World Economic Update

Tuesday, September 13, 2022

Vice Chairman and Head of Global Policy and Central Bank Strategy, Evercore ISI, Evercore; CFR Member

Chief Investment Strategist, Bridgewater Associates, LP; CFR Member

Chief U.S. Economist and Managing Director, Morgan Stanley; CFR Member


Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations; Author, The Power Law: Venture Capital and the Making of the New Future@scmallaby

The World Economic Update highlights the quarter’s most important and emerging trends. Discussions cover changes in the global marketplace with special emphasis on current economic events and their implications for U.S. policy.

This series is presented by the Maurice R. Greenberg Center for Geoeconomic Studies and is dedicated to the life and work of the distinguished economist Martin Feldstein.


MALLABY: Good morning, everyone. Are we good? The microphone’s working? Welcome to today’s Council on Foreign Relations World Economic Update. This series is dedicated to the life and work of the distinguished economist Martin Feldstein, who was a friend and mentor to many of us. The audience today consists of you in person, but also Council members across the country who are joining us online. And we’ll try and get questions from both sets of people.  

We’re meeting at a time when the latest inflation numbers in the U.S.—we’ll see in half an hour or so what the latest August one was. But, I mean, they’re looking somewhat more benign. On the other hand, the magnitude of the crisis in Europe is being compared to the economic shock from COVID. And meanwhile, we’ve got China in the grip of a sort of real estate-driven crisis, a COVID-zero crisis, which is raising questions about whether the Chinese leadership are still the pragmatic problem solvers they once were. And to comment on all of this we’ve got three wise observers, as ever: Ellen Zentner from Morgan Stanley; Rebecca Patterson from Bridgewater Associates; and over there, Krishna Guha from Evercore ISI. 

So, Rebecca, I thought I’d start with you and with Europe. And if we break this down into sort to the western European energy crisis and then later we’ll get to the ramifications of the battlefield changes. But just, Rebecca, thinking about the fuel crisis part of this, we’ve got western governments spending anywhere from 2.5 percent of GDP to more than 4 percent of GDP on fiscal measures to cushion companies and households from the shock. How do you see the macro consequences of this spending panning out? 

PATTERSON: So, first of all, thank you for having me. It’s always good to be here. And it’s wonderful, especially, to be here in person with many of you this morning. In terms of the European energy crisis, on one hand I think Europe has done actually a very good job in attacking the problem, looking for new supply sources, trying to fill up storage as quickly as possible, although it’s still a question whether the winter is unusually cold or not if that will be enough. But of course, making these changes, trying to build some resilience for the winter, has come at a high cost. And that’s just the prices they’re paying for the gas, which are translating into punishingly high electricity prices. 

And that’s going to feed through both to industry and to households. With the industry, they are protecting some industries that are of strategic importance—things like food, pharmaceuticals, chemicals. But there’s going to be a lot of industries, especially some that already have low margins that are very energy intensive, that are going to really struggle, even with some government transfers. Households as well. Even if there is a cap put on electricity prices, the price is still at such a high level and there is so much embedded inflation. We’re seeing real disposable incomes, real wages in Europe going sharply negative. And so this is going to continue to be a strain, even with the government fiscal support. 

So we’re already seeing a lot of fiscal support coming in. I don’t think it’s necessarily done. I think we could see more as the winter progresses, especially depending on conditions. And that is going to cushion the blow to growth. Our view is that we are going to get a fairly decent—decent is a horrible word choice—but we’re going to get a market recession in Europe as we go into 2023. That’s our base case, unless Europe gets extremely lucky. But the fiscal is coming, of course, against a backdrop of inflation that’s already at 8 percent. So even if inflation does moderate somewhat, it’s still so far from the ECB’s target. And at the margin, these fiscal measures create a risk that that inflation is stickier. 

So the cost of supporting your voters, your companies, means that you probably have even greater tightening. And I know we’re going to get to the ECB later, so maybe I’ll stop there. 

MALLABY: But just one quick follow on, Rebecca. Do you think that the risks of an Italian debt crisis or some other debt crisis, given all this fiscal spending, is that back on the table? 

PATTERSON: It’s interesting. You know, we’ve seen the ECB almost, I wouldn’t say a quid pro quo, but partly to get the national central banks onboard broadly with more tightening, they’ve been able to get permission, if you will, or accommodation to have this transmission mechanism tool. I love their terms, but basically trying to prevent spreads between the periphery and core from widening out, that it could create financial instability. And we have seen recently the—Europe’s pandemic purchases, the PEPP program, they’ve basically been using quite a lot of that to support Italy and prevent spreads from widening. And that could continue, as we go into 2023. 

What’s challenging, though, is Italy’s election on the 25th of September. Huge number of undecided. So we don’t know what the outcome is yet. But the polls are suggesting that a center-right coalition with Giorgia Meloni takes over. She’s softened her stances, but if they can’t get the government moving quickly enough to reach the reform targets—they have fifty-five reforms they need to get done this year. They’ve only done twenty-nine so far. It’ll take a month or two to get the government formed after the election. Does the recovery fund fiscal transfers to Italy get delayed because they’re not meeting their reform targets?  

And that would be troubling for Italy. And the ECB has been very clear that they will come to the periphery’s aid if spreads are fundamental. If the spread widening is because of political, homegrown problems, it’s going to be much more difficult—I think almost impossible—for the ECB to help Italy. And I think that’s the sort of thing that could cause a bigger crisis for Italy, and with risks obviously through Europe. 

MALLABY: Krishna, do you want to respond to any of that? I’m going to ask you in a minute about the battlefield shift, but go ahead if you’ve got an immediate— 

GUHA: Just a couple of follow-ons to what Rebecca said. And I agree with 95 percent of what was said. 

MALLABY: It’s more fun if you focus on the 5 percent. (Laughter.) 

GUHA: So I’ll focus on just a couple of small areas where—really, just add to, not contradict. You know, we also think that Europe is going into a recession, and that that will be the case even assuming that we get more fiscal, which we surely will. The debate is really about how disinflationary that recession is going to be, right? Because you’re going to have a simultaneous hit to demand and supply. So the question is, what’s the on net of that in terms of opening up slack and making sure that the headline inflation shock doesn’t feed through to ongoing second round wage price developments. 

The ECB is quite worried about that, that even a recession might not be very disinflationary. My own view is, actually, the recession that’s likely to unfold will see labor slack emerging. And once the unemployment rate, you know, is on a meaningfully rising trajectory it’s going to be hard to worry about those sound-round effects in wages. So I think in the end the ECB is probably going to find that it’s too hawkish and needs to step back. But of course, in the here and now, they’re, rightly, quite focused on the inflation. 

Secondly, just in terms of what Rebecca was saying about Italy and the risks that you raised, Sebastian. So, absolutely, there are risks associated with the election coming up. What I would say is that the European authorities have tried to create what I call a golden straitjacket for Italy. By way of saying that, look, if you play by the rules and you deliver on your promised reforms, you’re going to get roughly 200 billion of fiscal funding from the top of the house, from this pan-European recovery fund. If you play by the rules, the ECB has got your back in the sovereign debt markets, with this new instrument that can guard against spreads. So they’re trying to create an incentive structure so when the populists come in they have a rationally—are incentivized to adopt more prudent policies. This is a much better balance of carrots and sticks than the Europeans had in previous episodes.  

The other thing I would just add is that absolutely there is a requirement—there’s a fundamental requirement for the spread management instrument that the national government is acting in a way that’s consistent with its European obligations and commitment. But I think it—I think it’s important to understand, this new tool, this spread management tool that the ECB has introduced, it is not simply an economic and financial instrument. It is a geopolitical instrument. It is Europe’s shield against the hybrid economic warfare that Putin has unleashed by way of weaponizing gas to try to destabilize the politics of Europe. So in wartime—and Europe does face a wartime crisis—extraordinary things can be done and corners can be cut in the extreme, in order to ensure stability against that threat. 

MALLABY: Well, we noted that you said, the ECB may find itself to have been too hawkish. I’ll come back to that in a minute to ask us to contrast the ECB’s dilemmas with those of the Fed. But let—I want to hear, Krishna, on how this Ukrainian success on the battlefield in the northeast, how do you think that changes the way in which the war affects the rest of the global economy? 

GUHA: So it’s a great question. Sebastian, obviously, it’s still very early days. So, as all of you know, this stunningly successful Ukrainian counter-offensive has unfolded, and exceeded really anyone’s expectations over the last few days. Still, I think, in the baseline, it is unlikely that the, you know, Russian military simply sort of collapses and folds at this point—though that can’t be completely excluded. When we think about this in economic and market terms—and I’m not a military expert, so I’m not going to, you know, give you a handicapping of the battlefield developments themselves—and say a few things. 

First of all, what’s changed immediately is most of us operating in markets thought we had a fairly predictable and fairly stale battlefield situation that we would be dealing with between now and the end of the winter snows, sort of in February/March of next year. So there’s a sort of stasis. We were frozen in place. And then we’d see how this game—game, if you forgive the terrible term—I mean, you know, how this dynamic resumed in the—in the sort of early spring of next year. Now we’re in a much more fluid and dynamic situation. So that’s the first important point. 

In terms of the distribution of risks coming out of this to the economy, to markets, my provisional, early assessment is that on net Ukraine’s progress on the battlefield is a positive for the medium term. It’s a positive for markets, a positive for the economy, because it moves things in a direction where the necessity of Russia moving towards some kind of ceasefire agreement on terms acceptable to Ukraine is moving higher. But in the near term, the more relevant point may be that both barbells, both extreme parts of the distribution are moving up. 

So on the upside tail, there is a tangible, though still modest, possibility that a catastrophic battlefield defeat could lead to regime change, a coup against Putin in Moscow. On the other side, though, the adverse tail is moving up as well, with scope for hyper-escalation from Putin as he finds that his forces are losing on the battlefield. You know, this can extend to everything from, you know, a general mobilization in Russia, which would be politically risky for him but essentially threaten to transform this into a many-year conflict in which Russia would have the manpower, staying power over that long period of time.  

But also hyper-escalation, for instance, by way of deployment of WMD, certainly the threat of, and in the extreme tail—I think still not particularly likely, but again not zero—the use of tactical nuclear devices in order to stave off catastrophic battlefield defeat. That’s the sort of thing that becomes at least—at least worth talking about if, for instance, Russia’s hold over Crimea, which they feel is pure sovereign territory, becomes imperiled. 

So in short, these developments I think, you know, in the medium term on net are positive for economy and markets, not simply positive for the world. But watch out for both these tails rising as the situation becomes more dynamic, more unpredictable. 

MALLABY: I’d like to bring Ellen in. Two things then, Ellen. One is, I’d just be interested, you’ve been thinking about the way the war affects the global economy. Your colleagues at Morgan Stanley obviously as well. And I wonder if this picture of sort of bigger tail risks on either side as the assumed stagnation breaks down on the battlefield, does that chime with how you’ve been thinking about it? 

ZENTNER: Yes. I think it’s very difficult to handicap those outcomes. I think that means that you have this drag on the global economy from it, particularly directly on Europe. You’ve got the fact that we can’t point to China, as we normally do, and say, hey, China’s growth will buoy the rest of the world. So you’re dealing with a global recession. And I think at a time, because inflation is high across the global economy, central banks have to just focus on the near-term job, the job that they have to do with battling inflation, with an eye on the risks of spillovers from global growth. 

And in the U.S., we just haven’t seen those financial spillovers in a way that have tightened financial conditions that would threaten the U.S. outlook, and certainly not in a way that deals—its job would be helped by that, in terms of inflation. So what does that mean? It means that despite this global growth slowdown, central banks are going to have to add to that by taking rates higher—interest rates higher. And really, we’re all just wondering, you know, how high do they need to go? It’s not do they continue to raise rates, it’s just how high do they need to be. And so I don’t think it’s a unique problem for Europe, or a unique problem for the Fed. 

But here, the FOMC finds themselves in a very unique position, at least anyone that doesn’t remember the ’70s. Which I remember the ’70s. (Laughs.) The— 

MALLABY: No, you don’t. We don’t believe that. (Laughter.) 

ZENTNER: I had fun sitting—well, I wasn’t a practicing economist in the ’70s. But I was alive and I do remember waiting in the line with my mother for gasoline, and that stations were closed on Sundays. And I remember all that. And that inflation was the predominant word in our household growing up. But anyhow, so it’s a unique position, where, you know, you want to raise rates. You don’t—at least in the U.S., you don’t want that to create—to lead to recession. But you’re willing to risk that in the name of keeping inflation expectations anchored and doing the job that’s at hand today. 

MALLABY: Well, do you think that the Fed will engineer a soft landing for the business cycle? 

ZENTNER: I think they want to. (Laughter.) 

MALLABY: Of course they want to. (Laughter.) 

ZENTNER: So, I mean, you go back and ask, you know, any former Fed chair and say, oh, would you like a soft landing, or do you intend to create a soft landing? Well, of course. You know, there’s every reason to be more optimistic that the U.S. can avoid recession, a downturn. You know, we’re fully behind your view, Rebecca, as well that Europe is going to be in a downturn. The U.S. is in the midst of a slowdown. You know, it’s difficult to raise the probability of recession too high in the U.S.—like, say, to tip you beyond 50/50. If you have a labor market that continues to be this strong—300(,000)-400(,000) jobs a month—very difficult to see that persisting and there being a downturn. 

So job gains need to slow. That’s part of the Fed’s problem, is the unemployment rate is low, job gains are just too fast a pace. And that we do need to sustain at least below potential growth for quite some time. So they hope to avoid a downturn, but if the Fed’s actions lead to a downturn, that’s fine too. There’s some amount of pain that you need to accept because you need to raise the unemployment rate, create slack in the labor market. And the Fed won’t be this explicit, but that means you’ve got to put people out of jobs. 

MALLABY: So, Rebecca, you said that—I think you said you expect a recession in Europe. 

PATTERSON: Mmm hmm. 

MALLABY: And in the U.S., are you an equal-opportunity pessimist? 




MALLABY: Tell us why. So Ellen sounded vaguely more optimistic here. 

PATTERSON: Well, Europe is definitely facing a more acute set of challenges than the U.S. is, given the energy crisis there and the war on their doorstep. But in the case of the U.S., I think the real challenge for the Fed is the fact that we came through this pandemic with consumers in such a strong position. So higher wealth levels, higher savings than before the pandemic, which is unheard of during recessions. This was unique, because of the size of the fiscal and monetary easing. And then you have this labor market that is the strongest we’ve seen in forty, fifty years. And so for the Fed to be able to get inflation back down to target, or even close to target, they have to be able to crack the consumer, basically. And that means getting the labor market to soften.  

Now, how can you do that and get inflation lower? How can you get wages down? The Atlanta Fed wage tracker is now at 6.7 percent annualized. This is very strong wage growth. The benign outcome would be that you get a much higher participation rate, the supply comes back. But what we’re seeing today is that a lot of retirees aren’t coming back the same way they have in past cycles. And you have some segment, not huge, of the population due to COVID or other factors that aren’t coming back. And so supply could improve. That would make our view maybe wrong, or at least too aggressive. 

If that doesn’t happen, then you need the economy to continue softening and you need jobs cut. And so the unemployment rate is going to have to rise meaningfully for the Fed to do its job. So for the Fed to get what it wants, it almost has to engineer a recession. And the more the consumer’s resilient, the more they can spend. The more they spend, the more inflation stays sticky, which makes the Fed’s job harder. So, you know, we are humble about the environment we’re in. This is an incredibly difficult set of circumstances to try to understand and forecast. But when we’ve tried to come up with a view, like, how can the Fed get that soft landing, not impossible but the probability is low enough that we feel good about our base case that we’re going to have a contraction that the Fed will have to create. 

MALLABY: So, Krishna, the debate seems to be the good news is the U.S. economy is resilient in terms of the job market. The bad news is the U.S. economy is resilient in terms of the job market. (Laughter.) 

GUHA: Exactly. 

MALLABY: How do you see this playing out? What are your—what’s your base case in terms of recession or not? 

GUHA: Well, so I think you actually summed it up very well with the questions you started with, Sebastian, in the sense that, you know, the resilience of the U.S. labor market and its momentum is a double-edged sword, right? Because on the one hand, it’s pretty clear that we are not in or on the brink of recession in real time. How could you be, to Ellen’s point, when the labor market remains so strong. And to go to Rebecca’s point, if the labor market stays very strong then on some horizon it just means the Fed needs to do more by way of tightening in order to, you know, ease up things, to restore a better balance of demand and supply, tackling underlying, you know, component of inflation. So mixed blessing, then. 

Look, I find myself, I was saying in the green room—I guess we call it—you know, beforehand, I have rather uncomfortably sort of meandered between sixty-forty and forty-sixty in terms of my recession probabilities over the last—you know, last few quarters. I think it’s hard to get massive conviction, to be honest, in either direction. I think that is actually an important point. So, you know, as Larry Summers most famously, but many others, have emphasized, if you look at the historical record it’s just really hard to find examples where you can bring down, you know, inflation—and not just headline inflation, core inflation—from where it is today to something close to the Fed’s 2 percent target, without a proper recession and an increase in unemployment that is, you know, a couple of percentage points, let’s say, rather than, you know, half a point, which might be consistent with sort of soft landing—soft-ish landing scenario. And I take that very seriously.  

On the other side, I’m struck by the fact that this pandemic cycle is unlike any we’ve ever seen before. The nature of the inflation is also really unlike any we’ve seen before. So the historic regularities may not be a particularly good guide to how things pan out. And, you know, there are some historic episodes—and, you know, they’re all very imperfect analogies, for reasons that’ll be obvious to you. For instance, the post-World War II period, where you have—you know, you have a sort of level–shift of a crisis, the inflation sort of peters out, in a bumpy rebalancing of the economy as demand finds a new equilibrium and the supply and the allocation of resources to different parts of the economy sort of shuffles around and sorts itself out. 

So that sort of bumpy rebalancing, with the inflation rate subsiding by more than you would think, based on the historic pattern, while of course leaving the level of crisis still a lot higher than they would have been—that still seems to me to be a very plausible possibility. And I would add that, you know, to the point that Rebecca made, you know, the labor supply piece is crucial here. I am more optimistic than consensus about the scope for labor supply to return, you know, given enough time, over the next eighteen months or so. Of course, labor supply, that’s about—you know, that’s partly about post-COVID factors. It’s also, I think, about a resumption of cross-border flows of migration, where we’ve—you know, we have a lot of missing workers because of, you know, lost migrants over recent years. Some of that might pick up some as well. 

MALLABY: OK. So we’re going to come for one more question to Ellen, then I think we’re going to come to members. I think you wanted to react directly, Ellen, but I have a question for you as well. So you react first. 

ZENTNER: Oh, I just wanted to say, quickly on the supply side, I mean, that—I think it keeps coming up again and again on this panel, because that is extremely important. To the retirement point, the flows that we’re actually seeing right now back into the labor market are from self-employed back to being on formal payrolls, because I think things are enough uncertain in the economy that you’ve seen folks actually—and now that wages have risen enough, you’ve seen folks come out of self-employment, which is where they chose to move to post-COVID. And whether that was early retirement, and they became self-employed, and then they’re moving back into the labor market, that flow is there. And I think that is a really important point. 

And then—and then on inflation, I think what central banks globally have to underscore is their expectation for how long they think it will take to get back to target. Some talk in a way—some policymakers talk in a way, like, we got to get back to target by the end of next year, or even by the end of 2024. I think that’s extremely aggressive. Inflation is a slow-moving beast, and especially in the U.S. when a lot of it is driven structurally, demographically. And so, you know, I think a five-year period, I agree with Mary Daly, the Fed president of the San Francisco Federal Reserve, who said: I hope we can get back to target within five years. I think that’s doable. 

GUHA: Can I just add a quick— 

PATTERSON: A two-finger—I know, I know. 

MALLABY: OK, we want to get—very quick, very quick. 

PATTERSON: From a markets’ perspective, one of the most striking things today is that financial markets expect easing in the next eight, nine months. And it just does not square with anything any of us are saying. 

MALLABY: Yeah. What was your two-finger? 

GUHA: Oh, well, just to say that the key thing is once inflation gets down to three, ideally below three, degrees of freedom open up to the Fed. So I think when we talk about five years, right, you actually have get down below three by the end of next year, in my opinion. But once you’re there, boy, you can take a lot more time to then go from, you know, 2.9 to 2.0. Absolutely agree. The message—the Fed’s—you look back on this year, it’s a level step in rates from zero to four. That’s the game. And then you sit there until the inflation comes down enough. You hope that that four is enough. You don’t actually know. We’ll discover. But that’s the game plan right now. 

MALLABY: So we should open it up. I’m sorry we didn’t get to China, but maybe somebody will ask about China. So just a reminder that this meeting is on the record. We’re going to take questions from members here, and also members remotely. The first question is from New York. Gentleman with the yellow tie there. 

Q: Good morning. Larry Dworkin, JPMorgan. 

We’ve spent a lot of this morning talking about impacts in developed economies—Europe, the U.S. I was hoping you might speak a little bit to the secondary impacts on emerging economies. You know, Europe can afford high energy prices. It’s painful, but they can do it. Emerging economies, not all of them can. We see a potential for a recession in Europe and the U.S. That flows through to emerging markets and their export potential. What are some of the key secondary and tertiary impacts that you’re focused on? 

MALLABY: Who wants to take that? 

PATTERSON: So I can kick off. So I think everyone in this room and on the call knows at this point that we shouldn’t think about emerging markets as a monolith. There’s going to be a tremendous amount of differentiation, country to country. If I were thinking about the secondary impacts on emerging markets today, there’s the growth channel. There’s the commodity channel. And I’d probably add the U.S. monetary policy channel, which the dollar is an offshoot of that—and so the strong dollar. In terms of how it’s rippling through, you know, initially when we saw the run-up in commodity prices, some of the large commodity exporters were benefitting. And as commodity prices have rolled off their highs, and some of them coming down quite quickly, we’re seeing some of those economies continuing to spend as if the commodity prices were still going up, which is somewhat troubling. Brazil would be a case in point. 

The good news, perhaps, for a country like Brazil is that they do most of their borrowing today in local currency. Over the years, they’ve moved away from dollars. So they’re a little more protected, if you will. I’d say the one other thing that helps all the emerging markets today is that there’s very little investment in them. So if you contrast this with 2008, where people had been buying emerging markets during the heyday of the BRICS, had a lot of exposure to get out of, today you don’t have that amount of financial vulnerability that could add to the problems. 

But in terms of looking for the next Pakistan, the next Sri Lanka, you know, who’s really in trouble, you know, it’s horrible what’s happening in these countries from a humanitarian point, political, economic. But the countries themselves are not large enough to pose global systematic risk. I think if we were to see problems spread to a country like India, which is one that we would be watching carefully, that would be troubling. So India’s current account deficit has ballooned. The rupee has fallen, not nearly as much as the Sri Lankan or the Pakistani rupee this year, but it is down about 7 percent. And that’s with a tremendous amount of intervention to support it. So that would be a country that if it had bigger problems would be certainly something that could pose bigger global risk. 

The other one that we’re watching that is also, I think, a risk point, is Chile, which is so striking to me. Because I grew up always thinking of Chile as the Switzerland of Latin America, just incredibly good fundamentals, government, et cetera. But today what we’ve seen is copper prices falling extremely quickly, their current account deficit has ballooned to the largest level, as its share of GDP, in decades. So the external financing needs are huge. They’re intervening to try to support the currency, but at the pace they’re going they’ll literally run out of reserves at the end of this year. So if we’re thinking about balance of payments crises, crises that could come from slower growth, tightening liquidity, strong dollar, again, there are many countries—emerging market countries—out there today that are going to weather this storm, I think, relatively well. But there are a few countries that are big enough to matter for the global economy, and those would be two I’d highlight. 

MALLABY: Let’s go to a remote question. 

OPERATOR: We’ll take our next question from Tara Hariharan. 

Q: Thank you very much and good morning. My name is Tara Hariharan and I’m from NWI, a hedge fund based in New York. 

I’d ask the obligatory question about China growth, and how dire you see the prognostications there. But also link it to the prospects for energy prices. Given, of course, the ongoing Ukraine-Russia-Europe situation, but also the prospect that Chinese oil demand is much lower than people might have expected for this time of year. And so I would really enjoy a discussion on buying energy and China growth prospects together. Thank you. 

MALLABY: Krishna, do you want to take sort of general China outlook? 

GUHA: Sure. Absolutely. So, you know, I’ve been consistently in the camp of seeing China weaker for longer this year. And so, you know, I think things have, this time at least, panned out, you know, consistent with that—with that perspective. You know, the scope of ambition of what they’re trying to do in the real estate sector and in terms of, you know, sort of moderating and sort of working through the financial excesses associated with that, is really very sweeping. And their staying power is very striking. You know, they haven’t backed away from this is a serious way, at the first signs of weakness. 

You also have the—you know, the ongoing issues around, you know, the effort to establish more effective state regulation, monopoly control and, I would argue, political control over, you know, the tech sector and parts of the private sector more broadly. And then, of course, you have the zero-COVID strategy. And it’s been clear to me for some while that while, to be fair, zero-COVID was a winning strategy in the first year of the pandemic, and has, you know, China’s levels of, you know, excess morbidity and so on is a fraction of what we’ve seen, you know, in the U.S., and Europe, and so on.  

But that strategy ran out of road, you know, really by the beginning of this year, at the latest. And they’ve been struggling to find their—you know, an exit strategy out of this. Now, as you know, there’s a general recognition that nothing happens ahead of the Party Congress. The focus on political, social stability going into that, of course. But I think it’s important to really understand, it’s not a light switch that just gets turned off or tuned on, depending on your perspective, the morning after Xi gets his next term as China’s leader. You know, figuring out this exit strategy will be very challenging. It’s got to combine a health exit strategy, obviously, in terms of their own mRNA vaccines, their vaccine resistance, the concern about side effects, the resiliency of their wider healthcare system to cope with a wave of increased—you know, of increased infections. 

But it also has to have sort of sociopolitical strategy around it as well, because a lot of Xi’s personal prestige is tied up with the conquest of COVID post-Wuhan, and the contrast between what happened in the U.S. and Europe versus China, demonstrating the superiority of the Chinese model. So I think finding a way out of this is really very, very tricky. I think it’s going to take at least six months from the end of the Party Congress to sort of figure out and, you know, begin to implement an effective exit strategy. So I do think on some horizon we will get some, you know, firming of China’s growth and contribution to world growth. But I see that as not something that’s going to be, you know, kicking in at the turn of this year. It’s more something that might be a sort of mid of next year, you know, phenomenon. 

And then just finally on oil, so very clearly as, Tara, you know, this has been one of the surprise factors that’s helped to pull down oil prices of late. And the irony in a sense is that it—you know, China’s slowdown is actually undermining one of the key weapons available to its political partner Putin in his wider struggle with the West over Ukraine. 

MALLABY: Do you want to add something, Ellen, or? 

ZENTNER: Just the energy story is going to be about—more about demand than supply. And I think that’s what Krishna’s getting at, at the end there, as well. That, you know, it wasn’t until the realization of how slow China would grow that you started to get a correction in energy prices. And so, again, going back to what ails you and how much pain do you want to inflict, the way to get energy prices down is going to have to be from the demand side. And so slower global growth is what will help that. 

MALLABY: And I can see a question back there. 

Q: Hi. My name is Nina Schwalbe and I’m with Spark Street Advisors and at Columbia University. And I work in global public health. And you guys make us look like optimists. (Laughter.) 

I have a question about the free fall of the euro. Can you comment on that and what it means? And should we care? And what do you think is, you know— 

MALLABY: So which aspect of the euro? 

PATTERSON: The fall of the euro? 

Q: The free fall of the euro. 

PATTERSON: I’m happy to kick off. 


PATTERSON: I grew up covering currency markets at JPMorgan. So they’re near and dear to my heart. You know, I think this is much more of a dollar story than anything else right now. If you look around the world, you’re seeing the dollar gain against almost everything. And so there is a euro element to this, with the high level of uncertainty around their stagflationary pressures. Certainly, that’s going to be a factor that curtails capital flows into Europe. And that can be a force that can net-net pull the euro lower. But the challenge, of course, with the euro falling is that while longer term it’s going to make some of the exports in Europe more competitive. So eventually this is going to be a help for their economy. Right now, given the focus, as Ellen pointed out, by all central banks on inflation, it’s compounding the problem for the ECB, and making at the margin their need to tighten even greater. 

What’s interesting is, you know, you’re starting to see articles about, you know, references to Plaza Accord and joint intervention. When we’ve seen joint action to change currency paths in the past, you didn’t have the inflation dynamic that you have in the U.S. today. So for the U.S. to say, sure, we’ll help you, we’ll get a weaker dollar so we can take the pressure off you all, it’s just not going to happen today. The Fed needs a strong dollar because at the margin it helps reduce inflation pressure. And so the ability for governments to help each other right now, or central banks to help each other right now, is just nonexistent. So you’re seeing different countries take different steps to try to mitigate the currency pain, whether it’s different types of subsidies to industries or other types of steps. 

MALLABY: It’s interesting, because sometimes in some settings we talk about competitive devaluation by countries trying to grab export share. And now we’re talking almost about competitive revaluation. People want to fight inflation, so the fight is to have the stronger— 

GUHA: It goes back to a system— 

PATTERSON: Than China. 

MALLABY: Yes, absolutely. 

GUHA: No, I was just going to reference, actually, Jeff Frankel at Harvard came up with this great phrase, “reverse currency wars,” right? Where we used to all compete to undercut each other, right, to avoid deflation and to prop up growth. Now we’re all trying to compete to raise our currencies in order to—outside the U.S., at least—in order to prevent currency weakness from amplifying the dollar price of energy and food and wider commodities. 

MALLABY: I wanted to actually, before we didn’t have time to ask Ellen to comment on this thing that, you know, at the moment the markets appear to be, you know, up in the last few days, partly on the idea that inflation is down so the Fed can be weaker. Part of that inflation performance in what we think to be the performance for August, and what was certainly the performance in July, is dollar strength. So we’ve had this inflation holiday, one could say, because of dollar strength. Yet, the dollar might roll over. How do you see this as a risk to the inflation outlook? 

ZENTNER: Well, you tell me when the dollar will roll over and I’ll tell you when the risk emerges. (Laughter.) But, no, I—so I think— 

MALLABY: Yeah, of course. I was hoping to ask you when the dollar would roll over. 

ZENTNER: (Laughs.) But, no, the—we don’t expect anytime soon. But I think on—its impact on inflation, I mean, it takes about two quarters for a sustained change in the dollar to feed through to inflation in the U.S. I think it affects much more the goods side of inflation, which is about 25 percent of the bucket of core inflation. And, you know, so it’s helpful. It’s helpful on the smaller side of inflation. But it helps push down goods, prices which were—which experienced the biggest increase from COVID. And so it’s really the service side of the economy, though, that the dollar is not going to do a whole lot for. And it’s that service side of core inflation where the biggest and longer-term issues are things like rents and owners’ equivalent rents, which are a real problem for the Fed. 

MALLABY: A remote question, please. 

OPERATOR: We’ll take our next question from Chris Thomas. 

MALLABY: Hi, Chris. 

Q: Good morning, there. This is Chris Thomas with Brookings and Integrated Insights. 

On a different basis, this trend of decoupling, that China is trying to reduce its dependence on U.S. technology, the U.S. trying to reduce its dependence on Chinese supply chains. Been talked about for years, but actually very, very little has actually happened. But now the momentum from both governments is astounding, and the money is there. What do you see is the long-term impact? And does it actually happen? 

PATTERSON: I agree. We’ve heard so much talk. And outside of a few places—Vietnam clearly is an outlier. They’ve been a huge beneficiary of companies that had been producing in China, taking some of that production overseas. And there are a few countries elsewhere that have been the beneficiaries. But agreed, the rhetoric ratio to actual change is off balance. There was a McKinsey study that came out right before the war in Ukraine stared, suggesting that 90 percent of supply chain managers were expecting to make changes in their supply chain over the next three years. So one could say that maybe it’s—the talk is going to lead to more action this time, that this is in front of us.  

You know, when we look at it, what we’re seeing is companies that want to be close to their end consumers. So if China is your end market, maybe you don’t want to have all your production in China, because you want the resilience, but you want to keep it in the neighborhood, so to speak. And so if your end consumer is the United States, maybe you’re focusing more on production in Canada, or Latin America, or South America. So this—the idea Janet Yellen coined of friend-shoring, or I’d just put it as regionalization, I think is something we’d expect to see. 

I think from a macroeconomic what does this mean perspective, I think there’s both an inflationary impulse that comes out of this—whereas before we were looking at, you know, the lowest-cost supply chain now we’re having to replicate some of our production and not always live with the lowest cost. And so at the margin, it is adding to the longer-term inflation risks. And then there’s also going to be a major change in capital flows. As people are building plants and equipment in different countries to change their supply chains, you’re going to see the money follow. And so I would be thinking about what it means for local markets, local currencies, as that capital flows through.  

And then finally in the U.S., I mean, we are seeing—small start—but, you know, the CHIPS Act, 53 billion (dollars). We’re seeing companies like Intel announce major initiatives here in the United States. Those are generally strategic industries. But I think that rhetoric is increasingly turning into actual action, with real capital behind it. 

MALLABY: Quick commercial interlude. My colleague Shannon O’Neil has a book coming out next month about supply chains. So check it out. 

PATTERSON: And she’s fabulous. 

MALLABY: She’s fabulous, yeah. 

Yes, question, right here. Wait for the microphone, please. Yeah. 

Q: Sorry. Juan Ocampo with Demand Insights. 

I want to follow up on Krishna’s point on the Fed may be bringing rates up to 4 percent and seeing what happens. And also the idea of a step change in prices that could be kind of a different scenario. Suppose that happens, they go to 4 percent, inflation does drop to 3 (percent). And then at 3 (percent), things are pretty good. If you go back and look at what happened in the 1990s, you know, we had positive real interest rates, they were much higher than anything that we’re talking about today, with a very good economy. Is there a chance, do you think, that that actually is an end result, as opposed to, you know, the assumed scenario of going back to 2 and continuing that way? 

GUHA: So that’s a very good question. It’s certainly true that we know from recent decades, the economy can perform perfectly well with an inflation rate that’s stable in the 3 percent neighborhood. And actually, more recently, you know, with the experience of the financial crisis, the lower bound, and so on, a number of academic economists, you know, have argued that, in fact, it would be better to have a 3 percent average inflation rate, because it gave you a bit more of a buffer to cut during the downturn, as you know. 

The difficulty is really one of sort of path dependency, right? Where we started from, we—the Fed, I used to work there so sometimes I say “we”—but the Fed has promised us 2 percent inflation, right? And so to cheat and then accept 3 percent inflation undercuts confidence in the nominal anchor in the economy, you know, as a whole. And I think the difficulty is, you know, if you could credibly cheat one time, say 2 (percent) and deliver 3 (percent), well then everyone would believe from here to eternity you would defend 3 (percent) vigorously against all shocks, it would be fine. 

The problem is, can you really—can you really credibly do that, right? Or would businesspeople, households, investors say, OK, well, they’re saying 3 (percent) now, but the next time we play this out they’ll say, well, you know, 3.5 or 4 (percent) would be all right as well. So I think the real-world compromise is along the lines that I’ve suggested, which is you have to act very strenuously to bring underlying core inflation to, I think, actually, just below—ideally, below 3 (percent), let’s say, by the end of next year, roughly. And you have to do what it takes to achieve that, even if it’s the cost of a high recession risk, per our earlier discussion. 

Once inflation is below—you know, is around 3 (percent), providing it’s, you know, a bit below 3 (percent), wide degrees of freedom open up to you in terms of how aggressively you need to lean, while you still have a sort of general orientation to guiding inflation back down towards 2 percent over the coming years. With a reference to five years, you know, Mary Daly’s suggestion. There was an old idea of what was called opportunistic disinflation. And that was that, you know, when you have inflation rate that was a little higher than you wanted but it wasn’t worth causing a recession to get rid of it, what you would do is you would maintain an overall bias to try to guide inflation down over time.  

You wouldn’t cause a recession on purpose to do that, but what you’d do is when you had shocks coming in that pushed inflation up, you would oppose those, and you ordinarily would. But when you had shocks come in that actually pulled inflation down, you’d stand back and let that happen. So then over time, as you get the random draw of some inflationary some disinflationary shocks, inflation ought to trend lower without you actually making a, you know, active decision to cause serious economic weakness, with a difference between, you know, 3.0 or 2.8 and 2.0 (percent). 

MALLABY: Let’s go to a question over there. 

Q: Hi. Elliot Waldman with Point72 Asset Management and I’m also a term member. 

I wanted to help us along on our global journey and ask a question about Japan. We’ve seen the yen depreciate against the dollar to pretty striking levels. And I guess I’m just wondering what options do you see the policymakers having? At what point do they intervene? How long can this go on? I mean, Rebecca, you mentioned it’s primarily a dollar strengthening story, which I believe BOJ Governor Kuroda has also mentioned. But sort of if you could give us your view of what you see the reaction being. Thank you. 

PATTERSON: Sure. Thank you. So in Japan’s case, I don’t think they’d do it in public but behind scenes there might be a little joyous dancing taking place, because they’ve struggled for decades to try to get inflation re-anchored at a slightly higher level. And now it’s actually happening. And so how can they ensure that inflation expectations and inflation will stay at a healthier level for the economy longer term? So one of the reasons—and I’ll keep this quick, but just to make sure we’re all on the same page—it is a dollar story, the Fed tightening.  

But on the other side, particularly in Japan, it’s the fact that they’re one of the only developed economies that’s just die-hard about staying easy to ensure that inflation outcome. And so they have something called yield curve control, where they’re trying to keep yields depressed, and that differential between U.S. yields rising and Japanese yields is what’s largely—not only, but largely—pushing up dollar-yen. And as it gets harder and harder to maintain that yield curve control, is there a point at which they say we’re going to let it go, or inflation’s high enough that we feel like we can let it go, let yields adjust a little bit? We saw that happen in Australia. It became very painful to sustain a yield curve control policy, and they let it go.  

I think in Japan’s case, what we’re hearing from the policymakers is they’re not in a rush to do that. That they would rather have a weak yen and take other measures—whether it’s fiscal or something else—to help the companies and the households that are hurt by it get through this period. I think once we get through the next BOJ governor, which I believe is next April if I’m remembering correctly, then if their pressures are continuing, that would be the point in time where I’d say perhaps we’d see a change. But it is—it does feel like a change out of yield curve control is a matter of when, not if. But I think Japan for now would prefer to hang onto that weak yen, because even though it does cause some pain if they could reanchor inflation higher that could be a huge benefit for them. 

MALLABY: Let’s go right in the back, over there. 

Q: Thank you. Adam Silverschotz. I run an investment firm. 

Two kind of related questions, one going back to Europe. You know, they filled their tanks with gas for the winter. They paid a really, really big price to do it. If it’s not politically feasible to actually pass those prices through to consumers and small businesses this winter, there’ll need to be a debt-financed bailout of those prices, potentially absorbed by the ECB and then potentially rebalanced on a central banking basis globally. Curious your thoughts on kind of the game theory of how that might play out over the next six months or so. 

On a related matter, just from a market internal structure standpoint right now, you have a ton of big forces, right? Quantitative tightening is accelerating. You have a number of very big, very illiquid markets right now. Someone was talking about Japan and JGBs. And just the odds of something breaking, you know, a punctuated equilibrium. You know, the Fed I think last week was testing new overnight facilities with primary dealers and other central banks. So just, you know, odds of something kind of discontinuous happening over the next six, nine months, and kind of the game theory around especially Europe and the energy crisis as a catalyst. 

MALLABY: Krishna. 

GUHA: I’ll have a crack at that to start with. So with respect to the energy costs, first of all, in Europe. As I’m sure you’re aware, the UK has gone out with a super aggressive plan to try essentially arrest the passthrough of the wholesale energy prices to the end user energy prices for households and small businesses, at the cost of a, you know, huge and, frankly, very open-ended fiscal commitment behind that. There is at this moment no suggestion that the European Union intends to follow that model. But, you know, this is a fast-moving dynamic. Certainly, there’ll be large fiscal transfers to households in continental Europe. And one of the ideas they’re working on is to cap a sort of basic allowance of energy, potentially set at, say, 75 percent of average household consumption, at a fixed concessional rate, and then have a very high marginal price above that, right, to try to incentivize, you know, reduction of energy consumption. 

And part of the game here is to try to make sure that you can go through the winter with—ideally without—or with as little quantity restrictions as possible, right? So old Econ 101, we can ration by quantity or price. Ideally you want to do most of it through price, because when it gets down to quantity rationing the problem is that the households won’t, the industries don’t, right? So if you’re Germany in the winter and you have to do quantity rationing, it’s industry that’s—at least nonstrategic parts of industry—that are going to get a disproportionate part of that burden to hit. So I think that’s—you know, it’s a very important set of questions evolving there that we’re going to need to stay sharply focused on. 

And then with respect to your point about, you know, something breaking, so, you know, I glad you raised QT. It’s not that I’m a sort of, you know, QT equals apocalypse sort of guy, but I do think it is quite striking that we have 3 trillion (dollars) of intended QT, you know, coming down the pike over the next two and half years or so. We’re only just now stepping up to the—you know, the maximum caps, the sixty plus thirty-five. We have very, very, very little experience running these experiments. I would argue that we actually have zero experience, because what happened last time—the only one time we’ve done QT—is that the U.S. did QT at a time when Europe and Japan were doing QE on an approximately equal order of magnitude.  

So we’ve never run the experiment of reducing the global central bank aggregate balance sheet. And so I think we should be quite humble about, you know, how confident we are on how that’s going to play out. But in that context, and many other things going on—including, you know, tail risks around the war and so forth—it worries me a lot that there—that we observe this illiquidity in some very big asset markets, because obviously that runs the risk of, you know, more discontinuous price shifts under a shock. 

MALLABY: Anybody else want to comment on tail risks that, you know, keep you up at night? No? Yeah? 

ZENTNER: Well, I mean, maybe this isn’t near term, but longer term—and we were talking about this in the green room—just how little we understand of the long-term effects of COVID. So I think when we think about over the long run, right? And we’re talking about labor markets here. What about labor-force participation over the longer run? What about that employment to population ratio, which is such an important underpinning to the potential growth of the economy? And this is a global issue. And I think—I think humble is something that we have to remain, which is something that economists aren’t always good at being is humble. Because we don’t—we still just don’t understand the long-run effects. 

MALLABY: Look, we’re almost out of time. I thought I’d just take the last minute or two to ask each of you to say quickly: If you had to say how the world looks different, say, three years from now compared to prior to COVID, in sort of economic terms—I mean, Ellen has suggested one variable, which is whether labor force participation goes back to where it was before. Is there something else that you think looks fundamentally different? Let’s start with Krishna and come back this way. 

GUHA: So this is certainly where Ellen’s recommendation to be humble is—you know, is right up there. Look, my working hypothesis is that what we—what we end up at three or so years from now is not a return to the pre—you know, pre-pandemic world. But it’s not a return to the 1970s either. And if you were going to sort of weight then, I’d put 75 percent on the pre-pandemic world, 25 percent on the ’70s. So in other words, it’s a world that’ll look more like the recent past than the worst episodes of prolonged, sustained inflation. 

MALLABY: OK. Rebecca. 

PATTERSON: So two things two or three years from now that I think will be structurally different—and I think we’re all still getting our heads around what are all the various implications of it—one is that it’s been very clear in the last year or two that China is changing its policy model around growth. Accepting higher quality, slower growth. They’re not going to flood the market with liquidity to achieve a certain growth target. They’ll be comfortable with lower rates of growth for longer periods of time. And obviously that affects not just China, but it affects the world, given all the interlinkages. 

And then two to three years from now—and, obviously, I’m much more humble about this view, because who knows how the world will go—but I have to imagine when we get through this, however we get through this, that you’re going to have the anchor of Europe. Germany really having a lot of deep thinking about its economic model. You know, it has benefited tremendously from cheap energy imports from Russia. I have to assume much or all of that is gone. It’s benefited tremendously, and continues to, with trade with China. But if you have a slower China and you have geopolitical tensions, that might be sharply reduced. 

And so you’re going to have potentially a slower China, slower Europe, maybe not disastrously so, but how does that flow through to the global economy and what are the results of that? So I’m willing working through myself, but those two puzzle pieces to me seem increasingly likely. 

MALLABY: And last word to you. 

ZENTNER: I think three years from now we—you know, setting aside the cyclical effects on inflation that might be present—I think it’s still going to be higher. I think we have enough structural drivers, the inflation will be structurally higher, besides regulatory effects, globalization, which will include the supply chain, near-shoring, workers economy, higher share of—labor’s higher share of corporate income. So I think we’ll still be—that will still be playing out. 

MALLABY: OK. Well, thank you for joining today’s meeting. Thanks to our speakers. And please note that the video and transcript of the discussion will be posted on the CFR website. Thanks a lot. (Applause.) 

PATTERSON: Thank you. 

ZENTNER: Thank you.  


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