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Consumer savings rate is ‘providing some problems for the Federal Reserve’: Economist

Apollo Global Management Chief Economist Torsten Slok joins Yahoo Finance Live to discuss the state of the economy, inflation, Fed rate hikes, jobless claims, recessionary risks, volatility, and the outlook for wage growth. (Apollo is Yahoo Finance's parent company.)

Video transcript

JULIE HYMAN: Apollo Global Management chief economist Torsten Slok is here with us. And one little disclaimer-- Apollo's also the parent of Yahoo Finance. Good to see you, Torsten, in studio with us. And Torsten, of course, is someone we've talked to regularly through the years. And it's nice to see you in-person again--

TORSTEN SLOK: Thanks for having me.

JULIE HYMAN: As we come back. So as we are watching this delicate balancing act that the Fed has been doing between trying to fight inflation, not slow us down into an economic tailspin, how are you weighing the sort of economic factors right now as we're looking at likelihood of recession?

TORSTEN SLOK: Yeah. One thing that's very important in the current environment is that households throughout the pandemic had a very high level of savings. So that means that when savings are very high and cash holdings in checking accounts are very high, that means that we need first, quote unquote, "to run down those savings" before interest rates increases from the Fed are going to bite. So in that sense, a very important factor at the moment is that a significant tailwind to the US consumer is that the savings rate is very, very elevated.

And that's providing some problems for the Federal Reserve, because the Fed would like to slow the economy down, because it would like to slow inflation down. But the problem is there's so much cash on household sector balance sheets and also a lot of cash on corporate sector balance sheets that it's going to take more rate hikes to actually begin to slow the economy down, simply because the starting point is a level of cash, both for households and for companies, that is much higher than what we have seen before.

JULIE HYMAN: I mean, doesn't that, then, risk the odds of overshoot on the part of the Fed considerably? Especially because you get the lag effect that you're talking about because of that savings rate cushion, and then you also get the potential for maybe supply chain issues to start to alleviate and bring down inflation to some extent on their own.

TORSTEN SLOK: That's right. So today, as you know, inflation is 8.6% on headline CPI. And very simply, the target for the Fed is that inflation should be 2%. So if the goal is inflation should be 2% and it's at 8.6%, then there is a problem. And that problem, of course, is why the Fed is raising rates and doing QT, meaning doing things with the balance sheet, in an attempt to try to cool the economy down and try, ultimately, to cool inflation down.

But it's this process of cooling the economy down that is so difficult, because there's just a lot of indicators are still suggesting that the US consumer is doing well. People are traveling still, going up-- if you look at the TSA data for how many people are traveling on airplanes every day, if you look at hotel occupancy rates also going up. If you look at the OpenTable data for how many bookings there are in restaurants, also very strong.

And we also see, even here in Times Square in New York City, if you look at the number of pedestrians, it's now 94% of what it was pre-pandemic at this time in 2019. So the conclusion is consumers are still going out to do everything-- revenge travel, as it's been jokingly called, maybe you go out to see friends to do things. And that's still providing also a tailwind on top of the significant household savings. So to your question, yes, it may take some time before the economy actually begins to cool down.

BRAD SMITH: OK. And so with regard to the Fed's employment goals as well here and where that could kind of tip into a higher unemployment rate over the long-term, has that been put in the rearview mirror at this point in time-- a low unemployment rate for the Fed?

TORSTEN SLOK: Yeah, so that's very important. Because exactly as you're saying, Brad, there's a dual mandate of both inflation at 2% and full employment. But the issue is that the unemployment rate has not really started to go up. Employment rate, as you know, the last employment report was 3.6%. Everyone is watching, including us, the weekly jobless claims-- the weekly numbers that came out yesterday.

But they actually declined a bit. So that's suggesting that despite a lot of anecdotes about layoffs, in particular in tech, that's more than offset by hirings in restaurants, and in hotels, and in airlines. Therefore, at this point, the labor market-- despite some parts of the labor market cooling down a little bit, and again, in particular in tech and growth industries, that's just not been, quote unquote, "enough" to cool things down. So that's just saying, back to what Julie was saying earlier, maybe we need to see interest rates go up more, because we simply need to cool the economy down because inflation, again, at 8.6% is just too high for the Fed when the target is 2%.

JULIE HYMAN: Torsten, let's talk a little bit about how this has been percolating through the markets-- not very well, I guess. Our investors have been struggling with all of these dynamics, right? And you've been watching volatility, as we have as well-- not just for stocks but for bonds, the so-called MOVE index, which measures the volatility in bonds. We've seen volatility in both going up.

We've also seen stocks and bonds moving in tandem, which is something a lot of investors have been sort of wringing their hands over. What do you make of this and what the implications are?

TORSTEN SLOK: Yeah. If you look at the chart that you have up at the moment, that's really interesting. So the light blue line is the VIX, which is implied volatility for equities. The dark blue line is implied volatility for bonds or for fixed income. And it's quite interesting-- as you can see going back in time, normally they move together. Normally the narrative of the story that's being told in equities is actually the same story that's being told in the bond market.

But at the moment, all this fear of inflation is mainly showing up in bond markets. People are really worried about a recession in the bond market. People are really worried about a slowdown coming, potentially relatively soon, as we just spoke about maybe that's not coming as quickly because of the savings issue. But the bottom line is bond markets are very focused on inflation whereas, equity markets-- if you look at forward expectations to earnings in the S&P 500, they have not really been revised down.

So there is some of a disconnect between the story that's being told in the bond market relative to the story that's being told in the equity market-- namely that it seems like equity investors are not quite yet, at least, pricing in the expectation that inflation and higher input costs are going to have implications for the E in the PE ratio-- meaning the risk that, therefore, earnings could become lower-- and also in particular with the Fed stepping on the brakes, also the risk that the E could decline as a result of the Fed cooling the economy down.

BRAD SMITH: Even if the revisions, though, aren't coming from the Street, they're coming from the companies right now and some of the largest ones out there-- whether it be a target in how consumers are spending or whether it's a Microsoft and the FX headwinds that they may see as well. And so if you have companies that are that large that are essentially saying, we have to acknowledge this going into and in the midst of the current quarter, what does that spell out for the rest of the equity environment?

TORSTEN SLOK: Yeah, and this is really important because if you look at CEO confidence-- meaning you ask CEOs, what is your outlook for the future? What is your outlook for your own business? What's the outlook for the economy? How are things going at the moment? That has actually been plunging for the last six months.

In other words, CEOs are getting much more worried about the outlook. And likewise, consumer confidence, which we'll get here at 10:00 AM today from Michigan, is actually also very, very low. In fact, consumer confidence is at the lowest level ever since World War II. And then you ask the question, why is it-- to your quick question, Brad-- why is it that there is all this worry out there?

And the answer is probably that people are still quite worried about inflation. And for CEOs, that means higher labor costs, that means higher energy costs, that means also higher costs for distribution and logistics, meaning supply chain. So it's just piling on all the worries about inflation everywhere. Still, customers are coming in the door and shopping, as we spoke about before.

So the data has not quite rolled over yet. So we are at this interesting inflection point. And markets are trying to guess how long time it will take before we actually begin to see the data come down, just like the sentiment that we have seen, both from corporates and from households.

JULIE HYMAN: There's one more thing that may be, I don't know, either a bit of a cushion or a bit of an opportunity for unlocking of what's going on with the stock market, and that is the cash positions that investors have right now. There was some data just out from JP Morgan that looked at that and that investors are really overweight cash, or short-term instruments that are readily exchangeable into cash.

What does that imply? Are they going to be patient enough-- or are people going to sort of jump the gun and get back in the market before this rollover that you're talking about?

TORSTEN SLOK: We have seen a number of bear market rallies. But the starting point is that we still have inflation at, again, almost 9%. And it should be 2%. So there is absolutely no other option for the Fed than to continue to step on the brakes to try to cool things down. So with that backdrop, we should also worry that the E and the PE ratio is at risk of going down. Because, in some sense, that's what the Fed would like to see.

The challenge is exactly as you're highlighting-- that there's just a lot of cash among investors, on household balance sheets, on corporate balance sheets. And it takes time to withdraw that liquidity. It takes time to get that out of the system. So even if you across the street see the CD in your local bank say you can get 3%, 4%, does that mean that you're not going to go on vacation this summer?

You might say, oh, that's not really-- not quite yet enough for me. I'm probably still going to travel with my family. I'm probably still going to go out to a restaurant with my soccer friends. I'm still probably going to go out and stay at hotels over the summer as I travel around. So the conclusion, therefore, is that it's going to take some time to get those cash holdings down, not only for corporates and for households, but also for investors.

So in some sense, there was a lot of liquidity thrown at the economy, both from monetary policy, meaning Fed balance sheet expansion, and also from fiscal policy, meaning household balance sheets also getting very well above it because of fiscal policy of people saving a lot of money. And now it's just going to take time to reverse that, which is why, getting back to what we spoke about at the beginning, the risk is that maybe interest rates have to go up more.

And that just-- the conclusion for investors is, of course, leads us to the bottom line, namely that we'll probably have this volatile environment for quite some time. Because it's going to take some time for the Federal Reserve to succeed with cooling things down when there is so much cash among investors and everyone is sort of uncertain-- is this a time to buy? Is this not quite the time to buy? Well, the risk is that we will have a slowdown because that's what the Fed wants to see. And, therefore, the risk is still that we will continue this bear market until inflation at least begins to roll over, which we just, unfortunately, haven't seen yet.

BRAD SMITH: Can we talk internationally as well, though? Because it's not just the US that's in this state of tightening, perhaps, right now. It's also the potential risk for a shock tightening or instance where you've got more regulators that are looking across their policy and saying, all right, we might have to announce a surprise hike in those cases as well to dampen inflation that's taking place globally as well.

JULIE HYMAN: That's what we saw in Switzerland, right?

TORSTEN SLOK: Absolutely. And that's why interest rates are going up everywhere because inflation is not just a US problem, inflation is a global problem, partly because of supply chain issues, also because of energy. So in that sense, inflation going up is going up to varying degrees in different countries-- but in Europe and in the US, inflation in round numbers is about 8%, 9%, as I mentioned.

So the conclusion, therefore, is, to your point, Brad, that, yes, this is a global phenomenon that interest rates are going up everywhere. And that makes it such a challenging environment for equity investors, because when do you then start to buy risk? When should you buy the S&P 500? Should it be when inflation just has to roll over, even though it's at 8%, 9%? Or do you have to wait until inflation is down to the Fed's target of 2%?

So the question is, when will risk appetite come back? Because it might take some time before the Fed has certainty that we are actually going back to 2%. Let's say that inflation by the end of the year, which is what the consensus expects, will be 6.5%-- is that enough for the S&P to rally? Or 6.5% is still quite significantly above the Fed's target of 2%, so does the Fed worry about the level of inflation-- meaning 6.5% to 2%-- or do they worry about the direction of travel?

You could take that equities-- and my view would be that equities probably worry more about the direction of travel. So we could see some risk-on in the next six months here. But we absolutely-- a precondition for that to happen is that we absolutely need to see inflation begin to come down. And that has just, unfortunately, not happened yet.

BRAD SMITH: Torsten, we appreciate the time this morning in helping us kick off this Friday session, or at least this Friday show-- session will start start in about 17 minutes. Torsten Slok, Apollo Global Management Chief Economist joining us this morning. Thanks so much.