Welcome to Thoughts on the Market.
I'm Seth Carpenter, Morgan Stanley's Global Chief Economist.
Yesterday I sat down with my colleagues Mike Gapin, Chetan Aya and Jens Eisenschmidt, who cover the US, Asia and Europe respectively.
We talked about, well, we didn't get to the U.S.
We talked about Asia.
We talked about Europe.
Today, we are going to focus on the U.S. and maybe one or two more economies around the world.
It's Wednesday, October 1st at 10 a.m. in New York.
And 4 p.m. in Frankfurt.
And 10 p.m. in Hong Kong.
All right, gentlemen.
So yesterday we talked a lot about China, the anti-involution policy and what's going on with deflation there.
Talked a little bit about Japan and what the Bank of Japan is doing.
We shifted over to Europe and what the ECB is doing.
There there were lots of questions about deflation disinflation, whether or not inflation might actually pick up in Japan.
So there was all about soft inflation.
Mike, let me put you on the spot here, because things are a little bit different in the US when it comes to inflation.
A lot of attention on tariffs and whether or not tariffs are going to drive up inflation.
Of course, inflation in the United States never got back to the Fed's target after the COVID surge of inflation.
So where do you see inflation going?
Is the effect of tariffs, has that fully run its course or is there still more in train?
How do you see the outlook for inflation in the US?
Certainly a key question for the outlook here.
So core PCE inflation is running around 2.9%.
We think it can get towards three, maybe a little above three by year end.
We do not think... that the economy has fully absorbed tariffs yet.
We think more pass-through is coming.
The president just announced additional tariffs the other day.
We had them factored into our baseline.
I think it's fair to say companies are still figuring out exactly how much they can pass through to consumers, and when.
So I think the year-on-year rate of inflation will continue to move higher into year-end hit 3, maybe a little bit above.
The key question then is what happens in 2026?
Is inflation driven by tariffs?
Transitory, the famous T word and the year-on-year rate of inflation will come back down.
That's what the Fed's forecasts think.
We do as well.
But as everyone knows, the Fed has started to ease policy to support the labor market.
The economy has performed pretty well.
So there's a risk maybe that inflation doesn't come down as much next year.
All right.
So tariffs are clearly a key policy variable that can affect inflation.
There's also been immigration restriction, to say the least.
And what we saw coming out of COVID when people were reluctant to go back to work and businesses were reporting lots of shortages of workers is that in certain services industries we saw some pressure on prices.
So tariffs mostly affect consumer goods prices.
Is there a contribution from immigration restriction onto overall inflation through services?
I think the answer is yes.
And I hesitate there because it's hard to see it in real time.
But it is fair to say the average immigrant in the U.S. is younger.
They have higher rates of labor force participation.
They tend to reside in lower income households.
So their labor supply heavy in terms of their effect on the economy.
And yes, they tend to have larger relative presence in construction and manufacturing.
But in terms of numbers, a lot of immigrants work in the service sector, as you note.
And services inflation has been to the upside lately, right?
So the surprise has been that goods inflation maybe hasn't been as strong.
The pass-through from tariffs has been weaker.
But in terms of upside surprises in inflation, it's come in services and in many cases non-housing related services.
So I'd say there's maybe some nascent signs that immigration controls may be keeping services prices firmer than thought, but maybe hard to tie that directly at the moment.
So it's easier to say.
I think immigration controls may prevent inflation from coming down as much next year.
It's not altogether clear how much they're pushing services inflation up.
I think there's some evidence to support that, and we'll have to see whether that continues.
All right.
So we're seeing higher costs and higher prices from tariffs.
We're seeing less labor supply when it comes to immigration.
Those seem like a recipe for a big slowdown in growth.
And I think that's been your forecast for quite some time is that the US was going to slow down a lot.
Are we seeing that in the data?
Is the U.S. economy slowing down or is everything just fine?
How are you thinking about it?
And what's the evidence that there's a slowdown?
And what are maybe the counter arguments that there's not that much of a slowdown?
Well, I think that the data doesn't support much of a slowdown.
So yes, the economy did moderate in the first half of the year.
I think the smart thing to do is average through Q1 and Q2 outcomes because there was a lot of volatility in trade and inventories.
If you do that, the economy grew at about a 18 annualized rate in the first half of the year, down from about 25 last year.
So some moderation there, but not a lot.
We would argue that that probably isn't a tariff story.
We would have expected tariffs and immigration policies to have greater downward pressure on growth in the second half of the year.
But to your question, incoming data in the third quarter has been really strong and we're tracking growth somewhere around 3 right now.
So there's not a lot of evidence in hand at present that tariffs are putting significant downward pressure on growth.
So those growth numbers that you cite are on spending, which is normally the way we calculate things like GDP consumption, spending.
But the labor market, I mean, nonfarm payroll reports really have been quite weak.
How do you reconcile that intellectual tension?
On the one hand, spending holding up.
On the other hand, net job creation, pretty, pretty weak.
I think the way that we would reconcile it is when we look at the data –
For the non-financial corporate sector.
What appears to be clear is that non-labor costs have risen and tariffs would reside in that.
The data does show that what would be called unit non-labor costs, so the cost per unit of output attributable to everything other than labor.
That rose a lot.
What corporates apparently did was they reduced labor costs and they absorbed some of it in lower profitability.
What they didn't do was push price a lot.
We'll see how long this tension can go on.
It may be that corporates are in the early stages of passing through inflation, so we will see more inflation further out and a slowdown in spending.
Or it may be that corporates are deciding that they will bear most of the burden of the tariffs, and cost control and efficiencies will be the order of the day.
And maybe the Fed is right to be worried about downside risk to employment.
So I reconcile it that way.
I think corporates have absorbed most of the tariff shock to date.
And we're still in the early stages of seeing whether or not they will be able to pass along to consumers.
All right.
So then let's think about the Fed, the central bank.
Yesterday, I talked to Chetan about the Bank of Japan.
Their reflation is real.
Talked to Jens yesterday about the ECB, where inflation has come down.
So in those other developed market economies the prescriptions for monetary policy are pretty straightforward.
The Fed, on the other hand, they're in a bit of a bind in that regard.
What do you think the Fed is trying to achieve here?
How would you describe their strategy?
I would describe their strategy as a recalibration, which is, I think, technical monetary policy jargon, for where their policy stance is now is not correct to balance risks to the economy.
Earlier this year, the Fed thought that the primary risk was to persistent inflation.
Boy, the effective tariff rate was rising quickly, and that should pass through to inflation.
We should be worried about upside risk to inflation.
And then employment decelerated rapidly and has stayed low now for four consecutive months.
Yes, labor supply has come down, but there's also a lot of evidence that labor demand has come down.
So I think what the Fed is saying is the balance of risks have become more balanced.
They need to worry about inflation, but now they also need to worry about the labor market.
So having a restrictive policy stance in their mind doesn't make sense.
The Fed's not arguing we need to get below neutral, we need to get easy.
They're just saying we probably need to move in the direction of neutral.
That will allow us to respond better if inflation stays firm or the labor market weakens.
So a recalibration meaning You know we think two more rate cuts into year end get a little bit closer to neutral and that puts them in a better spot to respond to the evolving economic conditions.
All right.
That makes a lot of sense.
We can't end a conversation this year about the Fed though, without touching on the fact that the White House has been putting a lot of pressure on the Federal Reserve, trying to get Chair Powell and his committee to push interest rates substantially lower than where they are now.
You've noticed.
I have.
I've noticed from my understanding, a lot of people in markets have noticed as well.
There's been some turnover among policymakers.
We have a new member of the Board of Governors of the Fed.
This discussion about Federal Reserve independence, how do you think about it?
Is Chair Powell changing policy based on political pressure?
I don't think so.
I think there's enough evidence in the labor market data to support the Fed's shift in stance.
We have certainly highlighted immigration controls, what they would mean for the labor force and how that means even a slowing, growing economy could keep the unemployment rate low.
But it's also fair to say labor demand has come down.
If labor demand were still very strong, you might see job openings higher.
You might see vacancies higher.
You may even see faster wage growth.
So I think the Fed's right to look at the labor market and say, OK.
On the surface it looks like a no hire, no fire labor market.
We can live with that.
But there are some layoffs underneath.
There are signs of weakness.
Slack is getting created slowly.
So I think the Fed has solid ground to stand on in terms of shifting their view.
You're right that, looking forward into 2026, with the end of Powell's term as chair and likely turnover in other areas of the board, whether the Fed maintains a conventional reaction function or one that's perhaps more politically driven remains an open question and, I think, is a risk for investors.
I want to change things up a lot here.
Chetan, yesterday you and I talked about China.
We talked about Japan, two really big economies that I think are well known to investors.
Another economy in Asia that you cover is India.
For a long time, we have said India was going to be the fastest growing major economy in the world.
Do you still see it to be the case that India's got a really bright growth outlook?
And in the current circumstance, with tariffs going on, how do you think India is faring vis-a-vis US tariffs?
So, yes, Seth, we are still optimistic about India's growth outlook.
Having said that, you know, there are two issues that the economy has been going through.
Number one is that the domestic demand had slowed down because of previous tightening of fiscal and monetary policies.
And at the same time we have now seen this trade tensions, which will slow global trade, but also directly.
India will be affected by the fact that the US has imposed 50 tariff on close to 60 of India's exports to the US.
So both these issues are affecting the outlook in the near term.
We still don't have clarity on what happens on trade tensions.
But what we have seen is that the government has really worked quite hard to to get the economy going from the domestic demand perspective.
And so they have taken up three sets of policy actions.
They have reduced household income tax.
The central bank has cut interest rates because inflation has been in control.
And at the same time, they have now just recently announced reduction in goods and services tax, which is akin to like consumption tax.
And so these three policy actions together, we think, will drive domestic demand growth from the fourth quarter of this year itself.
It will still be not back up to strong growth levels.
And for that, we still need that solution to trade policy uncertainty.
But I think there will be a significant recovery coming up in the next few months.
All right.
Thanks for that, Chetan.
It's such an interesting story going on there in India.
Well, Michael, Chetan, thanks for joining me today in this conversation.
And to the listeners, thank you for listening.
If you enjoy this show, please leave us a review.
Wherever you listen and share thoughts on the market with a friend or a colleague today.
The preceding content is informational only and based on information available when created.
It is not an offer or solicitation, nor is it tax or legal advice.
It does not consider your financial circumstances and objectives and may not be suitable for you.
