Kathy Jones on Inflation: ‘The Worst Is Behind Us’
Charles Schwab’s chief fixed-income strategist on the interest-rate picture, the jobs market, the recession outlook, housing, and more.
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Our guest this week is Kathy Jones, the managing director and chief fixed-income strategist for the Schwab Center for Financial Research. Prior to joining Schwab in 2011, Jones was a fixed-income strategist at Morgan Stanley. Before that, she served as executive vice president of the debt capital markets division of Prudential Securities. Jones received her bachelor’s degree in English literature from Northwestern University and her Master of Business Administration from Northwestern’s Kellogg Graduate School of Management.
Twitter handle: @KathyJones
“U.S. Treasurys at ‘Critical Point’: Stocks, Bonds Correlation Shifts as Fixed-Income Market Flashes Recession Warning,” by Christine Idzelis, MarketWatch, Jan. 23, 2023.
“Don’t Give Up on the 60/40 Portfolio, Says Schwab’s Jones,” Bloomberg, Aug. 9, 2022.
Interest Rates and Bonds
“Bond Market Mess Is a Chance to Lock In Higher Yields for Longer,” by John Manganaro, Think Advisor, Sept. 29, 2022.
“For Income Investors, Bond Yields Are Looking Attractive,” by Tom Lauricella, Morningstar.com, Sept. 15, 2022.
“Has the U.S. Dollar Peaked?” by Kathy Jones, Charles Schwab, Jan. 12, 2023.
“Fixed Income Outlook: Bonds Are Back,” by Kathy Jones, Charles Schwab, Dec. 6, 2022.
“Fed Rate Hikes: Why Are Bond Yields Falling?” by Kathy Jones, Charles Schwab, July 6, 2022.
“Inflation Is Real Enough to Take Seriously,” by Jeff Sommer, The New York Times, July 28, 2021.
“Kathy Jones on Monitoring Inflation Risks,” TD Ameritrade Network.
Rates and Recession
“Is a Recession Coming Soon? This Bond Market Indicator Is Flashing Red,” by Mallika Mitra, Money, April 11, 2022.
“Liftoff: Fed Hikes Rates, Signals More to Come,” by Kathy Jones, VettaFi, March 17, 2022.
“Market Perspective: Slowdown or a Recession?” by Liz Ann Sonders, Kathy Jones, and Jeffrey Kleintop, Charles Schwab, Jan. 13, 2023.
“The Fed’s Policy Tightening Plan: a One-Two Punch,” by Kathy Jones, Schwab Moneywise, Jan. 11, 2022.
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest this week is Kathy Jones. Kathy is managing director and chief fixed income strategist for the Schwab Center for Financial Research. Prior to joining Schwab in 2011, Kathy was a fixed income strategist at Morgan Stanley. Before that, she served as executive vice president of the debt capital markets division of Prudential Securities. Kathy received her bachelor’s degree in English literature from Northwestern University and her master’s in business administration from the Kellogg Graduate School of Management. Kathy, welcome to The Long View.
Kathy Jones: Thanks for having me.
Ptak: Well, it’s our pleasure. Thanks so much for coming on. Some of our listeners might base financial or investment decisions on macroeconomic trends. But that could be hard to pull off successfully. In your experience what’s the best way to incorporate macroeconomic matters into a financial or investment plan?
Jones: I agree with you that it can be really tough to pull off and it can lead you off the path of sticking to your plan because there’s always something going on in the macro environment that might seem scary or a huge opportunity and oftentimes people will follow that trend and then get way off to where they really need to be from the long run. I think it’s best just to be aware of what the major macroeconomic issues of the day are. For instance, is there something going on in the financial sector, the banking sector to be aware of? Or is there an imminent recession, is that something we need to be concerned about in terms of how much risk you’re taking? But other than that, I would tend to just pay attention to it, keep it in mind, but not react to everything that happens in the macro environment.
Benz: One really practical consideration for investors today is how to approach their portfolios. We’ve seen a lot of chatter about whether the 60/40 portfolio is dead, and this seems to assume that bonds won’t be the reliable diversifiers they’ve been in the past. They weren’t reliable diversifiers last year for sure. Is there any economic basis to that assumption that the 60/40 portfolio or some sort of balanced portfolio just really won’t deliver in the future?
Jones: No, I don’t think so. Generally, when people say that they’re really worried about the 40, not the 60. They’re worried that because last year bonds didn’t provide diversification from stocks. They both went down together. That somehow they never will in the future, but I think the environment we’re in right now is completely different than last year, and I think last year was unique to the starting point. We had many years of zero negative interest rates around the world, very, very low yields and then a very, very rapid increase in those rates. So naturally there wasn’t a lot of places to hide in the bond market. And at the same time the stock market was reacting to that rapid rate of rate hikes and the sudden shift in Fed policy.
Now we’re starting from a very different place where bond yields are higher—that provides you typically a cushion against volatility because you’re getting a higher stream of income, regular payments. And typically, what you get out of a bond isn’t the price change so much as the income stream. And now we have very attractive yields that are available, and I think that from that starting point, we are back to a place where 60/40 can make sense again. From an economic point of view, bonds still are going to provide that capital preservation, that certainty of the timing of when you get your principal and interest payments, and I think that offset to risk your asset classes now that the nominal and real interest rate are actually moving back toward a more normal level.
Ptak: Maybe sticking to that topic, I wanted to ask you—obviously we know that bonds were down big last year—but now that yields have risen as you note, it seems they would afford some protection, which you’ve been describing. Does history bear that out? Have we seen that bonds have not suffered long routs because their higher income payouts offset further damage from rising rates? And I suppose that we probably should qualify nominal versus real, but let’s focus on nominal for the moment. Have we found that bonds do tend to protect themselves after an episode like we went through last year?
Jones: Actually, history tells you that it’s pretty rare to have a negative total return on a high-quality bond portfolio. No matter what the environment we’re in, because as you mentioned, it’s that income stream that delivers most of what you get in the bond. When we look back over history, there’s a handful of years when the total return, that is the income plus or minus the price change has been negative in the past, and that’s because of the income stream. And even in rising interest-rate environments all of the ‘70s and ‘80s when yields were rising, the total return was rising because the income generated was offsetting the price decline. It really is an anomaly to have bonds do so poorly, and I think it was a unique set of circumstances. I think going forward, they’ll return to the more normal stabilizer income generator that they have been in the past.
Benz: You mentioned just a minute ago, Kathy, that bonds are attractive to investors because they can help them meet their spending needs. They can match the bond to their spending needs. I’m hearing a lot of enthusiasm from investors about individual bonds versus bond funds, largely because of last year the experience that bond-fund holders went through. Do you think that it’s a good idea for individual investors to be out there trying to build diversified portfolios of individual bonds? How would you suggest that people approach that?
Jones: I’m agnostic as to the way people invest in bonds, because I think there’s a lot of different ways that can work for different individuals. The advantage, as you mentioned, to individual bonds is you have your own cost basis. You have that certainty of when you’re going to get your principal back and your interest payments and we do tend to find investors holding individual bonds ride out the ups and downs of the market, better than people who might be in funds, because the fundholders look at the NAV going down and get very nervous and sell and oftentimes they’re selling at the wrong time, because they don’t have the certainty of what they’re going to get down the road in the future.
The disadvantage of building a portfolio with individual bonds is you need a fair amount of capital to make sure you get enough diversification in a bond portfolio of individual bonds and so that can be difficult if you’re a smaller investor. The second issue is you have to do your own work in terms of the credit work. If you’re buying the individual bonds to make sure you’re selecting bonds that aren’t running into difficulties, have some risk of default, or you have to pay attention, if they’re callable. There’s a number of issues when you look at individual bonds, it’s a little bit more complicated than just buying, say a stock of a company that you know of. That company might have one stock out there; it might have 10 different types of bonds. It involves some work on the individual’s part to manage that portfolio.
And for a lot of people, that’s just a lot of work and maybe beyond what their capabilities are or their interest in learning is. Having a mutual fund or some ETFs can make sense, and certainly some combination of the two can make sense as well. We have a number of investors who will build us a pretty straightforward bond ladder for the core holdings. But then maybe add some mutual funds or some ETFs around that so that they have access say to other parts of the market where they’re not comfortable investing at a reasonable cost and getting that active management or that professional management at least in their portfolios.
Ptak: I wanted to ask you, at the time we record this, the debt ceiling impasse remains unresolved. What is your take on that? Is it the sort of thing that an investor should pay any mind to or do you view it more as theater?
Jones: I think ultimately it’s about politics and not about policy. And I’m hopeful that, as has been in the past, it will get resolved before it creates turmoil in the market. I don’t think for an individual investor there’s a “to-do” there. The biggest impact we tend to see, in the past at least, is maybe an uptick in short-term T-bill yields. And around the date when that drop-dead date for the debt ceiling, we may see a little bit of volatility, but I don’t think that there’s a high risk that the U.S. will actually default on the debt, or that the long-term impact will be significant. We generally suggest people just try to ride it out and try not to get caught up in the rhetoric around it.
Benz: Bearish economic forecasts seem likelier to go viral than rosier ones. What are the questions you think a casual observer should ask when they’re assessing dire economic forecasts?
Jones: It’s always popular to come up with some forecast that’s going to get a lot of attention. And those are usually the negative ones. Usually, we’ll say how often has it been smart to abandon your investment plan when things have gone wrong? So we’ve gone through the great financial crisis. We’ve gone through a pandemic all in the last 20 years or so and we’re still here and the economy is still rebounding. And the markets are doing reasonably well, and if you had paid too much attention to those dire forecasts, you probably took some actions. You probably sold at the wrong time, had difficulty deciding when to get back into the market, and really fell away from your long-term plan. Although it’s always compelling to read those forecasts—people forward them to me all the time. It’s always a compelling story—they’re usually really well written and have lots of documentation. But we really don’t usually end up in those situations and you have to sit down and ask yourself, just how realistic is this? And maybe if you are not, if you are very risk-on in your portfolio, you’ve got a lot of risk, and you see something that makes you nervous, maybe that triggers you to take some action. But by and large, ignoring those sorts of forecasts, I think over the long run is what you need to do.
Ptak: Agree with you on that. It seems like the more mundane issues are the ones that investors should be factoring, and one of which is inflation. We wanted to ask you about that. Inflation does seem to have eased a bit and bond yields have pulled back some. Do you think the inflation scare is behind us?
Jones: I do think the worst of it is behind us. We’re starting to see evidence that some of the causes for the big bursts in inflation that we had are starting to be mitigated, and supply and demand for whether it’s goods or services or even labor now seems to be coming back into balance. Also, the central banks have taken a lot of action to try to get inflation down. This has been a huge period of tightening policy, not just in the U.S. but in Europe, and other parts of the world in emerging-markets countries. Really you just set Japan aside—I’d say that’s about the only major country that hasn’t been tightening policy over the last year or so to address inflation. I think the worst is behind us. I do think we’ll have our moments of nervousness ahead of us, but when you have this much tightening and this much determination on the part of major central banks around the world to bring inflation down, I think they’ll succeed. I don’t see how it doesn’t succeed in the long run pulling inflation down. And I note that the last shoe to fall here has been in the labor market because we’ve had very low unemployment and pretty healthy wage growth. But even that’s starting to decelerate. Ultimately the price tells you whether supply and demand are in balance and the price in the labor market is the wage rate—and that’s starting to come down—tells me even the labor market now is starting to come back to a more normal configuration.
Benz: What were the key factors behind the bout of inflation we experienced. And what lessons does that hold for the future?
Jones: A couple of things were probably unique to this bout. The pandemic and having closed everything down and broken supply chains—so that when we emerged much more quickly than was anticipated, the central banks had boosted monetary policy, to the max, and then we had fiscal policy kicked in in most countries was a significant factor. Then we emerged with the vaccines very, very quickly. So, demand was very strong; supply was not meeting that demand and so there was a bit of a mismatch, and I think that that gave us this extraordinary bump in inflation. I think about the used car market and things like that. I waited six months to get a part for my dishwasher because, it was stuck somewhere and waiting for some piece it needed to get fixed. Inflation’s always just an imbalance between supply and demand. We have a lot of weird things going on or unique things going on, and I think the lesson learned is probably that inflation can be addressed. Maybe fiscal policy was too aggressive, but who knew in the teeth of the moment, in the panic at the moment that we’re shutting down the economy, that it was too much fiscal policy boost to the economy. Who knew that we would have this much trouble getting people back into the workforce and labor would be tight.
I don’t know that we can anticipate a lot of these individual factors, but what I take away from it is that an independent central bank in a major developed country with its own currency can bring inflation under control if it takes the right steps. And that’s what we’re seeing, so we’ll probably continue to make mistakes going forward, but in hindsight, I guess the biggest lesson I’ve taken away is it can be addressed. It’s a difficult process, and it’s fraught with a lot of uncertainty, but I think inflation can be brought under control in most places.
Ptak: One of the disconnects that I think many have observed is the bond market seems fairly sanguine about the risk of inflation if you look at inflationary expectations that are baked in—they’re pretty low across the curve, it appears, and if anything, they’ve been coming down a bit. So, what do you think the bond market is seeing that the Fed isn’t seeing where the Fed remains very, very vigilant and seems committed to raising rates, at least for the foreseeable future. Why that disconnect?
Jones: I think the bond market is saying, yeah, Fed, we think you’re going to do your job. And so, short-term rates are very much driven by the Fed, but as you go further out the yield curve, long-term rates are driven by expectations for growth and inflation much more than the path of Fed policy over the next year. And I think what the market is endorsing what the Fed is doing and saying, yeah, we see that we’re going to see slower growth and less inflation down the road. As long as the Fed is vigilant about that, I think the bond mark is very comfortable with the idea that long-term inflation will ease. It’s a conundrum of course for the Fed because they probably would like to see yields stay a little bit higher to ensure that they’re getting those results and that they’re slowing the economy. But I think the market is forward-looking. The bond market is certainly forward-looking and it’s probably looking at the idea that vigilant central bank can bring down inflation.
Benz: What seems to be the most important measure to the Fed in assessing whether it’s tightened enough to bring inflation under control?
Jones: Great question, because it seems to be changing every time we hear from them. We’ve got now myriad different ways of measuring inflation coming from the Fed and stripping out this number and adding in that number. I think at the end of the day, at least recently, it’s been very much focused on the labor market and making sure that the growth rate and wages slows down. So that we don’t get this demand-being-stronger-than-supply dynamic going, and they’ve talked a lot about inflation expectations being driven by that. So, if people’s wages are going up and they have the expectation of making more money in nominal terms, they may spend more. And as they spend more of that, drives demand beyond supply and then we get higher inflation—that sticky inflation. I think that’s where the Fed is most focused right now, but it does seem to move around pretty significantly.
Ptak: Wanted to go back to something you mentioned before, which is fiscal policy and it sounds like you feel like there were a mosaic of factors that contributed to the bout of inflation that we experienced. But to the extent that looser fiscal policy maybe pushed us over the edge, do you think that could have any implications on say legislators’ willingness to provide stimulus the next time a crisis were to hit?
Jones: I certainly think that’s possible. We’re seeing a fair amount of pushback right now about the budget, the budget deficit, and spending and where the money has been spent, and so on. So, I think that that is possible. It’s interesting because in the great financial crisis, of course, the criticism in hindsight was that fiscal policy didn’t do enough. And now pandemic, the argument is fiscal policy did too much. I do think policymakers will push back against that. Because the pendulum seems to swing in each direction, which may mean that going forward the next time we hit a problem in the economy, we don’t get the same amount of fiscal support that we’ve gotten. It’s always hard to read the tea leaves in Washington, but that seems to be the way the wind is blowing right now.
Benz: The yield curve has inverted and some observers see that as an ominous sign that the economy will tip into recession. There’s a close correlation between inverted curve and recession. Do you agree?
Jones: I’m a big fan of believing what the market tells me, having been in the market for a long time. And the bond market is pretty smart. I tend to think the inverted yield curve will indeed lead to a recession at some stage of the game. Timing is always difficult, but this is a steeply inverted curve and it’s telling me that the cost of financing is going to continue to get more difficult for, say, smaller businesses and individuals, and that runs the risk I think of tipping us into recession. So, if you think about the small businesses that have to refinance on a frequent basis, their costs have gone up five times in a very short period of time. That’s going to be difficult to deal with going forward if these rates stay higher. Similar story—we’re seeing much higher credit card rates and auto loans starting to see some more defaults in those sectors.
I do think that the yield curve is telling us something important—that the cost of money is high relative to probably where it should be sustainably, and that tells me that we’ll probably see a recession. The argument against that is that the yield curve isn’t what it used to be, that a lot of financing takes place away from the banking sector, and therefore it isn’t as big a constraint when you have an inverted yield curve. “I think it’s different this time” argument is always one that I push back against because it almost never is different this time.
Ptak: How would you characterize the state of the U.S. economy right now? I think that you’ve talked about various aspects of it that you’re seeing. Is it an economy still expanding robustly and what’s the trajectory that you think we’re on? It sounds like you think that eventually, just given what the yield curve is telling us, that we are going to go into recession, but, shallow, deep, any sense of when you think that could …? I know those are all million-dollar questions, billion-, trillion-dollar questions, but what’s your take?
Jones: My take is that you typically see a recession begin anywhere from about eight to 15 months after the peak in the fed-funds rate. That’s historical pattern. I don’t put too much emphasis on those patterns simply because recessions are unusual events. They happen fairly often, but it’s normal for the economy to expand. And the recession is an unusual event, and each one is a little bit different, and so I don’t want to overemphasize averages in this case. But I do think where we’re headed now we’re seeing certainly the economy is still growing in GDP sense. But some of the important drivers of the economy are weakening. We’ve seen some softness in consumer spending start to show up in recent numbers, the buildup in inventories, which typically means those will have to be drawn down means less production.
Manufacturing sector is very soft. I looked at the ISM numbers and those are indicating contraction in new orders and activity and in hiring. Now we’re starting to see some of the companies that were the real strong growers, like the tech companies, start to lay off, and although that’s probably rightsizing after the big expansion, every person who gets laid off, loses a job, subtracts from the overall economy, and that has a ripple effect. I think that we are probably looking at something in 2024—some sort of recessionary environment. We’ve maybe rolled from a manufacturing recession; maybe we’ll roll into more of a consumer recession. I do think it should be fairly mild, barring some surprises. We don’t have the huge imbalances that we’ve had in some of the other recessions that we’ve hit. So, it should be fairly mild, meaning a couple of quarters of really sluggish growth and output. But bearable compared with perhaps the financial crisis or some others that we’ve been through.
Benz: For a while there it seemed like bad news was good news as it was thought that the bad news would help placate the Fed and it would stop its tightening. Now it seems like bad economic news is actually bad economic news as it could hint at the possibility of a recession, which you’ve just been talking about. What should macro watchers be looking out for?
Jones: I pay attention to a lot of factors, as you would guess, to try to stay on top of everything. I’m old fashioned enough to still watch money supply growth. It’s not what it used to be in terms of an indicator, and it’s not what the Fed is targeting, but I do think as a base case when you look at … We had a huge explosion in money supply growth because of the pandemic. Now we’ve seen that come right back down and that is a big factor in terms of the liquidity available for the economy to grow. I do pay attention to some of those monetary figures. But more importantly, I pay attention to consumer spending. It’s probably at the end of the day what the consumer does is going to be more important than a lot of other factors out there. I would watch money supply growth. Certainly, watch Fed policy because it’s going to drive a lot of the ups and downs of the economy. I do watch the global economy because that does have some impact on the U.S., not as open an economy as others, but definitely we can be influenced by what’s going on around the world. And then I would zero in really here on the consumer, because that’s probably the big driver for the U.S. economy.
Ptak: It’s a good segue because we want to ask you about the consumer. But before we did that, I had one follow-up question. Which is, it’s an unusual cycle in a lot of ways, but one of the ways is that so many observers seem to be predicting a recession whereas the timing of the typical recession has been hard to pinpoint. Do you think the fact that this has been such an anticipated recession could actually serve to forestall or prevent it altogether? It sounds like net net you’re still expecting a recession come 2024, but is that a dynamic that somebody should be taking into account?
Jones: I think it can help mitigate it and offset it because if people get cautious and build up their savings, and although that slows the economy, it helps offset the impact of a recession so that people have some stability. Something to fall back on, if we do get a slowdown in the economy that’s significant enough to see unemployment rise. So, it can mitigate it I suppose, it could forestall it. I think that there’s in every cycle, as I recall, there’s been a period where people say, well, maybe it won’t be a recession, maybe it’ll be a soft landing. Or maybe we’ll miss it this time, and it’s a soft landing until it isn’t, I suppose. This cycle, my concern is really that the Fed feels the need to keep going at a very aggressive pace, even if they slow down their rate hikes, they really sound very determined to see the unemployment rate somewhat higher; to see real interest rates somewhat higher, just to make sure that they’ve got inflation under control. And I think there’s a greater risk they overdo it than underdo it.
Benz: Going back to consumers: Consumers built up a lot of dry powder during the pandemic as they ratcheted back spending and received various types of financial aid. Have they spent through that, or has inflation spent through that for them?
Jones: Quite a bit of it’s gone by our reckoning. There’s still some out there. Consumer balance sheets are in aggregate in pretty good shape, but that takes into account the fact that a lot of it is at the upper end of the wealth strata. So, it’s not as healthy as it was for lower-income, middle-income workers who tend to have less to fall back on. I think we’ve gone through the bulk of it. We still have some at the state and local government level, which has been a help as well. There’s been a slow pace of hiring there. I think there will continue to be some job openings. So, state and local government, whether it’s schools or bus drivers or whatever—that can provide some mitigating factor because some of those pandemic savings are still there. But by and large, I think that we’ve gone through most of it by now.
Ptak: Just to follow up on that, what besides the pace of consumer spending would you be monitoring just to see what the state of the consumer, especially in some of those at those income levels, that are maybe be a bit more vulnerable at this point to see how they’re faring?
Jones: We watch the credit card data pretty carefully. Are people falling behind on their credit card payments or are they accumulating? Are they paying the smallest amount because they’re accumulating a lot of debt? That’s going to constrain them going forward. A similar story with auto loans. That’s usually a high-frequency indicator when we start to see people default in their auto loans and the car gets repossessed. That’s a sign that consumers at the end of the game in terms of trying to continue to make it. Those sort of high-frequency numbers are things that we try to key on pretty carefully.
Benz: Thinking about corporate earnings, they’ve clearly slowed, but it doesn’t seem like we’re seeing cracks form in the credit market. Do you agree? And if so, what’s the explanation for that?
Jones: I’ve actually been surprised that the credit market hasn’t seen a little bit more stress. When you look at investment-grade companies, their corporate earnings have fallen. When you look at the MIPA numbers, they’ve definitely come down over the last couple of quarters. But they’ve managed to adapt and adjust, and typically those are the investment-grade companies that have the better balance sheets to begin with, so they’re managing through a lot of this. I’ve been surprised in, say, the high-yield bond area, that we haven’t seen the yield spread between high-yield bonds and Treasuries expand more because those are smaller companies. They typically have much heavier debt levels. They typically are much more procyclical in the sense that they depend on a growing economy.
And those credits spreads have held in pretty well. I think that some of that is that some of the companies were able to extend their debt when rates were low, so they’re still riding on some of that lower-cost debt level. But I’m surprised we haven’t seen more stress. I think it’s going to be showing up in the very small, more private companies that have taken out leveraged loans, have gone to private lenders—the shadow-banking system and they don’t have the earnings power. They don’t have the strong balance sheets. They’ve been living hand to mouth and in this environment it may be tough to raise more capital from current investors if they’re not making money. I think that’s probably where we’ll start to see it first, and then it will expand somewhat more to these smaller, more leveraged companies.
Ptak: You’ve already touched on the employment picture. It’s still pretty bright in fact; I think unemployment is historically low. What are some of the things that you’re watching for, we’ve obviously seen waves of tech layoffs. You alluded to that already, but in monitoring the health of the labor market writ large, what are some of the things that you’re paying attention to that you think maybe investors out there also ought to be looking at?
Jones: There are so many great indicators when you go into the unemployment numbers—it’s kind of a treasure trove for economists to dive into, because Bureau of Labor Statistics gather so much data, you could spend the rest of your life looking at it. And some of us probably spend way too much time on it. I would say when I look at it, one of the things when the report comes out that maybe other people don’t key into is hours worked. So, one way a company starts to cut back on its labor costs without firing or laying off people is simply to cut back on the hours worked and that says, well, maybe you have less demand right now; we don’t really want to lose our workers because we just went through a whole period when it was hard to get workers. We don’t want to lose them, but we really don’t have enough work for them, so we’re going to cut the hours back. And when you start to see hours worked tail off, that’s usually a leading indicator that consumption, demand is starting to slow down in the economy, and often the people whose hours are cut are the people who need the paycheck the most and that translates into slower spending.
I take that number, I look at the average hourly earnings and you put it together and you get an estimate of aggregate demand in the economy. And I think that that’s an important one that sometimes people don’t watch very closely. I guess if I had to single out the underlying numbers that are important, not just the obvious: number of people working or the unemployment rate or the underemployment rate—meaning those people who usually aren’t very well attached to the labor force, but really just how many hours are they getting in? At what pay are they getting it? And that gives me an idea of how much money is in the pockets of consumers.
Benz: We want to switch over to talk about housing a little bit. It seems like the residential housing market has been under pressure. What ramifications will that market slowdown have on the broader economy?
Jones: Housing is one of those leading indicators because it’s very interest-rate sensitive. When the Fed starts to hike rates and mortgage rates go up, you typically see housing react the fastest. And we had such a runup in house prices, particularly in certain regions of the country. But really over the entire country during the pandemic. That I think that this was a vulnerable spot for the economy. The ramification is that as those prices start to come down, activity slows down. There gets to be a little bit of a standoff between buyers and sellers and you get less mobility. That usually isn’t good for a healthy economy, so we’ll see less building, less demand for the goods that go into housing and appliances, the lumber, and so on. We’ve already seen that play out. And then eventually, as those prices come down, the market adjusts, you’ll probably start to see property tax revenues get affected and local revenues affected. It’s one of the leading indicators for obvious reason that it’s very sensitive to interest rates, and mortgage rates have been up for a while now and given the runup in prices of residential housing, now you’ll have a few people, or handful of people, maybe a lot of people are underwater in terms of if they want to sell, they might take a loss. That translates into a lot of stagnation in the economy.
Ptak: What do you think is the key to housing affordability? Mortgage rates spiked as we already talked about, but housing prices really haven’t come down to offset that. Can the market regain equilibrium without a wrenching decline in housing prices?
Jones: There certainly seems to still be a fair amount of demand, but I’ve been through enough cycles in housing that usually the price has to come down. If the mortgage rate is not going to adjust then the price has to adjust. Something has to happen. And I can remember this in the early ‘90s. I can remember this, of course, after the housing bubble that we had and that was with mortgage rates at 5%, by the way. So, it isn’t just the cost of the mortgage, but it’s how much leverage have people gotten themselves into. I think eventually something’s got to give and what has to give if rates don’t come down, even though there’s strong demand for housing, it’s not affordable. I think we still have to see some decline in home prices. It’s probably going to be more concentrated in those cities and areas that have run up so sharply in price and where there might be more speculative activity, it’ll be more pronounced in those places. But I think the equilibrium has to come back from the price side unless the Fed really reverses course and we get mortgage rates back to 3% or something.
Benz: People have heaped criticism on the Fed for being asleep at the switch when inflation pressures were building and breaking. I’d like to know if you think that’s justified and also whether you think that will have repercussions for the perceived credibility of Fed policymaking in the future?
Jones: I suppose some of the criticism is justified, but I do have some sympathy for the fact that this was a pretty unique and scary situation and I think a lot of us in the midst of the moments would probably have reacted the same way. I think they were asleep at the switch as we started to see the economy bounce back. I think they were ignoring some of the signals of a rebound in the economy for a while because they just didn’t have the confidence in it. And maybe that’s a legacy of what happened after the financial crisis. But I don’t heap too much criticism on them for that. This is a judgment call. And had I been in the same seat, I might have made the same call at the time. Is it going to affect their credibility going forward? Sure. They have something to prove now, I think.
And it’s one reason I think there’s a good chance the Fed will probably overdo it on tightening and getting inflation down, because they feel that they don’t have the credibility; they’ll have to earn it back. But, surprisingly, when you look at inflation expectations, they’re tame; they’re really pretty mild, and in fact, when we look at, say, what’s implied in the markets in the Treasury Inflation-Protected Securities market, those long-term inflation expectations are back down in the 2%, 2.5% area. Even the University of Michigan Consumer Sentiment Survey the five- to 10 year outlook is back at about 3%. So, despite the fact that we still have currently high inflation and there’s a lot of criticism of the Fed and doubts about whether the Fed will get inflation down, the evidence tells us that consumers and investors believe they will.
Ptak: I was struck by a comment that you made earlier, I think that you said something to the effect that you pay quite a bit of attention—I’m paraphrasing—to what the market is telling you, and when you look at the yield curve and the inflation expectations that are impounded into the yields that we’re seeing across the curve, the market should be telling the Fed that investors aren’t worried, particularly about inflation longer term. Do you think it really boils down to the Fed not wanting to make what’s perceived to be another policy mistake, and they’re just determined and hell bent to stamp out inflation even if they’re perceived as overdoing it?
Jones: It does seem to be the case. Fed chair Powell’s Jackson Hole speech, and some of the comments from some of the other Fed officials—we’re going to stay the course; we’re going to keep at it until we get inflation down. It’s now the single mandate because they, I’m not focusing on full employment, believing that we are at full employment and even willingly forecasting that we’ll have higher unemployment. It does seem to be the case that this is a case of having to be extra tough to prove that they will get inflation down. And again, it’s a little bit puzzling because the markets telling them that they have faith in it. But I think that J. Powell has evoked the name of Paul Volcker many, many times, now over the last year or so. Wants to do what Paul Volcker did, or at least be seen as doing what Paul Volcker did to get inflation under control. And that seems to be the legacy that he wants from this Fed. So that’s how I read their statements and the comments that they keep making. I think the risk is that they overdo it to try to maintain or regain some confidence that they believe has been lost.
Ptak: And maybe, if I may, just a quick follow-up to that before we ask you about fiscal policy. Do you think the Fed’s efforts to be more transparent has been a net plus? Or do you think that it has perhaps become overly beholden to the market and lost some maneuverability in the process?
Jones: I think there is some of that. I’m all for communications and providing information to the market. I remember when Volcker was in charge of the Fed and they didn’t talk to anybody. We had this Saturday night special when he raised rates over the weekend and we all found out on Monday morning when everybody was holding the wrong positions. So, I think some transparency certainly makes a lot more sense, and it should help businesses and consumers plan for their future if they understand where monetary policy is going. I think they probably just have overdone it now because they talk and they talk and they talk, and sometimes it can be confusing, or it can be in a loop. Sometimes the dot plot with their estimates can be confusing. Sometimes the summary of economic projections can be confusing. And so, there’s got to be some balance between providing a lot of information, but not providing too much information, because I do think they’ve boxed themselves in from time to time.
Benz: Wanted to ask about the deficit and debt. Question is when does deficit spending and amassing huge debts become the problem that some have warned us of in the past?
Jones: Great question. I don’t have the answer to it. But I’ve just been doing a lot of work on debt sustainability. Looking at what’s owed by the federal government now that we’ll have to roll over at higher interest rates; the federal deficit, what is that going to amount to in terms of spending on interest expense versus where we’ve been? And the good news is that the sustainability still is there if you consider that by and large the economy grows, so tax receipts grow. You’re offsetting to some extent some of the increase in interest rates we’ve also termed out or have locked in. You don’t just refinance everything all at once. The federal government has many maturities of bonds out there at various different yields that are significantly lower than where we are today.
But clearly we’re on a path where spending is outpacing our income at a pace that is concerning, and I’ve always said two things help us out. We have the world’s reserve currency and that means that we get a lot of foreign capital that comes into the U.S. to be here that ends up in U.S. Treasuries and helps hold down our interest rates compared with where they might otherwise be. And it allows us to finance that debt at a reasonable level and that reliance on the kindness of strangers is definitely to our advantage. I don’t see an imminent problem. It’s a long-term problem and I wish you could just sit every member of Congress down with this Excel spreadsheet and say here are the numbers; you need to solve this problem. But I don’t think it’s acute yet. I think we can go for a long time and there’s plenty of opportunity to manage the data if we give a thoughtful approach to it.
Ptak: As an economist do you worry about Social Security’s long-term viability, and if so, what should be done to shore it up?
Jones: Given the popularity of Social Security among the members of this country and people in this country, I don’t think that Congress will take it away. I think that there’s probably some maneuvers that will happen—again, increasing the age at which people start to take it, maybe shifting around the benefits, maybe increasing the income level at which you contribute to Social Security. I don’t worry that it’s going to disappear or go bankrupt, but I do think decisions will have to be made to keep it viable. But if there’s anything in this country that everybody of every political stripe seems to agree on it’s that they want their Social Security.
Benz: I’m wondering, are there any good rules of thumb in economic analysis and forecasting, and if so, what are the ones that are on your shortlist?
Jones: Rule of thumb. The first one is to not start with the conclusion and work backward. You often see somebody’s come to the conclusion that this is going be the outcome. Now let me just find the supporting evidence. It’s hard to do because we all have our biases and we all have our expectations. But first things first, let’s just sit down and look at the data and see what it’s telling us. Let the data speak to us. That’s what we try to do on our team. And again, it’s very hard because we all approach these things with a certain mindset, whether we try to or not and no matter how hard you try, it’s always going to be there. But the other thing is to be open-minded that things change. When I first started in this business many years ago, the relationships that I thought were forever and ever changed over the years. And so, you have to be adaptable when you’re looking at the data and saying is this really what it was in the 1980s or is this different? And is it what it was three years ago? Or could it be different in the future? And again, that’s a difficult exercise, but it’s also what makes it interesting, because it’s always changing. Markets are always changing, economies are always changing; individuals, companies are always adapting, so it’s a process of iteration. It’s not: I have a model and I’m going to stick with it for the rest of my life.
Ptak: Knowing that people suffer from recency bias and they tend to extrapolate, like you just described, maybe widening out from that—What do you think people tend to overrate the most in following the economy? And conversely, what do they underfollow or underrate?
Jones: I suppose they overrate very short-term events and so you’ll see things like—we’re having terrible storms over the last year affecting the economic data, and they might decide that that’s a permanent effect. Or I think they tend to overrate some theories about behavior as well. I think behavioral economics is really fascinating. But when you look at some of the theories that people are trying to develop now for, say, the lack of labor force participation, there’s no one story there. We’re talking about millions of people. There are millions of stories, millions of reasons why people aren’t in the labor force. And to try to boil everything down to one driving factor because it makes it easier to understand is probably the wrong thing. Getting caught up in just the day-to-day or the week-to-week or the month-to-month data du jour, hard as it is, you have to step back and say there’s no simple answers here. Things are complicated and ever changing.
They probably paid too much attention to those kinds of grand theories that explain today’s action. Over the years what I’ve found that I’ve underappreciated is the ability to stand back and say, what are the long-term trends? And we often get caught up in the six-month forecast and the one-year forecast and the two-year forecast. It took people a very long time to realize that inflation was on a downward trend from 1981. Forever people were expecting it to come back and come back and come back, and I think it took decades for people to turn around and look back and say, “Oh my gosh, I missed that whole trend. I missed that whole component of what was going on.” Sometimes you do have to sit back and look at, OK what are the long-term sustainable trends here. Again, really tough to do without sinking into some sort of theory that someone’s made up about the world. But if you can glom on to that, it can probably be much easier to stick to your financial plan than if you’re trying to shift your view every six-month forecast.
Ptak: That’s great advice. Kathy, this has been such an enlightening conversation. Thanks so much for your time and insights. We’ve enjoyed chatting with you.
Jones: Oh, thank you so much for having me.
Benz: Thanks so much, Kathy.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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