Diane Swonk and I have been talking about the Federal Reserve, the U.S. economy, and what drives them since the mid-1980’s when we were both starting our careers, me here in New York City as a financial journalist at Market News and hers in Chicago as an associate economist at First Chicago Corporation.
As we started doing interviews - first in print and then over the years on TV and radio - former Fed chair Paul Volcker’s term was about to end and Alan Greenspan’s 18 year reign was about to start. We have gone through many business cycles and Fed policy paths together in our conversations. So now that we are past the the Covid-driven 2020’s episode and the soaring inflation it generated, and have entered Trump tariff-driven uncertainty, where does Diane, now chief economist at KPMG U.S., see for the Fed now?
The jumping off point for our conversation was the latest PCE (personal consumption expenditures) report that revealed an unexpected drop in May consumer spending accompanied by a further rise in the Fed’s key inflation gauge. Important to note that she sees a mild stagflation risk, which she first sniffed out when last we last spoke in late February as consumer confidence fell sharply, inflation was still stubbornly above its 2% target, and Doge-driven layoffs where fuelling concerns about the labor market.
Importantly Diane sees inflation rising now and likely to move a bit higher than the 3.1% annual rate the FOMC just forecast at its June meeting. Dive in and find out why she agrees with those who expect the uncertainty generated by tariffs and more will start hitting the economy and open the door to one rate cut this year, but not until December.
Here’s the bonus question I just had to ask: who will Trump will pick to replace Fed chair Powell? This of course is heating up after the President said it’s narrowed down to three or four candidates. Diane says it’s likely to be one he thinks will be loyal to him and his desire for lower rates. She says he could be in for a surprise if the other 18 members on the FOMC decide not to back policy changes that a new Fed chair decides to make if they don’t agree it’s the right step to take.
Some cracks in the foundation for growth but no recession 00:01:26:04
Well, some of the pullback we saw (in Q1 GDP) was really due to the fact that we had front running of tariffs in late March and early April, and that was most notably in vehicle sales. So vehicle sales soared in late March and first weeks of April, and then it tapered off during the course of the month of April. And then we had a step back down to something that was sort of more normal in terms of vehicle sales in the month of April, but it was almost a 50% decline in vehicle sales. So it was a really big move down in vehicle sales. That said, there is some underlying weakness that we are concerned about, sort of cracks in the foundation, the economy is sort of showing signs of being fragmented and more fragile, but it's not yet fractured. We're not anywhere near a recession yet, and we think we're going to avert a recession. But the economy, we do worry about the headwinds that we face as we move from the first half of the year into the second half of the year.
A slowdown coming; hints of stagflation 00:03:11:01
And this is what the Fed is struggling with, is there's, you know, risks to the upside. They had a whiff of stagflation in their forecast that they just released for the month of June. In their consensus forecasts were they had marked up their estimates of both inflation and unemployment and mark down their estimates of growth. Now, I see a whiff of stagflation because the rise in unemployment is not rapid enough to qualify it as a official recession. They're not forecasting recession nor are we, but we are forecasting a slowdown, much like the Fed is with that sort of stagflation area undertone, an undercurrent out there, and that is that the tariffs are so large that they show up in some form in prices at the same time that they also erode purchasing power. And there are other issues that we're worried about in terms of growth, not only profit margins getting squeezed by the higher tariffs and higher interest rates, but also some of the cuts that we've seen in federal spending and freezes in grants and things like that.
Some hint of tariff price pressures in PCE 00:04:16:18
All of the collateral damage of that is still ahead of us, along with the bulk of the effect of tariffs. Now, we did see in the PC index some sign of tariffs. They showed up in things like, you know, child's toys. They also showed up in places like home furnishings and appliances. And that's where we saw some pickup in pricing pressures that were related to tariffs.
Tariff passthrough is in play 00:04:42:05
What we're concerned about is there was also a hotter than expected service sector inflation. It wasn't, you know, dramatic increase in service sector inflation. But one of the things that the Fed has done is they've done surveys. And as of early June, those companies affected by tariffs and those not they are starting to see some pass-through; about 75% of companies that have seen tariffs in their cost structure have passed them on in some form. 25% of absorbed them in full. But when you sort of break it out by service sector versus manufactured firms, what you see is some contagion effect into the service sector, which is something that we saw in 2018, 2019 trade war, and that was via the washer and dryer tariffs. The tariffs were on washers, yet they showed up in full on price of dryers as well during that trade war. And that's because the two tend to be sold together.
Elder care, nursing home and child care costs are rising- 00:05:39:22
So there was sort of this and that's one of the things we're concerned about. There's another area that we're concerned about, and that is that within that service sector inflation, a lot of the places that we're seeing inflation is in the care economy that care economy, everything from elder care, nursing home care to child care, those parts of inflation have been going up very rapidly. And that's important because that really squeezes a lot of it actually has had an impact on people's participation in the labor force. We've been tracking that as well. We have actually something called the Child Care Disruption Index. We'd like to do the same for elder care, but we just don't get as much detail from the household employment survey as we'd like on that.
Care need/cost is cause for labor force exit- 00:06:30:08
Men and women in prime age with a child under five are now making this decision to opt out. And some of what we're seeing in the care economy is also due to what we're seeing in immigration, which is something that also could be stagflation area in that we're seeing shortages of workers show up where foreign born tend to dominate in the care economy.
Early retirement disrupted flow of transfer payment in April/May 00:07:44:10
April was unusually high because we said some 3 million public sector workers that decided to retire early, tap into Social Security early and they got extra amount of money in the month of April. That's everyone. From fire workers to firefighters to police to public sector school and to federal workers as well. What we saw was they're eligible for, you know, their backpay, anything they didn't take and sick pay. All of that gets goes out to them when they retire and then go into the Social Security rolls that really popped up in the month of April. There are many people that were worried that they wouldn't get if they don't apply now, they might not get it. <That early retirement effect> really boosted up their incomes in the month of April. Now, we lost that and then some in the month of May. And what's important about that giveback was that it took us back down to excluding that effect down to March levels.
Harder for unemployed to reconnect in job market 00:09:06:06
Claims aren't going up rapidly and, in the last week, they actually fell a bit, those who have lost a job are finding it harder to find a job. And, of course, new grads, the unemployment rate among new grads has also gone up. And transfer payments due to unemployment insurance actually were contributing to the overall employment wage data or overall income data in the month of May. That's something that, you know, is a not exactly a strong sign. And it's something that when we stripped out just the Social Security effects alone before we got to those transfer payments, we're back at March level.
Fed is on the right side of history- 00:13:08:19
Fed officials seem to be either… they're leaning towards rate cuts at some point. Certainly, nobody at this point seems to be talking about rate hikes, but they're all waiting for the tariff impact. Right. And meanwhile, it's for the most part wait and see. Well, I think they're on the right side of this history. You know, the lessons of the 1970s are sort of seared into the institutional memory of the Federal Reserve. And why is that so important? And clearly the Fed doesn't want to make the same mistakes and cut too soon because they fear the lessons of the 1970s are that if you cut too soon and stimulate employment, that actually can come back and backfire on you with an increase in inflation again and you get that stagflation very more pernicious bout of stagflation, what they want to avoid.
Not all are on the Fed’s rate cut bandwagon 00:15:21:16
But it was really notable that there were seven participants at this last meeting in June at the Fed that saw no cuts for 2025. That's up from four in March. And so, you know, even though the median cut sort of stayed at two for the year, which I now think 1 to 2 cuts is reasonable, it really is a significant minority who now see no cuts for the year whatsoever, significant minority, rather than just a few outliers.
Last trade war is not this trade war 00:18:17:05
We were in this low inflation period where nobody thought they could pass price increases. And there was some pass along in the 2018 2019 trade war due to the tariffs, but it was a much more narrow trade war. We're talking about tariff rates that ticked a little bit above 3% and came back down a little below 3% at the beginning of this year. The the trade war was carried on with China between one administration to the next. But now we're seeing effective tariff rates that are already into the double digits and likely to move higher prior to the end of the year because of additional sector tariffs that are being investigated and will likely be added on to the suite of tariffs that we have right now.
Complex tariff dynamics possible 00:19:20:13
So you may have a one-time uptick in in prices that will boost inflation for a while, but it won't be inflationary. It's only inflation if the tariffs keep coming… Sequential tariffs. You know, some of them have pauses on them. And we don't know exactly what's going to happen at the end of those pauses. It'd be good news if, you know, they just sort of extend the pauses, which I seem to be talking about with some of them now. But we do know there's more investigations in the pipeline and that idea of sequential tariffs. But then we have another factor out there that we have to watch very closely. One is that the dollar's depreciated a little over 10% from its peak in January. Now, if it stays in this range, it's still about 20% overvalued. That's not exactly the right place to be. But if it were to continue depreciating, that would, with a lag, amplify the effects of tariffs and set us up for yet another wave of higher import costs that are not related to tariffs.
Expecting more inflation than the Fed and still other risk lurk 00:21:03:00
We're expecting inflation to peak a little bit higher than the Federal Reserve does. The Federal Reserve has the sort of consensus around 3%. We're just a little north of that, not a lot north of that. But at the end of the day, the tariffs don't completely disappear overnight and as rapidly as many would like. And also there is this risk that we don't have priced in to our forecast and that is a secondary more significant depreciation in the dollar. And we'll be watching that one closely
One cut this year? 00:22:44:17
It's a risk they take. I think what we have only one cut by end of the year. But, you know, that's a moving target in itself because of the uncertainty and we just don't know how this all will play out. We've got the same surveys and we're looking at them as well that the Fed is looking at and it makes us worried.
Risk of demand destruction from dislocation and inflation 00:23:01:12
If we were to see a more destructive demand side reaction from this <tariffs> because we do not have the cushion of the COVID era stimulus, that actually would give the Fed, even if inflation picks up, it signals, and if unemployment, is moving up more rapidly, that is a slam dunk… But, our view is that it's not going to be until December that they'll have enough information to feel really comfortable with that.
Rate cuts need the right timing 00:24:25:23
That, again, is wait and see. And you don't want to cut so rapidly that you reignite inflation when you're finally getting it, you want to make sure that you've tamed inflation. That's the lessons of the 1970s. You know, it's just something that it's seared into their institutional memory. And it's almost there's almost, you know, the anguish of central banking. If you cut too soon in an inflationary even in a supply shock, you can end up with a more pernicious bout of stagflation. And that's something you cannot guarantee the full mandate, the dual mandate, the full employment part of your mandate unless you tame inflation and get it really down. And as you noted, we've not even gotten there yet.
Do the ‘clothes’ make the man? 00:26:39:24
Alan Greenspan, famously back when Paul Volcker was actually sort of voted off the board back in 1987 and actually resigned after a board vote turned against him, that sort of ushered in the era of the Greenspan Fed. And many people at the time thought Alan Greenspan, because he was the one who famously also delivered the message to Arthur Burns that he should ease up on things in 1972, that the president meant it and wanted the Fed to ease up. He ended up not being sort of the person they thought he would be and the loyalist they thought he would be. So I think it's always very hard when you talk about, you know, people who could be in that position, many of whom are very well qualified. And I think all the people on the list could certainly be an independent Federal Reserve chairman.
Political pressure stoked by economic realities 00:31:05:20
<There is an> inability to move around like we once could. We know that the average cost per month to buy a house right now is up 87% from 2019. That is stunning. And incomes have nowhere near kept up to that. the average age of a person buying their first home has gone up dramatically and not as something that, you know, people are feeling. The very epitome of the American dream as it was once, you know, sort of put out there to be able to buy a home.
The allure of simple solutions 00:32:35:22
Tariffs sound good when you're telling people, well, it could bring home all these jobs. Well, we know as an economist, I know that the economic research shows that it also costs a lot of jobs. And the net effect is not what you really want it to be. There are reasons for tariffs, but when you attack so many things and attach so many reasons to them, you get the law of unintended consequences. The same thing when you start talking about simple solutions like just freezing rents. That then constrains the ability to develop more space.
Sound-bite economics 00:35:00:05
I am an economist, I would argue at this moment in time, economics has taken a backseat in nearly all politics. And now it doesn't matter which side of the aisle you're on. The best economic solutions are not being really debated. What is being debated are what sounds good on a campaign trail, and that's something that I worry about as an economist.
Diane Swonk
Chief Economist, KPMG US
Diane Swonk is one of the most respected macroeconomists, who maintains a unique perspective on the inner workings of Main Street as well as Wall Street. She is an expert on the economics of the labor market, monetary policy and structural changes that are distinct from economic cycles.
Diane Swonk began her career with money-center bank First Chicago. She climbed from entry-level to Director of Research and Chief Economist at Bank One, the merged bank. She spent more than a decade as Senior Managing Director and Chief Economist at the financial services firm, Mesirow Financial. Before joining KPMG, Diane had her own economics consulting firm and worked at Grant Thornton. Diane now heads up the growing economics team at KPMG to serve partners and clients, and to engage with the media to help showcase the firm’s achievements.
She has served as an advisor to the National Economic Council (NEC) on a nonpartisan basis. She regularly briefs the regional Federal Reserve banks and the Board of Governors in Washington, DC. She has provided Congressional testimony on income inequality and how to preserve and bolster the quality of government economic statistics. She is on the Advisory Board for the Bureau of Economic Analysis, of the Census Department.
She was honored by her peers as Fellow of the National Association for Business Economics (NABE) for outstanding contributions to the field. She serves on the NABE statistics committee to advocate for better information on the economy. Diane serves on the board of the Posse Foundation in Chicago, an organization dedicated to increasing access to higher education. She is active in supporting scholarships and programs to diversify the ranks of economists with more women and underrepresented minorities with her alumni groups and work on the NABE Foundation. She is a member of many business groups, including the Economic Advisory Board of the US Chamber of Commerce, the Council on Foreign Relations, The Economic Club of Chicago and the Chicago Network, the oldest networking group for women executives in the country.
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