The Misunderstood Debate About Central Banks

As markets contend with the recent volatility in the banking sector, global central banks face the challenge of continuing to combat inflation against this updated backdrop. Chief Cross-Asset Strategist Andrew Sheets and Global Chief Economist Seth Carpenter discuss.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. 

Seth Carpenter: And I'm Seth Carpenter, Global Chief Economist. 

Andrew Sheets: And today on the podcast we'll be talking about Global Central Bank policy and what's next amidst significant market volatility. It's Friday, March 24th at 4 p.m. in London. 

Seth Carpenter: And it's noon here in New York. 

Andrew Sheets: So Seth I know that both of us have been running around over the last week speaking with clients, but it's really great to catch up with you because we're coming to the end of the first quarter and yet I feel like a year's worth of things have happened in global central banks and the economic narrative. Maybe just take a step back and help us understand how you're thinking about the global economy right now. 

Seth Carpenter: You're absolutely right, Andrew. There is so much going on this year, so it's worth taking a step back. Coming into this year, we were looking for the economy to slow down. And I think it's just critical to remember why, central banks everywhere that are fighting inflation are raising interest rates intentionally to tighten financial conditions in order to slow their economies down and thereby bring down inflationary pressures. The trick, of course, is not slowing things down so much that they actively cause a recession. So the Fed having hiked interest rates already, we came into the year expecting a few more hikes, but then the data got stronger and Chair Powell opened the door to maybe going back to 50 basis point hikes. And now we've got this development in the banking sector. But it's not as if so far the central banks have seen evidence that things have gone so far that they're going to cause a recession. So all of this sounds a little bit simple maybe, but the key thing here is how can they calibrate whether or not they've done enough in terms of tightening financial conditions or if they've gone too far. 

Andrew Sheets: That's a really important point, because if you look at what the market is now pricing from the Federal Reserve, it's expecting significant rate cuts through the end of the year. And it's pricing in a scenario where the Fed has effectively gone far enough or maybe they've even gone too far and has to reverse their policy pretty quickly. How do you think about the path forward from here and how likely is it that central banks will ease as much as markets are currently pricing? 

Seth Carpenter: I mean, I do think there is a path for central banks to ease, but that is not and let me just start off with that is not our baseline scenario for this year. You led off with inflation and I think that's an appropriate place to start because what we heard clearly from central bankers in all of the developed markets was they are still hyper focused on inflation being too high and the need to bring it down. So one way of thinking about what's going on is that there's just a continuation of the normal tightening of monetary policy, so bank funding costs have gone up. If you read the the publications that our colleague Betsy Graseck, who runs Bank Equity Research in North America, she's pointed out that there's been a clear increase in bank funding costs that compresses net interest margins and that should, as a result, have an effect on what's going on with credit extension. In that version of the world, the Fed is in this fine tuning version of the world where they have to feel their way to the right degree of tightness and maybe they overdo it a little bit and then eventually pull back. I think the other version of the world that's very hard to get your mind around it is absolutely not our best case scenario right now, is that there's just a wholesale pulling back in terms of the availability and willingness of banks to make credit, either because of what's going on with their own funding or because of risk in the economy. And if there's an immediate cessation of lending, well, then I think you're talking about small and medium sized businesses that rely on bank loans not being able to say cover payrolls, or not being able to cover working capital. I think that version of the world is very, very different and that would lead to a much sharper slowdown in the economy and I think, again, would elicit some reaction from the Fed.

Andrew Sheets: So Seth, I'm really glad you brought the banking sector and its uncertain impact on the economy, because it goes to this broader question of lags and how that impacts some of the big debates that investors are having in the market. You have central banks that are looking at inflation and labor market data, that's arguably some of the more lagging economic data we have, by which I mean it historically tends to show weakness later than other economic indicators. So how do you think about those lags in inflation, in monetary policy and in bank credit when you're thinking about both Morgan Stanley's forecasts, but also how central banks navigate the picture here? 

Seth Carpenter: Very key part of what's going on is to try to understand that lag structure. I would say the best estimates are changes in monetary policy that tighten financial conditions, probably affect the real economy with a lag of two, three, maybe four quarters. And then from the real side of the economy to inflation, there's probably another lag of two or three or maybe four quarters. So we're talking about at least a year from policy to inflation and maybe as much as two years. One thing to keep in mind though, about those lags is we can look at the Fed and what they tell us about their own projections for how the economy would evolve under what they consider appropriate policy. And the answer is the median member of the Federal Open Market Committee sees core inflation at about 2.1%, so almost, but not quite back to target at the end of 2025. So if you think about when they started hiking rates until the end of 2025, they're thinking it's an appropriate time horizon for it to take well over three years. I think that's the kind of time horizon we should be thinking about in general, when everything goes, shall we say, roughly according to plan. Now, the banking system developments throw a big monkey wrench into everything. And to be clear, confounding all of this, even before we had any of the volatility in the banking sector, we were already seeing slowing, that always happens when interest rates rise. Deposits were coming down in the United States, even before any of the recent developments, the rate of growth of loans was coming down. We had on a three month basis, C&I loan growth slowed to about zero. So we were already seeing the slowing happening in the banking sector. I think the real question is, are we going to see just incrementally more or is there something more discontinuous? Our baseline view relies on this being sort of an incremental additional tightness in conditions, but we have to keep monitoring to make sure we know what happens. 

Andrew Sheets: Seth maybe my last question would be, given everything that's been going on, what do you think is something that is most misunderstood by the market or least understood by the market? 

Seth Carpenter: I definitely hear in conversations with clients and others this idea that there might be a dichotomy. Are central banks going to give up their concern about inflation and instead turn their focus to financial stability? And I always try to push back on that and say that that's a bit of a bit of a false dichotomy. Why do I say that? Because, remember, fundamentally, central banks are trying to tighten financial conditions in order to slow the economy, in order to bring inflation down. And so if what we're seeing now is just further tightening of financial conditions, that will help them slow the economy down, there's no trade off to be made. And in fact, Chair Powell, at the last press conference said what's going on in banking system is something like the equivalent of one or two interest rate hikes. So in that sense, there's clearly no dichotomy to be had. So I would say that's for me, the biggest misunderstanding in the way the debate is going on is whether central banks have to focus either on financial stability or on inflation. But if I can, let me turn the tables and ask a question of you. We came into this year with our outlook called the year of Yield, but now the world is very different. You've talked about how much volatility there is. So when you're talking to clients, how are they supposed to navigate these very turbulent waters with lots of cross-currents going in different directions? 

Andrew Sheets: One thing that I hope listeners understand is that when we set our views from the strategy side at Morgan Stanley, we work very closely with you and the Global Economics Team. And I think one of the core themes this year is that even though we've seen a lot of volatility in the narrative and in the data, the core message is that 2023 is a year where growth is decelerating meaningfully in the U.S and Europe and the 2023 is a year where growth is decelerating meaningfully in the U.S and Europe, and that's the case if you have a recession, which is not our base case, or if you avoid a recession, which is. And I think we've seen developments in the banking sector since we've and I think the developments that we've seen in the banking sector only reinforce this view, only reinforce the idea that growth is going to slow, given how hot it was coming in, given the effect of higher rates and now given the additional impact of a more conservative bank of a more conservative banking sector. I think you make a great point that there's a lot we don't know about how banks will react or how consumers will react to tighter credit conditions. Regardless, I still think at the core we should be investing for a decelerating growth environment. And I think that's an environment that argues for more conservatism in portfolios, owning less equities than normal and owning more bonds than normal. And that's very much premised on the idea that growth will decelerate from here and strategies will and that investing will follow a pattern similar to other periods of significant deceleration. Well, Seth, it was great talking with you. 

Seth Carpenter: It's great speaking with you Andrew. 

Andrew Sheets: And thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts or wherever you listen and leave us a review. We'd love to hear from you.