Research Affiliates Founder Rob Arnott joins Yahoo Finance Live to discuss recession concerns, economic challenges, rate hikes, and the outlook for the Fed.

Video Transcript

JULIE HYMAN: And with all of these recession and inflation concerns growing with rising inflation, our next guest says a recession may already be underway. For more, we welcome in Rob Arnott, Research Affiliates founder and chairman of the board there. Rob, it's good to see you.

Even as we have some alarming numbers here, we're having fun talking about rising prices, even if they're not fun in reality, because you have to laugh. So what evidence are you seeing that we're already in a recession here in the economic data?

ROB ARNOTT: Well, the real GDP numbers are likely to come in negative in the second quarter, two quarters in a row. That's the classic definition of a recession.

The thing this is, this is avoidable. There was no reason to push us into a recession. They don't naturally begin with two job openings for every job seeker. Rudy Dornbush back in 1998 said none of the post-war expansions ever died of natural causes. They were all murdered by the Fed. And I think we're seeing that again now.

The Fed began with a recklessly loose policy for a decade. And you don't want to start from there if you need to start tightening. You need to be in a position where you weren't unrealistically loose for a decade-plus.

BRIAN SOZZI: Rob, do you think the Fed is now likely to go down the route of recklessly tightening rates? I mean, now we're talking about 100-basis-point rate hike in just a couple of weeks. That is abnormal. And not a lot of folks in this market have seen rate hikes like that.

ROB ARNOTT: Absolutely. You have to have been around a while to have seen rate hikes of that magnitude. But be that as it may, the best clue for a recession is an inverted yield curve, short rates, three-month rates, higher than intermediate to long rates, 10-year rates. And the long rate right now is about 3%.

So if the Fed pushes Fed funds above 3%-- one of my colleagues, Cam Harvey, was the very first, back in 1986, to observe that inflated short rates and inverted yield curves predict recessions. I would go one step further and say they cause recessions. And they cause recessions because you're taking the short-term cost of money above what the market rate, the long-term rate, says is the appropriate rate.

And so to the extent that we push it above 3%, I think we're creating a risk of a more serious recession. And this is all in response to a burst of inflation predicated on causes, none of which the Fed has any control over. Prices are set by supply and demand.

JULIE HYMAN: Well, but don't they have some influence on the demand side though, Rob?

ROB ARNOTT: They do. That's the problem. To everyone with a hammer, everything looks like a nail. And so if your hammer is an ability to crush demand, which the Fed has the power to do, then that's the tool you're going to use. But what about the supply side? What about finding ways to promote increased supply of goods and services?

We have supply chain disruptions. We have the war in Ukraine. We have blowout spending. And all of these things have created a supply-demand imbalance. And the Fed has one tool, the ability to crush demand.

That's in the face of inflation that is not transitory, that is not poised to recede any time soon. In fact, I think it's very high odds that we'll finish the year materially higher in inflation than the 9% we have now.

JULIE HYMAN: So do you think then that the Fed should not be raising rates?

ROB ARNOTT: I think the Fed should feel free to raise rates up to wherever the long yield is but certainly no higher than that. And I think this is a Fed that believes it has a hammer and believes that it must use that hammer, that it must crush demand.

Again, supply and demand control prices. If you work to alleviate the supply challenges, reduce regulations, reduce impediments to businesses producing the goods and services that people want, all of these things can be done in order to rein in inflation.

But this is not transitory. The inflation that we're seeing is likely to remain elevated at least through next year, perhaps into '24, in the high single digits for a goodly time to stay.

BRIAN SOZZI: Good to see you, as always, Research Affiliates founder and chairman of the board, Rob Arnott. Great to see you. We'll talk to you soon.