Why the Fed May Have to Hike Far Higher Than Expected | Henry Peabody on the Fed’s Triple Mandate and Uneven Transmission of Monetary Policy

Jack Farley (0:00)

Got a very important conversation today. We are speaking to Henry Peabody, Senior Investment Strategist at GMO. Henry, welcome to Monetary Matters.

Henry Peabody (0:08)

Jack, thanks so much for having me. I'm really looking forward to the conversation.

Jack Farley (0:12)

I know you've been doing a lot of thinking about the Federal Reserve. Of course, they have their two mandates for stable inflation and a stable labor market.

But they also have some sort of other mandates. Tell us about how you're thinking about the Fed's third mandate.

Henry Peabody (0:28)

Yeah, so we published a paper on this a little while ago, and we certainly acknowledged the two statutory mandates from the Fed. Stable prices, full employment. But by virtue of transmission mechanisms, by virtue of the evolution of capital markets, as well as sort of the passage of time since we had that rate shock a handful of years ago, the Fed has a new, we think of it as a mandate, though it's not an official one, really the transmission of credit across the economy. The system has become certainly less banked, and I'm breaking new ground when I say that. The evolution of private credit, as an example, the proliferation of fixed rate bonds in the capital markets has loosened the connection between policy and the actual economy. So what we have here is a situation in which I think financial conditions are largely fairly easy. I think Warsh gave a nod to that just the other day in his press conference. Spreads are tight, equities are high. The dollar is at a sort of near-term local low, although it's rich on a real effective exchange rate basis. Volatility is subdued. Dated volatility is relatively subdued. So all these fit in with a relatively easy environment for those who have access to credit. And those who have access to credit are large corporations that termed out, large corporations that are accessing the market today with the AI build out, private credit as an example. Meanwhile, credit extended to individuals is getting expensive. Mortgages are 6%, something like that, and home sales are slowing. So I think what we're having now is a situation in which a lot of pro-cyclicality, whether it's AI with electricity demand, AI with labor demand, you're seeing a theme here.

That aspect of the market, and you certainly can't put a PV on prayer as a terminal multiple.

That is relatively immune to what we've seen in so far as the Fed raising rates. And that to us suggests the potential that we're on the precipice of higher than we expected for probably longer. We've been saying that for some time now.

But the risk that something, I don't want to say breaks, but the Fed is going to have to sort of look at past cycle playbooks to manage through asset price inflation. Meanwhile, those lower on the quality spectrum, CCC credit, marginal borrowers, are really being left out of that capital flow and maybe collateral damage.

Jack Farley (3:19)

So the real theme is that credit is easy for businesses and tight for consumers, and very easy for very high quality borrowers, and very tight for lower quality borrowers. And that spread always exists throughout history, of course, but it is particularly acute right now. Why is that the case?

Henry Peabody (3:38)

It's particularly acute now for a handful of reasons. One, the extent to which we've had to move rates off the zero bound.

Those consumers who are in need of financing on a shorter term basis are certainly more affected by this. It's also, there's a little bit of external factor here. I mean, you look at inflation, who's most susceptible to that? And it's certainly the low end consumer. I saw a great chart the other day, and it showed the cost of a breakfast throughout time. And it was toast, it was eggs, it was bacon, and it was deflated by various cohorts of wages. And the highest echelon of wage earners see that cost deflated throughout time over the past 50 and change years as being lower. They're able to afford more and more and more. However, the weakest cohort of consumer, while their affordability, the power of their earnings, improved in the 60s and into the early 70s, has unwound. So for that cohort of borrowers, considering their wages and the inflation rate they're facing, it's basically flat. So the gains they had achieved have been unwound, whereas other high quality borrowers, whether consumers or corporations, are seeing easy credit. And again, sort of coming back to this idea of the amplitude of what the Fed needs to do to right this ship. Warsh's commentary is completely irrelevant here. I said relevant, not irrelevant. He's concerned about the speed in which we come back down to target inflation. The unanimous vote behind him is telling of this concern. Since the Fed, that transmission mechanism, it's really, really important to understand. In a banked world, the Fed raises the discount rate of the Fed funds rate by a few hundred basis points.