‘Very difficult’ to achieve ‘soft-landing’ with aggressive Fed, economist says

Deutsche Bank Securities Chief US Economist Matthew Luzzetti joins Yahoo Finance Live to discuss the probability of a recession, inflation, the labor market, market volatility, banking turmoil, and the outlook for the Fed.

Video Transcript

JULIE HYMAN: Investors continue to face a series of headwinds with concerns over the banking sector, uncertainty over Fed policy, ongoing economic headwinds still weighing on sentiment. Our next guest warns that with the latest events, a recession still remains the most likely outcome for the economy in the next year. Deutsche Bank Securities chief US economist Matthew Luzzetti is joining us now. Matt, it's great to see you. So even though you're going to bring us bad news, I guess it's great to see you.

MATTHEW LUZZETTI: Sorry about that.

JULIE HYMAN: You guys were one of the early ones to say that a recession was, indeed, coming. And it sounds like you're still of that view. Has anything changed in terms of when it's happening, the severity of the recession, et cetera?

MATTHEW LUZZETTI: Yeah, so when, last April, we had this view that the economy would enter into a recession, it was always the second half of this year story. And the underlying fundamental story from our perspective was that the economy had a lot of momentum, inflation was very high and persistent, the labor market was very tight, and that was going to push the Fed to move very aggressively. And once the Fed moves very aggressively, it's very difficult to achieve a soft landing in that environment.

And so I think we've seen a lot of that play out. I think the incoming data that we've seen from the economy so far has been resilient to start the year. We've seen an acceleration in growth, the labor market. Inflation's remaining very high. We saw consumer confidence this morning that's resilient. But we are also seeing how Fed policy tightening is working its way through the system. And I think the most clear recent example of that is through bank lending conditions. And we think that that helps to amplify Fed tightening over the next year, bringing about the eventual recession in Q4.

BRAD SMITH: And so does that start to then show up-- does the effects of a recession start to show up? And there are two benchmark areas that they're tracking, especially employment where people are saying, OK, if there is a recession coming, what's that mean for my job at the end of the day?

MATTHEW LUZZETTI: No doubt. The Fed is focused on getting inflation far below where it is today, much closer to 2%. And they're focused on achieving kind of maximum sustainable employment. And I think the labor market, to use Chair Powell's words, is extremely tight at the moment. Both of those tend to be lagging indicators. So we would tend to see things hitting the economy earlier, whether it's in confidence or in jobless claims, so-- or in consumer spending. So far, we're not seeing that play out. And I that's really important from an economic perspective.

We've seen a lot of volatility in markets. We've seen turmoil in the banking sector. We haven't seen any of that play out into the data yet. And we haven't really had much evidence about how much bank lending conditions are tightening. So all that we need to learn over the next few weeks and months. And from our perspective, really, what it's done is it's kind of solidified the conviction in recession. It has led to risk that it might be a bit earlier than what we thought before. But trying to calibrate exactly the impact of the shock right now is very difficult.

JULIE HYMAN: Well, it seems like Fed Chair Powell is also grappling with some of the same issues. Dig into the bank lending conditions a little bit more for me, and talk to me about how that plays out as a slowing down the economy. How does that work? How does it work its way through the system?

MATTHEW LUZZETTI: Yeah, I think Chair Powell's comments last week were really interesting. We always talk about financial conditions and financial conditions indices, but most financial conditions indices don't include bank lending conditions. In our research over time, we've tried to emphasize bank lending conditions matter. They matter a lot. The Fed has the senior loan officer survey that I think will become increasingly important that we'll get the next reading in early May. And that tends to be a very good a leading indicator for a few aspects of the economy-- business investment CapEx, corporate profitability, and also loan growth that we see.

So where you would expect it to feed is through the corporate sector most likely, through likely a contraction in loan growth that takes place, through some retrenchment in CapEx that takes place. And as that happens, to your previous question, you're likely to see the labor market loosen more materially as that happens.

JULIE HYMAN: So just to put it really simply, if I as a company can't borrow as much money, I can't spend as much money. I mean, that's basically what it is, right?

MATTHEW LUZZETTI: That's the simple channel, absolutely.


BRAD SMITH: OK, and so within this, I mean, so many companies are trying to figure out not just how do we rightsize our business, how do we get through a recession, and the equities markets trying to price that in advance as best as possible, but from an economist perspective, if you were telling a CEO how they should be positioning themselves or even bracing for the impacts of a recession, what would be the word of warning to them?

MATTHEW LUZZETTI: Yeah, I think we've been in this very unusual environment. I mean, we called for a recession last April. So almost a year ago, but it was always an 18-month ahead story for us. It's a very unusual position for economists to be in to be calling for a recession that far in advance, but it was driven by how far out of balance the economy was and inflation was.

And so to a large extent, this is maybe the most anticipated recession that we've seen. We've heard it through, I think, corporate quarterly reports and calls. And so I think you've seen rightsizing taking place. Recessions tend to be these nonlinear events, so it's always really difficult to exactly, I think, gauge yourself where you should be. But to a certain extent, I think that should help to moderate the eventual impact. We're only looking for what is I would call a moderate recession. It looks like the early 1990s.

JULIE HYMAN: And do we see corporations sort of preparing in that way because we have been talking about it for a while?

MATTHEW LUZZETTI: In the macroeconomic data, limited, certainly, there's a lot of headlines about layoffs that are taking place. But a lot of those layoffs are concentrated in those sectors and businesses that hired a lot, that they were well above the pre-COVID trend. When we look at the broader labor market picture at this point, there's very little evidence. You look at jobless claims as of last week, initial jobless claims below 200,000, well below where we were pre-COVID. Labor demand looks very strong, so there's churn taking place in the labor market. There's some weakness in some certain sectors. But I don't think there's really much evidence so far that it's a macro story.

BRAD SMITH: The conversation and the response that we've continued to get was if the Fed were to cut at any time in the near future, then that would signal that they're seeing something much more dire than even the base case of a recession that we're talking about right now and the effects leading up to that. What do you think that would even look like if they were to see something in the data that says, OK, we absolutely need to cut right now?

MATTHEW LUZZETTI: Yeah, we do think there was one reason probably likely why they did raise rates last week. And Chair Powell was clear that there was some discussion about it, but that there was a very strong consensus to raise rates. But there's certain areas where the Fed probably has an informational advantage. And where they should have some advantage is in assessing the banking sector deposit flows. They're seeing more high frequency data than what we're seeing. And so we were concerned that if the Fed did not raise rates, that it would exactly send that very negative signal.

I think what we heard from Chair Powell last week so far was, look, aggregate deposits have stabilized. We saw that in the data last week. But that there's a lot of uncertainty about what the impact on the bank lending channel is going to be. And so I think they did the right thing, which was to say drop forward guidance. They're far more data dependent. They still have a tightening bias. We expect that they raise rates again in March-- in May. But we're in an environment that's clouded with uncertainty, and so don't provide a lot of forward guidance about where to go.

BRAD SMITH: Deutsche Bank Securities chief US economist Matthew Luzzetti. Matt, thanks for taking the time here on the set with us.

MATTHEW LUZZETTI: Thanks for having me.