Tariff pass-through raises the bar

Our Global Head of Macro Strategy Matthew Hornbach and our Chief U.S. Economist Michael Gapen discuss how oil prices, tariffs and inflation expectations are raising the bar for rate cuts by the Fed, and markets’ response to the new scenario.

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Matthew Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy. 

Michael Gapen: And I'm Michael Gapen, Morgan Stanley's Chief U.S. Economist. 

Matthew Hornbach: Today, the outcome of the March FOMC meeting and what it means for our economic and rates outlook for the rest of the year.

It's Thursday, March 26th at 8:30am in New York. 

So, Mike, as we expected, the Fed stayed on hold last week at the FOMC meeting and retained its easing bias. But what do you think the heightened macro uncertainty means for rate cuts this year? 

Michael Gapen: Well, Matt, I think the answer is caution and probably rate cuts come later than earlier. So, we've changed our view on the back of the FOMC meeting. We previously thought rate cuts would come in June and September. We've slid those back to September and December. The short answer here is I think with the rise in oil prices and at least some renewed upward pressure on headline inflation – it will likely take the Fed longer to conclude that disinflation is occurring. So, I think they need more time, and that obviously means the Fed pushes rate cuts out. 

Matthew Hornbach: Is there anything about the press conference that struck you as being interesting? 

Michael Gapen: Yeah, I think the almost near singular focus on inflation. So, after the meeting was over and the press conference was done, we did a little deep dive into the transcript. Because that's what we do as economists who follow the Fed. And there were about 18 questions on inflation or prices. There were only five on labor markets. And if you do, kind of, a word count on inflation- and oil-related terms, that would've popped about 200 answers. If you looked at labor market terms, you would've gotten about 40. 

So, by a five-to- one ratio, the press conference was dominated by fears or concerns around inflation, inflation expectations, and oil prices. And, you know, whatever message the Fed was trying to send, I think it's hard to send either a neutral or a dovish message when nearly every question was about inflation. So, for me, I think the singular focus on inflation was what surprised me. 

Matthew Hornbach: And one of the questions that I think market participants, and I'm sure you yourself expected Powell to be asked, was about how the Fed would respond to this supply side energy shock that would raise inflation. And whether or not the Fed would look through that type of supply side effect. 

How did you interpret his answer?

Michael Gapen: His answer was, for me, a little more complicated than I thought it would be. You're right that it is, kind of, traditional monetary policy knowledge or views that you're supposed to look through an increase in headline inflation from oil prices. History says in the U.S., they have little effect on core inflation.  Very little second round effects. 

So, you do, I think, want to come into this event thinking we're primed to look through. But what he said was, ‘Well wait. First of all, what we have to do is get through this tariff pass through to core goods first that I can't even tell you…’ I'm paraphrasing here. ‘That I can't even tell you whether or not we want to look through an increase in headline inflation until we get greater clarity that tariff pass through to core goods has ended.’ 

So, this, I think, contributes to our view that it's going to take a longer time until the Fed's comfortable easing, because I think that raises the bar for a conclusion that disinflation is happening. 

Matthew Hornbach: Right. So, they want to first check the box on being past the tariff-related inflation before they start to consider whether or not they look through the energy-related inflation. And as a part of that question, the reporter, sort of, framed it as: Well, in the context of missing your inflation target for five years – how are you going to think about it? And he layered that into his answer as well. 

Michael Gapen: They've missed their target for five years? I wasn't aware. Yes. No. That was the additional context, which is to conclude that you can look through increases in headline inflation from oil, one of the conditioning factors there is – that long run inflation expectations remain stable and well anchored around the Fed's 2 percent target. 

So, short run inflation expectations have moved higher. Just as they did when tariffs were implemented, just as they did during COVID. So yes, there's a multiple kind of step box checking – to use your term – that the Fed needs to go to before it can say, ‘Okay, fine. We think disinflation is in place.’ I still think they can get there this year. But obviously that's a later than sooner kind of decision. 

Matthew Hornbach: Absolutely, and I think in terms of the market response to the FOMC meeting and the press conference, it was that exchange with that reporter that was concerning to investors. And they said, ‘Well, if the Fed first needs to see tariff related inflation pass, and then they're going to consider whether or not to look through energy related inflation in the context of having missed their inflation target for five years.’ Market participants said, ‘Well, gosh, that really increases the chance the Fed doesn't ease at all this year.’ And so, at the end of that trading day, the market had been pricing about a 50 percent probability that the Fed would deliver its only rate cut in December. And of course, the market has moved since the FOMC meeting. But that was my takeaway, at least. 

In terms of inflation expectations… Because this is so critical in terms of how the Fed and other central banks around the world – who have slightly different mandates than the Fed does – how do you expect the Fed to think about inflation expectations later this year; when perhaps they're actually considering whether or not to look through the energy price inflation in the context of what happened to longer run inflation expectations in the wake of the pandemic? 

Michael Gapen: So, my view on this, and at least my takeaway from listening to Powell in prior press conferences – and hearing other FOMC members. I think they feel that coming out of COVID, yes, long run inflation expectations moved up. But they actually moved up for a good reason. I think they felt that long run inflation expectations were a little low going into COVID. So, still generally consistent with 2 percent outcomes. But kind of on the downside. So, a little increase in long run inflation expectations coming out of COVID, I think they were okay with. 

The risk now will be, COVID has been followed by a tariff price shock and an oil price shock. And in theory, these are supply side shocks that shouldn't result in long run inflation. But you never know, business and consumers may feel differently. So, I think as long as they – they meaning long run inflation expectations – are about where they are, I think the Fed's okay with that.

 Matthew Hornbach: Right. You did mention that the labor market didn't come up all that much. What’s your view on the labor market going into the end of the year? 

Michael Gapen: Well, I think that; I think it's pretty similar to the way Powell characterized it. Which is: it is abundantly clear that immigration controls have had a strong effect on the labor market and reduced growth in labor supply.

It's obvious also, we've had a year now where hiring has come down. So, on one hand the labor market… I'm an economist, so I have to say on the one hand, and on the other hand. On the one hand, the labor market's generally in balance – low labor supply, low labor demand. The unemployment rate has been, you know, broadly unchanged, pretty stable since September. 

That's what Powell in the past has characterized as “the curious balance.” So yes, the labor market is in balance. But what concerns me and concerns us is – it's not a very dynamic labor market. An economy the size of the U.S., about 360-ish million people or so. We're basically not adding many jobs every month. 20,000 to 30,000, if you, kind of, take a six month or so average is about all we're adding every month. That doesn't feel very robust. Rates of turnover, movement in and out of the labor market have slowed down. And so, I think you can say ‘Yes, the labor market is in a general equilibrium.’ But payroll growth close to zero doesn't feel good. 

This is also why I think it's reasonable to expect rate cuts out of the Fed in the second half of the year. It can come either because disinflation happens. Or higher oil prices can weigh on demand, slow consumer spending, delay business spending plans. If that happens, I think it'd be reasonable to think the unemployment rate may drift up a little. Not a lot, but enough to get the Fed thinking maybe we should give it some more support. 

Matthew Hornbach: And I think if that's what we end up seeing out of the economy and out of the Fed, then the U.S. Treasury market is set up for a decent run into the end of the year. The market today isn't pricing many rate cuts at all to speak of. And in fact, at one point after the FOMC meeting for a moment in time, we were pricing rate hikes. But I think if we get that outcome for the U.S. economy and for Fed policy, I think investors in U.S. treasuries will be rewarded. And even if they're not rewarded in the way that they might expect or hope – the U.S. Treasury market itself and the correlations that it has delivered vis-a-vis riskier assets like the equity market, suggest that U.S. Treasuries, despite the recent sell off, have been behaving as good hedge securities for broader risky asset portfolios. So, we certainly would expect the U.S. Treasury market to perform quite well in this scenario.

And so, with that, Mike, I am afraid I will have to bid you adieu until the next FOMC meeting. 

Michael Gapen: Thanks for having me on, Matt. It's great speaking with you. 

Matthew Hornbach: Likewise, And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.