the statement that said appropriate monetary policy will be, say, consistent with strong conditions and labor markets. They took that out because they can't promise that a downturn isn't in the cards. And we know we need to slow aggregate demand in order to bring inflation lower.

So I think you'll hear a relatively similar message because, certainly, the story hasn't changed all that much. We had another very solid CPI print today. Yes, we know energy was part of that story. And energy has come down recently. But underneath that, core inflation looks awfully strong. So I think the message is we know we need to address inflation. It's going to entail slowing down the economy. We think we can avoid a hard landing or some kind of recession outcome. But we certainly can't guarantee it. So I think it's a bit of a rinse repeat from the message last meeting to this meeting.

- Michael, but how aggressive do they need to be? 100 basis points, does that make sense?

MICHAEL GAPEN: You can make that case. We're in the 75 basis point hike camp. But you can make the case. Again, if you look at the last several months, the narrative has been, well, this is just food and energy responding to the geopolitical risks that we're dealing with. That's true. But underneath that, core is awfully solid. Core goods. Core services. There doesn't seem to be a lot of slowing.

So, yes, you could make the case that, look, we're not even at neutral. We're not tight. We're not even at neutral. Let's get to neutral quick. And then we can think about getting modestly restrictive. So, yes, you could make the argument that this type of data would prompt the Fed to go 100 basis points and get to neutral quicker. Then you start slowing down from there. Again, it's not our baseline call. But you can make that case.

- And you mentioned the housing market. In terms of the most immediate effects that we saw, what we saw with mortgage rates happen after the last Fed rate hike, what are you watching in that space?

MICHAEL GAPEN: Yeah. I mean, that's certainly key to any outlook for the US economy. We're watching a couple of things there. Starts and sales. General activity. And then the second component is home prices. Do we get a sudden market shift lower in those? I think we in the economist community are looking at the housing market and saying, doesn't feel overextended to us. Inventory levels, whether it's new homes or existing homes, are still quite limited.

So any downdraft in the sector should be modest. The risk there is that we're wrong and too complacent and that in addition to causing a more severe retrenchment in the housing market in terms of activity, starts and sales, you actually get home prices to move down. Then from a household balance sheet perspective, you've had large sell offs in equity markets. Those could be combined with a loss in real estate wealth. And maybe the consumer takes a step back and pushes the savings rate higher more quickly.

So I think we're all taking a fairly conservative view on housing. Yes, it needs to slow. And it will. But we're thinking housing isn't normally where it is when the cycle ends. Normally, housing's very overextended and primed for pullbacks. The risk is we're too complacent.

- Still very low inventory and a lot of customers on the sidelines. Good stuff. Michael Gapen, Bank of America head of US economics. Really appreciate it, sir. Thanks.