US Economy: Bigger, But Not Tighter

New data on both immigration and inflation defied predictions and may have shifted the Fed’s perspective. Our Chief U.S. Economist and Head of U.S. Rates Strategy share their updated outlooks.  

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Ellen Zentner: Welcome to Thoughts on the Market. I'm Ellen Zentner, Morgan Stanley's Chief US Economist.

Guneet Dhingra: And I'm Guneet Dhingra, Head of US Rates Strategy.

Ellen Zentner: And today on the podcast, we'll be discussing some significant changes to our US economic outlook and US rates outlook for the rest of this year.

It's Tuesday, April 23rd at 10am in New York.

Guneet Dhingra: So, Ellen, last week you put out an updated view on your outlook -- with some substantial forecast changes. Can you give us the headlines on GDP, inflation and the Fed forecast path? And what has really changed versus your last update?

Ellen Zentner: Sure Guneet. So, our last economic outlook update was in November last year. And since that time, really, the impetus for all of these changes came from immigration. So, we got new immigration data from the CBO, and just to give you a sense of the magnitude of upward revision, we thought we had an increase of 800,000 in 2023. It turns out it was 3.3 million. And so far, the flows of immigrants suggest that we're going to get about as many as last year, if not a little bit more. And so, what does that mean? Faster population growth, those are more mouths to feed. You've got a faster labor force growth. They can work. They are working. And data historically shows that their labor force participation rates are higher than native born Americans.

So, you've got to take all this into account. And it means that you've got this big positive supply side shock. And so, when the labor market has been about balance now between demand and supply, as Chair Powell's been noting, you're now going to have supply outrun demand this year.

And so, you basically got much more labor market slack. You've got -- and I'm going to steal Chair Powell's words here -- you've got a bigger economy, but not a tighter economy. So, it's faster GDP growth. We have taken out one Fed cut, and I know we're going to talk about that because inflation has surprised the upside recently. But you've got slower wage growth. More labor market slack. And so, we did not change our overall inflation numbers on the back of this better growth and better labor force growth.

Guneet Dhingra: That's very helpful. That's a very interesting read in the economy, Ellen. Do you think the Fed is reading the supply side story the same way as you are? And said differently, is the Fed on the same page as you? And if not, when do you think they could be?

Ellen Zentner: Yeah. So, you know, Chair Powell, if you go back to his speeches and the minutes from the Fed. They've been talking about immigration. I think we've known for a while that the numbers were bigger than previously thought. But how you interpret that into an outlook can be different. And it takes some time. It even took us some time -- about a month -- to finally digest all the numbers and figure out exactly what it meant for our outlook. So, here's the biggest, I think, change for them in terms of what it means. The break-even level for payrolls is just that much higher.

Now what does break even mean? It means it's the pace of job gains you need to generate each month in order to just keep the unemployment rate steady. And six months ago, we all thought it was 100, 000, including the Chair. And now we think it's 265,000. That is eye popping. And it means that when you see these big labor market numbers -- 250, 000; 300,000. That's normal. And that's not a labor market that's too tight.

And so, I think the easiest thing the Fed, has realized is that they don't need to worry about the labor market. There's a lot more slack there. There's going to be a lot more slack there this year. Wage growth has come down because of it. ECI, or Employment Cost Index, is going to come down for this year. The unemployment rate is going to be higher. They do still need to reflect that in their forecast. And that means that we could show, sort of, this flavor of bigger but not tighter economy when we get their forecast updates in June.

Guneet Dhingra: I think the medium-term thesis is very compelling, Ellen, but how do you fit the three back-to-back upside surprises in CPI here? How does that fit with the labor supply story?

Ellen Zentner: So, that is sort of disconnected from the bigger but not tighter economy, because we did have to take into account that inflation has surprised to the upside. I mean, these have been some real volatile prints in the last three months, and we're now tracking March core PCE at 0.25 per cent and we're going to get that number later this week. And so that's above the threshold that we think the Fed needs in order to gain confidence that that pace of deceleration we saw late last year, is not in danger of slowing down for them to gain further confidence.

Ellen Zentner: And so, the way I would characterizes this is that it's a bigger but not tighter economy. But we also had to take into account these inflation upside surprises, which is really what led us to push the June cut off to July.

So, after we get that March, core PCE print, let's see what that data holds, but we think a few prints around 0.2 per cent are needed to satisfy Chair Powell, and gain that consensus to cut. So, I want to stress to the listeners that, you know, our conviction that inflation will head toward target remains high.

And it was also helped last week by fresh data on new tenant rents. So that is a leading indicator for rental inflation in our models. And it's slowed again. And suggests an even faster pace of deceleration ahead.

But here's where I think it matters for the Fed. Whereas before, they were very convicted that this rental inflation story was going to play out, that rent inflation was going to come down. They used similar models to us. But because of the inflation data being so volatile over the past three months, rather than providing forward guidance on what you're going to do around rental inflation coming down, you want to see it. You want to see it in the data. And so that's why they've been so willing to say, you know what, we're just going to, we're going to hold longer here.

Guneet Dhingra: Perfect. So just to get the Fed call on the record, what exactly are you calling for the Fed? And I know investors love the hypothetical question. What is the probability in your mind that the Fed doesn't cut at all in 2024?

Ellen Zentner: Yeah, they do love scenario analysis. So here we go. So, our baseline is they cut in July. They skip September. By November, the inflation data is coming down to monthly prints that tell them they're on track for their 2 per cent goal and at risk of falling below it. So, from November to June next year, they're cutting every meeting to roughly around three and a half percent.

Now, as you asked, what if inflation doesn't go down? So, inflation doesn't go down, you know, then the Fed's forecast and our forecast are going to be wrong and the three rate cuts they envision is predicated on that inflation forecast coming true. So, you know, the most important takeaway from that scenario is that the result would be a Fed on holder for longer. But as opposed to a hike being the next move -- and I think that's really important here. The Fed is still very strongly convicted on they will cut this year. This is about the timing. Now, the hold period could last into 2025, I mean, we don't know, but what happens if inflation accelerates from here?

So, I'm going to provide another scenario here. So, there is a scenario where inflation accelerates on a backdrop of strong growth, which would suggest it might be sustained, and perhaps begins to lift inflation expectations. Now, you know, that's a recipe for a hold that then turns into additional hikes as the Fed realizes neutral is just higher than where rates currently sit. But at this point, I would put quite a low probability on that scenario. But from a risk weighted perspective, I suppose it should be taken into account.

So, given all this and the changes that we've made, what is your expectation for rates for the rest of the year?

Guneet Dhingra: Yeah, I think we also, based on the forecast revision you guys have, we also revised up our treasury yield forecast. We earlier had 10 year yields ending slightly below 4 per cent by the end of 2024. Now we have them at about 4.15 percent which again is a 20-basis point uplift from our forecast before this. But still, I think it's not the higher for longer number that people are expecting because when I look at the forecast you have on the Fed, I think Fed path you have is well below what the markets expect.

I think the forecast you have has about seven cuts from July this year to the middle of next year. The market for contrast is only four. There's a pretty massive gap that opens up, I think, between the way we see it -- and ultimately that does come down to the interpretation of the data that we're seeing so far.

So, for us, the forecast numbers are slightly higher than before, but the message still is: we are not in the hire for longer camp, and we do expect rates to end up below the market applied forwards.

Ellen Zentner: All right. So, you know, I've talked a lot about immigration. One could say I've been pretty obsessed with it over the last couple of months. But from a rates perspective, you know, what are the broader implications of the immigration story for that? You know, this, this bigger but not tighter economy. How do you translate that into rates?

Guneet Dhingra: Yeah, let me say your obsession has been contagious. You know, I've caught on to that bug, the immigration bug. And, you know, I've been I've been discussing this thesis with investors, quite a lot. And I think it seems to me as you framed it pretty nicely. It's a bigger but not a tighter economy. I don't think investors have caught on to that page yet. I think most investors continue to think of these inflation prints is telling you that this is a tighter economy. Bigger, yes -- maybe on the margin. But the tighter part is still very much in people's minds. And when I look at the optics off the CPI numbers, the payroll numbers, investors have just been very conditioned, very reflexively conditioned to look at a 250K number on payrolls as a very strong number. They look at the 3 per cent number of GDP as a very strong number.

And as you laid out earlier, these numbers may not be necessarily telling you about an overheating economy. But simply a bigger economy. So, I think the disconnect is there, pretty pervasive. And I think for me, most investors will take a lot of time to get over the optics. The optics of three strong points of inflation, the optics of 250K payrolls. I think it's gradually seeping in. But for now, I think the true impact or the true learnings from the immigration story is not very well understood in the investment community.

Ellen Zentner: Okay, but is there, is there anything else missing in your view?

Guneet Dhingra: Yeah, quite a few things. I think you can add more nuances to this immigration story itself. For example, when I think about last year, when rates were going up massively in third quarter, fourth quarter, one of the focal points was Atlanta Fed GDP Now. My GDP now was tracking close to four and a half, five per cent, and inflation was cooling pretty clearly in the second half of last year. And so investors had a choice to make. Do we actually trust the GDP growth numbers? Because they are probably an inflation risk in the future. And the markets very clearly chose to focus on growth with the belief that this growth is eventually going to lead to high inflation. And so, I think that disconnect has really translated into, sort of, what I would call like a house of cards where investors have built the entire market level on growth upside, and growth upside, and growth upside.

So, I think the market level -- when I do the math and try and suss out the counterfactual -- the market level of 4.6 per cent tenure should have and could have been a market level of 3.8 per cent tenure based on my calculations. And so, there's an 80-basis point gap from where we are to where we could have been based on a misunderstanding of the supply story and the immigration story.

Ellen Zentner: Yeah, I certainly wish the volatility was a lot lower here. It would make it easier for the Fed and for us to separate signal from noise. Certainly difficult for market participants to do that. But Guneet, thanks for taking the time to talk.

Guneet Dhingra: Great speaking with you, Ellen.

Ellen Zentner: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen to podcasts and share the podcast with a friend or colleague today.