INSIDE ECONOMICS

Mark Zandi:                       Welcome to Inside Economics. I'm Mark Zandi, the chief economist of Moody's Analytics, and I'm joined by a few of my colleagues. I've got Cris, Cris deRitis. Hey, Cris.

Cris deRitis:                        Hey, Mark.

Mark Zandi:                       How are you doing?

Cris deRitis:                        Doing well, doing well.

Mark Zandi:                       I ask you that every week, and you tell me, "I'm doing well." That's good.

Cris deRitis:                        Yeah, let's hope I continue.

Mark Zandi:                       I know I'm more for that.

Cris deRitis:                        You're doing well.

Mark Zandi:                       And we've got Marisa. And Marisa, were you here... No, you were AWOL actually.

Marisa DiNatale:              No, I was... Yeah, I've been vacationing, Mark. Sorry about that.

Mark Zandi:                       Oh no, that's fair enough. I know you were in Hawaii. I mean, boy, what a mess.

Marisa DiNatale:              I know. I know. I wasn't on Maui, but it's really sad.

Mark Zandi:                       So sad. The funny thing is, I was there this time last year, a little less than a year ago, Lahaina, and I'll have to say I'm pronouncing that wrong, but the town that got destroyed. And they had this restaurant called the Lahaina Grill. And I'm not exaggerating, it may have been the best meal I've ever had in my life. It was so good. It was just so good. It's such a shame. I feel so bad for those folks. What a tough, tough thing, and really tough. And we've got Bernard, Bernard Yaros.

Bernard Yaros:                  Hey, Mark.

Mark Zandi:                       Bernard, good to have you. You've become a regular, particularly when we've got the inflation numbers. This is the week for inflation statistics, CPI and PPI. So, a lot to talk about there. Good to have you on.

Bernard Yaros:                  Thank you.

Mark Zandi:                       You look like you're in a 1950s movie though. I don't know. What's that all about?

Marisa DiNatale:              [inaudible].

Mark Zandi:                       There's no color. I mean, what's going on?

Bernard Yaros:                  I don't know. The lighting in the room that I'm in is kind of weird. And then I've got the loom cube, so I don't know what effect. It's creepy.

Mark Zandi:                       Oh yeah, you look like you're in a Alfred Hitchcock movie or something. The birds, you know?

Bernard Yaros:                  Yeah.

Mark Zandi:                       There you go. Oh, we lost Cris for a moment, but I'm sure he'll be back. Hey, so the CPI, PPI, you want to give us the rundown on the statistics this week?

Bernard Yaros:                  Of course. Yeah. So the July consumer price index, I would say, was good news all around. And just for our listeners, the CPI measures the average change in prices that are paid by consumers for a given basket of goods and services. And in July, the overall CPI rose 0.2% and the core CPI, which economists like to look at because it strips out volatile food energy prices, that also rose by 0.2%. Both of these growth rates were in line with our and consensus expectations. So there was absolutely no surprise here whatsoever. And while we should feel good about the July CPI, there are some upside risks to the CPI that are lurking out there in the near term and that are tempering a bit of the optimism that I would otherwise be feeling. And right now, I guess my biggest future concern are in energy and food prices.

                                                So for the month of July, gasoline prices were really only a minor support to the CPI. They were up only two tenths of a percent. However, in August, gasoline prices are rising, the national average of regular unleaded gasoline is 30 cents higher than it was a month ago. And also, if we look at wholesale gasoline futures, which typically lead retail gasoline prices by about two weeks, they're also on the rise and suggest that retail gasoline prices are going to head higher throughout the rest of August. So that suggests that we're going to get a bigger contribution to the CPI from gasoline in August than we did last month. And also, elsewhere within energy, the price of energy services. So think electricity, utility, gas services, those prices fell by 0.1% in July. But also natural gas prices have risen to a six six-month high in August. And if that continues, that's also going to show up to a greater degree within the CPI for energy services moving forward.

                                                There's spillover effects from energy into the other most important essential good whose prices we interact with on a weekly basis. And that's for food. So last month, the CPI for food increased by 0.2%. It wasn't really a big surprise. I think one interesting development was that the CPI for food away from home, so this would be prices you pay at a restaurant. The CPI for food away from home rose at its slowest pace since March 2021. And this is probably just because wage growth in the food services industry has been relenting meaningfully in recent months, and it's no longer putting as much upward pressure on the menu prices that consumers are seeing at the restaurant.

                                                So while this was a good surprise, I think we are due for an unwelcome upside surprise in food prices in the not so distant future. And that's just because you look at, again, another energy price. If you look at the spot price for diesel that has risen sharply in recent weeks to its highest level since early February, late January, and diesel is the absolute workhorse fuel of the agricultural industry. We use it to power the farm equipment to pump irrigation water and to transport farm produce. So diesel prices typically lead grocery store prices or what we would like to call the CPI for food at home by a few months. So if we get further increases in diesel prices, I'm concerned that that's going to push up on food prices. So [inaudible]-

Mark Zandi:                       Hold on, hold on, Bernard. Yeah. Wait, wait, wait. It seems like you're going to the negative right away without even talking about the positive.

Bernard Yaros:                  I'm just looking ahead. There's stuff that's making-

Mark Zandi:                       Oh, okay. All right. Come on. That CPI report was great, wasn't it?

Bernard Yaros:                  It was great. No, it was great. It was great.

Mark Zandi:                       Okay, come on. Let's just dwell on that a little bit.

Marisa DiNatale:              He said that, he led with that mark.

Mark Zandi:                       Huh?

Marisa DiNatale:              He led with that.

Mark Zandi:                       He did [inaudible] for like five seconds, and then he's off and running about oil prices and food prices. Everything's going up. Come on, come on. All right, come on. Let's just take a step. And by the way, we lost Cris deRitis. I don't know what happened to Cris, but hopefully he finds his way back to the podcast. But I know we've been having all kinds of power outages here, and I know because we had a terrible storm here, he's coming back in, and I think he lost internet connectivity for a while. So that may be part of it. Okay. Bernard, okay.

Bernard Yaros:                  Mm-hmm.

Mark Zandi:                       I hear you. Tell me... I mean, what's the fundamental point here though? The fundamental point is what? Inflation is?

Bernard Yaros:                  Inflation's coming down. Inflation's coming down.

Mark Zandi:                       Yeah. Okay.

Bernard Yaros:                  Yeah. Yeah.

Mark Zandi:                       All right. Okay. And why is it coming down?

Bernard Yaros:                  Again, if we're looking year over year trend growth in the overall CPI, that's come down from little under 9% almost a year ago, and it's now at about just a little over 3%. So there's been a lot of moderation in inflation. And as we will talk later in the podcast, we've gone this moderation in inflation without a significant rise in unemployment or a significant deterioration to labor market. So we've really been able to achieve a lot less inflation without worse outcomes in the real economy.

Mark Zandi:                       Yeah. And I should have said upfront, because you alluded to it just now, just so the listener knows. We've got another guest, someone from outside, Sebnem Kalemli-Ozcan, and she's a professor of finance economics at the University of Maryland. She's going to be joining us a little bit later in the conversation, and we've already recorded that part of the conversation. So that's what you were alluding to.

Bernard Yaros:                  Yeah.

Mark Zandi:                       We lost Cris again. I don't know what's going on, but okay. So broadly speaking, it feels like inflation is moving in the right direction here. And when you look at the components... A lot of that year over year improvement in inflation is energy. The decline in energy prices compared to a year ago, as you pointed out, they are starting to rise again. And that's looking to the future reports that we're going to see here. But even abstracting from the energy prices, we're seeing a broad-based moderation [inaudible].

Bernard Yaros:                  Exactly.

Mark Zandi:                       Do you have a sense of... I'll ask one more time and then I'm going to turn to Marisa and get her sense of it. Fundamentally, what's driving this moderation of inflation? Unemployment hasn't risen. It's not like the economy's growth rate is... It's moderated with the Fed Rate X, but it's still pretty solid growth rates. We're still getting solid job growth and GDP in the first half of this year was close to 2%, which is close to the economy's potential. So what's going on here? What's driving this fundamentally?

Bernard Yaros:                  I would say, fundamentally, it's the unwinding of a lot of pandemic induced supply chain stress. So that's showing up in core goods prices. And then it's also the fact that shelter prices, so the cost of housing for renters and then the hypothetical rent that homeowners would pay. So that's equivalent rent, that has peaked and is starting to come down, and we're expecting that to really come down further. So I would say these are the two key elements that have allowed us to achieve this disinflation without worse labor market outcomes.

Mark Zandi:                       Got it. Got it. And Marisa, so what do you think? Is that [inaudible]?

Marisa DiNatale:              That's the correct answer. Yeah.

Mark Zandi:                       Okay. Yeah.

Marisa DiNatale:              Yeah, it is the unwinding of everything that's happened over the past two years with the pandemic and the Russian invasion of Ukraine, further exacerbating supply chains that were already mucked up during the pandemic. So it's just all of that coming back down to earth.

Mark Zandi:                       Right. Okay. Now the other alternative explanation is demand side push, the fiscal stimulus provided by the American Rescue Plan back, well, over two years ago now. What do you think? Is that playing a role here or maybe on the margin, not so? How big a deal is that or not?

Bernard Yaros:                  That was more of an issue. That played more of a role last year, whereas this year it's not as much.

Mark Zandi:                       Yeah, it's hard to connect those dots. Now almost two and a half years after the fact, right?

Bernard Yaros:                  Exactly. Yeah.

Mark Zandi:                       Because that was passed in March of '21, that piece of legislation.

Bernard Yaros:                  Exactly.

Mark Zandi:                       Okay.

Marisa DiNatale:              I think that staved off a deeper downturn than we would've had had that not passed. But I think at this point, middle-income, low-income households have likely blown through all of the excess saving that they had during the pandemic and including stimulus money that they got. So now we're really seeing the impact of stripping that out, right?

Mark Zandi:                       Right, right. I'm sorry, I'm a little distracted because Cris keeps coming in and out.

Marisa DiNatale:              Popping in and out.

Mark Zandi:                       He's popping in and out. He's trying different things, you can tell. He is trying different things to get into the podcast. So I think he was on his phone the last time. Okay. So let's go back, Bernard, to your rundown, and let's just explore that a little bit more. So what you quickly got to was, look, yes, we've had all this great inflation news, but it feels like it's going to get a lot harder to get inflation back all the way down here. So inflation is sitting... In terms of CPI, consumer price index, it feels like top line's round three, the core is still higher than that, still four and a half to five. And to get it all the way back into something we all feel comfortable with, certainly consistent with the Fed's target which for consumer price inflation is probably about 2.5%. That's going to be more difficult. And one of the reasons for that is this recent runup in oil prices.

Bernard Yaros:                  Exactly, yes. It's a concern. I mean, I think for now it's a yellow flag. I don't think we're... It's not something I'm too concerned about, but it's moving in the wrong direction.

Mark Zandi:                       Yeah, because with oil now is sitting somewhere between 80 and 85 bucks a barrel, depending on WTI or Brent, that's probably consistent with, what, $4 for a gallon of regular unleaded, maybe a little higher than that, something like that. Is that right?

Bernard Yaros:                  Mm-hmm.

Mark Zandi:                       And that is well above where we were last month. And certainly, I think the low was 3.25, 3.50, something like that not too long ago. So that's going to add directly to top line inflation next month when we get for month of August, next month. And then you're also making the point... Well, this is also going to be an issue for food prices because diesel has gone up, and diesel's key to the cost of food. That's it, that's the point you're making.

Bernard Yaros:                  Exactly.

Mark Zandi:                       Okay, fine. But you're saying if we stay at 85 bucks a barrel, this is in great for the near term, but it doesn't derail this steady moderation inflation impact.

Bernard Yaros:                  Yeah, yeah, exactly. Yeah. Yep.

Mark Zandi:                       Okay. All right. Let me ask you another question on negative and positive. On the negative side, is there any other price out there that you're worried about, any other commodity or service for which you're fearful that that's going to pick up and make it more difficult to get inflation back in the bottle?

Bernard Yaros:                  So the next risk I see out there, and this is probably going to be a podcast in September, is what's going on with the United Auto Workers strike against the big three US automakers, Ford, Stellantis, and GM. In July, new vehicle prices fell by 0.1%, and this was expected in our bottom-up CPI forecast. We expected a decline of this magnitude. And this was expected because we have had a welcome spike in US auto assemblies, especially during the second quarter.

                                                In April or May of this year, US auto assemblies rose to a level that was even higher than its average for all of 2019, which was well before we had all of these pandemic related supply chain disruptions. But if we do get a work stop, if the negotiations between the UAW with the big automakers, if that fails and it ends in a work stoppage sometime in mid-September, there just isn't enough inventory to really keep prices from rising because that's going to affect auto production, which empirically we do see that that does have an effect on prices with a two to three month lag. And it's important to remember that last time we had a UAW strike, I think it was back in 2019, we really didn't see that many major macroeconomic consequences, but that's just because the strike affected only one automaker, not three, which could be the case this time. And we also weren't being impacted by reduced auto inventories as is also the case now.

                                                So that's just one concern. But whatever upside we get to new vehicle prices, maybe in the fall or winter because of any potential strike, I think that should still be largely offset by the enormous disinflation or the enormous deflation that we will see month over month in used vehicle prices, which fell 1.3% in July. And that we should continue to see further declines in used vehicle prices just based on what we're seeing in auctions. Dealerships are just paying much less than they were before for the used vehicles that they then sell later to consumers.

Mark Zandi:                       Okay. So what you're saying is another threat to getting inflation back in the bottle is new vehicle prices, particularly if the UAW strikes and strikes against all the automakers, but that should be offset in part or in whole by continued declines and used vehicle prices, is that what you're saying?

Bernard Yaros:                  Exactly. Yeah, yes. At least through the early fall, I would say.

Mark Zandi:                       Yeah. And of course, these things will... Presumably, the UAW, if there is a strike, it isn't going to go on for a length. Well, it could be a few months, but that probably not longer than that. So this may be an issue for the second half of this year, but as you make your way into 2024, not so. It's just the opposite, you would say.

Bernard Yaros:                  Yeah, exactly.

Mark Zandi:                       Okay. All right. It's not great though. Hey, Marisa and Bernard, I've kind of come back and ask you if there's any other components out there that make you more optimistic about inflation going forward. But before I do that, I'm going to turn to you, Marisa. Any component of the consumer price index commodity or service that you're worried might add to inflationary pressures going forward? And you don't need to come up.

Marisa DiNatale:              No.

Mark Zandi:                       I'd be very happy if you can't come up with any-

Marisa DiNatale:              No, I'm not.

Mark Zandi:                       ... but I'm just asking.

Marisa DiNatale:              No, and I think even if we do inevitably see an increase in headline CPI because of energy prices, I think that the Fed will look through that and I think they're really focused on core inflation. And in the July CPI report, shelter is the key to really most of that. That accounted for 90% of the increase in core services over the month of July. So it's really hinging on what's going on with the housing market here, both owner's equivalent rent and rent of shelter.

Mark Zandi:                       Yeah. Okay. I-

Marisa DiNatale:              So I'm really keyed in on that.

Mark Zandi:                       Yeah, I'm sorry. I'm chuckling because I see Cris.

Marisa DiNatale:              Cris is resorting to communicating [inaudible]-

Mark Zandi:                       He's got a little hand. We're obviously in Zoom, and so he's got a little hand up. Hey, Cris, and I know what you're going to say because you've got-

Cris deRitis:                        You know.

Mark Zandi:                       I know it, but go ahead. Go ahead. Tell everybody what you're worried about.

Cris deRitis:                        Well, mark, have you been to the doctor lately?

Mark Zandi:                       I knew he was going to say that. I knew he was going to say. If he didn't say it, I was going to say it. Go ahead. Go ahead, Cris.

Cris deRitis:                        Medical care services, Mark.

Mark Zandi:                       Yeah. Yeah, exactly.

Cris deRitis:                        Just telling us prices fell 1.5% over the last year, fell 0.4% over the last month. This is a measurement issue. We've talked about this on the podcast before, but clearly this might be sending a little bit of a false signal, right? It's not a huge component of the overall CPI basket, but it's not represent. And I do expect this to reverse, right?

Mark Zandi:                       This goes to health insurance the way the Bureau of Labor Statistics, keeper of the data measures, the prices for health insurance. Bernard, I always botch the explanation, but do you want to take a crack at it with how the BLS measures this or not?

Bernard Yaros:                  So when the BLS tries to measure health insurance, they're looking at the retained earnings of health insurers. So during the worst of the pandemic, everyone was foregoing routine visits to the doctor. They weren't having life-threatening or they weren't having necessary surgeries. So insurers weren't paying a lot of premium. So the retain earnings really shot up. And I think in the year before, the health insurance CPI was really adding significantly to the overall CPI. But then this went in reverse this year as people were going back to the doctors after the pandemic, everyone was going back for regular appointments, routines, surgical procedures, and then those retained earnings of health insurers was crimped or was compressed. And then that has led to consistent... These are very sticky prices. They only really change, they're updated by the BLS once a year. And this isn't going to be updated until probably later this year, around September, October.

Mark Zandi:                       September, October. I think October.

Bernard Yaros:                  October.

Mark Zandi:                       Yeah.

Bernard Yaros:                  So health insurance prices have been consistently falling by about three to 4% month over month, over the past 10 months or so. But that's going to come to an end. And once that does, that's also one source, one methodological quirk that's been weighing on the CPI that's going to go away.

Mark Zandi:                       So I think you see all these negative month-to-month numbers for the price of health insurance, medical care services, but that's going to become a positive, I think it's in the month of October. And now instead of being a drag on inflation, it'll be adding to inflation.

Bernard Yaros:                  Exactly.

Mark Zandi:                       And it's more of a deal in the consumer expenditure deflator, the PCE, which is obviously important because what's the Fed core, PCE is what the Fed looks at. And this plays a much more... The weights are much higher, and I won't go into the reasons why, but much higher in the PCE than in the CPI. So this will be a bit of a irritant in terms of getting inflation back in. Okay. As I said earlier, let me ask you this, is there any component, commodity, good service that may surprise us in terms of helping us out here in getting inflation back in, Bernard?

Bernard Yaros:                  Yeah, I think one surprise this month, and it probably will continue, and it was one that I mentioned earlier on, was the CPI for food away from home, so restaurant prices, because that had been rising pretty strongly. And I really think that this was tied to just strong wage growth, especially in the food services industry. And this was an industry that really-

PART 1 OF 4 ENDS [00:23:04]

Bernard Yaros:                  Growth, especially in the food services industry. And this was an industry that really was suffering from high turnover from a lot of job openings, but we're seeing wage growth in that sector really moderate significantly, and I think that's starting to finally relieve a lot of that upward pressure that was on this particular category of the CPI. And just generally, it just highlights the importance of wage growth, especially for services, because empirically you do see a strong relationship between wage growth, between excess labor demand in the labor market, and a lot of these core services excluding shelter, components of the CPI and also the PC deflator. So if we do get more moderation, more slow down in the labor market, I think some of these categories of prices will start to moderate and I think that should help us get back down closer to the Fed's 2% target.

Mark Zandi:                       Got it. Marisa, any components that would help out here?

Marisa DiNatale:              Yeah, actually just in my labor research piece this month, I wrote about the different components of wages across industries and the industry that's had the biggest decrease in wage growth over the past year is leisure hospitality, which is where much of that inflation has come from, right? In the service sector. So wages peaked in the first half of last year at almost 9% year over year, and they're down to about 5.5% now, which is still elevated relative to where it was prior to the pandemic, but you're talking about almost a 50% decline in the wage growth rate. So that should eventually work its way through wages, and then the prices consumers pay for food, and that is perhaps what we're starting to see a little bit of now.

Mark Zandi:                       Got it. Hey Cris, are you there?

Cris deRitis:                        Yep.

Mark Zandi:                       Any positives you want to call out? I know that's not in your nature, but I'm just-

Cris deRitis:                        Oh, gosh. Wow, that hurts. I'll throw out shelter, right? The rents should continue to moderate here, but they're still pretty high on a month to month basis, even year to year. But the private market indicators for new leases suggest decline, so that should bleed in. But it's not going to be immediate, right? It's going to continue to be a fairly lengthy process for the CPI to pick up these changes, but yeah, it should continue to help get us down to the Fed's target.

Mark Zandi:                       Okay. So our baseline forecast, which assumes the Fed is done raising rates, the funds rates at the terminal rate and no recession, soft economy, some small increase in unemployment over the next year, but no recession has inflation, consumer price inflation, top line is now a little over three, the core is a little under five, that by this time next year they'll both be at the Fed's target at 2.5%. Bernard, what do you think?

Bernard Yaros:                  I agree with that, assuming because I think our shelter-

Mark Zandi:                       Go ahead, sorry.

Bernard Yaros:                  Because right now over this period of time, you're going to get significant housing disinflation and rents account for about, if we're just looking at core CPI, that accounts for about over 40% of the core CPI.

Mark Zandi:                       Right.

Bernard Yaros:                  Right now, rents are tracking at about 7.8% year over year. Our forecast is for that to fall to 6% and then to fall below 3% by the end of next year, and I think that's doable. I think that's to be expected given the weakness that we're seeing in leases for new tenants thus far. So that's really going to pack a big punch when it comes to just allowing for the CPI to disinflate closer to the Fed's target over this period of time.

Mark Zandi:                       So you're on board with the baseline?

Bernard Yaros:                  Yes.

Mark Zandi:                       Okay. Marisa?

Marisa DiNatale:              I am. Energy prices, if they remain elevated and they keep going higher, that could mess us up a little bit, but.

Mark Zandi:                       Barring that.

Marisa DiNatale:              Barring that, yeah.

Mark Zandi:                       Yeah. Cris?

Cris deRitis:                        Well, in the absence of a recession, I think it actually might take a bit longer for the reasons we described. So I think maybe a quarter or two to really get down to the Fed's target.

Mark Zandi:                       So you're saying the end of next year.

Cris deRitis:                        End of next year, yeah. Unless we have recession or greater weakness, then certainly that would speed things up.

Mark Zandi:                       Right. Okay. All right. Well, of course I'm on board with the baseline. I'm all in on the baseline.

Marisa DiNatale:              Your baseline.

Mark Zandi:                       That's my baseline. Yeah, I think.

Cris deRitis:                        I hope so.

Mark Zandi:                       I think we're on track. I do think this so-called last mile will be a little difficult. It's going to be two steps forward, one step back, but I do think by this time next year we should be back close to that 2.5% target on CPI. Okay. Let's play the game, the statistics game. That is we each put forward a number, the rest of the group tries to figure that out with questions and clues, deductive reasoning. The best statistic is one that's not so easy. We don't get it right away. One that's not so hard, we never get it. And if it's timely and apropos to the topic at hand, which is inflation, all the better. Okay. Marisa, you're up. This is tradition, we always begin with you. So what's your statistic?

Marisa DiNatale:              My statistic is 77.4.

Mark Zandi:                       77.4. Is it related to the inflation data?

Marisa DiNatale:              No.

Mark Zandi:                       No. Is it a statistic that came out recently?

Marisa DiNatale:              Yes.

Mark Zandi:                       Is it the University of Michigan survey?

Marisa DiNatale:              It is.

Mark Zandi:                       Okay. What component is 77.4? I think the overall is 71.4. Although Marisa's prone to getting negatives and positives wrong, could she have possibly gotten the 77 versus the 71 wrong?

Marisa DiNatale:              I am not prone, Mark.

Mark Zandi:                       No, you're not. I jest. Okay guys, what in the-

Bernard Yaros:                  Present condition.

Cris deRitis:                        The present situation?

Marisa DiNatale:              It is, it's the present conditions index.

Mark Zandi:                       Present conditions.

Marisa DiNatale:              Perception of present conditions from the University of Michigan Consumer Sentiment Survey. This was the August reading on present conditions, which maybe isn't that interesting in and of itself, but I picked it because this has risen for three months straight now, we're on a very downward trajectory. It's still very low compared to where it was prior to the pandemic, but in the past two months for the first time, the present conditions index has risen above the low point that it reached right when the pandemic started. So when the pandemic started in March of 2020, this plummeted, and starting in 2022, this University of Michigan survey has just been completely in the dumps, lower than it was in the bowels of the pandemic. So now for the first time, it's above that pandemic low, which I guess is good. I mean, it's a low bar, but it's still well below where it was prior to the pandemic.

Mark Zandi:                       What I noticed in that report was the inflation one year ahead, inflation expectations. Did you notice that?

Marisa DiNatale:              I was considering making that my statistic, but.

Mark Zandi:                       Yeah, that would've been a good one, 3.3%, which is not too far where I think you'd want it to be consistent with the Fed target because if you look historically in a time when inflation's right where they want it, it's about 3%. So we're within spitting distance of that expectations number that would be consistent with the Fed target. That was good. That was very good. Okay, Bernard, you're up.

Bernard Yaros:                  So my statistic is 91.9.

Mark Zandi:                       91.9.

Marisa DiNatale:              That sounds like an index.

Mark Zandi:                       Small Business Index.

Marisa DiNatale:              Oh, it's NFIB.

Mark Zandi:                       NFIB.

Bernard Yaros:                  Exactly. Yep.

Mark Zandi:                       Yeah. Marisa, I beat you to it.

Marisa DiNatale:              You'll have to replay the tape here.

Mark Zandi:                       Come on. Replay. That is the overall index, right?

Bernard Yaros:                  Yeah. So I didn't want to go into some of the details there or I didn't want to give some of the detailed statistics underneath. But one thing that is interesting about this index is it really speaks to this so-called vibes session. Everyone thinks we're in a recession, but they're not acting at all if that's really the case. And there's about 10 components to the NFIB index, and about half of them are what you can call hard data. So these are asking small businesses, what are their plans for employment, for capital expenditures, for inventories. Asking about their current job openings and earnings. And if you just recreate a hard data NFIB index, it's in positive territory, it's consistent with an economy and expansion. But then if you take the other components that make up the NFIB index, which are more about expectations, these are more soft data and you just compile them together.

                                                It's about as low as it's ever been in going back to the mid '80s, even lower than the great financial crisis. So the main streets, businesses on Main Street, they're very pessimistic when they look at the outlook, but when you ask them what are they doing? Are they planning to raise employment? Are they planning to make capital expenditures? If is now a good time to expand, or how many job openings do you have? It's still pretty solid, all of this looks good. And this is important because they account for a significant share of employment of private employment. And I think that's why everyone was looking at a lot of these negative sentiment. But when you actually looked at the, people were looking at these negative vibes coming out of consumers and businesses and saying we're headed for a recession, but when you actually looked at their actions, it told a much different story. And I think that's why we've been holding it together strongly.

Mark Zandi:                       Yeah, it's so interesting, this dichotomy between the hard data and the soft data. You can see that in all these surveys. The ISM survey, that's the purchasing manager surveys, and even in our survey we conduct, we have a survey we do every week of businesses, and you can feel it there, the broad atmospheric questions that are very, very negative, the specific questions about jobs or investment, they're fine, no problem. So I find it so fascinating, and maybe we should do a podcast on that. Maybe get a behavioral psychologist or something, what the heck is going on? I mean, I've got theories, but I find that so interesting. But that's the case. That was a good one. Okay, Cris, you're up.

Cris deRitis:                        All right, my number is 2.1.

Mark Zandi:                       2.1. And is it an inflation statistic?

Cris deRitis:                        It is not. If you don't get this Mark, I'm going to be very.

Marisa DiNatale:              It's a house price. Is it a house price index, Cris?

Cris deRitis:                        Nope, it's not.

Mark Zandi:                       Is it a delinquency rate?

Cris deRitis:                        Nope.

Marisa DiNatale:              What are the units.

Cris deRitis:                        It's actually an indicator that you cover, Mark?

Mark Zandi:                       Oh, I know it's a small, is it our business survey?

Cris deRitis:                        It is.

Mark Zandi:                       Okay.

Cris deRitis:                        It's the Survey of Business Confidence. You just mentioned it.

Mark Zandi:                       I just mentioned it. Yeah, you want to explain?

Cris deRitis:                        Maybe you should explain because you cover it. It's a diffusion index.

Mark Zandi:                       Yeah, I've been covering it since 2003, by the way. That's when we first started that survey. This is folks that are clients. They don't have to be clients, so you can participate in the survey. It's a weekly survey. We have nine questions and I mentioned there's some atmospheric questions around how do you feel about current business conditions broadly, how do you feel about the future six months from now? And then specific questions about hiring and investment inventories, office space, availability, financing, those kinds of things.

                                                Then we create a overall index. The percent of positive response is less negative, that diffusion index that Cris just mentioned. And slightly on the positive side, which is, it's consistent with an economy that's kind of, sort of treading water, not in recession, but certainly growing below its potential. And it feels like where the economy's been, but again, it feels like it's been weighed down a little bit by the atmospherics, the soft data, so to speak. But that's a survey that we've been doing for 20 years and I encourage people to look at it, participate. It's always important to have high level participation so we'd welcome that. And you can do that off our Economic View website, the EV website. Did I get that right, Cris? Anything I missed?

Cris deRitis:                        You did. No, you got it. It's free to participate.

Mark Zandi:                       Oh, all right. Right. Nailed that one.

Cris deRitis:                        It's free to participate. You'll get a report on it every week that you do. So there's a little give to get.

Mark Zandi:                       A give to get, yeah.

Cris deRitis:                        If you're interested in participating.

Mark Zandi:                       Right. And I do find it very valuable, particularly interestingly enough, the percent of respondents to the question about present conditions, how do you feel about your business and how it's doing right now broadly, the percent that respond positively, that's in my mind, the most useful in terms of gauging where you are in the business cycle. And we're right on the edge of no recession, recession. Economy that's just skirting its way through and it's global as well. So you might fund us some value. That was a good one. Thanks for calling that out, Cris. All right, I think I got a pretty good one. 2.5%. This might be a little hard.

Cris deRitis:                        Inflation related?

Mark Zandi:                       Inflation related.

Cris deRitis:                        Oh, that's less, what is it? Less energy, food, and shelter.

Mark Zandi:                       Oh my gosh, you're a God. That is great, Cris. I was afraid no one was going to get it I thought. You nailed it, perfect.

Cris deRitis:                        I saw that number 2.5, I said this matches perfectly with Mark's narrative. He's going to back out of it.

Mark Zandi:                       Well, okay, come on now. Listen, year over year through the month of July, CPI core, so I mean, exclude food and energy. Take out the shelter component. It's 2.5%, which is the target, the Fed's target. And the only reason we're not at target, if you buy into that measure, is the cost of housing, the growth in the cost of housing services. And as we've been discussing, we all know that that's going to slow quite dramatically here. In fact, we forecast lots of stuff, some of which we're very confident and some not so much. This we are pretty confident, about as confident as you can get in forecasting anything because it's tied to rents with a long lag.

                                                Those market rents are flat to down and then we know that's going to translate into slower growth in the growth in the cost of housing services over the course of the next year. Thus, my baseline forecast. A year from now, cost of growth of cost housing services is going to be normalized. It's going to be around two and a half percent, the overall index. The core index is going to be at 2.5%. We're going to be at target. Right? I mean, isn't that compelling? That's a compelling argument.

Cris deRitis:                        What about those medical services you just talked about?

Mark Zandi:                       Yeah, but all those other things. You got crosscurrents, you got medical services inflation going up, you got electricity cost inflation going down. You got new vehicle prices maybe going up briefly for UAW, but got used vehicle prices going down. All those other things, things obviously can happen between now and then, but barring something really going off the rails, all those other things feel like they're a wash. Some adds, some subtract. The net of all that is no big impact. No? I mean, I looked at that and I go, oh my gosh, I couldn't believe it. I couldn't believe it. Very consistent. Marisa, what do you think? You convinced?

Marisa DiNatale:              It is. I wonder.

Mark Zandi:                       It's compelling.

Marisa DiNatale:              I wonder about shelter costs. Does the OER component of shelter tend to lag? Rent-

Mark Zandi:                       OER. Okay. OER is.

Marisa DiNatale:              Owner's equivalent rent. So it's the implicit rent that a homeowner would get for their home were they to rent it essentially. So it's an implied calculation and I just wonder if you really need actual rent, rent to moderate before that works its way into the OER component.

Mark Zandi:                       I think the answer is yes.

Marisa DiNatale:              Yeah.

Mark Zandi:                       I mean, the market rents are a basis for them.

Marisa DiNatale:              Right.

Mark Zandi:                       Constructing the owner's equivalent rent. So it's a complicated like everything every data statistic I guess. A very complicated process from going from rents to measured prices. But yeah, that's effectively what they do. Bernard, right?

Bernard Yaros:                  Yeah. They generally, and you generally see tenants' rent and owner's equivalent of rent move-

Mark Zandi:                       They move the same.

Bernard Yaros:                  Largely in the same. Yeah.

Mark Zandi:                       Yeah. They try to get rents for homes that would be more consistent with homes that people own. So they try to line that up to make that work better. But they still, ultimately it goes to rents.

Marisa DiNatale:              Because OER is the bigger component of shelter.

Mark Zandi:                       Yeah, by far. By far. Yeah. Because two-thirds of people own their own homes. One-third rent. Here's the other interesting thing that if you think about it for a second, you go, oh, and it's important for people who own their own home, two-thirds of the population, they either own home outright. I think half of people own their own outright, and half of people have a long 30 year, 15 year fixed rate mortgage. Very few people have mortgages that adjust with market interest rates. So their cost of housing, the actual cash they're shelling out to pay for their housing, it's not changing. It's not changing at all, right? The cash outlay is not changing, but their cost of living is increasing as measured by the OER. So the actual economic consequence for their finances is much less serious than if I have to actually shell out more for food or for apparel or for gasoline. I'm shelling out more cash. In this case you're not, right? Isn't that interesting? I mean, you go duh. It just dawned on me, Cris, right? Am I missing something?

Cris deRitis:                        That's right. I guess it would apply for, well, to some extent for cars too, right?

Mark Zandi:                       Yeah, that's true. That's true too. Yeah, true too.

Cris deRitis:                        You own your own.

Mark Zandi:                       Yeah. You're not, yeah.

Cris deRitis:                        As you say, the CPI has a lot of complexity in it. I think we summarize it and we use a lot of shorthand, but there's a lot of detail here in both how it's measured and how to interpret it.

Mark Zandi:                       Right. Well, that was a great conversation about the inflation statistics. I think we covered a lot of ground. I think we at this point, better move on. This is going to be a very long podcast. We have a great guest and let me welcome Sebnem into the conversation. Sebnem, good to see you. How are you?

Sebnem Kalemli-Ozcan:Good to see you, Mark. How are you?

Mark Zandi:                       I am very well, thank you. And we met a couple three months ago at the New York Fed, that was a lot of fun.

Sebnem Kalemli-Ozcan:Yes, definitely.

Mark Zandi:                       Well, we're both on the, I guess it's called the Board of Economic Advisors or just-

Sebnem Kalemli-Ozcan:Yes, exactly. Economic Advisory Board, yeah.

Mark Zandi:                       Right. And this is a board of advisors set up. I guess we meet a couple times a year, maybe more than that.

Sebnem Kalemli-Ozcan:Yeah. It was I think four times before COVID. During COVID, it went down to two times through Zoom. So we are still in that phase, I believe.

Mark Zandi:                       Right. And we talked about, it was a couple of three months ago. So top of mind at that point was the banking crisis. And I want to come back to that. But before we dive into the subject matter, maybe you can give us a little bit of your background. I'd love to know a little bit more about your success and how I should say you're now a Professor of Economics and Finance at the University of Maryland, and I'd like a little bit know more about your background and how you got there.

Sebnem Kalemli-Ozcan:Sure. I'm originally from Turkey. I went to college in Turkey, Middle East Technical University. And then I came to United States in 1995 to do my PhD. I did a PhD in economics at Brown University in Providence. And after that, so that was 2000, so I got my PhD in 2000. So last 23 years, I have been busy doing economic research, trying to get tenure and all that. And at the same time visit policy institutions. So my work is in what we call macroeconomics broadly, but it is international finance and international macroeconomics. And it's very policy relevant, applied to policy. So I work on things like transmission of US monetary policy to other countries, inflation, capital flows, globalization, those type of issues.

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Sebnem Kalemli-Ozcan:... globalization, those type of issues. I started at the University of Houston actually at that point. We moved there in 2000 with my husband and then I have my kids there. I have two sons. Now they're 21 years old and 16 years old. They're now really old. I'm remembering those days when they were little.

                                                So then I was at University of Houston for 10 years. After that I had a stint at Harvard Kennedy School. I was at European Central Bank right around the entire big crisis of 2007-2008. I remember actually being at European Central Bank and the Chair then, Trichet, was saying, "Oh, this is just a little thing in the United States. It's not going to come here. It's just a little [inaudible]."

Mark Zandi:                       I remember that.

Sebnem Kalemli-Ozcan:And I'm like that's just not possible given the extent of global financial linkages, because that is my area of expertise. Anyway, so we did a lot of work on that. We-

Mark Zandi:                       Wasn't he raising ... As I recall, right in the teeth of the financial crisis, they raised rates as I recall, right?

Sebnem Kalemli-Ozcan:Exactly. It was just like [inaudible]-

Mark Zandi:                       Yeah. Like what are you thinking?

Sebnem Kalemli-Ozcan:Everybody was running around like headless chicken, right? Nobody knew what they're supposed to do. He was saying things like, "Oh, [inaudible] and I, we are talking every day," but that was actually the key moment for my research in a sense that I saw how important and relevant my research for policies. We wrote the first piece that shows the exposure of European banks to [inaudible] debt and this data, which is now very well known, BIS, Bank for International Settlements data, was sitting there at European Central Bank. Nobody was using it. Nobody even knew it was there.

                                                You would think if you're integrating several countries, you want to know the exposure of your banks to other countries' debt, right? That's the first thing you would want to know about. Anyway, so this came out in Journal of Finance, which is the top journal in finance so we published there. Then of course it became very fashionable. I mean this is 2008-2009.

                                                After that I came back. I was in Turkey also visiting a couple of universities there, Koc University, [inaudible] University. Then I came to University of Maryland. I have been in University of Maryland last 11 years since 2012, and it has been great. I had a lot of time because I was at University of Maryland, spent at IMF, World Bank, Federal Reserve. I visited all these institutions a long period of time, which helped me a lot to understand the linkages between academic research and policy application, how important it is to bring the state-of-the-art knowledge from academia to policy folks. Call it IMF, call it Federal Reserve.

                                                And this is where I am right now. So I wrote a paper for the Jackson Hall Conference in 2019 on the spillovers of US monetary policy. That became a big hit and now I'm here doing my research-

Mark Zandi:                       Very cool.

Sebnem Kalemli-Ozcan:... enjoying ... I'm actually now going to move again. Next year, 2024, I am going back to my alma matter. I'm going to be a professor at Brown University starting September 2024.

Mark Zandi:                       Congratulations. Well, good. [inaudible]. Thanks again for joining us. I know that you've done a lot of work with regard to the banking crisis, the recent banking crisis back in March. In fact, you gave a presentation at the New York Fed when President Williams was there and the rest of the Fed staff, and here we are three or four months after that crisis. And it strikes me that the impact, the fallout, has been rather modest in the grand scheme of things.

                                                I mean, yes, the banks have tightened up underwriting standards. If you look at the senior loan officer survey, the Fed conducts every quarter, that shows a further tightening in underwriting. But in terms of its impact on actual lending activity, you can go look at the Federal Reserve's H8 release which shows the assets that the banks have and gives you a pretty good sense of their lending. There's been some weakening in commercial and industrial lending, C&I lending, but in terms of commercial real estate lending, multifamily lending, construction and land development lending, it's slowed but hasn't really fallen off to a significant degree. Also, deposits after an initial decline back in March, they appear to have stabilized both for large banks and smaller banks.

                                                So I guess the question to you is am I characterizing this right? Are you coming around to the same conclusion and what do you think is going on here?

Sebnem Kalemli-Ozcan:You are exactly right and if you remember that presentation at New York Fed, Mark, one of the things I was saying at that point, we don't know if this is going to really turn out to be a huge scale banking crisis like the 2008 version, but my expectation at that point was it wasn't going to be.

                                                So basically I predicted the situation and that expectation and prediction is based on the fact that I look at granular data. I mean this is what my research has been. I look at these linkages between the real sector and the financial sector but not just, say, the entire corporate sector and the banks or the commercial real estate and that. It's literally at the granular level. So go and ask question. Where does Mark and Sebnem borrows from? So what is in Mark's portfolio, Sebnem's portfolio or Goldman Sachs' portfolio or Apple's or Amazon?

Mark Zandi:                       I hope you don't know my portfolio. Hopefully, you don't know my portfolio, Sebnem. I'm just saying. Yeah.

Sebnem Kalemli-Ozcan:The point is you have to do it at a very granular level. The problem why people got panic and said, "Okay, this is going to be big big and the economy is going to fall down because everybody thought that this started in regional banks, in the small banks, but there can be two things that can go very bad. One, it's just a contagion. Everybody's going to panic and now this is going to show up in Bank of Americas of the world, JP Morgans of the world, number one. Number two, these guys are the regional small banks and small firms borrow from small banks, and then this means once those firms go under, there's going to be a huge impact on employment because small firms are the bread and butter of the economy.

                                                I explained in that presentation, first of all, this is not correct. I don't know why but it is just very deeply ingrained thing in people's minds because people only look at Apples and Amazons of the world, like listed firms and [inaudible] firms, so these kind of large guys, and then jump from that to the conclusion that, "Oh, small guys must be borrowing from small banks." This is not true.

                                                The US economy is super heterogeneous and, unless you look at literally every single small firm, every single small and big agent, Mark, check numbers [inaudible] Apple, Amazon or these hundred employee firms versus 3,000 employee firms, you wouldn't know who is borrowing from who and who is exposed to what.

                                                The same goes for the banks. We understand these small regional banks like SVPs of the world did take interest rate risk, right? They didn't do their diligence which we can link back to the regulatory failures. But the fact is there are other banks in the economy, large banks like Bank of America, they are subject to regulation. They didn't take that much of this risk and small firms do borrow from those banks. So, in fact, the results I showed in that meeting is from our work, not rely on H8 data. You said at the beginning people are looking at this H8, some commercial loans. These are all kind of these-

Mark Zandi:                       Just to stop you for a second. So the H8 is the data that the Federal Reserve puts together on bank balance sheets, their assets and liabilities, and they release this every week. So it's an aggregation across banks.

Sebnem Kalemli-Ozcan:It's an aggregation, exactly, and not every bank is in it. That's the other thing-

Mark Zandi:                       Not every bank's in it, right.

Sebnem Kalemli-Ozcan:The big advantage is going to be that is something like that moves high frequency between quarters. So people just go and rush to H8 or datasets like that to find out information quickly. But the big disadvantage is not everybody is in it. So it doesn't cover every single bank and it's not going to tell you anything in terms of which firm, which company, borrows from which bank.

                                                That is the data called Y-14, which is also Federal Reserve's regulatory data. We work with that data. This data has been started collecting after ... The Fed started collecting this data after 2008 crisis exactly because of the purpose of we want to understand where the risk in the economy and how these isolated risks like the subprime of 2008 can be systemic risk, can become economy wide. So we work with that data and that data is going to cover a large set of almost the universe of the firms in the United States represented dataset.

                                                So you would know the guys with less than 500 employees, what we call SMEs. At the same time, you still will know the guys like Apple and Amazon and you have a more complete picture who borrows from who. And when you look at that dataset, going back to my presentation at the New York Fed, we see that small guys borrow from big banks, which brings me to the point that as long as these regional stress, banking stress like SVBs don't jump to the big banks, as long as the big banks' balance sheets are safe, we are not going to have a crisis because small guys are still borrowing from the big banks and small guys have very strong demand. Remember, this is the other point I make.

                                                Unfortunately, in this literature in this topic, we think a lot from the supply side, supply of credit side. So, oh, if banks are in trouble, we are doomed. This kind of was the case in 2008, but of course all banks were under trouble then, right? All banks, not just like SVB and First Republic and all that.

                                                We have to understand there is a boom side to this picture. There is a side when we are not in a financial crisis, when not all banks are in trouble, the boom, meaning the demand, matters a lot. The customer demand, the credit demand and tax situation we are in and this is the situation Fed is trying to slow down now over 15 months. Still not there. We have a strong economy. Demand is strong. I mean if the customer demand is strong, that firm is going to go and demand credit. And if a safe bank like Bank of America wants to give that credit, then you don't have any problem. So this type of [inaudible] is very important to understand, Mark.

Mark Zandi:                       Okay. So what you're saying, just to summarize, is the fallout from the crisis has been modest and one of the key reasons for that is that small businesses have been able to get credit because if you can take a closer look at the data at a granular level, as you said, you'll see that small businesses are also borrowing from the big guys, the JP Morgans, the B of As, the Wells Fargos, and continue to have access to credit and that has allowed them to continue to operate and allow the economy to move forward. That's kind of the message that you're-

Sebnem Kalemli-Ozcan:Exactly, exactly.

Mark Zandi:                       Got it. Well, let me ask you this. So one concern is that of course the Federal Reserve had to respond. The Fed, the FDIC, Treasury responded, guaranteed the deposits of whether folks were insured or uninsured in SVB and the other troubled banking institutions. The other thing that the Fed did was establish a funding facility to allow banks to borrow against their security holdings and they could value the securities at par, not at their lower value, given the higher interest rates. And that program is still in place. If you look every week, you can see that data as well from the Fed every week, the so-called H.4 That continues to increase slowly but surely over time. So it feels like the system is still under a fair amount of stress.

                                                And one concern is that, given the Federal Reserve's very aggressive rate hikes and the inversion of the yield curve, banks are under a lot of pressure because their net interest margin, the difference between their funding costs and their lending rates is under pressure. Now they've been able to manage that, particularly the big guys as you point out, have been able to manage that up to this point in time. Net interest margins have held up pretty well but, as time goes on here, it gets increasingly more difficult for banks to do that. They hedge, they match, but that gets very costly, very difficult to do. So their net interest margins come under increasing pressure.

                                                So if the Fed has to keep its foot on the brakes for an extended period, the yield curve remains inverted for an extended period, the worry is that the banking system, which is still under a lot of stress, the bank term funding program continues to be used at a very high rate, something's going to break in the system. What do you think? Is that concern overdone or is it a reasonable concern?

Sebnem Kalemli-Ozcan:It's definitely a reasonable concern. You're exactly right. But at this point, as you said, Fed has just underwritten the entire banking system. I mean that policy is there and, yes, we can look at who is using those, who is withdrawing from that and all that. That's the guarantee. Now, of course, that was a emergency panic moment underwriting. We shouldn't be doing these things like that.

                                                This is why if you were following the entire media coverage of this, emerging market banks were laughing their head off because this is Emerging Market Banking 101. Nobody would do this. I mean you wouldn't have an emerging market bank ... I remember Brazilians were saying this ... that would take this risk. You are in a tightening cycle. Every emerging market bank would know what would they do in a tightening cycle and a losing cycle. So clearly this didn't happen in the United States.

Mark Zandi:                       You're saying that this is Banking 101 meaning no one would've gotten caught with this interest rate mismatch problem.

Sebnem Kalemli-Ozcan:Exactly. But [inaudible] interest rate risk [inaudible] because you would crash and burn. Of course, they learn it the hard way. I mean all these countries went through banking crisis because of the similar situation and especially in those countries because inflation is more volatile, you go to this easing and tightening cycles of monetary policy more frequent.

                                                So they learned the hard way. But also regulation came and, after banking crisis after banking crisis, if you look at emerging markets right now, all of the banks are regulated. All. It is not like the United States where you have these 50 guys, the big guys are regulated, which is how we get the data, the Y-14 data, and the rest is not. And of course in the United States, we have a huge number of banks. We are talking about 3,000, 4,000, whatever. I mean we came down from 15,000 over the last 30 years but still it's a huge number of banks. There are a lot of small banks and they are not regulated.

                                                The way out of this problem is every bank should be regulated. I say this all the time. There are other people inside the Fed and outside sharing this view. This is what we learn through the bread and butter of banking crisis in the emerging market world. You regulate everyone. The minute you have these type of, "Okay, I'm going to regulate large guys because large guys are the systemically important guys, I will let the small guys be because they are small and regulation is costly for them," these things are going to happen.

Mark Zandi:                       But they're regulated. You're saying they have the same regulations, the same capital standard, the same liquidity requirements?

Sebnem Kalemli-Ozcan:You can think about that. You can fine tune that. You can fine tune and think the regulation in a countercyclical way, in terms of proportion to their size. But basically they should have been prevented from taking this type of interest rate risk on their balance sheet during a tightening cycle. That is the problem.

Mark Zandi:                       Okay, so they're regulated but you're saying they weren't regulated significantly enough. They didn't-

Sebnem Kalemli-Ozcan:Yeah.

Mark Zandi:                       Okay. So Silicon Valley Bank shouldn't have been able to do what they did.

Sebnem Kalemli-Ozcan:Exactly, because the interest rate risk exercise, if you look at the other guys, the big guys part of the CCRA, that's the stress testing exercise and the big banks are part of that. I say regulated, I'm using terminology ... Sorry about that. But when I say regulation, I'm talking about the regulation that the large guys, large banks, Bank of Americas of the world are subject to. Part of that regulation is this interest rate risk. These exercise is wrong for them. That's why they have a very diversified balance sheet. They don't have this type of low returning asset completely filling up their asset side of their balance sheet because they are subject to this type of stress testing exercise, and interest rate risk is part of that during a tightening [inaudible] cycle.

                                                Now, this wasn't done for the small guys because small guys, they weren't part of that. So this is what I'm saying. When I say regulated, everybody should be regulated for all sorts of risks basically. And this is such a plain vanilla risk, right? I mean interest rate risk during a tightening cycle? This is why I'm saying it's Emerging Market Banking 101.

Mark Zandi:                       Okay. So you're saying the reason why SVB, Signature and other smaller institutions got into trouble here is because they were not well regulated.

Sebnem Kalemli-Ozcan:Yeah. They don't have a diversified portfolio. Their balance sheet is completely ... Their asset side is completely filled up with these low return debt, US Treasuries and stuff. So I mean you have to diversify that. You have to have a diversified portfolio on the asset side.

                                                Then the liability side, they also have a problem with the liability side. They have the same type of depositors. This is the tech guys. This is why they caught up in this thing. All their deposits are the same group. They texted each other, "Let's get out of this bank," and then their assets cannot meet that type of all deposits going at the same time because it's not a diversified portfolio on the asset side.

Mark Zandi:                       Just to push back a little bit, some would argue, and I'm sympathetic to the argument, that it isn't about regulation so much as it's about the implementation of that regulation.

Sebnem Kalemli-Ozcan:Supervision. Yeah. No, I-

Mark Zandi:                       Supervision.

Sebnem Kalemli-Ozcan:I agree. Let me clarify. In fact, one of my very early [inaudible] on this topic, I did say exactly when this question was asked, "Is it regulation or supervision?" I said, "It's supervision." So this is why I said I might be abusing the word regulation. But the supervision, it is a failure of supervision. But I think supervision comes with regulation. I mean if the regulation tells you you have to be supervised if you are taking interest rate risk or not, and it's kind of very back and forth and supervision will come together with that. Okay, so I'm supervising you. I look and then you have so much interest rate risk on the balance sheet so it changes. But, you see, they go together.

                                                It is a failure of supervision. I fully agree. But if the supervisor had no way of enforcing it, I mean this is the story. We did actually hear that Federal Reserve of San Francisco did tell them this is not good. So they were warned, First Republic definitely. There was a warning sign, but they didn't do anything about it.

                                                So that's the thing. These things go together. It is a failure of supervision but if a supervisor is telling you, "Look, I don't like this. This is dangerous," then if the bank is saying, "Fine, I'm not going to do anything about that," then how are we going to get out of that situation? So that has to [inaudible].

Mark Zandi:                       So going forward, the banking system, financial system, is still under significant pressure. The Fed has its foot flat on the brakes, the curve's inverted, and other aspects of the operating environment that banks are dealing with are more difficult. Credit quality's eroding, delinquencies, defaults are rising. Loan growth, it's still positive but it's definitely slowing. The tightening in underwriting is slowing loan growth. We've got higher regulatory costs. The Fed and other regulators came forward with new capital standards and liquidity requirements, and that's going to be more costly. Supervisory costs are up. So you add all of that up and it says the banks, they're under a lot of pressure here.

                                                And it feels like the longer this goes on, the more likely something's going to break somewhere. Is that a risk? How worried are you about that? Or am I just overstating things here?

Sebnem Kalemli-Ozcan:No, there is risk but I don't think it is right to think that it is going to come from the bank side. I mean banks are under pressure [inaudible]. I don't think that's going to be from that side. Because banks, let's face it, after 2008 a lot of regulation rolled out. Banks now are in much better shape than they were in 2006 and 2007. So I don't think, again, unless a huge shock happens like that, what happened then, everybody exposed to the same toxic assets, unless we find out something like that going on, it is not going to come from the banking side just because Federal Reserve tightening [inaudible].

                                                Remember, this whole notion of Federal Reserve in a tightening cycle so banks are going to break, I don't think this is correct. Yes, there are going to be some banks breaking. They already broke but that's because of their own mistakes. So the system as a whole, if we again compare to 2008, is I think safe. I think the danger is going to come from the real side, real economy, and that is going to depend on which loans they gave out the banks, to who. And if during this zero lower bound, super low interest rate era started in 2008-9, if they really-

PART 3 OF 4 ENDS [01:09:04]

Sebnem Kalemli-Ozcan:... era started in 2008-9. If they really gave out bad loans to bad customers, yes, then okay, obviously at some point the real economy is going to slow down and those guys are going to start defaulting on those. And if the bank, again, on the asset side similar to this, the low yielding treasury story, if they literally focus on those type of customers, firms and households, I mean, then yes, then, okay, we are going to have a problem at our end. But I don't think that was the case. Yes, banks did give out some probably shaky loans during this cheap credit era, but I don't think it was that concentrated that everything is going to blow up at the same time.

                                                I think what is going on right now, and this is the question of soft landing. If Fed can engineer this soft lending immaculately until the end, until we come down to 2%, sure we are going to see some sort of defaults there and there, pockets of it, but as long as the entire SMEs, which by the way 99% of all the firms in the United States and they account for 70% of employment in the United States, if that entire group go under, if that doesn't happen, then we don't have a problem. We are going to see things but we are not going to have a huge crisis and recession. But that's the thing. And that comes back to soft landing.

                                                If the soft landing fails and if somehow going now from 3.5 to 2 is going to involve very, very quick slowing down of the economy, so demand is kind of crashing, then we're going to a problem our end of course. And that's what we are all hoping won't happen. And Fed so far has been successful in that, but of course it's yet to be seen still. We are not fully there yet.

Mark Zandi:                       Just FYI to the listener, SME is small, mid-sized enterprise, so it's effectively small business. It's kind of the acronym, mostly I think European maybe global, but most people... Cris, do people here in the US say SME? I don't know.

Sebnem Kalemli-Ozcan:No. This is true. Yes. People say small business.

Mark Zandi:                       Okay. Yeah. You do. Okay. Sure.

Sebnem Kalemli-Ozcan:People say small businesses but globally SME-

Mark Zandi:                       That's what you mean. Yeah.

Sebnem Kalemli-Ozcan:[inaudible] enterprise. But this is very important. I really want listeners understand. These guys always thought, "Oh, this is just a mom-and-pop shop, the pizza store on the corner, the dry cleaning." No, these are firms less than 500 employees. They're huge. They're 99.9% of the universe of the firms in the United States. Just to give you an idea, the average size in these firms are going to be something around 50 employment average. The average size of a listed firm is 4,000. So I mean, these firms are day and night. The problem is the big guys is 0.1% of the economy. In terms of employment, which is the big deal, of course, the SMEs run the show.

                                                I mean, remember the PPP program. When the PPP program launched, Paycheck Protection Program, during COVID, the entire thing is that's for SMEs, to save firms under 500 employee. That was done to save the economy because these firms are the backbone of the economy in terms of growth, employment and innovation. So we just ignore these guys because we don't know much about them, because first of all, we don't know anything about their financing. They only file returns to tax records. So there isn't any publicly available data we can look at it. But they are very important. And if they go under in large numbers, yes, then of course we are going to have a recession in our hands. Not all the banks are in trouble. Some banks are in trouble, but not all of them. And as long as there's still semi strong demand in the economy, the economy is not going to a recession with flashing light, like high speed, these guys are not going to go under in bulk in my opinion.

Mark Zandi:                       Okay. So what you're saying, just because I want to make sure I got it right, is you don't think if something does the economy in, it's not going to be the banking system or the financial system. That's not where this is going to come from. Something else has got to happen. What you're saying the banking, financial system could have a problem, yeah, no doubt, but that's got to be because of something going on in the economy and you're most focused on the small business or SME part of the economy.

Sebnem Kalemli-Ozcan:Yeah. Yeah.

Mark Zandi:                       Okay. All right. So I want to go on to talk about monetary policy because you kind of brought that up and I think we should explore that, but before I do, let me turn to Cris. And Cris, what do you think? You have any comments on Sebnem's... What she's been saying so far? Any pushback there?

Cris deRitis:                        I guess I was struck by this idea of regulation, that we need more regulation across the system. And that may very well be the case, but then I think you're also making a philosophical statement in terms of the structure of the banking. Do we have too many banks? Because if you increase the regulation on those smaller banks, you're going to see even more consolidation into a system that's more concentrated in these larger units. So if that's what we want, if that's what we think is optimal, that's fine, but I don't think we can have both. I don't think we can have much more regulation across the board and still maintain a very heterogeneous, diversified type of financial system. What do you think about that?

Sebnem Kalemli-Ozcan:[inaudible]. Yeah. No. I fully agree. Again, this is something very fiercely debated in the literature, in academia and in policy circles both. And you can write down both models. You can write down a model that it is optimal exactly to consolidate as you say and you'll have fewer banks. So we have the consolidation but they are fiercely regulated, so we decrease risk. Or you can also write down a model where it is optimal to have a heterogeneous, diverse system with many, many, many small players that keeps up the competition alive in the system.

                                                You can write down both models and you can have an optimal policy coming out of both model. This is why we have our jobs. I mean, this is what we do in academia and write down these things, like competing models, and then go and test them in the data. I mean, this is exactly why data and granular data is super important, micro data, bank level, household level, firm level data is super important, to test these different models that will give you different optimal policies. And my view is I think we are... Again, I mean, these risks, they kind of cumulate over time. And if you have too many small banks and yes, there is a competition advantage, there's a heterogeneity, diversity advantage, but there's also a big disadvantage that you don't see them and then they can easily overnight turn into a big event and then it is going to be harder to clean up the mess and all that.

                                                So you said trade-off. You trade that risk with you consolidate, you have a sharper bird eye, view, because you are going to regulate all these guys. Yes, now you decrease the competition because you might have a monopoly banking sector problem in your hand, but you're going to a better handle on the risks in the system. So this is a trade-off. So which one you do? And again it is not clear. The answer is not clear. I agree with you.

Mark Zandi:                       I don't know if I've ever told you this story, but I started a company, an economic consulting firm, that I sold to Moody's. Started with my brother and a good friend and we sold it to Moody's about 15, 16 years ago. And we were small company. Early on, we were expanding, growing quickly, needed a loan. I live in suburban Philly. So I go knock on the big regional bank. I won't tell you who it is. You'll figure it out. But I knocked on the door-

Cris deRitis:                        We can guess.

Mark Zandi:                       You can guess. "Hey. I need a loan." The big regional bank said, "No. What are you? You're out of your mind. It's not going to happen." And if I were in their shoes, I'd probably say the same thing, because I had no assets. I had a home, probably had 5% equity in it. So fortunately though I was the coach of my daughter's soccer team and on that team was a young lady whose dad was the president of Malvern Federal Savings Bank, three branches, Malvern, Pennsylvania. And he said, "I'll give you a loan," because he knew me, he knew me personally. He knew I would die before I wouldn't pay him back. It may take me 50 years to pay him back, but I would pay him back. I got the loan from Malvern Federal Savings Bank. So from that experience... And obviously we're all in on data, Sebnem. I agree with you. But I like anecdotes as well. Based on that anecdote, I go, "I kind of understand why we want a lot of the small banking institutions because they are really critical to those SMEs you were just talking about."

Sebnem Kalemli-Ozcan:Okay No. True. I mean, again, yes. So it was between the startup SME and an SME. I mean, that you can be still small but you can be a business in 20, 30 years, then you would get your loan from the large guy. But yes, if you're a startup, that is true. Small businesses that are younger than five year olds, so there's a size issue and then there's an age issue. So when you guys are starting like your case, Mark, it is important. You want that kind of neighborhood bank that either you have some sort of a personal connection or you can go and plea your case, and yes, these guys are important. So I'm not saying have JP Morgan buy out the entire industry and we go down to one bank. I'm not saying that. But at the same time, I mean, is 4,000 optimal number?

                                                So this is the thing. This is something we need to study. I mean, maybe yes, we don't go to 60 but maybe it is 200. I don't know. But we do need to protect some of that very American, "I'm going to go to my neighborhood bank. I will start up this business." We do need to keep that. I mean, that is very valuable and yes, that is you need to America. I fully agree there. But at the same time, we need to find a way of better regulate, better supervise. Maybe think about ways of not having regulation costly. So we keep these guys, these smaller banks but make sure we supervise and reinforce that they don't take these type of risks. So we have to find a better way here.

Mark Zandi:                       Yep. Got it. Let's move forward to monetary policy, and you brought in the Fed. Here we are. The Fed has been raising rates now for about a year and a half. The funds rate target is five and a quarter to five and half percent. What do you think? Are we at the end of the right hiking cycle here? Are we at the terminal rate? Or is there more to go?

Sebnem Kalemli-Ozcan:Yeah, I think we are at the end. So my terminal rate expectation has been now for some time. I mean, I have been saying this now almost 10 months. We are going to end somewhere between 5.5, 6-ish. I don't expect to go over 6 but 6.

Mark Zandi:                       I like the ish part, the ish.

Sebnem Kalemli-Ozcan:6 can happen. This is in my range. So maybe we will stop at 5.5. Right now, we are 5.25, .5 range anyway, but we are at the end. I don't expect rate cuts though. So here where I differ from the financial markets. Financial markets are pricing in interest rate cuts way earlier than myself and some other fellow economists. But yes, we are almost there at the terminal rate, although I expect they stay here for some time in the absence of a very, very harsh and deep recession. Again, this is a soft landing debate.

Mark Zandi:                       Do you have a view on that? Do you have a view on soft landing versus recession?

Sebnem Kalemli-Ozcan:Yeah. So I do think Fed is going to succeed in this. I think it's going to be a soft landing.

Mark Zandi:                       Cris, do you hear that? Cris is the bear. Did you hear that, Cris?

Cris deRitis:                        I am hopeful. I am [inaudible].

Mark Zandi:                       You're hopeful.

Cris deRitis:                        I hope that's the case.

Mark Zandi:                       Okay.

Cris deRitis:                        I'm a cheerleader.

Sebnem Kalemli-Ozcan:And maybe that's why. I'm also a very positive and hopeful person, but I have been saying this now for some time, not just because I want it to be like that and be positive and hopeful, but because of the research we did. We did these very early papers on COVID inflation starting as early as January, 2021 actually. We were in the group that says there is going to be inflation, but we also said Larry Summers is right for the wrong reasons. In fact, [inaudible] reported exactly like that. That's [inaudible].

Cris deRitis:                        Awesome.

Mark Zandi:                       I'm right with you on that one.

Sebnem Kalemli-Ozcan:Exactly. So [inaudible]-

Mark Zandi:                       Yeah. Yeah. You're saying it's supply side, more supply side [inaudible].

Sebnem Kalemli-Ozcan:Exactly. Supply side. So we said [inaudible]. And I had a presentation literally, I mean, WHO presentation January, 2021 before everything else. There's going to be inflation but it's going to start with supply chain. So it's going to start with the supply chain with the product prices. I mean, now there's a new paper by Ben Bernanke and Olivier Blanchard. They also show the same thing. It's not wages first. It's the prices first. That completely links to the supply chain problem. This is global of course. This is not just United States. This is local supply chain and global supply chain going back to China.

                                                So we did the first paper on that. We did a second paper showing how when fiscal stimulus came, put that on steroids. You started a supply chain problem. Inflation starts then of course. Maybe you would've stayed at 5. You went to 9 thanks to this huge fiscal stimulus. That's the demand side story. That's the second phase. And then of course the final phase, the Russia and Ukraine obviously added to that, more severely for Europe of course. But now we document all these three phases of inflation. Pandemical inflation starting with the supply chain issue. Fiscal stimulus of course amplifies that. And then you add energy.

                                                So we are coming down. So in that sense, we always told this can be a soft landing because the shock process is just very different. I mean, people compare to 1970s, but I don't think that's right comparison. That's just a part of it. You have a supply shock and a demand shock happening at the different times and there is a sectoral dimension to this and there's a global dimension to this. It's not just energy or it's not just manufacturing sector. It is like the services, the labor market. I mean, the labor market came to the picture because of course of the huge demand increase in the services sector, which combined with the recovery and opening up.

                                                So given all this research, I always thought a credible tightening cycle clearly communicated, which is what Fed was trying to do, which by the way, and we should all give it to Fed, very hard to do, because you get out of forward guidance and you go to a data-driven policy. Communicating clearly a data-driven policy is extremely difficult to financial markets, because financial markets are forward-looking. They want to know the [inaudible]. They to know the future. So that's how [inaudible]. And then you go and say, "Well, I'm going to look at the data and I'm going to look at six different indicators of the labor market and the energy and the..." So this is very difficult to communicate, but basically the research we have done says such a different environment with several shocks happening different times in the economy and a clearly communicated and consistent tightening cycle can engineer a soft landing.

                                                So in that sense, our research never hijacked by this Phillips curve story, because I mean, if you all always think in terms of the Phillips curve and say there's just this slope and it was flat, now it is steep, this is limiting to us in our view. So we work with these network models. These are also very complicated model, but basically you can connect every single sector to each other locally and globally. So when basically you don't import steel from China, the effect of that in the steel sector and then the labor steel sector users and the wage group, we can quantitatively trace this out.

                                                So in that sense, we really like our research of course but stand behind it that this is [inaudible]. In our view, this is the best way to quantify what drove inflation [inaudible] in 2020, 2021, 2022. And then once you do that quantification, you can see that why Fed is going very careful and why they keep talking about these different sectors of the economy. Remember, they said, okay. So there's the headline, the core, and then you peel that, the famous onion knowledge of John Williams, New York Fed President, and then there's the [inaudible], then there's the ex shelter one and there's there... All these because of the nature of the shock. And Fed had been right in looking at this all along, because the nature of the shock is you had different sectors being hit different times with different shocks and then you also add to that the global dimension of the problem. It is a very, very complicated problem. And we-

Mark Zandi:                       No. Not really. Not really [inaudible].

Sebnem Kalemli-Ozcan:Really, Mark? I-

Mark Zandi:                       Come on. You get a pandemic. You get supply chain disruptions. It messes up the labor market. You get a Russian war in Ukraine and oil prices go skyward, food... It's pretty straightforward in my view.

Sebnem Kalemli-Ozcan:Okay. The narrative. The narrative is very straightforward. I fully agree. But to get a handle on that in terms of quantification with numbers, difficult. Difficult why? Because of the models the Fed works with. They [inaudible]-

Mark Zandi:                       So you're saying disentangling the supply shock from the demand shocks is [inaudible].

Sebnem Kalemli-Ozcan:And also how long it takes and also... So recall the debate. I mean, the debate in the past 15 months has been about that. How long it takes? How long [inaudible]?

Mark Zandi:                       Okay. So, Sebnem. Sebnem. You said all this, but why does the funds rate have to go to 6% then? I mean, the pandemic and Russian war effects are fading. They're in the rear mirror. Inflation's coming in. Feels pretty good. All the trend lines look good. The things you can forecast in inflation with some certainty like the cost of housing services or vehicle prices, we know they're coming in. So why...

Sebnem Kalemli-Ozcan:No, it may not. It may not have to, but this is [inaudible], but this is about my complicated thing, because if you try to guess at the... Okay. Not yet. If you try to estimate the terminal rate and when you stop based on your one sector aggregate Phillips curve model, you cannot get an exact.

Mark Zandi:                       No, no, no, no. But that's...

Sebnem Kalemli-Ozcan:Okay. But you and I, we understand [inaudible].

Mark Zandi:                       We're on the same page. But obviously, the Phillips curve is not pertinent here. I mean, we're at three and a half percent unemployment rate for a year and a half and inflation's coming in.

Sebnem Kalemli-Ozcan:Exactly. Okay. Okay. But, Mark, now let me push back. This is why I said it's complicated because complicated means you have to be thinking about sectors first period. If you start thinking about sector, even you do a fairly decent aggregation, you are going to be dealing with 66 sectors in the United States economy. You open up globally, this is going to explode. And you are going to now think about those 66 Phillips curve. This is complicated. I mean, complicated in the sense that you're trying to estimate an hybrid number based on that. So it is complicated.

Mark Zandi:                       Okay. Fair enough. Fair enough. Okay. Fair enough. Yeah, that is complicated. 66 times 73 [inaudible].

Sebnem Kalemli-Ozcan:Exactly. Exactly.

Mark Zandi:                       Okay. Fair enough.

Sebnem Kalemli-Ozcan:Exactly.

Mark Zandi:                       All right. All I know is it feels like inflation's coming in as the supply shocks begin to fade.

Sebnem Kalemli-Ozcan:Exactly. No. You're exactly. So we may not have to go to 6. We may not have to go, but this is exactly what they're trying to. They never wanted to do more than they needed, but at the same time, they want to do enough that they wouldn't be in a position of, "Oh, we didn't do enough." And the risk of that, having the inflation, messing up the inflation expectations and becoming sticky is bigger. So this was the very delicate dance they were trying to do the last 15 months. And we might stay at 5.2, 5.5, Mike. And this again goes back to data-driven policy. Now this data came out great this week. The next piece of data coming like that. So we are in the right trend. They are going to stay. They're not going to go to 6. But this is exactly what I think they mean with data-driven policymaking.

Mark Zandi:                       Well, I'm all in on data. We're big fans of data. In fact, I think you use a lot of our data. [inaudible]. That's our data by the way, so.

Sebnem Kalemli-Ozcan:Yes. I know. [inaudible] your data. I'm a big fan of yours.

Mark Zandi:                       Yeah. We're all in on data. We're good. Bring it on, baby. I think we've taken enough of your time. I really appreciate you coming on the podcast. I'll have to say I feel a lot better. I actually was, still am, but I'm a little less concerned about the banking system. I feel like that could still be an issue. And I'm glad we're on the same page. And the listeners should know. I didn't know what your view was on inflation before I had you on, but I was glad to hear it. But I really do appreciate your optimism and I'm very sympathetic to it.

Sebnem Kalemli-Ozcan:Great.

Mark Zandi:                       So thank you for coming on.

Sebnem Kalemli-Ozcan:Thank you so much. This was great. Thanks, Mark.

Mark Zandi:                       I appreciate that. And with that, dear listener, we are going to call this a podcast. Take care now, everyone.

PART 4 OF 4 ENDS [01:30:43]