A Conversation with Katie Kolchin and Torsten Slok

In this episode of Top of Mind with SIFMA Insights, Katie Kolchin, CFA, Head of Research, is joined by Torsten Slok, Chief Economist and Partner at Apollo Global Management to recap the recent FOMC meeting, exploring the actions taken and shedding light on the future of rate hikes.

Transcript

Edited for clarity

Katie Kolchin: Hello and welcome to Top of Mind with SIFMA Insights. I am Katie Kolchin, SIFMA’s Head of Research. In this episode, we recap the actions taken at the recent FOMC meeting and discuss the future for rate hikes and how long the Fed could keep rates at this higher level. I am excited to be joined by Torsten Slok, Chief Economist and Partner at Apollo Global Management. Thank you for joining us, Torsten.

Torsten Slok: Thanks so much for having me, Katie.

Katie Kolchin: So let’s start with the actions taken, or perhaps I should say not taken, at the recent FOMC meeting. As widely expected, the Fed paused rate hikes, holding its target rate steady at 5.25% to 5.50%. The conversation among market participants has shifted from how high rates need to go to how long the Fed will have to maintain the rate at this higher level. During his press conference, Chair Powell commented that they will proceed carefully holding policy at a restrictive level until they are confident they have brought down inflation.

First, can we please get your take on the results of the FOMC meeting and on Chair Powell’s comments at his post-meeting press conference? Was there anything in his wording that surprised you or you felt was a shift in tone or guidance? Also, how do you extrapolate the Chair’s comments into, and perhaps you can also discuss, what any changes in the Fed’s dot plot might mean for your expectations for future rate hikes? What have you modeled for the rest of 2023 in the terminal rate?

Torsten Slok: That’s a really important question. I mean, you can summarize what happened yesterday as it was definitely a hawkish pause. You do wonder a little bit that if they now think that growth is stronger and they also basically saw inflation on the same trajectory as the team before, why didn’t they then hike rates? In other words, if they are now so worried about growth being stronger and having to keep rates higher for longer, why didn’t they take action and increase interest rates at the meeting? I think a very important reason for that, as he also pointed out at the press conference, is that they are proceeding very carefully with rate hikes. The reason for that is of course, that as they have been pointing out, and as he also said at the meeting and at the press conference, that we still don’t quite know if this will be a soft landing or if this might be a risk of being a hard landing, but what we do know is that inflation is just still too elevated.

As you know, core PCE inflation at the moment is higher than 4% at 4.3%. Unfortunately, that’s still well above the Fed’s 2% inflation target. So given that inflation both on PCE inflation, both headline and core, and also on CPI inflation, both headline and core, we’re still well above the Fed’s 2% inflation target. We are in the range of 3% to 4% and some of the indicators were a little bit above. Well, their conclusion is that it’s just a little bit too early to declare victory over inflation and that’s why the communication from Powell and also the dot plot, as you mentioned, did send some very significant signals about we are just not there quite yet. Most importantly on the dot plot, before the expectation was that the Fed would cut rates four times in 2024. But now in their forecast, they only see the Fed cutting twice. In other words, they were essentially arguing that markets should be expecting rates to be higher for longer. For the rest of this year, they also had another hike in either the November or the December meeting. We don’t know exactly which meeting. We only know that by the end of the year, they expect interest rates to be 25 basis points higher than where they are today. So I would summarize what happened at the last meeting as yes, we have made progress on getting inflation down.

He also suggested that he was surprised that the labor market was so resilient. But I think that on the dual mandate of getting inflation to 2% and getting the economy to full employment, my interpretation was that he was saying, we are approaching both those two goals slowly, gradually, and smoothly, but we still judge that we need to keep interest rates high to make sure that we proceed on the trajectory of getting inflation down to 2%. The final footnote in your question is that in the discussion, he has frequently highlighted super-core inflation. Super core inflation, as we know, measures services, excluding housing. Why do we exclude housing? Because housing is probably going to go down at least for some measuring reasons that contracts in housing are only renewed every twelve months. So it takes some time before housing inflation starts to move down. So if you exclude housing from inflation, you still have that super core inflation is between 4% and 5% in particular when it comes to PCE inflation. That’s a problem because that means that we are not really even on those indicators moving down towards 2%. So I still think they are probably very pleased with where we are, but their message is we are just not there yet. For that reason, we had to continue to send some hawkish signals.

Katie Kolchin: Interesting. So let’s continue down this holding rates higher for longer and dig into the inflation side of that a bit longer. So as the chair indicated at Jackson Hole, the Fed is navigating by stars under cloudy skies. This has been taken by many to mean the cloudiness of the data. So if you dig into the inflation, which has been the main driver of the Fed’s rate decisions, CPI coming in August for a year-over-year metric was at 3.7% which actually was the second month in a row that it ticked back up a bit. Core CPI was at 4.4% as of August, and this one actually has moved down two months in a row. Now both of the PCE, and as a reminder for our listeners, the PCE is the Fed’s preferred measure of inflation. PCE was 3.3% in July. Remember, PCE for the listeners is a month lag to the CPI data release. With Core PCE at plus 4.2% year-over-year. Now both the PCE measures of inflation had mixed performance over the last two months, down one month but then ticking up the next month and as you mentioned, all of the inflation measures remain well above the Fed’s 2% target, and as we all heard on the call at the press conference after the recent FOMC meeting, he is wed to his 2% target.

So in August, you were getting at some of this. In the August CPI reading shelter rose for the 40th consecutive month. However, the monthly trend continued on a downward path, which I think is what you’re getting at. We could see some movement in the shelter side of CPI, which is a large proportion of the overall index. Gasoline actually drove over half of the increase in August CPI as all energy increased. For those of us who have been following the price of oil, you know, it’s now been sitting in the 90’s having increased 16% since the July FOMC meeting. Now the Fed cannot control the price of oil and interest rates as we all know, have less of an impact on the services side of inflation and the main driver of course, CPI, rents, which increased again in August. Now adding to that and we could go on with this laundry list, but I would just like to point out we also now have the auto worker strike which could fuel inflation further depending upon how long it lasts.

So the inflation data continues to move around. We’re getting different directional paths for various components. So let’s talk a little bit more about how you specifically, as you think about your expectations, are looking at inflation and our path back down to 2% and then link this back to your modeling of terminal rate and how long we’ll have to remain there.

Torsten Slok: Those are exactly very important developments because as you’re highlighting, most importantly in this discussion is that basically, no matter what measure of inflation you look at, headline, core, if you look at trimmed mean, if you look at the various indicators that the Cleveland Fed is producing, we are still above 2%, meaning we are not quite at the Fed’s inflation target yet. So the consequence of that is that it is a fairly difficult exercise as we are talking about here to exactly model, in particular with the autoworker strike and also potentially government shutdown in the pipeline to figure out what are the trends in overall inflation over the next six months. Therefore, as we are talking about, I still think that the Fed is coming to the conclusion that if the broad spectrum of indicators that we normally look at when we talk about inflation are still well above 2%, and therefore we still need to step a little bit harder and harder and harder on the brakes, then their ultimate message to markets at the moment is, let’s just continue this work that we have started. Let’s, as you said, under these cloudy skies and this cloudy data, continue to just press a little bit more on consumers, press a little bit more on firms to make sure that we ultimately get what we need, namely that inflation continues on the downward trajectory in particular, of course, the housing inflation part, which as you mentioned, makes up 40% of the CPI basket, but has begun to show signs of recovering. If something makes up 40% of the CPI basket and that starts to go up, that’s of course a real problem when the Fed actually would like it to go down.

So that’s why the overall final answer to the final part of your question, namely about how are you linking this to what’s going on with the terminal rate, I still think that the Fed is clearly telling us that we may see rates higher for longer than what even markets are pricing today. Investors, in particular credit investors, but investors in fixed income, need to look at rates, in particular in the front end, as staying at these levels for at least, according to the Fed Fund Futures Market, until the middle of next year, and more likely really well into the end of 2024. So that’s another twelve months ahead of us when I’ll come back with pleasure on your podcast if you want me to, and we can discuss where we stand at the time. But for now, the clear outlook is that rates are higher for longer, and that’s what they fed wants because that’s what’s needed to get inflation back to 2%.

Katie Kolchin: Interesting. I saw this morning that we actually have a probability of not just a November, but a December hike now, according to some of the market data. So you’re right. We’ll stay tuned and we will have you back. But let’s continue on right now. Another piece of the terminal rate determination is the impact rate increases have already had on the economy. During his press conference, Chair Powell stated that the full effects of monetary policy have yet to be felt. I would love for you to discuss what is considered the normal lag time for monetary policy to impact the economy based on historical rate cycles. Although this cycle is not normal, is it? 525 basis points in around a year and a half with 475 basis point hikes in a row mixed in there. So what is different this time, if anything, in your view?

Torsten Slok: Yeah, this is a really important issue also. There is some research inside the Fed system that has looked at what is the length from the Fed raises interest rates until it begins to show up in the economy. Traditionally, the long and variable lags have taken twelve to eighteen months, but the Kansas City Fed a month ago published a new piece of research that was suggesting that maybe the impact is coming faster. The argument was very intuitive that maybe because monetary policy is no longer just hikes in the Fed funds rate, monetary policy is also two other things, namely balance sheet policy, meaning QT, and it’s also forward guidance. The argument was that if you not only have interest rates and therefore the traditional channels of the transmission mechanism of monetary policy, but now you also have that there’s a channel through QT, meaning the Fed running down their balance sheet, and also another new channel that we haven’t seen before where we have much more focus on forward guidance. In other words, the press conference that we are talking about here, is getting so much attention, every single word and sentence he’s saying. Well, the implication could be, according to Kansas City FED research, that maybe the transmission mechanism is shorter. They were arguing that maybe it’s as short as six months. So now, as you mentioned, given that we have moved 525 basis points in roughly eighteen months, then that process should begin to now, particularly with the eighteen months lag begin to have a more significant impact. In other words, monetary policy will probably begin to bite harder and harder over the coming quarters as a result of the lagged effects of monetary policy being tightened as much as it’s been.

The final point on this is another way to answer your question is to look at the Fed’s own model of the U.S. economy, which is called FERPAs. Remember, as you know,  you and I have talked about this a lot, what is FERPA simulation showing? The Fed has a model which basically has 250 equations where you basically can give a shock to different things in the economy. You can give a shock to interest rates, to productivity, to tax rates, to the dollar, and in this case, you can also give a shock to the Fed funds rate. If you, in the Fed’s own model, give a shock to the Fed funds rate of 525 basis points, you will see that that model is saying, and this is interesting because this is the model that they are using at the Fed to forecast what they think will happen, that model is saying that it takes about four quarters. In other words, about twelve months. So that’s just between six months and eighteen months, just in the middle. So that means also that we’re beginning to enter a period over the next six to nine months, where we’ll begin to see the lagged effects of monetary policy begin to show up in the economy. So that’s why also the lag affects, what’s in the pipeline that’s coming through. In other words, when you hit the ketchup bottle, it takes some time before the ketchup comes out and if the ketchup coming out is going to hit us in the next several quarters, then there is a risk that might begin to therefore have more of a drag on the economic data on non-farm payrolls, on consumption, cap expending, and the broader GDP. So the answer to your question is, yes, I absolutely believe that we’re still having the pipeline, the lagged effects of monetary policy, dragging the economy down, as the model would have predicted.

Katie Kolchin: That’s interesting. So just to go a little bit further into that, in your research, you’ve written that delinquency and default rates are increasing from more vulnerable households and firms, and capex spending and non-farm payrolls are weakening. So just maybe a little bit more where you’re thinking, where we are, it looks like we’ve hit, let’s say the lower quality balance sheets. When do you expect us to move into the rate hikes hitting the higher quality balance sheets and therefore, a more dramatic impact on the overall economy?

Torsten Slok: Yeah, and this is really important. I mean, if you look at the data from the New York Fed for delinquency rates, you are seeing delinquency rates going up on auto loans and on credit cards for people in their 20s, in particular, people in their 30s, and people in their 40s. In other words, generally speaking, younger households are beginning to fall behind on their payments, on their credit cards, and on their auto loans. If I just step back and then think about, in a situation where we have full employment and where we have had wage growth that was strong you are actually still seeing people fall behind on their payments, on their credit cards and auto loans. That’s a little bit peculiar because you would have expected that the key driver of the delinquency rates would be what’s going on with employment. So it is a little bit worrying to me that the delinquency rates are moving up on consumers, in particular consumers with generally speaking, lower incomes, lower FICO scores, and lower savings. That’s why exactly as you said, I think that the balance sheets that are weaker, meaning those that have more debt are going to be impacted more. Those that have lower incomes, those that generally also have lower savings, are going to be impacted more. That’s exactly what the data is already showing on the consumer side, that is also what we’re seeing on the firm side of the economy. If you look at default rates for high yield, default rates for high yield have also begun to move higher, in particular, the last six months, and the data actually just came out from Moody’s that the data for August also showed a continued increase in default rates and people in high yield are often pointing out this is just a normalization. But no, this is a normalization that’s happening because this is what the Fed is trying to engineer. Remember, the whole reason why the Fed is raising interest rates is that they want us to buy fewer cars, spend less money on our credit cards, and buy fewer washers, dryers, furniture, and iPhones.

The idea of raising interest rates is for you and me to spend less money in consumer spending. The idea is also on the corporate side to have companies hire fewer people to do less refinancing. That’s why it’s not a surprise, both for firms and corporates, that it is the weaker balance sheets, those with more debt, those with purer credit metrics, companies with more leverage, and companies with falling interest coverage ratios, that are getting more impacted by interest rates going up. So I think that the, call it the realization of the transmission mechanism of what the Fed is doing, is exactly showing up where the textbook would have predicted, namely that the delinquency rates are going up for consumers that are getting impacted by higher rates, and the default rates are going up for corporates that are getting impacted by higher rates. So I think it is playing out, and to your question, when will this have a more dramatic impact on the overall economy? I think that it is, if you look at non-farm payrolls showing up in non-farm payrolls growth over the last eighteen months, getting slower and slower and slower. So I would expect and that actually happens to also be the consensus expectation that in six months’ time, we could get non-farm payrolls at close to zero and remember what that means for markets if we in January, February, March, we get that there are zero jobs created in the U.S. economy for three months in a row. That of course raises some risk for equity investors in the S&P 500 and for credit investors in particular in lower-rated credit. So we do see that process in motion of Fed hiking also now showing up in particular as you highlight in the delinquency rates and also in default rates.

Katie Kolchin: Interesting, and then exactly what you were just talking about, the Fed trying to get everyone from slowing their spending. The other side of that is the credit tightening that we’ve seen since the regional bank turmoil earlier this year. Obviously, if your ability to get credit has slowed or has been cut off for some people, you’re going to stop spending. What role do you think, I know your team has looked at credit spreads for the regional and the larger banks, and the regional banks, their credit spreads still remain quite elevated to the start of the year, albeit it’s come down from the peak we saw in March and then a little spike again after the second regional bank takeover. How are you thinking about that and how do you think that plays into the Fed’s rate decisions, whether it be for the terminal rate or the time period for higher rates?

Torsten Slok: Yeah, this is also really important. The Fed produces weekly data for balance sheets for the small banks and for the large banks. That comes out every Friday at 4.15 p.m. and we study that every Friday afternoon very carefully. I know you and I have also talked about this before, as you said, going into Silicon Valley Bank, the large banks were already in the process of slowing their loan growth, loan growth here, meaning lending to consumers, lending to corporates, and lending to real estate, commercial real estate, residential real estate. But the smaller banks, when the Fed started hiking rates, they didn’t really respond with a slowdown. Loan growth in the smaller banks from March of 2022 when the Fed started hiking rates just continued to grow the lending. It was only in March, of course, of this year when Silicon Valley Bank went under that the small banks started stepping on the brakes. So the reason why this is all important is because we are now beginning to see the combination not only of the Fed hiking rates, making the cost of borrowing higher, not only for small banks, but also for large banks, but we’re also beginning to see the second effect that with the Silicon Valley Bank situation in March, we began to see, more discussions about deposits in the banking sector. We began to see more discussions about regulation, and we also have a discussion that is a little bit in the backseat at the moment but certainly could come back, namely that many banks have a lot of treasuries on their health to maturity book, and with rates having gone up, those treasuries in value have gone down and banks don’t do market to market on the health to maturity book. They do make that available in for sale book. But because of that, we still have some issues that as rates continue to move higher, in particular banks that have a lot of treasuries and mortgages in the health to maturity book, they are now facing, of course, a significant issue with some holdings that are more underwater than they’ve been for a long time. That as a third element, is probably also weighing on banks’ decisions whether they want to lend to consumers.

So combining rates going up is, according to the textbook, going to slow down bank lending. Now we also have these new features of both, again, as I mentioned, risk of more issues with regulation, more uncertainty about deposits, and the third thing is this issue about available for sale in a number of banks now being more of an issue. All those things combined are exactly telling us, and that’s what we’re seeing in the data, that bank lending, both for large banks and for small banks, is slowing down every week by week. That is something that we should all be watching in financial markets because if the trend in loan growth continues to go down in the next several months and is coming down quite quickly at the moment, then that will certainly also begin to have some macroeconomic consequences. So that’s why I think the Fed, and this is what you asked about, what does this mean for the Fed’s rate decisions? I think the Fed would look at that and say, well, maybe the Silicon Valley Bank situation was not what we had expected, but taken together, this is all tightening financial conditions, so this is all working out exactly as the textbook would have predicted.

Katie Kolchin: Interesting. So the terminal rate has to account the natural effect, of this credit tightening, as well as the actual monetary policy. So thinking about everything we’ve just discussed, when have you modeled the first rate cut and what could change your view?

Torsten Slok: Yeah, this has changed a lot with the Fed meeting that we just had here because before that, the market was pricing that the Fed would cut rates, or  I’m talking about Fed Fund futures, that the Fed would cut rates in May. Now we have had markets pricing that has been delayed to June, and we might even have another rate hike, which is what this market is also is pricing today. So I still think that from a broad perspective for investors and the way that we should be thinking about this is that we will have another three quarters, maybe four quarters of interest rates at these levels, maybe slightly higher if they do hike again here in November or December, as you exactly said, there is a chance also that they might hike in December. The conclusion therefore is that cutting coupons in the front end of the yield curve, popularly speaking, in particular up in quality, is the right strategy now that rates are likely going to stay higher for longer. So it really truly is the case that yes, we had all been walking around even before the last Fed meeting and said higher for longer, higher for longer. But the change after the Fed meeting that we just had here is that well, now it’s even higher for even longer. Therefore the consequence of this is that I still think we should prepare ourselves for rates staying higher for another year, meaning well into the summer of 2024.

Katie Kolchin: Interesting although unfortunate for many people in the country. But before we end, let’s just quickly touch on long rates and what you were seeing there.

Torsten Slok: Yeah, so I mean, a very important development that we’ve had since late July is that rates have gone up and as we speak, 10-year rates are approaching 450, which of course is not one literally anyone had predicted, definitely not twelve months ago or not even six months ago. So what I think is very important in this discussion is to think about are rates going up because the economy is getting better? If inflation is higher, if employment growth is stronger, then it would make sense for rates to go up. But that’s not what we have seen, employment growth has been slowing down and inflation has actually also been a little bit better. It’s still very elevated as we spoke about earlier, but it still came down from the 9.1% inflation that we had in the summer of last year. So what is going on in long rates, I think, is that long rates are probably being driven by what you would call non-economic reasons. There’s a long list of things that have come onto the radar screen, in particular, again, since late July, that are likely playing a role. First of all, the U.S. sovereign was downgraded, which has created some discussions about, well, if you downgrade the sovereign, what are the risks then for real money managers, meaning pension insurance, that look a lot at the ratings of the assets that they have and to what degree their risk, if there might be more downgrades, what does that mean for the asset allocation? Of course, in this case, in particular to treasuries, and that might play some role in some managers’ asset allocation decisions to maybe say, let’s go a little bit out of U.S. long rates, and that might be the first reason why long rates have gone up, simply all the discussions coming along with the downgrade that we saw here now a month ago.

The second force that has put long rates up is that Japan has exited yield curve control. They did that somewhat surprisingly in late July. The consequence of that is that Japanese investors are now seeing yields on JGBs in their own backyard go up. If suddenly Japanese yields go up and become more attractive, that might trigger that Japanese investors who are the biggest foreign holders of U.S. Treasuries they begin to say, well, maybe we should sell some of our U.S. Treasuries, which also are very expensive if you take currency hedging costs into account. So let’s maybe sell some of our Treasuries and take it home and invest it in Japanese JGB. So that could be a second reason why we have seen U.S. rates go up, namely that Japan made a policy change that had nothing to do with the U.S. business cycle, but just had something to do with what the BOJ decided. We also still have QT going on. We still have a budget deficit, that’s 5% – 6% of GDP. That means that the significant issuance of treasuries, significant requirements and we also have a significant snowball of T-bills in front of us that came around because of the debt ceiling situation in June when the treasury decided to issue very short-dated paper to keep it within the deadlines of the debt ceiling debate. That snowball of T-bills we now have in front of us, needs now to be rolled over into longer-dated maturities, meaning into seven-year paper, ten-year paper, and thirty-year paper. The consequence of all these things combined is that auction sizes could go up 20, 25% over the next several quarters. So taken together, there are a number of different, what I would call non-economic reasons why we might begin and why we might have seen some more upward pressure on the long end. A more complicated way of saying this is that the term premium has gone up because all the factors that are not related to Fed expectations have been moving higher. So that’s why I think to your question that this discussion about what’s going on in rates, it’s most important what’s going on with the short rates and the Fed. But there are also some things that we as investors need to monitor in long rates and figure out why is it long rates are going up so much? Why have we reached these very high levels, even in a situation where some of the economic data continues to gradually, slowly move in the right direction towards a slower path of the data simply getting more in line with what the Fed had been expecting.

Katie Kolchin: Well, I think that is a great place to end as we look forward to hearing more from the Fed. So thank you Torsten for your insights.

Torsten Slok: Well, thanks so much for having me. This was fantastic.

Katie Kolchin: Yes, great conversation. Just as a reminder to our listeners, you can find SIFMA Insights and other SIFMA Research reports, including our economic surveys, by entering SIFMA Research into your web browser. Thank you for listening, and we look forward to welcoming you to the next episode of Top of Mind with SIFMA Insights.

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Katie Kolchin, CFA is Managing Director, Head of Research for SIFMA and the author of SIFMA Insights.

Torsten Slok is Partner and Chief Economist at Apollo. 

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