The Fed will ‘struggle to respond’ to recession, market strategist says

TD Securities Managing Director Priya Misra joins Yahoo Finance Live to discuss the year ahead for markets, how investors are bracing for a busy week ahead, stock futures, inflation, economic growth, consumer spending, the labor market, and the outlook for the Fed.

Video Transcript

BRAD SMITH: Welcome back, everyone. Keeping tabs on futures this morning, you've got some up activity here with about 14 minutes until the start of today's trading session, the first of the new year as investors await to-- they're awaiting a busy start to 2023.

More on the year ahead. TD Securities managing director, global head of rates strategy Priya Misra joins us now. Happy New Year to you first and foremost, Priya. First, as we kind of get into this new trading session of the new year, what would you be looking for in terms of just what we expect at this point in time? I mean, we've discussed at length what is going to carry over from 2022, but what is the top thing that you'd be looking out for?

PRIYA MISRA: Sure. Happy New Year. Thanks for having me on. You know, I think the focus last year, I think some of that focus remains this year, which is going to be on economic data and the central-bank response function, and I would say globally but particularly for the US. We've got a lot of data over the next week, so we'll be watching particularly that payrolls report, wages.

I think the key question is inflation may have peaked, but how quickly is it going to decline? Is it going to get closer to 2% by the end of this year, which will allow the Fed to start to respond to a slowing growth picture?

Now in our view, inflation is going to be sticky. Getting down from 7% to 4% might be easier, but getting from that 4% or 3% down to 2% I think is going to take a while. And so our view is that as the economy slows down-- which we do expect a recession in the third quarter-- that the Fed is going to struggle to respond.

And I think that tension between inflation and how quickly it declines-- how quickly is the unemployment rate rising? I think that's going to be with us in a market that is less liquid, and I think conviction levels are not very high.

So I think we're going to see large moves. I mean, today you look at the bond market. We've had pretty big moves already the first day of the year. So I think that just tells us there's uncertainty. There's a lot of cross-currents here.

And I should bring up the global issue as well. What's Japan doing with YCC? How does ECB QT take over? I think all of that we're going to be grappling with. Even though the year has turned, I think a lot of those same themes will stay with us for the rest of this year.

JULIE HYMAN: Yeah, a big move to start off the year indeed and sort of a return to, I don't know, maybe what investors are looking for for this year, but we'll see what ends up happening.

When we talk about the Fed and how it's going to struggle to react, you're looking at a terminal rate that's higher than what the market is pricing in. Does that reflect that struggle and what the Fed has telegraphed? That is its willingness to sort of go hard against inflation maybe at the cost of growth.

PRIYA MISRA: Exactly. And I should say that growth right now is strong. We just had data over the last two weeks that shows that the consumer is still spending, and the labor market is very tight. So the Fed really, I think, has sort of a one-way trade to continue to raise rates until they see service inflation/wages starting to come down.

I think that dilemma for the Fed will actually grow in the second half because by then the unemployment rate rises to the point where they should start to ease policy, and will inflation allow them to ease? But for now, I think they're telling us that December Fed meeting was very hawkish, and we're going to get the minutes this week tomorrow. So we're actually waiting to see what we hear from the minutes, but the dots came in much higher than market pricing.

And I think the market's calling the Fed's bluff a little bit, but they remain very focused on inflation, and they need that service inflation. I think the focus will shift from CPI and core CPI to service CPI and wages, and that, I think, is just very sticky because the labor market remains tight.

BRIAN SOZZI: Will inflation reach a point this year that will allow the Federal Reserve to cut rates?

PRIYA MISRA: So I think it's both. We do think inflation comes down. We don't think it gets all the way down to a two handle. You know, we've got 3.1% by the end of the year.

So it's declining. It's moved a long way. But I think then we'll be looking at the labor market as well. If the unemployment rate is close to 5% in our forecast by the end of the year and you've got inflation still above target but we've done a lot of work, we do think the Fed starts to cut rates. So we've penciled in the first cut in December of this year.

But then we have 225 basis points of cuts penciled in for next year because by then the labor market is weak enough that the Fed may have to start to say, look, we've gone from inflation being public enemy number one to the labor market, and I think then they can start to respond. So I think we have to be looking at that unemployment rate as well.

Three handle or even 4 and 1/2%-- the Fed's own forecast has 4.7%. You know, I think it needs to be much worse than 4.7% for the Fed to start to respond by cutting rates.

BRAD SMITH: If we do see the Fed start to cut rates, what indications do you believe that they will need to see in order to ensure that inflation doesn't once again even spark back up even after they make that type of pivot?

PRIYA MISRA: Right. Yes, I think that's going to be a key thing they're going to be watching. They're really terrified. What I call the ghost of the '70s still haunts them, meaning they don't want to be early in responding to the slowdown.

So I think they'll be watching inflation expectations. You know, the Michigan survey-- we look at all sorts of survey measures for inflation expectations, consumer as well as market based. They'll want to see that being stable.

And then I think it's going to come down to services and wages. If wages have downshifted-- we're not looking at 5% wage growth but 3 and 1/2% or even 4%-- I think they can say, look, wages are starting to come off, and so some of that pressure on service inflation is declining.

And we'll be also watching for consumer spending. These are all early signs. If the consumer savings buffer-- accumulated savings is down and the consumer spending starts to go down, you would think inflation follows next.

So I think they're going to look at a bunch of things to make sure they are not early. I actually think the Fed was late to start to hike, and I think they're going to be late to start to cut because they are so worried that they might let inflation-- might stoke inflation expectations, and then it's very hard to bring that inflation back down.

BRIAN SOZZI: TD securities managing director and global head of rate strategy Priya Misra, good to see you, as always. Happy New Year.

PRIYA MISRA: Thank you.