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The Fed is on target to taper and raise rates in late 2022: Analyst

Michael Kushma, Morgan Stanley Investment Management CIO of Global Fixed Income joins the Yahoo Finance Live panel to discuss the latest market action

Video Transcript

ZACK GUZMAN: I want to shift over, though, to the broader market, as we're seeing today the Dow rebound from yesterday's sell-off here. And we have about 100-point gain to point to. Of course, there have been jitters, even as the economic data comes in a bit softer than expected. Interesting to see inflation come back in below expectations earlier this week.

And for more on what it all means in terms of the Fed's thinking perhaps around this and how investors are reacting to it, I want to bring on Michael Kuchma, Morgan Stanley Investment Management CIO of Global Fixed Income joins us now. Michael, appreciate you taking the time here to chat with us today.

I mean, as we've been discussing, it is kind of remarkable to see investors kind of settling in now on the inflation front, despite the fact that things are running so hot, more people buying into this kind of transitory debate. So what do you make of it when you look at kind of the underlying fundamentals in the market right now as kind of signs that things maybe are improving?

MICHAEL KUSHMA: Well, there's a couple of conflicting forces at work in the economy and impacting inflation, impacting interest rates. And that is while inflation expectations have risen, inflation has run hot this year. And if you look at where inflation is today, where most people, including the Fed, thought it was going to be at the beginning of this year, it's turning out to be much higher than expected.

On the other hand, the economy has decelerated much faster in the second half of this year than anticipated. The economy was booming into the first quarter. Interest rates reached their peak around the end of March. And since then, interest rates have been gently falling over the course of the year. So real interest rates, the inflation adjusted component of the nominal interest rates, have actually fallen, despite inflation rising.

And there's two-- the two forces at work are, one, we've got aggregate demand has been a bit weaker than expected because inflation has been high. People are holding back on purchasing things. The surge in purchasing has kind of slowed down from the post-pandemic, not to put the intra-pandemic fiscal largesse, which was given out-- money given out to people, that sort of slowing down. In addition to that, higher prices are reducing people's demand for certain goods. And then we have supply constraints on production of goods.

So we have a confluence of forces which are collaborating to generate this weird combination of rising inflation, falling real rates. And the falling and real rates has been overcoming the rise in inflation. So actual nominal interest rate, the 10-year Treasury yield, has actually been falling of late. The inflation report yesterday was, you know, good and bad news. It depends on what your-- where your stance are. If you're an inflation dove, you say good news. Second month in a row, it's fallen-- it's slowed down. It's all going well for an inflation soft landing next year or 2023.

On the other hand, inflation hawks would say, yeah, a lot of the COVID reopening sectors have showed lower inflation, but underlying inflation still looks pretty robust and no signs of really slowing down and coming down closer to where the Fed thought it would be, meaning the Fed is on target to taper this year and raise rates at some point in late 2022, early '23.

AKIKO FUJITA: So Michael, which camp do you put yourself in when you're talking about inflation doves and hawks, if we can just put you on the spot?

MICHAEL KUSHMA: Well, I had been an inflation dove for a while. I really thought that at some point later this year, early next year, the pandemic issues were washed out of the economic data and washed out of the economy. But the supply side disruptions, the resurgence of the COVID pandemic through the Delta variant, I think has put a spanner in the works. It's made it more complicated for economy and for analysts and investors like myself to figure out what's going to happen.

So I'm a disappointed inflation dove. So I'm more worried the probability of higher inflation than expected next year has risen. And unless the supply disruptions, labor supply shortages don't ameliorate in the next couple of months, I think the Fed will be confronted with a much higher than expected in 2022 inflation rate. But I'm still optimistic it will come down, but we're getting to crunch time soon.

ZACK GUZMAN: Yeah, I mean, I guess, you know, when we're getting to crunch time, it's all kind of the Fed's own timeline. And they've been navigating that and trying to give investors as much clarity as they can. But I guess, when you think beyond it and kind of this debate around whether or not the market is now prepared for that, because of the signaling we've heard from the Fed, it does seem like we've come a long way since earlier this year, when people were kind of worried about inflation, to where people are saying, look, you know, there isn't going to be a taper tantrum because everyone's prepared for it. I mean, are you also in that camp, too?

MICHAEL KUSHMA: I think that I am in that camp in the sense that tapering, I think, is well understood. It's discounted in the market as long as it's done in a reasonable fashion, and meaning that it's relatively slow, no faster than six months. The mortgage-backed security treasuries are done sort of equal proportionately such that there's not tilting one versus the other, and that it's not done faster than sort of by ending mid-year-- I mean tapering being completed by the middle of next year.

But with inflation running as hot as it is in economy, it's still doing well. It's been disappointing in this quarter, but it's still doing well. But you could easily argue that the need for emergency monetary policies, meaning QE, is no longer required. The zero interest rate policy is easy enough, especially with inflation where it is today.

AKIKO FUJITA: Michael Kushma, Morgan Stanley Investment Management CIO of Global Fixed Income, good to have you on today. Appreciate the time.