Is the Fed Behind the Curve?

As the US Federal Reserve mulls a forthcoming interest rate cut, our Head of Corporate Credit Research and Global Chief Economist discuss how it is balancing inflationary risks with risks to growth.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.

Seth Carpenter: And I'm Seth Carpenter, Morgan Stanley’s Global Chief Economist.

Andrew Sheets: And today on the podcast, we'll be discussing the Federal Reserve, whether its policy is behind the curve and what's next.

It's Thursday, August 29th at 2pm in London.

Seth Carpenter: And it's 9am in New York.

Andrew Sheets: Seth, it's always great to talk to you. But that's especially true right now. The Federal Reserve has been front and center in the markets debate over the last month; and I think investors have honestly really gone back and forth about whether interest rates are in line or out of line with the economy. And I was hoping to cover a few big questions about Fed policy that have been coming up with our clients and how you think the Fed thinks about them.

And I think this timing is also great because the Federal Reserve has recently had a major policy conference in Jackson Hole, Wyoming where you often see the Fed talking about some of its longer-term views and we can get your latest takeaways from that.

Seth Carpenter: Yeah, that sounds great, Andrew. Clearly these are some of the key topics in markets right now.

Andrew Sheets: Perfect. So, let's dive right into it. I think one of the debates investors have been having -- one of the uncertainties -- is that the Fed has been describing the risk to their outlook as balanced between the risk to growth and risk to inflation. And yet, I think for investors, the view over the last month or two is these risks aren't balanced; that inflation seems well under control and is coming down rapidly. And yet growth looks kind of weak and might be more of a risk going forward.

So why do you think the Fed has had this framing? And do you think this framing is still correct in the aftermath of Jackson Hole?

Seth Carpenter: My personal view is that what we got out of Jackson hole was not a watershed moment. It was not a change in view. It was an evolution, a continuation in how the Fed's been thinking about things. But let me unpack a few things here.

First, markets tend to look at recent data and try to look forward, try to look around the corner, try to extrapolate what's going on. You know as well as I do that just a couple weeks ago, everyone in markets was wondering are we already in recession or not -- and now that view has come back. The Fed, in contrast, tends to be a bit more inertial in their thinking. Their thoughts evolve more slowly, they wait to collect more data before they have a view. So, part of the difference in mindset between the Fed and markets is that difference in frequency with which updates are made.

I'd say the other point that's critical here is the starting point. So, the two risks: risks to inflation, risks to growth. We remember the inflation data we're getting in Q1. That surprised us, surprised the market, and it surprised the Fed to the upside. And the question really did have to come into the Fed's mind -- have we hit a patch where inflation is just stubbornly sticky to the upside, and it's going to take a lot more cost to bring that inflation down. So those risks were clearly much bigger in the Fed’s mind than what was going on with growth.

Because coming out of last year and for the first half of this year, not only would the Fed have said that the US economy is doing just fine; they would have said growth is actually too fast to be consiste