42 Macro Founder: The Fed's 'Boiling Frog' and K-shaped Economy

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 Federal Reserve chair on monetary policy, the consumption dilemma K-shaped economy brings to Americans, and why every investor must participate in asset markets to survive financial repression.

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

Darius: To answer your question, first I want to say we view Kevin Warsh as a "dove in hawk's clothing."

Host: What does that mean?

Darius: It means he ultimately wants looser monetary policy. Maybe it's due to his relationship with the current administration, but I doubt it. I think he genuinely believes AI has enormous disinflationary potential. However, he has to put on the armor of a hawk to create space and a landing zone for the Fed. So we believe that over the next two to three quarters, the Fed will either have to tighten monetary policy or use its communication tools to signal potential tightening to the market, 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 have started falling. Do you think that changes this need for the Fed?

Darius: Good question. Regarding inflation expectations, we've done extensive statistical analysis on the drivers of inflation, looking at which indicators lead or lag inflation. The results show almost no statistically significant causal relationship between inflation expectations and actual future inflation outcomes. What truly has a meaningful impact on future inflation are the monetary drivers of inflation, like changes in money supply growth and the expansion or contraction of money velocity—these are very important. Then there are policy drivers, most notably deficit spending and Fed debt monetization. Also, if there is substantial deregulation in banking that drives a credit growth cycle, that would be a leading indicator of inflation. Finally, there's the "output gap" driver, which I don't necessarily fully agree with: when economic growth is above potential or unemployment is below the non-accelerating inflation rate of unemployment (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 the market: the Fed must act.

Host: So, these data suggest inflation is either moving higher or peaking but staying at a very uncomfortable high level, so the Fed must act.

Darius: Exactly, these signals indicate two things: one, inflation is moving higher; two, inflation may be peaking, but peaking at a very uncomfortable level and staying flat there. Current data suggests we are not on a credible disinflation path at all, and certainly not on track to achieve the Fed's 2% inflation target in the short term. Let's break down these inflation drivers.

On the output gap, it's currently about 110 basis points. Usually around 200 basis points, the Fed has to tighten until recession, so we're a little more than 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 to 100 basis points below NAIRU, but typically at that point, the Fed has to tighten the business cycle into a downturn. On policy drivers, 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 roughly 7% to 8%, also well above the historical trend. Bank credit is growing about 7% year-over-year, also well above the historical trend. These growth rates are completely inconsistent with a 2% inflation environment. Additionally, according to our business cycle model validation, there's about an 18-month lag between policy rate changes and economic outcomes, meaning the lagged effect of the previous 175 basis point cut is now transmitting into the economy.

Host: Do you think the Fed has given up on the 2% target?

Darius: Definitely. You and I have been discussing this for at least five or six years. The Fed doesn't really want 2% inflation, but they have to signal to the bond market that they want 2%, otherwise they 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 opinion, Kevin Warsh is a very competent Fed chair for executing this job. The Fed's job is to boil us alive but not let us jump out of the pot. If we jump out, there will be financial stability problems, and the real economy and asset markets will face worse problems than high inflation, so it's a lesser of two evils.

Host: Even though inflation is currently high, there's no clear signal that it will accelerate sharply from here. However, the latest PCE (Personal Consumption Expenditures) data surprised many, with market sell-offs and rising concerns. Different indicators are sending different messages, confusing many people. Is this why the Fed chooses to "watch more and do less" (neither raise nor cut rates), kicking the can down the road? Letting the complexity resolve itself and deciding when a clearer picture emerges.

Darius: Yes, that hits the nail on the head of "complexity theory." I've been doing this for nearly twenty years and have tried building various models. If there were a simple "Occam's razor" approach that could accurately predict every inflation or nonfarm payroll data point to two decimal places, we would have cracked it long ago. Since we can build AI, statistically predicting nonfarm data should not be difficult, but the problem is the variance and standard deviation of these frequently revised time series data are enormous. Therefore, when facing financial markets and macroeconomic models, you must adopt a "mosaic perspective." It is never isolated data points, but like a school of fish swimming together, or birds in the sky changing formations, it's 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 sending a message to the Fed and financial markets: "Stop deluding yourselves that current policy is restrictive." I think the Fed has received this message, confirmed by the latest Summary of Economic Projections and dot plot. And we believe the next step (which is not yet consensus) is that the Fed may have to take more substantial tightening measures, or significantly raise forward guidance through tools like the dot plot, or even make major shifts on its balance sheet. Because we know Kevin Warsh doesn't like verbose verbal intervention.

Host: What about energy prices? Oil prices had a surge but recently retreated, even briefly falling below $70 per barrel in the past few days. If energy prices remain moderate or fall further, would that ease inflationary pressures and benefit U.S. consumers?

Darius: Definitely beneficial. We saw that moderate resilience in today's PCE report. Real personal consumption expenditures showed a faint positive impulse, with an annualized growth rate of 2.1%, slightly below the historical trend of 2.5%, but still present. It's important to 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 a significant contraction in income, consumption only slightly below trend shows the incredible resilience of the U.S. consumer. This is also the view I advocated back in summer 2022 when everyone was shouting "recession." Recall that in fall 2021 on your show, I said that over the next 12 months people would start discussing a word no one was talking about then: "R" (Recession). By fall 2022, I said everyone should stop talking about recession because the economy was incredibly resilient, and they were focused on the wrong "R" word. All current data supports our theme of "U.S. economic resilience," which gives the Fed the confidence and room to tighten monetary policy.

Host: Now asset prices are soaring again, U.S. consumers seem resilient, but everyone complains they can't afford anything. My view is that these three phenomena are simultaneously true. Due to the price surges over the past five or six years, the cost of living is indeed unaffordable. But at the same time, we live in a society of rampant output and conspicuous consumption: the Knicks are going to the Finals? Buy a ticket. Someone bought a new gadget on Instagram? I need to buy two. A travel destination is cool? I need to 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, is there any "median" or "average" statistical indicator in the world that 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 markets and policy reactions, these aggregates are actually not homogeneous at all; once you disaggregate them, they are highly 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 K-bottom), we see that 90+ day severe delinquency rates on credit cards, auto loans, and student loans have matched or even exceeded the peaks seen during the 2008 global financial crisis and the Great Depression. Amidst a macro boom where U.S. stocks hit new highs, nominal economic growth far exceeds trend, and corporate earnings are at record levels, the delinquency rates of bottom-tier households are at crisis-era levels, indicating extremely tough conditions at the bottom.

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

How did I come to this conclusion? Over the past ten to twenty years, I've been conducting field research in Montauk and the West Village. I noticed that in exclusive venues that are hard to get into, the biggest spenders aren't necessarily gray-haired or balding people like you and me, but young people in their twenties whose parents are wealthy. I mean this without any derogation; 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 monthly income on consumption because they have no savings pressure.

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

Host: That's insane.

Darius: Right. When households at the top of the K-shape across the country sit on nearly $8 trillion in new cash holdings, they can keep personal savings rates extremely low. Regardless of what happens to current income, they can always tap into these massive deposits to support daily and luxury consumption.

Host: How do you view the current stock market? Is AI a epochal salvation or a super-bubble with a deep abyss underfoot?

Darius: You've hit the core issue. Everyone must invest. If you don't tie yourself to the wealth-creating activities of those at the top of the K-shape, you will 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 today stems precisely from this nationwide Cantillon Effect caused by massive monetary expansion.

(PANews note: The Cantillon Effect refers to the fact that newly issued money does not simultaneously and proportionally push up all prices but trickles in along specific paths, allowing financial institutions and the wealthy who receive the new money first to buy assets cheaply before general price increases, while wage earners and ordinary people at the end of the monetary chain bear the loss of purchasing power after prices fully rise, leading to a hidden transfer of wealth from the latter to the former.)

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

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

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

Darius: Actually, these seniors are also victims. The prices of necessities they need for daily survival are skyrocketing, and most of them are in their later years with fixed or very limited incomes. I fully understand and sympathize with their anxiety, but the solution is definitely not to tax a group of young people who have no savings and barely earn any money. Scholar Peter Turchin clearly points out in his work that we are in a powerful "wealth extraction machine." Ray Dalio hinted at this in his research. For various reasons (mainly campaign finance), we allow the so-called "elite class" to exploit and oppress the ordinary people at the bottom of the K-shape through regulatory changes, fiscal policies (especially the thousands-of-pages complex tax code full of self-serving loopholes), and monetary policy.

Take 2021, for example, on the eve of the inflation outbreak, the Fed held policy rates a full 1,000 basis points lower than the classic Taylor Rule. For comparison, Arthur Burns, infamous in the 1970s, at his worst malfeasance, only held rates 700 basis points below the Taylor Rule. At the time, the Fed's balance sheet had expanded to 36% of nominal GDP (now down to 21%).

Why do central banks constantly dilute the purchasing power of currency, channeling wealth from the bottom to the stock market and the rich? If we want to save this country, we must turn off this wealth extraction machine immediately. But the question is, are the massive Baby Boomer generation willing to give up their own interests for future generations? I think most are still thinking: "What else can I get out of this?"

Host: Speaking of the stock market, there's another interesting dynamic with the famous "Magnificent Seven." I recently heard someone joke that they are no longer "Mag 7" but have become "Lag 7," and the other 493 stocks are soaring instead. On one hand, that's a healthy self-correcting mechanism of the index; but on the other hand, does this mean there are cracks in the tech stocks' armor? Are valuations not as unbreakable as people think? What do you think?

Darius: Two points on the Magnificent Seven. First, since last fall we've believed investors are using the Magnificent Seven as an "ATM," cashing out profits to inject into broader "AI application companies." As investors get excited about AI's penetration into the traditional economy, they start looking at the other 493 stocks in the S&P, or even the broader 3,000 stocks, for attractive relative value bargains.

Second, from a long-term operational perspective, as the Magnificent Seven transition from the original "asset-light model" to a "asset-heavy model" bearing massive capital expenditures, their maintenance capex will be pushed to astonishing levels 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 down and rebuild, upgrade. Currently, Wall Street sell-side expects these companies' free cash flow to show a perfect "hockey-stick" deep V-shaped recovery by 2029 or 2030, but historically, from all capex bubbles (e.g., railroads, canals, internet tech), such massive overbuilding usually punctures these unrealistic fantasies.

Host: No wonder Musk is now everywhere promoting the idea of "building data centers in space" to avoid angry people on Earth.

Darius: Indeed, if we don't actively turn off this K-shaped mechanism that fosters class division, if we continue to condone the Supreme Court's recent coddling of monopolies, and indulge the millions of words of complex tax code tailored 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 lived in New York for a long time, then moved to Miami. But now I'm fortunate to live in a special area that is neither rural nor truly metropolitan. The core area is wealthy, but surrounded by towns that the mainstream elite would typically 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 "poor white people." I grew up in deeply impoverished Black, Latino, Samoan, Tongan, and African immigrant communities. Then I went to Yale, all wealthy whites; then I moved to New York and Miami, where there were even wealthier whites and Latino elites. It wasn't until I moved here that I saw the white residents of ordinary small towns at the bottom of the K-shape.

I want to tell everyone two things.

They are nothing like the media portrays them. The media has demonized this group viciously and unfairly, labeling them "racist," "sexist," even "losers." That's all lies. They are the sweetest, kindest, most warm-hearted people I've ever met.

Human joys and sorrows are essentially the same. Having witnessed the struggles of Black, Latino, Samoan, African immigrants, and now the white working poor, I can say with 100% certainty that everyone wants exactly the same thing: to be able to support and take care of their families with dignity. That's it.