Can you see out into 2027? What are the second and third round effects of all this inflation, these yields, and the central bank policy?

Well, in, in one direction.

Well, first of all, good morning, Paul.

Good morning, Tom.

Uh, thank you for that introduction.

Um, the second round effects on inflation are related to, as you've been discussing, gas, diesel.

Normally, oil shocks are relatively short-lived.

Nobody's calling for that, but would that be a problem for the US economy?

What stood out to you the most in the decision? And when it comes to inflation, how do you think this twenty-five basis point rate hike is actually going to affect the inflation outlook?

Yeah.

So certainly the decision was in line with expectations.

You know, obviously what we've learned in the very broad sense is that inflation isn't moving fast enough in the direction that, that the Fed wants.

So it's responding by tighter monetary policy.

And that does set up a very interesting question, which you just asked, which is, well, is it gonna work? Is this the right response to the inflation that we're seeing? So if you do go back and reread that Jackson Hole speech, there's not a lot in there about the drivers of inflation, what's causing higher inflation, but it's clear the only response to above target inflation from the point of view of the chair was tighter monetary policy.

So the, the Fed is in a, a bit of a pickle.

Is this a one and done, or do you think that when the Fed actually goes ahead and hikes rates after a long pause, they are thinking about delivering more than just one rate hike?

So where do you think that leaves us?

Yeah, I, I think first of all, he did provide information, as you said, a little bit about the framework.

Yes, it's, it's, it's an interest rate story, not a balance sheet story.

And we, I may look at inflation from a wide set of indicators, but 2%'s 2%.

So we did get at least some information there.

Where we're headed, I mean, I'll take a slightly contrarian view.

I, I, obviously the Fed's speaking hawkishly.

Yeah

So I'm curious, if we're not going to get forward guidance on monetary policy and what will happen at the next meeting, and we're also not going to get much forward guidance on the framework that the Fed is using to decide on what to do with short-term interest rates, what are we meant to think about the framework?

I think ultimately, of course, we're gonna need to know this, and this is what economists would refer to as the difference between forward guidance and the, quote, "reaction function." So the framework is really, you've got a set of tools, how do you intend to use them to achieve your objectives? And a conventional Fed would say, "Well, if interest rates are, are low and inflation's too high, then we should raise rates," right? So high inflation brings high interest rates.

Low inflation brings low interest rates, all else equal.

There's still the employment side of the mandate, of course.

And the market had that view, at least initially, right? As we were in the June, July period and Warsh was talking hawkishly The curve generally flattened.

Expectations for front-end yields moved higher, and inflation-fighting credibility maybe kept the back end stable or brought the back end down.

So you could argue the markets looked at Warsh as maybe bringing a conventional reaction function and a conventional framework.

How do you think about that?

Can we kinda start with that and talk about how you get or how you got to those very bullish AI CapEx numbers and the risks around that?

Well, first, Dustin, thank you for that kind introduction.

It's a pleasure to be on.

It's a little unusual in the sense that normally when we write down forecasts for GDP business spending consumption, you know, we're looking at the broad macro data.

But in this unusual environment, we're actually taking the lead on CapEx spending from our equity analysts.

So the forecast that we write down for CapEx spending in the AI era are very heavily dependent on what corporates are telling us they will spend around CapEx.

And the, the key or the trick from the U.S. economics perspective is then translating a corporate sector announcement based on, say, corporate sector accounting principles to GDP-based accounting.

How do you think about it? How should investors think about the inflation impact of all this?

So Mike, what's your assessment of the situation beyond that?

Our assessment of the July FOMC meeting is actually the case for hikes is not as persuasive now as it was in June.

And I think when, when we say that and when we come to the decision the Fed will stay on hold this week, we're basing it mainly on the data that has come in since the June FOMC meeting.

And two important pieces on that front are employment growth moderated.

So in the June meeting, the three-month average payroll gain was running at about a hundred and eighty-eight thousand per month, and I think it gave the sense that the labor market was really accelerating and there was downside risk to the unemployment rate.

The subsequent employment data changed that view.

Now it looks like there is much less of an acceleration in hiring, and momentum has slowed.

What do you think about press conferences going forward?

So what is the underlying story for inflation in the U.S., and what does it mean for the Fed?

So our view is that inflation will come down in the U.S.

So we think disinflation will be driven by some payback in energy prices, some payback from tariffs, which have pushed up goods prices over the last year, and some further diminishment in housing-related inflation, namely shelter.

So we think on a broad-based perspective, inflation has already peaked and will start moving lower, and we think we've seen evidence of this in recent inflation prints.

A risk to that, though, is from the demand side of the economy and AI-related inflation in two parts.

One, higher software prices, chipflation, so the pass-through of some of the AI pricing components.

Fortunately here, they're about less than one percent of the consumer basket.

And so I guess the question then remains, what would it take for the Fed to hike this year if inflation has come down like we've seen?

Tell me a little bit about where Morgan Stanley Research is thinking about hyperscaler CapEx, how big it is, and then for you, when you think about the US economy, just how big of a driver is it for what we're looking for in the US?

Yeah, we continue to revise higher our estimates for hyperscaler and AI-related CapEx in the US economy.

Uh, we, we were thinking a little over a trillion for twenty twenty-seven.

Now we're more like one point two, one point three trillion, maybe as high as one point four trillion in twenty twenty-eight.

So the level of hyperscaler spending continues to keep rising.

The growth rate and its effect on the economy is likely to slow, but as you noted, it's still a major driver of momentum in the US.

You would look at that headline number and think, "Wow, that's, you know, three and a half percent or so of GDP.

So isn't the growth story also broader than that as well domestically? So what's going on in terms of consumer spending in the US, and is there a broader CapEx story in the US as well?

Is that really manageable? And if it's not, what economic indicators would warn us, uh, if we're crossing into the danger zone?

So this is really the tricky part.

As, as you know, y- we have a new technology.

We have to model how it diffuses through the economy.

And I, I would say I, I think there's a, you know, there's an argument here that penetration rates and usage rates are very different than what economists think about diffusion, which is how the production process is reshaped because of this new technology.

And so most economists look at the internet and digital era and think it took twenty to twenty-five years to fully diffuse.

Mass penetration in maybe ten years, but full diffusion in more like twenty to twenty-five years.

How do these knock-on effects change the, uh, AI labor story?

So what are your thoughts before the press conference?

A lot of thoughts, actually, before the press conference.

I do think it's basically a foregone conclusion that the Fed will be changing its easing bias in favor of more neutral language.

Seems clear the committee wants to do that, probably wanted to do that at the last meeting, and it does fit, I think, Warsh's preference for less communication, less guidance from, from the Fed.

So I, I do think that's largely a foregone conclusion, although obviously we need to see whether that happens and whether there are dissents.

I think, as you noted, the forecasts will be important, but I think what's really important from my perspective, more than the modal outlook or the baseline that participants have, is their assessment of the balance of risks around the dual mandate.

And I say that because obviously a year ago, the Fed eased policy when it felt that there were downside risks to the labor market that outweighed upside risk to inflation.

How are you thinking about the back and forth between Warsh and the reporters that are asking questions? Are there certain questions that you would anticipate him getting asked, and, and how do you think he might respond?

What catches your eye looking at this report?

Well, there's some hints of second-round effects of higher energy prices on core.

So those airline numbers, the food at home numbers, um, there's also kind of spillage into headline through food, 'cause a lot of food prices are related to transportation costs, right? So the concern here, the assumption here, I think, from the Fed's point of view, and ours, is that oil prices tend to give you headline effects, but not core effects.

And there's, at least at the moment, given the magnitude of the rise in energy prices, some hints of those second-round effects in core.

We need to see if those persist.

Um, so to me, that's what catches my eyes.

The four-tenth on core was not a surprise to us.

Mike, is there some stickiness to all of this?

But how much concern do you have when you look at some of those negative factors?

Yeah, so this is where I'm saying I think the report was mixed overall.

So I think the headline employment number, a very solid number, but yes, there are other areas of softness in there.

It's certainly clear that inflation will be eating into purchasing power over, over the next few months, whether you look at that on an average hourly earnings basis or kind of a payroll proxy that takes into account, uh, additional hours worked.

And so participation is, is a little soft.

The employment to population ratio has been trending down.

But I, I think what we are looking at is a lot of that we think is driven by demographics, just the aging of the population.

Do you have any data or take on that?

What are you seeing in the data about those more structural trends?

I think what we're seeing in the data right now is evidence that oil is not disrupting the positive structural trends in the US.

I think AI CapEx spending is largely orthogonal to what we've seen so far.

It doesn't mean that we can't see negative effects, particularly if oil rises to, say, a hundred and fifty dollars a barrel or more, where we think you might see significant demand destruction.

But with oil where it is right now, I would say the evidence is it will probably weigh on consumption.

Gasoline prices are higher.

It's going to squeeze lower and middle income households that way.

So how should we think about that?

Can you walk us through that thinking and also where the debate is with clients?

Sure.

So I, th- the evidence in the data, this goes back, let's call it several decades now, that oil price shocks in the U.S. do tend to push headline inflation higher by definition, but they have very limited second-round effects on core inflation.

And the higher oil prices go, the more likely it is that you get some demand destruction, some weakness in spending, maybe even some weakness in hiring.

So there is a bit of a non-linearity here.

In our baseline, where oil is elevated, but let's say not excessively high, I can completely buy the argument that the Fed is on hold, assessing the evolution of the data and wondering, are there second-round effects on inflation, or is this weakening demand? So Seth, our view is that the Fed is right in its assessment that tariff pass-through to goods prices will eventually moderate, and that the oil price effect on headline will diminish, and later this year, core inflation moderates.

That should open the door for the Fed to cut two times this year.

I agree with you.

What do you make of this blockade? What does it actually mean for investors?

Well, you're right that I, I think investors, I don't want to use the word complacent because certainly they're not complacent, but I, I think they're optimistic in the sense that the interpretation of markets is that the day-to-day events here are probably still what they would call in a de-escalation camp, meaning it doesn't appear like things are escalating in a way.

So oil is staying around this hundred dollar per barrel level.

That's certainly a lot higher than it was going into it.

Um, but the view from the market is hundred dollar oil may not be great, but it's something the US economy can withstand and the global economy can withstand as well.

So it's, it's, inflation's rising.

Yes, that will crimp purchasing power.

Yeah.

There are other factors clearly involved besides AI.

I'd say when we look at the labor market today, do we find evidence that AI is disrupt- disrupting it? Yes.

Is it showing job destruction in a way that would push the unemployment rate higher? That's a lot harder to find, right? What we do in one of these reports is break down occupations by AI exposure.

Now, the unemployment rate across all those occupations has drifted higher over the past 18 to 24 months, but occupations have different cyclical sensitivities, right? So once you wash that through, the cyclical, you control for cyclicality, we do find some evidence that occupations that are highly exposed to AI are seeing higher unemployment rates.

But you really have to drill down, and we find that the overall magnitude is maybe about 0.1 of a percent on the unemployment rate.

So it's, the evidence is micro.

You're not really seeing it broad-based.

Mm-hmm.

Is there anything about the press conference that struck you as being interesting?

Yeah, I, I think the almost near singular focus on inflation.

So after the meeting was over and the press conference was done, we did a little deep dive into the transcript, 'cause that's what we do as economists who, who follow the Fed.

And there were about eighteen questions on inflation or prices.

There were only five on labor markets.

And if you do kind of a, a word count on inflation and oil-related terms, that would have popped about two hundred answers.

If you looked at labor market terms, you would have gotten about forty.

What's your view on the labor market going into the end of the year?

Was there anything else we found out, anything that is perhaps unusual, interesting, or maybe changes the situation in any way?

Wouldn't say that there was anything unusual because the, the standard playbook for the Federal Reserve in, in a situation of getting an oil price shock is to be predisposed to want to look through any increase in headline inflation.

Um, but so I think what I heard a lot of, though, and you, you noted it, the repetition of uncertainty, uncertainty, uncertainty.

Writing down a forecast at this point in time, very difficult.

Powell said, "Take our forecast with a grain of salt." Um, and he said, "This is one of those moments where probably not submitting a forecast would have been, uh, easier than, than submitting one." And so I think, yes, the, the Fed is saying, "Okay, headline inflation will be rising," but that's only part of the story.

This is another supply shock that puts upward pressure on both inflation and the unemployment rate.

So that leaves our goals in tension.

[laughs]

Where do you fall on that? Do you think that that's a legitimate argument, that you should proactively cut rates at a time of structural change?

I think they've done some of that.

I, I think it's, it's easy to see that they've, they've done that over the last two years.

The question is kind of where do, where does that process end? I, I think the June/July period for the next rate cut is about right, and this, this data today says rate cuts, if and when they come, will be based on inflation.

So when does the committee get evidence that inflation is decelerating, that tariffs are a transitory upward push on, on inflation? Sometime around the middle of the year is probably where that evidence comes through.

But to your question, I think they have done some cutting preemptively to support the labor market and prevent some downside risk.

We'll see ultimately if that was enough.

Is that right?

H- what was your impression of, of his response, and what were the takeaways from that part of the press conference?

Well, clearly, he's been reluctant to, say, preannounce what he may do when his term as chair ends in May, but his term as a governor extends into twenty twenty-eight, so he has options.

He could leave.

Normally, that's what, what happens, but he could also stay, and he's never really made his intentions clear on that part, I think, for maybe personal or professional reasons, but he has his own-- he has his own reasons, and, and that's fine.

And I do think the recent subpoena by the DOJ has changed the calculus in that.

At least my own view is that it makes it more likely that he stays around.

It may be easier for him to act in response to that subpoena by being on staff.

I'm curious as to what you think that means for Fed policy later this year, if anything, and what it might mean more medium term.

Pick who you think is responsible for the, but it, you know, so I'm curious from your point of view, Michael, is this something worrisome? Does it raise on the margin the risk of important inflation? Because I'm pretty sure in the literature, when you use tariffs, your currency is supposed to appreciate, not depreciate, right? So if we impose tariffs, which raised import prices, and then the currency falls 10%, which further raises import prices, at some point, aren't we gonna have an inflation problem?

Well, you do risk it.

What's nice about the U.S. in that regard is the trade channel is pretty small.

Their imports are not a significant contributor to inflation.

So, I mean, if Barry's right and there's a secular move in the dollar, maybe you'll get some persistent upward pressure on import prices.

But historically, it would be very unusual for import prices to drive inflation in the U.S. And I'd just say one other, you know, What do I always have in the back of my mind about dollar weakness? It's the net international investment position of the U.S.

The rest of the world holds $62 trillion in U.S. dollar liabilities.

Michael, is that kind of what you're talking about? Or are you referring more to the fact that there's so many people who need dollar exposure?

Walk us through what investors need to understand about consumer spending in the U.S., what's driving it, what's gonna hold it up, and where are the risks.

I think the primary thing to remember here is that the upper-income consumer drives about forty percent or more of total spending.

So there can be higher inflation that eats into real labor market income growth.

There can be inflation dispersion, which hits lower-income households more than upper-income households.

We can have tariffs that get applied to goods, and lower- and middle-income households buy goods more than upper-income households.

But when asset markets continue to appreciate, when home prices hold onto their prior gains, sometimes that doesn't matter in the aggregate statistics because that upper-income household keeps spending.

I do think that's a lot of what happened in, in twenty twenty-five.

First, would you agree with that statement that CapEx spending last year was characterized by AI CapEx spending? Second, should we feel confident that that underlying sort of momentum in CapEx spending should continue for this year? And then third, what's it gonna take for there to be a broadening out, maybe like what you said about consumers, but a broadening out of investment spending so that it's not just the AI story that's driving CapEx?

As we head into twenty twenty-six, what are we thinking about? Are we going into a more stable expansion? Is this just a different phase with the same amount of volatility? What do you think's gonna be happening in the US as a baseline outlook? And then if we're gonna be wrong, which direction would we be wrong?

Yeah, Seth, we, we took the view that we would have more policy certainty.

Recent weeks have maybe suggested we're incorrect on that front, but I, I still believe that when it comes to deregulation, immigration policy, and fiscal policy, we have much more clarity there than we did a year ago.

So I think it's another year of modest growth, above-trend growth.

We're, we're forecasting something around two-point-four percent for twenty twenty-six.

That's about where we finished, uh, twenty twenty-five.

I think what's key for markets and the outlook overall will be whether inflation comes down.

So if that's what we just came off of, why isn't it the case that we'd see even stronger growth, maybe even a re-acceleration of growth in twenty twenty-six?

Can you just flesh out what you do expect to see in the labor market in the months to come?

Yeah, so, uh, there's certainly a tension in the data.

The activity data's solid, AI-related spending, you know, off the charts, upper income households doing, doing well.

You were emphasizing that in the previous segment.

But the labor market data looks different.

So our, our view is we're maybe a third of the way through the process of firms passing tariffs onto the consumer.

So that's gonna extend at least into the first quarter of next year.

How do you square whether they're potentially, uh, adding fuel to the fire?

Right, or the shipping data, which I think you guys are also following closely, like what's happening with container ships and imports and freight volumes.

That's right, and that's our narrative at the moment is we are possibly in a race against time, that given, as I said, where tariff levels are and it makes so much trade just not viable, what we are seeing in the very high frequency shipping data is a collapse in trade volumes.

Now, that doesn't mean the world is ending today because those orders can come back on.

So maybe you delay a month and then they come out in the next month.

But yes, the high frequency shipping data suggest that the Trans-Pacific shipping routes have really taken a step back.

So, you know, we probably have a window of, let's say, 60 to 90 days where we might hope to get some de-escalation in trade policy in order to allow for a resumption of trade flows.

But that's the tension as I see it right now.

And then I don't know if we're expecting a rebound in the quarters to come.