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Fed policy effects ‘hard to decipher,’ economist says

Michael Gapen, Bank of America Global Research Head of U.S. Economics, joins Yahoo Finance Live to discuss inflation, the outlook for Fed rate hikes, and how markets are pricing in recession risk.

Video Transcript

AKIKO FUJITA: Well, we closed out the quarter, as we said, with the Fed's preferred inflation gauge coming in stronger than expected. Also, this morning, Fed vice chair Lael Brainard warning against retreating from the fight against price pressures too early.

Joining us now is Michael Gapen, Bank of America Global Research head of US economics here. And let's start with that number that we got this morning. Certainly something a lot of investors are watching. Core PCE up 0.6% month on month, nearly 5% year on year. Stronger than expected, but what do you take away from that when you consider the sole focus right now for the central bank being about taming inflation?

MICHAEL GAPEN: Right, so some of that upward revision and stronger than expected data was about methodological changes on how they account for used car prices within the index. So some of that strength is a methodology issue, but it's not all of the strengths. So I think the conclusion here is, there are still broad-based underlying price pressures in the US economy.

And so what early on in the pandemic seemed like this transitory story about goods has broadened out over time. And the data suggests it's even a little bit more persistent than we had thought before. So it certainly cues up a Fed that's likely to continue to lean against the wind, wanting to keep monetary policy tight or moving into restrictive territory in order to bring inflation lower.

AKIKO FUJITA: Michael, when you look at the market moves, we got a number of Fed officials speaking this week that seem to suggest that, look, investors are finally getting this message about where the central bank's focus is. And yet, when you look at a day like yesterday when we saw a big selloff, you still have to wonder if the expectations are aligned with where, in fact, the economy is right now. When you look at some of those moves, what do you think they're missing right now in terms of where we are headed domestically?

MICHAEL GAPEN: Actually, I don't think it's missing a lot. When an economist like myself looks at where are financial conditions, we're looking at more than just, of course, where equity markets are. In your prior segment, you spoke about the dollar. That certainly moved quite a bit. And we would need to look at the level of yields and spreads and so forth. So across a number of indicators, both in currency markets, rate markets, with real rates moving higher and equity markets back to roughly around June lows, financial conditions have tightened a lot.

So I would argue that markets have gotten the message and are pricing things appropriately for the outlook. Obviously, that will change over time, as the data evolves and Fed policy evolves. But I do think markets have received the message. And that's one of expecting tighter financial conditions for longer, which is having an adverse effect on several markets.

AKIKO FUJITA: We have continued to see relative strength in the labor market. We got that number yesterday on weekly unemployment claims. Not something that often moves the market, but we did see it coming in at a five-month low, which raises the question of, to what extent the Fed's policy has actually taken hold. How are you looking at that piece of this? And when we hear the Fed Chair talk about some pain that Americans need to be bracing for, what does that look like to you?

MICHAEL GAPEN: Yeah, I mean, this is the tricky part for the Fed, right? Because as the backdrop, the economy is rotating to services as we reopen and emerge from the pandemic, so you would expect the goods side of the economy to be weak anyway. And now we have the Fed tightening, which should put more weakness on the goods side. So it's really hard to kind of decipher exactly how much Fed policy is working at the moment.

And so I think in this myriad of data that's really dispersed, what does the Fed do? And I think in the end, you hit on the point that the Fed's going to be focused on the labor market. It's going to be focused on payroll growth. And so it's going to know its policy setting is correct when payroll growth starts to slow in a way that would tell them, yes, our policy is restrictive.

Right now, that doesn't seem to be the case. Last month, over 300,000 jobs added. Consensus is looking for a similar-sized number next week. So we think the labor market is pretty robust, and the Fed has more work to do in order to slow the labor market down. That's why we're all kind of looking for, say, another 125 basis points of rate hikes by the end of the year.

AKIKO FUJITA: Well, that was going to be my next question, given that there's still some data that's about to come out between now and the next FOMC meeting. 125 basis points by the end of next year. How long does this rate hiking cycle continue when you look into 2023?

MICHAEL GAPEN: Well, we think it extends into the early part of next year. So we have 75 basis points of hikes in November, and then 50 in December, and then we have another 50 by the March meeting of next year. So I think it can extend into the early part of next year.

Our forecast is that things will be slowing in the first half of next year consistent with a harder landing than the Fed is forecasting. So I do think by the time we get into the first quarter, the slowdown in the data will be more evident, including labor market data. And so the Fed can tighten more rapidly through the end of this year. Then they slow down a bit, we think stop by March.

AKIKO FUJITA: OK, well, I'll be watching if that timeline holds. Michael Gapen, good to have you on, on this Friday. Bank of America Global Research head of US economics.