Inflation, Interest Rates, and Instability

Madhav Rajan:
Good afternoon, ladies and gentlemen, and belated happy new year to all of you. Welcome to Chicago Booth’s Economic Outlook 2022. My name is Madhav Rajan, I’m the dean and the George Pratt Shultz Professor of Accounting at Chicago Booth. Hope you are all healthy and safe during these unusual times. I’m truly grateful to all of you for taking the time to engage with the school in this fashion. We had, of course, hoped to have our audience together in person in Chicago at this time. But we’re just grateful that we were able to shift relatively easily to this virtual program. Our audience hasn’t missed a beat. We have over 5,700 people registered for today’s event, which is quite astonishing.

The Economic Outlook series will continue virtually on January 26th in Hong Kong, where our experts will discuss supply-chain disruptions, risks to recovery, and the economies of Asia.

Madhav Rajan:
Economic Outlook provides a forum for our pathbreaking thought leaders to confront the future, evaluate emerging trends, and share insights that help reframe our understanding of the world to come. We have an excellent program today. We have an amazing set of panelists. We have Austan Goolsbee, Randy Kroszner, and Raghuram Rajan. And I thank them for being here to share their insights related to inflation, labor markets, and the future of the global economy. And my thanks also to Kathleen Hays of Bloomberg Television and Radio for returning to Economic Outlook to moderate today’s panel.

Chicago Booth has a long tradition of informing public disclosure through platforms such as Economic Outlook, which began way back in 1954, as well as our Initiative on Global Markets and our Chicago Booth Review publication. We look forward to hearing what’s on the mind of today’s panelists. And with that, it’s my pleasure to introduce them to you.

Madhav Rajan:
Austan Goolsbee is the Robert Gwinn Professor of Economics at Chicago Booth. Austan served in Washington as chair of the Council of Economic Advisers and a member of the President’s Cabinet. He has earned recognition for his research as a Fulbright Scholar and a Sloan Fellow, and was previously named one of the top 100 Global Leaders of Tomorrow by the World Economic Forum.

Randy Kroszner is deputy dean for executive programs and the Norman Bobins Professor of Economics at Chicago Booth. Randy was a Governor of the Federal Reserve System from 2006 until 2009. He chaired the Committee on Supervision and Regulation of Banking Institutions and the Committee on Consumer and Community Affairs. And took a leading role in developing responses to the financial crisis and also undertaking initiatives to improve consumer protection and disclosure.

Madhav Rajan:
Raghuram Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth. Raghu served as the 23rd Governor of the Reserve Bank of India from September 2013 to September 2016. And between 2003 and 2006, Raghu was chief economist and director of research at the International Monetary Fund. Raghu has done work on a wide variety of areas, including banking, corporate finance, and economic development.

Our moderator, Kathleen Hays, is global economics and policy editor for Bloomberg Television and Radio, covering economies and central banks around the world, from the Federal Reserve and the ECB to the Bank of Japan and the People’s Bank of China, and the people who run them. Thank you all again. And with that, I will hand it off to Kathleen.

Kathleen Hays:
Thank you so much. It’s really always a great pleasure, if not very entertaining, to join with this panel of smart, well-informed economists with backgrounds that bring so much together.

A year ago, think where we were. We’d gotten through 2020, and that was such a tough year. Things were opening up. Things were looking up. We went through a year where the economy really came back very strongly. We got monetary stimulus, fiscal stimulus. Inflation kept rising, but a lot of us figured, it won’t last. It just has to do with these things reopening and suddenly prices for airfares and hotels went up. By the end of the year, we hit Delta again, and that was certainly a big bump in a road for a lot of people in their lives, but even for the economy. And now here we are—Omicron. It is spreading. It has surged. There are estimates that in the first quarter of this year, more than half of the US population is going to get infected. The World Health Organization is already predicting the same kind of thing for European countries in the next six to eight weeks.

Kathleen Hays:
Let’s start on inflation. We’ve got a lot of questions here already. Thank you, audience. You’re so great. And we’re going to be watching the questions that come in and I’m going to be sprinkling all of this through the discussion. But with inflation having risen, what, 7 percent last year, it is the topic du jour for many people. Randy, you were at the Fed, let’s start with you. You want to weave the Fed into it. First of all, I really want to know what everybody thinks about inflation. Where are we? Where are we going?

Randall Kroszner:
Well, I think we now know it’s not transitory. We heard a lot of that word last year, and that word needs to be transitory and just put into the dustbin of history. It’s been with us for a while, and it’s going to be with us for a while. And we’ve seen a very important pivot that Jay Powell and his colleagues have made a little bit more than a month ago, starting to take the inflation threat quite seriously. And they’re on a much more rapid path for trying to bring down the asset purchase program. And I think they’re pretty much on a path to start raising rates in March, roughly when they’ll stop the additional asset purchases. And I think it’s important that they do so, because so far inflation expectations have not become unanchored. That’s always the thing that you worry about in this.

Randall Kroszner:
You can have a temporary inflation, whether it’s due to supply-chain disruptions or other disruptions. But if people start losing faith in the central bank and start assuming that inflation’s going to stay at high levels going forward, they ask for higher wages. If firms feel that they can push through these price increases, which is really the first time in more than two or three decades that they feel that they’ve been able to do it, you pass that along. And that can be a very, very difficult situation for the central bank. So far we’re not there, but I’m really glad that the Fed is starting to move.

Randall Kroszner:
But I see these price pressures continuing with the Omicron variant that you had just mentioned, that’s leading to enormous lockdowns throughout China and so city after city, and these are cities of 10 to 15 million people, that are being effectively locked down. There have been a number of articles about how a lot of production is really stopping in China. We may get a little bit of relief for a month or two, because it’ll take a little while for this to have an impact, but I think this is going to constrain supply. And so we’re going to see a lot of pressure on prices continuing through at least the first six months of the year. And the Fed really needs to move.

Kathleen Hays:
Austan, you like that word, transitory. I think you’ve got to take off your mute to boot.

Randall Kroszner:
Oh no, keep Austan muted. That’s great.

Austan Goolsbee:
It’s payback time. OK. I think there are a lot of things going on, and I’m worried for the Fed that they’re going into a period that’s going to be quite difficult. It’s still critically important that we figure out how much of the inflation is coming from, let’s call it excess demand, and how much is coming from supply shock. Because one of the lessons of the 1970s is that when you start getting supply shocks, it’s extremely uncomfortable, but it’s not obvious that the Fed can fix that problem. And certainly, tightening doesn’t fix a supply problem. Now, the markets still remain very oriented into their thinking that the inflation will not be lasting. I’m going to try not to ever use the word temporary. Randy said it’s banned. So non-lasting-forever inflation. The real interest rate is literally negative. We had 7 percent inflation for the year, or 5 percent, depending on which measure you want to use, and the interest rate remains very low.

Austan Goolsbee:
So somebody must think that there’s not going to be 5 percent inflation for a long time; otherwise, you would’ve already seen that into the rates. Now, one danger is we have to figure out this nature of supply versus demand. And it’s complicated by the fact that the virus has not gone away. When we last met, it absolutely felt like, we’re finally getting this thing under control; we can just go back to normal. And that didn’t happen.

Austan Goolsbee:
Then the second is, we had a large fiscal impulse. And the tyranny of the GDP accounting is that now that turns into a massive headwind for 2022. All that matters for the GDP growth is how much did you add? So, that we added a whole bunch in 2021 means that when you don’t add it in 2022, it becomes a big negative. And that negative fiscal impulse is going to be about as large a cut as we have ever seen. So if the virus ramps back up and slows output and we get complications from China shutting down, plus we have a huge negative fiscal impulse, that’s going to be a really difficult spot for the Fed to be in.

Kathleen Hays:
Raghu, hop in there. Randy talked about inflation expectations. Depending on the timeframe, inflation expectations for the next year—they’re the most affected in the short run—have soared. And even when you start looking out in some of the surveys, they’re getting higher. Austan, you just mentioned, well, rates are so low. Obviously there are some people who don’t expect inflation, or maybe they just expect the Fed to not be aggressive. Maybe they expect the Fed to keep buying so many securities, they’ll keep yields low forever. And all the money overseas looking for some return is pouring into the US. Raghu, what do you think?

Raghuram Rajan:
Yeah, I think there is a problem with some of these prices. They simply don’t add up. When you look at the 10-year treasury at 1.8, and it’s come up over the last few days, but the 10-year break-even inflation expectation is two and a half percent, which means we’ve got negative real rates in the US despite a red hot economy at this point. Unless we have a really sharp slowdown, it’s very hard to reconcile these two. And of course, the equity markets don’t seem to reflect the sharp slowdown. They’re suggesting higher profits for the foreseeable future. Somehow, I don’t take a lot of comfort from the prices in the markets, notwithstanding this be Chicago. There’s something that seems to be off, and I don’t know what it is. I think at this point, yes, there’s lots of not-forever forces at work, and some of them will go away, some of them will stay. I think it’s useful to start thinking about what’s going to be lasting over the next six months and beyond.

Raghuram Rajan:
And clearly, what we’re seeing right now is a labor market which is red hot. You talk to any employer, they say it’s impossible to get people. Of course, there’s more unemployment in New York City, perhaps people from the restaurant industry, etc., who haven’t gone back into the labor force. Much less unemployment in some of the manufacturing hubs, very hard to find people. Certainly, very hard to find people in IT today. There are some red hot sectors. But I think also this whole issue of labor and change in attitudes towards careers, the change in public support towards higher wages at the bottom, the more pro-union stance of the public, all these would suggest that with a tight labor market, perhaps wages will go up faster than they used to in the past.

Raghuram Rajan:
And so that’s one question that probably is more long lasting than the next six months. Housing, of course, has a momentum of its own, and that will show up in inflation rates for some time. But oil, that’s the one that created the problem in Europe energy prices, not oil so much but natural gas. But one of the big concerns is about investment in oil. Yes, it is a transition fuel; over the long term, investment doesn’t make sense, but in the short run, before renewables come in, we do need more oil. And there hasn’t been that much investment; even Shell has become much more circumspect about producing oil. And therefore, supply constraints exist in oil, also. As the economy comes back, that’s going to contribute.

Raghuram Rajan:
So these are more longer-lasting forces than any short-term increase in demand or constraint in supply, some of which will go away, hopefully, by the end of the year. But there are some other factors also one has to think about, which is globalization. That used to keep a lid on wage demands. If you demand wages too strongly, we’ll shift operations to Mexico or China—catch a firm trying to do that in this political environment, extremely hard. Think about central banks. Central banks at the first whiff of inflation used to square their shoulders, look sternly into the camera, and say, “We hate inflation. We’ve got to bring it down.” Thus far, with the exception of the Fed, and the Fed moved only recently, they’ve all been saying, “This will go, this will go, this will pass. Don’t worry about inflation.” It’s a different view. And it’s a view consistent with the new frameworks, which are much more tolerant of inflation.

Raghuram Rajan:
And so, one of the concerns is central banks. With where the financial markets are, with the amount of fiscal spending that has happened, they’re going to be extremely wary about pulling the plug on the economy. And clearly, if you want to bring down inflation, you have to slow the economy. They have a really strong balancing act to manage. And you can see, even in Chairman Powell’s testimony yesterday, how much of an effort he made to say that the financial markets; he wouldn’t pull the plug on the financial markets, so he’d try his best not to. I think this is not the inflation-fighting environment we had in Volcker’s time. It is very different. And so central banks have to navigate much more carefully. And that’s part of the reason why I think there’s more legs to inflation than we think.

Kathleen Hays:
OK. I want to quickly hit, and then especially on this one question, it’s popped up a couple of times now, before we started talking and during this conversation, and you hear it a lot on Wall Street. In fact, I think people who are more “bullish on the Fed” not raising rates very much this year are counting on these rate hikes just pretty quickly slowing down the economy. Now, some people would say, “Well, you’ve got to have an impact on expectations and what the Fed is doing to make a difference.” But one form this is asked in, do you think the Fed can control inflation or attempt it without major disruption to the economy when interest rates rise? And Austan, you can hop in on this one first because I get the feeling you’re a little more concerned about this.

Austan Goolsbee:
Well, I am concerned about that, but going back to my thing of, is this a supply shock, or how much of what we’re seeing is coming from a supply shock? Because take a world where capacity and potential is reduced by 10 percent. The correct answer is not that the Fed try to tighten the hatches down to meet this lower capacity. That’s the tightening into a supply shock argument. If you think that it’s primarily demand driven, then that is what you should do. Now you’re into the difficult spot over the next six months is, one worldview of inflation says we should sit and wait for five to six months and figure out, is this going away? And the other says, the last thing you should do is sit and wait for five or six months, because the thing will run up on its own. Now, I still think if you’re going to have minus 7 percent up to minus 9 percent of GDP from the fiscal headwind, that’s a massive reduction in aggregate demand. And we better think about what will be the impact of just that part before they start the ...

Kathleen Hays:
OK. Although a lot of people, there’s a lot of data out now about how much money people have in their checking accounts. I mean, there’s really a lot of carried over from all the stimulus before. So Raghu, back to you, because you frequently have taken the [inaudible 00:19:31], not frequently, but significantly at times taken a contrary view on what central banks are doing. And I think that Austan is certainly bringing a view that is shared by many people, notably not shared by someone like Larry Summers. Where do you come down on, should the Fed be moving now? Is it so much supply chains? Are there other factors, and is the risk that they do too much? Because the market’s starting to price in the fourth rate hike this year.

Raghuram Rajan:
No, absolutely. Look, I think when you say supply shock, what’s important is you don’t have second-round effects and third-round effects feeding into everything else. And one of the worries is that it is starting to feed, you’re starting to see wage expectations going up. You are certainly seeing a more tolerant environment, where firms are not only passing on price increases, but also paying higher wages. So the question is how much this becomes entrenched by the time the supply shock, if that’s what it is, sort of goes away. But let’s not forget that this is on the backs of a tremendous increase in demand. And there is still some pent-up demand. I think Austan asked a good question, which is how long will that last once you get the fiscal tightening? But it is going to be there for some time.

Raghuram Rajan:
So I think the Fed is doing the right thing at this point by saying, “Look, whatever it is, we need to start moving, because we are an economy which is pretty much at full employment, and we are seeing higher inflation. And to be true to our objective, we need to move now.” Now, there is a real question, which is the following: Are those rate hikes going to be enough to slow the economy down? And if so, what is the channel through which the economy slows? I mean, you may have enough rate hikes to slow the financial economy down in the sense that all these risky assets, the cryptos, etc., fall in price, but you still don’t get a substantial slowing in the real economy in terms of output and growth. And so then the Fed is in a tough situation because if it does a lot more, it could tank both.

Raghuram Rajan:
I don’t think four rate hikes is excessive given that inflation is two and a half and we are at zero, getting to one. I mean, a lot of people, if you look at the price and think that the Fed is going to be done by two and a half. If long-term inflation is two and a half percent, historically, you’ve needed to go at least a percent or more higher in order to bring it down. The notion that the Fed will stop before two and a half means something else coming in to stop inflation. And I don’t know what it is that people are looking at.

Kathleen Hays:
And Randy, as you come in on this, I just want to mention a couple of comments/questions. People talking about the balance sheet, what is the proper level? We know they’re going to start working that down. Does that become more of a tool? Someone else noting that since the Fed has purchased 75 percent, this is William Carpenter, of all new treasury issuance since the pandemic broke out, are real rates actually real anymore? Good observation.

Randall Kroszner:
Well, real rates are quite negative, as both Austan and Raghu have mentioned. And I don’t think they can be this negative for a very long period of time. We’ve got inflation that’s running, depending on your favorite measure, some core measures around five and a half percent, some headline measures 7 percent or so. And 10-year treasuries at between one and a half and two percent, let’s say, they bounce around in that range. You’ve got negative real rates of three to five percent. That’s pretty significant. Now, of course, that can happen, but can it be sustained for a long period of time? I think it’s very difficult for it to be sustained. And this gets back to some of what Raghu was saying about not all the numbers quite adding up. With very negative rates, that makes investment look really good, because you can have a project that is slightly negative in its return, and it’s still worthwhile to do when you can borrow at very negative rates.

Randall Kroszner:
And so you may be getting some investment that may not be especially productive. That’s something that we have to worry about. As I had mentioned, and Raghu and Austan also mentioned, you’ve got issues in the labor market that with rising wages and in service firms, 70 percent of costs are labor costs. As those start to go up, especially they go up at the entry level, that means the entire stack of wages goes up. That means costs go up, and right now firms feel that they can pass those on. That’s potentially problematic. And that’s where the interesting link comes between what the Fed can do and the supply side. Even if it’s a pure supply-side shock, if that changes inflation expectations, the Fed needs to act.

Randall Kroszner:
Even if they can’t do anything directly about the supply side—obviously, they can’t produce more chips, they can’t do that—but if inflation expectations become unanchored, the Fed has to act and has to try to prevent that. And that’s how the supply side can lead to, I think, Fed action and necessary Fed action, even if they can’t directly address the supply-side pieces. I think this is going to be a really difficult challenge. And I think that the Fed needs to act. And if it’s going to be raising ... I think rates will go up at least 1 percent this year, and I think quite possibly more than that, because I think we’re going to see a lot of inflation pressure.

Kathleen Hays:
Austan, you brought the fiscal side of this into the equation saying there’s going to be a pullback, there won’t be as much, and that could be a headwind for the economy. I always have to keep my winds straight here. But we’ve had a couple of question about it. And just before we leave the question... Well, I guess all of you, I’m wondering, the progressives, Democrats in Congress seem to, we have a story today on Bloomberg about how they realized they’re not going to get this. Well, they wanted 10 trillion, then two and a half trillion, then one and three-quarters trillion.

Kathleen Hays:
And there’s also been this idea argued that it’s helping to fuel inflation. Seems to me the more important question than that is just with an economy where unemployment is at 3.9 percent, jobless claims are back down to that 220 average that you’ve only seen, what, 10 or 15 percent of the time in the past 50 years. I mean, the labor market is tight. People who want jobs can get them. If fiscal stimulus is really still needed at this point for the economy, and does it have any role in inflation? Just a quick comment from each of you, and since you raised it, let’s start with you.

Austan Goolsbee:
Kathleen, I would disagree a little bit with the premise of that, the argument about the Build Back Better, which as we highlighted last year, the critical point of economic theory, what does Joe Manchin think? I think Joe Manchin doesn’t think that there’s going to be a Build Back Better bill. In a way, it’s moot. But that wasn’t fiscal stimulus. It wasn’t intended to be fiscal stimulus. It’s spread out over 10 years, it’s paid for with higher tax revenue. So in the context of our discussion about inflation, I think that’s not relevant to the fight over that one.

Raghuram Rajan:
Yeah. On that, I agree it’s not immediately relevant to inflation. The question of paid for, I think, we can debate whether [crosstalk 00:27:40].

Austan Goolsbee:
I don’t think it was 100 percent paid for.

Raghuram Rajan:
Yeah. But yeah, there are aspects of it, such as the child payments and so on, which will keep some element of stimulus in place. But I think it may be second order on the inflation question. The inflation question is already out there today with what we have.

Kathleen Hays:
Randy, I want to jump to you on a question that’s come in just in the past few minutes. Is the reluctance to address inflation in Europe due to the fact that higher interest rates might cause strain in debt affordability in various European countries? I know you’ve got some questions yourself about the ECB’s current stance.

Randall Kroszner:
Yes. Let me just quickly comment on the fiscal side then hop to Europe. And so I think that there’s still a very large fiscal impulse that’s there. I think not all the money that was put out into people’s pockets last year was spent, and it’s still ready to be spent. Many of those programs are still leading to spending coming out, and so I really don’t think there’s going to be a very strong fiscal contraction. And I think it’s really worthwhile to think about cost benefit in doing government spending. A lot of the discussion about the Build Back Better was the headline number. It was three and a half trillion, then it was 3 trillion. Then it was 2 trillion. Then it was 1.75 trillion. That doesn’t seem like it’s about careful cost-benefit analysis. That seems like it’s a headline number. And so I think there are many programs that are worthwhile to do, and I think it would be super valuable to do a careful cost-benefit analysis of where we could be [crosstalk 00:29:20] spending, try to reduce bottlenecks.

Randall Kroszner:
On to Europe. The ECB has taken a very different approach than the Fed has taken. They’ve said inflation’s not, this is just a temporary phenomenon. We’re not going to be raising rates anytime this year. They’ve just doubled down on that, [unclear] has just said that. I think that’s a mistake, because I think that these supply-chain pressures are global. They’re not just something that’s in the US. I think we’re going to see continued very high inflation. They just reported 5 percent inflation in the Eurozone. The highest since the euro was created. Exactly the same issues we’ve been talking about here about the potential for inflation expectations to become unanchored or to move up significantly. Wage demands to move up will be there.

Randall Kroszner:
And so I think that even though the ECB, just like the Fed, can’t do anything directly about the supply issues, it does need to take a stronger stance against inflation, because otherwise, you get this… these inflation expectations becoming entrenched, and it’s the same problems that we’ve been talking about here. But I think it is a challenge, for them as well as in the US, to raise rates, because we have so much debt outstanding on the government side, as well as on the private-sector side. Increasing rates will have a much higher impact on debt service and overall debt-financing costs than in the past, because we have so much more debt outstanding. That puts all of the central banks in a much more difficult political position to do the right thing.

Kathleen Hays:
OK.

Austan Goolsbee:
Can I add one thing to that? I think that’s perceptive and in a way, it’s like, yes, there was an argument about you don’t tighten into a supply shock, but you don’t loosen into a supply shock. And Randy’s saying if there is a supply shock, they’re loosening into the supply shock. A few months ago, I wrote my New York Times column about why I didn’t think that we should call this a recession. That it’s a serious slowdown, even a collapse, but it wasn’t a recession. It looked nothing like a recession. And the reason it didn’t look like a recession also makes it harder for the Fed or other central banks to deal with. Which is the normal mechanism of a recession, is there are cyclically sensitive sectors that go down. That’s what drives a recession. Housing goes down. Durable goods consumption goes down.

Austan Goolsbee:
And a lot of those cyclically sensitive sectors are very sensitive to the interest rate. And so they loosen the interest rate to try to re-juice durable good purchases, investment purchases, and housing. And then when they want to tighten, you raise the interest rate to cool the demand off of those. The problem here is that durable-goods demand went up in the downturn, housing demand went up in the downturn. And so now, what went down were a bunch of recession-proof things like going to the dentist. And now the Fed is trying to figure out, how do we raise the interest rate to slow people from going to the dentist? And it doesn’t really work because the normal channel is not as effective. Kathleen Hays:

Well, final comment from you, Raghu. Then I want to continue on this more international track. But I think one thing that’s important here is that you push the key rate down to zero when you are about to fall off an economic cliff. You had record peacetime stimulus in 2020, so for the Fed’s point of view, put the fiscal question aside, it seems that, is it really so surprising that maybe it’s time to “normalize policy”? And maybe that won’t stop inflation. Maybe it won’t make a difference, but it still seems, and Raghu, if you want to hop in on that, a logical thing for the Federal Reserve to do now.

Raghuram Rajan:
Yeah. Well, just to address that question directly, I have been one of the old conservative central bankers or former central bankers saying that there’s only so much central banks can do. And when they claim they can do more than that, they tend to get into areas where they should not be. One of the areas they should not be is supporting financial markets because, eventually, the financial market distortions get big enough that they can’t resolve it, and then they get blamed for it. I do think that normalization makes sense. If there was some way you could also convince the financial markets that the Fed no longer has its back, that would be a good thing, because that would then allow financial markets to price things a little more effectively than they’ve been pricing.

Kathleen Hays:
OK.

Raghuram Rajan:
I think there is a need to normalize, even if it weren’t for inflation. But of course, you don’t want to normalize into a recession, you want to normalize when things [crosstalk 00:34:19] fine.

Kathleen Hays:
OK. Let’s jump into a point, and I’m going to stick with you, Raghu, because I want to get into China. I know it’s one thing you wanted to bring into the conversation. And we’ve got a question here, could Beijing’s efforts to cool raw material prices, and their property sector and big tech companies and education companies—I’m adding a few more sectors that they are—trying to cool off, quote unquote, could this cause the US to experience a sudden deflationary cooling off of the currently high inflation? I think there’s a couple of other questions about how this connects inflation in the US, Fed raising rates, certainly through China, the world’s second-largest economy, and then how that reverberates through the rest of the world.

Raghuram Rajan:
Right. I think this is an important issue because what’s going on in China is certainly unprecedented. Of course, there are lots of China watchers who say, “Don’t worry, this is the greatest government on Earth. They know what they’re doing. They’ll fix it. They’re very sensible, etc., etc.” I think there’s a little more reason for concern, that they certainly are trying to move away from the age-old pattern of growth, which is low wages and cheap capital. And one of the main things to fix there is then to fix the property sector, which has benefited tremendously from very cheap capital, but also very aggressive investment. And if you believe some commentators like Ken Rogoff on China, they have really overbuilt housing at this point. Their old method of reviving the economy, which is when in trouble, reduce rates and lend to the property sector, lend to the real estate sector, and the economy will revive because there’ll be a lot of demand for steel, copper, and everything else, that’s no longer effective, especially because of overbuilding.

Raghuram Rajan:
So first, they’re trying to resolve the problems. So they have to deal with all the bad debts, etc. Second, they’re seeing a slowing of the economy, and the usual tool for reviving the economy, which is press the construction button, is no longer there or not as easily available. So they will have to muddle through. And it’s not clear that they know how they can muddle through, which is why I think we have to watch the China space very carefully. And this is the world’s second-largest economy, big manufacturing power, its own domestic market is huge and getting bigger still. So there will be disinflationary impulses coming from China if they can’t manage this well. And that’s, I think, a legitimate fear. It won’t impact the US as directly, it’d be indirect, but it does suggest that there will be, for example, for commodity prices and so on, some disinflationary impact down the line if they can’t do it reasonably.

Kathleen Hays:
Austan, I guess to you on this, in terms of, since you worked for the Obama administration, I want to ask you a question, but I guess about US economic policy, in China in particular, is it a good stance? Should we be dealing with China differently? Or do you think that we are sufficient, we don’t depend on exports? Is it something that would concern you and you were advising Joe Biden right now?

Austan Goolsbee:
Well, I mean, if I was advising Joe Biden right now, I’d say, “Get rid of the stupid tariffs.” Why do we have? We ramped up the tariffs. You want to reduce inflation, that’s one place that we could do it. I found myself in virtually total agreement with the observations that Raghu had there on China. I would observe, in terms of the direct component, there will be some deflationary or reduced inflationary impact from that. But the direct interaction dependence of the US economy on the Chinese economy is actually very small. China’s the second biggest and we’re the biggest, but we’re both mostly big, national-oriented, domestic-oriented economies. If you take exports as 15 percent of GDP in the US and China’s maybe a quarter of our trade, if something slows down substantially in China, it’s not a very big direct impact on GDP. It would mostly go through the channel of freaking out, that the markets would freak out or business would freak out. That can lead to problems. But it’s worth, at least, remembering that that indirect channel is the one that we go through.

Kathleen Hays:
In terms of geopolitical aspects, we have a question here, and I guess now we’ll start with you, Randy. And they could be, there’s Ukraine, there’s Kazakhstan, Iran nuclear. I mean, it’s a very, very, very, very long list. You’re just getting back from your two and a half years in London, so you can take that global view. When you look at the outlook for the US and for the global economy, how do you fit those risks into your outlook?

Randall Kroszner:
Those are substantial and significant risks. There’s no doubt about it. I mean, we see what’s happening on the border of Ukraine. We also saw an intervention in Kazakhstan. We’re seeing missile launches in North Korea and lots of tensions between China and Japan, the US and others in the Pacific. This is not a time of great global cooperation and calm. There are a lot of risks that are out there. And so I think people, when thinking about their portfolios and thinking about their operations, have to take all of those sorts of things into account. It is a very, very fragile situation, and I’m not quite sure that our negotiations are going to smooth these things out. I mean, I think there’s hope that diplomacy will work, but I think realpolitik, often, is what is successful. And that sometimes means actual actions and interventions that occur.

Randall Kroszner:
I just wanted to chime in on one aspect of China. And one of the challenges that they will have is a dramatic change in their demographics. They are now experiencing a very rapid aging of their population. And so, one of the things that had to do with the housing market before, that you could just keep building and you knew that there were more and more people who were coming in. Well, that’s not the case, because the growth of the population is much lower than it was. And so you’re not going to have as many people coming in to buy these things.

Randall Kroszner:
It’s also going to slow overall economic activity, because that was one of the things that was driving such high rates of growth in China, was so many people coming in, really, from the informal sector, not really being part of the formal economy, moving to the coastal areas. You’re just not going to have that going forward. That’s going to put downward pressure on Chinese growth in general, and in particular, in the housing market. You have that uncertainty in addition to these geopolitical forces, which I think are very real. And so I think the chance that there is going to be some sort of, rather than cold war, but hot war somewhere in 2022 is very high.

Kathleen Hays:
Raghu?

Raghuram Rajan:
Well, I think coupled with this notion of a hot war between big powers, there’s also the political difficulty within a number of countries, which suggests the possibility of meddling. One of the impacts of the pandemic has been, it’s scarred a number of economies, both in emerging markets and developing countries who haven’t had enough resources to put to work, haven’t had the vaccine in time, and certainly have had really bad outcomes for their middle classes. Many countries, there’s been a lot of slippage of families into the realms of the poor. And so what this means is, it gets very difficult politically, because now people are angry with the regime. If it’s the middle-of-the road regime, they look to the extremes, the extreme left, the extreme right. I mean, Chile was a poster case for middle-of-the-road policies, maybe, perhaps, a little to the right, in Latin America.

Raghuram Rajan:
And now the two main candidates who were extreme left, extreme right, and the extreme left has won the presidency. Of course, he’ll navigate a little more towards the center. But certainly, this is the most stable country, at least for a while, in Latin America, which has moved this way. I think that across the world, we will see, as people are able to come out on the streets, more and more of the effects of the pandemic demonstrated in political sort of conflict, political discussion. And that allows the possibility of countries meddling to get allies. And we already know there’s meddling through social media. Whether there’s meddling through other means is something we have to wait and see.

Kathleen Hays:
Austan, there was a question about political instability in the US. And what about it could get worse after the midterms, etc., etc. You can weigh in on any of that or any part of this question of geopolitics. The situation in the US or other countries and how it does, or doesn’t, enter into your economic and even investment outlook?

Austan Goolsbee:
Let’s start in the US. The US political system is one in which the president does virtually everything that they’re going to do legislatively in the first year they’re in office. And I said it when Trump first got elected, and I will say it again for Joe Biden, the first year you’re in office, that’s the most fun you’re ever going to have as president. So if that doesn’t seem like it’s fun, just wait! Because it’s only going to get worse. You’re going to lose the midterm. Then your own party is going to distance themself from you. The media’s going to treat you worse. Everything gets worse and worse until you’re done. And then they revive your reputation when you’re out of office. That’s the system we have, like in the Godfather, this is the business we’ve chosen.

Austan Goolsbee:
And so I saw one of the questions is what’s to be the fate of Build Back Better? I think you’ve got eight days, and then the first year is over. I think Build Back Better is going to be in big trouble because I don’t think they can pass it in the next eight days. That instability makes politics nasty, but we have shown decade after decade that the economy can still succeed even with Washington in total dysfunction. I’m not necessarily nervous that that means that that dysfunction has to spread to the economy. But this meddling point is a serious one.

Austan Goolsbee:
The rise of populism and the extremes on both parties, where if somebody said, “My big achievement was I got 10 members of the other party to go along with me. And we came up with a bill to do 75 percent of what I said I was going to do,” that used to be a triumph, and now you would be primaried for doing that. That’s a tough environment. Hopefully, we will not end up like El Salvador, where you might have seen the president was elected on a campaign to make Bitcoin the legal currency. As that has unraveled, they’ve announced they’re going to build a city in the shape of a Bitcoin and power it with a volcano.

Kathleen Hays:
Wow!

Austan Goolsbee:
To mine and to fund the deficit. Once you open the door to populist policies, it’s an unlimited downside of what could happen.

Kathleen Hays:
And who knows, in the almost, we hope it’s postpandemic, or at least pandemic becoming endemic world, who knows what people might come up with before those midterms, Austan Goolsbee. But I think, there’s been a few different questions about the impact of Omicron. And I think one of the most interesting ones is [inaudible 00:47:33] encapsulated by this one: Pandemic is exacerbating wealth inequities across populations. And certainly, we’ve seen the developed, richer nations vaccinating people to the extent they want you to get a booster every four months, while in many emerging markets, people can barely get one or two. And so could this imbalance in financial well-being, I would say also just basic well-being, health, and consumer power, impact global inflation, the global recovery? It seems that this is one of the big things that’s come out of 2021 that isn’t always at the top of list things we’re looking at. And so on this, [inaudible 00:48:16], let’s start with you.

Raghuram Rajan:
Yeah. Look, I think it’s complicated to see the effects on developing countries and emerging markets, because there’s both a reduction in demand, but also the supply side has been impacted in those countries. A lot of firms have gone out of business. What’s the net effect on inflation? We don’t know. What we do know is the net effect is anger. A lot more people angry at what has happened and trying to do something about it. I think the broader question right now for many emerging markets is, as the Fed tightens, do they start seeing the outflow of capital that they saw in the past? And what does that do to their markets? Because every market in the world has been buoyed by the capital flowing in from industrial countries, and certainly, as the tap sort of slows down or reverses.

Raghuram Rajan:
Now, a lot of people say things are different. Yeah, things are different, but it’s hard to put a sign on that: different positively or different negatively this time around? Because certainly, for a long time, emerging markets developed religion from looking at the industrial countries and went towards tighter fiscal deficits, better monetary policies, more inflation targeting, etc., etc. But as we discussed, I mean, some of those issues are now being questioned in many of these emerging markets, again, looking at the industrial countries. If they can do various forms of quantitative easing, if they can lend to firms directly from the central bank, if they can act as if there’s no limit to fiscal spending, why can’t we? Well, we can’t because we saw how that ended up in disaster.

Raghuram Rajan:
But certainly, this debate has started up in a number of emerging markets. The broader point I’m trying to make is, it’s unclear what the net effect of all this is. This is a difficult environment for a number of emerging markets. And I think many of them would be better advised to be as circumspect as possible and direct spending, not so much cut it off, but direct it much more towards those who are really suffering rather than spend unwisely at this point.

Kathleen Hays:
Either of you have a thought on that? Randy? Austan? OK. Let’s move on. Because I think, Raghu, you really summed it up very, very nicely. There’s a very specific question that one of our lovely audience members would like you all to weigh in on, and you can even do it very quickly if you like, because this person notes, Raghu, that your comments suggested equities are overvalued when you look at real rates, etc., etc. And more broadly, wants to know, what do you guys think about, here we are, we had 26 percent gain in S&P 500 last year, and there’s hardly anybody who’s saying we’re going to get that, although a lot of people are still pretty bullish. What about valuations? As professors, economists, finance teachers, how does it look to you? And we’ll start with you on this one, Randy.

Randall Kroszner:
All right, put me on the hot spot.

Kathleen Hays:
You bet.

Randall Kroszner:
I guess there are different stories you can tell. And so you can tell the productivity story. What was the key thing that the virus did in terms of the economy? Obviously, a terrible personal tragedy, but it pushed us forward in using technology in a way that was not possible before. I mean, just like the Economic Outlooks that we’ve done over the last few years on Zoom, having thousands of people engaged with them. People don’t have to come down to listen to us. It’s much easier for them, well, we can have a larger audience of people just listening on Zoom. And then, of course, it exists on YouTube and on our website. And so you’ve got just an enormous move forward in so much technological adoption that would’ve taken a very, very long time to do.

Randall Kroszner:
So if you want to take the positive aspect you can say, one of the reasons why equities in general are up is that we’re seeing a productivity boom. We’re on the verge of having a very significant productivity boom. And at first, we saw that in terms of the technology stocks. So initially, the growth stocks exploded in value and the traditional stocks, more the traditional value stocks, all came down. Then when people started saying, “Hey, maybe the whole economy is going to come back and could benefit from this,” we’ve seen this rotation so that now the so-called traditional value stocks are doing well relative to the technology stocks.

Randall Kroszner:
So that would be like a coherent explanation for why you have relatively high valuations. But the question is, are they at the right level of high valuation? Are they too optimistic about the future? And I think that has a lot to do with getting policy right. Will we be able to get through this without having to have a major crunch and recession trying to wring inflation out of the system? And there’s a lot of optimism about that, and it doesn’t seem that that much downside risk is being priced in right now for that.

Kathleen Hays:
OK. Austan, you want to quick comment on that?

Austan Goolsbee:
Well, look, it always makes me nervous, makes us nervous, but we also are not, we tend to be just buy and hold as a profession, and try to get out of the business of, is this value correct, or is it one that’s higher? I will say that for all our discussion about wages and the tightness of the labor market, corporate margins, the profit margins, were already at record levels before the pandemic, and they have actually gone up during the pandemic. So it has not been the case that the tight labor market has pinched the margins of corporate America. The fact that the future profits might remain high would lead to high valuations, low interest rates would lead to high valuations, or people being nuts would lead to high valuations. And I vary each day which of the three I think is driving it.

Kathleen Hays:
Raghu?

Raghuram Rajan:
I think with interest rates really as low as they are, there’s a lot of room for being optimistic about the way, way out future, where we know very little. And you see a number of assets, these tech stocks, which have huge losses right now, the hope that it’ll become an Amazon down the line, or cryptocurrencies that pay nothing right now, the hope that they’ll become the dominant sort of form of payments down the line. What low rates do is allow you to build hope and change way into the future without too much information right now. And I think what we are seeing is possibly some movement in those rates, which is, as Austan said, weighing on those hope and change assets.

Raghuram Rajan:
The question is how much is there to move there? Certainly, central banks moving on their policy rates. But I think as important central bank purchases are going to change, there’s a lot of movement when it came out that the Fed is discussing quantitative tightening, reducing its balance sheet over time, which I think it should. And also, there’s a fair amount of private-sector purchases of long-term bonds in an attempt to lock in some of the gains that have happened. The search for yield was there in the past. Now it’s I think search for protection, if I’m an insurance company or a pension fund. I don’t really know what the true level of the long rate should be. There’s so many forces on it right now. And if it is likely to go up over time, certainly, those assets priced on hope and change will come down substantially.

Kathleen Hays:
OK. We’re just about out of time, but I want to ask a couple of quick, what I call lightning round questions. For example, you can each weigh in quickly and we can cover a couple more topics, because we’ve mentioned Omicron but I think a lot of people are also, like, a basic question, “Well, gee! How’s it going to affect the economy this year?” Shrug it off because we’ll have a surge and it comes down and we just move on. The potential for it to become a bigger threat. And I’m going to go back to you for this first, Austan, because I think you mentioned this in one of your very first answers.

Austan Goolsbee:
Look, from where we sat here last year, we had two different variant surges, Delta and Omicron. So I don’t think anyone should become complacent like, “Ah, the Omicron is mild so this is the end of COVID.” I don’t see it.

Kathleen Hays:
Potential threat to the economy though?

Austan Goolsbee:
Yeah. Definitely.

Kathleen Hays:
OK.

Austan Goolsbee:
[crosstalk 00:57:23] The virus is the boss. I’ve been saying from the beginning, when the virus surges, the economy is going to stall out, the job market’s going to stall out, service sector is going to stall out.

Kathleen Hays:
OK. Raghu?

Raghuram Rajan:
Well, I’d add to that, just that, how much more stimulus can we give on the fiscal side? I mean, you’ve seen Europe going back to some fiscal stimulus to help on energy prices. But if this thing lasts much longer and gets worse, I mean, there are limits to how much you can do. So it is a source of worry. And I agree entirely with Austan, we ain’t done until we’re done. And right now we are not done.

Kathleen Hays:
Randy?

Randall Kroszner:
Yeah. We’ve had sort of an orgy of fiscal spending in the US over the last few years. And I think it’s coming to an end, or at least I hope it’s coming to an end, and that has important consequences. For the virus, as I said, I think the short-run impact is going to be significant lockdowns through much of Asia, tightening supply constraints and so leading to higher inflation pressures that will also slow economic growth in the short run. And then hopefully, the data that suggests that it’s not very much of a challenge in terms of health are right.

Randall Kroszner:
And if you want to take the optimistic, since my colleagues took the pessimistic view, I’ll take the optimistic view. If it is that so many people have now become infected that it helps to spread immunity, that could allow us for a foundation for a stronger recovery. But I would not declare victory. This virus is not something that we’ve been able to predict with great certainty. But it is now three years on and sort of similar to what happened with the Spanish flu pandemic in terms of timing. And we have had a lot of success with the vaccines. So I’m hopeful that over the next year, we’ll have it under more control.

Kathleen Hays:
OK. Final question: When we do this in a year—maybe we’ll do it in the middle of the year like we did one year when things changed enough to say, hey, we’re going to come back to the table. But assuming we don’t get to do it for a year, where are we going to be in a year? How are we going to look? What are we going to say when we look back over this year? What happened, and where are we heading next? Raghu, this time we’ll start with you.

Raghuram Rajan:
Well, I hope we’ll be together in a big room with lots of people on a stage where we can talk to one another than across the screen. So if we’re there, we’ve made a lot of progress.

Kathleen Hays:
Randy?

Randall Kroszner:
I certainly agree with, Raghu, on that. I think the key issue will be inflation, whether inflation has come under control and inflation expectations have not moved up, or that they have moved up. And I think that there’s a risk that in a number of countries that it will have moved up. They won’t have it under control.

Kathleen Hays:
OK, Austan?

Austan Goolsbee:
Look, I think if we get to meet in person, then it means we will have gotten control of the virus. And I believe that that will mean consumer spending in the US will have shifted back to services away from goods, which will relieve supply pressure. And I believe that if we got control of the virus, the economy wants to come back, and you can see that GDP growth would be really high. If we’re meeting via Zoom, then all bets are off. And I don’t think that we will have gotten to [inaudible 01:00:57].

Kathleen Hays:
Well, I’m the optimist here. I’m feeling pretty good about how this thing is working out and where we’re going to be in a year, back together on that stage, and it seems to me the economy’s already had a pretty good year last year. Again, unemployment low, lot of good things happening, in spite of everything we’ve gone through. And as much as I could hardly wait to be there on that stage with you guys, I’m so happy we have Zoom, and it has really helped so many of us continue to have these conversations, to get together with this audience. My only regret each year is, couldn’t we go a little bit longer? But in showbiz, always better to leave them when they want a little more [crosstalk 01:01:40]. There you go. Thanks so much to all of you.

Randall Kroszner:
Thank you. Bye-bye.

Raghuram Rajan:
Bye.