DAVID ZERVOS: If you really look at the meat and potatoes of trade and what has been done, 25% tariffs on $200 billion worth of stuff is an odd lot in the global economy. The real story is not trade. The real story is that the Fed tightened a bunch in '17 and '18-- 250 basis points and $800 billion of QT. And that slowed the economy down in '19 and will do it again in '20, because monetary policy operates with long and variable lags.
Inflation is just a tax like any other tax, and it's a way to raise revenue like any other tax. I think what we're finding in developed markets is that we're not using the inflation/taxation structure optimally.
ED HARRISON: This is Ed Harrison for Real Vision. Today's interview is with David Zervos he is the chief market strategist at Jefferies. And he's also a former Fed insider. So we're going to talk to him about where the fed has come from in terms of its model, in terms of how it applies monetary policy and where it's going, and what impact that's going to have on asset markets. Hope you enjoy.
David Zervos, it is very good to have you here at Real Vision. I want to talk to you because we're at a pivotal point in terms of this economy, many people think, in terms of monetary policy. We had a massive above phase from the Federal Reserve, and we're moving potentially into a new paradigm.
So maybe we can start there. What's going on at the Fed in terms of the switch that we saw in December of last year. And where is it going to head?
DAVID ZERVOS: So I think it's been a kind of crazy year if you look back at what's gone on with the Fed. Jackson Hole August of last year, Jay gave a speech about the stars, if you remember, astrology. He was comparing our star and you star and pi star to astrological constellations, things that we don't know a lot about, things that aren't very scientific, things that are pretty nebulous concepts.
And I think that was a great speech. It actually coincided with S&Ps at record highs. I think we touched almost 2,950. Nobody was getting too worried about interest rates at that point. They were obviously higher than they are today, but we had kind of come off the highs. The inflation scare of the early part of '18 went away as some of the wage data dissipated.
But the Fed went through some sort of transformation that summer. Jay went through some sort of transformation, and he came out in October and he started talking about being a long way from neutral, making a couple of off-the-cuff remarks about autopilot on the balance sheet. And the market just couldn't handle the flipping and the flopping, and we flopped pretty hard by December.
I'm not really sure what caused the Fed to get that sort of overly aggressive bias, or Jay, throughout the year. It might've been the fiscal stimulus that was coming through. Nobody really liked end-of-cycle fiscal stimulus. They were kind of worried about the inflationary component of that and probably didn't like it for political reasons as well. And I think there was just still a lot of confusion about the models at the Fed. Like, are we going to get with near 50-year lows in unemployment a bunch of inflation?
And Jay just had a pretty rough time communicating with us. And it took a big shift in January and all of Q1 to kind of get those multiple rate hikes in 2019 out of the system. And July was really, I think, the culmination of taking a very hawkish-- much more hawkish than necessary-- view, shifting it to kind of a neutral, OK, we know exactly know where we're going, ultimately to the cut that we got in July. And that was the culmination of many months, a few quarters, of change.
And I think it's indicative of a Fed that's probably a bit tormented by its models, the Phillips curve being dead or near asphyxiated at this stage, and a Fed that's probably got some political demons. It's fighting Trump on one side, and it doesn't want to seem like it's under the thumb. But also, if you look underneath the committee, there's not a lot of Trump supporters amongst the staff or the FOMC. And the idea that they're going to do something particularly friendly for the administration going into the election year is probably a little harder pill to swallow.
So you've got two political undercurrents that I think are difficult to manage at the Fed. That said, look, the reality is that they've missed their inflation target by a lot for many years.
ED HARRISON: For a long time.
DAVID ZERVOS: For a long time. I mean, if you go by the numbers-- and this is the eighth year-- then we're going to have missed probably by an average of something like 70 basis points, cumulatively over 500 in the PCE.
So I think they've got a lot of soul searching to do. How can you have a whole model based on labor market slack being the driver of inflation when we're sitting at a 50-year low in unemployment and the PCE's coming in at 1,516 and it's not accelerating at all? In fact, at least according to the PPI, last week there's a little bit of deceleration in core, and we keep getting these undershoots.
So I think that's a big issue for the Fed, and that's why they're changing or thinking about changing their inflation framework. That was what the Chicago conference was all about in the early part of this summer.
ED HARRISON: So two things I think about when you say that. One is about the inflation framework, which I want to get to. But almost the immediate thing was this pivot that the Fed's now doing.
I get the sense, actually, that they're not as dovish as they initially were when they first made the pivot. When Powell was talking in July, he almost made it seem like, I want a one-and-done kind of thing. And it seems like Powell's been dragged along, kicking and screaming the whole time.
DAVID ZERVOS: Today I was watching some other program where they were playing Pinball Wizard before they were talking about the Fed. So it was a pinball machine kind of back and forth. It was one of the TV shows out there.
And I think that's kind of how Powell has come across. One minute, at the semi-annual testimony, he's talking about the inflation misses. And it's a big deal, and we need to think about changing the inflation framework. And we're going to go ahead and cut, no matter what the data are over the course of the next three or four weeks. Doesn't matter how strong it is. And then we get the press conference where he's kind of like, yeah, it's a mid-cycle slowdown. We're going to do one. Maybe we'll do another. We'll see how it goes.
It's just the market's getting tired of someone who just can't keep the ship on the same trajectory. And in that sense, I think, Powell's statements that seem to flip and flop become less relevant, because we've all kind of gotten used to what he is. He's just sort of not navigating a direct line. He seems like he's kowtowing to one faction and kowtowing to another faction, dealing with the president, dealing with Congress, dealing with the markets.
There's lots of factors that are driving him in different directions. And I don't think he has-- I don't know this for a fact, but I don't think he has that strong a view. I think there are other people on the committee that have more passionate views about things like price-level targeting or nominal GDP targeting or average inflation rate targeting. John Williams has spent a good part of his career writing about average inflation rate targeting. And I think Rich Clarida the same, and Charlie Evans the same. Jim Bullard obviously a big supporter of these sort of look-back strategies to make up for past misses.
And then you've got a faction on the committee that just kind of wants to stay out of this and not get too involved, whether it's the Esther George on one side, who dissented in the last meeting, or the surprise dissent, which was Eric Rosengren. Someone who's been a dove has actually--
ED HARRISON: Has become a lot more hawkish.
DAVID ZERVOS: And you know, you have to wonder how the political dominoes are falling inside the committee. And there's plenty of people on the committee that are-- they're not very excited about changing the inflation framework at a time when that would imply a lot of dovishness just in front of an election.
ED HARRISON: I mean, to wrap up what you're saying from my perspective is that there are so many moving parts to this. There's the Trump part. There is the unspoken part about, we got two dissents here, but we could if we did the wrong thing get a dissent on the other side from Bullard or someone else who is a little bit more dovish.
DAVID ZERVOS: We could also get more than two. We could get three or four dissents on that side.
ED HARRISON: Right. And so basically Powell is having to juggle a lot of things. And as a result of that, he's not coming across in a clear way.
DAVID ZERVOS: And he's also not as commanding of a presence as a Bernanke, a Yellen, or a Greenspan. I mean, I think you had titans in there before, and he's-- I think part of the reason he got the job to begin with was he didn't have these strong economic views. He wasn't a PhD economist. He didn't come up through the ranks debating all of these concepts like Taylor rules and Phillips curves and price-level targeting and nominal GDP targeting and all the-- he's more of a technocratic-- he brings a more technocratic structure.
And I think the reason the Trump administration went with him over someone like, say, Kevin Warsh or John Taylor is they felt like the other Republican candidates would have a little more grounding in their models, a little more grounding in their beliefs. And it may have made them less likely to be politically swayed.
So it kind of backfired, I think, for the administration. But nevertheless, I think that was the original thinking on why Jay probably got the job to begin with over others that may have seemed more consistent with historical figures that populated that chair with the academic credentials to go with it.
So I think, look, Jay's in a tough position. If we get a Trump win, he won't get reappointed. If we get a Democratic win, he won't get reappointed. He's kind of got to make the best of a pretty messy situation, and he's got a lot of factions inside and outside that are pressuring him. And so his communications do become quite complicated.
And the good news, as I said before, I think the market is getting used to this flip-flop thing. So they know he can change on a dime. So if things get messy and S&Ps drop 250 points, we kind of know where Jay's going to be. And so the backstop story really hasn't gone away.
The question is, in the big picture, are we headed for some sort of major inflation framework change which would actually cause a very significant rate structure move? I think the likelihood of that before the election is really low, just because it would be such a momentous change for the Fed prior to an election that's so controversial.
ED HARRISON: And you were on the inside of the Fed. I mean, who would be driving that process in terms of making it happen of the present governors and presidents at the Fed right now?
DAVID ZERVOS: I think the academic sort of push for that would be-- the two more powerful figures there would be Clarida and Williams. I think you'd have Evans and Bullard behind you-- again, academic powerhouses themselves. I think there are others that are certainly willing and open and want to think about it. Obviously, Neel Kashkari's involved in that, would be another one, although I don't think the academic credentials are as strong on that particular case.
But I think this is going to evolve, but it's got to evolve outside of a political structure. And this next year-- look, we're going to be in the fall. This is August. You're going to hit September, October, November. We're going to be one year from this election. And it's just going to get heated and nasty and mean, and the Fed's going to be in the crosshairs of both sides, laying low.
Changing the inflation frame framework in the middle of that? I mean, that seems like a really complicated thing to do. I think they just go with the punches. S&P down, financial conditions tight, dollar up, EM weakness-- throw a 25 at it. Throw a 50 at it.
Watch the data. Obviously, if the economic data start to show signs of material weakness, again, throw something at it, maybe more. But if the economy comes in a little strong and the inflation data surprises a bit on the upside, I don't see-- it's very unlikely we would get anything like a hike. We would just slow the pace of cuts.
ED HARRISON: And so the big elephant in the room is what you just mentioned about the dollar, because external environment-- Powell, he was mentioning that in his last press conference-- that had deteriorated significantly. Before the interview, we were talking about Argentina as an example. You look at what's happening in Germany and Japan.
With the dollar being as high as it is now, what sort of impact is that going to play over the next year-- not necessarily only in terms of the Fed's policy framework and what they're thinking about, but also in terms of the constraints on their ability to act in one way or another?
DAVID ZERVOS: I wouldn't get too nervous about Japan. Their GDP came out last week at 1.8% in Q2, so they look pretty good. UK came out negative for the first time since 2012, and Germany is going to publish this week. That'll be a big piece of data. Market's looking for maybe something negative there. So the Japan story doesn't bother me. Chinese exports came out pretty strong last week, too.
Look, there's weakness in the manufacturing side. There's weakness on the investment side, because people are kind of trying to figure out how this trade story is going to evolve. But if you really look at the meat and potatoes of trade and what has been done, 25% tariffs on $200 billion worth of stuff is an odd lot in the global economy. It's just not a lot.
Is it going to escalate to $500 billion and go from 10% and then 25% on the remaining $300 billion? Then we can talk about a little bit more meaningful numbers. But again, you can circumvent supply chains. All this stuff can be thrown to Vietnam. Vietnam sends it over here. To me, the trade story is just such a red herring. And it's also a crutch.
Going back and thinking about last year, how many people sat in a chair like this being interviewed by gentlemen like yourself, talking about 4% interest rates, runaway inflation, four rate hikes, the Fed going way beyond neutral? And that's where everybody was.
The reality is, those guys were 100% wrong about their models. Their Phillips curve view of the world was just flawed. This idea that labor market slack was driving inflation was wrong. It's been wrong for a long time, and nobody wants to throw it out because they built so much architecture around it.
ED HARRISON: So we're talking about the--
DAVID ZERVOS: The trade story was a crutch. Oh, I know why I was wrong. Because Donald Trump started tweeting about trade and started putting tariffs on it. So now, I'm not wrong. This new exogenous shock came in to knock me down, so now I have to go for rate cuts instead of rate hikes. That's where pretty much every big bank went.
You know what? That's bogus. It's really bogus. It's basically falling back on a story that really isn't the real story. The real story is not trade. The real story is that the Fed tightened a bunch in '17 and '18-- 250 basis points and $800 billion of QT. And that slowed the economy down in '19 and will do it again in '20, because monetary policy operates with long and variable lags, as the great Milton Friedman always told us.
That's what slowed us down. Trade's had a little bit of an impact, but they failed to recognize what was in the pipeline on monetary policy was actually enough to break things-- break Argentina, break Turkey, break other parts of the economy-- because those rate hikes were big. And they thought we would have to go to four to break things-- just wrong. And they thought there was inflation coming because of labor market slack-- again, wrong. Technology, demographics, other sources of disinflation are much bigger.
What the street failed to recognize last year, what the Fed failed to recognize, what a lot of people fail to recognize is that 250 basis points of rate hikes and $800 billion of QT, which is probably 50 to 100 more, constitutes 350 to 350 basis points of rate hikes, cumulative. It's enough to break stuff.
I remember my first cycle sitting on a trading floor. It was 1994. The Fed raised rates 300 basis points in 1994. By the time they were done, they had broken Orange County-- bankrupt. The Mexicans were going through the tequila crisis. The dollar was strengthening. The entire agency mortgage market had blown to shreds because of a guy named David Askin, who had over-levered himself. And basically you couldn't sell duration because the entire duration market was broken.
It was the worst year in the history of the Lehman Agg in terms of total return. Fixed income markets were decimated. Equities were down a little, but not a lot. Economy was pretty strong. There was not a lot of inflation.
And it wasn't long after that we started to break a whole bunch of things, that the Fed reversed. And by mid-'95 they cut three times. That story rings very true to me today. 300 basis points of tightening is enough to break stuff. That's what people forgot last year when the Fed had gotten to 250 and $800 billion of QT.
And what's breaking? Argentina's breaking. Turkey's breaking. A number of Southeast Asian countries had a pretty rough ride last year. We've had plenty of problems from the stronger dollar.
You know what? It's not really going away. And what I think we saw in '95 that-- you want to call it some sort of correction from overtightening-- is sort of the storyline. Do we need one cut, two cuts, three cuts, five cuts? Do we need to go all the way back to zero? I don't think anybody knows.
The reality is that when you put that amount of tightening into the system, it comes in pretty slowly, it goes into the pipes over years, and it starts to bust stuff. And that's where we are today.
By the way, the cut that we just did? That effect is down the line. That's not immediate. You don't get to feel that immediately. That's