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World Economic Update [Transcript; Federal News Service, Inc.]

Presider: Edward M. Gramlich, Interim Provost and Executive Vice President for Academic Affairs, the University of Michigan
Speakers: Ethan Harris, Chief U.S. Economist, Lehman Brothers, and John P. Lipsky, Vice Chairman, JPMorgan Investment Bank
Presider: Daniel K. Tarullo, Professor of Law, Georgetown University Law Center
June 27, 2006
Council on Foreign Relations New York, NY


DANIEL TARULLO:  Good morning, everyone.  I’d like to get to started, please, in the interest of getting everyone out on time.  

Welcome to the last World Economic Update of the season.  A couple of reminders:  First, this is an on-the-record meeting.  Secondly, as you all know by now, please shut off or silence your BlackBerries, cell phones and any other electronic devices.

We have with us this morning John Lipsky, who you all recognize. And as I’ll explain in a moment, this is the last time John will be with us, at least for a while.  

Sitting next to—between John and me is Ned Gramlich, late of the Fed, now back at the University of Michigan, where he has successively, over the years, been the chairman of the Economics Department and the dean of the School of Public Policy, and is now serving as the interim provost.

And to my right, Ethan Harris from Lehman Brothers, another return engagee.

Now, as you know, Steve Roach was scheduled to be on this program today.  The public story is that Steve had to stay in China.  The real story is that Steve has just flown too close to the sun, and with this sudden glare of optimism in his eyes, he’s now just not able to navigate around more generally.  (Laughter.)  But we will have him back in the fall, where he will be required to explain himself to all of you who have been listening to him over the last few years.

As I mentioned or alluded to a moment ago, this is John’s last visit with us, at least for a while.  And the reason, as I’m sure you all know, is because in just a couple of months—couple of months?

JOHN LIPSKY:  Yes, September 1st.

MR. TARULLO:  September 1st John will become the principal deputy managing director of the International Monetary Fund.  And so he will then become an object of our analysis, instead of a participant in it. 

John and I are the remaining participants in the very first World Economic Update.  Back in the fall of 1999, I think, was the first one we did.

That’s 30-something World Economic Updates ago.  A lot of people have lost their jobs since then.  John and I have not.  (Laughter.)  We’re still coming to these things.  And so we are very pleased, obviously, that John is going to be in this position, but we are very sorry to lose him, as you can tell from the fact that he keeps getting invited back. 

Richard Haass, by the way, John, wanted to come this morning, but he is in Washington, ironically.  And he sends his best regards and thanks for your participation over the years as well.

Now, this morning we’d like to deal with three somewhat related topics.  We’ll begin by taking a look at recent market developments. Obviously, there’s been a bit of roiling in markets, both in the United States and abroad.  And we’ll want to ask ourselves what’s going on there.  Is this a ripple, a little technical correction, or something else.  In the course of that conversation, we’ll try to move towards the underlying phenomena of inflation and growth and how Ben Bernanke is doing in his first couple of months on the Fed.  And then, towards the end of the discussion, we’ll turn to the chronic issue of imbalances, but now looking at the imbalance correction—or the external imbalance correction question from this apparently new lens which the IMF, among others, has adopted, some sort of coordinated approach to redressing the imbalances.

First, anyone here who owns assets of any sort knows, over the last five or six weeks there has been a downturn in markets.  This can be explained in any number of ways, not necessarily inconsistent with one another.  One is a technical correction; another is a heightened sense of inflation expectations; a third is some sense that growth is just slowing; a fourth is that there’s some uncertainty about the helm at the Fed, and so people are hedging their bets a little bit; fifth, that finally risk is being priced in, where it hadn’t been before. The overarching question, obviously, is—or has been, is this the beginning of a greater trend, or is it something which I guess in the last week or so you might say has just been a bounce and now we’re leveled off and waiting for something else to happen.

So, Ethan, why don’t you take the first shot at that.

ETHAN HARRIS:  Well, I think the answer is all of the above.  But I think the bottom line is—and I want to emphasize this at the outset, is that we don’t think this is the beginning of a big bear market because we do expect a healthy economy going forward, healthy    earnings, corporations flush with money to spend.  It doesn’t make sense to us that this is the beginning of a big bear market in stocks.

So, why did stocks come down in the last couple of months?  The first explanation is technical.  Our equity strategist over in London, Ian Scott, predicted this precisely.

They’re not always right at Lehman, but at the beginning of May, he said, we’re due for a correction in the stock market, and investors are overbought in the market.  There’s—long positions are exaggerated.  We haven’t had a correction in a while.  We’re due for a correction.  So I think that’s part of it.  I’m not a technical analyst, but that was their view.

The second reason, I think, is fundamental.  I mean, the Goldilocks economy is over.  We’re now in an environment where you do have some unwarranted inflation, and you’ve got a Fed that’s no longer, you know, the grandfatherly Greenspan hiking the new trail, we’ll never do anything to surprise you Fed, but now, hey, we’re trying to impose some restraint on the economy.  You know, let’s try to provide some resistance to this inflation.

So the stock market, I think, had become very complacent about inflation.  Inflation’s a thing of the past.  (Columnists ?) warned about it all the time, but it never happened, so there’s little repricing going on around the risk of inflation and a tougher Federal Reserve, so I think that’s important as well.

And then finally, I agree with you about, you know, Ben Bernanke’s kind of rough ride here in his first year as chairman.  I wouldn’t blame Ben Bernanke for this.  You know, if you go back in history, you’ll remember that Alan Greenspan, when he replaced the irreplaceable Paul Volcker, also had a rough ride in the markets.  And in turned out that Greenspan turned out to be a pretty good chairman of the Fed after all.

But Ben Bernanke’s suffering the same problem—the business press frequently misinterpreting his comments, everyone takes out their Greenspan decoder ring to see what Bernanke said—“Oh, he says we may pause at some point.  That means we’re definitely pausing at the June meeting.”  And there’s been a lot of misinterpretations of Bernanke.  He’s a different guy than Greenspan, and the markets need to get used to that; a guy who speaks more directly, admits to uncertainties in a very uncertain environment.  So, you know, it’s a little bit of a rough ride, and I think that has also affected confidence in the markets.

MR. TARULLO:  Okay.  Ned, what about that last point on the transition at the Fed, whether or not specifically Ben Bernanke has himself saying?  To what degree is that an independent factor affecting market judgments as opposed to their look at fundamentals or what the Fed’s actually doing? 

EDWARD GRAMLICH:  Well, let me first off try to stay out of the business of explaining what’s going on in the market.  I—you know, we didn’t try to do that at the Fed, and I’m not too eager to take it up now.

I would support what Ethan said about Ben.  He—I know both Greenspan and Bernanke very well.  I served for at least three years on the Board with both of them.  And Ben is—no doubt about it, a more straightforward talker than Alan.  If he says we may pause at some point, the obvious meaning of that is, well, they may pause at some point, and they probably will pause at some point.  

What point?  Who knows?  And I wouldn’t have read any signal into that.

In terms of the more basic issue, I think it’s actually unfortunate to Ben that he takes office at exactly the time he did, because we, as you all know, went through a period where, because we were honestly worried about price deflation a few years ago, we got rates at a pretty low level and they were going to stay there for a considerable period and all of that.  And there was an awful lot of monetary accommodation put into the system.

We all know that that can’t be a permanent situation.  That is a policy response to the need—the perceived need at the time, which I still think was the right response.  But whether it’s the right response or not, it has to be withdrawn at some point.  And so for the last several meetings with Greenspan, we were withdrawing it. Everybody kind of knew the routine, very little uncertainty, the Fed funds futures market was predicting what we were doing and saying right down to the last basis point, and it was kind of an easy ride for markets that way.

Well, that period’s going to be over at some point or other whether Bernanke takes over or not.  I mean, even if Greenspan were there, that period may at some point be over, and now we get to a more traditional period where the Fed looks at the data. 

And so are things more uncertain about what Fed policy is going to be?  Of course they are, and they ought to be.  And so I wouldn’t—I think there’s a feeling that we ought to blame that on somebody. I wouldn’t blame it on anybody; I think it’s just the reality of the situation.  

And I also agree with Ethan that the stock market—this is more a technical adjustment than the herald of a long-term new trend.  But I think the Fed part—we’ll get used to it.  You know, we’re in a more uncertain world now and we’ll go on that way and it will just be like it’s always been for the Fed.  You know, for most of the Fed’s history you haven’t known what we would do one or two meetings out, and we’ll probably go back to that.

MR. TARULLO:  To the degree that what is happening is that the Fed is removing liquidity from the market—and liquidity, of course, has been the source of the run-up in a lot of asset prices over the last number of years—shouldn’t we conclude that if you begin to    remove liquidity from the market, liquidity is what’s propped up asset prices, including stock prices, shouldn’t we expect a further decline in stock and other asset prices?

MR. GRAMLICH:  Now you’re getting me to take a position here, and I’m going to try to stay—

MR. TARULLO:  That’s what I try to do up here.  (Laughter.)

MR. GRAMLICH:  I just—just stay away from that.  You’re right theoretically; that as liquidity comes out, asset prices will adjust. But as you know, the timing of that is very complicated, depends on all kinds of things about what was expected when and so forth.  And so it would be foolhardy to make a prediction of—from now forward, if the Fed does X, the market will do Y, because you can’t parse out who knew what, when, you know, and these things have been expected for a while.  So I wouldn’t be very precise about that kind of link.

MR. TARULLO:  So now, John, from your new-found vantage point of sympathy with those in control of running—(laughter)—running the domestic and global economies, and in the light of the conversations we’ve had in the past up here about the transition at the Fed, what’s your take on all this?  And maybe you could also say a word about the impact in emerging markets because that is a place that’s also felt—

MR. LIPSKY:  Yeah, first, if I can add a caveat, I’m here—I’m a fish, but it is known that on September 1 I become a fowl.  So you could say I’m here as neither fish nor fowl, but I insist on the fish.

MR. TARULLO:  You’re still John Lipsky in other words. (Laughter.)

MR. LIPSKY:  I’m still here as the vice chairman of JPMorgan Investment Bank, and nothing I am saying today should be construed as reflecting any opinion of the—or position of the IMF.  So that means that I did want to—I thought it would be useful here to try to take this context and make them—take a more—slightly more global context for what’s going on right now.

I’ve been telling both clients and colleagues for some time that I thought 2006-2007 represented a very important turning point for the global economy, and so I would—even though I share some—many of the views that have already been discussed, I would hesitate a little bit to call what’s going on just a technical correction.  I think there is a much deeper uncertainty that is going to be resolved over the coming months.  But as a very deep one, think of it this way, starting in 2000-2001, if following a series of unanticipated and potentially very serious shocks to the global economy, there was a universal move towards monetary accommodation and accompanied in the United States and some other places, fiscal accommodation as well, in compensation for the risks that were created by these shocks:  the Asian crisis, et cetera.  I don’t need to go over them with you.  And I would say that the response has been far different than was widely anticipated.  After all, how many people in 2002 would have agreed with the proposition in the next four years we’re going to constitute the fastest four-year period in global growth in 30 years, that it would be accompanied by a sharp rise in energy and commodity prices, and yet, nonetheless, core inflation rates around the world would remain at 40-year lows. 

I think that that has been quite unexpected.  

When you look at the stock market you can see—for example, look at the U.S. stock market, there’s still a lot of uncertainty. Corporate profits in the U.S. doubled between 2000 and 2005, and yet PE ratios fell.  So, if you had known for sure in 2000, in January 2000, that corporate profits were going to double in five years, would you have expected the stock market to decline or to increase?

So there’s a lot of uncertainty because now, after this accommodation was put in place globally in 2000, 2001, it produced results far more favorable than were anticipated by either the policymakers or by financial markets.  It is now—we have now reached, for the first time since 1990, a kind of normalization in the G-3 economies in which not just the U.S., but Japan and Europe are growing at trend rates of growth.  And so globally there’s been—it’s been seen as appropriate, and I think it’s inevitable, a withdrawal of the stimulus that was put in place in 2000-2001.  

So number one, the uncertainty of can we continue with this kind of combination of solid, balanced growth and low inflation in the absence of policy stimulus.  Point number one.

Point number two, that I think we have to think about, the past 10 years, I think the easy way to think about it, global growth has depended inordinately—not inordinately, excuse me—to an unusual degree on growth in domestic demand in the United States.  And I claim that we are witnessing before our very eyes a turning point in savings rate in the U.S., and that after 20 years of sustained declines in household savings rate, private savings rate in the U.S., that I suspect that the adjustment in asset markets that we’re seeing is also going to usher in a period of rising savings rates that I suspect will continue on—will begin now and continue on for the next five to 10 years, if not more.  Or to put another way, in the next decade, growth in the United States is going to depend to an unusual degree on growth outside, on domestic demand growth outside the U.S.

So all these are pretty big deals to start dealing with, then I’m not surprised that investors are not quite sure that they know what the results have been, especially given they’ve been so wrong, but happily so, wrong about the results of the past four years.

MR. TARULLO:  So, John, if I understand you correctly, the implication of what you say is that it’s too soon to know exactly    where things may be headed, and that it’s too soon to denominate this either a correction or the start of something more basic?

MR. LIPSKY:  I’ll go with that.


MR. LIPSKY:  But I also—if I could add—it seems to me a lot of the discussion of the Fed strikes me more—better to understand in terms of psychology than fundamental economics in the sense I find people projecting their own uncertainties onto the Fed and sort of quietly just either disappointed or angry with the Fed that they’re not resolving these uncertainties by telling us all exactly what—

MR. TARULLO:  And there we can see that there is this coincidental dynamic of a new chairman of the Fed at the same time as there’s uncertainty generally, and so that does increase the uncertainty.

MR. LIPSKY:  Exactly.

MR. TARULLO:  So let’s turn a bit to the fundamentals.  And I think everyone’s mentioned inflation.  And Ethan, you began by mentioning inflation.  

How—it’s been interesting to watch over the last six or eight weeks, because current inflation is clearly up.  After a period in which inflation expectations were up, they seem to have dropped down some, maybe because of Bernanke’s hawkish statements themselves.  Most economic models are predicting a slowdown towards the end of this year and into next year, which would suggest a reduced inflationary pressure.  

What do you see and what do the people at Lehman see going on with inflation?  Is this a return, as some have suggested, to an earlier period, in which it will be the principal economic policy challenge, or is it too somewhat more transient?

MR. HARRIS:  Well, you know, I think we’re at the beginning of an acceleration, certainly for the United States.  And the problem is that, you know, whereas a year ago we had an environment where you had rising commodity costs but spare capacity in the economy—so those two forces were offsetting each other, spare capacity putting downward pressure on inflation, commodities putting upward pressure, and they kind of fought to a standstill—now, by most measures, we have full employment, and we still have the commodity pressure in the pipeline.  

We know from history that, you know, stamping out modest inflation requires a period of below-trend growth.  Stamping out serious inflation often means a recession.  

Probably it’s a moderate inflation environment.  It’s still the case that central banks have a lot of credibility on inflation, so businesses are slower to turn around and pass on their costs; workers are more reluctant to push for higher wages.  So it’s not that kind of explosive 1970s environment.  

But there is the beginnings, I believe, of modest upturn inflation, and I think the Fed’s doing the right thing here.  They’re saying, “Hey, we got two potential wars to fight here.  Do we fight the inflation pickup, or do we resist the growth slowdown?”   

And the first priority is to deal with inflation, because if you deal with inflation, if you try to keep it reasonably under control,   then you have flexibility down the road to ease or do whatever you have to do address the economy.

So the first priority is to make sure serious inflation expectations don’t get embedded in the system.  So I think, you know, we’re in for a slightly higher inflation environment.

MR. TARULLO:  Ned, do you agree with Ethan both on this positive observation about the inflationary trend or on the normative one that the Fed should continue to tighten here?

MR. GRAMLICH:  Well, I certainly agree on the normative side.

On the positive side, I’m not quite so sure.

But let me first go back to what John said a minute ago, and the—we can get mired in bad news, but I think it’s worth spending a minute thinking about the good news.

You probably held a session like this five years ago.  And I think John is right, that if anybody had—if you had gone around and everybody write down their economic results five years hence, that you would find that output throughout the world has done a lot better than you all would have put down, that if we had known about the rise in oil prices—those of us who remember the ‘70s would, I think, be highly pleasantly surprised at how little the huge rise in energy prices has crept into the continuing core inflation.

So there’s actually some very good news there.  And I personally think that part of the credit ought to go to central banks around the world—not only here, but in other countries—because they have managed to steer through this situation in a way that was far more successful than in the 1970s.

So I think, you know, it’s great to worry about everything, but I think we ought to look back and think that actually we came through a difficult time pretty well.

Now, in terms of what Ethan just said, I—you know, there has been a slight uptick in quorums.  I shouldn’t—and I think about at least half of the open market committee has been on record lately as saying that it’s at the upper end or maybe above their comfort zone; and we’ll let my former colleagues speak for themselves.  But it—you might read in that that certainly normatively, I think, everybody agrees with what Ethan said, that we really have to keep inflation down as the central linchpin of monetary policy.  And I think positively, you know, you can read those statements for what they’re    worth, but I—my guess is that’s what my former colleagues are intending to do.

We’ll talk about this, I guess, in a second.  But going forward, I think there is a question about the, you know, what was this whole rise in output over the past five years fueled by the low U.S. saving rate, and what happens if the saving rate reverses itself.  So first off, I think I would put that more as a question.  I’m not so sure it will, but maybe it will.  I actually hope John is right about that.

There is an important country in the Far East, however, that has also fueled a lot of this growth; it’s not only done by U.S. consumers.  And the way I read the evidence, growth will continue in China.  So it may be that a little bit less of the locomotive will be supplied by U.S. consumers, but I think there will still be a lot of forces around to push us forward.  So anyways, number one, looking back, I think we ought to be somewhat thankful that things haven’t been worse.  

Looking forward, output, I’m not so worried.  On inflation, I’m actually not so worried there either.  I think the lesson has been learned that this is an important part of central bank credibility, and we seem to be hearing a lot that that lesson is learned, and my guess is that people will follow through.

I should also, by the way, give a disclaimer, and that is that I’m  under very strong ethics rules not to talk to anybody at the Fed and I have not.  So I’m saying this out of here, not because of anything that came about on a telephone.

MR. TARULLO:  And besides, right now they talk freely anyway, so we don’t need—(laughter).

MR. GRAMLICH:  That’s true as well.  

MR. TARULLO:  So let’s see, before I turn to John, let me see if we can isolate particular points of difference, even if in nuance, between Ethan and Ned.  

Ethan mentioned continuing pressure on commodity prices.   You mentioned full employment, by which I take it you mean pressure—upward pressure on wages.  And obviously, within commodities, oil is in some sense the biggest commodity of all.  How do you look at those factors, Ned, and why do you have a somewhat different view than Ethan appears to, which is that together they do produce a moderately inflationary environment?  MR. GRAMLICH:  Well, that can be offset by policymakers.  And I think with suitable—I mean, they may put a little more burden on policymakers, those forces, but I think with suitable leaning against the wind, those forces can be combated.

MR. TARULLO:  I see.  Okay.   But that—

MR. HARRIS:  We agree.

MR. TARULLO:  Yeah, I guess you agree, but that means what you’re both saying is that in order to contain—yes, you can contain the inflationary forces, but it does require interest rate increases, and so it’s not—it is a question of there being underlying inflationary forces that require the policy response.

I guess you’re both saying that if the policy response comes, we’re going to contain them, but presumably at the cost of lower growth.

So, John, shortly after the Bank-Fund meetings, there was a fairly senior European economic policymaker in town in Washington, whom I happened to have lunch with.  And he—after the inevitable preliminaries, he dove right in to what was clearly bothering him, which is the following.  He said, you know, the Fed has a new chair, the ECB is still obsessed with being the Bundesbank—which is exactly the way he put it—and even the Bank of Japan is now showing some impulse to monetary tightening.  His view was that although there are the sorts of inflationary forces that Ethan and Ned were talking about in the air to a greater degree than at any time in recent years, he did not regard them as having a lot of continuing impact.  He was heartened, actually, by the fact that labor costs had not been pushed up as much as one would expect.  

And so he has been concerned, and is concerned, that each not just of the major central banks, but a lot of other central banks around the world are now all tightening; they’re tightening even as in Europe in the face of quite modest headline inflation numbers, and that in the absence of the emergence of the domestic demand that you talked about, which he still doesn’t see in Europe, that we could face, by the beginning of next year, a circumstance in which we’re kind of slipping into a very slow-growth period because of excessive tightening by the central banks.  

Along these lines, I noted that David Rosenberg of Merrill Lynch has now said he thinks there’s a 40 percent chance of a recession next year, I guess because of some of the same factors.  

What’s your take on that European policymaker’s perspective?

MR. LIPSKY:  Well, I would certainly agree with the concerns.  I would characterize things somewhat differently.  First of all, a caveat, which is not meant to be a criticism of my colleagues here on the platform.  But one of economics’ dirty little secrets is that economists don’t actually have a very good handle on the process of price formation.  That’s a technical way of saying economists don’t really understand inflation all that well, though supposedly we understand the price of everything and the value of nothing. (Laughter.)

But I think the point here— MR. TARULLO:  But, John, can I stop you here?  

MR. LIPSKY:  Yeah.

MR. TARULLO:  Because they may not understand what makes inflation go up, but isn’t it now true that central bankers do understand they need to stop inflation?



MR. LIPSKY:  Without a doubt.

MR. TARULLO:  And that is different from 30 years ago.

MR. LIPSKY:  Absolutely.


MR. LIPSKY:  And in other words, I would certainly sign up with—from Ned’s characterization, that central banks deserve a lot of the credit for the favorable outcomes, the low-inflation outcome of the past few years, and that that focus is absolutely appropriate.  That being said, I think an awful lot of the chatter, certainly Wall Street chatter you hear about inflation is disturbingly of the cost-push variety, an explanation that when you stop and think about is neither logical nor supported by empirical evidence.  Nonetheless, it’s because it’s so easy to explain—(laughter)—it’s so easy to explain, it sounds so logical:  If the input price is up, output price is up, right?

It’s funny I don’t noticed anymore that many firms operate on fixed margins with controlled prices, but the most important point here is, there are—it strikes me that there are two basic ways you get accelerated inflation.  One is inappropriate monetary policy.  In other words, the central banks really want to create inflation they’ve got the means to do so—accelerating inflation.

Secondly, it strikes me that typically why inflation is a late- cycle phenomenon is it requires a combination of producers having great confidence in the strength of final demand, but uncertainty about the availability of inputs.  And you start a process in which they bid up the price of inputs, confident they can pass it along in increased output prices, and that’s a typical way in an industrial economy that that happens.

So in the current environment, you have to ask yourself, okay, are we in the face of either of those circumstances in which producers are—can be worried about shortages, i.e. about supply availability, and highly confident about the strength of demand, then it doesn’t strike me that either is a good description of the current environment in the United States.

When we’re talking about manufacturing, it seems ironic that, as I read the news this morning, 35,000 GM workers are going to take this retirement package.  Broadly put, it doesn’t strike me that there’s a global shortage of manufacturing capacity right now, and a lot of the run-up as been noted widely.  A lot of the run-up in commodity energy prices has been driven by places like China, which are busy sucking up inputs so they can produce low-cost output.  Now, secondly, when you look at the U.S. labor market, it strikes me that the only evidence here of—that points towards any labor shortage is the unemployment rate itself.  Every other measure suggests the opposite.  Unit labor costs are growing more slowly than even the core inflation rate.  In other words, I can’t see an argument that says, “Labor costs at the current moment are putting upward pressure on inflation.”  They’re doing the opposite.  So I don’t quite get where—this assertion that we’re facing rising inflation risks.

At the same time, I look at the measure of the core CPI, and you can see something weird’s going on.  Over the last three years, just at this time of year there’s been an acceleration in the measure of core CPI that has then gone away.  Now, that suggests that there’s something wrong with the seasonal adjustments, that—because inflation doesn’t just go up and go down. 

So—but that’s what’s happened in the data the last two years, in the sense it’s gone up and then gone down.  This year, you’ve got an acceleration again at this time of year.

Now, you would expect that if you have measurement problems, that markets are supposed to look through that stuff.  But when you look at this measure of the market-based measure of inflation expectations, which is the break-even yield between—the difference between the yield on Treasury inflation-adjusted securities and the yield on normal securities—and the difference between the two is called a break-even yield, and it’s considered to be a measure of inflation expectations—you can see, uh-uh, the inflation expectations so measured have followed exactly this pattern, this funny seasonal pattern in which, for the last three years, you’ve seen a rise and an acceleration in the core CPI, you’ve seen an acceleration in the so- called inflation expectations, a deterioration of expectations, that have then turned around and gone away.

MR. TARULLO:  So, John, do you think that central banks are overreacting here?

MR. LIPSKY:  I will agree that the Fed is at the verge of going too far, yes.

But I do think—and I think the evidence that would suggest that that might be the case is it’s persistently flat.  The yield curve—i.e., the long-term interest rates, are about the same as short-term interest rates—and if the that’s the case, somebody’s probably wrong—if either the markets misjudged the inflation risk and long-term interest rates are too low, the Fed’s too high or at the verge of being too high.

The challenges facing the Bank of Japan and the ECB, I think, are very different.  The Fed has done something this time they’ve never done before.  This has been novel.  They have been raising interest rates at a time in which inflation was consistent with their medium- term goals.  Every other time you’ve seen in the past, the Fed has raised interest rates, long-term—medium-term inflation—I’m sorry—current inflation has been higher than their medium-term goals.

So in the past, you could see an easy modus operandi for knowing when enough was enough.  You move a ways up until the economy starts to crack, and then you back off.  But you’re not worried because inflation’s too high.  You’re trying to push it down over time.  That    wasn’t the challenge this time.  The challenge was, how do you figure out enough is enough when inflation was consistent with your long-term goals?

MR. TARULLO:  Well, more than one person has suggested that the Fed and possibly the ECB have used the runups in current CPI figures as not quite an excuse, but as an occasion for tightening in order to sop up the liquidity that they still think is excessive.

MR. LIPSKY:  Forgive me for going on, but so you think the challenge facing the ECB has been so broad-standard, its Central Banking 101?  Growth in the oil area economy is now at trend rates or slightly higher.  The ECB is enjoying by its constitution, if you will, with following a nominal, a headline inflation target goal. They won’t call it a target.  And that goal, that inflation rate is above their mandated goal.

So, I mean, here you have—growth is at trend or above. Inflation is above your target and your policy is accommodative.  

MR. TARULLO:  Ethan?

MR. HARRIS:  Yeah.  It’s good the two of you are between us here, because we finally have some disagreement up here.  (Chuckles.) 

It’s true that we’ve had several years where the core has come in a little strong in the early part of the year, only to fade in the second half.  But the economy has strengthened a lot over the last several years, where now the unemployment rate’s dropped about a half a percent in the last year.  So we—you know, the environment for potential inflation’s greater than it was a year ago or two years ago. 

Also, if you look at the data—and I hate to bore this crowd with this, but the month at which we’ve seen the strong numbers has been different each year, even though it’s tended to be in the early part of the year.

So I think that one thing economists can do is, we can forecast history well.  And we know that we’ve had three months in a row of strong core CPI numbers.  In an environment where you’re worried about inflation, you start to think:  Well, maybe we have finally found inflation.

The second thing I would say is that there’s been—the Fed has had everyone focused on the core measure of inflation.  But we know that headline inflation’s been high for three years in a row.  

We also know that a lot of the run-up in headline inflation has been in energy prices, and at least some of that run-up in energy prices is really core inflation, because it’s reflecting a strong U.S. economy, strong demand from U.S. consumers and firms.  That portion of the energy price run-up belongs in the core, along with, you know, tennis balls and cars and everything else.  There’s no reason to be taking it out of the core just because it has the label “energy” on it.

So the truth is that we’ve already had a little bit of inflation in the system.  And when I see actual core readings starting to pick up at about the time where you’re in the stage of the business cycle where, because of the drop in the unemployment rate and other measures, spare capacity, historically you’ve seen a pickup in inflation—you know, this smells like inflation to me.

MR. TARULLO:  Okay.  Do you want to say anything on this, Ned, or should we—

MR. GRAMLICH:  A few things. 


MR. GRAMLICH:  To go back to your first question, Dan, you know, the question is, essentially, are all the central banks ganging up on inflation too much and at the wrong time?  It’s a very hard question to answer.  

There is a lot of strength in the system now, and it is, I think, different from two or three years ago.  And so whether there is excessive gang-up, I don’t know.  I mean, the ECB—we all have picked on that.  But they actually haven’t raised rates all that much, and their charter may be a bit constraining.  But I think that’s an open question.

However, if it is true, if they are ganging up on inflation too much, then it does eliminate Ethan’s strongest argument for worrying about inflation, which is the growing tight capacity.  So you know, there is a self-adjusting mechanism in here.

    Having said all that, let me say that for the central bankers, I think turning points are the hardest challenge of monetary policy.  If you’re on a steady growth path, you know, you expect that we’ll do something, we do it, everybody’s happy, and so forth.  But when you’ve had a policy adjustment over, you know, a number of meetings, let’s say, as we did back in 2000, it is really hard to know when you’ve gone too far.  

And so I think that—I just say that in the hopes that you’ll be a little kind to my friends because this is indeed a very difficult situation to sort out.  We all want to keep inflation low and stable; that’s the fundamental principle of central banking nowadays. Everybody agrees with it.  But you also don’t want to overshoot.  And it’s really hard to know just where to draw the line.  So I’m just going to plead for a little sympathy and not answer your question. (Laughter.)

MR. TARULLO:  All right.  I pushed you once, I won’t push you again.

Let’s turn, finally, to the global imbalance issue.  And instead of analyzing why we have the global imbalances, or whether they’re a good thing or a bad thing, we’re now in a position to talk prescriptively, because at least nominally, the economic policymakers from around the world agreed during the Bank-Fund meetings that global imbalances are not only something they should address, but should address collectively, or at least in a coordinated fashion, through this nascent IMF idea about bringing people together to talk and, presumably, to act.

So let me ask each of you in turn—and John, I’ll start with you, not because of where you’re headed, but just because you haven’t spoken for a while—I want to make that clear.  (Laughter.)  Ethan’s the only guy up here who’s not disclaiming anything, I would just—(laughter).

Let me ask you, what is the optimal mix of policy measures by different countries to be taken in order to deal intelligently with the redress of the global imbalance situation?

MR. LIPSKY:  Well, let me take one step back from that.  You said what policy changes are needed.  It’s possible that policy changes aren’t needed, but the question needs to be asked.

I can say something that’s slightly IMF-y, but won’t be at all controversial.  

It seems to me remarkable that heretofore, even though you’ve been hearing for years that global imbalances are the biggest concern or the biggest threat to the continued progress and stability of the global economy, yet there has not been a venue in which all the relevant policymakers—or the representatives of the relevant economies have been able to sit down and discuss this issue in some kind of frank and coherent way, in a useful way, rather than just simply in some big, public meeting reading speeches.  

So if I could—this is an easy answer.  The idea of creating a—enhancing what’s called in the vocabularies multilateral surveillance operations in the—or activities of the IMF is basically trying to create that kind of a discussion that has not—it’s almost astonishing that it hasn’t really occurred heretofore.

Now, that being said, what’s needed, it’s pretty clear what’s needed.  What’s needed is the United States is not going to long persist with—or it’s unlikely—Ned may have a different view—I think it’s unlikely to long persist with private savings rate as low as they are.  They are natural; there’s nothing that’s gone wrong; they’ve reflected the astonishing growth in net worth that has raised household net worth to record highs.  I think that we’re going to see a reversal of that, and that’s the basis of my claim that growth in the U.S. in the next 10 years is going to depend less on the growth of household spending and more on net exports and business investment.

Now, to make that all work, to continue growth at a solid pace globally, what you need, obviously, is the other parts of the G-3, the rest of the industrial world, that constitutes—that together with the U.S. still constitutes more than two-thirds of global GDP—to accelerate domestic demand growth.  Heretofore, until this year, basically growth in Japan and the euro area has depended much more on growth in external demand than on domestic demand, and that’s neither healthy nor likely nor should be sustained.

Then finally, in the countries of emerging Asia, particularly China, but not just China, similarly there needs to be development of strengthened domestic demand and less concentration on growth through external—through exports.

Now you say, what policies need to be put in place?  I don’t want to hog the time here, but I think these are not mysterious, and it strikes me that they are being put in place.  Namely, I think the U.S.—most of the adjustment is going to happen organically.  Certainly    we need to address our long-term issues of government entitlements in health and retirement spending.  That’s also true—easily as true, if not more true, in the other industrial countries.  They need structural reform that will help make their domestic economies work better.  And finally, places like China need to introduce more flexibility, I think, through developing their domestic financial markets.  

So I’m reasonably optimistic about the outlook because it strikes me that we got here for good reasons, not bad reasons, and progress is consistent with every country’s own individual goals.

MR. TARULLO:  You don’t get—I’ll come back to that in a second because I’m not—Ned, what, if any, policies that are not currently being pursued by the key actors need to be pursued?  And a second important question, do they need to be done in a coordinated fashion?

MR. GRAMLICH:  Well, first off, John said I may disagree with him.  The only disagreement we have is on the—whether our private saving rates will rise.  I’m not so sure.  In a normative situation, I actually support every word that John said.  I think that we should—the way I’d put it is we should raise our national saving rate if private savings doesn’t go up.  And we’re going to have to cut budget deficits, and we ought to do that, and that—now to—so the basic idea—and I’m perfectly normal here, I think—is that U.S. has got to reduce its budget deficit, Europe’s got to worry about demand, Asia’s got to begin thinking about exchange rates at some point.

Now, Dan’s question is, do they phase in correctly, automatically?  And maybe not, but just because the phasing problem isn’t perfect, it—that should not be excuse to avoid the adjustment.  We have to start making this adjustment.  In a particular case, suppose the U.S. actually does get serious about its budget and begins to reduce the deficit, do we have to worry about worldwide demand?  I would say no because, first off, I’ve watched the Congress many years, and they’re not going to reduce the deficit that quickly. It’s not going to be a really abrupt fiscal shock.  It’ll take place over many years.  In the way central banks make policy these days, I’ll be looking at output, and they’ll—if there is a little softness, they’ll adjust.  So I’m really not worried about the phase- in problem, and I think we ought to get cracking on the adjustment problem.

MR. HARRIS:  Yeah, I mean, I agree with John and Ned in almost every respect.  I think that realistically we need to accept the fact that there has to be serious entitlement reform, and there have to be higher taxes.  I mean, I don’t see how you move forward from here with the current tax structure and kind of sweeping under the rug the longer-term entitlement problems.  So that’s part of the adjustment process. 

MR. TARULLO:  And, by the way, to the degree that those two things are key to the adjustment process, Ned’s prediction of relative inaction will surely be correct.

MR. HARRIS:  Right.  Exactly.  (Laughter.)  That’s sweeping under the rug, yeah.

The other thing that obviously is true here, and that is that there—you know, there are two kind of danger points in all this.

One is, of course, you know, with Asian exports flooding into the U.S. economy, protectionist pressures will grow, and something’s going to happen on that front.  I mean, China has to change their development policy, start thinking about a domestically driven economy.  You can’t pump out 30 percent export growth forever.  When you’re a small country, you can do that.  When you’re a big country, suddenly, you are stepping all over everyone who’s—and so the current environment where China loans us ever increasing amounts of money so we’ll buy their exports is not a stable equilibrium over the long haul, and there need to be adjustments on both sides of this.

MR. TARULLO:  They are clearly thinking about that.  I don’t think there’s any question but that they’re thinking about it.  Their problem is they’re afraid to do anything about it in what they regard as a politically fragile, domestically fragile situation in which holding together a lot of potentially centrifugal forces in China is 10 percent-a-year growth.  And that’s the dilemma that they’re in, which supposedly Roach is figuring out over there in China right now. (Laughter.)

Okay, so let—we have—yeah, good.  We’re exactly where I wanted to be.

Now we’ll turn to questions from you.  And as always, please give, when I recognize you, you would state your name and wait—oh, wait for the mike first and then state your name.  Okay?  All right. Any questions here?  Yes, right there.  Sir?

QUESTION:   John Swing.  I would like to ask about the question of housing starts domestically and housing—we’ve talked about housing and the housing bubble, and housing starts slowing down.  How does that affect both the domestic economy but, much more important, what about worldwide housing starts and housing in general as a bubble?  MR. TARULLO:  Ned?  

I’m sorry.  The question is about housing starts both in the U.S. and abroad.  There’s obviously been a lot of attention paid to the slowdown in housing starts, and the question was, how does that affect the—ripple through and affect the economy as a whole?

MR. GRAMLICH:  Yeah.  We’ve been through a period where we’ve had very low interest rates, lots of liquidity in the system, and the types of spending that would automatically go up in that period are those that depend on that liquidity and on the cost of capital, and housing is top of the list.

Okay.  So you get to a period where we get to a more normal monetary policy, there’s not so much liquidity in the system, it’s withdrawn.

What goes down?  Well, housing will go down, or at least it won’t grow as rapidly.  And that is very natural.  And the idea here is that other types of spending would then take over and carry it forward. And as far as I can tell, I mean, the timing may not be perfect, but that seems to be happening.

So actually, in some sense, a bit of a slowdown in housing would be a very natural development at this point.

MR. TARULLO:  Anybody else want—Ethan?

MR. HARRIS:  Yeah.  I mean, we—I mean, housing’s been adding about a half a percent to U.S. GDP growth over the last several years. So it’s been a very—the construction part of housing.  So it’s been an important driver of growth.  It’s probably going to subtract a half a percent from growth over the next couple of years.  

And something else has to fill the void.  And what fills the void, I think, is the corporate sector, to some degree, not completely, but to some degree.  Corporate sector—extremely conservative in the last several years, underspending on capital and labor.  Perhaps we’ll get some further pickup in nonresidential structures.  So some of those construction workers will simply change jobs.  So there will be some offset to this slowdown in housing.  

But it’s hard to believe that the economy would be as strong in the next couple of years as it has been in the last couple years.

MR. TARULLO:  Okay.  

Other questions?  Yes?  Right here.

QUESTION:   Lester Wigler, Citigroup Smith Barney.  How will failure to reach agreement on the current WTO round ripple through into the economy?

MR. TARULLO:  I’m sorry.  How would failure to or—

QUESTION:   Failure.  Failure to reach agreement.

MR. TARULLO:  Failure to reach—

John?  MR. LIPSKY:  Yeah, I’m—thanks for asking that.  I was—(laughter)—

QUESTION:   (Off mike.)

MR. LIPSKY:  Yeah.  (Chuckles.)  No, I find it disturbing, frankly, that there has been so much willingness to accept the possibility or likelihood even that—of failure in the Doha round. If I’m not mistaken, this—if it were to happen, if your premise were to be right that there would be failure, it will be the first time in the post-World War II era that a multilateral trade liberalization round will have been allowed to fail.  And if it were allowed to fail over such trivial differences that exist strikes me as worrisome in the long run.

In the short run, it's hard to say.  Certainly markets aren’t going to tremble if Doha fails.

And even—I suspect the worst thing is it will not fail, but there will be an agreement that will be almost content-free.  (Laughter.) And I would worry about this because I view the—I think that especially from the U.S. side, the payoff for success in Doha could be so big.  

If there is a meaningful round—if there is a meaningful result in Doha, it will be because there is an agreement on agriculture.  If there is an agreement to further liberalize agricultural trade, this is the key to unlocking the possibility of a meaningful free trade agreement in the Americas, because the big deal there is Brazil, and we’re not going to have a trade liberalization deal with Brazil without agriculture; you can’t do agriculture regionally.  

So the payoff to us, to the U.S. from Doha—real Doha success, is, it seems to me, palpable.  And yet, I just can’t understand why there isn’t more focus on this issue.  

So in a way, it’s not that if we fail that disaster will ensue, although you worry that it will mean that in the future, that down the road there will be less and less dedication to future liberalization or to resist protectionist pressures.  But it seems to me, especially from the U.S. side, a potentially squandered opportunity.  And if the major protagonists here are unwilling to make the relatively modest compromises needed for success, I just find that terribly disturbing.

MR. TARULLO:  Let me add a couple of things there.  This is an area that I do look at fairly closely.

First, there is a real chance of failure, which I think has not been true with any other prior rounds.  

Second, whether this round succeeds or fails, I think it’s quite likely it’s the last big round of multilateral trade negotiations. There’s going to have to be some other system for liberalization.  

Third, John, I’m not so sure the differences are all that modest. And the reason for that is if you look at the numbers that the United States and Europe have both put out about what they’re willing—the cuts that the EU is willing to make on their agricultural tariffs, the cuts that the U.S. says it’s willing to make on its agricultural subsidies, when—remember when we used to look at the Japanese budget promises and spending and stimulus promises, we all used to say we’d look at what was the real—(word inaudible)—as opposed to    the headline figure.  Well, this is a case in which the U.S. and the EU are putting out big headline figures with relatively modest real changes underneath.  They’re doing the sort of thing of, you know, we’re saying we’ll cut the limit of authorized subsidies, when in fact there’s already a big gap between the actually subsidies and the authorized subsidies.  So the real effect is not that great.

The fourth thing that’s going on is in order to get this thing started, we called it a development round.  And now the U.S. and the EU—big surprise—have slipped into saying we, the U.S. and the EU, need more for our exporters.  So I think that the problems are real.  

President Bush has now, for the first time, focused on this.

I mean, he’s had three really first-rate trade representatives, and the White House has been completely uninterested in the Doha Round. Now the president is interested in it himself, and so maybe that will shake things up.  I think we’ll see in Geneva.  But for me the big story here is, succeed or fail, this is it for big rounds of multilateral trade negotiations.

Okay.  Other questions?  Yes, Dick.

QUESTION:   Dick Gardner, Columbia University.  Fred Bergsten and others have argued for years that the U.S. external deficit—

MR. TARULLO:  If it’s a Fred argument, you know it’s been for years.  (Laughter.)

QUESTION:   Well, not just Fred, others too have argued that the U.S. external deficit is headed inexorably toward something like a trillion dollars a year by the end of the Bush term, and that this can’t be corrected without a major change in exchange rates in which the Chinese and Asian currencies would be revalued to—by something like 20 or 30 percent, and that this is an urgent matter, this can’t be just continually postponed.  Is that a view that is shared by this panel?

MR. TARULLO:  Ned, why don’t you start on that.

MR. GRAMLICH:  Well, if you do the numbers—and the current account deficit is palpably close to a trillion dollars.  I don’t know what it is this minute, but it’s getting up there  If you do the numbers, it’s just hard to find any economic variable other than relative exchange rates that will cut into that kind of a number.  I mean, relative income growth won’t do it, you know?  We could have a recession here, and that changes the current account deficit in fairly trivial order.  So I think that if there is going to be correction of this current account deficit, it has to rely on relative exchange rates.  I just don’t know that there’s any other variable that does it.

Now, a question that John is going to be working on—and I’m going to just say it here and then let him comment on this—is, can we go on like this?  And, you know, when you  go on like this for 10 years, maybe you begin to think, well, maybe the disequilibrium here is not so serious.  And I think that’s an issue that there is some thought.  But on the other issue, if we do have to correct this, what corrects it, I just don’t see any other candidates.  MR. TARULLO:  Anybody else?

MR. LIPSKY:  Sure.  I think the basic question has to be asked whether correction over any—you know, do we have to correct anything or does any correction have to occur over any particular time frame?   As a starting point I’ll quote—I think our mutual friend—Dick Cooper of Harvard University, who points out that if there were no what economists call home bias, if there was true globalization in the sense that— home bias means that investment tends to occur close to where the savings takes place.  

In other words, savers feel more comfortable investing close to home than abroad.  You’ve seen that as a measure of globalization, and that’s been one evidence that globalization has increased, that home bias has declined.  In a world in which there was no home bias, in other words, you would you would just—investors everywhere would invest wherever in the world they found opportunity, reasonable to expect that U.S. savers would invest about 70 percent of their savings outside the U.S., since only about 30 percent of global GDP is in the U.S.  And likewise, savers in the rest of the world would invest 30 percent of their savings in the U.S. and 70 percent in the rest of the world.  If that had happened last year, the U.S. current account—and there was no home bias—the U.S. current account deficit would have been, according to Dick, $800 billion.  In other words, just about exactly what it was.

So was the prima facie case that something terrible is going wrong at a time in which the U.S. economy is growing very healthy, in which corporate profits are the highest in history, in which household net worth is at record highs, and inflation is very low.

MR. TARULLO:  Ethan, what if?

MR. HARRIS:  Well, I guess the worry I would have is that we know that in 2003 and 2004 central banks funded about two-thirds of the current account deficit, so the markets were basically saying, you know, we can’t do it; this is too much.  And the central banks had to do the work.  Last year, there was less central bank funding.  Japan got out of the intervention business, and the—but why was that? Why was the dollar able to handle this loss of funding from central banks?  Well, it’s because the Fed all year sounded more hawkish than other central banks, and this changed the attention of the foreign exchange traders.  And there were—you know, act like little kids—they get fascinated with a toy, and that’s their—that drives the dollar for a while, and then, they throw that aside and focus on something else.

Well, we got distracted by the Fed, but now, we’re back in an environment where, you know, the Fed is no longer the only central bank in town hiking interest rates.  And can we rely on central banks of Asia to again fill, you know, two-thirds of the current account deficit?  That’s the problem for me.  It’s not that—too much of the funding is based on central bank interventions.  Yes, they could do that for a long time, but is that really a healthy thing for us to be mortgaging our country over to foreign central banks.  MR. TARULLO:  Two little readings that I might mention for people who are interested, John mentioned Dick Cooper, who is in the economics department at Harvard, you know, the Michigan of the East. He’s got—

MR.     :  Thank you.

MR. TARULLO:  That’s—(laughs, laughter)—he’s got a piece that he wrote for the Institute for International Economics, in which he argues that imbalances—the external imbalances are not a problem. 

And he addresses both Asian exchange rates and U.S. savings rates. And you can get that on the IIE website, if you’re interested.  It’s from last November.

Secondly, Dick Berner, the chief U.S. economist for Morgan Stanley, had a piece yesterday in which he makes the case for the proposition that the U.S. current account deficit has peaked, and that now there’ll be either sort of more or less plateau, or indeed, potentially a decline.

Okay, last question right here, and then we’ll let you go.  And we need to be pretty quick on this one.

QUESTION:   John Watts, at GW.  This has been very stimulating and seems wise and prudent and insightful and all that.

MR. TARULLO:  Oh, oh!  (Laughter.)

QUESTION:   What might make it all go wrong?  What is sufficiently likely in the surprise area, outside of the economic forces we’ve talked about, and would have enough impact to really cause you to retract almost everything you said?  (Laughter.)  For example, everything turning right, as it might, you know, where we’re having a war.  Or really wrong.  Or a spectacular terrorist attack.  Or transmittable chicken flu.  Or what is—is not just, you know, a scare thing, but possible and really could change things?

MR. TARULLO:  I should say before anybody else offers their answers, that we almost always in this discussion bracket off big geopolitical developments because they obviously have a huge effect on the economy, but they’re not usually endogenous to the economy, so it becomes a little hard for us to talk about them.  But I think everybody up here would agree that a major adverse geopolitical event could have an enormous effect on confidence, and if it were something like an oil cutoff, on the real economy as well.

Anybody can talk about it, nonetheless, if they want to.  But is there anything endogenous to the economy?

MR. LIPSKY:  Yeah, I have my list of three worries.  First of all, inflation.  If inflation were really accelerating, I would be very worried about the outlook.

Secondly, a lot of what’s been happening is a global acceleration in productivity growth.  If that were suddenly to reverse, as it   appears to have done in the U.S. in the early 1970s, that also would be a big risk.

And third, the possibility of some big financial market dislocation.

I happen to think all three are not very likely or I would be less optimistic.

MR. TARULLO:  Okay.  


MR. GRAMLICH:  I’ll take those three and add imbalances.  We think—we may begin to think that Cooper is right and there’s no home bias.  But if the Asian central banks start dumping their Treasury securities, we could have a big adjustment in store.  So I do think the imbalance, it may not be a clear and present danger, but it’s at least a risk at some level.

MR. TARULLO:  Nathan, anything else?

MR. HARRIS:  Well, I’ll take those four and—(laughter)—

MR. TARULLO:  (Off mike)—if we had eight panelists!

MR. HARRIS:  And I’ll just underscore the inflation story.  And if you look at the history of U.S. and global business expansions, what kills expansions is inflation.  Too much inflation, tough central banks, weak economies, some second shock comes along—China dumps the U.S. dollar assets or bird flu or a terrorist attack or whatever, and that finishes the job, and now we have a recession.

So we don’t need to look too far into the exotic answers.  I think inflation is the classic end-of-cycle phenomenon.

MR. TARULLO:  Okay.  I want to thank Ned for having a first visit with us, Ethan for a repeat visit, and most of all, John for the last seven years.

Thanks very much.  (Applause.)

See you all in the fall—except for you.  (Laughter.) 

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