Morgan Stanley Chief Global Economist Seth Carpenter joins Yahoo Finance Live to discuss the global economy, volatility, supply chain issues, recessionary risks, and the outlook for central banks amid inflationary pressures.

Video Transcript

- All right, the Federal Reserve's new interest rate hiking cycle is the first one since the 1970s where the aim is to lower inflation rather than prevent it from rising, points out our next guest, and that could have major implications on the path of the US economy. Seth Carpenter is Morgan Stanley's chief economist. Seth always great to get some time with you. So you went back and looked at past hiking cycles. What did you learn about what the Fed may do this time around?

SETH CARPENTER: What I think comes out very clearly is that they're in a very challenging situation. And I have a lot of sympathy for the bind that they're in. So if we think about recent cycles that are comparable, I think about 2018, 2019, the Fed was raising interest rates and running off its balance sheet. That should sound very familiar. But at the end of 2018, risk markets started to crack and the Fed reversed course-- reversed course really quickly.

It sounds a lot like the word that Chair Powell been using recently, nimble. I had also been pointing clients to 1994 and 1995, where the Fed hike got more aggressive, hiked faster, and then paused, eventually reversed course, so again, trying to read the economy as it's evolving.

But as you point out, the key difference now between those two episodes is they are trying to pull inflation down. They're not trying to keep it from rising. And so what that means is they're trying to slow the US economy. They're trying to slow growth so much that inflation pressures come down but not so much that they tip us over into recession. And that's tricky.

- It is tricky, especially when the part that they do not control, the supply side of the equation, is-- the issues there are much more persistent than most, including those in the Fed, had anticipated, in part because of Russia's invasion of Ukraine but also just in part of what we're seeing globally, that there's still a lot of supply chain crimping. So how do those two things collide, if you will, as we see the Fed start to raise rates?

SETH CARPENTER: They collide very uncomfortably, unfortunately for the Fed. I completely agree with you that the Fed does not have control over the supply side of things. And we know that a chunk of the inflation that we have seen over the past year is in core goods inflation, where a massive surge in demand met this very sclerotic global supply chain, and prices just soared.

So they can't control the supply side of things, but they can influence the demand side of things. And that's exactly what they're trying to do. They're trying to bring that demand back down, hopefully within the bounds of what the supply side can handle.

Very, very tricky, especially because I suspect that over the course of the rest of this year, we will see further healing in the supply chains barring further disruptions. But that's a forecast not a given fact because, of course, now we know Shanghai is facing another COVID wave, Shenzhen is facing a COVID wave. The supply chain is still at risk. So what they're trying to do is slow demand because they know they can't control supply directly.

- Seth, in light of these looming interest rate hikes, how severe is the economic slowdown going to be in the US?

SETH CARPENTER: Well, I think the first point is it has to be very, very noticeable. If you think about what the Fed itself thinks is the long-run sustainable growth rate of the economy, they think that rate of growth is below 2%. And so if you take a growth rate in the economy that's above 5% or 6%, and you're going to try to bring it down to below 2%, that 4-plus percentage point deceleration is just a massive, massive deceleration to happen, even if it happens over the course of two years or so. So I think no two ways about it, the slowing in the economy has to be dramatic.

Now, the good news is some of that's going to happen organically. We had a lot of strength last year because of all of the fiscal stimulus. We're not going to see anything like that fiscal stimulus this year or next year. A lot of that strong growth came because we had massively accommodative monetary policy, and the Fed has already taken its first steps to removing that monetary policy accommodation. So we will see slowing. The question is, how do you get it to slow just enough? And how do you keep it from slowing too much? That's the challenge.

- And Seth, there are two-- I hesitate to ask you to comment on your colleague at the other banks calls directly, but we have started to get recession calls, right? And I mentioned Matt Luzzetti over at Deutsche Bank talking about a recession perhaps next year. Jan Hatzius this morning from Goldman is saying we could see the Fed having to raise rates to as high as 4%. I'm just curious how you're thinking about these two different issues, right now.

SETH CARPENTER: I'm getting more uncomfortable by the day, which is one of the reasons why we always have a baseline forecast, but then we also think about alternate scenarios, because as the old saying goes, forecasting is hard, especially about the future. I think a recession early next year is a very real risk. It's a scenario we need to contemplate. I do not think it's the baseline outlook.

But what would be the components that would make that kind of scenario come around? I think one thing that sticks out to me is the Russian invasion of Ukraine has clearly created a global shock wave that is adverse for growth and has boosted inflation. So there's no two ways about that. By itself, where it stands now, I think it's unlikely to cause the US to fall into recession.

However, we now are having more and more headlines over recent days about possibly cutting off coal going from Russia to Europe. If we have a complete cutoff in energy going from Russia to the Euro area, that by itself could tip the Euro area into recession. And the US is not going to come out unscathed in that circumstance.

Now, probably not enough to put the US in recession all by itself. But then when you layer on the fact that the Fed is looking at what is right now objectively a very strong real economy, and they're getting bulled up in terms of how much hiking they're going to be doing and how aggressively they're going to be running off the balance sheet, as we heard on Wednesday this week, if the timing ends up poorly, where the Fed keeps getting more confidence about the strength, and as a result tightens aggressively and front loads things, and yet subsequently, we do see Europe fall into recession, I think that combination of facts is what really poses a risk for the US sort of slumping at the beginning of next year.

- Seth Carpenter, Morgan Stanley's chief economist, always great to get some time with you. Have a good weekend. We'll talk to you soon.

SETH CARPENTER: Thank you. Bye bye.