Corporate Meeting

The Economic Outlook for 2023

Thursday, January 19, 2023
REUTERS/Danish Siddiqui
Speakers

Chief U.S. Economist, Deutsche Bank

Chief Economist, Emerging Markets, S&P Global Ratings

Former Chief Investment Strategist, Bridgewater Associates

Presider

Host, Velshi, and Chief Correspondent, MSNBC

Corporate Program Virtual Meeting

Panelists discuss the global economic outlook for 2023, including the risk of recession, the state of inflation, and the geopolitical events that could affect markets in the coming year.  

VELSHI: Thank you very much for this. I am always honored to be invited to preside over a CFR function because they’re all so good and so smart. But this one I jumped at because the answers to what we talk about right now are going to be the answers I actually need.

I am somebody who spends a lot of time thinking about U.S. and global economics and I’m just a little confused right now about where experts like the ones you’re about to hear from think we’re going in 2023, which is going to be pivotal one way or the other.

So I’m really excited about this conversation. I want to introduce and thank my panelists. Matthew Luzzetti is the chief U.S. economist at Deutsche Bank. Rebecca Patterson is a former investment strategist with Bridgewater Associates. And Satyam Panday is a chief economist at—for emerging markets at S&P Global Ratings. All three of them have a remarkable and extensive resume that you should look up, trust that they are the ones you want to talk to.

We’re going to chat amongst the four of us for a little while and then sometime before the half hour I will come to you for questions, and there are various ways that you can do that, which Alexis will alert you to at the time. But you’ll be able to interact and ask the questions that we haven’t already discussed.

So, with that, let’s kick it off. Thank you to all of you for being here.

Matt, let me start with you, because about a year ago you put out a report—your team at Deutsche Bank put out a report in which you argued that 2022 was going to be critical for determining whether and how the U.S. returns to so-called normal inflation rates and interest rates that prevailed before the pandemic.

And, you know, we were talking at the time about inflation. Some people, perhaps erroneously, described it as temporary. They used various words to describe the fact that this was not going to be something that was going to set in and affect us.

We got to a midterm election in which polling indicated that this concept of inflation was going to be very, very important to voters. In the end, it was not a decisive matter for voters but it still may be.

I want to ask you about how you think 2022 played out and whether or not you can take that report and just sort of install it at the front of 2023 and say, hey, it’s going to be critical this year to find out whether we get back to normal inflation rates and interest rates.

LUZZETTI: Sure. First, thanks so much for having me. Really excited to be able to discuss the 2023 outlook.

You know, I think you’re exactly right. If you go back to late 2021, we were looking at the year ahead as one that would be pivotal in determining whether or not we would return to what was called the new normal—you know, that environment that had set in before the pandemic—low inflation, low interest rates, not much volatility, certainly, in markets or in the economy, a Fed that was overly easy, that could focus on the labor market, had just undergone this big policy framework review focused on the labor market and average inflation targeting.

I think 2022—over the past year—you know, we, certainly, learned that that transition and getting back to that period, one, it’s uncertain if that’s where we’re going back to but, two, the transition path is a very, very difficult one.

And so, I think, you know, early last year, certainly, as, you know, some were thinking about the inflation shock being transitory, we very quickly learned that it was not going to be and I think the nature of the inflation shock evolved very quickly to one which was initially driven by goods. It was initially driven significantly by supply chain disruptions. It was initially very narrowly focused in terms of the price pressures that we were looking at and, you know, everybody was focused on used car prices rising 50 percent over several months.

But very quickly it morphed into something that, I think, was far more concerning, one that was broader based. You know, we would look at the trimmed mean inflation gauges or the median inflation gauge, which really started to skyrocket, as one that moved just from goods to services items, which tend to be more persistent.

It became more demand driven, and I think all of these things were very worrying from the Fed’s perspective, from global central banks’ perspectives.

We then had the invasion of Ukraine, which overlaid on top of this a massive inflation shock in the energy market which risked an un-anchoring of inflation expectations. And I think that triggered the very aggressive policy response that we saw from the Fed over the past year, one which saw them raise rates by seventy-five basis points four times, really, the most aggressive tightening that we’ve seen since Volcker in terms of what the Fed has done.

Now, I think that has put the Fed in a much better position to respond to the incoming data. I think we’re looking at risks that are now more two sided. I think for the most part of the past year we were very much worried about upside inflation risks. Now I think we are seeing some evidence in the growth data that is softening. We, ultimately, think that a recession is the most likely outcome in the second half of this year.

But I think, ultimately, what we have learned and I think what is pivotal for 2023 is that getting inflation back down to target is going to be—is likely to be a very painful or at least require some pain in the labor market and economic outlook in order for that to fully happen.

I guess just as a concluding remark I would note that there are structural changes that are ongoing. A lot of the global disinflationary forces that we talked about before the pandemic, many of them are probably shifting. It probably means that the inflation outlook on a structural basis is different. It probably also means that the yield curve and term structure, I think, is structurally different.

But maybe those are some topics that we can get into in more detail a little bit later.

VELSHI: I just want to clarify two things that you’re saying.

One is while you think this will be a year in which we will experience some negative growth, your estimates are that it’s not going to be a lot for 2023 and that the increase in unemployment is also not going to be a lot. We might get back to what we used to think of as full employment, around 5 ½ (percent). Five, 5 ½ percent is what you’re thinking unemployment peaks at.

LUZZETTI: Absolutely. So I want to be cautious and be humble here.

VELSHI: Of course. Yeah. Yeah, I understand.

LUZZETTI: So we started calling for recession in April, and for an economist to kind of call for a recession that far ahead is very unusual. I think you have a very unusual environment where, you know, you look at the Wall Street Journal survey and economists think 75 percent of recession—chance of recession over the next year.

We do think that it’s going to be moderate from a historical perspective. I’d liken it most to the early 1990s recession. There’s arguments on both sides. I think the arguments are for it to be either deeper or longer or that, one, the Fed may be constrained in how much they can respond due to high inflation; two, there are, obviously, very clear fiscal risks out there with the debt ceiling, which could make this more severe.

But on the other side, if you look at household balance sheets we still have significant excess savings, there’s not a lot of deleveraging that needs to take place, and the housing sector is already going through a meaningful correction.

So I think that all tends to moderate the type of recession that we anticipate we’ll see. You know, ultimately, we think that leads to something that’s moderate from a historical perspective, seeing the unemployment rate rise by about 2 percentage points by early 2024.

VELSHI: Thank you for that.

Rebecca, you just published an op-ed in the Financial Times and the reason this is important is because we are very focused on what the Fed can do about the situation we’re in, and it’s an unusual situation in that they need to get their interest rate hikes out before we have any significant slowing of economic growth.

You argue in your piece that there are a few other things at play, that regardless of the Fed’s constraints the Fed may not have an effect on or the effect of the Fed may be blunted because of external forces.

PATTERSON: Or even that these external forces could affect the Fed’s thinking.

So what I was talking about in this specific piece was the dollar. But I think maybe, given that we’re starting right now on the global economic outlook, let’s talk about the economics.

The big one to focus on is, really, China here. So as we all have read about now and are familiar with, China has pivoted from hard lockdowns to a fast reopening and there is now a very quick change in sentiment towards Chinese growth on the back of that, and I think the question as we take this back—we can talk about China. I think there’s a lot to talk about regarding China.

But as we take this back to the United States outlook and the Fed, to me, there’s two questions. One is, will the continued improvement in supply chains, thanks to China’s reopening, be a disinflationary force, especially for goods. But then contrast that—as you have a reopening people are traveling more. They’re flying more. They’re demanding more products, which means more production, more energy needs. That pushes up commodity prices.

And so when you net those two things out, we think there’s still likely to be a modest inflationary impulse that comes from the Chinese reopening. So if you have this inflationary impulse that comes from China and at the same time you do have a relatively weaker dollar that’s also going to be modestly inflationary for the Fed, it could make the Fed’s job that much harder—again, at the margin, but that much harder getting down to its 2 percent inflation target. As the markets are discounted it’s going to happen in a pretty benign way by May that they—you know, the markets are saying the Fed is going to be done and start easing. To me, that seems pretty unlikely.

VELSHI: Thank you for that. And I do want to actually explore the China question along with emerging markets a little bit more with Satyam.

Satyam, give me a sense of how this conversation translates to the rest of the world and how the—both this—the lifting of COVID restrictions in China and, you know, some news that came out this week that has people concerned, generally, about China’s growth, how this all plays into your evaluation.

PANDAY: Sure. So the couple of factors that have already been said here they do matter quite a bit for the emerging market space, in general. You know, take China, for example. That’s the first one that’s a big—you know, the pivot that we just saw in terms of the COVID strategy that does matter for the overall emerging market more than anything else, just given the weight of the trade and the financial flows that goes with it.

In general, we do think where does the impetus for this growth in China come from? Is it a consumer-based growth now that’s going to be rebounding or is it industrial-based growth, right? So that does matter for the various, you know, emerging market economies.

Right now, at least, from the COVID rebound we are thinking it’s more on the consumer spending side of things rather than on the infrastructure or the property sector side of things that is going to really increase this rebound in growth for China itself.

That means most of the Southeast Asian industrial complex that’s more tied with the Chinese manufacturing, the consumer sector demand, that may be more, you know, looking at some gains from what we had thought earlier. You know, that also ties with the tourism sector, a lot of the pent-up demand for going out and visiting places that also is going to be seen in places like Thailand or in Indonesia, things like that.

But in terms of commodity side of things, when you think of LatAms—the Latin American countries—yes, we have seen the copper prices start to move up. We also think that there will be some extra positives than what we have thought earlier for these Latin American countries.

But, again, it’s not clear to me yet at this point in time how much of the policy pivot that we saw in terms of credit condition loosening for the property sector is it really going to be more than just stabilizing that sector.

So it’s a little bit hard to tell at this moment. Maybe there will be more loosening in the coming months. But that does matter for the outlook.

Then the one that will be considered U.S. and, I would add, eurozone as well—these two big, you know, economies for the globe—they are both sort of expected to have at least a shallow recession right now. That’s the consensus and, you know, our own U.S.—you know, our own U.S. economists, eurozone economists, think so, too.

So that is going to impact a lot of these countries that are kind of tied with their industrial sectors itself. So you can think of Eastern Europe, some of the—you know, some of the—the auto-related industrial sector for South Africa with eurozone, you know, Mexico with the U.S. All of those are going to be impacted.

So, all in all, below longer-run potential sort of a trend growth rate for the emerging market space after a nice bump up that COVID rebound-led tailwind that we saw last year. But, again, looks like LatAm is going to be the weakest of all with Southeast Asia, perhaps, more closer to its, actually, trend rate because it is going to enjoy more of that, quote, “China rebound” than anybody else.

VELSHI: Let me just ask you quickly, because you mentioned Eastern Europe, we’re approaching on February 23 and 24 the first anniversary of the Russian invasion of Ukraine. How does that figure into your calculations?

PANDAY: Yeah. They have already been hit pretty hard, you know, since then and we do expect them to have a very weak profile, you know, about a shallow recession. You know, the German industrial complex is going to sort of matter for them and it is going to impact, you know, some of the oil and the gas prices, especially natural gas, you know, depending on how that dynamics plays out for the next winter.

It’s not just about this winter itself. They have sort of seen through this in a quite positive than what was expected manner. But for the next winter as well it does matter.

But all in all, we do expect a much below trend growth rate for most of Eastern Europe. Again, it’s very hard to tell right now. That is something that is up in the air. Yeah.

VELSHI: Rebecca, let me ask you about that as well, because part of the good fortune so far has been a milder winter than—the start to the winter season than we thought in Europe. But the bottom line is anything can happen, right. We just don’t know where this goes.

We don’t know what the plans—what plans Russia has. There’s going to be a new aid package—military aid package—announced by the U.S. on Friday. We believe there’s more mobilization going on in the Russian and the Belarusian side.

What’s your sense of how we think about the effect of this war, which could escalate or could end in 2023?

PATTERSON: Yeah. So the war is the third big question mark for this year. If the Fed is the first—how much do they tighten, do they start easing later this year as the markets are discounting—second question being China—how big a reopening bounce do they get, how long does it last—and then the third one, of course, is the war and no one can predict when it’ll end or if it could escalate—hopefully not—before it ends.

And so when you’re thinking about Europe, obviously, you have to bake that into the cone of outcomes that could happen economically and from a financial market perspective.

I guess what I would say that’s interesting to me is that while Europe has done better than feared so far we’re still seeing plenty of evidence that things are slowing. Germany, obviously, the engine of growth for Europe, has seen a big turn lower in new orders for manufacturing. That tends to be a slightly leading indicator for industrial production. So that’s starting to soften further.

Retail sales have been softening for the last several months now, and so things are slowing. But similar to the U.S.—not to the same degree—you have tight labor markets, you have rising wages, and, of course, the big thing is the energy shock.

And the European Central Bank—the ECB—just this week from Davos Christine Lagarde reiterated that the markets have it wrong, that the ECB is going to continue tightening, possibly by fifty basis points at its next meeting, because it really is focused on its inflation credibility and getting that back down under control.

So even though hopes have started reemerging around Europe, I think they might be a little bit too early and the risk that we do have at least a modest recession in Europe this year almost regardless of what happens with the wars is still what I’d be looking for, partially because of that tightening that’s not fully discounted and partly just because of the toll the sustained war takes on Europe and we’re starting to see that reflected more in the economic data.

VELSHI: Matt, I want to take you back to your days at the Fed—in the Philly Fed and to your days when you were writing economics theses to tell us a little bit about the situation that the Fed is in.

You made a comment in your last answer when you said the Fed may be constrained as to how much it can do because of inflation, and so this is an important consideration, right. A lot of people are critical that the Fed waited too long to start interest—raising interest rates, and may keep raising interest rates into a dramatically slowing economy or a slowing economy.

But the Fed is worried about the fact that the economy turns down prior to the fact that it’s finished raising interest rates to fight inflation. Give me a little sense of how that plays out for you. We don’t want to get ourselves into a position where we’re in May and inflation is not comfortably lower than it is, even if it’s peaked, and yet we’ve got ourselves into some kind of a slowdown. Because then what does the Fed do? Does it raise interest rates or does it lower interest rates?

LUZZETTI: Yeah. I think you’ve heard Fed officials, Chair Powell, many times talking about this in terms of risk management.

On the one hand, they have, you know, not being hawkish enough, not tightening enough, and that doesn’t bring inflation down and we repeat, you know, perhaps, what we saw during the 1970s where, ultimately, that leads to worse economic outcomes, worse recessions, a labor market that is materially weaker; on the other hand, the risk that they, you know, do too much, perhaps triggering a recession in an environment where they need not do so.

I think very early on the risk—that risk management was very clear. They were coming from a world where real interest rates were very negative and the economy was very far away from their objectives.

I think what we’ve seen over the past several months is that there are some divergence in views in terms of those risk management considerations. You know, certainly, there still are upside inflation risks. We have seen inflation coming down over the past several months.

At the same time, the Fed has done a lot. You know, they’ve raised rates by more than 4 percentage points over the past year and there’s lagged effects of what that’s going to have on the economy.

I really do think the next several months are going to be critical but I think they’re also going to be very difficult in the sense that we’re likely to see inflation probably reaccelerate somewhat over the past several months. Some of the big items that have been deflationary the past several months like used car prices are going to be turning around.

At the same time, we are just beginning to see evidence that growth is weakening. We saw it with retail sales, industrial production, the services type indicators. And so this tension in the Fed’s dual mandate it’s not there today because we still have a historically tight labor market and inflation that’s well above their objective.

That tension will no doubt be there this year. We think by the end of this year you have the unemployment rate around 5 percent, inflation is around 3 percent. That is still above target inflation at a time where the labor market has eased a lot.

It does present a tension for them. We think they start cutting rates in that environment, though, and, importantly, if you were to look at any of the policy rules that they would typically follow it does say that they would be cutting rates under that environment.

No doubt they’re not saying that—they’re not saying that today. I think they have reasons to do so. They don’t want the financial conditions to ease. But I think if you get our forecast, the Fed will be easing monetary policy this year.

VELSHI: But that’s—you know, somebody with your level of training and expertise would think that that’s logical, right. The danger is if that’s not the case, right. We get ourselves into a slowing economy, maybe one that slows more than your forecast indicates, and the Fed doesn’t.

I mean, they’ve got gas in the tank now to drop rates if they needed to to goose the economy. Is there any danger that they don’t and we get ourselves into a weird spiral where the Fed’s raising rates in a slowing economy?

LUZZETTI: I think there’s no doubt danger that, you know, ex-post we found out that they’ve raised rates into an economy that is going to be slowing. That is, I think, the natural risk that you take and that was inevitable with, you know, being somewhat behind the curve because we were all surprised by this inflation shock, and having to move so aggressively.

I think they can help minimize that risk by getting down to twenty-five basis point rate increases in February. I think that’s the very likely outcome. They will be able to assess the lagged effects a bit better. But, you know, I think that risk will still be there.

VELSHI: Satyam, generally speaking, central banks around the world followed the roadmap put out by the Fed. Lots of countries were late to raising interest rates. Lots of countries got aggressive. Lots of countries sort of look at what the Fed does and does the same thing.

Is it your sense that everybody’s moving correctly at the right velocity despite the fact that they may have gotten a late start to raising rates?

PANDAY: So, Ali, just to rewind back a bit here, there were some—you know, countries like Brazil, Chile, that actually were ahead of the curve this time. When they saw inflation expectations start to move they immediately were moving. So they actually moved a year earlier than the Fed did. So that’s one thing.

And the second thing, there are countries like Mexico and others which are very much closely tied they’ve got an eye on the Fed. Exactly whatever the Fed does they are looking at it and they have been moving together in tandem even though their growth may have slowed down and that’s because they do want to protect their capital. They don’t want to see capital outflow and they do want to protect some of that exchange rate valuations as well, and we have seen that throughout this year.

In fact, the emerging market as a whole had a lower depreciation against the U.S. dollar than the advanced economies if you were to consider that. Some of it has to do with the terms of trade as well. But, still, this time around emerging markets, central banks, were on top of their game. Yeah.

VELSHI: Do these standout emerging markets worry you, the ones that have inflation that is many times the rates that we’re talking about in the developed world?

PANDAY: Well, there are a few but, again, it has to do with the commodity prices. It has to do with the oil price. You know, Eastern European countries like Hungary, Poland that comes to mind. Some of the countries have more of a core. Like, South Africa is going through this supply-based electricity, you know, issues and things. That has—

VELSHI: And they’ve got rolling outages two times a day.

PANDAY: The rolling outage is very bad. It’s sort of they were not able to capture some of the terms of trade that comes with the high coal prices because of that but—and then in the LatAms you’ve seen some of those inflation already peak and start to come back down.

But, again, yes, there are some countries—there are always some countries in the EM space that are a little bit above in general terms. Yeah.

VELSHI: In a few moments I’m going to go to questions.

Rebecca, I want to ask you about the situation going on in the United States right now. Today, Janet Yellen said that the country has reached its 31-point-something-trillion-dollar debt limit and she described some of the things she’s doing to try and stretch things out until June and she says in June she’s going to run out of headroom and the United States will miss some payment on something.

There is a Republican plan that the Washington Post has said is being floated about whom to pay and whom not to pay, except credit experts understand that if you miss any payment it’s the same as missing all payments, right. Missing your car payment is not better than missing your mortgage payment.

Talk to me about the effect of this micro situation and sort of political polarization and dysfunction in the United States as a threat—how you evaluate it.

PATTERSON: Sure.

So yes, it is a potential policy mistake that could be—even if it’s known well in advance could be very material both for financial markets and the economy. But before I address that just real quick—when we’re talking about policy mistakes one thing we haven’t mentioned yet but I just want to make sure we touch on at least briefly is not only is the Federal Reserve raising interest rates but it is also reducing its balance sheet.

VELSHI: Right.

PATTERSON: So quantitative tightening, which is happening at double the pace that it did when it tried this in 2018.

And the Fed itself admits it doesn’t have a large sample size to understand how this is going to play out and so, again, when we’re talking about how far should the Fed go, how fast should the Fed go, when should it ease, et cetera, there’s a lot less certainty this time around not only because of the economic conditions but also because they’re using a policy tool that they just don’t have as much experience in.

VELSHI: Right.

PATTERSON: But going back to your question on the debt ceiling, so I think we have, as you put it, the tactical—(audio break)—the dynamic that it’s reflecting. On the tactical micro issue, if you can go back to 2011, the last time we flirted with a default the S&P rating agencies downgraded the U.S. sovereign credit rating to AA and we saw the U.S. stock market fall nearly 20 percent in just a few months. We saw the ten-year Treasury yield fall almost by half, from 3 percent to 1.7 (percent). We saw an 18 percent rally in gold prices.

Now, what I worry about this time around—now, at that time, Europe was also a mess. They were going through their debt crisis. That might have contributed. This time around we’ll see where Europe and China are.

But what we do know is the Fed is probably going to be looking at a world with inflation still above target so it might be harder for them to ride to the rescue if we do have this shock. And I do think the risk is probably the highest it’s been at least since 2011 that this does materialize even if it’s for a very, very brief period.

And then, finally, going from the tactical issue to the broader dynamic, I have spent a lot of time trying to understand the linkages between politics and policy with economics and financial markets, and there isn’t a ton of great data to analyze.

But what I have been able to find suggests that when you do have less functional governance, and I think we could argue that’s what we’re looking at here today, it can affect the economy and markets simply because if you don’t know what regulations are going to be, tax rates are going to be, fiscal monetary policy is going to be—not the monetary in the U.S.—but then it’s harder for businesses to plan and if they’re having a harder time planning they’re probably going to be more cautious and that means less investment, less hiring.

So that’s going to slow growth. It’s going to weigh on earnings expectations, which in turn can feed into stock prices, and we’ve actually seen evidence of that across countries across time. It doesn’t always work that way. If you had extreme fiscal easing or monetary easing that could dominate that political effect.

But at the margin, the functionality, if you will, of governance absolutely matters and the degree we’re seeing what’s happening in the U.S., all else equal—again, fiscal policy aside—I think, is a tax on growth and a tax on markets in the United States.

VELSHI: Yeah. It’s an interesting point because I’ve been focusing on my show on this less functional governance issue and what the question I get on social media from a lot of people is how is this going to affect my 401(k).

And, by the way, they really are interested in that. They want to know that. It’s been a rough year in markets and they want to know how that nonsense going on in Washington affects them.

You are all fantastic. My head’s exploding with all the various threads we can go down. But, unfortunately, I don’t get to ask all the questions here. Fortunately, for the audience, they get to ask questions.

So I want to hand it over to Alexis to start us off with some of the questions that we’ve already got lined up.

OPERATOR: (Gives queuing instructions.)

We will take our first question as a written question from Michael Godley, who asks: Are there any expectations for additional rate hikes coming from the Bank of Japan? If the Bank of Japan raises rates what impact would that have on your global economic forecasts?

VELSHI: Very, very good question, given that there’s been a lot of activity—economic activity in Japan, a lot of concern that Japan does not want to get itself into a pickle around interest rates and inflation.

Matt, is that for you or Satyam or both of you?

LUZZETTI: I can give a brief comment there.

I mean, certainly, from a global market perspective the Bank of—recent Bank of Japan meeting was a key focus. And I think it’s a key focus for the global yield curve because if there’s one area that, I think, can lead to a big rise in the term premium and a big steepening of the curve, people are focused on the Bank of Japan relenting from their yield curve control targets.

Obviously, they didn’t do that this week. Our expectation is that they will move that band at least higher, perhaps abandon it later this year. That should be a—something that does lead to higher interest rates. And then, ultimately, whether or not you get further tightening, I think, is a big question for are we seeing core inflation in Japan continuing to move higher; are we seeing the labor market producing wage growth that suggests that inflation is going to become a more persistent story there.

So I think, yes, there will be movements into that direction. But the Bank of Japan has showed a pretty substantial and meaningful commitment to yield curve control in the current environment even when it was anticipated they were going to back off from that.

VELSHI: Why is that different than the U.S.? The Japanese are concerned that inflation is higher than wage growth. Inflation is higher than wage growth in most countries right now, certainly, in the United States.

LUZZETTI: Yeah. No, I think the inflation data that you have there is simply very different than what we’ve had in the U.S. We had this massive inflation shock where core inflation, broader measures, trimmed mean, median, were very elevated and moved—and are coming lower but at levels that are still, you know, double or more the Fed’s objective.

We’re just beginning to kind of see core inflation move higher in Japan. At the same time, you had the coincidence of the labor market in the U.S. historically tight, 4 ½ million more job openings than unemployed individuals, unemployment rate at, you know, fifty-plus year lows with wage growth inconsistent with the Fed’s 2 percent objective.

We just haven’t had that sustained type imbalances in the Japanese economy as of yet, which, I think, has allowed the Bank of Japan to hang on to their policies a bit longer.

PATTERSON: And if I can jump in just very briefly on this.

I think it’s important to put the historical perspective on Japan’s thinking today. You know, Japan has been trying to exit zero inflation, or deflation, for over a decade and now it’s finally gotten positive inflation rates and some wage growth, which, I think, they’re actually very happy about.

And what has happened in Japan for, again, the last decade is every time the economy started to reflate—better growth, better inflation—they would start doing fiscal tightening or premature tightening of some sort and push them back to the beginning.

So it just—they kept having these false dawns, and I think part of the reason they’ve been reluctant to leave their yield curve control policy—their easing monetary policy—in contrast to the rest of the developed world is because they don’t want to have another false dawn. They want to make sure that this positive inflation environment can stick and so they want to be very, very careful how they get out of it.

VELSHI: Yeah. There’s sort of an historical memory in Japan that is making them more cautious, something we sometimes forget about here. Thank you for that.

Alexis?

OPERATOR: We will take our next question as a written question: Alongside conversations about how to lower inflation there have also been some debates about the target number itself. Is 2 percent the right number or should we also reconsider our target?

VELSHI: Who’d like that?

PATTERSON: I’m happy to start.

I’ve been involved with the New York Fed for a lot of my career on different committees and working with them on different projects. It’s, certainly, something I follow carefully.

I think right now the Fed’s primary worry is credibility. If they were to stop tightening or start easing interest rates with inflation—you know, core PCE much above target—I think they’re worried about credibility. I think that also goes with—let’s say they say, well, we could raise the target from 2 (percent) to 3 (percent) or we get to 3 (percent) and we just say that’s good enough.

The problem is then the next time we have higher inflation do they settle for 4 (percent), do they settle for something else. And so the Fed, I think, is extremely focused on making sure inflation and inflation expectations stay anchored because that price stability is supportive for the broader economy. So, in the short term, I think that is critical.

That said, there have been talks even before the pandemic about what the right target number is and most Fed officials will admit that 2 percent isn’t necessarily scientific. It was not too hot, not too cold.

So in the next coming years could we see another policy review that leads to a slightly different inflation target? I think it’s absolutely possible. I just don’t think it’s likely to happen in the current environment, given that credibility worry.

VELSHI: Interesting. I’m reading between the lines here, Rebecca. If you have these types of policy conversations and recalibrations in normal times they’re just reasonable discussions that doesn’t affect your credibility. If you have them today it feels like you might be copping out.

PATTERSON: Correct. Absolutely.

VELSHI: Satyam, how does this work in the rest of the world? Do people come up with the higher expectations or do they think the U.S. 2 percent target is a little silly?

PANDAY: Well, not really. I think—I do agree with Rebecca on the credibility issue. They should probably—they do know that they would want to keep that as is. There is something called the time consistency effect. You want to make sure your credibility is intact. You don’t want to be flip flopping here.

But something very similar that came out just the other day—I think it’s from Brazil—that Lula was overheard saying that maybe, perhaps, the central bank should not be as independent and maybe they should be just increasing their inflation target rate in Brazil from 3.25 (percent) that they have right now to maybe, perhaps, to 4.5 (percent) and that sort of—immediately your ten-year bond yields, the risk premium that you, you know, put on that immediately jumped up.

And so you have to be very careful as a politician, especially, and that, you know, stature to say things that don’t really spook the market, don’t really get the credibility of your own central bank in, you know, jeopardy. So I think—

VELSHI: That’s a good point.

PANDAY: —that would be something to learn. And it’s probably not like that for the U.S. but at least for the rest of the EMs they have to be very careful. Yeah.

PATTERSON: Well, and the U.K. almost became an EM late last year, you know, and a year ago you were seeing policymakers in the United Kingdom talking about the Bank of England’s independence.

And after we saw Liz Truss and her cabinet suggest some very, very extraordinary fiscal stimulus with inflation at double digit rates and the market reaction forced the Bank of England to jump in and, frankly, save the day, I think that talk’s gone away very quickly.

But I think it’s a great point everyone’s making here about central bank independence. If inflation stays stickier for longer when the unemployment rate starts going up, as this starts to be felt more painfully among the electorate policymakers could decide to try to point fingers toward central banks.

So I do think that’s something we should watch out for over the course of this year around the world emerging markets and developed.

VELSHI: Matt, your take on the inflation target and its reasonableness and this question of credibility?

LUZZETTI: Sure. I think maybe there’s just two ways to think about it.

One is a nice theoretical argument about whether or not 2 percent is the right target or not. I think, you know, Fed officials and most—maybe many central bankers might tell you that no, you know, if you were to run simulations with the Fed’s model about how often we’re going to hit the zero lower bound and how often that’s going to be binding with a 2 percent inflation target. It’s just much more of an issue than they thought it was going to be at the time when they set that 2 percent objective. So there’s a theoretical argument for a higher inflation target.

That said, what everybody said makes complete sense. There is no way the Fed change their inflation target, moves the goalposts when they’re missing it from the upside. There’s no better way to ensure that they’re not able to get inflation expectations while anchored than to move the goalposts at a time where they’re not meeting their objective.

I would only maybe just conclude with Chair Powell had a really interesting comment in the December FOMC meeting when he was asked about that. He said, basically, you know, today we’re not thinking about it at all but it may be a longer-term project, which I was surprised that he at least admitted to considering that over the longer term, given where we are today, from an inflation perspective.

VELSHI: Where do you think we’re going to—when do you think we’re going to get to 2 percent or a place that the Fed can reasonably have that conversation without it affecting credibility? In other words, close to 2 percent.

LUZZETTI: So we have inflation in 2024 getting down to 2 ¼ percent.

VELSHI: Got it. OK.

LUZZETTI: And, you know, it takes a recession to get there. I think there’s these structural inflation drivers, which mean that we’re going to be above 2 percent rather than below. They have a policy framework review out in 2024-2025, which will be the next time where they’re rethinking their framework.

You know, I don’t think that’ll be a key area of discussion but it could be one if we’re in a world where inflation is below their target.

VELSHI: But it would be the beginning of the time when you can think about that being a discussion.

LUZZETTI: Yeah.

VELSHI: Mostly I’m trying to just underscore your point, that your scenarios about growth and inflation and unemployment over the next couple of years nobody likes any kind of recession. But you’re not thinking about a severe one right now. You’re thinking about one in which most things bottom out in 2023 and start to improve economically by the end of the year.

LUZZETTI: That’s right. That’s our central scenario.

VELSHI: Got it. Thank you. Thank you. A very robust set of answers from everyone. I appreciate that.

Alexis?

OPERATOR: We will take our next question as a written question from Andy Stull, who asks: What is the significance of the interest expense on the national debt approaching the amount of fiscal tax receipts in terms of limiting monetary and fiscal tools to manage the economy?

VELSHI: Excellent question.

Rebecca, you want to start with that?

PATTERSON: Sure. Happy to.

This, to me, is something we’re going to see in the U.S. but also globally. As interest rates reset higher and interest expense on debt is higher and a bigger part of the pie, governments are going to be faced with tradeoffs, and we can’t forget how much our debt levels have changed.

We saw a big ramp up from the financial crisis in 2008-2009. We saw another ramp up with the pandemic and then the responses after the pandemic. And so we’re looking at extremely high debt levels, again, across a lot of the developed world.

It’s interesting right now. You’re seeing a hint of what could come in France. So Macron is trying to change the retirement age in France by two years—sixty-two to sixty-four—and we have riots and protests on the streets, and the reason he’s doing it is because the government simply can’t afford to spend that amount of revenue on retirement and social spending programs.

We’re going to see the same thing when it comes to Japan, when it comes to China, when it comes to the U.S., across Europe, South Korea. As economies age and you have a higher dependency ratio, you have more retirees and you have less revenue coming from the labor market, you’re either going to have to have higher taxes, which is never very popular if you’re a politician. You don’t want to have to pass that. Or you’re going to have to have cutbacks in spending somewhere.

And so, yes, you want to have reflation in an economy. You want to have growth. But you need that growth to be higher—the pace of growth to be higher than the pace of the interest rate increases or that interest rate expense is going to nibble away at everything else and cause some very hard tradeoffs for politicians, which, in the case of France right now, is leading to social unrest.

VELSHI: Yeah.

Satyam, let me just ask you about this because this particular question becomes relevant, obviously, with the debt levels that we’ve got here in the United States.

It’s been a very relevant question for emerging markets for a very long time. There are lots of countries that you cover where debt limits are crippling to the economy and changes in interest rates like this are really something that is existential for some of them.

PANDAY: Yeah, and especially, you know, after the COVID, all of those stimulus and the tax exemptions that were given in order to make sure that the households’ balance sheets were not completely, you know, shattered and the businesses as well, I think some of the core EM countries they do have their debt as a share of GDP gone up quite a bit than what we have seen in the past cycles.

There have been some countries where, you know, like Sri Lanka, you know, Pakistan, and, you know, Tunisia, these have already started to kind of sort of, you know, come in a new cycle. But they are quite small in a broader scheme of things that don’t really have that systemic issue here.

But this time around, at least in the EM space, a lot of the debt that were taken out were in their own local currency rather than in, you know, U.S. dollar. So that sort of gives them a little bit more cushion in terms of how this is going to play out.

But, again, I think the private sector side of things more than the sovereign side of things have been getting more and more debt burdened and this is something that is going to be playing out when—especially right now when the interest rates have moved up quite a bit.

So the debt burdens and the debt ratios as a percentage of their income is going to be pressured in the next twelve to eighteen months. So that’s something to look out for.

VELSHI: And Satyam has brought up matters relating to the dollar, which takes us back, Rebecca, to the op-ed you wrote and the topic of it. Let’s just talk about that dollar weakness and its implications.

PATTERSON: Yeah. Well, last year—2021 and—part of ’21 and most of 2022 we saw a very rapid, fairly broad-based dollar rise, again, more against some of the developed markets than most of the emerging markets, although Turkey, Argentina—there were a few outliers—and that’s kind of turned about face. You know, since September/October we’ve seen a pretty rapid dollar decline.

Now, part of that is changing expectations for the Federal Reserve. Now the terminal rate—so where the rate finishes, the hiking cycle—is under 4.9 percent. Just a few weeks ago, it was above 5 percent. And I think Fed officials are at pains to say, hey, we may not finish till we’re above 5 percent. So the changes in Fed expectations could continue to create some dollar volatility.

But as we mentioned at the beginning of our conversation today, forces externally matter as well. You know, the dollar is extremely expensive by historical standards and currencies, over time, tend to mean revert.

The other force that tends to drive currencies structurally is their funding needs. So the U.S. tends to run a current account deficit. It’s around 3 percent or so of GDP right now. So that means it needs to attract capital to support the dollar, and what we’re seeing today and since late last year is the opposite.

As expectations towards Chinese growth have improved with the spillover that has to other emerging markets, especially in Southeast Asia, as you’ve seen Europe have a better than feared winter, you’re starting to see money go from the U.S. out to some of these other markets looking for better valuations and an opportunity to position for that improvement in growth.

And so I think it’s really been not just the changes around the Fed but also changes around expectations in investment opportunities overseas that have led to this dollar weakness. And so when I look ahead, say, OK, will we continue to have a weaker dollar or could this flip flop again, could we see another bout of dollar strength volatility, I would be pretty careful.

We don’t know how strong the China reopening will be. We don’t know if it’ll be a straight line, given the number of cases that could erupt even right now as we go into their lunar new year. We don’t know what’s going to happen with the war in Ukraine and how that flows through to Europe.

And so I think investors just need to be pretty humble about these trends and whether they can be persistent and strong over the coming months. This is an environment with so much uncertainty, whether we’re talking about wage inflation in the U.S., COVID in China, the war in Ukraine, that you really want to make sure you keep your financial market positioning, so to speak, and your economic views humbled.

VELSHI: Yeah. Smart idea. Thank you for that.

Back to you, Alexis.

OPERATOR: We will take our next question as a written question: Do the recent tech layoffs impact your outlook for the broader labor market in 2023 or do you see those changes as mostly confined to that sector?

VELSHI: Rebecca, let me start with you on that as well.

PATTERSON: Sure. I mean, we have seen massive layoff announcements from the tech sector. But, so far, the layoff announcements we’re seeing are fairly confined to parts of the economy that saw massive hiring into and during the pandemic. It doesn’t reflect a more broad-based trend yet. Key word there is “yet.”

When I’m trying to understand where the U.S. economy is going I’m really looking at this interplay between the U.S. consumer and wage inflation. The U.S. consumer, as Matt pointed out earlier in our conversation today, was a huge beneficiary from the pandemic economically. The fiscal and monetary easing left them much wealthier into the pandemic than they were beforehand. So they had all this money they could spend, that demand shock adding to inflation.

So, today, they have worked down that excess savings but they’re continuing to spend at a decently robust pace, primarily tapping into their credit cards. So one of the key indicators I’m watching is how long can the consumer hold up. Consumer confidence is starting to come down. Retail sales is starting to come down.

I want to see that reflected in credit card usage, and when we get earnings from the banks, as we did last week, and we hear from the banking executives at Davos this week, it’s suggesting that, so far, U.S. consumers are still spending.

Now, that’s important because if they’re still spending it means that companies are producing and they need to hire the workers to produce, which means the labor market stays strong and wage inflation stays elevated. Wage inflation, based on the Atlanta Fed today, is still over 6 percent and the service sector, which is very labor dependent, is by far the biggest sector of the economy.

And so understanding the interplay of the consumer and wages, to me, is going to help us understand what the Fed needs to do to get inflation to target later this year and how big of a recession we might see.

Right now, it’s early. The consumer is slowing but they’re not that weak yet. They’re still tapping into their credit.

VELSHI: Matt, you’ve made an interesting point. Just tacking on to this question of tech sector unemployment, you’re talking about the unemployment rate exceeding 4 percent by midyear 2023, reaching about 5 ¼ (percent) by the year, the end—by the end of the year, peaking at about 5.5 (percent) in 2024.

We referenced this earlier that, you know, for some of us 5 percent we always thought of as full employment. So that’s not critical. But you mention that the chronic under supply of workers may lead some companies to hoard.

In other words, if they don’t need them—despite the fact that they don’t necessarily need anyone, either the acquisition cost or the difficulty in rehiring replacement workers might look too hard for the next couple years so let’s just keep them on the books.

LUZZETTI: Yeah. I think you’ve seen some evidence of that over the past year. You know, we had a technical recession in the first half of last year but we’ve had a labor market that has remained incredibly tight. Job gains have been very strong. We got jobless claims data this morning—less than two hundred thousand on initial claims.

So very, very low, suggestive that although there are high-profile tech layoffs, the broader labor market remains strong at the moment.

I do think, you know, there’s—when you look across sectors what the most important explanatory factor for employment growth is it’s how far above or below the pre-COVID trend that sector is.

Those sectors that overhired or saw this big boom in hiring are now slowing more materially, perhaps, lifting layoffs, reducing hires. Those sectors that are undersupplied or underemployed are health care and education. Leisure and hospitality are still hiring pretty robustly.

It does set up this big question over the next year. It’s been this big macro debate between the Fed and Governor Waller and Larry Summers and Olivier Blanchard about, you know, how does this labor market come back into better balance; can we just have job openings come down without layoffs picking up.

One, we haven’t seen that ever happen historically. But, two, I think when you look across sectors today we’re seeing those sectors that are reducing job openings are reducing their hiring pretty materially. So, to me, that tells me if new job openings come down by 3 million over the next year to bring the labor market into better balance, it’s very likely we’re going to see the unemployment rate rise. The extent of that rise may be constrained by the fact that firms want to hoard some labor because they’re concerned that if this is a shallow recession on the other side they won’t be able to re-find those workers.

VELSHI: Right. Thank you for that.

Alexis, over to you.

OPERATOR: We will take our next question from Andy Stull, who asks: Notwithstanding the privacy and control concerns or congressional approval requirements, are there other tools in the future like implementation of central bank digital currencies that offer new options to manage economic cycles?

VELSHI: Thank you for that.

Matt, let me start with you on that.

LUZZETTI: Sure.

So, I guess, you know, certainly, from the Fed’s perspective in terms of managing economic cycles, the unconventional tools that they’ve had have become conventional tools. So, obviously, the policy rate remains their primary tool, will continue to do so. They have tools like QE, which have become conventional. Certainly, forward guidance has become a conventional tool.

The Fed really expanded their boundaries of what they could do during the pandemic by opening up many of these credit facilities, which extended credit under exigent circumstances to a broad swath of the economy.

You know, I think reopening those requires unprecedented events like we saw during the pandemic. I think the Fed would not like to make that the norm, going forward. And so I do think we’re in a world where, you know, the Fed’s tools are reasonably well defined at the moment. It’s the policy rate, first and foremost.

If and when that gets down to the zero lower bound it’s restarting QE, and that being mostly through MBS and Treasury security purchases, and in environments where you’re seeing credit markets seizing across the board, you know, perhaps, going to the Treasury in order to get approval for these credit facilities again.

But certainly I think the Fed hopes that we don’t get back into an environment where that becomes part of the new normal of their toolbox.

VELSHI: And do you have a view on digital currency in the Fed?

LUZZETTI: Not a strong view. I mean, the Fed, I think, has—within different officials there’s mixed views within the board at the moment. I think that they’re, you know, looking to see how this plays out in other arenas. I don’t think that they’re likely to be at the forefront of this. It’d be a little bit more of a reactionary. But not a strong view at the moment about how or when it’s going to play out.

VELSHI: Rebecca, I’d love to hear your thoughts. Yeah.

PATTERSON: Sure. Yeah. I have been trying to follow—I started my life in currency markets so I’ve been trying to follow crypto currencies as well.

You know, the country that we’re seeing at the forefront is China of the major economies and they have been using a digital currency as a policy tool in very, very limited ways but they have been.

Over the last year, year and a half, they’ve actually done what some people refer to as helicopter money but using a central bank digital currency. So they can target the exact people. They can target what they want them to spend on and for what period of time and say, we’re going to give you a digital red envelope and you can spend it on this, that, or the other over this period.

So you can get extremely targeted fiscal stimulus to different parts of the economy, which I think is fascinating. So far, that sort of tool, again, has been very limited. I’m sort of surprised they haven’t used it more in the last year as the consumer has been so beaten down.

In the case of the U.S., though, I do think we have no interest on being on the forefront of a digital currency. I think using more digital payments is something the U.S. is very, very keen on. But actually having a digital dollar there are so many implications, given the importance and size of our banking system, that the Fed and the U.S., I think, generally, are going to tread very carefully.

I think of the major economies we’re more likely to see progress earlier from Europe. The European Central Bank has suggested they will have a digital euro within the next few years. The U.K. is also talking about that, and all of these countries are looking to those smaller, if you will, experiments happening across the emerging world to learn lessons to try to avoid mistakes as they move ahead with this.

VELSHI: Satyam, I have no credibility on this conversation. In order to get some, I bought a thousand dollars’ worth of bitcoin at one point. I just checked my balance—I don’t know if you can see that—$371.

So I’m going to recuse myself. But if you have a view on digital currencies and the role they’re playing, certainly, in emerging markets, as Rebecca was just referencing?

PANDAY: You know, the only thing that I want to add in terms of emerging markets, you know, again, there are—they have been used as payment systems where, you know, cost of transmitting monies through the banking system is much higher over in the emerging market space. So some kind of a, you know, problem has been solved over there.

But in the U.S. I’m not so sure what problem exactly it’s, you know, solving in terms of giving some, you know—

VELSHI: Well, if you happen to be in Williamsburg at a bar and you don’t have cash on you it solves that problem. (Laughter.)

But yeah. No, I get your point. For Nigeria and for Iran and for Russia and places like that where you needed a Dell computer and you couldn’t buy one with your credit card it solved some problems.

PANDAY: Right.

VELSHI: But I get your point.

Alexis, do we have time for one more?

OPERATOR: Of course. We will take our next question as a written question: To Satyam, could you elaborate on which emerging market economies seem to be at greatest risk in 2023? Do these nations have any common vulnerabilities?

PANDAY: So, you know, I would look at some nations with, you know, twin deficit vulnerabilities in terms of your current account, you know, deficits and fiscal account deficit together.

You know, Colombia sort of comes to mind right now when you sort of do a scatterplot and see where exactly these fall. You know, Colombia, Chile, they have recently been in your northwest, where both the debt and the current account, you know, deficits had been rising.

In terms of Chile, though, however—you know, China does matter, maybe, and the fact that they’re going through a recession right now actually may actually get their current account deficits to move back down.

Some other countries that you can think of they’re not really in your core emerging markets, per se, but they are kind of sort of on the sidelines. I think Tunisia is one place. Egypt has been in the news quite a bit. A lot of it has to do with, you know, your international commodity import prices being very high. You know, food prices have come in play for Egypt and some of the North African countries.

If those were to stay, if it sustains this environment with Ukraine and Russia, you know, transferring into higher commodity prices and oil prices, I think they will be pressured to do more of, you know, consideration of how to adjust their balance sheets.

So, but besides that, I wouldn’t quite point out one single country yet at this moment. You know, there are Turkeys and Argentinas. They are sort of, you know, always there that we can talk about. But, again, at this moment, there’s no other one that just sort of pops out in my head.

VELSHI: Thank you for that and thank you to my colleagues here who helped us through this. This is remarkable.

You know, most of my interviews on TV are five minutes long so we can never get to these things and never get to the extra question or follow a line. And I’m so deeply appreciative. We’ve taken a world tour here and I am, certainly, smarter for it.

So I’m grateful to all three of you. To Matt and to Satyam and to Rebecca, thank you. Thank you to you, members of the Council on Foreign Relations, for your remarkable questions, and thanks to CFR for hosting this.

Please enjoy your day.

(END)

This is an uncorrected transcript.

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