Uncertainties about the financial sector could lead the U.S. Federal Reserve to take a less hawkish stance on interest rates. Beata Caranci, Chief Economist at TD, speaks with Kim Parlee about the Fed’s future policy path as it weighs stability concerns against inflation fears.
- How does this impact-- or does it impact the broader economy, the US economy, in the longer term? Let's start there.
- Yeah, so what we're looking at is basically a confidence crisis, specifically related to the banking sector, but even more specific to those regional banks, in particular. So from a Federal Reserve perspective, as they try to plan out or plot out the policy path, their number one priority is always towards financial stability. Otherwise, it's quite defeatist to raise interest rates when you have markets in turmoil.
So the biggest economic impact is-- aside from a bit of a confidence crisis-- within a segment of the market is that it could sideline the Federal Reserve in terms of the degree to which they would like to increase interest. It may not stop them altogether but could throw off the timing in which they can move and the peak level they'd ultimately want to get to, which means you have to do a bit of a trade-off between the financial market stability and maybe more stubbornness or lingering of inflation than you'd otherwise like.
- Yeah, because as we speak, I think we've just learned this morning the US CPI came in-- I think was around 6%. I think that's a little bit higher, at expected. So inflation is still there.
- Very much so. And when you look at those numbers, we're really focused now on what's called the core services. The Fed has mentioned this, and they're taking out things like shelter costs, which we know are super, super sticky. But you can see that rent rates are coming in, so that will turn over time. So let's look at everything else and all those service costs that are related to the business cycle and the job market-- those are sticky.
And so that tells us-- until that job market cools, it's going to be very difficult to get wages to cool. And that, in, turn makes it difficult to get prices to cool. So this is the transmission mechanism that they're looking at, and the inflation data we had today just confirmed that they have to walk and chew gum here at the same time in managing the financial risks on the banking side. But ultimately, they still have, very much, an inflation problem.
- I think that-- also, too, when you talk about the confidence, too-- just-- I was looking at-- I think, at the Fed futures rates. I think it was 4.84% before SVB, and then it bottomed out to 3.8%. Now it's jumped up again. Just for context, these are historic moves in what we're seeing right now. What is the impact of that, I think, on just how the economy functions? Because this is supposed to be the stable part, where people rely on these things, and that seems to be the issue.
- Yeah, a lot of bond volatility coming through, and it directly impacts what you're seeing in credit spreads. So if you look at your lower investment grade spreads-- triple Cs, Bs-- you saw those spreads widen out to over 100 basis points just on these moves. So the treasuries are dropping at the same time they're getting pressured up because they carry that higher risk element to them. So there is a direct impact that starts to feed through.
I think, in these type of situations, though, most businesses would go into a let's wait and see mode. So they're not going to throw out those investment plans and start over. It's more-- let's see how the dust settles. But it definitely signals that there's more caution ahead. It definitely gives you pause that it's not really just about the level of interest rates and lowering inflation. Now you have to think about specific interest rate sensitivity within segments of the market, and it shows the complexity of it. And that can certainly make businesses more cautious as they go forward, as opposed to just the event itself.
- A lot of people are watching what the Fed is going to be doing, of course, next week, and so we should talk about that. Does this change-- it the market's already priced in the changes. What are you expecting to have happen?
- Yeah, we left our quarter point hike in for next week. Markets were leaning towards 50 basis points prior to this. That's pretty much priced out of the markets completely. It was fully priced out, meaning the markets were leaning towards no rate hike at all. After today's inflation data, you saw that pricing creep back in that, well, actually, there's still a good case here to have these smaller, incremental moves from the Federal Reserve. So we've left our 25 basis points in.
However, what we're telling people is it really comes down to where you are on the day of or the day before the meeting. If you have a financial storm kicking in, they will not be raising interest rates. They could do something similar to the Bank of Canada-- pause, observe, and then move back in on the policy side once the market calms down. If we're in relatively calm waters in terms of financial market volatility in the banking sector, then they certainly have more than enough economic reason to raise interest rates.
- I guess the Bank of Canada, which paused, is actually going to be looking a little more prescient maybe, but-- in terms of their choices. But does this change anything in terms of the ramp-- where we're going or any of the issues that the Canadian economy is dealing with?
- Yeah, it's interesting because the Bank of Canada paused in order to monitor the lag effects of the rate hikes on the economy, which some might argue maybe the Fed should have done.
REPORTER: The speed was the issue, maybe.
- Exactly. So certainly, from the Bank of Canada's perspective, this is one of the things they would be monitoring. This would fall into the checklist of market stability. For the economy itself, what's interesting is-- in their last meeting, they had talked about much tighter financial conditions. So even though they indicated a pause in January, we had seen yields rise quite substantially, about 80 basis points, since that pause because it was riding the wave in the US. Now it's riding the wave coming down, and we've seen yields retrace.
So they still have to have this in high consideration because if they felt that some of the financial tightening was coming from the US, well, we've now just seen some loosening coming through on the yields side in Canada, and we certainly don't embed the banking risk that they have in the US. So it's not the same degree of financial tightening from the credit side that you see in the US as you're adopting here in Canada. So it'll be something they monitor as they go forward. But ultimately, at the end of the day, it's what affects the real economy.
And for this degree of financial market stability to really affect the real economy, it generally has to persist well over a month. You need it to continue to be in this tumultuous situation, where it gets to the point where it starts to undermine business confidence, household confidence, investment intentions, and then eventually hiring intentions. So it has to have longevity to it.
So we've only been a few days into it, and we've seen a lot of backstops put in by the FDIC and the US-- the Federal Reserve, the Treasury. So we'll see how the dust settles on that. It already looks like it's having a little bit of a calming effect. As long as this doesn't persist into a month or two, they would just treat this as a one-off aberration.
- And I guess the other thing, too, is-- I would expect you're going to be watching inflation data. If things loosen, you could see inflation start to solidify at current levels instead of dropping or even moving up. Is that a danger as well, too?
- Yeah, that's what Carolyn Rogers had mentioned-- the senior deputy governor-- that there is a possibility we can get this reignition of inflation. Now, her references were more in relation to the strengthening global outlook, so China in particular, Europe doing a bit better, and that this could put a firmer commodity base under us. But certainly, if people are thinking, oh, yields are dropping, and that's getting transmitted to mortgage rates or other lending products and they start to get back into the spending mode, then the Bank of Canada is not-- that pause is not going to last that long. They would have to react to that. So I think we're just going to have to just play it by ear in terms of how sustainable the drop in yields is because, as we saw today, there was a very swift backup of about 30 basis points just on a single piece of data.
- Yeah, no, it's quite remarkable for-- to watch those markets move. You mentioned about the job market-- just everything, how it transmits to the labor market. But it's still pretty toasty, pretty hot.
- Yeah, it is in the sense that we got a "normal" employment report last week, meaning just over 20,000 jobs, and that would be normal if this was a normal situation in terms of the pace of job growth. But the prior two months created over 200,000 jobs, which is normally what you create over an entire year. So we don't want normal anymore. You actually need it to calm down quite a bit more.
So the good news is we didn't get another print of $150,000. The bad news is this is not showing the degree of softness that would pretty much give the Bank of Canada comfort that inflation will continue to trend down on a more sustainable basis. I will say this on the job market. There are some little cracks starting to show within the private sector. There were sectors, like professional and finance sector, that had seen job losses for two months in a row.
Where we saw the job gains in the most recent months are actually coming-- of what we define as non-cyclical sectors of the economy. So these would be the public sector, health, education, and utilities. And they are accounting for the bulk of the job gains that we're now seeing, which means it may not actually-- we actually may be seeing a little bit of private sector fatigue coming through. But it's getting masked by the side of the economy that's not responsive to interest rates. So I think, if we see that a couple more months, that would be encouraging data for the Bank of Canada that we won't get this wage push-type inflation persisting.