Why the Fed's latest move on interest rates 'makes sense'

The Street

Mark Zandi, Chief Economist, Moody's Analytics, breaks down the logic behind the latest Fed decision.

Transcript

00:00Joining me now is Mark Zandi, Chief Economist at Moody's Analytics.

00:04Mark, thanks so much for joining. Great to have you.

00:07Thanks for having me. It's good to be with you.

00:10So, Mark, the Fed decided to hold interest rates steady,

00:13although two Fed governors didn't agree with that decision.

00:16Do you think it was the right move or do you side with the dissenters?

00:21No, I think it was the right move.

00:22I think sitting on their hands makes a lot of sense.

00:24I mean, you've got inflation picking up.

00:27It's above target. The direction it travels for higher inflation

00:31as the tariff gets passed through to consumers.

00:34And I think that will be the case over the next 6, 9, 12 months.

00:38But then you also have an economy that's weakening.

00:40Growth is slowing. It's still moving forward, but at a slower pace.

00:44So, you know, given these cross currents, what should the Fed do?

00:50Respond to the higher inflation or respond to the weaker growth?

00:53It's hard to know, certainly at this point.

00:55So, yeah, I think it makes a lot of sense just to sit on their hands

00:59and do nothing and see how this plays out going forward.

01:04Do you think the door is open for a September cut, though, Mark?

01:08I do. You know, my sense is that the next move will be a cut.

01:14Now, whether that's September or October or December or early next year,

01:17that is a reasonable debate.

01:19But I do think that the inflation will be more one-off,

01:22that these tariff increases, once they get passed through,

01:25that the inflation will begin to abate relatively quickly.

01:28Although that'll be pretty tough to know when you're in the middle of it.

01:32And I do expect some pretty significant increases in inflation

01:35over the course of the next 6 or 12 months.

01:38But I do think growth will weaken.

01:42It's already on the soft side.

01:44It's come way down since this time last year.

01:48And I think all the trend lines here, too, suggest weaker economic growth.

01:52So, ultimately, I think the growth fears will prevail over the inflation fears.

01:58And we'll get some rate cuts.

02:00But, again, you know, whether that's September at the next meeting

02:03or October or December of next year, that's, I think, a reasonable debate.

02:09Your view has been that the U.S. economy will avoid a recession,

02:13but that it will be close or a close call.

02:16What's the variable that could tip us into the recession?

02:20And in the next breath, what's really keeping us afloat?

02:24Layoffs.

02:25I mean, I think the firewall between the soft economy

02:29that appears to be weakening in recession

02:32is that businesses at this point have not laid off workers.

02:35They've done everything else but that.

02:37They've stopped hiring, so hiring rates are very low.

02:40They've cut back hours worked.

02:42The job growth has come pretty much to a standstill,

02:45except for a couple sectors like health care and education

02:50and parts of government.

02:52So the last thing they'll do is lay off workers.

02:56And I think they're very loathe to do that.

02:58They've been through, most businesses have been through

03:00some pretty severe labor shortages since even before the pandemic.

03:04And I don't think they want to get wrong-footed,

03:06particularly in the context of immigration policy,

03:08which has a lot of immigrants leaving the labor force

03:11and not working.

03:13So I think, you know, I think the key here is layoffs.

03:18They're low, and as long as that's the case,

03:20we'll avoid recession.

03:20That's kind of my baseline,

03:23but, you know, it's a very tenuous kind of situation.

03:26And if we see any pullback in consumer spending,

03:30you know, I do think those layoffs will begin

03:32and we'll be in recession.

03:33So it's going to be very, very close,

03:34but that's the key variable.

03:35It's layoffs.

03:37Are you getting any signals that we could be close to that?

03:40Yeah, I mean, I think everything,

03:45it's really, you know,

03:47American consumers have really kind of,

03:50are now very cautious.

03:52I mean, if you go back over the period

03:55from the end of the pandemic

03:57up until the end of last year,

03:58consumers were out spending with,

04:00you know, a fair amount of gusto.

04:01Spending growth was strong and very consistent.

04:04Since the beginning of the year,

04:06consumer spending has gone flat.

04:07Now, flat consumer spending, I think,

04:10isn't enough to push businesses

04:12to start laying off workers.

04:14But if, you know,

04:15the tariff price increases start to kick in,

04:18undermine real incomes and purchasing power

04:20and consumers actually do start to pull back

04:22on their spending even a little bit,

04:24that's when businesses may decide,

04:25hey, you know, look,

04:27we're going to have to reduce payrolls.

04:28We're going to lay off some workers.

04:29And the thing about layoffs

04:30that's a bit disconcerting is,

04:33you know, once one company in an industry lays off,

04:36you tend to see all the other companies

04:39in that industry lay off as well.

04:40And you can go from no layoffs

04:42to a lot of layoffs pretty quickly.

04:45And, you know,

04:46I think we're right on the edge here.

04:48You know, hopefully American consumers hang tough,

04:50continue to do their thing,

04:52don't pull back,

04:53and, you know, we'll avoid that downturn.

04:54But if they do pull back even a little bit

04:56and businesses respond by lying off,

04:58you get into that kind of self-reinforcing,

04:59vicious cycle called recession.

05:01Well, we also have the tariff deadline on Friday.

05:06We know that President Trump has said

05:08it will not be extended.

05:10We'll see if that's actually the case.

05:12But it sounds to me like you think

05:14that will be more of a one-off kind of price shock.

05:17But how should we be thinking about

05:18the economic impact of even one-off higher prices?

05:23Yeah, it's not good.

05:25I mean, and in fact, you know,

05:27you look through all the ups and downs

05:29and all the rounds of the tariffs and the noise,

05:32tariff rates are going up,

05:33and they're going up a lot.

05:34I mean, you go back to the beginning of the year,

05:37the effective tariff rate

05:38across all countries' products was just over 2%.

05:41Now, with everything in place,

05:44it feels like we're going to settle in

05:46somewhere around 15% to 20%.

05:48That's a very substantive increase,

05:50and that means higher prices

05:51and inflation will pick up.

05:53I think the price level will rise

05:55by a point, a point and a half.

05:57So instead of inflation,

05:58where it is today at 2.5%,

06:00that's the consumer expenditure deflator,

06:02that measure,

06:04will be at 3.5%, 4% by next spring, summer.

06:08That's pretty substantive.

06:10And it'll also mean weaker growth

06:11because, you know,

06:12those tariff increases,

06:14those higher prices are effective.

06:16A tax increase,

06:18it cuts into people's purchasing power.

06:20You know, if I have to spend more

06:21on an imported good in food

06:23or clothing or whatever it is,

06:26less to spend on everything else.

06:28And so that cuts into economic growth.

06:30So, you know, I buckle in.

06:32I think the next 6-12 months

06:34are going to be uncomfortable

06:35for the economy.

06:35You know, I think we'll be able

06:36to avoid recession,

06:38but it's very close,

06:39and I think we can stay

06:40with a high degree of confidence

06:42that it's going to be

06:43an uncomfortable environment.

06:44Well, we have seen the stock market

06:49turn modestly lower

06:50as Fed Chair Powell speaks,

06:52but stocks are back

06:53really near all-time highs.

06:55Would you say the market

06:56is overestimating the resilience

06:58of the consumer and the economy then?

07:01Yeah, I think so.

07:03I mean, part of that is just

07:04the AI, right,

07:07and driving a lot of activity

07:09among a very small group of companies

07:12that have done very, very well.

07:13And that's running on its own dynamic.

07:15It has nothing to do

07:16with the business cycle.

07:17That is just completely independent.

07:19And that helps to lift

07:21the entire market.

07:22I think if you exclude that group,

07:25then the rest of the market

07:27is more representative

07:28of kind of the thinking

07:29around what's going on

07:30with earnings and companies

07:31and interest rates

07:32and that kind of thing.

07:33There's more of the increases

07:34in stock prices

07:35are more pedestrian.

07:36But even that,

07:37I suspect, you know,

07:38markets are now,

07:39investors are now at a place

07:40where they're listening

07:42to people like me

07:43and they say,

07:43OK, I hear you,

07:44but, you know,

07:45I got to see it.

07:46Show me.

07:47And so they're waiting

07:48to see it in the data

07:49before, you know,

07:51they respond.

07:52But I think they'll see it

07:53in the data.

07:53I'm confident that they will.

07:55And so it wouldn't be surprising

07:57to me if we saw,

07:58you know,

07:58some sell-off

07:59in parts of the market.

08:00But again,

08:01the folks,

08:03the companies

08:03that are in the world

08:06of artificial intelligence

08:07and everything

08:08that drives that

08:09and benefits from that,

08:10that's running independently

08:11of everything else.

08:14All right, Mark,

08:15just finally

08:15and just quickly

08:16bringing it back

08:17to the Fed.

08:18Obviously,

08:19the Fed holding rate steady

08:20wasn't a big surprise here.

08:22Did you learn anything new

08:24from Fed Chair Powell today?

08:25Were there any surprises

08:26to you about

08:27what the Fed had to say?

08:29No,

08:29it was kind of right down

08:30the strike zone,

08:31I thought.

08:32I mean,

08:32it was,

08:33you know,

08:33obviously when you see

08:34two Fed members

08:36on the Board of Governors

08:37actually dissenting,

08:38that's very unusual.

08:40I think you've got to go back

08:42into the early 90s

08:43to find that happening

08:45the last time that happened.

08:47So,

08:47you know,

08:48there is a growing

08:49fracture in thinking

08:51on the board.

08:52But it's not a surprise,

08:54but it is,

08:55you know,

08:55noteworthy

08:56once you see it happening.

08:58It's very unusual

08:58to see this kind of dissent

09:00and that dissent

09:01is,

09:02you know,

09:02in full swing

09:03right now.

09:04But,

09:04you know,

09:04having said that,

09:05if you believe

09:06that we would get rate cuts

09:08down the road,

09:09it wouldn't be surprising

09:10that you start to see

09:11some dissent

09:12among board members.

09:13You know,

09:13some people are going to feel

09:14like it's important

09:16to cut earlier

09:16rather than later

09:17and that's what we're saying.

09:19But that,

09:19to me,

09:20that was the one thing

09:21that stood out

09:21from this meeting.

09:23Okay,

09:23we'll leave it there.

09:24Mark Zandy,

09:25Chief Economist,

09:26Moody's Analytics.

09:27Thank you so much.

09:28Really appreciate your insights.

09:29Yeah,

09:30anytime.

09:33We'll see you next time.

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