Fed ‘needs to continue’ rate hikes, economist says

S&P Global Ratings Chief Economist Paul Gruenwald joins Yahoo Finance Live to discuss U.S. banking confidence, the state of the economy, and the outlook for the Fed’s rate hike path ahead of Wednesday’s FOMC meeting.

Video transcript

BRAD SMITH: Well, switching gears to something that you mentioned earlier, Julie-- the Fed. Investors intently focused on monetary policy ahead of the Fed's FOMC meeting this week, as confidence in the banking sector wavers. Here with deeper insights on the Fed's rate hike path and the state of the economy, we've got Paul Gruenwald, who is the S&P Global Ratings Chief Economist. Paul, good to have you here in studio with us.

PAUL GRUENWALD: Good to see you, guys.

BRAD SMITH: Absolutely. So help us dive in first, into what the Fed's read on some of the banking confidence has been, how that might show up in their decision and in their conversations, as well.

PAUL GRUENWALD: Right. Well, first of all, the job of the Fed is price stability. So they have a 2% inflation target and a full employment target, but obviously, they need to be mindful of financial stability. Our view has been that the Fed and other central banks can kind of walk and chew gum at the same time. So they can use the balance sheet, which the Fed did over the weekend, to try to stabilize the financial sector and at the same time, free up the Fed funds rate if they need to continue to tighten conditions.

Our view is that the macro needle really hasn't moved much, yet. The risks of moved, but not the baseline macro needle. So bottom line is, we still have an inflation problem and the Fed needs to continue to raise rates. So they've, obviously, got one eye on the financial sector, but we still think they're going to go 25 basis points later this week. But the language should be sort of softer and slower.

JULIE HYMAN: There are some strategists who suggested they forgo the dots this time around, as a way of still raising, but signaling a little bit of a pause vibe-- I don't know.

PAUL GRUENWALD: Pause vibe, I like that term. The dots aren't forecast. They're just kind of the thinking of the various governors in the same way that we put our thinking out a couple of days ago. So it's helpful in the sense that we know what the governors are thinking about main variables, but to your point, Julie, we think the tone is going to be softer. Even if the Fed goes 25, which is what we think, there'll be more talk about the downside risks. We may have a slower path up, but we still think the Fed has more work to do. And we know, we've been saying this for the last year-- pausing and then having an uptick in inflation and getting behind again is not the best scenario. So it's really a balance of risk, but we think they're going to go.

BRAD SMITH: OK. And so, to that extent, it sounds like you believe that even if they were to pause, in a pause scenario, that they would actually have even more explaining to do as to why they paused, what were the mechanisms, what they saw, and how severe it was that led them to pause.

PAUL GRUENWALD: Well, it's a balance of risks. So they can-- a month ago, 50 was priced in. If you look at the Fed funds forwards, it was 80% going 50 basis points on 25 and then it flipped. One risk is they still really, go hard and then the economy slows and people ask why they tightened too much or if they do nothing and then inflation takes off. So 25 seems to be the middle ground.

But again, we've got an economy that's running hot. The last time we looked at the data, I know we haven't looked at macro data too much in the last week, but the unemployment rate's at 3.5% and we're kind of above our potential GDP path. So we've got a slow anyway, but it's finding that balance of bringing inflation under control and keeping the macro going.

JULIE HYMAN: We've talked to some other economists over the past week who have said the chances of recession have gone up markedly in the last week because of the events that we've seen, because if the Fed is going to raise another quarter point on top of the already tightening financial conditions because of what's happening in the banking system that, that double whammy is going to get us there.

PAUL GRUENWALD: Yeah. Well, let's remember where we are in the macro. The story has been services fueled by a strong labor market fueled by drawing down savings from the COVID stimulus plans. So the interest rate sensitive sectors-- tech, capital goods, et cetera-- they're already kind of weak or even borderline recession. So the narrative has been kind of this labor market services story. If that's still got legs, then we go into sort of this slower growth path, but our baseline is still that we've got the Fed kind of flirting with recession later this year.

I think the downside risks, as I said, have gone up so we're still in flux. We just showed that on the board. So if you look at our forecast and then the risks around the forecast, they're tipped to the downside. But we're not ready yet to make the big shift and have a hard landing yet.

BRAD SMITH: And so, for what the Fed-- and we continue to bring up-- what their dual mandate actually is versus everything that's actually happening, as well, how can the average investor or even consumers right now kind of wrap their heads around where the Fed still has work to do, perhaps? Because they're still looking at even the price of eggs, which-- yeah-- came down.

JULIE HYMAN: Came last month.

BRAD SMITH: Came down. That's a good thing. But in their daily day in, day out purchases, how do they continue to think about where the Fed is in this broader policy pathway?

PAUL GRUENWALD: Yeah, the way I like to explain it is we want low and stable prices. And that means, to your point, you really don't think about them on a day-to-day basis or you don't think about is my real wage declining because inflation is picking up? So we, economists, have kind of interpreted that and sort of codified that as 2% inflation targets, but the Fed is still facing 5%-ish inflation on core PCE, which they target.

So there's more work to do, but if we get success here, we've got an unemployment rate that's a little bit higher, but more sustainable-- 3.5% isn't really sustainable-- and inflation is 2%, and we don't think about prices on a day-to-day basis anymore. So that's what they're really trying to do. It's just, in the last week, we've had this other thing thrown in, which is financial stability. So we've got three things going on. We've got the dual mandate of inflation and unemployment and then with this other instrument, we've got financial stability. Nobody said central banking was easy. So there you go.

JULIE HYMAN: Yeah. I mean, it certainly feels like we're a long way away from not thinking about prices. I mean, I went grocery shopping this weekend, I'm still thinking a lot about prices. I'm still getting-- I'm still shocked that I'm getting sticker shock, but it's still happening. I want to come back to the financial stability because we haven't really-- paused there for a moment. How concerned are you about financial stability? Do you think that what we've just seen is a banking crisis and that the banking system is in any danger, as you think about it from your economic framework?

PAUL GRUENWALD: Yeah, we don't like the "crisis" term. We save that for a very special events. 2008 is probably, a good one. We've been tracking. We do this quarterly exercise in the ratings business called credit conditions. And we've been tracking interest rate risk for the last couple of years and we've seen pockets of that risk materialize with SVP and Signature and other banks, but the banking sector as a whole looks in pretty good shape. We think the macro picture, again, as a whole looks in pretty good shape.

But we're going to have some collateral damage as the Fed goes from essentially 0% up to 5% plus, which is where we have the base rate. So the best scenario is we have these pockets of risk that are contained and then we've got a policy response that seems to be well-received. But nobody said it was going to be a straight line from the Fed going to 0% to the peak rate, and we've seen a little bit of that over the past week. And we will continue to watch that.

JULIE HYMAN: Yeah, definitely. Paul, good to see you. Thanks for coming in.


JULIE HYMAN: Appreciate it. Paul Gruenwald is S&P Global Ratings Chief Economist. Thanks.