Dr. David Kelly:

On this episode of Market Movers, we're going to dive into the outlook for the US economy and the Fed. Since the Fed's last meeting in July, inflation has continued to moderate and economic data have proved resilient, raising hopes for soft landing. Meanwhile, stock markets have continued to fare much better than last year with investor sentiment resembling the start of a new bull market, rather than a temporary one, with the clouds of recession still looming. For investors, many questions remain before we can call an all clear in the economic outlook. To answer some of these, I'm very glad to be joined today by Mike Feroli, Chief Economist for the JP Morgan Corporate Investment Bank. Let's get started. Mike, welcome to Insights Now.

Michael Feroli:

Thank you. Good to be here.

Dr. David Kelly:

Let's start with the economy overall. Over the last year, a lot of people have been predicting a recession, and yet the economy has proven very resilient.

Michael Feroli:

Yeah.

Dr. David Kelly:

Why do you think we're still growing?

Michael Feroli:

Yeah, so a couple of things. First of all, before we sound the all clear, the Fed really just got very aggressive last summer, so about a year ago. We should still consider that the lags may kick in and tip the economy into recession. We don't want to be too confident here about things. Now that being said, third quarter growth is holding in very well, so it doesn't feel like we're on the precipice of a recession, even a little over a year after the Fed got very aggressive.

Why has the economy, to your point, why has it exhibited such resilience? I think there could be a few things. One, is that the fiscal support has probably been greater than we were anticipating about a year ago, and we're seeing that in a number of dimensions. But when you look at the fiscal deficit on a cashflow basis, it looks like it widened about three percentage points, going from 22 to 23. That may have offset a lot of the monetary tightening we've seen.

I think another thing perhaps, particularly when we look at the labor market, is some of the post-pandemic normalization, which was always going to be difficult to calibrate correctly because we've never had a global pandemic in the modern era, some of that post-pandemic normalization seems to still have legs. When we saw last Friday's jobs report for August, where you see continued strength is in sectors that still have not recovered employment gains to where they should be by this point. Healthcare would be an obvious one. Still seeing some of that in things like leisure and hospitality. Some of that tailwind from the reopening, which has been fading, will continue to fade. It's just fading a little slower perhaps than we thought. A lot of that is going to be, I think, not too responsive to monetary policy. Certainly, healthcare is probably one of the least interest sensitive sectors you can think about.

Dr. David Kelly:

Sure.

Michael Feroli:

I think those are a couple of reasons why things are holding in better than, certainly than we expected.

Dr. David Kelly:

Holding in better than we expected, but still every quarter is a new quarter. How long does our luck hold out? How long do we go before, I suppose the cumulative probability of entering a recession exceeds 50%?

Michael Feroli:

Yeah, so that's a tough question. Right now, we're about in the third year of this expansion, so by certainly the standards of the last three quite long expansions, this still looks like a young expansion. By that metric, simply looking at time, you'd say we have a way to go.

On the other hand, when you look at how tight labor markets are, when you look at arguably the corporate profit margin cycle is rolling over, these things would suggest we're late cycle, even though we're only three years in. I would tend to lean a little more toward the latter. I wouldn't want to put a precise number or date on it. Right now, we're not expecting a recession next year, but we do think recession risks remain pretty elevated, in part because we don't know if we've seen the full extent of the monetary tightening that's already been in place. But right now, we don't have a firm date on when we're looking for a recession.

Dr. David Kelly:

I think to your point about maybe you don't want to just go chronologically on how long expansions last, the last long expansion was one in which the unemployment rate came down very slowly. It took us years to get to full employment, whereas right now we're below 4%. We've been below 4% for a year, so we are, I think by most people's measures, at full employment right now, which certainly wasn't the case for most of the time in the last long expansion.

Michael Feroli:

Yeah.

Dr. David Kelly:

Okay, that's where we are, in terms on economic growth. Okay, so far, but eventually there are dangers of falling into recession.

How about inflation? The Fed seems so fixated on, "We've got to get to 2% inflation," before the pandemic. It's obviously gotten much higher than that last year, and has been coming down. Do you think there's a residual inflation problem or we'll actually be able to get down to that 2% number?

Michael Feroli:

First of all, I would say for the Fed they might declare a success if we get down to something like two and a half, just given their new flexible average inflation framework. Now, I do think there are good reasons to believe that the disinflation we've seen so far has been the easy part because a lot of the disinflation we've seen has been in the normalization of a lot of the supply chain distortions we've seen, so in goods inflation. I do think that the second half of this battle is probably going to be the harder one, particularly as it relates to wage inflation. Again, we saw last Friday some welcome deceleration in wage inflation, but we still need to see that go further.

I do think there is good reason to believe that some of the service inflation we're seeing on the price side, the wage inflation we're seeing is going to be a little tougher to ring out, which is, I guess another way to say that perhaps the Phillips curve is non-linear and maybe it may take a little bit more of an increase in unemployment than we've seen. We've only really seen one month of an increase in unemployment, so I do think there's reasons to believe that we probably are going to need to see the unemployment rate drift above 4% before we start to see the type of wage inflation declines or deceleration that makes us a little more comfortable that we can get back to somewhere, again in the neighborhood of 2%.

Dr. David Kelly:

It's really tough though, trying to apply models that we've developed over many decades to the post-pandemic environment because what I'm trying to figure out is yes, technically wage is now rising three, four or 5% year over year. It's clearly higher than you would think is consistent with 2% inflation, but is that payback for higher inflation that workers already experienced? As job openings come down, as job gains ease off, can workers be persuaded to not ask for such big wage increases going forward and might that happen even without a recession or without unemployment going about 4%?

Michael Feroli:

Yeah, I think that's interesting, which is... Just to set the stage, we've seen a not trivial decline in wage inflation without, again until last month, and any increase in unemployment. Why was that the case? Maybe it was the case because this year we've seen headline inflation come off pretty significantly so those wage demands, which last year were probably really fueled by higher gas, and food prices, and other things, this year maybe those catch up demands are a little less. The real wage bargaining may be turning a little more friendly in inflation perspective.

I guess I would add two related points, which is when you think about the linkages between wage and price inflation, there are two sources of slippage. One is productivity growth and the other is profit margins. I think on both of those, there's some reason for optimism that we can sustain a little bit higher than average wage inflation and still see some further declines in price inflation. Productivity, we're starting to see a little bit of signs of life there, and then margins are still very high so there's room to come down and still be at the higher end of the historical range. I do think applying a mechanistic rule, we need to have wage inflation at 3.5% or below may be true in the very long run, but I think we could see further declines in inflation with wages running right now in the low fours or whatever.

Dr. David Kelly:

We're going to obviously be looking at wage growth and really watching this very closely, and so will the Federal Reserve. The Fed used to be very dovish I thought, and then has suddenly turned very hawkish over the last year. Do you think they really are hawkish at heart or what sort of animal are they? What sort of bird are they, I guess?

Michael Feroli:

I think they're situational. Look, they were dovish when we had a decade of below 2% inflation. There was a lot of worries about Japanification. They had a generation high inflation problem and they responded accordingly. I would say it's not just pretend hawkishness. Look, I think perhaps the best example of this, in my opinion, is if you go back to the March FOMC meeting, which was about a week after Silicon Valley, all the other banks failed, and they hiked. They hiked. If you look back in history, it's pretty rare for the Fed to hike in a period of financial stress like the one we had in March. I think that shows you just how committed they are to that inflation problem.

Dr. David Kelly:

All right. Is any of this changes in personnel at the Fed? Are new members more hawkish than the old ones?

Michael Feroli:

I think the new members, certainly the new board members, are probably going to lean a little more dovish. I think there's general, I don't know if you'd call a stereotype or generalization, that democratic appointees are going to be a little more dovish. We just today and yesterday had the Senate, I think confirmed or reconfirmed three governors, who in their confirmation hearings I did think were a little on the dovish side. Perhaps that's one of the things contributing to this little more dovish tone we've had out of the Fed over the past few months.

Dr. David Kelly:

Speaking of dovish tone, one of the things that seems to have survived over the pandemic and the inflation scare, is the Federal Reserve's view of where short-term interest rates ought to be in the long run. I've done research, you have too on this, and in the 50 years before the great financial crisis, the average real federal funds rate was about 2% positive. The federal funds rate was 2% above the inflation rate, and now they're looking for trying to get 2% inflation in the long run and they think that the federal funds rate ought to be 2.5% in the long run, which seems like a very low real rate of half a percent. First of all, do you agree with that? Second of all, do you think there's a chance that they may actually move that up? Is that what they regard as R-star and they think R-star maybe needs to be nudged up a bit?

Michael Feroli:

Yeah, so I guess I would say in their defense, they're probably looking back at the experience of the first 20 years of this century, which most estimates, certainly in the decade after the Great Recession, there was a lot of reasons to believe that R-star was depressed then. Now, it may have been depressed for reasons that were somewhat cyclical in nature and that's-

Dr. David Kelly:

Sorry, before we go any further.

Michael Feroli:

Yes.

Dr. David Kelly:

R-star is the rate of interest which should cause supply and demand of the economy to be balanced and so keep the inflation rate essentially stable.

Michael Feroli:

Exactly, yeah the real inflation rate that keeps the economy in equilibrium. Now, how cyclically sensitive is R-star, I think is a big question because perhaps some of the reasons it was depressed after the GFC, after the Great Recession, was because of credit headwinds. Perhaps now part of the reason it maybe appears to feels to be perhaps a little elevated, is that this fiscal situation is not only supporting growth, it's also leading to a lot of issuance of government debt.

It does seem like while the median has been at, as you say, two and a half percent nominal for several years now, in two weeks when we get the new updated dots, I do think there's a risk here that the median drifts up, if for no other reason then that in that period of stability of the median, we've seen the mean drift up. It does feel like that's where they're going. I would also add that some of the econometric models that the Fed looks at, like the ones kept by the Richmond Fed, suggests that R-star has been moving higher lately.

Dr. David Kelly:

The Federal Reserve, in other words, in two weeks may well say that upon further consideration, the rate of interest necessary to keep inflation at 2% might be a bit higher than they thought before.

Michael Feroli:

Mm-hmm.

Dr. David Kelly:

Okay. The other star that they think about a little bit is U-star. What's the unemployment rate which is consistent with keeping inflation at 2%? I think the Fed thinks it's four or has said that, but we've certainly been seeing unemployment below that. Where do you think U-star is?

Michael Feroli:

Yeah, so I guess maybe just to back up a little bit. You're right, the Fed has had it at 4% or the median participant has had it at 4% for, again several years now. That being said, I think many of them and ourselves included, believe that certainly in the aftermath of the pandemic, that this was probably elevated for reasons that were likely temporary in nature and perhaps this is one of the reasons we saw wage and price inflation start to pick up even before we got to 4% unemployment. I do think some of those dislocations and reallocations that are associated with this, hopefully once in a lifetime event, are starting to normalize. I think you see that in the behavior of the Beveridge curve. Without getting too much into technical details here, the relation between job vacancies and unemployment is moving in a direction that suggests that matching job seekers with job openings has become a little more smooth over the last six to 12 months.

Dr. David Kelly:

Sure, okay. A lot of this been about short-term business cycle, but how does this factor in, and I guess it sort of confuses things in the short run, but longer term, how fast do you think the US economy can really grow?

Michael Feroli:

We've had an estimate of around one and a half percent for potential, potential GDP growth, which embeds an estimate of the growth in the workforce of a little less than a half percent and growth in productivity of a smidge over 1%. As I alluded to earlier, there are some, not to get back to the short run, but short run signals that some things are looking a little bit more favorable. On the labor force side, some of these things, again, are probably on the more of a short run thing, is that we've seen participation pick up, and we've also seen foreign-born workforce growth pick up. Again, maybe that's something that fades.

However, on the productivity side of things, again, a few hints here that perhaps we are getting some better productivity performance. Certainly, over the past year we've seen that, and it looks like the third quarter should be another good productivity quarter. It's a little hard to say, but perhaps we're seeing some of the fruits of investment in technology start to pay off. Obviously, very difficult to tease that out from quarterly numbers that don't give you a lot of granularity, but there are reasons to hope.

Dr. David Kelly:

I remember in the late 1990s when we had a very tight labor market back then, I remember I used to say the productivity is just another word for having no one left to hire. If you couldn't find anybody to work for you, then you had to work everybody you had smarter and you ended up with productivity gains. Maybe we're seeing a little bit of that with so many months of low employment.

Obviously, productivity is key here and one of the questions we've been wrestling with is there's a lot of hype, and a lot of enthusiasm perhaps is a better word, around AI, artificial intelligence. Does that impact your view of productivity growth in the long run? Do you think productivity growth will be better because of it?

Michael Feroli:

Certainly, there are a number of, I think pretty good studies out there that suggest AI could have meaningful impacts on productivity growth. Whether we should expect to see it in the near term, I think is a little bit more of a for grabs, but certainly our bank has been investing a lot in AI and we're seeing those investments economy wide as well. I do think as we look at the outlook, it could add certainly a couple tenths to productivity growth, which a couple tenths may not sound like a lot, but when you compound that over several years, that definitely has big impacts for living standards.

Dr. David Kelly:

Sure, and very important in a world where labor supply is pretty constrained.

Michael Feroli:

Yeah, definitely. The demographics long run, we are going to need more help in doing things and if we can get that from AI, I think that would be a big help.

Dr. David Kelly:

Yeah. One of the questions we get a lot from our clients and a lot of people are very worried about, is the fiscal situation. As you mentioned earlier, we have seen that deficit rise somewhat this year. What's your outlook there? Do you think that continued economic growth and maybe resumption of student loan payments, can that help a little bit or do we have a very significant deficit problem?

Michael Feroli:

We have a significant deficit problem. The things you mentioned will help. Every little bit's going to help. The debt deal that was arrived at earlier in the summer, that will help. We will see a modest amount of fiscal contraction we believe going into the coming fiscal year, but should still leave deficits running around 5% of GDP with no prospect of that narrowing further as we look several years out from there. Right now, the situation does not look good. We don't see much happening between now and the next election. Beyond the next election, of course is anyone's guess. But right now, the situation doesn't look favorable, and I think you see that to some degree reflected in interest rate markets.

Dr. David Kelly:

Right now, we've got divided governments, which actually usually actually constrain the deficit a little bit. If we end up with single party government going after the next election, the dangers are we could see a further surge in what's a very significant deficit.

Michael Feroli:

Yeah.

Dr. David Kelly:

All right, let's end on something a little cheerier and near and dear to my own heart, which is the American consumer because I've lived my life in America just in amazement as the American's willingness to buy stuff they don't need with money they don't have. What's your view on the state of consumers and how consumers will impact the economic outlook going forward?

Michael Feroli:

The state of consumers, we think is good. It was great if you go back a year or two. Some of the really pristine elements we were seeing on consumer balance sheets now aren't bad, but they're not quite as good as they were. We see slightly increasing debt to income ratio, things of that nature. That said, we think the outlook remains pretty favorable. It's going to be tough, I think to beat what we've seen certainly in the first... It looks like the first three quarters of the year were very good. I would expect slowing from here.

Even in the event, should we slip into recession, which remains a risk, I think the consumer still probably puts up positive growth numbers because even in mild recessions, you tend to see that. Overall, a few modest headwinds here and there. You mentioned the student debt repayment issue. We think that'll probably maybe be a little hiccup for spending growth in the fourth quarter. We do have a depletion of excess saving, which gets a lot of attention. That said, wealth to income ratios still look pretty good and that holds across most demographics as well. Overall, it's going to be, as I said, hard to beat what we've seen in the first part of this year, but I still think the outlook for consumers is relatively stable.

Dr. David Kelly:

That's adding a little bit of stability to the outlook?

Michael Feroli:

Yes, definitely.

Dr. David Kelly:

All right, listen, thank you so much.

Michael Feroli:

Yeah, thank you.

Dr. David Kelly:

And thank you all for listening. This episode wraps up our Market Movers miniseries. I hope you've enjoyed your summer and the conversations this season has featured. Our next season will begin in October and we'll focus on key strategies investors should consider when building portfolios that last. I'll be joined by some of our thought leaders across our alternatives, active ETFs, models, and portfolio insights businesses. Until then, thank you all for listening, and speak with you soon.

Disclaimer:

This content is intended for information only based on assumptions and current market conditions and are subject to change. No warranty of accuracy is given. This content does not contain sufficient information to support investment decisions. It is not to be construed as research, legal, regulatory, tax, accounting, or investment advice. Investments involve risks. Investors should seek professional advice or make an independent evaluation before investing. The value of investments and the income from them may fluctuate, including loss of capital. Past performance and yield are not indicative of current or future results. Forecasts and estimates may or may not come to pass. JPMorgan Asset Management is the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.