Deutsche Bank Securities Chief U.S. Economist Matthew Luzzetti joins Yahoo Finance Live to discuss why the Deustsche Bank is the first major bank to call for a recession in 2023 as the Fed pivots to fighting inflation.

Video Transcript

AKIKO FUJITA: OK, Brian, let's bring in another voice into the conversation here. We've got Matthew Luzzetti, Deutsche Bank Securities Chief US Economist. And, Matthew, you've gotten a lot of attention over the last few days on the back of that note you put out calling for a recession. We're talking about 2023 right now, but talk to me about what you saw in the Fed minutes yesterday and how that connects the dots for you when you think about the recession at the end of 2023.

MATTHEW LUZZETTI: Sure. First, thanks so much for having me. I think what we heard from the Fed minutes yesterday was kind of a continuation of what we've heard from Fed speak in recent weeks, which is it has been meaningfully more hawkish, it has been, I think, more worried about the inflation outlook. There was a paragraph in those minutes where it was kind of some of the most concerned and hawkish messaging that I've heard around inflation in quite some time from the Fed-- them being worried that price pressures are being pushed on without hurting demand, worried about the inflation dynamics in the economy possibly changing relative to what we saw pre-COVID, and really worried about the broadening of price pressures that we've seen.

And so I view it as a continuation of what we've heard from the Fed, what we've heard from Chair Powell. And what it means to us is that the Fed has said inflation fighting is their number one goal today. It will mean that they will be much more hawkish. They're going to be raising rates aggressively, they're going to be doing quantitative tightening, as Brian just laid out. And those two things, we think, next year puts them into a restrictive stance which ultimately tips the economy into recession by the end of next year.

BRIAN CHEUNG: Can you just explain for us exactly how that would happen? Because a lot of economists are saying, well, the Fed is eventually going to have to cut interest rates-- that could be at the end of 2023 into the beginning of 2024. What does that actually do to the economy? Because the people that are watching the show might only understand it in terms of, do I have a job and are prices going up at the store?

MATTHEW LUZZETTI: Absolutely. And that's essentially the Fed's dual mandate. And so I think it's good to consider what we're looking at today within that context, both inflation and the labor market. And today, what we are seeing is inflation at 40-year highs. We're seeing a labor market which is historically tight-- tight to an extent that Chair Powell actually called it unhealthy how tight it is.

And just a data point there-- there's five million more job openings today than there are unemployed individuals, which is by far a record high. And we're seeing wage growth pick up substantially. And so when you add those two things together, how far we are away from the Fed's inflation objective and actually how far we are away from kind of the natural rate of unemployment, I think the economy looks as far away from the Fed's target as it has been since the early-1980s.

And so to me, it suggests that the Fed does need to tighten, does need to get to a restrictive stance-- getting to neutral as simply is not enough in order to tame inflation pressures. You know, what it will mean for everyone-- we've seen some of the implications already. Mortgage rates have been picking up significantly, market volatility has been picking up, equities have come off a little bit, but probably not enough, I think, to hold the Fed back. And so I think, ultimately, it will mean tighter financial conditions and lower risk asset pricing.

AKIKO FUJITA: Matthew, you know, it's worth noting, because I think when viewers hear recession, it is kind of a scary word, but we're talking about two straight quarters of negative growth. In your note, you specifically highlight Q4 of 2023 and Q1 of 2024. It sounds like what you're saying, essentially, a lot of this really does depend on the Fed's policy. But I mean, what are you watching to see how long that recession, if your forecast does hold up, lasts?

MATTHEW LUZZETTI: Yeah, I guess I would highlight two things. One, we're pretty optimistic or constructive on the economy this year. We think consumer spending has good momentum, business investment has good momentum, household balance sheets look in great shape. Obviously, the labor market has a lot of momentum.

So this year, we are actually still pretty constructive on the economy. The second point we noted in the piece-- I think both timing the exact quarters of a recession is very difficult-- certainly 18 months ahead is very difficult. But I think what we do believe pretty strongly is that, fundamentally, the economy is very far away from the Fed's targets-- that getting back to those targets requires restrictive policy.

It means that growth needs to decline, aggregate demand needs to come in, labor market demand needs to come in, and, most likely, that the unemployment rate does need to rise. So we see the Fed tightening to a restrictive stance in the middle of next year, the Fed funds rate getting to about 3.5%, a bit above that, and the Fed undertaking quantitative tightening, which we think will add a few more rate hikes equivalent into the tightening that we anticipate.

So for more than four percentage points in tightening in total-- we think that really does begin to slow growth in the second half of next year. And we've pegged as a baseline our negative quarters in Q4 of next year and then Q1 of 2024.

BRIAN CHEUNG: So, Matt, under the baseline scenario, let's give you the benefit of doubt and say that is going to happen-- the Federal Reserve will tilt the economy into a recession-- how quickly would they get backed into zero rates again? Would it be more dramatic of a money printer that they'd have to roll out in the next recession than they did in 2020?

MATTHEW LUZZETTI: Yeah. So the past few recessions what we've seen is the Fed getting back down to the zero lower bound, basically cutting interest rates to zero as they've tightened-- and, as you mentioned, doing QE asset purchases. Our baseline is that this is a relatively mild recession-- two quarters of growth, but moderate, negative-- one where the Fed does not have to cut interest rates all the way to the zero lower bound.

The reasons for it to potentially be more mild are, one, household balance sheets and corporate balance sheets are in pretty good shape. So you really don't have a lot of deleveraging that needs to take place. And two, a lot of the cyclical sectors, whether it's housing or capex, really are not overextended. Consumer durables are, but these other sectors are not.

And so I don't think that there's a lot of undershooting or underspending that needs to take place there. So our baseline is that the Fed will be able to cut rates, we think, by 100 basis points, perhaps a little bit more, and be able to stabilize things and not really get back to the 0 zero bound. Taking it back to quantitative tightening, which is where you started-- it does mean on our baseline that the Fed probably pauses that process at the end of next year.

And so we don't see them fully normalize the balance sheet, which would take three years under the Fed's plan. On our view, they probably pause that at the end of next year when they are forced to cut rates.

BRIAN CHEUNG: All right, Matthew Luzzetti, Deutsche Bank Securities Chief US economist, thanks so much for the warning there. Definitely have you back on again soon.