What Can the Sahm Rule Tell Us About the Economy?

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

Well, happy new year, Liz Ann. Good to be back on the podcast after a couple of weeks off. I hope your voice is back. How was your break?

LIZ ANN: Oh, it was awesome. I'm Norwegian by descent, as I think you know, and have a lot of family over there. And five of them came over for actually about 12 days. So we did the holidays with them and New Year's. And the weather was a little cold in Florida, unseasonably cold. But they came from Oslo, where when they went back, it was 40 below. So 60 degrees was still quite lovely for them, but it was, you know, chill and relaxing. How about you? What did you do? Were you in warmer climate or colder climate?

KATHY: No, we were in New York for the holidays, and, you know, New York is so festive around Christmas and New Year's, and, you know, everything's decorated, people are all, you know, in a great mood, and boy, were there a lot of tourists, though. I made the mistake of walking past the tree at Rockefeller Center in the evening as we were going out to dinner one night, and it was just mobbed with people. It was fun, but it was crazy busy.

But, you know, speaking of crazy busy, the new year has gotten off to a pretty fast start here. You know, at least in the bond market, I think in the stock market, too, we've seen quite a bit of volatility. So you know, I'm excited this week. I'm speaking with Claudia Sahm. And for people who aren't familiar with her, she's a former economist at the Fed who came up with a way of dating recessions based on job growth.

And I know you know about this, Liz Ann, but not everybody is probably on top of it. But the rule is now named after her, so she's gotten pretty famous because of it. So the Sahm rule identifies signals related to the start of a recession. And the way it works is when the three-month moving average of the unemployment rate, that's the national unemployment rate, rises by half a percentage point or more, relative to its low from the previous 12 months, that indicates a recession. Now she has a lot of interesting things to say about where we are at this moment in the economy. And I think our listeners will learn something by hearing her thoughts on a wide range of subjects, including inflation and whether we're in a soft landing, whether that will continue. So really, really fun conversation.

LIZ ANN: Yeah, so great get, and I think it's going to be awesome. The timing is perfect because the December jobs report, which as we're taping this, was released last Friday, and I wrote my monthly missive on that subject. At the timing it's great because the headline numbers of payrolls and unemployment rate looked healthy and strong, but the details were much more mixed. And I think this is one of those times where you really have to fine-toothed comb the data and look past just the headline numbers. So I know I'll be interested to hear what she has to say. But I'm also going to bring in our colleague, Kevin Gordon, who helped me put not just the most recent report that I mentioned together, but most of our reports, and he and I will discuss the December jobs report and some of those tidbits I mentioned. Many podcast listeners may remember that Kevin was a guest back on the market outlook episode, and he and I work closely every day on analyzing a lot of the economic, of course also market, data that gets released.

So I'm excited. Joining us on this week's podcast is my maybe not-so-secret-anymore weapon, Kevin Gordon, who I work very closely with. I'll just start, Kevin, by just talking about those headline readings, and then we'll each dive into what was maybe more interesting under the surface. 

KEVIN: That sounds great to me.

LIZ ANN: All right, so the payroll's release of 216,000 was better than the consensus, but a couple of rubs, so to speak, under the surface. Yet again, we had downward revisions to the prior two months, this time to the tune of more than 70,000, and at least through November because we don't have potential December revisions yet, but through November, that means we've had 10 of the 11 months downwardly revised. In addition, the BLS, the Bureau of Labor Statistics, has an adjustment or an estimate that they add into the mix every month, and it's called the birth-death model. And we're not talking about the birth and death of people.

We're talking about the estimated birth and death of businesses. And as is often the case, when you're at a turning point in the economy, a slowdown at or near an inflection point, what can often happen is there's too much optimism embedded in that birth-death adjustment, where the BLS is estimating too many business births and not enough business deaths. And that ultimately is what causes some of the significant, ultimate revisions. 

You also had weather flattering the number this time. But as mentioned, it's the establishment survey from which we get payrolls. The separate monthly survey that the BLS does is called the household survey, from which the unemployment rate is calculated. And unlike the establishment survey, which is of companies' payrolls, the household survey is of people. And that's where you really saw some interesting things. So Kevin, share some highlights of what was telling that came out of the household survey, including what the headline was for that particular survey.

KEVIN: Yeah, well, what's interesting about this is it's kind of a theme that, you know, we've been seeing for a couple of years now. And the big divergence in December was the fact that, so as you mentioned, the establishment survey showed that we had 216,000 jobs created in the, you know, in the payroll world, but in the household world, the decline was actually almost 700,000. So it was this huge spread between the two. And, you know, there have been several months over the past couple of years, and this divergence really started in April of 2022, when you started to see the payroll survey move higher and the household survey move lower, and since then, actually, you've seen actually almost 6 million jobs created from payroll survey, but only 3 million jobs created in the household survey. So again, a huge divergence, which is not typical all the time in a normal cycle. And as you said, at turning points, you do see these divergences. You do see the household survey moving in a different direction. And more often than not, it's the household survey that tends to be correct. 

But even within that survey itself, there were a lot of sort of glaring statistics in there. Probably, in my view, the most notable was this spread between part-time employment moving higher and full-time employment moving lower. So the decline in full-time workers was almost one and a half million. And that was the biggest decline since April of 2020. And sometimes that's seen as an unfair comparison by some people because that was clearly the drop during the pandemic shutdown. 

But even if you excluded that month and you looked from May 2020 up until now, that one and a half million decline is still huge. It was the largest in that entire period, that sample size, which obviously completely offset the slight increase that you had in part-time employment. So there were a lot of nuances, and you know it's always the case in any given month even if you're in, you know, I guess I'll put in air quotes "normal economic times" that you're going to have all these details under the surface that you can sort of pick at, but I think there are just such glaring divergences today where, you know, as you mentioned things might look OK on the surface, but you really have to start paying attention, you know, as to what's going on below the surface.

LIZ ANN: And not only that, but the unemployment rate is calculated from the household survey, but part of that calculation is also tied to the labor-force-participation rate. And you mentioned the near 700,000 loss of jobs that came out of the household survey, but the decline in the labor force amounted to almost that much in terms of number of people. When that component of the report is released, the labor-force-participation rate, it's typically shown as a rate, a percentage rate. But the actual number, I think, was 657,000. So the decline in the labor force was about the same as the decline in jobs, which is why the unemployment rate stayed steady. It's sort of that ultimate on the surface, an unemployment rate staying low at 3.7% is good, but it stayed low. It was flat for the, you know, we'll air quotes here on an audio podcast, "the wrong reasons," given the decline both in household jobs as well as the labor-force-participation rate. And that was not expected, the decline in labor-force-participation rate. And it wasn't just overall, it was also for prime-age workers. So maybe it's not a new trend, but certainly something that we should keep an eye on.

KEVIN: Yeah, and it's important too because, I mean, that's really been the, I think, the focus point for a body like the Fed in trying to combat inflation this entire period over the past couple of years. A big story, I think, that has been underplayed broadly, I mean, we've tried to highlight it as much as we can when we write about the labor market, but it has been this comeback in labor supply. I mean, if you go back a couple of years ago, the stories were all, "Well, nobody wants to go back to work. It's going to take forever to get these workers back into the labor force." But that proved to be, you know, fortunately, drastically wrong. And the labor-force-participation rate shot up in almost dramatic fashion. And yes, in level terms, now it looks healthy again. In some areas and in some demographics, you've actually surpassed, you know, prior peaks. You've gone back to multi-decade highs, which is great.

But, to your point, when you see an unchanged unemployment rate for the reasons that we did see with the decline in the labor force and a labor-force-participation rate that has now started to roll over a little bit, that's a little bit cause of concern. Not outright, "we're facing an imminent danger here," but you need to start paying attention at this point in the cycle to some of those trends, whether you are starting to see labor-force participation roll over, because if that were the case and you were starting to now see a little bit more of a downturn there, in terms of participation receding, that sort of, I think, doesn't aid the Fed's ability to fight inflation as well as it maybe has been. I mean, not that they're in the same position that they were a couple of years ago. They're operating now from a totally different standpoint, with rates being where they're at. But I think now, in part of our whole theme for this year, this is where the labor side of the story starts to come more into focus, not just the inflation-statistic story. It's much more, "Are you going to see softness in the labor market? And is that ultimately going to be a driver of what the Fed's going to be doing?"

LIZ ANN: Yeah, and what the Fed clearly wants in its fight to get inflation back down to their target is not a significant deterioration in the labor market. They're not pushing for a significantly higher unemployment rate or layoffs to kick in. They're really just trying to maybe see the job market loosen up a little bit, sort of go after job openings without going after jobs. But the other interesting thing that we got within the release of the numbers was another little divergence that I think bears watching and may have added another little bit of a cloud in terms of the outlook for Fed policy this year, which is that overall wage growth ticked up. I'm going to have you weigh in a second, Kevin, on maybe a caveat associated with that. But nonetheless, a little bit of an uptick in wages all else equal doesn't move the needle in the direction of how aggressive the market has been in terms of pricing in an actual pivot by the Fed to cutting rates as soon as maybe March. And even before the December release, we thought that was maybe a little bit aggressive, but those expectations are going to change with every data point that comes in. 

But released alongside with the average hourly earnings, you also get hours worked. And there, the story is that's been a bit more consistent over the past, really, couple of years, where you've had still fairly elevated wage growth, although down from the peak in 2022. But hours worked in general continue to compress. And I think that, number one, reflects that economic uncertainty. It may also be a way to think about things like labor hoarding, the skills gap, and I think that maybe the more unique desire in this cycle for companies to hang on to their labor, but in cutting hours, that is reflecting macro concerns, uncertainty, desire to protect margins, et cetera. So I think that continues to be something to watch.

KEVIN: Yeah, and I think that's the dynamic that's been interesting when you talk about the Fed trying to crush job openings, job demand, not necessarily labor supply and the current sort of labor force that is employed and sort of similar dynamics with the average work week coming down, but average hourly earnings not necessarily reflecting recession-like weakness. So yeah, it's been, I think, the focus of companies to sort of navigate that, especially in a time you have to consider and investors sort of have to have to take in, I think, the broader picture here of what unit labor costs and productivity have looked like over the past couple of years. I mean we've seen these massive swings in both directions for those statistics, and when unit labor costs are running really hot, you know, that tends to coincide with really hot inflation, which no surprise, that's what's happened over the past couple of years. 

Now you're in a little bit of a better position where that growth in unit labor costs is still positive, especially for many industries, but now that's starting to roll over, and you're getting back into a territory that I think is a little bit more comfortable. Probably not anything that you could declare victory right now and say, "Everything's fine," but at the same time you can have, and I think this is the caveat you were alluding to, you can have relatively strong wage growth as long as productivity holds up and unit labor costs are not soaring. 

I mean that was the case really for you know much of the '90s, you know, that mid-1990s soft landing is what a lot of people talk about these days, but again back to the point we were talking about with labor force participation now easing a little bit, if that were to be a new trend where you are rolling over and wage growth is still elevated where it's at today, that's, I think, one of the sort of the thorns that the Fed is trying to remove in its, you know, sort of quest in quashing inflation. So you know, it's not something that's going to be solved overnight, but it is a dynamic, I think, that needs to be watched very closely because, you know, and Powell has mentioned this, I think, most recently in the last FOMC press conference, that strong growth or strong wage growth in and of itself is not a negative thing. It's not a bad thing. It's just when you have, you know, a supply sort of crunch, which is what we had a couple of years ago, that's when you start to see inflation getting out of the bag and really reigniting. So if you have a better supply-side story, you can have strong growth. We've had it before. It just kind of needs to all fall into place a little perfectly. And I think that's the tough part about threading this needle, but that's the dynamic really that the Fed is looking for.

LIZ ANN: By the way, I can't help but chuckle sometimes when you talked about the mid-90s because you were either not born or, and I know when you were born, but depending on what you're talking about, you were, you know, an infant. It's the same as me talking about the mid-60s. I know what was going on. I'm a student of market history, but you know, being born in 1964, the reference point is not directly from my experience.

But we have to go to the '90s to have that same comparison. So let's just say our lovely team has, we have a wide range in terms of our experience and stages in …

KEVIN: I think we do well on age diversity. I think we score really well.

LIZ ANN: Yeah, exactly, exactly. One last thing I wanted to touch on that we hit in our report was, and this ties into what has been our longstanding view of this being a rolling-type cycle, meaning we've had rolling recessions in certain segments of the economy, like housing and manufacturing, but recovery and strength in areas like services. And there was another potentially interesting divergence that was picked up in the last week or so's worth of data, part of which was embedded in the jobs report for December, which is, and we show a bar chart in the report, at the economic sector levels and where job creation was strongest and where it was weakest. And then some potentially divergent data that came out of ISM, which in a minute I'm going to turn to you on that, Kevin, but what was interesting about the employment change by economic sector, we're not talking about market sectors here, we're talking about economic sectors and the categories that the Bureau of Labor Statistics uses.

The three largest areas where you had job gains were education and health services. That's one category, often called eds and meds, which I think is kind of fun. Government and then leisure and hospitality. So leisure and hospitality, that continues a trend that's been in place since the revenge spending on services and travel and all things experiential has continued, but the eds and meds and government are sort of the ultimate non-cyclical segments of the economy. They tend to be somewhat recession-proof.

And if you are trying to find hope for better economic news coming out of the jobs report, you would want to see more growth in those cyclical areas, and maybe in keeping with that, the biggest decline in terms of jobs, and it still falls officially under service-producing, but it was transportation and warehousing, and I think that is a somewhat subtle reflection of some of the uncertainty and/or weakness we're seeing, but separate from the jobs report—in fact, just prior to the jobs report—we had a pretty eye-popping release from ISM, which is a PMI, Purchasing Manager's Index, its survey comes out once a month. They look at manufacturing and non-manufacturing, which is how they term it, non-manufacturing being services. So what jumped out at you in terms of that release and what maybe the contrasting message is from the ISM services employment component?

KEVIN: Yeah, so it was interesting because we always get the ISM manufacturing component first, and then a couple of days later we get the services component, always at the beginning of the month. And for a while now, I mean, it's been really the case that ISM manufacturing has been weak, and its components have been weak, you know, new orders, sort of that proxy for demand, has been in sort of contraction for a very long time. It's one of the longest stretches in history. Employment has been in contraction for a while, so there's no surprise there. 

What was the glaring surprise, and really I think nobody was expecting, it was such a jaw-dropping number, was the decline in services employment. So that fell sharply into contraction. And not only that, but if you sort of exclude the pandemic period and actually the global financial crisis, and you go back to the recession in 2001, what I find interesting is that the current level for ISM services as of December is lower than at any point during the 2001 recession. 

So what that means, if you were to take that literally, what that means is that when services employers were surveyed in December, they were saying sort of collectively that the conditions around employment and hiring were worse in that month than at any point during the 2001 recession. And you know, that recession, as you and I have talked about, written about a lot, was really not that drastic. If you look at the drawdown in GDP, yeah, you had sort of more drawn-out increase in the unemployment rate, but for the big-picture purpose, it was not drastic relative to other recessions. But I think it was so interesting because it came at a time when services employment broadly in the non-farm payrolls report was generally pretty resilient. So you had all this commentary that was saying, "Well, how could it be that ISM services is telling us that things are so bad, but the payrolls report was saying things were fine?" I think my first reaction to that is that, well, ISM services tends to be forward-looking. So it's not always going to be consistent with what the jobs report is saying. But number two, I mean you have to really see if that's going to be a durable trend. If that is the case then, you know, you probably have to start paying a lot more attention to that and you could probably start to expect more weakness in the services sector. But I will say one of the more interesting aspects is that as ISM services fell so hard in December, there was actually a little bit of an improvement in the manufacturing employment component. Still in contraction, so still below 50. 

But that was an interesting divergence and something you and I have talked about for the past, I think, more than a year now, Liz Ann, which is the concept of rolling recessions, the fact that you've seen it in manufacturing. You haven't yet seen it in services, but if it ends up being the case this year where maybe manufacturing starts to recover a little bit, but services now starts to take a hit, that's entirely possible. The question really looming is, "Is the hit to services big enough to sort of tip us into a traditional, you know, National Bureau of Economic Research–defined recession?" because it's a larger employer in the economy, it's a larger part of the economy, you know, the output there really matters. That's going to be the dominant question. But, you know, as we always remind people, you can't just take one month and say, you know, "That's definitively a trend. Oh my gosh, everything has turned, you know, on a dime for services." You sort of have to wait for a couple of months to start to form that trend and really form that analysis.

LIZ ANN: So that's a perfect segue to just a concluding comment that I'll make as a tie-in to Kathy's discussion with Claudia Sahm, given you mentioned NBER recession. And particularly given that the unemployment rate, regardless of for what reasons, didn't move up. And even with the jump up a little bit more in the unemployment rate that preceded this flat reading, you still have not had the so-called Sahm rule trigger. So that makes it an even more interesting conversation to hear from the woman behind the rule. But Kevin, thanks as always for joining me. 

KEVIN: Thank you.

LIZ ANN: You and I could talk about this for hours, but we might end up with maybe your mom and my mom as the only listeners left …

KEVIN: That's fine, we'd still have an audience. 

LIZ ANN: Thanks for joining us.

KEVIN: Thank you.

LIZ ANN: So with that, over to you, Kathy, for your conversation with Claudia.

KATHY: Thanks, Liz Ann. Joining me now is Claudia Sahm. Claudia is a former economist for the Federal Reserve and a former economist for the White House's Council of Economic Advisors. She's a regular guest on Bloomberg News, CNBC, MSNBC, and many other places. You've probably seen her, certainly heard from her. She's the founder of her own advisory firm, Sahm Consulting, S-A-H-M.

You can keep up with her on her newsletter called Stay-at-Home Macro, which, by the way, matches up with the letters in her last name. And you can subscribe to that for free at StayAtHomeMacro.Substack.com.

Claudia Sahm, thank you so much for joining us today. I'm really looking forward to this conversation.

CLAUDIA: As am I. I'm really excited to be here.

KATHY: So let's start out with what you're famous for, the Sahm rule, which is really cool because it's named after you. And I know you've done this a thousand times, but I feel like the interpretation of the Sahm rule sometimes really gets confused and muddled. So could you give us a short definition of what it is?

CLAUDIA: Absolutely. The first thing to remember, it's an indicator that we're in a recession. It's not a forecast of a recession. The reason for the Sahm rule, which I did not name after myself, is to start relief in a recession. Send out the stimulus checks, bump up the unemployment benefits. That's what it exists for. It's been very helpful in the conversation about "Are we in a recession?" It has gotten used in the conversation of "Are we headed towards one?" That's not exactly its use, and yet the logic of it … so the Sahm Rule looks at the unemployment rate. Takes a three-month moving average. You got to smooth out the bumps and wiggles, and it looks at the most current value of that series, compares it back to the low over the prior 12 months, that same series. If it's a half a percentage point or more higher, we're in a recession.

And that has been the case since the 1970s. And you even go back to the post-World War II, and it's accurate, not perfect, but since the '70s, every time, and never outside of a recession. So that's an important indicator, right? That we're in a recession. It has a logic to it that's very simple that we see in the economy. Once the unemployment rate starts rising, it can create this dynamic. People lose jobs. Then they stop spending. Then more people lose jobs, and then they stop spending. The unemployment rate often takes a while to really hit its peak, often after a recession. And so that's why the Sahm Rule, even a small increase, half a percentage point, that is a really bad sign. We're not there right now. That's no guarantee that we aren't headed there. And yet, looking at the labor market, it's been really strong. So for two years, having to argue back, "No, we are not in a recession," has been kind of exhausting, and yet, you know, I'm just doing my part to help out.

KATHY: Yeah, I think what's really important is that definition, and then what it's really meant to be used for, right? As an indicator so that policymakers can take some steps to mitigate the recession that they may not yet know is actually happening, right? So I think that's really important. And yeah, there's been so much talk about it, which is great for you, but on the other hand, I feel like it hasn't been clear to a lot of people what it's all about.

So we just got the December unemployment report, speaking of the labor market. You know, let's talk about the labor market. What are you seeing? You mentioned you think it's strong. What are you seeing in those numbers?

CLAUDIA: We have continued to see a very resilient labor market. It's come back into a lot more balance. We really had to dig out of a massive hole after the COVID recession. So we were going to see some really big job gains getting back on track. We're more in a place of kind of averaging around 200,000 jobs on net created in these last several months. And that's a good number. That was very close to the expansion period right before COVID.

We absolutely need to get back into balance, get on a sustainable expansion. And you know, like we might even be there already, if not very close to it. And I will say the unemployment rate stayed at 3.7%. We have had unemployment below 4% for the longest period since the 1960s. And if you think about what the labor market is buffering right now, the Federal Reserve raising interest rates 500 basis points plus, and inflation's been high, which is a drain on consumers. You lose the consumers, you lose the labor market, and then it's all over. So to me, it's very remarkable if you think about where we could have been. I'm not as interested on Friday, people are like, "Oh, it beat expectations in December, but the downward revisions. …" And I was like, "I really don't care if on net that we didn't the market expectations or whatever," I think back to, "Hey, how are we doing relative to before COVID? Are we in a place we could stay in?" 

Now, I will say there were things under the hood that we should be keeping an eye on. It's not that it was a slam-dunk perfect report, and everybody, including myself, are looking for as we rebalance, as things slow down, that could be getting into a smooth path, or it could be we keep going down. We're still in a place where it's very hard to discern the two.

Anytime you look under the hood, you're often going to find a mess, and yet at this moment in time, it is so important to try and read the tea leaves. But I mean, my goodness, it was a good report, right? Gonna take it.

KATHY: Yeah, I think that it has been probably the biggest surprise or one of the biggest surprises of this recovery has been the strength of the labor market in light of all those headwinds that have taken place. So especially the Fed tightening, which many of us thought, you know, was a little aggressive and could have tipped us into recession. And I will admit, I was really worried about that. But so far, it's really working out pretty well from a labor market perspective. And you're right, when people have jobs, they spend money, and that helps keep the economy going. 

So in light of the fact that it looks like the labor market's going along pretty well, may have some softness under the hood, but OK so far. You know, you've been championing the view that inflation that we've seen over the past few years has really been more about the supply side shocks. And I think implicit in that is, "Gee, the Fed really should be watching out what it's doing because its tools work on the demand side," right? They try to slow the economy to bring inflation down, but that doesn't do much when you have an oil price shock or your shortage of goods all over the world, as we did coming out of COVID. So what are you seeing in terms of inflation going forward?

CLAUDIA: So after we lived through 2023, I feel both vindicated and absolutely relieved. So the argument had been all along, there were disruptions, and the supply disruptions were so wide ranging. It wasn't just the supply chains, the goods getting here. We also had demand shift wildly to goods because of we all had to stay home and services were dangerous. That's kind of a strange demand thing, but it's due to COVID, right? And then with the labor market, we had millions of people walk away from work when the pandemic began for a whole lot of reasons, caregiving, not wanting to die. You know, I mean, there were just a lot of things. And then one of the big pieces that came back in 2023 is we saw the labor market really make a move in terms of labor-force participation. And a good bit of that was we finally processed a bunch of work visas.

We shut the border down because of COVID. Again, that was so related to the pandemic. With all of these, it has taken longer to unwind them. And yet, if you had this story of "It's COVID. It's these disruptions," well, that's going to unwind itself. Like, we don't need the Fed. I wrote a piece recently arguing, Jay Powell is not landing this plane, right? Like, he didn't go out and drill oil, take a second job, unload the docks in LA.

I mean, like he was busy doing other things. And yet those are the people who are landing this plane. And because we saw, I mean, the amazingness of 2023, regardless of whether we get the soft landing or not. I mean, I think we could, is we saw inflation come down massively. I mean, its peak was 9% in the summer of 2022. It's ending the year around 3%. And we saw again, the unemployment rate below 4%. Like that's not supposed to happen. And that, I mean …

The arguments have already begun with my peers about if you twist and turn the Phillips curve and jump on your head or something, maybe you could have a story it's demand and the Fed, and they're in there. We did a lot of relief money. The labor market really moved. I mean, again, put money in people's pockets, and they spend it. There's absolutely demand in there too. The Fed should have raised rates. I think they were a little aggressive, but there was a lot of buffer to it. And so, you know, we're getting to the other side of this. There's a huge relief. And, you know, frankly, this time last year, I wasn't so sure. I mean, I had my call. I really had the logic of it, but reality was not on my side coming out of 2022, because it was really, it was bad.

KATHY: It was a brave call. You really stood out among macroeconomists making that call, which is very brave of you to stick with it. So do you think we'll get to that 2% target to the Fed? You know, there's a lot of story about, oh, the last mile is the hardest. What do you think of that argument?

CLAUDIA: Well, come hell or high water, the Fed is getting us to 2%. Right, like they are so committed to that. We've had all these, "oh, 3%?" I was like, "no." Like they talked about that in the last framework review. They will not go there for all kinds of reasons. And the Fed knows how to get 2, right? Like they, and I give the Federal Reserve a lot of credit because they could have gone very aggressively, very early, and they have tolerated to some extent and been more patient than I think a typical Fed would be in terms of giving time to get to 2%. 

I think there's a real case that the last mile might be the easiest here. Frankly, the first mile, I mean, that was the hardest, like to finally unwind some COVID. There's a piece that I've come around to that is not in my quote-unquote "mainstream" training. And I think Isabella Weber is the one that's made this case the most eloquently or like really bases it in theory. And it's this idea that the COVID disruptions gave, and Ukraine, the invasion of Ukraine, gave a particular pricing power to businesses. And I mean, if you have some extra price, you're going to go for it. Like I'm not big on the "greedflation" label. I mean, we're all greedy, right? So but there's something about the environment that gave them an extra kick, and I think if you listen to the earnings calls, and I've talked to a lot of people that work in markets, they're like, yeah, I mean, this is, there was an extraordinary situation, and that's unwinding. 

And that's a piece, I mean, you've got really feisty consumers on the prices, you have a lot of the input costs for businesses have come down. Like they can stop being so aggressive with the price increases and still have the profits. So that piece, that's one that we really haven't seen unwind.

And yet I think you can kind of hear hints of it in the earnings calls. So and if we get that, that can get us down to, we're not that far. And there are other things, but I, you know, I just see, I'm not convinced. And honestly, you know, I think Goldman is one that had a report recently. I mean, we could undershoot this, you know, if you get enough momentum.

KATHY: Yeah, the run rate right now is, you know, three-month, six-month moving average on inflation is actually right around 2. So if that just continues, if nothing changes from here, we'll be there by the end of the year or maybe even sooner. So yeah, I've never quite understood the "last mile is the hardest part," but, you know, it's out there. It's something that's really expected.

I do want to, though, ask you what are you watching for to kind of confirm your view, or what would change your mind about where we are right now? What are the indicators? A lot of our listeners really interested in following the economy, and what are the indicators you watch that would kind of give you a hint as to whether you're on the right track or something's changed?

CLAUDIA: Front and center getting to this soft landing is the labor market. I mean, we've got, it is buffering. It's not the only buffer. I wrote at Bloomberg Opinion recently about, you know, why I feel this conviction that we could really nail this landing in a soft way. And you have consumers with balance sheets that we have not seen, like, these are historic gains in wealth from 2019 to 2022 for like median families across all different kinds of demographic groups.

We never have had that, as we approach a potential recession. You have that, you have the labor market is so good on lots of dimensions. You've really brought in a lot of people from the sidelines. And I mean, I talk about this potential inflation unwinding with the pricing power. We just have all these buffers. If we start to see the buffers go, I watch credit delinquencies very closely.

Not so much the, "Oh, they're increasing." It's like, "Well, they actually fell during the recession." It's kind of seeing, it's the same thing as with the jobs. Are we balancing it out? With credit delinquencies, you would expect them to kind of rise up. If they keep going, that's a problem. That's really telling us there's a problem. So it's mainly this keeping an eye on, I mean, really the consumers, like if we lose, I mean, two thirds of the economy, as long as people continue spending, we're good. 

Oh, one that I'd said is a buffer is we finally, the consensus has finally taken out the recession call. I mean, we talk about, "Oh, why are consumers so extra gloomy," and it's like for two years we have been telling them the bottom is about ready to fall out. That would make one a little, and it's actually for businesses too, like for hiring. So I'm actually really happy to have people come over to my side, because I think it's taking some pressure off.

And on the inflation, it's, you know, I mean, that's what's driving … everything the Fed does will be about inflation. Like on Friday with the payrolls, yeah, there was stuff in there and blah, blah, blah, but nothing that we learned about the labor market in December will change anything that the Fed is thinking about in terms of when does it cut, how much does it cut this year? Like it really is about the inflation data, which in some way is unfortunate. Like I want the Fed to be data driven, but it is like data driven to an extreme right now. And every month is not going to be a good CPI, right? They're going to bounce around because that's just how this works.

KATHY: Right, this Fed does seem to be somewhat backward looking in terms of setting policy, which is unusual. And I guess the circumstances explain it, right? They got behind the curve and therefore, now they're super cautious and don't want to do anything and change policy until they absolutely are sure that inflation's coming down. But I do agree it's a little bit backward looking compared to the usual pattern. 

But this brings up something that I would love to hear from you, a little bit of inside baseball since you worked at the Fed for a long time. What do you think is really going on right now? What is the debate? Is it about the labor market? Is it about things like consumer spending? Is it about trying to balance quantitative tightening with rate cuts down the road. What do you think the conversation is about right now at the Fed?

CLAUDIA: Inflation, right? You know, it's, but more, and they're looking at all this. I mean, the Federal Reserve looks at the subatomic particles of data and like brings it in like a Hoover vacuum cleaner. I mean, like everything is being looked at. And yet the decision about when do we cut or even just how do we message, like where are we going with this? It's in the inflation data. Now it, while they are data driven, there is a real effort to go under the hood, piece it apart. This question about what's left there, is it demand? You know, if that last mile is all demand, and I said, we've got all these buffers, well, the Fed is going to have to keep at it. If that last mile is not much demand, or demand that's temporary, we had a lot of pent-up demand from the COVID shutdowns. If it's not about the Fed, they should get out of the way.

But we don't know. And I think that is the ongoing debate about "What is this? What's left?" How much more do they have to do? And I do worry. I think the other place that they're looking is like the interest-rate-sensitive sectors where they should first have an effect. And the housing market has been so messed up.

Like the Fed did so much, like between all the asset purchases and the rates, I mean, like they really did all kinds of wackiness in the housing market, which makes it, I think, pretty hard to get a signal of how much, like you can see their imprint in the housing market in a big way. And you actually can't see their imprint in the consumer spending in a big way, but they're going to keep, you know, because that's their transmission, you know, and this decision about like how much do they want to let markets go do their job or not? I mean, the press conference for the Fed in December, I mean, Jay Powell, that was almost a like "pop the champagne bottle" in Fed speak. And I mean, markets picked up on that. They're like, "Oh, this is great." And he knew, Jay knew exactly what he was doing. He is very good at talking to markets. But you can tell the FOMC hasn't quite … like they're arguing about it, which is totally healthy. I would want them to be doing it. When you have John Williams, so president of the New York Fed, not even days later going out and trying to talk the market back down. And it's like, "Good luck, John," right? Like the chair just, you know, so I think they're kind of, they're still all over the map. My, I'll say my biggest risk factor for this year is that the Fed confuses markets, and something breaks, and unlike Silicon Valley Bank, they don't get it under control. So the Fed is the risk factor, but honestly, I think they're the risk factor first through financial markets, not consumer spending or housing purchases.

KATHY: Right, so if they send the wrong signal, the market craters or something, and they have to step in and change what they're doing. So let's hope that doesn't happen. Let's hope champagne continues to flow. But I will say, one thing we hear a lot from, you know, Schwab clients is, well, "They're all over the place." As you mentioned, you know, Powell will come out and say one thing, and then two minutes later, you'll hear from other members of the Fed saying other things. That gets very, very confusing to try and figure out where they're going and what they're doing. And, you know, investors, businesses, consumers, they all want to have some sense of the direction we're going. 

CLAUDIA: Yeah, I would have a cap on how many times the FOMC members can speak in public between meetings, except for Jay. He can talk all he wants. But I mean, they've created a lot of noise. And that's unfortunate because, again, you confuse markets, you confuse investors, you're walking a tightrope. Like that could cause problems.

KATHY: Yeah, I mean, I remember the days of Paul Volcker when the Fed just didn't hardly talk to anybody ever, even when they changed policy. It just kind of came out later. So now we're absolutely at the other extreme. And I think it is very confusing, even for those of us who spend all our time, you know, kind of focusing on this. So we kind of focus on our everyday investors. They're very well informed. What would you have them keep in mind? Would you have them listening to Jay Powell? You've mentioned the labor market. How do you cut through the noise to focus on just what's important if you're an investor?

CLAUDIA: Jay Powell speaks for the FOMC. And again, Jay speaks most clearly to markets of any, frankly, any chair that I know and FOMC members, right? Like he is not a macroeconomist who is in love with the R star, this neutral rate of interest. I mean, John Williams, that's part of his thing, right? I love the macroeconomists. We have, I am one, we have a place, and yet we are not well endowed with speaking to markets or even thinking our Fed tools work the same way as markets do. And honestly, I'm kind of on the sides of markets with how they think the asset purchases work, and really I'd love the Fed never to use that tool again. Like that's been a big problem. But yeah, no, Jay speaks very clearly. One thing that I don't think has been appreciated enough by markets is the Fed has a lot of history, right? What's happening right now is, you know, we have the high inflation, I mean, though it's come down a lot, but they want to make sure that they really nail this and get it under control. Nobody at the Fed wants to be Arthur Burns, right? Who, as unemployment started to creep up, cut, and then inflation came back. So they don't want to do that. So you're going to be "little c" conservative in the first cut this year.

So in my opinion, it's whatever you think the Fed will do, just knowing kind of how you've looked at the Fed in the past at a meeting. Like I just, I don't get how anybody's got money on March. Right, like there's three CPIs, they're not going to be convinced, there's no way all three of them are awesome. I mean, if they are, maybe. But May, yeah, to me, that's what Jay, popping the champagne bottle was like, we could have this in the first half. But then everybody's like, "Oh, March, March." And I was like, "Hey, great, cut rates, markets. I'm happy. I'm not going to get in your way." 

KATHY:  But you think that the markets jumped the gun. And we have penciled in mid-year start with the rate cuts, maybe three or four, just kind of taking into account how cautious the Fed has been. So you'd be on the same page with that.

CLAUDIA: Yeah, absolutely. And then that's the this history of they're going to just because of this very specific inflation is coming down, like they're just not going to want to make the mistake because again, they don't want to be Arthur Burns. Jay Powell's on record that Volcker is his hero. I mean, I kind of gasped when he said that. But I get it. And then, I mean—this will only be subconsciously, the Fed is not going to do this intentionally—but it is an election year.

And that was the other piece of Arthur Burns, Nixon leaned on him, and he did what he needed to do to help Nixon get re-elected. They're going to deny this is in their thinking. Yeah, I mean, I get it. And yet, I think it's probably hard for them. Like they really want to stay independent, which means, like, they don't need to just act like it, they need to convince the rest of us that they're neutral to this. And I actually don't know how they thread that needle. I mean, inflation's just got to get so convincingly at 2 for them to be able to say, hey, look at this, it's time for us to cut. Because if it's just like kind of discretionary, I just think they're going to have a hard time staying out of the fray.

KATHY: Yeah. I don't know, this being an election year is huge in every market right now. It's going to have some influence. OK, I'm going to wrap this up with a final question that I love to ask, and the question is, what do you read, and what would you suggest our listeners read to stay informed?

CLAUDIA: Oh, goodness, I wouldn't subject anyone to my reading. 

KATHY: Hahaha.

CLAUDIA: I, you know, the one of the, I mean, one of the ways that I grab the most information is I am still on Twitter. I mean, it's gotten markedly worse, but I learned so much. I learned so much, Kathy, from your tweets, right? When data come out, and there's a very rich discussion. And I also spend a lot of time interacting with regular people. I mean, I work a lot on macro-policy, not just, you know, talking about the Fed.

The other, I mean, I spend a lot of time thinking about the Fed. I read Fed transcripts. I read, I have a whole section of my bookshelf that's Fed stuff. And to be honest, like, I really appreciate reading the history. 

KATHY: Is there a favorite book you have on Fed history?

CLAUDIA: There's so many that are good. One that I've been enjoying recently, there's, well basically anything that Alan Blinder writes about the Fed is very good. And he's written, I mean, over several decades. To me, he's the most aligned that I've found anyone that's macro policy in Fed. Like he really resonates in terms of like old school, has some judgment, you know, that's not, he's not so tied up in the models. I also, Ben Bernanke has written some very, he has a monetary policy book recently. I'm not real fond of his memoir ones, but when he sits down and writes about the history and how the policy, I thought that was a nice book. And it's a good one to see the Fed the way it sees itself. Right, he's really monetary policy macro. Now Jay is not of that ilk, but it does give the way the Fed sees itself over time, which I don't always agree with, but it is instructive to see what the narrative is they tell themselves. 

So I found those things very helpful. And I will say, as the last thing, you asked me what I read and I was like, oh, I'm on Twitter. Jay Powell is a total Twitter junkie. So I'm not the only one that goes out, I mean, all in the background. He isn't tweeting like I am, but it is a place to go out and absorb a lot of information and frankly, right now, everything is moving so fast, it can be really helpful, and then you talk to people that push against your priors. But I mean, I don't know for the listeners, it's kind of the wild, wild west, and it's not for everyone.

KATHY: That's for sure. And it's become wilder in the last year or so. But I agree, I interact with people that are really smart, people I wouldn't, like you, I wouldn't otherwise probably have contact with. So it is valuable in that way. And I like the idea of how the Fed sees itself. I think that's really an interesting perspective for us to kind of take into account. So. Well, thank you so much. I really appreciate you coming on. It's been a highlight for me to be able to chat with you and listen to your thought process.

CLAUDIA: Thank you so much.

LIZ ANN: That was awesome, Kathy. You know, I always like when, particularly guests that we have on, how candid they are, especially with her responses. 

I know we've seen some movement on the 10-year Treasury. That's movement in the 10-year Treasury has been sort of the huge theme for the last year or so, but what else are you keeping an eye on in the next week or so?

KATHY: Yeah, it's interesting that the 10-year's been moving around, but it keeps kind of gravitating back towards 4%. So we're going to need to see some news, I think, that's going to push it out of its tight range, or the range it seems to be holding in. Next week, well, it starts with a holiday on Monday. So we have a short week. I think what I'm really paying attention to right now, we certainly have a number of economic reports out that are important. But we've got some Fed officials speaking and the release of the Fed's beige book, which is kind of their assessment of the economy. I'm most interested in now what Fed officials have to say about their use of the balance sheet. There's been some news around that, some hints that they're going to taper quantitative tightening. And for me, I think that's, and the Treasury market, I think that that's a big issue that we need to stay on top of. We've been waiting to hear this news. So that's what I'm paying a lot of attention to.

What about you, Liz Ann? Today kicks off a season of fourth-quarter earnings reports, right?

LIZ ANN: Yeah, we are starting earnings season. And I think these days in particular, earnings season can be a volatility driver, extremely important, but maybe not for the reasons that is often the case that earnings can be a big market driver. Historically, there's always a lot of focus when you're in earnings season on metrics like the beat rate and the percent by which companies beat, and that drives performance. But what's been unique about the past, particularly the past few quarters, is number one, the beats are being rewarded to a lesser degree than the misses are being punished. And I think that may have to do with a lot of companies that are beating, they're doing it because they have been cutting costs, whether it's labor costs or other input costs, in a more challenging environment.

So the story behind the beats is one of a little bit of uncertainty, economic uncertainty. It's also the case that I think the outlooks, the commentary from companies have become increasingly important, not just because we get a better flavor of where uncertainties lie, what issues are paramount of importance, how companies are protecting profit margins, especially in an inflation environment that although has improved, is still there in terms of high input costs, particularly labor costs. But also, analysts are just not being provided as much detailed information in terms of year-ahead-type outlooks from companies. That's the nature of the pandemic. CEOs, there are so many macro uncertainties that CEOs are not being as precise as they have been in the past. And that leaves analysts not flying blind, but adjusting forward estimates nearer term. 

They wait for the earnings season, they listen to the outlooks, and maybe they'll adjust their estimates for the next quarter or two, but not further out than that, which makes things like calendar-year 2024 estimates probably not terribly realistic, but the more commentary you get, you start to get a sense of the trajectory. So I think it's more what's embedded in the commentary and the outlooks that is probably most important to focus on versus just those traditional metrics like the beat rate and the percent by which companies are beating. 

You know, in terms of next week, we've got retail sales, especially coming out of the holidays. I think a metric like that as a proxy for consumer spending is important. You've got important export prices, so that's another way to just judge the broader inflation environment. Industrial production, that's a key metric that the NBER, the official arbiters of recession, uses, so I think that's important as well. You've got some more housing releases, including the NHB housing market index, that's a home-builder sentiment survey. That can sometimes be a tell. And then things like building permits and housing starts, which are key leading indicators. And then finally, later in the week, you get the University of Michigan consumer sentiment data, which not only has that sentiment information, it has in it inflation expectations, which has been a big focus lately. So that's what I'm watching next week.

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