World Economic Update

Wednesday, February 15, 2023

Co-Chief Investment Officer, Bridgewater Associates, LP; CFR Term Member

Founder and Chief Executive Officer, Exante Data

Visiting Professor, School of International and Public Affairs, Columbia University; 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: So good morning, everyone. I’m Sebastian Mallaby. I work here at the Council on Foreign Relations. Welcome to the World Economic Update.

This series is dedicated to the life and work of somebody who is dear to many of us: Martin Feldstein, the distinguished economist. We have an audience which is mostly online today, but some of you—thank you for coming in person here in New York.

So to discuss what’s going on in the world I’ve got on the—my far right, your far left—Karen Karniol-Tambour, the new chief investment officer—co-chief investment officer of Bridgewater Associates, and she may not look like Ray Dalio, but she kind of is.

Jens Nordvig, in the middle, who is the founder and chief executive officer of Exante Data, and now a new company, right, MarketReader.

NORDVIG: Yes. Thank you. MarketReader.

MALLABY: And next to me, Alan Taylor, a visiting professor at SIPA at Columbia University.

Right. So I thought, you know, we’ll start off by just saying that in 2022 everything fell in the markets. In 2023 even bitcoin went up, but the reasons for the recovery in the early part of this year differ quite a lot across geographies. The biggest turnaround—or maybe the sort of like the obviously explainable one is Asia because of the surprising U-turn on the Chinese lockdown—COVID lockdown policy. So you’ve gone from lockdown to a kind of dramatic opening up, so China and China-linked economies are looking promising.

And therefore my first question is for Jens, who has been tracking this reopening data. You know, how dramatic, Jens, is this going to be? And what will be the spillovers outside of China?

NORDVIG: I think it’s very dramatic, like we started to see the very first signs of this in November, right? There was some little snippets that came out that maybe policies were changing in certain cities, right, and then in December it turned into be a full-blown reopening, right, and then for a couple of weeks there was the question about, OK, can the hospitals handle it, and so forth, right, and now we’ve been through a huge COVID wave in China, right, but everybody is looking ahead, right? Nobody is really talking about the actual virus anymore. Now people are talking about what comes after the virus.

So it has been an incredible quick shift, and it’s not just, OK, domestic policies have been changed. It’s also people are allowed to travel, right, so we’ve had many years—not many years, but several years—(laughs)—in Asia, right, where there was very little international travel going on, and that’s coming back. And it’s going to impact everything, right, so it’s—the consumer sector is the most obvious where the people have been unable to consume, they are doing those things, similar to what we saw around the rest of the world, right, like we saw it in the U.S. when we had reopening here. In the U.S., Mexico, tourism went to more than 100 percent of normal, right? And I think in Asia you’re starting to see some sectors are going to go from this extremely depressed level of activity to something that may be actually higher than the benchmark was from 2019 very quickly. That’s going to—like one angle that has typically been an obvious one when China is reopening is the commodities angle, right? And that comes from people using more gasoline when they can move around domestically, it comes from the jet fuel, and so forth.

Actually, when you look at what’s happening in financial markets, right, we’ve had big moves in Chinese stocks. We’ve had some relatively big moves in Chinese currencies until a week ago; now we stand to, you know, get second thoughts.

But the one area where you’ve not seen such a big move yet is in crude oil prices, right—still kind of bouncing around the bottom, partly because they have some inventories they can use. But this is a big shift.

And then I would just highlight one thing that—I sent out some tweets over the weekend where I pointed out that, OK, China has actually seen very little foreign direct investment in the last couple of quarters, right? So we are at a tricky juncture where there’s a lot of—(laughs)—different things going on at the same time, right, so clearly they had a COVID shock, right, where multinational companies got extremely cautious on China—really, like is this the time to invest in China? And foreign direct investment on a quarterly basis went from, you know, $75 billion to $20 billion—a big, big drop.

The question now is if we are out of the COVID lockdown situation, is that going to come back, or is it actually something structural that is holding back that part of China.

MALLABY: Or geopolitical.

NORDVIG: Yeah. So that’s a big open question where we’ll see essentially whether we—is this bounce in the Chinese economy like a technical bounce that can be forceful, but are there still some big structural issues around foreign direct investment being more cautious. Obviously, the housing sector has big structural issues in it. And at the moment the data is a mix of all those forces together.

MALLABY: And Karen, another part of the rebound in Asia has to do with—I guess it has to do with Japan, where the market has expected longer-term interest rates to be lifted—in other words, Japan would exit from its famous yield curve control—but aside from one small move at the end of last year, the central bank has resisted that. And so interest rates have probably been lower than predicted by markets, and the new—we don’t really know what to make yet of the new central bank chief, Kazuo Ueda, who has just been announced. But he is thought to be cautious, and most of the commentary I’ve read suggests that he, too, will stick with this yield curve control.

So I wonder how you see this. Is this a trade that hedge funds can make something out of, and what does it mean for the wider Asian growth story?

KARNIOL-TAMBOUR: I think Japan is a really interesting story because they are very unlike the U.S. and Europe. They are not yet in a place where they have inflation that’s, in any way, shape, or form, threatening to them. If anything, they’ve been dying to see reasonable inflation for a long time, and they are not yet kind of out of the woods on the deflation that they’ve been experiencing.

That said, for Japan a lot of what made them so easy is the relative story, the fact that they were so easy when everybody else was tightening. And I think there is some realization in Japanese policymakers—even the most dovish ones—that you want to be careful as that differential grows, and grows, and grows, because even when you do nothing on a relative basis, you get easier, and easier, and easier when everybody else is raising. That said, they certainly were in a place where it was time to aggressively tighten like you saw in the U.S. or Europe.

I think they’ve been actually relatively clever about it. A lot of hedge funds have come in there and started betting the rates will rise, and their response to that was we will print unlimited amounts of money—(laughs)—and, you know, make sure that bonds stay at the yields that we say they are. And what that does is basically it means we keep pumping liquidity into the system while at the same time the pricing already moves to reflect that rates will rates will rise somewhat, a little bit, and gradually.

So I think the market is really well prepared for them to slightly, slightly, slightly, slightly tighten; let rates rise a tiny bit over some period of time in 2023, 2024, and for that not to really be a market event, and that the effect of everything they printed is sort of still in the system, and continues to kind of keep conditions there very, very easy as is probably appropriate given that the staff there are not nearly strong enough to say this is time to really be tightening.

And I think for money managers, Japan has been kind of an ignored country, and there’s not a lot of reason for it because the valuations there do look a lot better. And it’s kind of nice to have some of your assets in a place that is not experiencing potential significant inflation problems and significant tightening ahead. And so it’s diversifying and better priced.

MALLABY: So we’ve touched on a couple of the big Asian economies, China and Japan, and then let’s switch to Europe. And there the driver of improving sentiment is nothing to do with China reopening—or not much to do with it. It’s really about commodity prices falling, right? It’s the natural gas prices which were causing stagflation as they went up and now are causing the opposite as they have come down 80 percent since August.

Do you think this improved sentiment in Europe can last?

TAYLOR: Yes, I do. I mean, I kind of feel embarrassed on a panel of economists that, you know, the first five minutes it’s like optimism from everyone. (Laughter.) I’m like, what’s going on?

But think of the mindset we were in six months ago, or nine months ago, or eleven months ago just after the war started. It became very quickly consensus that, oh, Europe is going to have a really hard time. Recession is pretty much baked in. Look at the magnitude of this energy price shock and what kind of adjustment is going to be needed in a lot of countries, but especially in Germany, which is like the motor of the European economy.

So you look back to how you thought then, and now we’re in a position where, you know, it looks like Germany skirted recession for now. Europe is, so far, maybe just going to avoid a recession or get close to a technical recession, so it’s kind of fifty-fifty. I mean, growth is pretty flat but, you know, credit growth is slow, rates have tightened, so yeah, all of that means things are muted, but relative to where we thought we were heading, you know, nine, ten, eleven months ago, this outcome is pretty good.

And I guess we’re going to talk about the Fed and the U.S. later, but it certainly looks like—relative to what we thought would happen—Europe is going through a kind of, say, a sort of soft-landing trajectory where it was really not expected at all given, you know, they had a much bigger exposure to the energy shock given proximity and especially the overdependence of Germany’s energy on Russia. They’ve got less flexible labor markets, they have had less fiscal support overall, and a lower-trend growth rate.

So you just have—all of those things are like strikes against Europe’s chances of a soft landing, yet right where we are right now it’s not looking too bad. So I take that as overall an optimistic take, their reorienting quite rapidly away from Russia which will insulate them from further downside risk of that sort.

There are still bad things that could happen on that front. And the other—

MALLABY: Bad weather among them.

TAYLOR: Yeah, and the other front is there is room for policy mistakes. ECB could overtighten; for that matter, the Fed could overtighten which will have spillover effects on Europe, but they’ve weathered things very well—surprisingly well so far.

MALLABY: Jens, do you see a risk in Europe around credit markets?

NORDVIG: Yes, so obviously I can echo that natural gas prices have fallen just incredibly fast now the last five months, right, and really changed the sort of—the tail risk has really been reduced dramatically.

Also, like I think when you look at the numbers in Europe, it is extraordinary how weak some of the numbers got, like, so if you pull up some of the consumer confidence numbers, like, consumer confidence a couple of months ago was way lower than the global financial crisis in certain European countries, right, so I remember walking around here in New York in 2008. It felt a little bit—(laughs)—a little bit like, OK, the world was falling apart, right? But if you look at the consumer confidence numbers, the European consumers felt that this was way worse than the global financial crisis, right, so that’s how bad sentiment got.

And now, the next couple of months are really important, right, because now actually it depends on how the subsidies deliver and that kind of thing, whether the consumer is actually going to feel that these wholesale prices have come down, but I do think consumer confidence will bounce. But the one thing that is still in the pipeline that does go in the other direction is that we’ve moved from negative interest rates—or zero interest rates, depending on which country you’re looking at, right—to rates that were really—people couldn’t really imagine that we were going to be looking at 3, 4 percent interest rates from the ECB, right, which is what is priced on the curve now. And that’s where we are.

And in Europe, a lot of countries have a lot of floating-rate mortgages, right, so they reset relatively quickly. That’s going to hurt the disposable income. And you can see it in the credit numbers already, right? And I don’t think the ECB has spoken about it a heck of a lot already, like, they have focused on the inflation. Understand they have a single mandate; they should focus on that. But if you look at the actual credit flow, the last couple of months it has really started to show that, OK, the higher position of the yield curves have an impact.

So I think for now the ECB will focus on inflation, but I think in a couple of months’ time, they will start to have to keep an eye on how dramatic the slowdown on credit is.

MALLABY: So turning to the U.S. where the cause for optimism is sort of this idea that a soft landing—that the Fed can thread the needle and slow the economy enough to get inflation out of the system without causing a recession. It feels like maybe the least sort of obvious of the supporters of any region’s optimism story. I mean, China as a clear reopening, Europe has a clear energy price—piece of luck. And in America it’s all about, you know, faith in the Fed.

One of the interesting things, Karen, is that—and it’s kind of slightly an echo of the question I asked you about Japan with the markets versus the central bank on the yield curve control there. In the U.S., the interesting thing is that you’ve got the Fed hiking, saying they’re going to have to continue to hike, saying it’s going to be really difficult, and the markets saying, oh, you’ll be fine, you know. (Laughs.) So it’s like this is a case where, you know, don’t fight the Fed has proven to be a misleading market motto. The Fed has been tightening and yet markets have recovered in the first part of this year. It’s pretty unusual.

KARNIOL-TAMBOUR: I think that what’s happening is that you have a generation of investors that have never experienced a time where inflation was an important factor. You can basically look at markets the last thirty, forty years, you could more or less ignore every inflation print, and it wouldn’t matter, and trade market’s great. And so that’s just deep in people’s bloodstream and psychology.

And then you see a really deep underlying assumption that the push of inflation is toward the natural 2 percent. That’s sort of the natural inflation rate so, all else equal, that’s where it’s going to go—because that’s what it has felt like, and not enough realization of how many secular deflationary forces were in the system that kind of pulled inflation down all the time, and then those things mostly reversed and now you have a lot of secular reasons for inflation to actually be higher.

So a day like yesterday where, you know, you get a CPI print, and you say, you know, inflation is not coming down that fast, and if you looked at kind of classic economics, it makes sense. You have a very strong economy still and you don’t have these deflationary forces to sort of keep bringing you down.

So I think the markets are pricing perfection in a way that’s sort of everything the market is pricing can’t happen at once. So the market is pricing that growth is not going to slow very much; that earnings are basically—yes, they’ve slowed a bit, but they’re going to be fine. And I think that’s plausible—very plausible—but if that is true then the rates market pricing absolutely cannot be true, which is why would the Fed let that stand; the rates market pricing says, yeah, the Fed is going to start easing relatively soon and be able to ease for a while. They’re not going to do that into a continued strong economy because inflation is going to be much too high relative to their mandate.

Now on the other side, if the Fed keeps kind of rolling ahead, you know, I think that we might get an economic slowdown even without the Fed tightening a lot more than they did because you already have all these interest hikes that are kind of in the pipeline, and some of them are still making their way through. But certainly if the Fed keeps tightening to handle the fact that inflation is much higher than you would expect it to be where they would be comfortable with, when you look at yesterday’s report, you say, how lower would it have to go before they’re very comfortable—then you’re going to get a much weaker economy.

So one of these things I think can’t be true, and it’s because the underlying assumptions behind markets have just changed and shifted, and we just can’t rely on what the last forty years were like.

MALLABY: So Alan, you mentioned in passing this possibility that the Fed might overtighten. We’ve just had these CPI numbers that Karen referred to; even core inflation is, you know, just a bit under six. I mean, it’s still way above two. Talk about that risk of overtightening because there’s sort of—to me the basics are that, you know, inflation is still way high. You’ve had a lot of the corrections in commodity prices, you’ve had a lot of the reopening. Is there really enough sort of downward momentum in inflation for the Fed to be able to get to the target without quite a bit more tightening?

TAYLOR: I think we’re at that balance point on the seesaw, right? The last six months, twelve months it was kind of unambiguous the direction the Fed had to go. I mean, they went fast. They did seventy-five at a time, but you kind of knew that was coming. They were maybe late out of the gate, but it was sort of like we know the train has to move in that direction.

Now we’re getting close to or above where neutral might be in the long-run sense. We’re heading into tightening territory, and so I think the next six to twelve months are where—you know, it will be telling whether we get the mistake or not.

So, you know, my take is core is coming down. Like, team transitory was wrong in one direction but team permanent—if there is one, but whatever the opposite is—can be equally wrong in the other direction. It’s never—it was never going to come down as fast as you go up, but it doesn’t necessarily mean it’s there forever. We’re not in a replay of the ’70s where, you know, energy or oil goes from two to ten, to twenty, to fifty, and it’s unidirectional. We’re not probably in that scenario unless, you know, radically bad things happen that are sort of off the radar at the moment.

So in that sense we do expect that commodity, food, energy, whatever shock to dissipate as we go back to normal, and there’s always bumps in the road coming from the fact that this is all on the back of the COVID shock, and the supply chains and, you know, bullwhip after bullwhip kind of still filtering through the system. So it’s going to be a bumpy ride. I think it’s coming down. It’s probably good that the Fed took some insurance and tightened. But now we’re at that cusp where you are in danger of doing twenty-five, fifty, seventy-five, and keep going until you break things. And, you know, you can look back at those previous cycles and say, yeah, maybe the Fed went a bit far in ’06, ’07, and ’99, and so on.

And there’s always this kind of problem of learning for the policymakers, as much as for the markets. I mean, we’re all familiar with that chart, like, after the global financial crisis, you know, the policy rate is at zero, and the whole street is saying, rates rising, rates rising, rates rising, and it’s got this, like, tick-tick-tick. And the Fed’s own forecasts are going tick-tick-tick on the dots, and it just stays flat.

And then you have the hiking cycle and, you know, the error is in the other direction because—you know, so people overshoot both ways. And so I think we’re at that time now where, you know, the Fed learned its lesson, but it may have overlearned it and may oversteer, and we skid out on the other side. So that’s why it’s getting a bit hairy for me.

MALLABY: I sometimes wonder whether there is a political point here which is that if the Fed has got to do some tightening, so much better to do it not in an election year, and so now is the time. And what you really don’t want to do is underdo it and then find that you are tightening in 2024.

But Jens, I have one thing I’d like you to just weigh in on in this debate, which is the January employment number was shockingly strong, right—517,000 new jobs—not suggesting a cooling economy at all, or is it just seasonal. What’s your take on that?

NORDVIG: So I think that the first thing we can say is that we can adjust the number using different methods, right, but it’s not a weak number, right? So there’s a lot of people who expected that we were going to assume season weakness, right, and that was going to be the confirmation that the recession was just around the corner. And I think we can say with confidence that’s definitely not what the numbers show, right?

So if we go into the more nitty-gritty details, right, we did have very warm weather in January, right, so it’s literally like 4 Fahrenheit above normal on average in the U.S., right? So if you look at how January normally behaves, it’s often the case that in warm Januarys you don’t have the normal seasonal layoffs, right? So it depends on how you model it, but I think that might have added 100K, maybe 200K, right? But even if we take 200K out of the number, 300K is still a strong number. So it’s a high reading.

I would also push back a little bit about what Alan said on the—well, it’s actually just because I don’t like the neutral concept—(laughs)—so you made reference to the neutral. And it goes back to what Karen said, as well, about there is this long history of just assuming that we’re going to get to 2 (percent) very quickly. And that even pertains to the neutral rate discussion, right, because people calculate kind of in their heads as if the neutral rate was something you could easily calculate. But they do calculate in the head—ah, if the longer-term expectations of 2 (percent), then if I get to 4 or 5 percent nominal interest rates, then those rates are high. But that all assumes that we’re actually going back to 2 (percent), right, so really thinking about what the neutral rate is in this cycle, right, where the inflation prints are 6 or 7 (percent), right—is 5 percent interest rate really high if inflation is actually 7 (percent), right?

It’s very hard to say what is actually a tight policy, like, so when I look at the inflation numbers—like people always have their own ways of dissecting the numbers, stripping certain things out. I prefer just to look at medians, right—not stripping anything out. Let’s say look at the thing that is moving the median amount, right? If you looked at services yesterday, the median service in the United States moved 7.2 percent annualized in January. There is nothing for the Fed to relax about. Like, there are certain components in the basket, right, that dragged it down. So when you look at your Bloomberg screen and it said 0.4—and the market liked 0.4 for a couple of hours, right, and then maybe looked at some of the details of it, actually some of the details were quite horrific.

So we are in a pretty interesting situation right now where we have, like, the labor market shocker. We can argue whether it’s a 500K shock or 300K shock, or both. It’s kind of shocking relative to where we came from. And then we had like three months where the inflation looked better, which is the reason why we started to price cuts, essentially, right? And now, if we look at the momentum, there’s a lot of momentum indicators like—not year-on-year, but like this lull over the last three months, they look a heck of a lot worse now than they did like over the last couple of months. So it’s very early to say that the Fed has any reason to chill, right?

So I strongly agree with what Karen said. This idea that we can just price cuts quickly is—it’s not in the data. That’s based on you seeing something that’s coming soon that we have no real evidence of yet, right? So obviously maybe some people are great at forecasting and maybe predicting that, but there is no evidence of yet.

And I would also just make the more structural point, right? This cycle is like nothing we have seen; certainly not for forty years and maybe longer than that, right? There’s a lot of the—like the big macro things, the huge transfers, the big wealth accumulation, right? We can talk about excess savings. We can also talk about excess asset allocation, like people actually got wealthy, like you can see how much money they had in the bank and in other assets. Those things have not adjusted to normal, right, so if you think about that from a big-picture perspective, this cycle is not over yet. It’s not going back to normal in a couple of days, even if some people would like to think so.

MALLABY: You know, one aspect of the cycle which is weird relative to history and certainly hasn’t corrected yet—and I’d like Karen to weigh in on this—is the U.S. fiscal policy, right? So you had this fiscal splurge during COVID because of the response, and then you have another one because of the need for green transition, infrastructure, trying to get a semiconductor manufacturing industry off the ground in the U.S. So it’s something like 2 trillion (dollars) over the next decade has been committed by the Biden administration. And this is a type of—you know, as a share of GDP it’s not as big as it was in the 1950s when it was about interstate highways and rural electrification, but it’s big.

So I’m wondering whether, Karen, you think history will judge this continued fiscal spending kindly. What do you see as the effects?

KARNIOL-TAMBOUR: I think that these lessons about what the fiscal lever can do are part of what will contribute to inflation being secularly higher than it was. So the first push was really intended, as you are saying, to counter COVID, and I think a lot has been learned from that by policymakers, that, wait a minute, it’s a lot more effective to get the fiscal levers involved in addition to monetary levers; that just printing money and having that money get printed and go into the ether, it doesn’t necessarily impact the economy that directly. People who received the printed money may or may not use it into the economy. You can kind of get just to inflate asset prices and not really get into the economy.

But then it turns out if you print money and use fiscal levers to literally go give households checks in their hands, or in Europe, you know, make sure people have their paychecks made up for, even if they are not working, that a very effective way to get money into the hands of those who actually spend it. It’s a lot more inflationary and supports the economy a lot more. And so this combination of monetary and fiscal, it’s the first time we’ve done it since, you know, World War II, and it’s incredibly effective, and that lesson is going to be, you know, in people’s minds now they just experienced it. So it will be very tempting any time you get a downturn to say, we actually know now how to counter effectively; you should use fiscal policy alongside monetary policy. That’s a lot more effective—we just saw that—and that’s going to be a much more inflationary set of policies than when we just printed money. And sometimes when we get stuck—with the most extreme case being Japan, which was talked about before, where it sort of got stuck.

Then the second major kind of lesson we’re going through is, you know, such a long time where it was sort of a bad word to talk about industrial policy, and bad for the—it was bad for the government to get too involved in sort of what markets are supposed to solve themselves. And this looming China threat, this idea that China is, you know, this unnamed—but the clear enemy and the thing we have to be countering—everyone is sort of looking at China and saying, well, they have a lot of government direction into the economy, and they are willing to very explicitly take government resources and say, I want to see these outcomes. I’m willing to spend in order to achieve these outcomes, and they’ve been successful in areas that we care about like the green transition. They are leading in solar and in—a lot of electric vehicle capability, and so on. And so I don’t think we would have seen any legislation that, you know, we just saw without China kind of in the back of our minds.

And now—as you sort of said, Sebastian, we have these three very large bills that are going to make their way through the system, and in my view some of them are going to be ineffective, but some are going to be effective. We’re going to spend so much money that we’re going to look back and say, actually, we really accelerated countering climate change by putting a massive amount of fiscal spending and firepower against that.

Climate change is a great example where the kind of classic economic tool might be you’ve got to go and just tax carbon, and that sounds great, but we all know politically very difficult and going to be much more difficult in an inflationary environment to say what we should do is actually raise the prices of the energy that we all use. It’s a lot easier, because every person who is transacting doesn’t see a higher price, to give lots of subsidies. That’s very expensive.

So when we look back and say, actually, we found a formula to deal with climate change, and it involves a lot of fiscal involvement. That’s also going to be a lesson that’s, you know, hard to unlearn, and it’s a great, more successful way of going about it, and China is doing it so we should, too. So if you combine the idea that, one, when we have important goals like climate change, fiscal is effective. And, you know, for many years we haven’t done anything about it, and now finally the IRA is doing something about it using fiscal money. Number two, when there is a big downturn, actually using fiscal levers alongside monetary—very effective.

Those are two things that are going to keep making it very tempting to keep going back to the fiscal well, because we’re going to keep having goals to accomplish. Climate change is not going away. There will be others. And we’ll have another downturn, eventually, and fiscal will look a lot more effective. And I think that’s one of the things that’ll make, you know, the next decade have a more inflationary backdrop than we did before.

MALLABY: So we’re at the moment where you guys are welcomed into the conversation. So we’ll take the first question from New York. And I want to remind you that this is on the record. And if there are questions virtually, we’ll toggle back and forth.

So who has a question? Yes, right here in the front.

Q: Thank you. My name is Tara Hariharan. I work for NWI, a hedge fund based in New York.

I’d like to broaden the discussion to emerging markets. And based on what the panelists, especially Karen and Jens, have suggested, it looks like the peak is not yet in dollar interest rates, and in the U.S. dollar itself. So, is some of this early, you could say, enthusiasm in emerging markets that we have seen in the beginning of the year, is it misplaced? Or do you think we are going to see a reversal in assets? And of course, setting aside idiosyncratic emerging market issues, just the broad trend for emerging markets, for the following year. Thank you.

MALLABY: Yeah, good question. Who wants to take that? Jens?

NORDVIG: Yeah. So you always ask difficult questions.

There’s a lot of moving parts in the—in the EM outlook, right? So, there’s a China reopening dynamic that is well advertised, and we all know about, and maybe that’s sort of well embedded. Then, there’s this notion that, OK, there’s a lot of EM central banks that actually have been ahead of developed markets’ central banks, right? Interest rates got to elevated levels. Like, if I look at Latin America and Eastern Europe, we have high interest rates that we have really had since the ՚90s. So, very high yield curves, right, so there’s attractive carry there. So, those are two important things.

There’s a third thing that I think is really important when you think about, like, big capital flows in the next couple of years. And that is that we had a period where the world only had one risk asset, effectively: U.S. equities, right? So, I have clients all around the world, right, so in Singapore, they were only focused on U.S. equities; in São Paulo, they were only focused on U.S. equities—i.e., when they hadn’t done the raise in interest rates yet, right?

So, we have had an extraordinary period where everybody was congregating—(laughs)—around U.S. equities, and that was the only, like, risk exposure. And that’s changing, I think.

So, I do think emerging market equities, and fixed income that is also a risk asset, is viewed as a real alternative to having that U.S. equity exposure. And I think that’s a durable theme. But that depends on the country, exactly how it’s going to play out.

MALLABY: It’s an interesting—just to stick on this for one second—it’s an interesting thing that, you know, all of the pieces for emerging market crises were in place—you know, strong dollar, rising interest rates, commodities shock—and we’ve had some: you know, Sri Lanka, Zambia, Pakistan. But it is kind of, in a—in a bigger sense, the dog that hasn’t barked.

Do you want to weigh in on this as well? Or are you—

TAYLOR: Yeah, I think that’s—that fits in with this unusual level of optimism, about where we are, that if you had said, this is going to happen over the last twelve months, we would have all said, oh, there’s going to be—there are going to be some crashes. And those haven’t materialized.

I think, on the emerging market question, we should have attended to that more. We were—we were kind of dotting around the globe. But that optimistic take that we had, does spill over. I mean, I think China reopening is a positive tailwind, and the fact that they were ahead of the curve. In a more longer term structural sense, if we have this—not deglobalization, which we didn’t talk about—but a change in the shape of globalization, is foreign investment going to flow to China as much as it did in the past? Where is that going to go?

Other emerging markets on the sidelines, ready to, you know, possibly be manufacturing hubs and as, you know, the global value chains reorient, potentially, there are opportunities. And what’s in the price? You know, the emerging markets so underperformed for a decade or so, that it’s like, you know, there was going to come a time when markets would say, OK, now the price is right. And I think that’s sort of where we are.

MALLABY: Bob, did you have a question?

Q: Yes.

MALLABY: Yeah. Microphone just coming.

Q: Hi, Bob Hormats. I’m a former government official.

I thought your China point was really brilliant, and less understood than it should be. And that is, China, in a way, is driving the way we look at industrial policy here, on the defense side, on the chips side, on virtually everything that we’re doing.

And I wonder if you could dig a little bit deeper into this, because I think we wouldn’t have had a lot of this legislation that we’re having now, on infrastructure, on export controls, on chips, on a variety of things, without the notion, A, that the China model is not such a bad model. We’ve always pooh-poohed it—can’t have too much government, and that distorts the economy. Well, we’re effectively picking up that China model.

And the same is true with security issues, where we’re doing a lot of things in a much more proactive, aggressive way, because we’re doing it to defend ourselves against China and reduce our dependence on China. So, I wonder if you could elaborate on this, because I think it’s something we don’t fully understand the depth of.

And then the question is: What are the longer term implications of it? Because if we’re redoing supply chains, that’s—that is an inflationary factor. And I wonder how we’re modeling that, because it’s at the early stages. And even when the—when the Ukraine war is over, that concern about excessive dependence on countries that we see as adversaries of various levels is going to still be there. And that’s going to mean that you can’t depend on just-in-time inventories, and you can’t depend on full reliance for them to supply things like drugs, or a lot of other products.

So, I wonder if you could dig a little more deeply into these structural and longer term implications of this, because I think it’s a fascinating and much less-understood factor in the long term.

MALLABY: Karen, do you want to take that?


There’s a lot of elements to this, but I think that the Chinese have been really thoughtful about both not being shy to set clear national goals and then to use a really wide range of tools at their disposal. And seeing what they’re doing is making us and the Europeans more comfortable at both saying we have national goals in certain areas, and widening the toolkit of what we’re willing to do.

But because we’re at the really early stages of that, we haven’t really, in a medium-term perspective, had to live yet with what is it like to have some of these tools operating, what do you have to be able to stomach. And so, one example is, the Chinese have learned to stomach a lot of failure of government policy, knowing that that’s just part of the equation. And so, if you look at the fact that they have a lot of leadership in electric vehicles, you know, you can look at lots of money they spent, and say, that was unbelievably wasteful; it didn’t work; they tried this, it didn’t work; they tried this, it didn’t work.

And in their system, they’re willing to stomach that, and say, look, this is an important national goal. We’re going to try, try, try again, try, try, until we succeed, and it’s OK. And we have not lived with that yet.

And so, I’m really interested to see, as these, you know, three big acts—you know, chips, infrastructure, and the Inflation Reduction Act—as that starts kind of running, we’re going to have failures too. Some of these policies are not quite going to work, and it’s going to be easy to point and say, you know, this particular thing ended up being wasted—that technology didn’t work; we put it towards the wrong direction. Are we going to have the stomach to say, this is a national goal, we’re going to keep at it in the same way, and we realize some of it is—you’re not always going to bet exactly on the right mix of things? But I think we will have to because we’re going to see that those tools are necessary.

The other thing is, I think it’s underappreciated how much, when the government is, quote, not involved, you still do have a set of incentives that have been laid out there, and then guide what is the private sector going to do in response to those incentives. And some of what’s happening in U.S. legislation is just starting to shift the incentives towards the goals we actually have. And you know, climate’s the easiest example, where if we actually think we have a goal to try to lower our emissions, we have to grapple with the fact that there are a lot of incentives already in the system, that basically, actually, you know, subsidize getting fossil fuels out of the ground.

And so, actually putting in place something like the IRA, you’re just starting to shift the landscape towards the type of incentives that we want to have on the ground, to get the private sector to do what we want it to do. And again, the Chinese have been very smart about this, realizing that everything they do lays the groundwork and incentives for what the private sector’s going to choose to focus on. Are they going to go do education at a price, or are they going to go get people addicted to video games? They’re going to put incentives out there that kind of determine what the private sector does. We’ve been less comfortable kind of acknowledging that, you know, it kind of depends what we put out there.

And the last piece is, yes, all of this is inflationary. And the reason is just that, I think in the last forty years, pretty much every time a corporation spent a dollar, they could connect it very literally to why prices will be cheaper in the future. So, yes, I’m spending money—yes, this is CAPEX and I’m spending it—but let me tell you why that’s going to make my labor costs cheaper, this cheaper. That’s why I’m spending it.

That’s no longer true. There are so many reasons for companies to spend, but they cannot connect to lowering prices in the future. And they really need to do it. I mean, all of this discussion about resilient supply chains—you’re not lowering prices by doing that. You’re building resilience. You’re worried, what if China attacks Taiwan? What if there are rules against what I’m doing? I’ve got to go prepare for that. That’s not going to lower prices the next day. That’s not the same as outsourcing to India–type of spending.

Decarbonization—I’m very, very happy people are doing it. It’s going to in the long term save us a lot of costs over many, many years. But it’s not like tomorrow, I’m going to have a cheaper cost structure because I’m decarbonizing today.

And so, having a lot of sources of spending that are not literally tied to cost reduction, that’s inflationary spending. And all of this is now in the system, to have the government and corporations, and it’s all for good reason. We want these national goals. These are good, positive things. But it means that we need monetary policy to be aware of that.

MALLABY: Jens, you want to come in?


Because, Rob, you asked about the—well, how do you model the inflation impact? So, we’re not—I’m not going to—we’re not going to do complicated equations here, but I’ll just give you one perspective on it. Like, if you look at when China entered the WTO, right, and then you look at literally what happened to goods prices globally, from then until ʼ19—like, everything changed after ՚19, right? Goods prices have not gone up. We’ve literally had a multidecade period where there was no inflation at all in goods, right? So we’ve had central banks that were targeting 2 percent generally, but the goods prices of the inflation was actually below that. And China played a huge role in that, right?

So, if that role is changing and the focus is shifting—we have no FDI into China, and for all those reasons, right—then the whole inflation picture is different. It’s a totally different situation to meet the 2 percent inflation target if the goods prices are 2 (percent) or above compared to zero (percent), which is where we came from.

So, that’s a big, big structural difference, potentially.

Q: China was really the Fed’s biggest ally for a long time.

MALLABY: There seems to me like, also, a kind of missing trick in the—in the—Biden’s playbook, which—you know, I agree with Karen that a lot of the sort of intentions of the fiscal splurge are good. And I also think that for security reasons, you know, cutting down on interlinkages with China makes sense. But there are some things where, with no cost to your security at all, you could increase, you know, trade, put some deflationary juice back into the system. If you did a free trade deal with Europe; if you did a free trade deal with, you know, APEC; there’s sort of—you know, that whole trade initiative which we had ten years ago is gone.

And the Trump tariffs on China have no security merits and no economic benefits. So why doesn’t Biden even raise the possibility of undoing them? Obviously, the answer is politics, but that’s not really a great answer policy-wise. And so, I mean, some of this inflationary impulse that you’re acknowledging could be reduced, if a free trade agenda were pursued, where it’s possible to do that.

Do you want to—

TAYLOR: Yeah, I mean, I see the glass as half-empty. And you know, if there was this reorienting away from China, there’s a dreg there.

But as Sebastian said, there’s lots of the rest of the world. And remember, in terms of long-term structural forces, demography, China’s shrinking, right? So, what—where is the next frontier market, or emerging market, or group, or continent, that steps in?

So, I think, you know, in 2004, did we know that goods prices were going to be flat for two decades? We had no idea that was coming, and we may have no idea what’s coming, if globalization reorients in different directions. And so, trade policy, or geoeconomic policy, or whatever we want to call it, will shape that. And so, I think that could—that can be positive surprises there, as well as negative for the inflationary impulse.

The other thing I wanted to turn to, is the fiscal lessons. I think a lot of this is slow-moving, like, the trade reorientation. How will history judge this mix of fiscal policies, which has been, like, you know, spaghetti thrown at the wall in the fiscal policy sense, from COVID—the start of COVID, onwards.

I think there’ll be—historians will say, well, you know, the initial COVID response was amazing, in lots of countries, necessary. But by the time you’re doing the fourth or fifth round of stimulus, especially in the U.S., when you’re getting back to full employment, well, that was overegging the pudding, and you paid a price with a bigger inflationary impulse.

And then we get to, you know, infrastructure, Inflation Reduction Act. There are long-term goals that are worthy. You need to address climate. But as we roll forward with this sort of larger, kind of fiscal set of ideas in our heads, I think it’s going to get very bumpy. People are going to say, well, OK, but how do you manage the debt? And how are you going to pay for this? And where are the taxes coming from? And then you start making errors because, you know, in China you can just say soft budget constraint—we’re the state, we made an error, too bad—but in a democracy you can’t.

So I think there are going to be lots of fights about that, and the danger is, you throw out the, you know, the long-run necessary stuff, the 2 trillion that takes ten years, well, in year nine, or year ten, will it still be being spent? Or will there have been some huge fights, someone said, that fiscal policy has taken us down the wrong path, and you never get the outyears? And so, there are setbacks on maybe worthwhile infrastructure or climate spending, because there’s, like, you know, some discrediting of redistribution, or it was too inflationary. And it all gets mixed into one, you know, bad fiscal argument.
So, I think that’s a sort of headache we’re going to start seeing more and more, perhaps, in election year.

MALLABY: Another question? I can see one at the back, over there.

Q: Morning. Larry Dvorkin, JP Morgan.

We’ve talked a lot about the dynamics between U.S. and China, and how that’s influenced more of an industrial policy approach here in the U.S., and the implications of the IRA. One thing we haven’t talked as much about is the European response to the IRA. And clearly, this is causing a lot of—(inaudible)—in European capitals.

What would you say—maybe more of a tactical question. What would you, number one, expect the European response to be? Number two, what should the European response be? Maybe not the same thing. And how would you see that playing out, maybe near- to medium-term?

MALLABY: Alan, do you want to have a crack at that?

TAYLOR: Yeah, it goes back to a conversation we were having on Monday night here. And there’s going to be some rapprochement or deal, I think, between, you know, what the—what the Europeans and the Americans can jointly agree on. They probably have too much joint interest in getting this right to go into trade war over this. So, there was talk then of maybe some kind of narrow trade deal occurring in the near future.

So, yeah, I think that’s part of the reorienting one can—one can imagine. It will depend on a lot of statecraft, but I know, if you want to chime in on this, Sebastian, you had some thoughts on what might play out there.

MALLABY: Well, I mean, I think that the risk is, that everybody kind of gets querulous with each other, out of precaution to the actual size of the economic stakes involved. So, it’s true that it would be better if the green push in the infrastructure spending in the U.S. was not saying, we can only take electric batteries, or whatever it is, from North America. It would be better to include Europe. Europe is a clear case of friend-shoring. When you pursue a public policy with, like multiple objectives you’ve already got—we want, for defense reasons, more semiconductors. We want, for environmental reasons, more green technology. And we want to fix our bridges, and so forth. And then, you add onto that a kind of buy America, America first thing, that’s a fourth objective. And leaving aside the fact that the idea of kind of recreating manufacturing as a major source of employment in the U.S. is probably hopeless, and also not even desirable, because this sort of romantic idea of manufacturing jobs doesn’t actually chime with the reality in a lot of cases, if you’re doing green infrastructure. And that means you need to sort of do a lot more electricity pylons. You’re going to have people climbing up in the winter, you know, fixing these electricity—it’s not all that glamorous, actually.

So, I think that, you know, it would be much better if the administration dropped this additional America first part of its agenda. I understand why the Europeans are mad at the U.S. for that America first part of the agenda. But I also think that, as Alan was saying, that the stakes in the relationship are so high, that blowing it up over a politically understandable, albeit policy-wise unattractive, Biden choice would be crazy.

And I think particularly, when you look at the U.S. leadership on Ukraine, the Europeans have a lot to be grateful for, with respect to the United States. So, I think that some kind of accommodation should be—should be possible.

TAYLOR: Yeah, on a—on a slightly broader dimension of this, I think—if you think of the history of economic policy, or whether it’s capital controls, or the way we do trade policy, how it’s evolved since Bretton Woods, when we went through rounds of GATT and so on, we—I mean, this is, you know, kind of stylized or, like, a caricature. But we kind of ended up with—maybe through the Washington Consensus, or the Brussels Consensus, whatever it was—in a very small box, where these were the permitted policies or these were the permitted instruments, right? So, you know, quotas are bad. Tariffs go like this. Those kinds of trade rules are verboten.

And this Inflation Reduction Act, an argument about, you know, one side wants, you know, pure carbon tax, or pricing, or border adjustment, but they’ve got to fit in this shoebox, whereas over here, it’s got to be more subsidies, and carrots versus sticks—I see that as—like, we’re going to break through this idea that, you know, different regions or places or polities have their sort of principles, that you could only use these instruments.

We all know we can write down economic models and theory, where, you know, here’s the tax version of doing that, and here’s the price version of doing that, that implements exactly the same outcome. And so, the principles are, like, just, you know, so much window dressing around that, and you’re paying for it in different ways. And you can also write down models where the welfare implications might be different. But it seems like, if you’re fighting over these principles but it’s just different ways of implementing the same thing, maybe people just need to chill out, and that will eventually kind of soothe the differences and settle the waters.

NORDVIG: It probably also matters who’s president of the United States as to the probability of getting these deals done, just to—

MALLABY: Yeah. Yeah.

Do we have another question from the room? Yeah, just over there. Zoe.

Q: Thank you very much. I’m Zoe Liu. And thank you, Sebastian, and the panel.

So the question really is about the price cap on Russian oil. And it’s just a little bit puzzling from my perspective the idea to what extent you would be concerned about that might potentially be an inflationary pressure, given that China is reopening and to what extent OPEC broadly speaking might be thinking about, well, you know, we do not necessarily like the idea of a buyers—a cartel or the idea of buyers to set the price. And should that be something that we need to be worried about—(laughs)—going forward? Thank you very much.

MALLABY: Karen, you want to have a shot at that? Sort of—

KARNIOL-TAMBOUR: Sure. I mean, I think that—probably the most important question in the commodity markets broadly right now, is how China’s reopening will actually flow through to demand, less so at what exact price it will flow through. I think it’s underestimated how deflationary China has been over the period where it was running its COVID policies, because it was massively, massively exporting goods, without actually having any consumption in China itself.

And on the commodities side, you know, they thought it was sensible to, you know, sort of use the capacity it had internally to keep people employed, and make things like steel, and metals, and so on, and actually get them out on the world market. And it was one of the ways that they could kind of export the extra energy they had, when everyone else had an energy crisis, just export metals, which is basically energy plus some other stuff. And so, they were actually a pretty significant deflationary force when the world kind of needed it, and inflation was at the peak. And that’s obviously changing right now.

And so, I think that it’s pretty clear they're going to have access to a bunch of commodities at a cheaper price than other people. But for most kind of rural markets and economies, it doesn’t really matter exactly, in every spot in the world, who’s paying what. The clearing price that most people pay will still be mostly affected by just how much supply and demand is out there.

So, I think the question of, when you look at China’s reopening, how will that translate into commodity demand, how much will we travel, what will be happening in terms of what their industrial production ends up being, what they will consume domestically, and then really importantly, what happens with this property overhang—and that’s a very nuanced question, because it’s literally, what spot in the property, you know, kind of story do things get stuck? Because you don’t use all the commodities in all the same stages. At different stages of the house, you know, you’re building different things, or buying furniture. And in China, there are these very long lead times between when people go and commit financing, or spend the money, versus actually use all the commodities all down the chain.

So, how they end up handling all that will affect more, I think, what will happen to global commodity prices, than, you know, some of these political machinations about who exactly is paying for it.

MALLABY: It seems to me that—you know, on your question, Zoe, the administration is—you know, we’ve been talking about a new paradigm in lots of different ways—fiscal, the kind of the weird exit from COVID, and all that. But one other aspect of new paradigm is the incredible innovation in sort of geoeconomic warfare, right? So that goes from freezing Russia’s reserves, which was sort of partially effective; to all these different sanctions, including this rather novel design, rather complicated design of a—of a price cap on Russia's energy, enforced through, sort of, you know, shipping insurance. I mean, it’s quite inventive. And I think most of these tools are somewhat effective, and not totally effective. And there’s slightly a kind of—we’re in a—you know, if you think about post-2008 experimentation with new monetary tools, I feel that—(laughs)—we’re doing the same thing now, with geoeconomic warfare.

And I agree with you, that, you know, OPEC’s reaction is not totally predictable. And it’s not clear that this oil price thing is going to work. But I kind of admire the effort to experiment.

If any of you want to add.

TAYLOR: Yeah, I had a comment on the paradigms and the longer-run shift. I think—we talked about resilience. We talked about—mainly, the discussion has been mainly in terms of friend-shoring, reshoring, and what happens with trade and goods and services, and maybe FDI follows that.

And that was kind of the lesson of the COVID shock. But I think there’s another resilience question, that we’re only just, like, grappling with now, which is energy. I mean, we’ve now discovered decarbonization is not going to happen overnight. It’s going to take a long time. We’ve placed bets on solar and wind, but the sun doesn’t shine at night. The wind doesn’t always blow.

So, you know, we thought, you know, peak carbon is steady, and peak green is coming down, and when they intersect, they’ll both flip, and everybody’s happy. It turns out, peak carbon is going up; peak green isn’t falling, or it—you know, it goes way up at night and in bad times. So, there’s, like, a rethink.

Now, the optimistic take is Germany, you know? Crisis hits; Greens are in government; well, we have to reopen coal plants. We just—you know, we have to embrace nuclear. But, you know, I just moved here from California, and I’m not sure if the environmental kind of sides of the U.S. political spectrum are ready to move as fast as the German Greens in that dimension.

So, I think there’s going to be that debate. It may also depend on who’s in the White House, and so forth. You know, Biden’s releasing oil from the strategic reserve, all of those calculations are front and center, I’m sure, in terms of national economic and strategic thinking. But how is this going to play out, you know, five, ten years out? The biggest insurance against energy shocks is to make sure you’ve got your energy taps or reserves that can insulate you, until you’ve gotten to that transition, which is, you know, a decade-long or more kind of process.

MALLABY: So, thanks a lot for everyone, for joining. Thank you to Karen, to Jens, and to Alan. We’ll be posting the video and the transcript of this discussion on the CFR website. And thanks.

NORDVIG: Thank you very much. (Applause.)


Top Stories on CFR



The closely watched elections on July 28 will determine whether incumbent President Nicolás Maduro wins a third term or allows a democratic transition.

International Law

The high court’s decision could allow future U.S. presidents to commit grave abuses of power with impunity, with serious implications for U.S. foreign policy and national security.