As most of my students know, I enjoy following the Fed — I believe that it’s the best way to track the economy. As luck would have it, I’ve had the opportunity to hear Dallas Fed President Robert Kaplan speak three times in the past month, most recently when he visited the McCombs School of Business to meet with faculty members and participate in a public Q&A session moderated by Dean Jay Hartzell.
President Kaplan seems to have tremendous energy and passion. He’s as good of a listener as he is a speaker, and after watching him it’s easy to understand the success he’s had in his career. We’re particularly fortunate to have a district Fed president who is interested in helping the district’s universities and collaborating with researchers and educators.
It’s informative to know what factors a Fed president and CEO considers important in evaluating the state of our economy. Here are the points from his presentation that stood out for me:
Part 1: The Energy Industry
1. The oil market is still in a state of oversupply. From a global perspective, supply exceeds demand by more than one million barrels per day. Even though capital expenditure cuts have been substantial, we haven’t seen a dramatic reduction in supply. In addition, even when we’ve seen a reduction in U.S. supply, it’s been more than offset by increases from Iran, Russia, and other producers.
2. Hopefully, supply and demand will be in balance by the second quarter of 2017. We will see supply decrease because of the decline curves of shale. In addition, on an annual basis, demand is growing by approximately 1.2 million barrels per day.
3. Even when supply and demand are in equilibrium, we will still have excess inventories. Currently, it is estimated that the OECD countries have 430 million barrels of excess inventory. But the market doesn’t need this inventory (which is still increasing) to clear before the price firms. The market needs to see the supply/demand situation improving on the horizon.
4. Oil prices have firmed recently. Bombs have interrupted pipelines in Nigeria and Iraq, and this has taken a significant amount of oil offline. In addition, markets may be giving credence to the recently announced OPEC freeze. Finally, short sellers may be covering, and unhedged parties (such as airlines) might be starting to hedge.
5. Energy may still be challenging in 2016, but the future could be brighter (for producers). We could still see downside in 2016. There will likely be more bankruptcies and restructurings. But, it’s possible that we could have a shortage of supply three or four years out. Outside of the U.S., producers are operating at a high rate of capacity utilization.
Part 2: Texas
1. Job growth is expected to increase .7% in Texas in 2016. The risk is to the downside.
2. Texas has both advantages and challenges. We have a central location (a natural distribution hub), a pro-business environment, a good climate, and low taxes. But wealth inequality in the state is growing, high school and college graduation rates are lagging (particularly among minority groups), and there are many people that don’t have access to health care. Other issues include infrastructure and home affordability.
3. Education is a long-term important issue. There is a direct correlation between productivity and income. High school and college graduation rates are related to the quality of the work force (and productivity). We need to be able to assimilate new residents so that they become productive citizens.
4. Higher home prices will not create systemic risk, but this can cause other problems. The price increase is driven by supply and demand. Back in 2008, some of the price increase was driven by speculation and leverage (lots of leverage). President Kaplan is not concerned about housing creating systemic risk, but he is concerned that high housing prices could make it harder to recruit workers to relocate here.
5. In addition to the impact of oil prices, Texas has been affected by the strong dollar. In particular, the dollar has a negative impact on the border. Fewer people come to Texas to buy goods.
Part 3: The U.S. Markets and the Economy
1. There is a difference between the S&P 500 and the underlying U.S. economy. Approximately 11% of GDP is comprised of exports of goods and services. But, more important, as much as 50% of S&P 500 earnings originate outside of the U.S. When you see the market going down, it may be telling us what is going on globally.
2. The S&P 500 has been affected by the strong dollar, softness in global demand, aging populations in advanced economies, and high debt-to-GDP ratios (a problem that includes the U.S.). Foreign weakness can hurt margins, and this financial tightening can impact our economy. The bottom line is that the S&P 500 and global markets are more interconnected than they were in the past. As a result, we’re more susceptible to bouts of financial tightening than in the past.
3. Economic growth is determined by more than just monetary policy. We’ve had six or seven years in which monetary policy has been the primary determinant of economic policy. Monetary policy can’t be used in isolation. We need to think about fiscal policy and regulatory issues. Important issues include access to education, demographics, infrastructure, high debt-to-GDP levels, and the burden of entitlements.
4. The Phillips curve (showing the relationship between inflation and unemployment) is still important, but the relationship seems to have weakened. This could be due to globalization, slack in our labor markets, or a change in power between capital providers and workers. In addition, we’re seeing a large number of disruptive businesses that are reducing pricing pressure. As a result, wage pressures don’t necessarily translate into pricing pressure.
5. We’re moving toward full employment. The participation rate was 66% before the crisis, and recently it’s been in the mid-62% range. We believe that half of the decrease was due to demographics (baby boomers starting to retire). But, we still have some slack.
Part 4: International Issues
1. The Fed’s job is to oversee the U.S. economy. But, in order to do this, we have to understand monetary policy abroad.
2. Too many people think China’s economic issues are short-term in nature. China is transforming from being investment- and export-driven to being consumer- and service-driven. This will take 10 to 20 years. There are 350 to 400 million people who will need to move to cities — or rural areas will need to change to support this new economy. It wouldn’t be surprising (over the distant future) to see devaluations, capital flight, and stock market turbulence.
3. The world must get used to slower growth. China had 6.9% GDP growth in 2015. This is expected to be 6.3% in 2016. China has been responsible for 50% of the world’s GDP growth in recent years. That tailwind is receding, and we need to get used to it.
4. China has other issues (in addition to their transformation). In particular, they have overcapacity in state-run industries. They also have demographic issues due to their one-child policy and their aging workforce.
5. Japan recently went to negative interest rates. Japan has several problems, including demographics, low inflation, and high debt. Negative rates won’t solve all of these problems.
6. It’s hard to know what global growth engines will emerge. India has challenges but will grow faster than 7%. Commodity exporters will improve, but many will still be in recession.
Part 5: Banks
1. Negative interest rates and pressure on net interest margins are not helping banks. The yield curve has become flatter, and that makes the traditional banking model less profitable.
2. Many banks made mistakes leading up to the crisis, but the country needs a banking system. In particular, President Kaplan worries about small community banks. They are crucial to business formation. We need a banking system that makes loans. A healthy money market industry is also important due to its role in financing corporations (through the commercial paper market).
3. The size of banks does not, in itself, create systemic risk. It’s important to think about capital, liquidity, and interconnectedness. These are the factors that drive risk. Remember, the three biggest banks (at the time of the crisis) were Bank of America, Wells Fargo, and J.P. Morgan. These banks acquired weaker non-bank financial companies. The crisis wouldn’t have been “less bad” if these banks had been smaller. In fact, the crisis might have been worse because it would have been more difficult to merge banks. Today, banks have more capital, better liquidity in a downside scenario, and less interconnectedness. We need to continue to watch non-bank financials.
Dean Jay Hartzell interviewed Robert Kaplan, president and CEO of the Federal Reserve Bank of Dallas, on March 29, 2016.