Ethan Harris has been “on the economy” in one way or another for many years, starting when he was head of the Domestic Research Division at the Federal Reserve Bank of New York, and continuing when he moved on to become Chief Economist at Lehman Brothers, and then Global Head of Economics at Bank of America. So what does this Substack author of “Ethan on the Economy” see now for the Fed as the latest consumer price report is released and the Fed gets ready to meet next week?
Ethan says it’s not just about the August consumer price report, which many see as a little “hotter” than expected. It’s also about the producer price index which came in higher than expected too.
” I think the data are confirming sticky high inflation <after> the inflation was nice and soft in June,” he says. “But … it came up a little bit in July, came up a bit more in August. And you know, it's very hard to argue that we're converging to target right now.”
And he is certain that the first Fed rate hike since July 2023 is on the way, driven by persistent inflation and a lack of progress toward the Fed’s 2% target. And he backs it up by recent statements made by Fed Governor Chris Waller and NY Fed president John Williams.
“It’s the context. It’s the fact that things just aren’t moving the direction they want. They’ve (Waller and Williams) set us up for a hike in some ways by putting a spotlight on the CPI.”
”So I think they’re very likely to hike next week. And in my forecast, I actually have them hiking again in December.”
Shouldn’t the Fed hike its key rate now and then wait and see? Aren’t rising oil prices and the Iran war temporary supply shocks that will eventually dissipate and help bring inflation back down? Not in Ethan’s view.
“There <is> a lot of persistence to these supply impacts. They’re not just, you know, prices go up and then come falling down again. You know, they’ve gone up and they’ve stayed high. They’re still passed through going on...this is not a purely temporary shock.” And it’s not just oil. He also points to other persistent inflationary factors, including labor shortages and tariffs, which contribute to the ongoing challenge.
Bottom line: Ethan says the Fed’s inflation-fighting credibility is at stake, especially in the face of political pressure and market skepticism. “If I’m at the Fed, I’m looking at this and saying, listen, we’re in a credibility situation here. The bond markets saying it’s very nervous. We’ve started to see yields creeping up significantly. Bond markets worried about Fed independence...So it’s very important for the Fed to prove its independence now.”
Ethan makes a powerful critical point on the Fed’s gradualist approach to bringing inflation down.
“Why are they trying to approach their inflation target asymptotically? They should be trying to get inflation down quickly. We’ve had 65 months of high inflation. You know enough is enough...They should be saying we want it down fast and if we undershoot...that proves our credibility. ” He believes a more aggressive stance would reinforce the Fed’s commitment to price stability and reduce the risk of unanchored expectations.
So dive in and hear Ethan explain why the Fed may be entering a cycle of rate hikes rather than a one-off move.
Spoiler alert: “Once they get started, they don’t start with the idea that, well, we’re probably going to do one and done...we’re now signaling a high risk of more hikes to come.” Supporting this forecast. Ethan also challenges the Fed’s estimate of the neutral rate, arguing that “the neutral rate is 4% or higher...So they’ve got room to hike just to get to be slightly tight. Right now they’re loose.”
PPI and CPI give indications of sticky, hot, inflation 00:01:35:24
Well, I think we got both the PPI and the CPI right. And together they give you a pretty good indication of what the Fed’s target variable will do. And both are a little bit hot, particularly as CPI. I think the data are confirming sticky high inflation that the inflation was nice and soft in June. But that’s it came up a little bit in July, came up a bit more in August.
Hard to argue that we are converging to target right now… 00:02:04:24
And you know, it’s very hard to argue that we’re converging to target right now.
The straw that broke the camel’s back on the rate hike decision. 00:02:31:18
Yeah, I think like everyone else, I was viewing this as kind of the critical report going into this. And remember where we’re starting from here. We’ve had, as you mentioned, we’ve had above target inflation for, you know what 65 months now. Right. And so, it’s not like this report is the reason they’re hiking, or I think they will hike.
Putting the CPI is the Spot-light was a set up for a rate hike 00:02:53:22
It’s the context. It’s the fact that things just aren’t moving the direction they want. They’ve set us up for a hike in some ways by putting a spotlight on the CPI. So, I think they’re very likely to hike next week. And in my forecast, I actually have them hiking again in December.
Avoiding a rate hike here would be a mistake 00:03:19:15
You know I think it would be a big mistake. I mean, they could there are doves on the committee. You know Waller’s dovish. You know Williams sounded a little dovish. Those are two pretty important members of the committee.
Rate hike? See you in September! 00:03:37:00
Warsh is ambiguous. You know he’s ready to hike at some point but he’s not giving a timeframe. But you know as I said the spotlight’s on the data. The Fed’s kind of set us up for this moment. I think we would have had to get a number, you know, below consensus and soft kind of similar to that June reading that would have turned off the signal. But I the odds of them not hiking next week are quite small. Maybe 10% chance.
So far biggest oil price impact is on inflation not on growth 00:04:46:20
Yeah. So, supply shocks like the shutdown of the Strait always have an ambiguous effect on the Fed. It depends on whether it hurts growth more than it causes inflation. And so, the natural reaction is always for the central bank to process the data. What we’re learning is that it seems to be having a much bigger inflation than growth impact.
Price effects with persistence 00:05:12:14
The growth in the economy remains resilient. Economy is still growing at roughly 2% or so. Labor market is still healthy, but the inflation effects have been quite noticeable. And the other thing about this supply shock is its persistence. I think that when you watch the inflation outlook and the economy, you really want to recognize the fact that there is a lot of persistence to these supply impacts.
An oil shock and more… 00:05:43:06
They’re not just, you know, prices go up and then come falling down again. You know, they’ve gone up and they’ve stayed high. They’re still passed through going on the so this is not a purely temporary shock. And there are other supply side shocks hitting the economy that are inflationary. You know you have a pretty big weakening of the labor force which creates labor shortage issues.
Tariffs, too 00:06:09:08
You know you’ve got tariffs creating inflation pressure. They’re not going away anytime soon. You know there’s a lot of stuff leaning towards persistent inflation. Even if you know it’s transitory in the sense well maybe two years from now will be fine. The Fed can’t sit back and wait that long a period of time. So, this particular supply shock is having a much bigger inflation impact.
A series of shocks; hard to ignore them all 00:06:37:11
It’s coming at a time when inflation has already been high for a long time. It really does push the Fed much closer to hiking rates.
Warsh did a bit of an about-face at Jackson Hole 00:07:31:06
Yeah. So, he’s gone through. He’s changed his communications. By the way. He said he came in and said, I’m not going to talk at all. You know, you guys figure it out on your own. What he did to Jackson Hole was a huge turn because he knew exactly what he was doing. He checked the boxes on why the fed could be hawkish.
Policy isn’t really tight…00:07:53:01
Policy isn’t really tight. Inflation is very persistent. You know, we have to finish our job. He really put a rate hike on for the first time. He said something that suggested that this isn’t just in theory. We want to get to target, but actually put a bull’s eye on the short run data. And so this was I know he doesn’t like the word forward guidance, but that was forward guidance right there.
Living on the edge of a rate hike 00:08:24:19
The Fed doesn’t tell you we’re hiking next week. They say they check the boxes and why they might want to hike and that’s how they signal it. And so he’s changes communication strategy. And he’s caught up to the committee because most of the committee’s been on the edge of or at least thinking seriously about a hike for some time.
Will Walller and Williams be reluctant? 00:08:44:09
He’s refused to answer that question. Now he’s answered the question and said, I’m on the same page as the rest of my committee. Now for Waller and Williams, it’s going to be close for them and how they vote, because this latest data is not friendly, and they’re not saying we’re never going to hike. They’re just saying, I need a little bit more of a nudge. Is this enough of a nudge? I think probably they’ll vote for a hike. But you know, you know, it’s a close call for those guys.
Goods Vs Services inflation is a productivity issue- 00:09:48:17
Yeah. And so we need to remember that when you look at the division of inflation between goods and services, goods are most of the time much weaker because there’s much bigger productivity gains going on in the good side of the economy. And so firms can keep their prices low knowing that they’re getting more output per year from their workers service side, much less productivity gains, and therefore just chronically service inflation’s higher than goods inflation.
Services are driving inflation 00:10:20:22
What we’re looking at right now is it’s heavily service driven. Goods are not as weak as normal right. The way they measure inflation. You know you can have disinflation. You can have negative inflation in goods because they treat price increases as reflecting improvements in quality. They don’t count as inflation. When your computer gets better and you pay a higher price they count it as a real increase.
So the good side of the economy has very low inflation. In normal times it’s a slight bit above normal. Now services are also a bit above normal. You put it together and you know the Fed’s just not hitting its target.
Earth to Fed, earth to bond market, yes, inflation is a problem 00:11:59:15
I think the whole debate over whether inflation expectations are elevated or not has kind of a weird intellectual craziness about it. Ask the average American, do you think inflation is a serious problem? And the answer is absolutely yes. It’s in all the polls. It’s when they tell you what they think inflation is going to be, they say they think it’s going to be high. The only ones who haven’t gotten the message are economists and the bond market. So there’s a disconnect between what the average Joe sees and what the markets it’s. And I’m not saying the average Joe is right or wrong. It’s just that’s what their psychology is right now. And the other thing about so there is hints of inflation expectations being too high.
The anchoring argument- a disaster to be avoided 00:12:52:05
But the other thing that’s important is unanchoring of inflation expectations is a disaster for a central bank. You don’t want to risk it. You don’t. Because once you unpack it, once the genie’s out of the bottle, you have to create a recession to get it back in. That’s the history of it. That’s what Paul Volcker was all about. He had to crush inflation expectations and he hammered the economy. So it’s too late once it starts to seriously anchor. That’s why the Fed should be sitting on the edge of its seat right now, watching developments, and worried that every month that passes with high inflation could be the straw that breaks the camel’s back. The Fed should be very concerned.
Why walk on eggs shells to reach your target? 00:13:42:19
The other thing I would say, and I don’t see this from Fed officials, why are they trying to approach their inflation target asymptotically. Why are they going to forecast where it’s going to gently slow. And then, you know, a year and a half or so it’ll finally hit 2%. Why are they doing that. They should be trying to get inflation down quickly.
Why worry about undershooting? 00:14:04:02
We’ve had 65 months of high inflation. You know enough is enough. And everyone at the Fed seems to have accepted this idea that under shooting, the target would be the horrible result. But I’m sorry. We’ve been overshooting for 65 months under shooting the target is not a bad thing and they’ve given themselves to dovish and objective here. They should be saying we want it down fast and if we undershoot But not by a lot you know. But if we undershoot on the way down okay, that proves our credibility. That makes it much less likely that expectations on anchor. So the anchoring question should be front of mind for everyone on the Femke.
Will Warsh Fed get Trump honeymoon? 00:15:25:22
Yeah. So I mean yeah, as you said he’s been pushing the Fed for years. I mean, it was only like four months into Powell’s term that Trump went after him for the first time. He had a four-month honeymoon. We’re now like in four months or so for war. So we’ll see if that honeymoon also gets a hit here.
A credibility crisis may already be mounting 00:15:45:16
If I’m at the Fed, I’m looking at this and saying, listen, we’re in a credibility situation here. The bond markets saying it’s very nervous. We’ve started to see yields creeping up significantly. Bond markets worried about Fed independence. They’re worried about mostly about the budget deficit. There’s no signal of any attempt to control the deficit. You know if we give out $5,000 checks to everyone, that’s another trillion, $1.2 trillion, in debt for the US government.
Near a bond market tipping point? 00:16:18:20
So there’s no there’s the bond market is saying we may be at a tipping point here. So it’s very important for the Fed to prove its independence. Now when Warsh was appointed, both Bessent and Trump said, oh, the Fed’s independent, we’re not going to tell them what to do. Yeah. You’re not going to say next week I cut by 25 and the next month by 20. No, he’s sending a message that you guys should definitely be cutting. He’s actually hurting himself with this because it’s forcing the Fed to be a little bit more hawkish than it would like to be. They can’t just totally ignore this. Their credibility is being put on the line here. And they have to… They’re not going to hike out of spite or something. But they do have to lean a little bit towards hiking rather than cutting because otherwise their credibility could get seriously damaged. So it’s extremely counterproductive. The other thing the message from the president was anything you do is not going to be enough. You can go ahead if you cut by, let’s say they decide to cut to keep the president happy.
No appeasement 00:17:45:19
He’s not going to be happy with 25 basis points. He wants the funds rate down to 1 or 2%. So you’re not going to you’re not going to gain anything in terms of taking pressure off the Fed by capitulating. You’re just you know, you remember the children’s book. If you give a mouse a cookie, he’ll always ask for more. Well, that could be the case here as well. So yeah, I think on the margin it actually makes the Fed slightly more hawkish.
My outlook has been for higher rates/Normalization 00:19:00:13
Yeah. Well, at the start of the year, when I did my year ahead piece as an ode to my old job on Wall Street, I argued that we, the ten-year (Note) should end the year at about 5%. And the argument was twofold one, sticky high inflation, that that was a very big part of it. And the other was normalization. When you look at the bond market, I really think as an analyst, it’s you want to throw out the 2009 to 2020 period. That was a weird world we were in. We were recovering from the great financial crisis. The Fed was desperately trying to get a strong recovery and failing. They cut rates. They bought a bunch of bonds.
Remove period after GFC and we are back to normal 00:19:52:03
They just the recovery took getting the bond these the labor market back to normal took eight years during that period. So this was a damaged economy limping along. And it created an incredibly low inflation low interest rate environment. So that period is not really relevant. If you kind of chop that off your data set and look at where we are now on ten year yields, we’re not much higher than we should be.
Still upside risk to yields 00:20:21:17
We’re right about where we would have been prior to the great financial crisis (GFC). It’s very similar. So and on top of that we’ve got, you know, potential sticky inflation and a much worse budget situation. So you know the lot of upside risk to bond yields. You know I haven’t I’m not a bond guy. So I don’t change my forecast every month or something. But you know I still think you know going above 5% makes sense. And I’m and like a lot of economists, I’ve been kind of sitting here thinking, when are we going to have a break here? When are the bond vigilantes going to come back? Right. And so you’re sitting there saying, I don’t know. I just don’t know when they’re going to come back.
Oblivious to fiscal risks 00:21:10:17
The people seem oblivious to the fiscal challenges of the United States and other big, big economies. But now you’re kind of saying, well, maybe we’re there. Maybe this is the beginning of that break, that tipping point. And so, you know, there’s a there’s a real risk that we’re well above 5% next year, particularly if we keep in this environment where there’s no serious attempt to address the budget deficit.
Upward bias to bond yields ahead 00:21:39:04
So yeah, bond yields have an upward bias going forward.
The Fed’s wait for policy clarity causes rate change clusters 00:22:42:16
You know the reason the Fed always or doesn’t always but usually hikes in a series is because they don’t hike on a whim. They hike when they’re really convinced. And we’re right at that point it feels like now The CPI’s the straw that broke the camel’s back, I think, for the Fed. And so but once they get started, they don’t start with the idea that, well, we’re probably going to do one and done and then we’ll know they start with the idea that we’re now signaling a high risk of more hikes to come. So if the when the Fed hikes next week I don’t know what the bond markets pricing in for the October meeting right now.
Policy needs to buck interference 00:23:28:03
But you’ll see that that should be rising that that there’s a real chance now that even with the election see that by hiking. Now they’ve already, in a sense, interfered, if you want to call it. We’re just doing their job and not allowing politics to dictate the timing of the move. So they’ve if they hike next week, they’ll have kind of broken that barrier in a sense, which I don’t think is that strict.
It’s not 2022 - not runaway inflation 00:23:59:13
I think the Fed would rather if it’s a close call, they’d rather not do it right at the election. But I do think that there it makes sense to start thinking about a longer cycle. And you know, we’re not in runaway inflation. Let’s say that we get stuck at between two and a half and 3%. You’re not talking about, you know, 2022 or you’re not going to catch up and do very aggressive hikes.
Could be a slow cycle of hikes 00:24:28:17
We’re talking about a slow hiking cycle. That’s why I did it September December to be slow. So but yeah I mean if inflation doesn’t come down if it doesn’t look in the next, you know, couple months that it’s continuing that downward trajectory that we were hoping for, they could do a cycle of hikes. So yeah.
Looking for neutral 00:25:23:00
And so, yeah, we could be in a in a series now one little marker I would put there just to pay a little more specific here. The Fed’s been saying that the neutral funds rate’s just above 3%. I don’t understand what they’re talking about. The economy is doing great or good. It’s done very well. During a period when the Fed is allegedly tight, the financial markets are great.
Neutral is higher than the Fed thinks 00:25:53:08
The stock market has weathered a lot of bad news. You know, tariffs and Middle East and all that credit spreads are narrow. I can’t believe that the neutral rate is 3%, I think it’s 4% or higher. That’s been my view for ten years now that once we get out of the great financial crisis mess that will return to normal, neutral rate, which is about 4%. So, they’ve got room to hike just to get to be slightly tight. Right now, they’re loose. And so, I think that’s where my two hikes came from. I want to get above 4%.
Ethank Harris is former US Chief Economist at Lehman Brothers and Global Head of Economics at Bank of America. Previously, Head of Domestic Research Division at the NY Fed. Ethan holds a Ph.D. from Columbia University and is the author of "Ben Bernanke's Fed."
