World Economic Update

Wednesday, June 14, 2023

Chief Economic Strategist, Rokos Capital Management LLC; CFR Member

Chief Economist and Head of Global Investment Research, Goldman Sachs Group, Inc.

Managing Director and Global Head, Official Institutions Group, BlackRock


Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations; @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. I’m Sebastian Mallaby. Welcome to the World Economic Update here at the Council on Foreign Relations. This series is dedicated to the life and work of the distinguished economist Marty Feldstein. The audience consists of you guys, you happy few, you band of brothers. How many sisters? Not that many. And the audience also consists of members across the country who’ll be joining us online.

So with me to think about what’s going on in the world I’ve got three friends and distinguished panelists: Lewis Alexander, who is now the chief economic strategist at Rokos Capital Management; Jan Hatzius, in the middle, head of global investment research and chief economist at Goldman Sachs; and Isabelle Mateos y Lago, managing director and global head, Official Institutions Group at BlackRock.

So we meet at a time when the world economy is growing at a bit less than 3 percent. So that’s slower than the 3 ½ percent or so last year, which is not surprising given that central banks have been deliberately trying to slow things down to fight inflation. And of course, the growth picture is mixed in different regions, which we’ll get to in a minute. And there’s plenty of uncertainty to keep things interesting.

I was struck by the estimate from your group, Jan, that over the next decade you could get a 7 percent expansion in global output thanks to artificial intelligence. That’s like adding India and the United Kingdom to the world economy. Of course, there’s also the talk about de-risking of supply chains—this is especially with respect to China—the ripple effects from Ukraine continuing, and the backwash still from COVID, notably in the form of inflation.

So I thought I’d start with that last point, and maybe go to Jan first, and ask: You know, we’ve got the Fed meeting, which will produce some sort of verdict later on today. Do you think the Fed is going to skip hiking rates this time for the first time in a while? And should it do that?

HATZIUS: I think they’re not going to hike today. And, yeah, best guess would be a skip. So a hike at the July meeting. But I wouldn’t say that that’s a particularly high confidence view. But today, you know, very likely is not going to be a hike. I think if you look at the broader sort of environment, my read is that we’re on track for below trend but still positive growth, with, you know, some clear negatives—accumulated impact of five hundred basis points of Fed rate hikes and drag from tighter lending standards. I think those are the main reasons for why I do think it’s going to be below trend growth.

That said, the drag from Fed tightening that’s working in particular through the mortgage market and through the housing market, that’s probably diminishing. And so far, the impact that we’ve seen from working through banks, especially in view of what happened back in March, has been, you know, pretty moderate. Our estimate is it’s going to be worth an extra four-tenths of a percentage point of growth drag. And I think what we’ve seen in the lending standards, what we’ve seen in, you know, bank lending data from the Fed is consistent with that, and not something bigger.

We also are getting, I think, a pretty sizable boost from real disposable income as inflation, you know, while still high on a year-on-year basis, has come down a lot in sequential terms, headline inflation. And that means real disposable income, with the labor market still doing reasonably well—slowing, but still doing reasonably well—real disposable income is now growing pretty rapidly at 3 ½ percent, or so. So below trend growth. At the same time, it looks to me that, you know, the inflation news is getting better, and is likely to get quite a lot better in the second half of the year.

It’s already a lot better, if you look at the headline numbers. We’ve seen, you know, a 5 percentage point decline in inflation. Core has been much slower, but there are I think good reasons to think that core goods inflation will come down more. Used car prices probably are going to decline in the second half of the year. Supply chain easing is still working its way through the inflation numbers. Rent inflation is going to come down

a lot. It’s already come down a lot in reality, but for various reasons that are pretty well known the CPI measure of rents lags behind the—what’s going on in reality to a pretty significant degree. And then the labor market adjustment is occurring.

And we’ve seen a lot of good labor market adjustment, with declines in job openings, declines in quits, declines in the share of firms that are saying—complaining about labor shortages. And, you know, over time—that’s not been the main driver of the inflation. So, you know, it’s not the labor market that drive inflation up. But on the question whether inflation can get back down to something, you know, in the twos, 2 ½ percent or so and stay there, whether we can rebalance the labor market—in particular, whether we can rebalance the labor market in a sort of gradual manner is very, very important.

So that’s my expectation for the economy. And then on—to come back on monetary policy, you know, I think we’re in the neighborhood of where we’re probably going to be for, you know, several quarters from here. Best guess is you get one more hike, but somewhere in the 5 to 5 ½ percent range. I think then we’ll have a lengthy period of no moves. Our baseline is, you know, first cut occurs in the second quarter of next year, and then, you know, funds rate stays higher than what markets are still pricing. But that’s obviously part and parcel of the more constructive outlook on growth in particular.

MALLABY: So, I mean, just to play devil’s advocate on this for a minute, what you’re describing is sort of almost a perfect Goldilocks scenario, saying you’re expecting a soft landing in growth terms, you think inflation will come down. You don’t have to be more aggressive—the Fed doesn’t have to be more aggressive, even though the core month-on-month has remained 0.4 per month for, I think, three months in a row now. But you’re saying that’s going to correct itself. And that, you know, the Fed has kind of got rates to within a quarter or something, you know, twenty-five basis points, of where they should be, ultimately. So everything is perfect. If you were to be proved wrong six months from now, what’s the most likely reason why something didn’t go quite according to plan?

HATZIUS: Yeah, so I do feel very good about the soft landing call. That has been our call for a long time. And I think the data increasingly confirming that call. So we took down our estimate of the probability of recession to 25 percent. This is over the next twelve months. Obviously, it depends on the horizon. The further out you go, the higher it gets. But we had lifted that from 25 to 35 percent right after SDD (ph). We’ve taken it back down to 25 (percent).

And that’s not certainty. Twenty-five percent is not a small number. It’s obviously still an elevated inflation risk relative to some average point in the business cycle. Of the things that you mentioned that are part of our forecast, I’m least confident on where the funds rate is going to be. That’s going to depend, obviously, on the incoming data flow. And, you know, it could be certainly be that they still have to do more than one additional hike.

And I think the biggest risk to the sort of soft landing view is on the side that, yeah, inflation does not come down as much as what we have in our forecast. I mean, we’re expecting sort of 3 percent sequential core PCE inflation in the second half of the year but, you know, we’ll still probably be closer to 4 percent than to 3 ½ percent in year-on-year terms. So it’s still an ongoing process and an ongoing struggle to get the inflation numbers down. And it’s certainly conceivable that it continues to take longer, and that requires more monetary restraint. And that obviously, all else equal, would also mean a higher risk of recession.

MALLABY: So, Lewis, you may want to comment on that cyclical stuff, but I’d also like to ask you about the structural side. It seems to me that if you think about the U.S. structurally on AI, that’s a big trend out there, it’s extremely well-positioned. Nvidia, Google, Microsoft, OpenAI, these are all U.S. companies. In terms of climate, U.S. has got plenty of wind, plenty of sun, plenty of land on which to put the new facilities. The demographics in the U.S. stand out as by far the best among the rich economies in terms of, you know, there’s

actually not going to be a reduction in the sort of working-age population in the next couple of decades, which is, I think, the only case in the G-7 plus China where that is true. So structural, cyclical, what do you think?

ALEXANDER: Let me just say a few things about the cyclical stuff first. In some ways, I largely agree with the way Jan characterized it, but I would—but I would emphasize different aspects of it. I’m perhaps a little more skeptical that we’re going to get inflation down with the kind of labor market scenario that I would characterize as a soft landing.

So I do worry that real incomes are—real incomes are down, labor market is incredibly tight. It does seem to me that’s a risk of the persistence of inflation going forward. I would add to that, credit can act like a negative supply shock. And so I think that’s another reason to be concerned about how quickly inflation is going to come down. And so that highlights the risk that Jan mentioned about—that the Fed ultimately will have to do more to sort of get inflation down to where it wants. And that does involve higher recession risk.

I think on the longer-run issues, I would agree with you—sort of the premise of your question, that it’s actually a reasonably positive environment in the U.S. I do think, with respect to AI, one of the questions you kind of have to ask yourself is how is this going to show up in productivity? How do I think about that? It’s clear that it’s boosting investment already. One of the things which I think is underappreciated in the U.S. is how strong construction activity has been, particularly in things related to IT. And it does feel like that is something that is going to be a longer-run trend for a while.

I think the fundamental question of how AI is going to play out in the aggregate is a hard one to know. To be perfectly frank, I think it’s more of a continuation of a trend than it is something that’s fundamentally new. Frankly, Moore’s Law’s been around for a long time. I think we generally underestimate how important it is in the world in which we live. AI is at a particular moment when we’re kind of doing more with it, but I think if you simply think about the transitions you’ve seen in finance over decades, I think we—the way in which finance is conducted today, before AI, is just fundamentally different than it was ten or twenty years ago.

Now, has that dramatically changed the productivity outcome? I think the case for that isn’t obvious. So while I’m—AI is big deal, it’s going to affect the world we live in, in all sorts of ways, the thing that’s clearest to me about that is what it’s going to do to the distribution of income. I think when you look back over what IT has done, again, over the very long term, there’s this basic question of are you a substitute or a complement for a computer?

If you’re a substitute for a computer, this is a bad world for you. And in some sense, AI is just going to make that worse. If you’re a complement, it’s a very good world for you. And I suspect all of us are trying to figure out how to be complements and not substitutes. I’m certainly spending a fair amount of time trying to figure out how it can help me do what I do. And I’m reasonably optimistic about that. But I do think it is going to change the world in ways that are probably hard to predict.

MALLABY: Isabelle, do you want to react to any of that, what’s come up so far?

LAGO: I mean, I don’t see the world as very differently to what Jan said, certainly on inflation. I think there are—there are wide margins of uncertainty. Certainly the Goldilocks scenario seems to be the consensus. But for me, what—you know, what is striking, and perhaps we’ll come to that later, is, you know, we’re not—I mean, it is in a way kind of Goldilocks kind of null-ending or soft-landing scenario. But I think we’re going to be, for a protracted period of time, in a place where central banks face a hard tradeoff between growth and inflation.

And if we do see signs of growth slowing down more meaningfully, they’re going to be very constrained in coming to the rescue. And that is something that is completely new, compared to the last, you know, decades where at the first sign of a slowdown in growth, central banks were able to come in and cut rates aggressively. I

don’t think we’ll be able to see this this time. So that’s going to create a challenging environment for some time to come.

MALLABY: So that’s an answer which could be applied both to the U.S. and to Europe, right?

LAGO: Yes.

MALLABY: How do you see the difference between the two?

LAGO: I’ll tell you, before going into that, the one part of the world which is looking better from that standpoint is emerging markets. Perhaps because they started their anti-inflation fight much earlier, they have now got to the end of that. And they’re seeing very fast disinflation. And they find themselves quite well positioned to—since it seems, you know, we’re not going to see a hard landing in the developed markets—they find themselves actually quite well positioned from that—from that standpoint.

In terms of the differences between the U.S. and the Euro area, first on growth, I mean, both were expected to have a worse outcome than what we’ve seen. But when you look at activity over the last eighteen months, it’s actually been stagnant in the U.S., and marginally positive in the EU, which I think has been—

MALLABY: Activity.

LAGO: Activity, yeah. GDP, GDI average since end of 2020.

MALLABY: I thought there was a shallow recession in Q4/Q1.

LAGO: Exactly. So Q4/Q1, both U.S. and Euro area have been experiencing a mild decline in activity. But if you look at the last eighteen months, U.S., stagnant, Europe marginally up. Which I think is underappreciated.

Secondly, when you look at the drivers of inflation, as of today—well, and over the past year or so—in Europe it was predominantly COVID, you know, supply chain shock, and in terms of trade shock following the skyrocketing of gas and other energy prices last year. In the U.S., it’s been much more of a traditional overheating inflation scenario. And what you see today, U.S. inflation, you have a huge component—the largest component is services. And that’s only just started to come down, and at a very slow pace that I don’t think anybody would be too confident to call, OK, this is a—this is a downward trend.

In Europe, it was almost entirely driven by food and energy prices, which are now coming down very quickly. Wages have started to roll over as well. And so actually the dynamic—the endogenous dynamics of inflation in Europe seem less challenging than in the U.S. Now, the ECB started a bit late, so it probably has a bit more way to go—a bit longer way to go. But I think, you know, the dynamics, the drivers are different. And one could actually argue that the tradeoff between inflation and growth faced by the ECB are a bit less challenging than the U.S.

MALLABY: So what you’re saying is that, in a way, you know, Europe had inflation done to it by the Ukraine war, whereas America had inflation self-inflicted by excess stimulus, and so forth.

LAGO: You could say that.

MALLABY: (Laughs.) Do either of you want to agree, disagree?

HATZIUS: I think that’s an element—an important element, for sure. There’s also probably a little bit more inertia built into the European inflation process. So in response to the kind of first round effect, just somewhat more indexation—

MALLABY: In terms of labor as a cost?

HATZIUS: Yeah, labor. I’m thinking of the labor market in particular, if you think about the wage bargaining process, and how important that is, and how relatively backward-looking that is. So on the—on the wage numbers, I kind of go back and forth month after month just, you know, whether I agree that, you know, wage inflation is starting to roll—in the U.S., it’s clearly rolled over. In Europe, I’m not yet sure. And these numbers still vary a bit. But I certainly would agree that over time we will see a substantial amount of disinflation in Europe. And I certainly think that, yeah, the external impulse has obviously been much more extreme, though temporary.

MALLABY: Yeah. Isabel, how do you think that the sort of technology angle plays into this comparison, U.S. versus Europe? I mean, you know, crudely, the EU does not have the equivalent of Nvidia or Google or Microsoft or OpenAI. What it does have is an instinct to respond to this new stuff with regulation, and say we’re worried about it, precautionary principle, we’re going to restrict it. Is that unfair?

LAGO: So it’s not unfair, but it’s only one part of the story. And when you think of what is going to be the impact of AI on growth and productivity over the next, whatever, ten, twenty years, sure, the companies that are providing the AI, the ones you cited, are an important part of the story. But, frankly, the biggest part is going to be what happens in the entire rest of the economy? What companies are able to generate higher profits by using AI to offer a better product, better services, by leveraging the vast data pools that they have access to? And then which companies are able to cut costs and generate efficiency gains by using AI provided by others? And I would argue that the makeup of the EU economy offers plenty of scope for AI to reap from in a positive way and generate—and generate growth.

The other thing that’s important to keep in mind is that the—we also have in Europe companies that I would put in the enabler camp. So, for example, the machinery to produce the supercomputer chips, some of the main producers are European-based companies.

MALLABY: Sure, ASML in Holland, yeah.

LAGO: Dutch-based, exactly. Exactly. And then all the data infrastructure—(coughs)—sorry—that is required to power AI, you have all the industrial giants in Europe that produce, you know, electric cabling, all that stuff. So I think you need to take a much wider lens to the impact of AI on the growth prospects of one part of the economy versus another.

And just to finish on this with a slightly more market-y touch, if you look at—sorry—stock markets, comparing the S&P 500 versus Europe, let’s say, while the S&P 500 has done great since the start of the year, actually all the performance is explained by six, seven stocks. And if you look at the—whether the equal rated or the S&P 500 minus these stocks, it’s been flat. In Europe, you see very strong performance, double-digit growth in sales across a bunch of sectors, whether consumers, both luxury and general, financials. You know, the situation of European banks, completely different story to U.S. banks.

And, again, industrials which are benefitting hugely from the boost to infrastructure spending, grain infrastructure spending happening all over the world, and the reshoring, you know, de-risking of supply chains story that you touched on at the outset. Again, a lot of infrastructure construction, et cetera. And European industrial companies are big enablers of that. So a much wider set of strengths, I would say, than in the U.S.

MALLABY: Lewis, one of the things that strikes me about Europe is that, relative to what the politics seemed to predict a year or two ago—maybe two or three years ago—Europe’s become more—less het up about immigration, less anti-immigration, than the populist wave would have predicted. So in terms of the demography and all that, that’s a good sign? Or how do you feel more generally about this structural debate on Europe’s outlook.


MALLABY: I was going to—

LAGO: Oh, sorry, sorry. Sorry.

ALEXANDER: No problem. Look, I think that is obviously a positive if Europe can, in some sense, really sort of turn that into something that will allow them to sort of deal with that problem. There’s no question that population growth is, like, a major issue sort of around the world. I think when you look at the differences around the region in particular, look what challenges that China is facing versus the opportunities in a place like India. I think it’s—you know, those issues are very important.

I hope you’re right about the positive trends from Europe. Obviously, there’s an element of it that has been sort of related to what’s going on with Russia-Ukraine. They have to sort of—they have to figure out how to take advantage of that. I think the emphasis on expansion for the EU now is another challenge. In some ways, it’s good for all of those reasons, but the fundamental tradeoff between deepening versus expansion for the EU, we’re sort of back into that. And if we—if the EU sort of goes down the path of further expansion, which it seems like they’re going to do, I think the other—that other agenda is inevitably going to get slowed down, and that’s important as well. So I think the EU, as ever, is kind of two steps forward, one step back.

MALLABY: So we’ve got another five minutes, let’s say, before we open it up. I want to get to China, and maybe start with Jan here. I mean, I guess the question is how worried should we be about the near-term outlook? You’ve got, you know, growth in Q2 which was very disappointing relative to the expectations around the opening up boom. That happened in the first quarter, but in the second quarter we’re way down. You’ve got 20 percent youth unemployment, COVID cases spiked in May. The government seems set to unveil a stimulus, but there are questions about whether the channels for delivery of that stimulus, in particular, you know, telling local governments to do more real estate and infrastructure, given all the bad debt associated with that infrastructure spending, do those channels still work? So I’m wondering how you think this factors in, both for China itself and then the ripple effects externally.

HATZIUS: There’s a lot of crosscurrents and a lot of uncertainty. We’ll get the May economic data, so we’ll have a better sense of what the—you know, what we’re going to have for the second quarter. It certainly does look a lot weaker than the first quarter. Now generally the surveys have been a little bit more mixed recently, not as bad as I would have said if we had had this discussion a month ago. And my best guess would be that we’ll still see decent growth in 2023. There’s still, you know, a boost from the COVID reopening that’s occurring. We’re not that worried about the size of the COVID outbreak. And we think that there is still, you know, room to expand and recover in the service sector.

On government policy, I think there’s a decent amount of chatter about additional stimulative measures. We’ve already seen some monetary stimulus. You know, we may well see some additional stimulus. But I think 2023 still looks like a year of, you know, significant recovery in China.

MALLABY: So, 5 or 6 percent growth?

HATZIUS: Yes. Yeah, 6 (percent) or maybe a little bit less would—for the annual average. Obviously, very front-loaded. I mean, Q1 was very strong, and sequentially we’ll see much less growth in the remainder of the

year. The bigger issues for China really are the longer-term questions, which we already touched on. The demographics, obviously very concerning. Very rapid—you know, if you look at the U.N. projections—very rapid rates of shrinkage in the labor force.

And we’ve seen—you know, we do have a housing market, you know, construction activity in residential property that’s still extremely high relative to the sustainable level. I mean, we had twenty million housing units built per year in the years before the pandemic. Twenty million. I mean, it’s an unbelievable number if you think about the fact that if U.S. housing starts at two million in a year, that’s a really big number. We’re talking about twenty million here. So those numbers are going to have to come down very, very substantially.

And then there are the questions around, you know, globalization, deglobalization, U.S.-China, et cetera. So plenty of things to be concerned about. But, yeah, in the near term I think there is still some tail winds that should keep 2023, I would say, reasonable.

MALLABY: Lewis, what about you? I mean, is it too much to talk about the Japanification of China? You’ve got this situation of—you know, you had an asset bubble, now there’s all this bad debt. It’s not fully transparent how much the bad debt is. It’s all in these local government financing vehicles. And there’s quite a lot of opacity around that. You’ve got a demographic bust at the same time. You’ve got a sense that the growth model, you know, when—exactly like in Japan, really, from an export-driven thing to an investment boom to, oh my God, what’s next? Do you feel like it’s the 1990s again in Japan?

ALEXANDER: I think it’s early. Part of the difference, I would say, is we are still in a world where essentially every financial institution in China is fully backed by the government. It’s hard to imagine a financial crisis like we saw in Japan. I would note, though, that one of the things which is interesting in this particular moment is the Chinese authorities have already started to ease monetary policy, in an environment where it feels like sort of neutral interest rates in China are probably very low. It is a case where they have a huge amount of financial intermediation, a huge amount of debt. We do any comparison between China and any other country on those metrics, and they’re sort of off the charts.

And it does raise the question of the sort of financial overhang that you’ve got. And if you slow the rate of nominal growth in an environment where you’re sort of used to that being supported by a very rapid model of growth, it is a sort of a concerning dynamic. I’m not sure Japan is necessarily right model for what they’re facing, but this is a new set of challenges. I do think the question of how they deal with this sort of financial overhang in an environment where growth is slowing is going to be one of the big challenges they face going forward.

MALLABY: Isabelle, you raised the point about emerging markets earlier. Do you think there are going to be ripple effects from—you know, even if Chinese growth is going to be 5 percent, which might be optimistic, I mean, structurally in the future, that’s a lot less than it was before. And, you know, that has knock-on questions, right?

LAGO: It does, but as usual this is not something happening in isolation. And another big structuring force, you know, over the next few years, is going to be this reshoring, de-risking of supply chains away from China, to a large extent. And I expect emerging markets, at least some of them, to be beneficiaries of that trend. That’s one thing. The second thing is, also under the heading of geopolitics, I guess, the rise of economic relationships within the so-called global south. There is a clear desire, political desire, from a number of the large emerging market countries to do more with one another, as opposed to trading with the north. And that, again, should really help offset some of the headwinds coming from this slowdown in Chinese growth.

MALLABY: OK. So let’s open it up and invite members to join the conversation with questions. Just want to remind you, this is on the record. And if there’s a question here in New York, we’ll take that first. Yes, let’s go there. Please identify yourself, yeah.

Q: Arthur Rubin, SMBC.

For the better part of a year we’ve been hearing economists predicting impending doom as a result of the Fed’s rate hikes. And they were either premature or wrong. We’ll see. But is it possible that there’s been a structural shift in the way that developed economies react to changes in interest rates? And could that be an explanation for why the doom that’s been predicted, after this almost unprecedented rate hiking cycle, hasn’t happened?

HATZIUS: Yeah, I can give that a—give that a try. My view would be it’s less a structural shift and more the specific circumstances that we find ourselves in. So you’ve seen, you know, a big increase in mortgage rates on the back of the big increase in the funds rate. I mean, thirty-year mortgage rates went from 3 percent to 7 percent. That’s a huge increase. That did have a pretty sizable impact on the housing market. You know, second half of last year was very weak for housing, with housing subtracting nearly 1 ½ percentage points from real GDP growth. So, you know, a big tightening in financial conditions.

Our financial conditions index tightened by, you know, something like four hundred basis points at the peak—so I’ll call it 3(00) to 400 basis points. That is a, you know, large drag on growth, to the tune of, you know, two hundred, three hundred basis points. But it was all coming at a time when there were still some very important positives, in particular the recovery in the service sector as the economy was still normalized post-COVID. So some of the interest rate-sensitive sectors and FCI-sensitive sectors were taking a significant hit, but there was this ongoing improvement in the background from the normalizing service sector and face-to-face services.

There was also, you know, a large amount of pent-up savings in the household sector, which basically offset, I think, the fiscal tightening. So, I mean, there was monetary tightening. There was also a meaningful amount of fiscal tightening in early 2022. But households had, you know, $2 ½ trillion of pent-up savings that were effectively used to keep consumption growing at a, you know, small but positive rate, even though real disposable income was down a lot. So I would pin it more on the specific circumstances than the idea that this cycle is different from previous cycles, in part because it’s a post-COVID cycle.

MALLABY: And, Lewis?

ALEXANDER: Yeah, just a couple of points to build on that. Recessions are about feedback that generates synchronous movements across the economy. So it’s about the whole economy kind of moving in one pattern at a time for various reasons. As Jan suggested, the thing that’s different about this cycle is just how extreme the differences are across sectors. So you look at the COVID contraction, there really is nothing in the record that shows the collapse of services, the strength in goods. And so as the recovery happened, in some sense you didn’t get that mutual feedback that is what you’d get in a recession.

The other thing I would just comment on is I do think we have to think about what’s happening with neutral rates. And so the other part of this question is, like, what’s normal? This is obviously a topic of active debate. I would argue, personally, that I’m kind of on the side that I think neutral rates are going to be higher, I think investment’s going to be higher, for a variety of reasons. And so partly when you think about how the economy’s responded in this cycle, you have to think about that too.

MALLABY: OK, we have another question, I think, coming from externally. How does this work now?

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

Q: Thank you. Good morning. My name is Tara Hariharan from NWI. A great conversation.

Two quick questions. The first is, what is the panelists’ outlook for oil in the near to medium term, given that some of the demand factors that had been expected to push up oil have not quite materialized the way they had been expected, particularly China. And also, the supply side seems to be more resilient? And my second

question pertains to emerging markets. I’m sympathetic to Isabelle’s comments about the tailwinds for emerging markets going forward from falling inflation and benefitting from nearshoring and reshoring.

But given the arguments that I think and that I sympathize with, that I think Jan and to a certain extent you have also put out about the possibility that even in the U.S. especially that the interest rate curves are pricing in perhaps too many cuts within the next year, and perhaps the growth will more resilient, is it really fair to see room for central banks in emerging markets to be able to ease in the short term? Despite inflation coming down, if they take their cues from the Fed and from the U.S. dollar, will they really be able to ease materially? Thank you.

MALLABY: So, Isabelle, choose between oil and emerging market interest rates, or both.

LAGO: No, I’ll leave oil to better-informed panelists. Now, look, in terms of how quickly emerging markets will be able to cut rates, it’s probably a bit soon to be talking about that, including because we don’t know if the Fed is done. And I think until we know that for sure, there’s just too much risk there. But certainly we’re getting closer to that. And I think the other element that is very important is the extreme volatility in EM rates that we’ve seen over the course of the last year. That’s essentially—that should be nearly over, and the volatility itself in rates has been so damaging to EM as an asset class and to the policymaking process. I think that also being behind us, I think, you know, one can be confident that the next step is going to be a cut. How quickly? Probably one needs to be a little bit—a little bit patient.

MALLABY: Anybody want to talk about oil? (Laughter.)

ALEXANDER: I was just going to say, we’ve been surprised too that oil has come down as much as it has. Some of it, obviously, is a growth surprise in parts of the world, but as a variety of people have indicated if you look globally demand hasn’t actually been that weak. So it is a bit of a puzzle. We continue to be—sort of think that oil—energy prices in general are going to remain relatively high, in large part because of constraints on the supply side. So I wish I had a better answer for you, but we’re a bit surprised too.

HATZIUS: That’s our team’s view as well. And I think it’s reasonably widely shared. So I think you’ll find a lot of people who have been surprised. As we dissect sort of what happened, what we have found is that supplies have actually been a lot stronger than what we have built in. And, I mean, Russian supply has been redirected, but has continued to be very strong. That’s been a very important factor. The demand side’s been kind of OK. It’s really been on the supply side. So I think one question is, how much longer can that continue? And if it’s—if we don’t have the same kind of elasticity and a global economy that continues to expand, where oil demand grows—at least at a—you know, at some rate, then that should put some upward pressure on oil prices. But so far, it has not.

MALLABY: I mean, one thing that struck me is that we’ve run a bunch of natural experiments in the last two, three years around sanctions, right? So in 2020, I think it was, China hit Australia with sanctions targeted at commodity trade. Obviously, you’ve got Russia sanctioning Western Europe with is gas embargo. And you’ve got the sanctions on Russia in terms of its oil. And in all these cases, what seems to happen is that, you know, there’s a big disruption when the sanctions are imposed, prices spike because people are worried and because the sort of typical patterns of export flows are, indeed, blocked. But then they adjust.

And so in some sense, one could say that the spike maybe before was to do with that geopolitically driven shock, but these shocks—and one of the things about commodity sanctions is that in the end you route around them. And we’re going to be—it’s going to be interesting to see whether the same is true or not true when it comes to a more specific technology sanctions—i.e., semiconductors on China—which may be easier to police than a general commodity embargo.

Let’s take a question there. Yeah.

Q: Good morning. Scott Borgerson. Fantastic discussion.

My question actually is about shocks. To what degree do the models providing these forecasts do you think are robust to, you know, shocks? Looking backwards on forecasting is a fun game. And health pandemics, a land war in Europe, state of American politics, the Denver Nuggets won the NBA championship. No one predicted any of these things. And so it’s going to probably be a right or left tail event that shapes things moving forward. So I know behind you all are really smart folks with pretty extraordinary models, I’m sure, and you have lots of statistical views of confidence at both tails, and black swans, and stuff. So how do you feel about the—you know, I guess, the robustness quantitatively of the forecast?

And then, second, is the American economy resilient at the moment or brittle to the next shock? A climate shock. I mean, yesterday was kind of an interesting moment in American politics. I mean, it’s a really dynamic moment in time. So as economists, how do you think about that forecasting game relative to all the black swans that we just experienced over the last few years, and this prediction moving forward around interest rates, inflation, GDP growth, all that kind of stuff.

ALEXANDER: Let me say a couple things. First of all, I think anybody who’s lived through the last couple of years has got to be pretty humble about that and recognize that the stuff you haven’t thought about is going to be an important part of this. I would distinguish between, in some sense, the formal forecasting and, once something happens, your ability to think it through. I think we should not—I think the fact that we didn’t see stuff like Russia invading Ukraine coming shouldn’t get in the way of the fact that once it happens, there’s lots you can do to think it through and, relatively quickly, get a better sense of that. And that—I would say the same thing about the pandemic. I didn’t have that in my models going in, but I think if you looked at the analysis that was done very quickly after, it sort of wasn’t bad. And so I think the challenge is really to do that.

I think there are different pieces of this where you can be more or less confident. For example, I did not see the bank failures coming that we had in the last several months. On the other hand, I spent a lot of time over the last ten years thinking about systemic financial risk. And I was pretty confident at the time, and I feel like this is the right judgement, that there were good reasons to say that those three bank failures were not the beginning of a systemic financial crisis. And so, you know, it is—it is absolutely the case the world is a more complicated place than we can imagine, and an awful lot of our failures are failures of imagination. But I don’t think that you should—one should jump to the conclusion that that means all of this effort is not worth it. I don’t know if that’s responsive to your answer.

MALLABY: Anybody else want to—anybody else want to defend the economics profession? (Laughter.)

HATZIUS: Well, I agree with—I agree with all that. Just one additional quick observation. I’ve sort of done forecasting for about a quarter-century. And I would say in the first ten years of—you know, I started in 1997. And in the first ten years, I was much less worried about exogenous shocks and much more worried about kind of endogenous brittleness of, you know, the financial system, and of, you know, private sector finances and things like that. I would say in the last fifteen years, it’s really been much more about exogenous shocks, like, political, geopolitical shocks becoming, you know, much more substantial.

At the same time, as, you know, the private sector, having been in some ways a bit more resilient in our private sector—the private sector in the major advanced economies generally run financial surpluses. The stability of the financial system and the banking system has been shored up. We can’t be, obviously, overly confident of that, but more so than fifteen years ago.

MALLABY: But why do you say fifteen years? I mean, that takes you back to 2008.

HATZIUS: In the pre—in the pre-pandemic—I’m sorry—in the pre-GFC period there were—you know, we didn’t have a lot of shocks. We did have 9/11, but we didn’t have, you know, a large number of shocks. But there was a lot of vulnerability that was just building up in the system because of the bubbles that were forming.

MALLABY: So what was the first exogenous shock, post GFC 2008 which made you think, oh, new world?

HATZIUS: Probably sort of the 2016, you know, Brexit, I think would probably be high up on that list. There was obviously worry about that with the U.S. presidential election as well. But, I mean, Brexit is a very clear one, I’d say.

MALLABY: Isabelle, your life in forecasting.

LAGO: So, no, the only thing I would say that—I agree with everything that Lew and Jan said. But the only thing I would add is that all of us implicitly, or explicitly in the case of some models, have a playbook in our heads to analyze all those streams of data coming through. And that playbook is informed by what happened in the last ten years, the last twenty years. And most of the time, that works OK. And then you have a structural break and you need a different playbook. And I strongly think we’re at that sort of point in time.

We’ve had, like, twenty—sorry—twenty years or more where interest rates were structurally falling, whatever—the finished concept of interest rate, neutral, real, et cetera. You had central banks pricing inflation from below, you know, struggling to get to their targets. You had the geopolitical order that was fully settled. You know, you had globalization that was expanding. And now all of these things are different. And so you need a fundamentally different playbook to analyze the shocks that are coming through.

MALLABY: We’re going to take a question from outside again. OK.

OPERATOR: We’ll take our next question from Dan Katz.

Q: Hi. Dan Katz here. I’m a former Treasury Department official.

Question for Jan on the soft-landing hypothesis. You know, as inflation comes down, as you indicate you expect it to, isn’t the real risk that that causes real rates to become significantly tighter, and then you end up in an environment where you have monetary policy acting as an increased brake on the economy and generating a slowdown in and of itself?

HATZIUS: Potentially, to some degree. I’m not that worried about it for a couple of reasons, though. One, it’s unclear what you should really use to deflate nominal rates, to turn them into the real rates that affect behavior. I mean, if you look at, you know, inflation expectations in the bond market, for example, those are already quite low. So I would say, monetary policy is restrictive, but isn’t necessarily going to get much more restrictive if inflation, in fact, comes down in a way that’s already sort of priced into markets. Obviously, other measures are going to give you somewhat different—a different implication.

But I also think, in general, that the link between, you know, the real federal funds rate—the direct link between the real federal funds rate and aggregate demand and economic activity is quite loose. I mean, it works through a lot of different channels. It works through financial conditions. So if all that’s happening is that the real federal funds rate, calculated as the nominal rate minus, you know, some kind of actual or expected inflation measure, goes up but you don’t see, you know, big tightening in financial conditions, it wouldn’t worry me that much.

The last point I would say is that, of course, the Fed can adjust to this if inflation comes down and you do see slower growth for whatever reason, maybe for the reason you outlined or another reason. Of course, they can

but. There’s no, you know, commitment to keep the funds rate in the fives. It’s my forecast but, of course, if reality turns out differently, then they’re going to react to that.

MALLABY: Next question from Bob Hormats. The microphone’s just coming.

Q: Bob Hormats. Thank you.

I was very impressed by one key element that was made by all of you, and that is how different the world economic order is now from the way it was, say, ten or fifteen years ago. And that relates to the question I have. And that is, in 2008 we were able through a substantial measure of collaboration and cooperation, including between the United States and China, which was quite exemplary at the time, to deal with the problem. Now, the world order is much more diffuse, more of a feeling that each country is going to do what it’s going to do. There was some collaboration among the G-7. But generally, you have the developing south wanting to trade more amongst itself.

And so my question is, if there are shocks over the next X number of years, how does the world order cope with that in a way that’s different from the way it has done it in the past? Does it rely on the IMF, or are there going to be a lot of countries that simply decide we’re going to play our own game, or we’re going to get little groups together and do it, but we’re not going to have a more full-throated economic collaboration of the kind we had in the past. Or, do they resort to sort of fake or real protectionism to avoid being disrupted by what happens in other countries?

MALLABY: Maybe we could try Isabelle on that. I mean, I’d just—I’d piggyback slightly and say that we’ve had a little bit of an experiment, I think, on emerging market debt, where, you know, dealing with the Zambian debt problem, for example, in a way that it would have been done twenty years ago is complicated by the fact that the major creditor today is China, and it doesn’t want—it’s not part of the Paris Club. It doesn’t want to play by those rules, right? So we do have that—it is a good issue that, you know, the next shock will face a different institutional context.

Q: And numerous other countries all play the same game here.

MALLABY: Yeah. Go ahead.

LAGO: Yeah. So I think that the answer is we don’t know. And we don’t know because we know that the old rules don’t apply anymore, and we don’t have a set of new ones. So a little bit like, you know, at the start of the Cold War, where it took a bit of trial and error to come up to a more system of, you know, rules of engagement.

Q: (Off mic.)

LAGO: That’s right. So having said that—and so I think what we’re hearing from all the large economies, with slightly different wording, is, going forward, we’re not going to pursue global integration and coordination blindly for the sake of it. We’re going to put national security first. Our own definition of national security and prosperity. And then economics will be second. We’ve heard that very clearly. And that’s a gamechanger.

Having said that, that doesn’t mean cooperation is entirely broken. And where countries see it in their self-interest to collaborate, it can still happen. I think the emerging market debt issue is an interesting one, where—and Zambia is one case, but there is—there is others, unfortunately, and probably quite a few more coming down the pipe. The old architecture has stopped serving its purpose. A number of these cases have been stuck. However, a new process has been kicked in by the IMF, the World Bank, and the G-20 presidency to create a new kind of grouping of people to—in the same room—to discuss, OK, how do we fix it? And given that ultimately both the creditors and the debtors have an interest in resolving these situations, how can we work together to write new rules of the game?

And this process is ongoing. It’s progressing slowly, but it’s progressing. And, you know, hopefully we’ll come up with new and better rules at the end of the process. That’s just one dimension. There’s many more problems requiring global cooperation. But I think we just don’t know. We may not have good outcomes in all cases.

MALLABY: And Lewis.

ALEXANDER: I’m going to be—engage in a little glass half full optimism on this point. But the challenge you cite are obvious, significant. And as somebody who’s spent a non-trivial part of my career in U.S. international economic policy, at some level I don’t recognize the debate now. And it’s the role of sanctions and all of that. It’s a very different kettle of fish. And it has all the challenges you lay out.

However, China is simply a more important part in the global economic system than the Soviet Union ever was. And I am oddly optimistic that we are going to have to evolve this system towards something that will be closer to fit for purpose, to a world where you have major constituent parts of the system that are ruled in very different ways. The problem with the old system was we kind of all assumed that the rest of the world would get rich by becoming more like the West, and therefore the system was designed with the presumption that the major parts were more or less operated consistently.

And China has—it turns out that’s not right. And we’re going to have to adapt the system. But, frankly, the stakes in some ways are so large that I think that kind of has to happen. And so I totally accept the challenges you describe. And, you know, it’s going to be an interesting world. But I don’t think the Cold War, for example, is the right model.

Q: I totally agree with that. I—

MALLABY: You’re off mic now, Bob, so we’ll—no one will hear you. Maybe—we’ve got one minute. I’m going to give the last word to Jan. But one aspect of the international cohesion in response to some sort of shock has been central bank swap lines. And I guess one question therefore is whether, in the case of a future shock, they would work as well as they did in 2008-2009. Do you have a feeling for that?

HATZIUS: I think—well, I think the politics are going to be more—a lot more difficult than they were back in 2008, which was still a world in which, you know, the consciousness was still very much the old world. Now I do think that having really large balances building up in central bank swap lines is probably something that would run into a lot of political opposition. So while there are aspects of the system—I think if you look at private sector balance sheets—that look more stable, there are aspects in terms of the ability of policymakers to respond, that are looking more brittle.

MALLABY: So to Scott’s earlier point, the next shock will be interesting. We’re going to wrap it up there. Please note that the video of today’s discussion will be posted on the CFR website. Thank you for coming. And thank you to our speakers. (Applause.)


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