Energy, Trade, and Economic Growth: A Conversation with Robert Kaplan

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Robert Kaplan of the Federal Reserve Bank of Dallas discusses his outlook on the energy market, the future of trade relations and NAFTA, as well as potential threats to U.S. and global economic growth.

HUBBARD: (In progress)—to the Council on Foreign Relations C. Peter McColough Series on International Economics. Today we have Robert Kaplan.

Rob, welcome. Welcome home.

KAPLAN: Thanks. Thank you. Good to be here.

HUBBARD: I’m Glenn Hubbard, the dean of Columbia Business School, and I’ll be trying to be a gentle steerer of at least the first part of today’s discussion.

Your materials have a more fulsome introduction of Rob. He is the 13th president and CEO of the Federal Reserve Bank of Dallas, where he has been since 2015. Prior to that, he did the Lord’s work of teaching in a business school, where he was Martin Marshall professor of management practice and a senior associate dean at Harvard Business School. Prior to that, he also was at a firm doing the Lord’s work, at Goldman Sachs—(laughter)—where he had a very distinguished career, ultimately vice chair of the firm in charge of investment banking and investment management. And I would note on this stage you have one person from Prairie Village, Kansas; one from Apopka, Florida; but here we are in New York.

So I want to dive right in and start with the topic which is where all the money is, which is growth—

KAPLAN: Yeah.

HUBBARD: —and prospects for growth. Now, there’s a debate, obviously, in the economics profession and among serious thinkers generally about whether we can get back to 3 percent growth. I know you have a point of view on this. I’ve heard you talk about demographics and debt and technology, globalization. What do you think about the 3 percent target? What are the structural headwinds on productivity, on labor force participation? And do you think policy can make a difference?

KAPLAN: Yes to the last point. We can get to 3 percent growth, but we have to do the things to get to growth. And GDP growth is made up of two things: growth in the labor force and growth in productivity. You need one or the other if you’re going to grow GDP. And as you mentioned, our population in this country is aging. This is true of almost every advanced economy. We’re aging and workforce growth is slowing. This is not the first time in our history we’ve had this issue. And the way we’ve dealt with it in the past, we’ve got more women—have more incentives for women to enter the workforce—childcare, transportation, other things. Immigration has been a key part of workforce growth in this country also.

But the reality is participation rate—labor force participation rate was 66 percent in ’07; it’s 63 percent, approximately, today, a little below that; and we think at the Dallas Fed it’s going to be 61 percent in the next 10 years, mainly because of demographics. And for those who are hoping there’s some untapped pool of labor on the sideline, there are a lot of discouraged workers—previously incarcerated, people on disability, all that. But U-6 is the best measure I look at, which is unemployed plus discouraged workers plus people working part-time for economic reasons. That’s 7.8 percent. That is past its pre-recession low. So I’m worried about workforce growth. And then the second thing—but we can do things to improve that.

And then the second is productivity. And productivity growth—with all this investment and with the recent legislation, you would—and technology, you would think productivity would be better. And at companies and industries, I’m convinced it is. But we look at productivity workforce-wide, OK, which means if you’re one of 46 million workers in this country who has a high-school education or less, you are likely seeing your job either restructured or eliminated. And you can find another job in this—in this labor market—you’ll find another job—but it’s likely, unless you get retrained, that your productivity will go from here to here. And I think this is the one of the big reasons why, despite all this technology and all this investment and improvement in investment, we’re not seeing more productivity growth. And I don’t think that’s going to improve.

We are ranked 25th out of 35 OECD countries in math, science, and reading. We’ve slipped. Our studies have shown that if we could just improve that, we would improve productivity and GDP growth. And skills training is improved in this country, but it is not nearly fast enough to keep up with technology-enabled disruption.

So, at the moment, unless we change policies, no, I don’t see us growing—I see, more disturbing—and I wish—I hope we’re wrong, by the way. Good thing is economists are—I’m not an economist, but our team is—we’ve been wrong, so I hope we’re wrong on this.

HUBBARD: Well, economists are always confident. We are sometimes wrong, but we’re always confident.

KAPLAN: Right. So we think GDP growth this year will be 2 ½ (percent) to 2 ¾, aided a lot by this recent stimulus. It will fade next year, somewhat slower growth. And by 2020-21, we believe GDP growth in this country will be down to 1 ¾ (percent) to 2 percent because of those two monster trends that I don’t believe yet we’re doing enough to deal with. We could, but we haven’t done enough yet.

HUBBARD: Let me press you on the “we could.” If you look at the period since the Second World War and you look at rolling 10-year averages of productivity growth, two-thirds of the time productivity growth at a GDP level has been 2 percent.

KAPLAN: Yeah.

HUBBARD: To be in the weeds, that was nonfarm productivity of 2.3 percent. So it happens, and it happens generally and regularly.

KAPLAN: Yeah.

HUBBARD: What would it take—you’ve said there we could do other things. What would it take—let’s start first with productivity—to get back to that more favorable past?

KAPLAN: So my own—my own view is the continued investment in plant and equipment is—and technology, on the one hand, is positive. But we—I think we need to do the harder stuff, which is locally around this country improve math, science, and reading. That means—this is hard stuff—have a national early-childhood literacy program, starting with kids zero to five. A meaningful percentage of children are starting first grade behind grade level. They never catch up. We need to—we need to improve college readiness. And we need to dramatically beef up skills training, not at some junior colleges—a number of junior colleges in this country are doing a great job—but we need to have a nationwide effort to dramatically improve skills training, not just for young people but for people in the middle of their careers. I think if we did those three things, it’s not going to—it’s not going to be the magic answer and it’ll take several years, but I think—we think at the Dallas Fed we’d improve productivity.

The other great hope is that AI—artificial intelligence—which right now is probably gobbling up jobs, will eventually get developed enough that you don’t need as much education to be able to access it and use it. But we’re not there yet, but the people I talk to in the technology industry—Intel and others—believe we could get there. But in the meantime we’ve got to dramatically improve the skill level.

We’ve got to invest, like any company would—and most of you are companies. You’ve got to invest in our human capital. We’ve let that slip. We need to recognize we’ve let it slip. We are not investing in education or skills training like a company would. And at companies I’ve worked in, if you let your human capital slip, you shouldn’t be shocked that you’re not going to grow as fast.

HUBBARD: Well, let me—let me ask you on the other piece, on hours worked. In 2006 the Bureau of Labor Statistics looked 10 years out and said we think the labor force participation rate will drop from 66.2 (percent) to 65.5 percent, and presumably they had demographics in mind. The actual number was 62.7 (percent).

KAPLAN: Yeah.

HUBBARD: So something was going on other than demographics, and of course, the financial crisis, lots of things.

KAPLAN: Yeah.

HUBBARD: But given things other than demographics, what could we do to try to push that back up—if not all the way back to trend, part of the way back?

KAPLAN: The participation or the hours worked.

HUBBARD: Participation.

KAPLAN: Participation, yeah. And oh, by the way, you know, I’ll just mention last year, for as good a jobs growth year it was, we grew jobs less last year than the year before. The only reason we grew GDP was because hours worked increased. There’s limits to that.

What could we do to improve participation? I think then you get into also child—some of the—this is—this is the reason why there’s been talk about—ability for people who can’t otherwise work to travel to their job and leave their kids. So transportation where it has to be locally, childcare that has to be done locally.

And, by the way, the skills gap in this country, there are by our estimate at least a million jobs or more that are unfilled. Half of all small businesses in this country say they have open jobs; they cannot find skilled workers. That’s affecting participation. And so, again, back to skills training and just—and worker mobility is historically low, so we probably have to do a lot of these things locally. But I would guess childcare and local transportation are probably two things which you don’t read a lot about that would help improve participation.

HUBBARD: OK.

KAPLAN: Make it economic for people to go to work instead of not working.

HUBBARD: OK. I want to change gears with this topic, but move to your day job at the Fed. How does your outlook presently for the growth picture set the stage for current monetary policy discussions, yours and your colleagues’? And then I want to talk to you about the balance sheet. But let’s first talk about just the conduct of policy. We’ve got a shift in growth. How does it affect your discussions?

KAPLAN: Yeah. So, stepping back, when I think about monetary policy, we’ve got two conflicting things going on. I just talked about—we just talked about a lot of these structural drivers that affect the medium term. The short run, actually, looks pretty good, OK? We talked about 2 ½, 2 ¾ percent GDP growth. Not great by historical standards, but better. Unemployment rate headline is 3.9 percent. A lot of people would say but it doesn’t affect discouraged—doesn’t deal with the discouraged workers. So U-6 is about 7.8 percent. So we’re at or near full employment. And then, secondly, the inflation rate is starting to approach 2 percent. I don’t think it’s running away from us. But we’re basically achieving both of our dual-mandate objectives. In that kind of scenario, the right thing for the Fed to do—I believe the right thing for us to do—is to remove accommodation, meaning raise the fed funds rate and move toward neutral.

These medium-term issues we just talked about to me get to that second issue, where’s neutral, right? And the surprise is, if you asked me 10 years ago what’s the neutral nominal rate—this is the rate at which we’re neither accommodative or restrictive—I would have said that’s between 4 (percent) and 5 percent, I would have said 10 years ago. Today my own view of what the neutral rate is is somewhere between 2 ½ (percent) and 3 percent. Why? Because prospects for future GDP growth are sluggish, and I think that’s the number-one driver. It helps explain why the yield curve is flat. It helps explain by the 10-year has not been running away from us.

So I believe we should be raising the fed funds rate. But the path to get to neutral is going to be flatter because the neutral rate is lower. And we’re going to have a decision over the next year, year and a half, once we get to neutral, as to whether we want to do more, and we can make that judgment when we get there. But for me, this is why we’ve been saying—I’ve been saying gradual and patient removals of accommodation.

And on the balance sheet, I think we’ve done the right thing to continue to run this balance sheet down. We’re not in a crisis situation. We went from 800 billion (dollars) to 4 ½ trillion (dollars). I think we should be running this balance sheet down. But we’re doing it by letting maturities run off. We’re not selling securities, Treasurys and mortgage-backed securities. We’re just not replacing them as they mature. And I felt strongly we should deliberately continue that process.

HUBBARD: Let me probe two things about what you talked about as normal. So if you were to head to, say, a 2 ½ (percent) to 3 percent normal rate, that’s a real rate of interest of ½ (percent) to 1 percent, given your inflation target.

KAPLAN: That’s right.

HUBBARD: As you approach that in your target-setting, what are you looking at in the world to tell you in real time whether you’re doing it correctly? Is it just accelerating inflation? What would tell you you’re on or off track?

KAPLAN: So I’m looking at a range of things. So, number one, all the way from—we have our own models at the Dallas Fed of the neutral rate. I look at Laubach-Williams and everybody else’s models. So that’s number one.

And by the way, all that would tell me the real neutral rate is between zero and 1 percent, OK? So add 2 percent inflation, that’s how I get to the 2 ½ (percent) to 3 (percent).

Second thing I look at, the most important thing I’ll look at to see if this has changed is rather prospects for medium-term growth have improved. If I saw something—policies, other actions—that made me think medium-term and longer-term growth was going to be higher, I’d think, you know what, I think the neutral rate should be higher, no matter what the model said. Right now everything I see suggests to me that the medium-, longer-term growth rate is going to be sluggish.

And I haven’t mentioned a few other reasons. Another reason is while the stimulus we just put on is helpful to GDP growth, in the out years I think it could create a headwind for GDP growth because we’re going to have to moderate debt growth at this level of debt.

But those are—all the things I’m looking for is are there actions or structural changes that might improve medium- and long-term growth. That’s what I’m looking for.

HUBBARD: Let me probe normal on the balance sheet, because you described a runoff strategy. But what is the right-sized balance sheet for the Fed? Some people have said, well, we should go back to the status quo ante balance sheet.

KAPLAN: Yeah.

HUBBARD: I’m not persuaded by that personally. But what is your view on what the right size of the—not how you’re going to get there but just, in equilibrium, how big should it be?

KAPLAN: It should be on the 2s, so I would say in the mid-2s most likely. And the reason it’s not going to go back to 800 billion (dollars) is the economy is dramatically bigger. The needs of the economy, cash in circulation, a whole series of other metrics are larger than they were. I don’t think it needs to be 4 ½ trillion (dollars), but I think it certainly can be below 3 trillion (dollars). Do we know exactly what that number is? We don’t know exactly what that number is. My guess is it’s in the—it’s something below 3 trillion (dollars) and probably in the 2s.

HUBBARD: And should it ultimately be all Treasury securities? How should we think about a normal balance sheet?

KAPLAN: So—and just for those who know, the bulk of our balance sheet just—it’s, let’s say, 2 ½ trillion (dollars) of Treasurys and approximately 1 ½ to 2 trillion (dollars) mortgage-backed securities.

I personally think in the long run it probably is more appropriate for the Fed to hold primarily Treasury securities, because by holding mortgage-backed securities—we originally put them on to impact, you know, housing. We did that deliberately. We didn’t make a secret of it. But I think in the future it may be more appropriate for those agencies of the government that dictate housing policy to own the mortgage-backed securities, probably the Fed get back eventually to owning primarily Treasurys. We’ve got a long way to go to let this run off, but I think that probably would be more appropriate.

HUBBARD: I want to change gears now to your literal day job at the Dallas Fed. And let’s talk about taxes, which is a bright spot for the U.S. economy in many respects.

KAPLAN: Yeah.

HUBBARD: A, what are you seeing in the outlook in Texas? And what can that tell us about the country? In particular, what you see in crude oil prices and the energy sector.

KAPLAN: So I made all these comments about demographics, slowing workforce growth, all that. Not Texas. Texas is going the other way. It’s one of a handful of states in the country that is going the other way.

I get a heat map every week from the folks at SMU who do this demographic stuff for me and you’ll see 30-35 states in this country, their population is flat to down. What’s the most valuable thing a country or a state or a city can have? Population, growing workforce, because of the impact on GDP. That’s how you get tax revenue.

Texas has got migration of people and firms to the state. It’s been going on for 15 years and it’s not slowing down. And that’s not just Dallas. It’s Dallas, it’s Houston, it’s San Antonio, it’s Austin. We’ve got four of the fastest-growing cities in the United States, and the population of Texas has gone from about 22 ½ million 10 years ago, it’s pushing up 28-29 million. And it’s a little scary to say over the next 20 years we think population of Texas is going to get into the 40s. I mean, we are—we are growing population.

So we’ve got a natural tailwind. The concern I have is we’re taking it from other states in the United States. Why is that happening? You know, you can go through—central location; business-friendly environment; no taxes, you know, state or corporate or individual. And also, it’s kind of a virtuous cycle. Amazon moves there, Burlington Santa Fe moves there, more people want to put their digital warehouse there, and it’s just a virtuous cycle.

Now—and then I’ll talk about the threats. The other thing—so we did have one big headwind: energy prices. In, you know, ’15 and ’16 and part of ’17, it was a headwind. It’s now—only to tell you—has turned into a tailwind. Seventy percent of the oil production in the United States comes from the Permian Basin. We think the U.S. is going to produce about a million barrels this year, net. And the problem in the Permian, why we won’t grow faster, is shortages of people, sand, water, and all the raw materials.

But the—and I think the prospect for the energy business over the next five or 10 years is very positive. Why? Global supply/demand is now in balance, and I don’t think we—it’s our view at the Dallas Fed that shale alone won’t be enough to supply incremental global growth, and these long-lived investment projects haven’t been made now for seven or eight years by the majors, OK? Those fundamentally add global supply. Shale has a very rapid decline curve. Literally in the first year or so it—you have a substantial decline, so you have to keep drilling just to keep up with the same level of production.

It’s why you saw an article in The Wall Street Journal this morning about companies diversifying away from the Permian. You just can’t find enough workers, not enough materials. But the prospects for the energy business are positive, and that helps Texas.

Now, what are the threats? We need more infrastructure, highest number of uninsured in the United States, growing wealth inequality, housing affordability, quality of the air, quality of the water. These are—the good news is these are all issues that we’re talking about in the state, including with the governor, and there’s a working group that works on these things there. Because we have population growth, we can—we may not solve all these problems, but we can. I’m much more worried about states in this country—you can think of who they are: Illinois, Connecticut, a range of others—who, because they don’t have population growth and they have slowing workforce growth, may not have enough money to deal with the issues they face. Texas has got everything that it needs if it chooses to make the right decisions, and I believe actually we will.

Set aside the politics. The one thing I’ve learned, if anything—and I’ve been going to Texas my entire life with my father, who was—that was his territory as a jewelry salesman—Texas, as its core, is practical. We will do what you need to do to build business. And so there’s a lot of investments and adjustments that need to be made—including education, by the way, which is lagging the country. So the country’s lagging globally and Texas is lagging the country. And I spend a lot of time with groups in Texas right now trying to work on investments and people’s time that will fix this. But prospects for Texas are bright because of this demographic issue.

HUBBARD: And the price of oil, for West Texas Intermediate over the next, say, five years, what are we looking at?

KAPLAN: Here’s what I’d say. You know, and you could argue—and luckily, I have a lot of things I have to do in this job; predicting the price of oil precisely is not one of them. But direction—thankfully—but directionally, our own analysis is—over the next three to five years our own view is you’re going to see—and our contacts suggest you’re going to have a fragile equilibrium. What do I mean? We’re in the 70s now. With all the production here and when geopolitical issues die down, you could see—you could see some decline in the price of oil. So we think we’re going to be like this with shale for the next three to five years, in the short run probably being enough to supply incremental global demand. We think global demand’s growing per day about a million-and-a-half barrels a day. Shale could be enough to supply that. Once you get beyond three to five years, we are much more doubtful that shale will be enough to supply that.

And we would—our judgment would be the spike risk, the price risk for energy in the next three to five years or after that, is to the upside because we still are not getting investments in these long-lived projects, and nothing I see suggests the majors are going to invest. They’d much rather invest in shorter-term, more-nimble projects. And their shareholders are putting pressure on them for—those in the business know—to generate returns. And so I think the spike risk on energy is to the upside. My worry is at the time that happens may not be good timing for the United States because it’s like a tax increase for consumers.

HUBBARD: Texas also gives you another vantage point beyond energy, and that’s in trade, and NAFTA in particular.

KAPLAN: Yeah.

HUBBARD: Given what’s going on in the discussion of a renegotiation of NAFTA, how would you see that affecting both the Texas and the U.S. economies?

KAPLAN: So we do a lot on this because Texas is the largest exporting state in the country, and so we do a lot of research on trade. And then we spend a lot of time—I spend a lot of time in Mexico and with the leaders of Mexico. And here’s the long and short of it. And I’ve said this many times, so this won’t be new.

We’ve been saying at the Dallas Fed we ought to be segmenting our trade relationships, and here’s why and a basis. Our primary deficit with China is a final goods trade deficit, final goods. And also, we have the big issue with them on intellectual property and technology transfer, which is affecting our ability to be globally competitive. Those are real issues. They need to be debated and discussed, and it’s going to—it’s a serious issue that will affect our place in the world. We are in a global competition with China.

Move to North America. While you’re fighting that battle, the trade relationship with Mexico is not a final goods relationship. It’s an intermediate goods relationship, completely different, based on our analysis.

What do I mean by this? Seventy percent of the imports from Mexico to the United States are intermediate goods. What is—what are intermediate goods? Logistics supply chain arrangements. They’re goods that are going back and forth across the border, sometimes 15, 20, 25 times, OK? And so they’re partnerships. They’ve been developed over the last 20-25 years. Our research shows those partnerships with Mexico, and to a lesser extent Canada but to some extent Canada, have allowed the United States to keep jobs here, grow GDP, add workers. And it’s our own analysis if we didn’t have that trade relationship, for example, with Mexico, we would likely lose share in North America, probably to Asia, OK?

So what’s been going in the last several years, we’ve been taking share—our research shows we are taking share from Asia globally. North America is a competitive hemisphere, the same way Asia’s a competitive hemisphere and Europe is a competitive hemisphere. And our concern has been if you were going to fight a very legitimate battle with China, you would shore up your own relationships. Yes, you would renegotiate NAFTA. You would upgrade it, both sides agree. You would fight it out, but you would get it done. And so make sure that North America is globally competitive. And we think we should be thinking more strategically and segmenting our relationships, shoring up our relationships in North America, which have helped us add jobs in this country and be globally competitive and take share from Asia, and then go ahead and fight the battle with China and other parts of the world.

And so we finally look like we’re working toward getting NAFTA done—late, we think, and here’s the only concern about the late part. I wouldn’t feel this way as much or be concerned if we didn’t have an election in Mexico coming in July of 2018. We were very concerned and we’ve been saying, including to elected officials and appointed officials in the administration, that we’re worried this rhetoric is going to make it more likely the left-wing candidate is going to win in Mexico, which will make all of our relationships tougher. We actually think we may be—this may be so firmly embedded at this point that that will be the outcome, and it’s unpredictable what the impact of that will be.

So the geopolitical relationship with Mexico has served us very, very well and has allowed the United States, we think, to be much more competitive. It’s not enough—last comment—not enough to add a job in the United States. If it’s not globally competitive, 10 years from now that job won’t be here. That’s the criteria. “Do you add jobs, but are they globally competitive?” must be the second question. The trade relationships with NAFTA—with Canada and Mexico have allowed jobs to be added here that will stay here because we’re more globally competitive.

HUBBARD: So how do we make this case in the political process that trade is different in certain situations, it can add a lot of value to the economy? We’re not winning that argument with the body politic—maybe not even with some elected officials, but certainly with the body politic. I know that’s not the Fed’s issue.

KAPLAN: No, well, my job is to stay away from politics, but at the same time to share this—our work with elected officials and appointed officials. And we do, aggressively and very thoroughly, and we get a lot of questions back.

Most elected officials I talk to within the first three minutes say I agree with you, I get it. I know there are different views, and all we can do at the Fed is disseminate these to the relevant parties.

You and I were talking before. I was just in China, mainly for trade reasons, and the trip was hosted by the Treasury. And so they see what we’re saying. And, you know, I’m hopeful—I’m hopeful that we will get to where we need to get to even if it’s a little slower than we need to get there.

HUBBARD: Let me take you, if I might, though, into politics because it does affect the Fed. The Fed is almost uniquely, in my experience, in bipartisan crosshairs. There are Republican and Democratic leaders who for different reasons are very concerned about the Federal Reserve. It’s everything from how appointments are made to organization and the conduct of monetary policy. How does the Fed, albeit an independent agency, navigate these troubled waters? And sort of a part B to that: As chair, should we expect Jay Powell to, you know, use his formidable personal strengths to try to navigate that?

KAPLAN: So, number one, I think on the one hand our job is to, on the one hand, be—make good decisions and do our analysis without regard to political considerations or political influence, and strive to the extent humanly possible to do that. And I believe strongly the people around the table, that is what each of us do. That’s on the one hand.

On the other hand, I do believe that it’s critical that we remain independent, but I think what comes with independence—remember, I come from the business sector—is I actually think the Fed would be well-served—and I’ve—and I’ve said this publicly and I’ve said this around the table—we would be well-served to do a little bit what Canada does, what the U.K. has done, which is do every two or three or four years some type of strategic review, OK, where we step back, review our frameworks, review our governance, review our practices. A lot’s been made of inflation targeting. And all those considerations, every X number of years step back and do a very open process, and be seen to be policing ourselves and doing a re-review. And I think we would be better-served in keeping our independence if we did that.

So when somebody on the outside says you should do this or you should do that, the answer should not be, no, that’s a terrible idea. It should be, all right, here’s my view, but we’ll consider it. And I think that’s the one thing that’s been missing.

I do think regular communication—I think if we had a press conference after every meeting, that would be healthy. But I think this review, like other central banks have done, I think would be a very healthy thing. And that would be the one significant recommendation that I’ve said publicly that I would recommend I think that would be healthy for us.

HUBBARD: I would definitely agree with that. The alternative is the audit the Fed type movements that are not about auditing at all, as you know.

KAPLAN: No. And listen, we spend a lot of time—when there are people protesting, which you have occasionally outside the building, what I do normally is we go downstairs and we invite them up, and we sit with them and engage with them. And, you know, if they make—which they have—make demands that we want you to tour blighted areas, the answer is yes. Why not? It’s a good thing. So I think we’ve managed to, I think—and we’re well-served by engaging with different groups that are worried about, you know, at-risk populations, blighted areas, whether the Fed is, you know, elitist, all those things. I think we’re well-served to be listening and to try to be responsive and to be transparent.

HUBBARD: OK. But now it’s our turn to listen to you, so we’re going to pivot to a conversation with members with questions. And I’d remind you a couple of things. One, this whole conversation is on the record. And then, if you would like to ask a question, raise your hand. We’ll get a microphone to you. Give your name and affiliation, and please make it an actual question for Rob.

Q: Thank you. This was very interesting.

In your list of obstacles to growth, I thought there were two missing in action. I’d like to hear your view on that.

KAPLAN: Yeah. Sure.

Q: The first one is infrastructure, the second regulation.

KAPLAN: Yeah.

Q: On infrastructure, I think calling U.S. infrastructure Third World would be an insult to the Third World.

KAPLAN: Sure.

Q: Every time I take a cab in New York, I need a new set of kidneys.

KAPLAN: Sure.

Q: As regards licensing—and not going to the financial sector licensing and regulation, which is—or NIMBY regulation, which is a problem, but a look at the labor market here. When I came to this country in ’71 for the first time, 4 percent of the occupational—of the labor force was under occupational licenses. Now it’s a quarter. And we’re not talking brain surgeons—

KAPLAN: Right.

Q: —we’re talking florists and we’re talking shopkeepers, and this I think is a huge obstacle to dynamism and mobility. How would you think about that?

KAPLAN: No, I—listen—and I’ve written a lot and said a lot—I do think the regulatory review we’re undergoing now is a healthy thing if it’s thoughtfully done. I don’t agree with everything being done, but I think—and by the way, this regulatory review needs to be done not just at the federal level, but a lot of these issues are local—they’re state and local. That’s been the biggest thing I’ve learned in this job. A lot of the problems we’re having are local—local fees, other issues—and I think a national review of regulation would help us grow more.

Second, we’re about three—our analysis in Dallas says we’re about 3 trillion (dollars) underinvested in infrastructure in this country. We talked about productivity. You know, one of the things that would likely help productivity is if we had better infrastructure, and we’re underinvested in it. It would not bother me as much if we were building up debt-to-GDP, which is now is substantial—76 percent debt held by the public—if we were investing it in things that could help long-term growth. Infrastructure, we believe, is a critical priority, and we believe that some percentage of it could be financed from the private sector. We know there’s an enormous zeal for fixed income and risk—you know, safe assets, and we think we need to be dramatically investing in infrastructure.

I actually think, by the way—to add a third one—the tax reforms part of the recent legislation we actually thought was a positive thing. The part we’re struggling with is the tax cut part that was financed by increasing debt-to-GDP, and the fact that we didn’t close enough loopholes to pay for the tax reform part—that’s the part we think will ultimately create more headwinds for GDP growth in the out-years.

HUBBARD: Well, we here in New York did contribute to some loophole closing—

KAPLAN: Yeah, so I’ve read.

HUBBARD: —with state and local—

KAPLAN: So I’ve read.

HUBBARD: Merit.

Q: Good morning. Merit Janow, Columbia University.

One of the things that is worrisome about the trade policy is this focus on bilateral deficit reduction. With China, as you know, the administration has asked for a $200 billion reduction by 2020.

KAPLAN: Yeah.

Q: And most economists I know—I won’t implicate Glenn unless he wishes to speak to it, but—feel that U.S. fiscal policy is likely to increase deficits. And so it’s not going to pull in the right direction for that trade policy objective and isn’t necessarily the right focus anyway. So, you know, is the Fed doing work on this?

KAPLAN: Yeah.

Q: Is there a way you can sort of get some insights around this into the Treasury and elsewhere in the administration?

KAPLAN: Yes. Yes to all the above.

Listen, it’s our view, and we’ve said this—said this several times—the measure of your trading relationship probably for us is not whether there’s a deficit or not, and some people have humorously said, you know, I run a—I run a deficit with my dry cleaner. It doesn’t mean that it’s unfair or unreasonable.

The issue for us is does it help you improve GDP growth in your country, and does it help you add jobs. And then there are issues of fairness and a level playing field. It’s not unreasonable that you might be running a trade deficit.

And the other issue we like—in the work we do at Dallas we look at where the value added comes from. Sometimes the final country that ships is—while it’s—it may be a fraction of the value added goes in actually that price because it has come from other countries, sometimes from your own country, so we don’t think it’s a great way to look at trade relationships—number one.

Number two, our concern is we could talk about—and I won’t get into TPP and a lot of these bilateral versus multilateral, and there are pros and cons, and we could go through that debate—our bigger worry is, in the vacuum now, we see that—and our work suggests that China and other countries are aggressively stepping in and building their own relationships, and while they are doing that, they are also changing global standards, which is not being talked about at all.

What do I mean by that? You know, changing a socket from U.S. standard to Chinese standard—all these things that will help make it more difficult for us to compete—but the bigger one is do we eventually get to the point where people trade other than in dollars. One of the reasons we are able to very constructively finance our deficit and why we can run the type of balance sheet we have with confidence is that the dollar is still the safe haven, the desire globally for safe assets. While it has kept rates low, it has also helped us finance this deficit. Our own work would just suggest we hope that continues for the rest of our lives, but it would be wise not to take it for granted, and one thing about a proliferation of bilateral arrangements is you start having some change in the basis of transacting. We’re not close to that yet, but we’re keeping an eye on it at the Dallas Fed in the work we’re doing.

HUBBARD: Maybe it will all be in Ethereum and we can—(laughter)—

KAPLAN: Yeah.

HUBBARD: Ma’am, and then sir, right here. Yeah.

Q: Thank you. Good morning. Nili Gilbert, co-founder of Matarin Capital. Thanks for being here this morning.

KAPLAN: Thank you.

Q: I was really interested in your comments about the potential in the future for AI to strengthen workforce productivity.

KAPLAN: Yeah.

Q: So far in the current tech revolution—call it the fourth industrial revolution—we really haven’t seen a contribution of tech to productivity similar to what we saw in the ’90s, and if anything, some technologies are pushing down on inflation because of the way they aid in the price discovery process.

KAPLAN: Yes. Yes.

Q: I was wondering if you could share more of your thoughts about how tech innovation and total factor productivity are affecting current GDP dynamics.

KAPLAN: Yeah, and we’re actually hosting a conference in Dallas on this on the 24th and 25th because we think it’s such an important subject.

So let’s start with the basics: technology replacing people—and most people would say, that’s not new; it has been going on forever. Fair enough. It’s happening, though, at an accelerating rate, and why? We think the primary reason is distribution of computing power. That’s the part that’s new—the cloud, for example. Know what I mean? Consumers now have in their hands more computing power than most companies did 30 years ago, OK?

And so the second point is consumers now are able to use technology to shop for goods and services and get lower prices, and sometimes now even greater—as good a convenience, and so what’s happening is most businesses, unless they have very distinctive product, do not have pricing power. Businesses have less pricing power, we think, than at any time in our lifetimes.

What are companies doing to respond to this? They are further investing in technology to replace people, OK? And with a tight labor force, they feel even more zeal that—why are they doing it? Not so they can get pricing power. What businesses are doing—they’re trying to get more scale, and they’re merging. The reason we see so much merger activity, we believe, is not to they can get more pricing power. It’s to defend margins because they don’t have pricing power, and just to—you need more scale to protect the margins you have. Looking at—you could go through—give me an industry and I’ll tell you the—you know, car dealerships, there’s a reason that industry is consolidating, and we could go through lots of others. I think this scale—zeal for scale and investment in technology is increasing.

So the only premise is—people say, where is the productivity? I think if you look at any company or any industry, it’s unusual to see a company or industry, I think, that’s not dramatically more productive than it was five and 10 years ago. So why are the statistics so lousy? Because we don’t measure industry productivity, and we look at aggregate data, OK, and if you look at—and we look workforce-wide.

And again, if you’re working at a company, and you’ve kept your job, and you have a college education, I’m convinced you are more productive than you were five or 10 years ago, and you are highly likely to be employed, you’re high—likely to be in the workforce. Again, if it’s—if you’re one of the 46 million—there’s 160 million members of the workforce in this country. Forty-six million, though, have a high-school education or less. If you’re one of those people, you’re getting buffeted around by this where your job again is either being restructured or eliminated. And you may find another job in a good market, but unless you get retrained—which is easy to say, hard to do, especially if you are mid-40s—your productivity is going like this. That’s the—that’s the issue, I think.

It’s not that businesses and industries aren’t far more productive. I’m convinced they are. It’s the workforce, and we haven’t invested enough in human capital, workforce development. And the reason I mention AI—so maybe in the future AI will advance enough so those 46 million workers will be more adaptable, and you won’t need a college education. We’re not there yet. People in the technology industry hope that someday we will be, but we’re increasingly—and I hate to say it this way, but when I talk to companies, which I do—we do surveys, and I talk to 30 CEOs a month, and I rotate them every month—most companies are now talking about, among their customers, the haves and the have-nots, and it breaks by education levels. Got a college education, you’re—finish college, that is, you’re likely able to adapt to this. If you haven’t finished college or you haven’t—you’ve got high school or less, you’re getting buffeted around by it, and increasingly, even on consumer-facing companies, they talk about the top 20 percent income levels of their customers and the bottom 80 (percent).

And there’s a reason why, if you go into a mall in this country, unless they have an Apple Store, and a Tesla, and luxury goods, mall sales are down. And most mall developers in this country will tell you that. It breaks out in this demographic way, and I think technology and our slowness to adapt to it is fueling this.

HUBBARD: Sir, you had a question right—

Q: Thank you. My name is Hariharan.

HUBBARD: I’ll come to you.

Q: I want to go back to the conduct of monetary policy.

KAPLAN: Yeah.

Q: Until recently in your hiking cycle, you had a very friendly U.S. dollar environment. The dollar was weak.

But in more recent times, the big dollar is on the rise with two important implications: potentially anchoring inflation, but more importantly, causing serious stresses in emerging markets.

KAPLAN: Right.

Q: Would you care to comment as to how that might influence your thinking?

KAPLAN: Yeah. So we watch it—I watch it very carefully, and we watch it very carefully at the Fed and, you know, we had this situation you may remember in the first quarter of 2016 where China had severe currency outflows, we had a very strong dollar—currency outflows, big sell-off in their markets, and very rapidly, it created a tightening of financial conditions globally.

So we’re very well aware that the dollar and our policies could potentially have that effect, and the only comment I’ll make is it’s just something I watch very carefully, and we need to keep watching. You have to be aware—and this is why we spend a lot of time looking globally—you’ve got to be aware of the ripple effects of our policies in order to be a central banker in the United States.

HUBBARD: Craig and then Andrew. Craig?

Q: Craig Drill, Craig Drill Capital.

A question for both of you regarding inflation, regarding predicting inflation. If we went back nine years to May 2009, who predicted that we were about to begin a nine-year economic expansion, and the output gap would close, unemployment would go to a 17-year low, and yet inflation would barely be 2 percent? What do we learn from this? Rob?

KAPLAN: And you’re—yeah, and you’re welcome to come in any time, Glenn, you want. (Laughter.)

Here’s what—so here’s my own two cents on this. What we faced post-Great Recession is—the big thing we’ve been working through is we know the corporate sector had to deleverage, particularly through the financial sector, even though corporate debt-to-GDP is higher today than it was in 2008. At least the financial sector deleveraged. OK, so that’s that part.

The part that was most troubling is household debt. In 2007—not ’08—’07, household debt-to-GDP was historically high, OK? The reason we didn’t pay much attention to it is household debt-to-asset values looked reasonable. When housing prices declined, households were historically highly leveraged, and we knew we had a very weak job market.

The household sector spent the last eight or nine years deleveraging, OK, and we’re finally now to the point where it’s not perfect, but household debt-to-GDP is now in pretty good shape. It’s a little bit—and every sector, by every income level, you’ve seen the household sectors deleverage. Household debt-service-to-GDP is in pretty good shape.

The consumer is 70 percent of the economy, so if the household sector is deleveraged and they’ve got a good job market, you’re going to—you’re likely going to have a pretty good economy, which is why I’m confident. I’m not thrilled with out-year growth, but I think the consumer sector is in pretty good shape. And so that’s one thing we learn, is you’ve got to watch household debt-to-GDP.

But the second thing is, for me, most of the big forces in the world are deflationary, and I’d say that still today. Aging demographics, sluggish productivity that I talked about, but the reality is technology-enabled disruption, by itself, basically is deflationary, and I think that it’s not a shock that you are not seeing more wage pressure than you are seeing, and even if you have wage pressure, you can’t pass it on in prices because of technology.

So I think inflation is firming, but I don’t think it’s running away from us even from here. I think in the short run, because of steel, aluminum, other—oil being higher, you are seeing some pressures on inflation, you’ve got a very tight labor market. But I think in the medium term, I think inflationary forces are still going to be more muted.

HUBBARD: I would agree with all of that.

Andrew.

KAPLAN: Hey, Andrew, how are you?

Q: How are you? Thanks, Glenn.

How—Rob, how prepared do you think the Fed is for the next financial crisis. It sounds like, on a numbers basis—interest rate, balance sheet—you’re going to get there, but the rest of the world certainly hasn’t started raising yet, so maybe it’s a worldwide question and not a Fed question.

KAPLAN: Yeah.

Q: But also, politically, do you have the same political capital to execute this brilliant strategy which Ben Bernanke started to—(inaudible)—nine years ago?

KAPLAN: Yeah. OK, so let’s go through the pros and the cons to this. So, first of all, I’ll start with, on the one hand, given government debt-to-GDP—I’ve mentioned 76 percent debt held by the public of the U.S. government, but 49 trillion (dollars) is the present value of unfunded entitlements.

Even before this recent legislation, I think we were talking about—at least at the Dallas Fed—that the path of future debt growth in this country was likely not sustainable, and we—had to be moderated. With this recent legislation we think this issue now is more challenging.

So what does that tell you? It tells you in the next downturn don’t count on fiscal policy being an option, OK? We just used it. We used it—you can debate it pro or con, but we used it late cycle in the recovery—or in the expansion. But we may well not have it in a downturn.

So that—then that means what other tools do you have. I’ve said that when we—when we get to that recession, probably the fed funds rate was going to be lower than we’re historically accustomed to because the neutral rate is lower than we’re historically accustomed. I am hopeful we’ll make progress in working down the balance sheet, so at least we’ll have an option to have the debate as to whether we want to use—some people don’t think we should use our balance sheet, but at least—it’s not even a viable debate unless we work it down.

The other thing I would say is I’ve been a strong proponent of regulatory relief for small, mid-sized banks, but for big banks—systemically important banks—I feel strongly we have been well-served by tough capital requirements, and in particular, stress testing, OK? And so that tool I don’t think we should back away from here, and I think we’ve been well-served by it. The bigger worry I have is what’s going on in the non-bank financial sector where we don’t have great visibility. We don’t regulate them. Nobody does stress testing. And we saw a little bit of—maybe—coming attractions—I’m hopeful not—in February where you realize there’s a little more embedded leverage in the system than people may have thought. Now embedded leverage comes in a lot of forms, including derivative form, vol-targeting, risk parity, blah, blah, blah. And so I’m worried that the next crisis financial may not come—won’t come from the bank—I’m hopeful it won’t come from the banking sector because we’ve got better tools. It may well come from the non-bank financial sector.

But our tools at the Fed will be a little bit more limited, and I think it’s going to be a challenge. It’s less likely we’re going to have fiscal policy as a tool. And I don’t think that’s just true in the United States. That’s true in most developed, you know, Western economies.

HUBBARD: You still have prayer as an option. (Laughter.)

Sir.

Q: Arthur Rabin, SMBC Nikko.

If the equilibrium rate of interest indeed is plateauing at a level significantly lower than where it has been historically, what are the implications of that for institutional investors—pension funds, insurance companies—who may have taken on liabilities with an expectation of fixing terms considerably above what you seem to think they will be in the near to medium term?

KAPLAN: It’s a challenge, let’s face it. And I talk to—I am friends with a few governors, and I talk to them about, you know, they have an assumed pay rate, earnings rate, and if—you know, if you have the conversation—if you lower it, then you have to say that your pension fund is underfunded, then you have a—you have to make a decision. You want to raise taxes, you want to deploy other funds. They’re in a dilemma. And so it is a—it is a challenge.

Now low interest rates, some would argue, have certainly lowered PEs, they’ve improved cap rates, they’ve helped increase asset values, but for fixed-income investors who rely on a fixed coupon and have fixed retirement obligations, there’s no getting around—this is—there is a gap. And if you add to that—gets worse—companies have one set of issues if you are a state which has large pension funds—if your population is going like this, and your workforce is going like this—because population growth in the United States is slowing, and workforce growth is slowing, and you’re in a fight with other states for people—makes this problem worse.

HUBBARD: Ravenel?

KAPLAN: So one of the solutions—we’ve got to grow the population, we’ve got to grow the workforce in this country. We’re going to have to find ways to do it. There’s no getting around it, in my opinion.

And by the way, the United States has one—I lived in Asia, ran the business for my firm in Asia for many years. We have one significant—we have many competitive advantages over other countries, but one of them is we’ve historically been very receptive to immigrants. My grandparents were not born here. They came to this country, they got assimilated, and a lot of people in this room have the same story. It has been one of the distinctive competencies of the country, and when you have a distinctive competence that has helped fuel your growth, you hate to jeopardize it or lose it.

HUBBARD: Ravenel?

Q: Ravenel Curry.

If most companies don’t have pricing power, doesn’t that mean they have to pass their corporate tax cuts on to customers?

KAPLAN: They may. And there’s a big debate which I—luckily in my job—don’t have to get that involved in any more. In my previous life I got involved in it a lot. Yeah, there’s—in some industries there’s a big concern, and when I talk to CEOs, they think ultimately that some of these benefits from corporate tax cuts will get passed on because they will be competed away, and it will depend on the industry.

Q: That sounds moderate, though—sounds like—(off mic).

KAPLAN: Well, so in this job I talk—I’m careful to talk a little bit more about the economy and no particular industry, but I have—as I’m talking to you I have industries in mind, that I think—there’s a continuum, and I think CEOs are asking the question more today than ever in my career, which is a good—what is it we do that’s distinctive, how do we maintain pricing power, how do we restructure our product or service offering in order to maintain that pricing power? And in certain industries, there’s a continuum about their ability to do it. Technology is a part of it. There are other parts of it, but this is a big challenge. In the short run, we know corporate profits are much higher, and we’ll have to see how this unfolds. By the way, integrated supply chains and logistics have been another way to manage costs so that you can deal with this issue.

HUBBARD: Sir?

Q: Stephen Can from Blackstone.

How do you think about the consequences of right-sizing the Fed’s balance sheet, which may amount to taking a trillion or two trillion dollars of demand out of the market?

KAPLAN: So I was actively involved in devising the plan, and I come from a markets background. So what are the things I look at—just to give you—and this is why I am comfortable with this—I look at—again, I mention we’re not selling securities. We’re letting maturities run off. So then the thing you look at—OK, let’s look at monthly—plot out over the next years what the size of the maturities are, and then let’s look at the size of the trading—daily trading volume, and also new issuance in Treasurys, and then you look at the trading volume in mortgage-backed securities. And I do believe that we’ve designed this plan to be a very manageable percentage of the daily trading volume and monthly volumes of Treasurys and mortgage-backed securities.

Overlay on that—which is an issue—we’ve got a lot more issuance of Treasurys than we did. But my own judgment is that this runoff should be manageable. It helps explain why I don’t think you’ve seen undue impact of this runoff on either Treasurys or mortgage-backed securities. And by the way, we’ve been very transparent. The entire plan is known by the market, and you have not seen a meaningful impact. So I’m hopeful, and I believe we will be able to see this plan executed.

There are other central banks in the world that are a larger percentage of the markets they are invested in, whether it’s corporates or sovereigns—you know, ECB being an example—where I think they’ve got a different challenge. But I think we’re fortunate that the treasury market, for starters, is a big, liquid market, and we’ve done—devised this plan to be a relatively manageable percentage of that total market. And that gives me a lot of confidence we should be able to execute this.

The last comment I’d make—people don’t realize—and there’s a lot of talk about China, what—China does this or that. In ’07-’08, the size of global central banks’ balance sheets was about $4 ½ trillion. Today it’s around $22 ½ trillion. So, I mean, global liquidity and size of central bank balance sheets has grown up dramatically. So we’re fortunate; we were the first one in with QE. We’re at the leading edge out, and I think we’re fortunate there is lots of global liquidity. So I—that’s another factor that I think should help this be manageable.

HUBBARD: OK, sir, in the back.

Q: Thank you. Rick Niu from C.V. Starr.

Two questions, if I may. Oil prices—do you see that the new energy, renewable energy, green revolution effect may be five year or less impact on the oil prices, or may be for much longer term?

Secondly, if you were the Chinese central banker, would you continue with the capital control policy? Why or why not?

KAPLAN: OK—(laughs)—all right, we’ll come back to the second one.

Our view is—when I say we don’t believe shale is going to be sufficient in the medium term—after three to five years—to supply incremental demand growth, we’re assuming in our analysis that you have substantial growth in alternatives—wind, solar, other alternatives. We think that’s—even with that—and that will cause a plateauing, in our view, in the out-years of global demand growth for oil. Even with that, we think shale will be challenged, OK? We still believe that the price risk in the medium term will be to the upside, particularly if you have a geopolitical disruption, all right?

On China—listen, in 2016, given the turmoil they had, they put in very strict capital controls, and they’ll be the best judge of—I mean, I think they will continue to be concerned about—depending on the dollar and other factors, they don’t want to have a repeat of currency outflows, which I think could be destabilizing. And I think that the trauma of the first half of 2016 they haven’t forgotten about based on everything I know and my conversations.

HUBBARD: Time for one fast question for Rob. Sir?

Q: How worried are you about—how worried are you about the future changing leadership in the ECB, the post-Draghi policy there?

KAPLAN: So I’ve met a number of the central bankers in the ECB, and I’ve been very, very impressed with them, and I’m impressed. Now there are obviously tensions within the ECB. If, for example, there are some countries—without getting into who, like Germany, who want to see more fiscal austerity in countries—and that tension will have to play itself out.

I think the biggest issue that ECB has is underlying—even though growth has been on the—a surprise to the upside, it’s still at relatively sluggish levels—aging demographics, high levels of government debt-to-GDP, and the bigger issue they have is their balance sheet is much more invested in sovereigns and even corporates where they are a meaningful percentage of the daily volume to where managing that balance sheet is a lot more challenging than for us.

And so I think—I think—I’d be hopeful that the leadership will—they will—they will forge a leadership consensus, but I think the challenge they have are—our challenges are difficult; I think their challenges are very difficult. And then they’ve got a bunch of structural reforms, you know, that they’re trying to do in France, and Italy, and other countries that are very challenging, that strain the coalition. So it’s a tough job.

Q: (Off mic)—to the way in which the Fed is looking at monetary policy?

KAPLAN: It tells me that the possibility of divergence, where we’re trying to “normalize policy,” quote, unquote—I think it’s—I think, in fairness, there needs to be—it’s more challenging for them to do that, so you could have more policy divergence, which we have to be mindful of, where we may be doing more to reduce our balance sheet, normalize monetary policy, where they’re going to have to do it, I would guess, much more slowly than we do it. So we already have policy divergence, and you could see that, I would think, continue.

HUBBARD: OK, well, to borrow a Fed metaphor, I’m going to have to take the punchbowl away—(laughter)—while the party is still going.

Join me in thanking Rob Kaplan—(applause).

KAPLAN: Thank you. Thank you, Glenn. Thanks, everybody. (Applause.)

(END)

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