The Fed Will Tighten "As Far As They Can" Into 2023 | Joseph Wang & George Goncalves

Episode Summary

Executive Summary: George Goncalves and Joseph Wang argued that 2023 would likely move from an inflation fight to a growth and credit slowdown, with the Fed pushing rates to around 5% and holding them high longer than markets expect. Both saw structural labor shortages, sticky inflation risk, and a recession or stall-speed economy as the key backdrop, while noting QT, yield-curve dynamics, and financial conditions would shape the timing of any eventual pivot.

Main Topics: 2023 macro outlook: inflation first, growth later (Priority: 5/5): Both guests expect inflation to keep easing but remain uncomfortable, while economic growth weakens materially by mid-2023, increasing recession odds and shifting the market focus from price stability to downside growth risk. Fed hiking path and terminal rate (Priority: 5/5): The discussion centered on the Fed’s aggressive tightening cycle, with both speakers expecting policy rates to peak near 5% and remain restrictive longer than markets currently price. Why the Fed can hike despite high debt (Priority: 4/5): They argued that debt burdens are less binding than many expected because much of it is fixed-rate and long duration, so higher rates affect new borrowing and financial conditions more than existing liabilities. Structural inflation and labor shortages (Priority: 5/5): Wang emphasized that recession could occur alongside elevated prices because labor and energy are structural supply constraints, especially in the U.S. and Europe. Financial conditions, wealth effect, and market reaction (Priority: 4/5): They explored how equities, credit spreads, the dollar, and bonds transmit policy into the real economy, and how the Fed uses expectations management to tighten conditions even before cuts or hikes fully hit activity. Yield curve inversion and recession signaling (Priority: 4/5): Goncalves argued that the curve’s inversion matters less than the subsequent re-steepening, which would signal recession and likely force the Fed toward cuts. Quantitative tightening and balance sheet runoff (Priority: 3/5): The guests discussed QT as a gradual, non-sale runoff process that is constrained by mortgage prepayments and offset by demand for safe assets amid recession fears.

Key Arguments: The Fed is likely to take policy rates to around 5% and keep them there through much of 2023, because it remains committed to restoring price stability even as growth weakens. The market has been too quick to price in cuts; the Fed wants to shape expectations so that financial conditions stay tight enough to slow demand and cool inflation. A recession may not look like the demand-driven recessions of the past; it could be a supply-constrained downturn where prices stay relatively high because labor and energy inputs are structurally scarce. High debt levels did not stop hiking because a large share of U.S. debt is fixed-rate and long-duration, especially mortgages and corporate debt issued at low coupons during the pandemic era. QT is less disruptive than feared because the system still has abundant liquidity, but it will continue until recession or market stress forces a change. The inverted yield curve is not the final warning; the more important signal is when it begins to steepen again, which historically coincides with recession and eventual Fed easing. Financial conditions matter through wealth effects, credit spreads, housing, and the dollar; if equities and bonds fall again, that could finally deliver the tightening the Fed is aiming for.

Data Points: Fed hikes in 2022: 425 basis points - George described the pace of Fed tightening by year-end 2022 as exceptionally aggressive. Current fed funds rate at time of discussion: 4.5% - The host referenced that rates sat at about 4.5% in December 2022. Expected terminal rate: around 5% - Both guests said the Fed would likely push policy to roughly five percent. Probability of recession: 75% - Goncalves said his recession conviction was about 75%, the highest he had ever had. Fed SEP 2023 GDP forecast: 0.5% - Goncalves noted the Fed’s 2023 growth outlook was near stall speed. Fed projections above 5%: 17 of 19 participants - Powell noted most dots in the December SEP showed rates at 5% or higher in 2023. Workforce shortfall vs pre-pandemic projections: about 3.5 million - Wang cited Fed demographic work showing labor force participation remains far below pre-pandemic projections. QT cap: $95 billion per month - The Fed’s stated maximum monthly runoff pace for Treasuries and MBS was discussed. Fed balance sheet runoff target: at least $2 trillion - Goncalves said the balance sheet should shrink by at least this amount to remove excess liquidity. Excess reserves in system: about $3.5 trillion - Goncalves argued QT was not disruptive because reserves remained very abundant. Reverse repo facility balance: about $2 trillion - Used as evidence of lingering liquidity in the system. Corporate interest coverage ratio: highest in 20 years - Goncalves cited Fed financial stability reporting to show corporations could service debt easily. Treasury bond drawdown: close to 30% - The host referenced losses in long-duration Treasuries as part of 2022 wealth destruction. Wealth loss from equities: $8 to $10 trillion - Goncalves estimated the stock market’s drawdown in wealth during 2022. Inflation move to target under normal monthly readings: by June 2023 - Goncalves’ CPI scenario suggested that if monthly inflation normalized, headline inflation could approach target by mid-2023. Inflation base-effect timeline: until October 2023 - The host noted that even with 0% monthly inflation, year-over-year CPI would not drop to 0% until then, illustrating base effects. 10-year Treasury target: above 4% by end-2022 - The host noted Wang had earlier predicted this accurately when markets saw it as a tail risk. Potential 10-year Treasury level in 2023: a 5-handle - Wang said long rates could continue trending higher and might reach 5% sometime next year. Mortgage prepayment impact on QT: lower than hoped - Wang explained mortgage QT would fall short of the cap because higher mortgage rates suppress refinancing and prepayments.

Pivotal Quotes: "“team transitory is defeated”" — Joseph Wang: Wang summarized his view that inflation is proving persistent and the old inflation narrative has failed. "“price stability or bust”" — George Goncalves: Goncalves described the Fed’s determination to keep tightening until inflation is clearly controlled. "“This is not a pivot”" — Joseph Wang (describing Lagarde/ECB): Used to characterize the ECB’s message that rate hikes and QT would continue despite slower step sizes.

Implications: Listeners should expect a restrictive-rate environment, more downside for risk assets, and growing recession risk in 2023. The key watchpoints are labor market softening, yield-curve re-steepening, and whether inflation cools enough for the Fed to pause without quickly reversing.