Dialogue with the founder of 42 Macro: The Fed's "boiling a frog slowly" and the K-shaped economy

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Source: "Anthony Pompliano"

Compiled by: Felix, PANews

Darius Dale, founder and CEO of investment research firm 42 Macro, recently appeared on the "Anthony Pompliano" podcast. During the interview, the two discussed the impact of Kevin Warsh as Fed Chair on monetary policy, the consumption dilemma K-shaped economics brings to Americans, and why every investor must participate in asset markets to survive financial repression.

PANews has compiled the highlights of the interview.

Host: What did you think of Fed Chair Kevin Warsh's first press conference? How is he different from his predecessors?

Darius: Regarding your question, first, we believe Kevin Warsh is a "dove in hawk's clothing."

Host: What does that mean?

Darius: It means he ultimately wants looser monetary policy. Maybe it's because of his relationship with the current administration, but I doubt it. I think he genuinely believes AI has massive disinflationary potential. However, he has to put on hawkish armor to create space and a landing zone for the Fed. So we think over the next two to three quarters, the Fed will either have to tighten monetary policy, or use its communication tools to signal that tightening might come, or both, to create room for subsequent easing.

Host: Why do you think tighter monetary policy is needed? If you look at inflation expectations over the past few weeks, they seem to be falling again. Do you think that changes the Fed's need?

Darius: Good question. On inflation expectations, we've done extensive statistical analysis on the drivers of inflation, studying which indicators lead or lag inflation. The results show almost no statistical causal relationship between inflation expectations and actual future inflation outcomes. What really meaningfully impacts future inflation outcomes are monetary drivers of inflation, like the rate of change in money supply and the expansion or contraction of money velocity—these are very important. There are also policy drivers, most notably deficit spending and Fed debt monetization. Additionally, if there's substantial banking deregulation that drives a credit growth cycle, that would also be a leading indicator of inflation. Finally, there are "output gap" drivers (which I don't entirely endorse): when economic growth is above potential, or when unemployment is below the NAIRU, these are indicators that lead inflation. While no single indicator perfectly predicts inflation, taken together, they are currently sending a very strong hawkish signal to policymakers and markets: the Fed must act.

Host: So the data suggests inflation is either rising or peaking at a very uncomfortable high, so the Fed has to act.

Darius: Exactly, the signals are saying two things: one, inflation is moving higher; two, inflation may be peaking, but peaking at a very uncomfortable level and plateauing there. The current data shows we are certainly not on a credible disinflation path, and short-term achievement of the Fed's 2% inflation target is certainly not happening. Let's break down these inflation drivers.

From the output gap perspective, the current output gap is about 110 basis points. Typically, at around 200 basis points, the Fed has to tighten until a recession hits, so we're a bit over halfway there. We also see unemployment already below NAIRU, currently about 20 basis points below. In the context of AI, I don't know if we'll push it 100 basis points below NAIRU, but typically at that point, the Fed has to tighten the business cycle into a downturn. On the policy driver side, the annualized change in Fed deficit spending is currently about 8%, well above the historical trend line. The annualized growth rate of Fed debt monetization is also about 7% to 8%, also well above the historical trend. Bank credit is growing about 7% year-over-year, again far above the historical trend. The growth rates of these statistics are completely inconsistent with a 2% inflation environment. Additionally, based on our business cycle model validation, there's about an 18-month lag between policy rate changes and economic outcomes, meaning the lagged effects of the previous 175 basis points of rate cuts are now transmitting into the economy.

Host: Do you think the Fed has abandoned the 2% target?

Darius: Definitely. You and I have discussed this for at least five or six years. The Fed doesn't truly want 2% inflation, but they have to signal to the bond market that they want 2%, or they'll lose control of the long end of the yield curve, which would be counterproductive to their dual mandate of "maximum employment and price stability." 42 Macro has been telling the global investor community for years that we are all "frogs being boiled alive" in a pot of financial repression and currency debasement. In my view, Kevin Warsh is a very competent Fed chair for executing this job. The Fed's job is to boil us alive without letting us jump out of the pot. If we jump out, we create financial stability issues, and the real economy and asset markets face worse problems than high inflation, so it's the lesser of two evils.

Host: Even though inflation is currently high, there's no clear signal it will accelerate sharply from here. However, the latest PCE data surprised many, leading to market sell-offs and growing concerns. Different indicators are sending different messages, confusing many people. Is this why the Fed chooses to "wait and see" (neither raise nor cut rates), pushing the problem forward? Letting this complexity sort itself out and making decisions only after seeing a clearer picture?

Darius: Exactly, that hits the core of "complexity theory." I've been doing this for nearly twenty years, trying to build various models. If there were a true "Occam's razor" method that could predict every inflation or nonfarm payroll data point to two decimal places, we'd have cracked it long ago. Since we can build AI, statistically predicting nonfarm payrolls shouldn't be hard, but the problem is the huge variance and standard deviation in these frequently revised time series data. So when facing financial markets and macroeconomic models, you must adopt a "mosaic perspective." It's never an isolated data point, but like a school of fish swimming together or a flock of birds changing formations in the sky—the interweaving and resonance of all data points.

Host: Vivid analogy, "school of fish" and "flock of birds."

Darius: Indeed. Currently, this "school of fish" is signaling to the Fed and financial markets: "Stop deluding yourselves into thinking current policy is restrictive." I think the Fed has received this signal, as confirmed by the latest Summary of Economic Projections and dot plot. And we think the next step (not yet market consensus) is that the Fed may have to take more substantial tightening measures, or significantly raise forward guidance via the dot plot, or even make major changes to its balance sheet. Because we know Kevin Warsh doesn't like verbose verbal intervention.

Host: What about energy prices? Oil prices spiked before but have recently fallen, even dropping below $70 a barrel in the last few days. If energy prices stay moderate or fall further, would that ease inflationary pressures and benefit U.S. consumers?

Darius: Definitely a positive. We saw that modest resilience in today's PCE report. Real personal consumption expenditures showed a slight positive pulse, with an annualized growth rate of 2.1%, slightly below the 2.5% historical trend line, but still present. Note that this consumption occurred against a backdrop where real disposable personal income fell about 1.5% on a monthly annualized basis, well below trend. With income contracting significantly, consumption only slightly below trend shows the incredible resilience of U.S. consumers. This is also why I was the first to argue in the summer of 2022, when everyone was shouting "recession," that we were resilient. Remember, in the fall of 2021 on your show, I said that in the next 12 months everyone would start discussing a word no one was using: "R" (Recession). By fall 2022, I said everyone should shut up about recession because the economy was extremely resilient, and they were focusing on the wrong "R" word. All current data supports our theme of "resilient U.S. economy," giving the Fed the confidence and room to tighten.

Host: Now asset prices are soaring again, U.S. consumers seem resilient, but everyone is complaining that everything is unaffordable. My view is that all three are true simultaneously. The cost of living is indeed unbearably high due to the price surge over the past five to six years. But we also live in a society of extreme consumption and one-upmanship: Knicks going to the Finals? Buy a ticket. Someone on Instagram bought something new? I need to buy two. A travel destination is cool? I need to go take a photo. Has this become the norm of our consumerism?

Darius: It's been the norm since we proposed the economic resilience theme in September 2022. Tell me, what "median" or "average" statistical indicator can accurately describe and formulate policy, or discipline your four children?

Host: Of course not, each child is completely different.

Darius: Exactly, same with macroeconomics. While aggregate statistics are useful for predicting financial market and policy reactions, these aggregate statistics are actually not homogeneous at all. Once you break them down, they are very heterogeneous. In our reports to global investors, we highlight the "K-shaped economy" characterized by two dimensions.

At the bottom of the K-shape, the 90+ day severe delinquency rates for credit cards, auto loans, and student loans have now matched or even exceeded the peaks of the 2008 Global Financial Crisis and the Great Depression. Amidst the macro boom of U.S. stocks hitting new highs, nominal economic growth far exceeding trend lines, and corporate profits at record highs, the delinquency rates at the bottom are at crisis-level severity, indicating the dire situation there.

Meanwhile, those at the top of the K-shape, frankly, are making a killing. The core driver stems from the "West Village-Montauk effect" I shared on your show before. The core of this effect is that when you have very high savings, you don't need to save much from current income. So data shows extremely low savings rates but extremely high consumption.

How did I come to this conclusion? Over the past ten to twenty years, I've done field research in Montauk and the West Village. I noticed that in exclusive, hard-to-get-into places, the biggest spenders weren't necessarily people like you and me with graying or balding hair, but those in their twenties whose parents are wealthy. I don't mean this pejoratively; it's because they don't need to save for retirement, for a rainy day, or to support their parents. So they can spend a higher proportion of their income monthly on consumption because they have no savings pressure.

Applying this personal experience to macroeconomics, we see that the cash holdings on U.S. household balance sheets (checkable deposits plus money market fund exposure) have grown from $3.5 trillion pre-pandemic to nearly $12 trillion, an increase of about $8 trillion in cash.

Host: That's insane.

Darius: Yes. When the top of the K-shape households nationwide are sitting on nearly $8 trillion in additional cash, they can push their personal savings rate extremely low. No matter what happens to current income, they can always dip into these massive deposits to support daily and luxury consumption.

Host: How do you view the current stock market? Is AI a epoch-making salvation, or a super bubble with a deep abyss beneath it?

Darius: You've hit the core question. Everyone must participate in investing. If you don't tie yourself to the wealth creation activities of those at the top of the K-shape, you'll be left far behind and mercilessly harvested by the historic "Cantillon Effect" in the process. I believe the enormous political anxiety and anger surging within this country right now stems from this nationwide Cantillon Effect caused by massive money printing.

(PANews Note: The Cantillon Effect refers to the phenomenon where newly issued money does not raise all prices proportionally or simultaneously but seeps in like "drops" along specific paths. Those who get the new money first—financial institutions and the wealthy—can buy assets at low prices before general price increases and benefit, while those at the end of the monetary chain—working class and ordinary people—suffer purchasing power losses after prices have fully risen. This causes a hidden transfer of wealth from the latter to the former.)

Host: Are you referring to the fact that the wealthiest counties in the U.S. are all clustered around Washington, D.C. (the core of political power)?

Darius: Exactly, that's part of it, and it's the result of both parties sucking off the government. I recently saw another shocking statistic: 89% of people over 65 strongly support raising taxes on the young to ensure their own retirement benefits are fully paid.

Host: Why isn't that number 99%? The remaining 11% must really care about their grandchildren.

Darius: Actually, these elderly are also victims. The prices of necessities for daily survival are skyrocketing, and most of them are in their later years on fixed or very limited incomes. I completely understand and sympathize with their anxiety, but the solution is definitely not to tax a young demographic that has no savings and barely earns any money. Scholar Peter Turchin explicitly points out in his book that we are in a powerful "wealth pump." Ray Dalio has hinted at this in his research. For various reasons (mainly campaign finance), we allow the so-called "elite class" to frantically loot and squeeze the ordinary masses at the bottom of the K-shape by amending regulations, fiscal policy (especially the thousands-page-long tax code full of self-serving loopholes), and monetary policy.

Take 2021, for example. Just before the inflation explosion, the Fed kept policy rates a full 1,000 basis points below the classic Taylor Rule. For comparison, the infamous Arthur Burns of the 1970s, at his worst, only kept rates 700 basis points below the Taylor Rule. At that time, the Fed's balance sheet swelled to 36% of nominal GDP (now back to 21%).

Why do central banks continuously dilute the purchasing power of money, pushing wealth from the bottom to the stock market and the rich? If we want to save this country, we must immediately shut down this wealth pump. But the question is, are the huge baby boomer generation willing to give up their own interests for future generations? I think most are still thinking, "What more can I squeeze out of this?"

Host: Speaking of the stock market, another interesting dynamic is the famous "Magnificent Seven." I recently heard someone joke that they are no longer "Mag 7" but have become "Lag 7," while the other 493 stocks are soaring. On one hand, this is a healthy mechanism for the index to self-correct. But on the other hand, does this mean cracks are appearing in the armor of tech stocks? Valuations are not as unbreakable as people think? What are your thoughts?

Darius: On the Magnificent Seven, I have two points. First, since last fall, we've believed that investors are using the Magnificent Seven as an "ATM," withdrawing profits from them to inject into the broader "AI application companies." As investors get excited about AI penetrating the broader traditional economy, they are starting to look at the other S&P 493 stocks, or even the broader 3,000 stocks, searching for attractively valued bargains on a relative basis.

Second, from a long-term business operations perspective, as the Magnificent Seven transition from their original "asset-light model" to a "heavy asset model" bearing massive capital expenditures, their maintenance capex will be pushed to astonishing heights and remain high for a long time. You can't build a data center and leave it for 10 years; you have to constantly tear it down, rebuild, and upgrade. Currently, Wall Street sell-side expects these companies' free cash flow to show a perfect "hockey-stick" deep V-rebound by 2029 or 2030, but historically, all capital expenditure bubbles (like railroads, canals, internet tech) have shown that such dramatic overbuilding usually punctures these unrealistic fantasies.

Host: No wonder Musk is now trying to sell the idea of "building data centers in space," so they can avoid the angry crowds on Earth.

Darius: Indeed, if we don't voluntarily shut down this K-shaped mechanism that creates class conflict, if we continue to tolerate the Supreme Court's recent leniency toward monopolistic giants, and the millions of words of tax code tailor-made for the wealthy, then sooner or later, the bottom will revolt.

Host: In a country with 400 million guns and 300 million legal gun owners, if a revolt really happens, the noise will be deafening.

Darius: I used to live in New York for a long time, then went to Miami. But now I'm fortunate to live in a special area that is neither rural nor a big city. The core area here is wealthy, but the surrounding towns are exactly what the mainstream elite would call "Trump Country." I go to church with these people, and this experience completely shattered my preconceptions.

Because this is the first time in my life I've truly lived among the "poor white demographic." I grew up in extremely poor Black, Latino, Samoan, Tongan, and African immigrant communities. Then I went to Yale, surrounded by rich whites; then I moved to New York and Miami, surrounded by even richer whites and Latino elites. It wasn't until I moved here and saw the ordinary white residents at the bottom of the K-shape in small towns.

I want to tell you two things.

They are nothing like the media portrays. The media has demonized this group in an extremely vicious and unjust manner, labeling them as "racist," "sexist," or even "pitiful." This is a complete lie. They are the sweetest, kindest, and most warm-hearted people I've ever met in my life.

Human joys and sorrows are fundamentally the same. Having witnessed the bottom—Black, Latino, Samoan, African immigrants, and now poor whites—I can say with 100% certainty that everyone wants exactly the same thing: to be able to feed and take care of their family with dignity. It's that simple.

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