Fed vs. inflation: Economy is ‘doing well under pressure being put on it,’ strategist explains

Michael Kushma, CIO of Broad Markets Fixed Income at Morgan Stanley Investment Management, explains the Fed's latest thinking on inflation.

Video Transcript

DAVE BRIGGS: While the Fed's battle to fight inflation is far from over, Federal Reserve Chair Jerome Powell remains hopeful of getting inflation back to its 2% target.

JEROME POWELL: We expect 2023 to be a year of significant declines in inflation.

My guess is it will take certainly into not just this year but next year to get down close to 2%.

DAVE BRIGGS: For more on the Fed, we're joined by Michael Kushma, CIO of broad markets fixed income at Morgan Stanley Investment Management. Nice to see you, sir. Powell also said we may have to do more and raise rates more than is currently priced in. What surprised you from the Fed chair today?

MICHAEL KUSHMA: I thought he was still pretty optimistic that inflation was on a strong downward trajectory. We had that surprisingly very strong employment report on Friday, which I think they're looking through and have said multiple times, as they should, that one piece of information, one piece of data, particularly if it's out of line with other data, would change their minds about how things were going.

So I think it supports the idea that they're comfortable with the downward trajectory of inflation. They're comfortable with their general forecasts going forward. So there's no reason to change current policy trajectory.

SEANA SMITH: Well, Michael, speaking of those forecasts going forward, we heard Powell once again reiterate that he thinks a soft landing is possible. He thinks we can get inflation back to that 2% number without invoking a pretty severe economic decline or significant decline in employment. Do you think that's still possible?

MICHAEL KUSHMA: It's certainly possible. A lot of the supply-- the inflation shock was due to supply issues, both in terms of goods production and inability to buy services for a number of years. Then we had an aggregate demand shock. There was a lot of money floating around the system.

And a big chunk of that is going away. The decline in goods-price inflation, if not outright deflation in goods prices, is that transitory component of the shock that we had in '21 and '22. The service sector is going the other direction because we're in the initial phases of a recovery back to normal in that part. So it's possible that the transitory component of inflation is transitory, but it's going to take a long time, multiple years, to work through. So the Fed, as long as they keep policy on the restrictive side, they can be patient to bring down inflation over time, which I think is their core strategy.

DAVE BRIGGS: Yeah it's interesting. We had the former labor secretary, Tom Perez, on who feels that we can have robust job growth like we did last month and bring inflation down. Do we need the labor market significantly cooled off to bring that number back to the target?

MICHAEL KUSHMA: I think we need to get employment growth back to a trend-like component, which if you understand the demographics in the US and immigration and all those things, it's somewhere around 100,000, 150,000 a month would keep things stable. Getting 200,000 plus per month still suggests there's downward pressure on the unemployment rate.

And most importantly, we do know that the labor market has shrunk, that the participation rate has fallen. There's fewer workers in the US than there were three years go, and that will naturally put upward pressure on inflation. It's not clear what the Fed should do about that. If there's an aggregate supply shock of fewer workers, does that mean we need to slow the economy down? Or cost of labor will be higher in the months and years ahead, and the economy will have to adapt to that.

SEANA SMITH: Well, Michael, in this environment right now, the tight labor market of falling inflation, improvement in inflation we certainly have seen most recently. How is this shaping your view on credit at this point?

MICHAEL KUSHMA: Well, it's quite positive because as we're seeing all the worries about a recession that we saw last year at various points keeps being pushed farther and farther into the future that the economy is holding up quite well considering the pressure it's been under from the push higher interest rates as sharply as they've been. So I think that the economy is doing OK, and it's holding up well under this pressure that's being put on it.

DAVE BRIGGS: Similar volatility do you expect from the markets in the months ahead?

MICHAEL KUSHMA: I think we're-- it'll be a different kind of volatility. Last year we had volatility. We had no idea where the Fed was going, how high rates would have to go. I think everyone is coming around to the idea somewhere between 5% and 5 and 1/2% is going to be the right number in terms of getting to the peak. So that-- the volatility coming from that judgment as to where that's going to be is going away.

The new sort of volatility that's going to come is from how long is it going to stay at 5%? Right now, the market thinks it's not going to stay very long at 5%. It will start coming down by the end of this year, which I think is a bold assumption currently.

DAVE BRIGGS: You think '24?

MICHAEL KUSHMA: I think '24. There's no signs the labor market is weakening, and why would the Fed cut rates if everything's fine on the employment front?

DAVE BRIGGS: Yeah, indeed. Michael Kushma, it does look that way. Thank you, sir. Appreciate that.