Rob Kaplan on How the Fed Will Think about the Tariffs

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1:20Hello and welcome to another episode of the Odd Lots podcast. I'm Jill Weisenthal. And I'm Tracy Alloway. Tracy, there are many dimensions of the ongoing market turbulence and trade tensions that we can't stop talking about. But a big one, and in a way, it's almost like people aren't talking about it that much right now because there's so many other things top of mind. A lot of questions about how the Fed is going to think about what's happening right here. Right. And I know it's probably not very popular to sympathize with the central bank, but I got to say, I would hate to be Jerome Powell right now.

1:53Because in my mind, the consensus right now seems to be that we're heading for some sort of stagflationary scenario, at least in the short to intermediate term. So higher inflation, lower growth, possibly even recession. And that, to me, just seems like a nightmare scenario for a central bank, which constantly has to balance its twin mandate of price stability and low unemployment. It's really tricky, right, because we've sort of been used to environments where it's really obvious. So in 2022, 2023, it was clear that they were missing on one specific side, which was the price. For much of post-2007 or 2008, the story was weak growth, disinflation, whatever, so poor employment.

2:38I mean, this is going to be tricky. And look, when we're talking about restructuring the global economy or the internal economy, these are questions that there is a limit to the degree to which monetary policy can solve them. They can maybe, you know, maybe smooth things out a little bit. But at the end, these aren't really monetary policy questions we're talking about here. Right. And I think we all internalized that lesson in the 2020 pandemic, right? We saw all these real world disruptions, supply chain issues, and that gave rise to the infamous transitory inflation, as the Fed called it. And it seems very much like that's a possibility again, right?

3:16Totally. And like we've been saying, we've been going back to talking to all our old supply chain guests because, you know, the whole world may be redrawn. Anyway, we are recording this after the market closed. It's April 8th, 2025. It's 4.09 p.m. We just had another crazy day in the market. S &P 500 ended down 1.57%. It had been up over 4 % at one point. So we continue to whipsaw. Anyway, I'm excited to say we really do have the perfect guest, someone we've had actually on the show once before. We are going to be speaking with Rob Kaplan. He is a vice chairman at Goldman Sachs, member of the management committee.

3:49Prior to that, he was the president and CEO of the Federal Reserve Bank of Dallas. Prior to that, he had been Harvard. Prior to that, he had been at Goldman Sachs. Truly the perfect guest for right now. Rob Kaplan, thank you so much for coming back on OutLots. Thanks for having me. Good to talk with you. Tracy said she wouldn't want to be Jerome Powell. I would still take that job, but I'm just let's start. You're on this. Let's say, you know, this is all happening a few years ago and you're still at the Fed. How stressful is this kind of environment for charting a course for monetary policy? Well, the last time we had a tariff issue, you got to go back to 2019.

4:25I was at the Fed at the time. And you may recall, we preemptively cut the Fed funds rate three times. I think we called it a tactical recalibration or something like that. And the reason we were able to be preemptive is we didn't have an inflation issue. So we could afford to be preemptive. As we're sitting here today, the Fed goes into this already before the tariff situation with an inflation issue and that inflation sticky. Now, the irony going into this, the source of the sticky inflation has been services, not goods. Goods have been disinflating up to now, up until, say, two months ago or a month and a half ago.

5:15And China overcapacity has fed that disinflation. But despite that, you know, we're hanging around two and a half, two and three quarters on the PCE. And I would argue that the excess inflation has been more about excess demand due to outsized fiscal spending. So we are now in a new administration where they are dialing down fiscal spending. So that excess demand is being pulled away. You would normally consider that disinflationary. But now we've got a supply shock issue related to tariffs, which relates ironically to goods, not services. And so the most important thing the Fed is thinking right now is we don't have to have this figured out because we can't have it figured out.

6:11If anything they learned from the transitory episode, don't try to jump ahead to predict things that you can't know. And I think they're going to sit back, let the situation unfold and try to understand it. And they're going to be more reactive, not proactive. And I think that will be the difference. You know, I mentioned stagflation before, which seems to be becoming the consensus economic environment that everyone is talking about. What's the playbook, I guess the traditional playbook for a central bank that's starting or trying to battle stagflation? You know, I'm thinking back to the 1970s, maybe Volcker.

6:54He raised rates really aggressively and ultimately he was willing to sacrifice employment in order to get inflation down. Is there like a normal playbook that central bankers can follow here? Not really in this case, in that you're right. In the 70s, we had a situation where we had slowing growth and an inflation issue. One of the things I would say about this situation, I think you have to assess it for what's driving it. What are the structural drivers? And I think that we have a lot of uncertainty. You have government spending cuts. You have a dramatic reduction in immigration and shutting down the border, which normally would slow growth and might actually create some stickiness in the labor force.

7:45And then you've got these tariff issues. But the issue with the tariff situation is it's in flux. You had the announcement last week on Wednesday, and it's still very unclear how much is the administration, our administration, willing to negotiate? How much is this really about reciprocity? And I think, honestly, how much of this is about the administration might want to create more revenue and tariff revenue. And actually, while countries may come back to us and say, we'll go down to zero and remove non-trade barriers, I think we're going to find out how willing our administration is to, in fact, negotiate or how much do they actually want higher tariffs to keep the revenue.

8:36And so all those things are going through the Fed's mind. And so we don't know. And so I think you just have to be patient. Don't be a prognosticator. Be a risk manager. Allow this situation to clarify. Well, let me ask you a question. I mean, you must talk all the time to both investors and to real businesses of various sorts. Right now, when we're talking on April 8th, do you think there is still some belief that this can't be what the final tariff schedule looks like? whatever it ends up being, maybe negotiations, et cetera, that the idea that, no, these numbers that were unveiled on that chart on April 2nd, they can't really be what the new trading relationship with the rest of the world is going to look like.

9:20Okay. So let's talk about both groups, businesses and then capital allocators, investors. I think there's a hope. There has been a hope by both that, yes, this was more about reciprocity and there was going to be a negotiation. And so this isn't where we're going to end up. I think one of the reasons why the market is behaving in the way it is, I think businesses are still hopeful that this will be a negotiation, but they're not sure about that. And they're starting to make plans on how they're going to adjust. And there's a series of things they could do. They're already talking about pressuring suppliers to cut prices.

10:00They're talking about potentially taking some of this out of margin. They were hoping up to now that maybe the dollar would strengthen. And then the other thing they're talking about is pricing. But they're in the middle of trying to figure that out. They are not, as much as you would hope, actively talking about expanding capacity here, because they're concerned that something they build here is globally competitive, and you don't want to build a high cost facility that only is competitive because of a tariff mode. So that's where they are. They're treading water and trying to be receptive and figure this out and giving their views to the administration.

10:41Capital allocators, on the other hand, started the year wanting to be long the dollar, dollar denominated assets. And what's happened is they have been moving on the margin away from the dollar, And you're even seeing in the last week that some dollar weakness, 10-year Treasury backing up, as opposed to rallying, which you would normally expect to see. And you're seeing a move, I think, not between asset classes. You're seeing a move away from dollar-denominated assets. That is extremely unusual. and again, they're doing it to hedge their bets depending on what the administration is trying to accomplish.

11:27I wanted to ask you about exactly this. You mentioned earlier, don't be a prognosticator, be a risk manager. And that sounds like, we should make like inspirational posters with like little kittens hanging from trees with that text below. But on this note, one of the reasons this market move is particularly painful is not just because it's very, very big, a big downward shift, but also we're seeing bonds sell off at the same time. And I think we've moved from like just under 4 % on the 10-year to something like almost 4.3 % now. Again, that's happening while stocks are selling off, which is something you wouldn't expect to see normally.

12:08I have seen all sorts of explanations for why this might be happening. I've seen people talk about, well, maybe investors are liquidating what they can sell in the current environment, not necessarily what they want. And then secondly, maybe it's the basis trade being unwound. Thirdly, maybe it's investors shifting away from U.S. assets altogether. Where do you sort of lie on that spectrum of reasons? Like, what is the mix for why exactly The yields are going up right now. So we're seeing all those potential explanations. I think the truth is we're not sure. There's certainly been comments in the market, and we've seen inflows about the unwind of the basis trade you referred to.

12:52We're seeing among some asset allocators a desire to reallocate and rebalance their dollar exposures to other markets. And I think the most insightful thing I can say, certainly if I'm at the Fed and sitting here at Goldman Sachs, the only thing we can all agree on is something we are watching very carefully because it's a concern for a country that has a, let's say,$36,$37 trillion of Treasury debt outstanding and growing by at least$2 trillion a year. It's very critical that we are able to market our debt. We've struggled over the last few years to sell duration and that we've tried to front end load it.

13:39But it's critical for a country with debt to GDP, 100 percent plus, you want to be able to market your debt. You want confidence in what we're doing here. And I think it bears watching. And certainly if I were at the Fed, I'd be watching that very carefully. Thank you.

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15:13Easy Cater, your business tool for food. To learn more, visit easycater.com slash podcast. You've had a very long career, and Joe, his intro for you included many titles, many hats. Over your history as a financial market veteran, have you ever seen anything like this? I think that normally what you're accustomed to in a week like this last week, you would normally see a flight to quality. You would see treasuries rally and you would eventually start to get a better grip on what's going on. Obviously, COVID was a good example of enormous uncertainty that took a while to resolve. it's been unusual in my career to see a government-led action as opposed to an external shock, a government-led action, i.e.

16:04man-made, that has in turn created this kind of uncertainty. The good thing about this kind of situation, if it's man-made that created the uncertainty, it can also be susceptible to man-made actions that will address the uncertainty. And I think that's what people in the market are hoping for. Do you worry that, I mean, this has come up and it's certainly true, right? Because at any given moment, Trump could say, no, we're taking this back, but this is his life's mission. Or we're doing some pause and we saw the sort of incredible rally Monday on a fake headline about the pause, tells you something about the environment.

16:40But what the president can't do is unring the bell because he can't really credibly say he'll never do this again, right? Like, do you worry that like this is going to permanently change America's economic relationship with every country in the world? Yeah, I just got back from Europe. Yeah, there are certainly, yes, our strains around the world. Yeah. And yes, those bear watching. Having said that, I do believe that there's a great opportunity to get this puzzle right and make this work. But yes, there is some cost to what's happened up to now. But I still think this can get resolved, but it's going to require some action on our part in order to do that.

17:23And I think the markets in their up and down reaction today, they're just not sure how imminent that is and whether that's going to happen. And so you're seeing this uncertainty prevail in the markets. The problem with uncertainty going on for too long is it slows activity. If I'm a consumer thinking about taking an action, I might pause it. I can tell you, talking to companies, they're not saying no, but they're saying not now. They have already had other uncertainties they're dealing with in their business, how to approach AI, which use cases for AI spending will work. They have other issues that they're always wrestling with.

18:07And I think all this does is cause them to be more careful, pause actions they might have otherwise taken. And I don't think you want that to go on indefinitely. Just going back to the Fed for a second, what's the pain threshold for the central bank in terms of movements in the financial market? Like, how bad does it need to get before maybe they start rolling out some tools to try to calm things down? All right. So at the Fed, back to the headline, what I'm worried about is full employment and price stability. Stock market going down substantially does not by itself necessarily cause me to do anything other than I'm aware of it.

18:52Credit spreads beginning to gap out gets my attention more because I'm concerned that that, in fact, would be an amplifier of a potential slowdown, i.e., businesses might not fire people because their stock is down, but they might start to if they see their business slowing and credit spreads widening and they're worried about financeability. So I'm watching that, still not acting. Normally, if you see a potential demand shock and the soft data, which is what we're seeing, weaken, but the hard data is still hanging in there, you might start thinking if you didn't have an inflation issue, you might think about taking some action.

19:34But the The Fed does have an inflation issue. And so I think you'll see the Fed, as we said, be more reactive until you're clearly seeing evidence that there is a slowing and you're going to want to see it, the Fed, to act more than just an inching up in the unemployment rate. You start seeing a much more dramatic move up. And then you're going to realize that we could be entering into a demand shock, which would actually be disinflationary, which might offset part of this supply shock. And that's where you'd see the Fed be more willing to act. But it's going to be at least a period of time. It's not the May meeting.

20:17I think they're going to watch it very carefully. And I think the soonest you might see that materialize would be into June and over the summer. The only other thing I'll mention that I'd be watching for very carefully at the Fed is you want to make sure there's orderly market function and particularly quarterly treasury market function. And again, as long as that's the case, I think the Fed will watch all these things I just said, but be patient. And they're going to want to see real hard evidence of the slowing before they took an action. And the reason is they don't want to jump. The tariff situation gets resolved.

20:54And in the aftermath, we still have an inflation issue and they regret that they've jumped into it and cut the rate. I think they're going to need to be more reactive, which does mean that by the time they move, you know, normally say they're going to be on, maybe you could be accused of being late, but I think they're willing to take that risk. Let's pivot a little bit. Tracy wrote about something last week, or maybe it was two weeks ago. My brain is getting fried, so I don't have any concept of time anymore. Time is a flat circle for Joe. The Dallas Fed's energy survey, which I think comes out quarterly, unlike the manufacturing service.

21:32It's just unbelievable stuff in there. And this is from an industry which we all know tends to be, you know, probably pretty sympathetic to the current administration politically. They're talking about uncertainty like they've never seen. They've talked about the increased cost of all of their parts for drilling. Right. I mean, it was like kind of apocalyptic. And that was actually before the last week and a half. One of the things in Besant's 333 plan was getting 3 million more barrels of oil drilled and expanding energy dominance. Meanwhile, WTI just falling to its lowest level in four years, in part because OPEC is turning on the gushers, in part because of these recession firms.

22:10Tell us what's going on down there in the energy patch. So we started the Dallas Fed Energy Survey when I was running the Dallas Fed, and we did it particularly for this reason. We wanted to get a grip on what were breakeven levels. At what levels are you profitable? At what prices are you more likely to drill? And what we're seeing is the following. Four years ago, when the industry heard drill, baby, drill, they were very excited about that. I think over the last three or four years, they have been drilling subject to cash flow. They've been pressured by shareholders to return more capital. And costs to drill have gone up, and tariffs will increase costs to drill more.

22:56And so the industry will drill at one level if the price is$80, but it's going to drill at a lower level, all things being equal, if prices get into 50s or 60s. And so I think we may well find over this next year that actually the level of drilling activity doesn't increase. and I think people who are drilling are going to be more careful, particularly as the prices come down. You see OPEC. I think the U.S. may have more success pressuring OPEC and Saudi Arabia to produce more. And we will in this country make it easier to permit a refiner. We'll make it easier to build transmission. So I think the price will come down, is coming down, and may stay down, But it may not be because of more U.S.

23:43drilling. It may be because of demand falling off because of concern about tariffs and also because OPEC actually producing more, probably under some influence from the Trump administration. Hmm. I'm looking at a chart of the Baker Hughes oil and gas rig count right now, and it's kind of funny, I guess. We'll take what we can get nowadays. But it went up in 2021 and 2022 quite a lot under the Biden administration. And since, I guess, for most of 2024, it's kind of been flatlining. And in fact, Joe, the energy survey that I wrote up, I think the headline on our newsletter was instead of drill, baby, drill, it was nil, baby, nil, right?

24:26Because there's no new oil and gas rigs actually getting built and not much more production coming on stream. That's right. And you're seeing the reason for that trend you just described is prices were higher in 21 and 22. That led to more drilling. as prices moderate and they're actually lowering now, I think you'll see more tepid activity, as you just described. And in terms of your experience at the Dallas Fed, I wanted to ask you because you were there, I think it was 15 through 21. Thank you. Thank you for doing my research for me. But that that included 2018 when we saw the tariffs under the first Trump presidency.

25:08That's right. What was your experience like then and what lessons or surprises did you encounter at that time? So Texas is a very large exporting state and we did an enormous amount of work at the Dallas Fed on the impact of tariffs. And I probably in those years read every tariff paper that I could get my hands on. And what we concluded, me and my team concluded, is tariffs could have some price impact, but the biggest impact we saw of tariffs is of the potential of they had to slow growth. And so as a result of it, you may remember back in 18 and 19, I said, I think we should be more proactive here, lower rates, and that if you wait to see the weakness in GDP and employment, you've waited too late.

26:00And the thing is, I had the luxury of being able to argue that in those years because we did not have an inflation issue. All right. So clearly there is a lot going on, some of it in many ways very unprecedented. What are you looking out for next in terms of not just the impact on the Fed and how this might influence their immediate monetary policy path, but also in terms of the sort of big structural trends of the global macro economy, of geopolitics, you name it? Yes. So they're including tariffs. There are five big structural changes going on right now. We've already hit on them. Number one is we are attempting to reduce fiscal spending with the desire, and obviously it's been somewhat at risk of stating the obvious, it's been jarring, but with the desire to try to reduce the current 6.5%, 7 % of GDP deficit to something lower than that.

26:59We've gone from 2019 to today, debt to GDP in the United States net approximately in the mid-70s to over 100%. And so first structural change has tried to have an economy that is less fiscal spending-led and more private sector-led. That's number one. Fiscal spending reductions, though, slow growth, might in fact be disinflationary, but that's the first one. Second one is regulatory review in every industry with the ambition of improving productivity growth. In an aging country that is highly leveraged, the X factor that can help you deleverage is productivity growth. The issue with regulatory review is they'll take some time for that to translate into greater growth.

27:50And that's the issue. It'll be a time lag. Third big change, which we've talked about, is I would say a restructuring of the energy ecosystem, encouraging drillers here we just talked about to drill, although they're going to be more reluctant, but then encouraging Saudi Arabia and others to produce more. And additional be easier to permit a refinery, easier to create transmission. And the idea is to help low, moderate income families here visibly who've lost 25 percent plus purchasing power to allow them to pay a lower price at the pump and for power. The fourth big one is two big drivers of U.S.

28:32excess GDP over the last three or four years. One, I would argue, was excess fiscal spending. And then the second was immigration and labor force surges due to some percentage of undocumented immigrants entering the workforce. That obviously has ended. Workforce growth will decline this year from previous years. And there are millions of undocumented immigrants in the country who are uncertain of their status and they make up half the construction workforce in a state like Texas. They make up a chunk of the agricultural workforce and other workers in the service sector. And what I'm hearing from employers is some number of those workers are not showing up at work because they're concerned about an ice raid and they're concerned about their status.