Economy is looking strong? It is. Would you say it's strengthening? That's a different kind of assessment.
Yeah. I think the broad economy is strong. There are obviously pockets of weakness. Housing is weak, as you all have discussed many times, and anything related to AI is growing. Overall, the economy is growing, and it keeps surprising me how resilient it has been in the face of tariffs and the conflict in Iran.
And in the face of high yields as well, which raises the question whether your policy effort is going to work, is going to be effective. Do you think it will be, and why? What's the channel for that effectiveness?
Well, it will be effective. I mean, we will do what we need to do to get inflation back down to our target. Now, the question is ultimately how high. Of course, what you're asking is how high the rates have to go. I don't know the answer to that. You know, you think about — you were both just talking about massive demand for investment capital. I think about that in the context of what does it do to the neutral rate. The neutral rate is set by the balance of savings and investment in the economy. And if there's massive demand for investment capital, that has to come from savings. Ultimately, that is a higher clearing price for that capital, and that means rates go higher.
One of the questions that arises out of that, though, is what time frame are you looking at for neutral? Because we're having this enormous spend on AI, which is boosting this... the neutral rate. Everyone kind of agrees. But how long does that last, and can you get yourself offside by moving too much?
Yeah. It's a great question. So the SEP has this long-run dot, which is a theoretical dot, a theoretical interest rate that balances all of this out when all the shocks have passed the economy. It's like this nirvana state that we'll never actually experience, sometime in the future. I also have a concept of a near-term neutral, which is what you're getting at, Mike. Then the question is, how long does this AI boom continue? And are the returns to this investment — do they materialize the way that the investors expect? If AI proves to be as productive as people hope it will be, then this investment cycle could go on for a long time. If it ends up being not as productive as the investors are hoping, then maybe it won't go on for as long. So I just don't know the answer to that right now.
Now, for a long time, the Fed was driving what the yield curve looked like because you were buying bonds. You're not doing that anymore. Are you getting the kind of cleaner signal that Kevin Moore says he wants in terms of what the market thinks prices should be?
Well, I think a place where I'm focusing right now — the long end is obviously getting a lot of attention. There's a big gap between the two-year and the short rates. So, for example, my staff and I computed an implied two-year yield from the SEP dots. If you take the SEP median, you can calculate an implied two-year yield. This is the biggest gap between the actual two-year yield and the implied two-year yield from the SEP. The actual two years were around 4.88 or $4.90. My implied two-year yield from the SEP is around a little above four. That's a very, very large gap. There have been other times where there have been gaps before. So I actually think markets are pretty good. When they want to send a signal, they will send a signal regardless of what the Fed is telling them. If you go back in time, post the financial crisis, the Fed — through the dot plot — kept forecasting that they were going to raise rates, and the market said, 'No, you're wrong.' Turned out the markets were more right than the Fed was. So, you know, there's a little bit of looking in the mirror. The markets are looking at us, we're looking at the markets. But I also have a lot of confidence: when markets have a view, they're not shy about expressing those views.
What is your view of what the market is telling you now? And I ask because I was speaking with one of your colleagues yesterday who told me that they don't think that it's inflation in the sense that people don't trust the Fed anymore — that your move last month basically gave people confidence that the Fed is going to fight inflation. So it's a combination of a lot of other things.
I think that's right, but there is, you know, this magical thing we call the term premium, which is the residual of all the stuff we don't really... can't really explain with any kind of confidence. One of those elements might be this thing called an inflation risk premium. So markets say, 'Yes, we believe the Fed. You're going to keep inflation at 2% over the next ten years, but we want a little extra compensation just in case we're wrong.'
All right. That's like... if it's an inflation risk premium, that's like the cousin of inflation expectations. That doesn't give me much comfort if that's why investors are seeing... Because there's a term premium embedded in the nominal curve, but there's a term premium embedded in the real curve. And to the extent that it's investors wanting compensation for potential inflation mistakes in the future, that's something that we need to pay attention to.
There's been a lot of concerns about the efficacy of Fed policy given how much debt is outstanding and given that a lot of the areas that are driving inflation are kind of less sensitive to rates. I'm talking about AI spending. Do you not like, but feel some comfort when something like Aura is taken off the market in terms of an IPO, when the capital markets activity starts to slow down because of concerns that maybe we're mispricing rates?
I think... I mean, I do look at capital markets activity as one imperfect signal of the stance of monetary policy. If deals are getting done — you know, record... they're oversubscribed and oversubscribed and markets are wide open — that makes me question, is policy as tight as I previously thought it was? And so I'm not celebrating anybody's IPO being shelved. But I think to the extent that there is some tentativeness creeping into broad financial markets, that indicates, okay, this rate environment may be having some effect.
And ultimately, we're seeing it have effect. I mean, we're seeing that in terms of market performance of the more consumer, the more rate-sensitive sides of the markets. Is the sort of one channel left that the Fed has the wealth channel? The idea that markets kind of can't be at this level and generating that kind of spending among the wealthiest of individuals to bring inflation down — that that's sort of the tool ultimately the Fed really has.
That is a tool. But I think on the margin, when yields go up... So, you know, yields have gone up for a lot of reasons. You all have been discussing it. Part of it is Fed policy. Part of it is credibility of the Fed. Part of it is the growth environment. You know, that all does price into even data centers. How are they able to fund themselves, at what rates? How many more data centers are going to get built? How much are they going to invest? All of this stuff on the margin does have an effect on these investment decisions that are taking place.
