ANDREAS STENO LARSEN: Good afternoon, everyone, and welcome to the Real Vision Daily Briefing. I'm Andreas Steno from Real Vision sending to your live September 1st of 2022. Today, we're going to ask the question whether the Federal Reserve will stay at higher interest rate levels for longer. And no one's better at answering that exact question than my guest of the hour, namely Darius Dale, the founder of 42Macro. It's very good to see you again, Darius.
DARIUS DALE: Andreas, that is a high bar you're putting me on, man. We're going to disappoint a lot of people today. How are you doing?
ANDREAS STENO LARSEN: I'm doing good. I hope you're doing good as well. But before we answer the question, Darius, we've basically received a bunch of data prints from the US today. First of all, the ISM manufacturing figure. What do you make of the headline number and the subcomponents?
DARIUS DALE: Yeah, it's a very important report, a very important week for macroeconomic updates. The bottom-up guys, the guys and gals, they get like, four times a year where they get new information. We get new information all the time, particularly the first week of the month. As you mentioned, we got the ISM for the month of August. Good report. And obviously, we were flat on a month over month basis from a headline perspective. But we did see both the new orders and employment components take up.
To me, I think you tweeted out a chart of this, the slowdown in prices paid continues to point to a pretty material deceleration of inflation in the coming months and quarters. That's something that I think is worth showing highlighting, Brian, I think that chart of yours is really, really important.
ANDREAS STENO LARSEN: Darius, do you find it to be a valid signal when we see such a slowdown in prices paid in the ISM manufacturing index? Is it a valid signal for the inflation in a couple of quarters from now?
DARIUS DALE: Yeah, great question. Phenomenal question. When you regress it on a levels basis, the level versus the level of inflation, you tend to get a valid signal there, correlated to cointegrated, but when you regress it on a first difference basis, i.e., from a rate of change perspective, the signal breaks down more or less entirely. You cannot use the ISM prices subcomponents to anticipate either the momentum of inflation on a month over month or three-month annualized basis, nor can you use it to predict with any specificity where inflation will be on a given particular date.
You more or less, you retain the cointegration of the time series, but you lose the tight correlation. One thing I did notice in that report, in that ISM manufacturing report today, that is very positive of inflation and we can take to the bank from a signaling perspective is the continued breakdown in the percentage of respondents reporting slower supplier delivery times. In my opinion, this indicator, both the ISM manufacturing and the ISM services has been the key barometer alongside global shipping prices throughout the pandemic of global supply chain disruptions.
We've seen this percentage of respondents reporting source by delivery times has ticked down to 19.6%. This was trending at 70%, 80% throughout most of the pandemic. And so now, we think it's basically crashed, it's cratered, and it's suggesting that a lot of the transitory supply chain driven inflation that we've been accumulating over the last 18 to 24 months has really come out of the system, we're now back at more normalized levels of this particular indicator.
You should expect to see that in goods pricing and this inflation reports in the coming months. But it doesn't necessarily mean the Fed's job when inflation is done, because clearly, there's a whole lot more inflation, when you look at services and median inflation, et cetera.
ANDREAS STENO LARSEN: Yep, makes a whole lot of sense that point, Darius. If we look at the Federal Reserve, I've made a chart on the historical correlation between the PCE price index, so the target variable of the Federal Reserve, and the Federal Funds Rate. And basically, when you look three, four decades back, we've never had a pivot until the Fed Funds Rate actually printed above the PCE price index on a year over year basis. With PCE prices running clearly above Fed Funds Rate still, should we expect the Fed to continue to hike?
DARIUS DALE: Absolutely. There's been some positive, you and I've talked about this in recent Real Vision Daily Briefings, specifically about the breakdown in core inflation momentum, the aggressive and historic breakdown outside of recession, break down in core inflation momentum we observed in July. That is very positive, but in terms of taking that to the bank and straight lining that and saying, hey, this is going to continue to happen at this pace and magnitude, and therefore the Fed's going to pivot anytime soon, I don't think we have enough, nearly enough information on that as investors.
In fact, when you do the statistics on it, it's suggestive that, hey, the base case scenario should be this won't continue to happen. And we should expect the Fed to be tightening policy for at least another quarter, perhaps a couple of quarters in terms of that regard, but one thing I do think is positive from a medium-term perspective, because right now, I think you and I could talk about this in a second, in terms of the three phases of monetary policy, as a matter of fact, I might as well just talk about them now, because I introduced it.
But anyway, let's take a step back. If you think about the world through this lens of my US monetary policy, we've been in three phases. The first phase was from like November to March, if you will, with the Fed having to acknowledge that transitory, their transitory forecasts views were wrong, catching up to the market implied pricing for Fed Funds, et cetera, with persistent in terms of their policy guidance. No, sorry, phase one was November through let's call it June.
Phase two was June through mid-August, where investors in markets were saying, hey, look, all this accelerated tightening you're doing in phase one is going to cause the economy to crash. And eventually, you're going to be forced to pivot. We know you, Jay Powell, you'd like to pivot, we're going to go ahead and price it in already.
Phase three is, oh, hold your horses, is the economy is very clearly still growing robustly from a labor market perspective, it may be contributing to further upside inflation pressure in the system and this is where you're getting Federal Reserve officials culminating obviously with Powell's speech in Jackson Hole coming out and effectively saying, no way, Jose, we're going to be tighter for longer. That is the key a phrase to take away from phase three.
To answer your question, tighter for longer has obviously created a lot more volatility in asset markets over the near term, as markets had to price out phase two, and price in phase three. But from my perspective, from a medium to longer term risk management perspective, let's call it six to 12 months from now, I do believe that phase three tighter for longer is actually positive at the margins relative to the prior phase one tightening, because if you don't go as high, and you just stay tight for longer, you don't necessarily need to crash the economy, they could just take rates to let's call it 4% and sit there for a year or two, as opposed to going to 5%, crashing the economy and then having to turn around and doing about face.
I think that's implicitly what they're targeting, which is a policy where they get restrictive, but not too restrictive, which allow them to remain tighter for longer.
ANDREAS STENO LARSEN: If we take a step back and debate the speech given by Jay Powell at Jackson Hole last week, it seemed as if he basically wanted real rates, so inflation adjusted interest rates, to move into positive territory, also in the very front of the yield curve. Right now, it seems as if that is a mission accomplished by the Fed. Can they get any more hawkish now?
DARIUS DALE: Oh, they can. Look, if inflation data misbehaves, we're going to get the CPI report for August on the 13th. If that data point misbehaves, it's unlikely to misbehave in a material fashion, just given the leading indicators we're seeing in commodity markets, et cetera But if it misbehaves, because again, we still have this whole thing called services and then the labor market, then we're going to get an incremental step function higher in terms of policy rate expectations, because again, I don't know that the Fed has put a lid on that. It's just saying, we're not going to just blow through it and take you way past neutral in terms of their policy setting.
I think the jury is still out, I think we need to analyze the data in terms of what it means for I think the-- I think we all know inflation is going down over the next four months. I think we can all agree on that as investors. But what we're trying to ascertain is, is that going to be a linear process where we get too comfortable levels of inflation that will allow the Fed to say mission accomplished? What time horizon will that occur? And is that going to occur three months from now, six months from now, 12 months from now?
Is that process is going to be smooth and linear? Or is the process going to be very stochastic with fits and starts? If it's the latter, then we're talking about incremental tightening relative to what's currently priced in markets. If it's the former, then we're probably fairly priced in terms of expectations for monetary policy.
ANDREAS STENO LARSEN: If we look at the labor market, we've actually had a bunch of data prints out this week already. And they seem pretty decent, at least on the surface. When you make your assessment of the labor market in relation to the Fed reaction function, what's your live assessment right now?
DARIUS DALE: Gangbusters booming. Booming. I've been saying this for months now, the labor market is booming. You can read as many Zero Hedge articles as you want, but you can just look at the data. We got a couple of charts here, Slides 75 and 76 from our Macro Scouting Report. Slide 75 just highlights the labor market from a levels perspective. The upper panel on that chart shows the JOLTS relative to total unemployed. We got that data this week.
It hit basically back at all-time high of 2.0 in terms of the ratio. Private sector quits rate, we got that in that report, flat at 3.1%, which is basically in the 90 plus percentile of that time series going all the way back to I think I want to say 2000 or something. So very, very tight labor market. The bottom panel in that chart shows private sector employment cost index, that's the broadest measure of compensation in the economy, and at 5.5% year over year through the second quarter, that's the fastest rate we've ever seen.
The second chart shows the labor market on a growth rate, on a momentum basis. And what we're showing in this chart, there's four different indicators. There's private payrolls growth, there's average hourly earnings, average weekly hours, and then aggregate labor income, which is the product of those variables. As you could see, relative to the light blue line, light blue bar in this chart, relative to the dark blue bar, you can just see that the growth rate that we're currently observing in the labor market.
And this again, this is data through July, on a three-month annualized basis, is double across all the measures that really matter from the Fed's perspective, in terms of growth rate of jobs, earnings, and aggregate income is basically double the level we trended at in the pre-COVID period in the five years prior to COVID, which is the light blue bar. This is a labor market that is both tight and growing at very extremely robust levels. That's clearly contributing to core inflation pressure building in the system.
ANDREAS STENO LARSEN: We obviously have the big report upcoming tomorrow, the monthly job report, do you have any firm views on that report, Darius?
DARIUS DALE: I've tried this so many times in my career. It's varying degrees of success I'm sure we've all have. Built models using the ADP report and trying to forecast NFP. Don't waste your time. If you're a young economist or young investor, take Andreas and I as word for it, don't waste your time, you'd be better off just leaving work early.
Yeah, look, we got the ADP report, they revised their methodology. It was a pretty significant slowdown from 270,138, or something like that. That's still by the way, that's basically the trend level we've grouped private payrolls at in the pre-COVID period. At best, we're still comfortably at trend from a structural perspective. But again, I'm not going to anchor on that in terms of our expectations for payrolls.
The one thing I will say is, we have not seen enough degradation in things like jobless claims. And certainly if you look at the PMI reports in the most recent months, employment PMIs ticking up, consumer confidence ticking up. Those kinds of things, they're telling you that we should not be expecting a significant deceleration in the labor market outlook, or sorry, the labor market data over the very near term.
Now, clearly, these things take time to play out. Labor's a lagging indicator relative to the broader business cycle. But just in terms of the near-term data we're going to see maybe in July, or sorry, not July, in August, September, maybe even into October, you should not be expecting Armageddon from that perspective. I think that's a very low probability event based on the current leading indicators.
ANDREAS STENO LARSEN: Within this very solid labor market, the financial market is basically rightfully chasing this title for longer narrative right now for the Federal Reserve. And one side effect of that is that we see new highs in the mortgage rate sector. Again, we see this upwards pressure on financing for housing. What do you make of the housing market in relation to this debate on interest rates?
DARIUS DALE: Yeah. The housing market is getting destroyed. We got housing starts contracting an 80% annualized pace on a three-month annualized basis. We're going to have no housing starts if we annualize that, and so, no, clearly, the housing market is falling apart. And again, we're analyzing data on a percentage change basis. We've got to consider the context, it was the base level.
We're coming off bubbly conditions in the housing market, not necessarily bubbly from a credit creation standpoint in terms of the credit supply and credit quality, but certainly bubbly conditions from an activity standpoint, and a demand standpoint. You couldn't buy a house, you put a bid and there'd be 30 other people offering cash and buy a house for the last 18 months. That's not normal. So to see housing measures, the housing market activity contracts significantly from that level of activities, we should be expecting that given the move we see in mortgage rates.
And also, it's welcome. It's welcome. It's adding a considerable amount of pressure on both the labor market and inflation. In order for us to get out of this tighter net liquidity environment, we have to see things like housing collapse, we have to see some pressure come out of the labor market and ultimately out of consumer spending, et cetera.
ANDREAS STENO LARSEN: One of the stickier components of the consumer basket is the shelter cost. And we know that the shelter cost tends to lag the economic cycle by maybe 12 months or thereabout. Given the signals that you see in the housing market, what's your assessment of this very sticky component of the consumer basket, the shelter cost?
DARIUS DALE: Yeah, our model suggests shelter inflation on a year-over-year rate of change basis should peak sometime in the first quarter of next year. We've already more than likely peaked from a sequential perspective in terms of the annualized rates of change there. We all know that whole-- problem is, you and I've talked about this on the program, that lag with which owners' equivalent rent gets priced through to CPI is partially fundamental, partially technical so we need to unpack that.
But the key takeaway is that, yes, we will continue to see upward pressure on core inflation based on this dynamic. There's a real going back to this discussion on the supply chain disruptions, there's a real improvement, organic improvement in inflation that's happening under the, I don't know if enough investors are paying attention to this stuff, its what I spent all my day doing, but there's a real positive developments happening in inflation. The question is, is after we get those positive developments that are associated with supply chain disruptions coming unglued, then what happens to inflation?
Now, we're left with an economy that has a labor market that's growing robustly at basically double the pre-COVID trend and is as tight as it's ever been through a variety of metrics, and so what kind of inflation is core inflation? Is that the economy generating on a sequential and year over year rate of change basis? That to me is something we don't know yet. And I think we're going to find that out throughout the fourth quarter of this year.
And if the answer at the end, going back to the question I posed earlier, if the answer is, we're going to trend lower but it's going to be a stochastic process, and we're not going to get to a comfortable level of inflation anytime soon, then we should expect much tighter liquidity conditions for asset markets for an extended period of time. I'm talking multiple quarters, several quarters.
If, however, that process is fairly linear, because the Fed is-- maybe the Fed has gotten policy into restrictive setting, which I don't believe it has, then I think the liquidity conditions will start to brighten up by the end of the year.
ANDREAS STENO LARSEN: One of the reasons why central banks currently forcefully fight inflation is obviously to regain trust and credibility. And in relation to that debate on trust and credibility, I want to play a soundbite for you from an interview with Vincent Deluard on Real Vision in relation to how inflation can actually spiral out of control if the population loses trust in the authorities. Let's listen to the soundbite and get back to that debate.
DARIUS DALE: Yeah, sounds good.
VINCENT DELUARD: The biggest driver of inflation is I would think, trust. And you can see that in high trust economies can do anything that would be very inflationary in any place and have no inflation. Like Japan, for example. Japan has been running huge deficits, building bridges to nowhere, monetizing its debt, doing QE, negative rates, all of that. And yet, there is no inflation in Japan. And I think part of the reason is because it's a high trust society.
Things work the way they're supposed to work so people don't question their institution, the value of their currency. When they enter transactional contract with someone, with structurally low trust like Brazil, Argentina or Southern Italy. Inflation there is ingrained, because people don't trust each