¶ Intro / Opening
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Hello and welcome to another episode of the Odd Laws podcast.
I'm Jill Wassenthal and I'm Tracy Alloway.
Today you are listening to a special episode of the podcast. It was recorded live at the future Proof conference in Huntington Beach.
Yep, we're going to be speaking with former Dallas FED president Robert Kaplan. He is now vice chairman of Goldman Sachs. Again, this was recorded live on stage at future Proof. So take a listen.
All right, let's just kick it straight off that jobs report that we got last week. In your view with your FED hat on, maybe is a fifty basis point rate cut in play for the next meeting.
I think fifty basis points is still unlikely. I think we've been of the view for the last few months the job market was weak.
This latest report was a little weaker.
Having said that, the reason twenty five is more likely than fifty is it wasn't The jobs market is not.
Falling off a cliff.
We didn't get shrinkage, and inflation is running at two and three quarters to three percent above target, and so it sort of puts a little bit of a headwind on doing more than twenty five basis points.
I mean, I take your point, but the report was still a huge surprise. So if you were in the newsroom when that number came out, just twenty two thousand jobs added, there was a sort of collective gas because it was way below basically the entire range of expectations for that particular month. If you're at the FED and you see a number like that, what does twenty two thousand actually tell you? Or are you sitting there going well, maybe I'll wait for the revision until I really make up my mind.
I don't know that the weakness and the jobs market was a big surprise to the Fed. They didn't know exactly what the number would be, but they expected to be anemic. The reason that the unemployment rate is stayed low is we are not we've shut down undocumented immigration.
¶ Fed Rate Cuts, Labor Market, and Restrictive Policy
We have not ramped up legal immigration, and as you well know, we are deporting some number of workers and chilling ten to fifteen million undocumented immigrants who were in the workforce, and some percentage of them are not going to work, and so supply is anemic. We've thought for the last few months that hiring was kind of we.
Said at stall speed. You should assume if GDP.
Growth is one a quarter one and a half percent, hiring is going to be anemic. So we could debate the number, but I don't think it was a big shock that it was weak, and I think it wouldn't surprise me to see the next number also lethargic.
So why aren't we falling off a cliff.
We still are running a large deficit, we have tax and sofs coming, We're in the middle of an AI data center power boom, as you just heard about in the previous session, and I think that's still bolsterining the economy.
Well, then let me take the flip side of Tracy's question, because, okay, maybe setting aside reasons for concern, the flip side, as you mentioned, inflation is still running above target by most measures. The stock market I haven't actually I don't know what it's doing today, but it's very close to all time highs. Regardless of what it's doing today, all kinds of people are having a really nice time on the beach in southern California. What is the evidence that, as currently standing,
that FED policy is actually restrictive? Clearly the FOMAC has come around to this view of cuts, it seems like cuts are locked in, but you don't have to have the FOMAC I view anymore. Like, is it obvious that cuts are needed at this point?
Yeah.
I think if it were not for the weakness that we've seen in the labor market, the FED would want to stand pat because we are It's one thing to be above your inflation target. We're not moving toward the inflation target right, We're going sideways to backing up. But with this week labor market, I think it brings the fact you need to cut into play. Now, what's the neutral rate? I think the neutral rate today you got
a two and three quarters percent inflation rate. Seventy five basis point real FED funds rate means the neutral rate to me is around three and a half percent.
We don't have a lot.
Of space to cut to get to neutral, but I think you've got seventy five to one hundred base points. I think the goal of the Fed will be cut in September, stay restrictive, and if the labor market stays, we keep going. If it stabilizes, then then you have the option to hold off, and I think that's what they'll do.
Just going back to financial conditions and stock markets at all time highs. I mean, if the FED cuts at this current juncture, you know, call it an insurance cut or whatever. But if the economy reaccelerates after that, which it may, Yeah, which it may, would you be worried about that side of the outcome, given that, as you said, inflationary pressures seem to be going sideways too, possibly up.
Yeah.
So a lot of people look at financial conditions and see it as a reason the Fed shouldn't act. I actually come at it from someplace different. The economic statistics are reflective of.
What's going on right now.
In fact, even more than that what has gone on, not even what's going on right now. The stock market and other financial markets are a assessment of what's going to happen for the next three to five years. As we know, we're in the middle and the early innings of an AI data center power boom. I don't think it's showing up yet in a lot of productivity, but I think a year or two from now it will.
The stock market, rightly or wrongly, I think is making that bet.
It's betting that productivity is going to improve, corporate earnings are going to get better. You're not seeing a show up in the current economy. The Fed's job is to look at financial conditions, but adjust policy based on the current economy, not the bet the market's making for two or three years.
I'm glad you brought that up about the AI boom, the powers, the data center boom, and so forth, and
¶ AI's Economic Impact, Power Grid Strain, and Fed Dilemmas
that it's not showing up yet in productivity, but it may be showing up in greater strain on the grid.
It may be showing up in greater strain.
On certain electrical gear that's necessary that's been in shortage for all manufacturers for years now. As of right now in September twenty twenty five, could we say that, if anything, the AI boom is like sort of having a crowding out effect or slightly inflationary where the costs right now just on a static stent setting aside the bet, are a bit of a drag.
There are two big structural initiatives that are being pursued by this administration. One is regulatory view and regulatory relief because they want to ease the speeding to adoption of AI and get more capital available. But the second thing is there's an extensive re review of the power grid. We are behind China in having enough power to fund.
The AI explosion.
We've got to invest more in geothermal, more modular nuclear. We need to make it easier to run a refinery, make it easier to do transmission. And I think you're going to find there's going to be enormous efforts because we are behind, and in some states, to your point, there is a crowding out and I think people are afraid. At some states, the leaders are afraid to take more data centers for fear it's going to crowd out individuals.
So this is a big structural initiative that isn't getting in the press a lot, but it's a big initiative going on in this country.
That's a dramatic change and it's needed.
What does that actually mean for FED policy? Because if I think about this crowding out idea and all the demand for databases and the things that power them, we have seen electricity prices start to go up. I know the FED, the fed's preferred inflation measure is x energy and food prices. But on the other hand, electricity prices feed into the cost of pretty much everything. And also this doesn't seem like a bottleneck that we're going to be solving, you know, within the next two or three years,
or even ten years. To be frank, if you're at the FED right now and you see electricity prices going up, how are you thinking through that pressure?
So let me put it in context. There are cross currents, I mean real cross currents.
You just mentioned one.
On the one hand, you've got the government is trying to reduce government directed spending and replace it with more incentives, tax incentives. Obviously the tariffs have been put in place. Those are slowing growth and they have a tendency to raise costs they might be one time. And the labor force I just mentioned, we are actually decelerating and reducing labor force growth because of immigration policy. That's actually helping us be at full employment, and the Fed's been taken
by that, but also makes prices stickier, wages stickier. At the same time, you just said, you've got these booms and AI and the grid, and you've got don't we need more labor, we need more power and that.
Actually stresses prices.
So when you're at the FED, when you've got this kind of confusion, I think that's one reason why they've done nothing so far this year. But I think the labor market is forcing their hand where if it gets even weaker, they really don't want that, and that's why they're acting.
Let's talk about AI and China a little bit more. You mentioned the power element, and there are a lot of people anxious about the constraints on the US grid and you all these big CAPEX numbers and can the great even support that? What else is different besides the electricity component, because some people we've talked to you talk about there is a very different attitude towards detech diffusion, particularly out of China or supply chains that run through China.
So uh, and I just got back from Asia and I was in China last week. When we talk about AI, we tend to look at the hyperscalers, these big giant companies that make up a disproportionate share of the S and P five hundred, and they're spending hundreds of billions of dollars.
They're making a lot of money. When I'm in China.
And we talk about it about AI, they talk about the word used diffusion. They talk about regular businesses, the McDonald's of China, Luke and Coffee in China.
Ray, you look them in New York City right now, and I tried one and it's very good.
Yes, but those companies are actively using AI to lower costs. So why is that happening. I'd say we're further along. China's further along than we are. Why their margins are lower. They're doing it out of necessity. Our margins in the US and our companies are higher, and so they're not as much pressure to lower costs and make AI experiments. In China, they don't have a choice. It's so competitive
they need to lower costs. But the thing that struck me there's a lot to learn from what they're doing in China. Normally, if we were a little more globally integrated, we would learn those things and bring those learnings back to the United States. And it reminded me that globalization is not dead. United States is choosing to play a different role in it and stepping back. But I got to tell you, the other thing I saw there is there's more coupling going on between China and other countries
that are aggressively. Canada is much more aggressive in trying to form new partnerships. So I think globalization and the Ai story go together. And I got to tell you, globalization not going away, and the US is going to have a choice in the years to come how much of a role we want to play in participating.
But it's going to happen with us or without us.
So we can sit here and ask you what you saw in China and what your thoughts were about China. But I am very aware that when you go on that type of trip, you have Chinese clients who are asking you your thoughts on the US and what's going on here. What are the type of questions that you're getting from Chinese clients at the moment, what are they interested in?
So the biggest item i'd say of discussion is and I used to be in Asia for the first part of my career and what I found in Korea, Taiwan, China, to a large extent, their whole effort was to go from low value added manufacturing to high value added manufacturing. And they try to wean off of lower value added manufacturer. What's an example. T shirts and sneakers used to be
made in China. Today they're made in Vietnam. Why China wants to move up the value chain because their feeling is they're going to raise the standard of living.
To higher value added manufacturing.
The question sometimes I get when I'm over there is if you're going to reshore to the United States, are you going to really reshore lumber, aluminum, some of these other lower value added manufacturing wouldn't. Solidifying the relationship with Canada and Mexico makes sense where you can get cheap
¶ AI Diffusion, Globalization, and US Trade Policy
natural resources from Canada, cheap labor from Mexico, and solidify North America. And so I'd say that they're not critical of us, but they're scratching their heads a little bit to say, what's the strategic rational Because you're tied on labor, you normally want to move up the value chain. And I think they realize that some of these tariffs are also intended to help generate revenue and reduce the deficit. They understand that, they're just questioning how strategic it is.
Well, let me ask you a question of the on the question of what are we going to bring back in the United States, if anything, just from your purge at Goldman, do you see any private money that's come into the US for fresh sort of I don't know Greenfield capital investment either in something low margin or high margin because the terriffs have changed the math and made that investment economical.
So I will say there, yes is the answer. I think there are US companies that will do more on the margin manufacturing here. I've talked to overseas companies, including I won't mention the name of one contract manufacturer in China. They are building more in the United States, and so the thing is, I don't know how long it will take, what the magnitude will be, but yes, it is happening. The flip side of that is there are many companies
in the US that benefited from access to lower cost goods. Yeah, and I won't mention their name that you can you know some of them and their margins are being squeezed. And then I talked to a number of small businesses that don't have the levers to manage these tariffs, and some of them will actually go out of business or considering it by the end of the year.
This is a little bit of an unfair question, but I'm going to ask it anyway. If you had to, if you have to choose one right now, would you say that tariffs are more effective at bringing back manufacturing to the US, or more effective at raising income for the US government at a time when people are worried about the deficit.
I think they'll start with the second part. Tariffs raise revenue, but they slow growth, and so for every dollar of tariff revenue you have to accept, you may give some back in a little bit lower growth. I think that trade is very much worth it if you're bringing back high value added manufacturing. I don't know if it's such a good trade if you are pushing to bring back lower value added I think this administration knows that, and I think they'll be more strategic.
I think you can do both.
I think you could level the playing field, get a more tariff revenue. With some level of tariff revenue, I think we were thinking they were going to be closer to ten percent than twenty percent. You mean the high teens is a little higher than we expected. And you can also yes on semiconduct in other strategic areas, you can redomicile those. I think the question is you sure you want to go down the road of lumber and aluminum or do you want to let Canada do it?
Is that a good strategic trade? I'm not sure.
Since you mentioned it.
Why is the neutral rate of interest to the extent that we can form some educated guess as to what it is. Why is it so much higher than it was in say twenty nineteen in your view.
So the fact of the matter is, I think if you go way back in the Stone Age to twenty nineteen, and.
It does seem like forever ago.
It does.
I think if we had not had COVID, I think at the right before COVID hit, the ten year treasury I think was in the neighborhood of maybe one in three quarters to two, the Fed funds rate was in the mid ones.
I think we would have inched our way up a little.
Hard know how good we had all those people complaining, oh, yields are so low, and then now they all wish they could go back there.
Yeah, Listen, the inflation rate today is stickier. Back in nineteen it was probably one and a half one and three quarters. I still think even then the neutral rate real rate was three quarters of one percent. So the neutral Fed funds rate back then I think was two and a half ish. Today it's closer to three and a half. But there's only one reason for that. The inflation rates higher. If inflation got back down to two. I think you'd see the neutral rate back down to two and three quarters.
Since you mentioned sticky inflation. There's one other thing that seems to be top of mind at the moment, which is federal reserve independence, and we should talk about that. But I guess we can get your thoughts on you know, that specific idea in a second. But one thing that seems surprising so far is that we're having this debate about what happens to the federal reserve with what seems to be a more activist Trump administration that seems to want to have a heavier hand in monetary policy. We
haven't really seen much response from the market. If you look at the long end, it doesn't seem like there's a big risk premium building there. What's going on?
So's make two comments.
So regarding political independence, let me just make sure I frame this regulatory policy at the FED is not, underline, not politically independent. It hasn't been for a number of years. What do I mean by that? You get a new president, they pick a new head of supervision, and it's very much has been influenced for the last many years by whoever's in office. The balance sheet I would argue, is maybe a little bit in the gray air on setting
the FED funds rate. Though the Fed has been politically independent. Why is the market, you said, well, not reacting more to this.
I mean, the.
Reality is the stock market likes the idea of lower rates. I think the thing, it's not that the markets aren't reacting. The stock market likes it. So it's starting now to take into account. It makes the real acceleration you talked about more likely. The gold market is very much taken note of it, and gold is up more than thirty
five percent year to DA eight. I see it's up another one percent today, So it has and I actually think duration on the long bond while while the tenure is rallied because of slow growth, I still think we have an issue. We've got thirty seven trillion of debt to sell on our way to forty trillion. I think that the bond market may pay at the long end. We'll pay attention to how this current situation works out.
What is going on?
How much more gold talk is there these days than there were a few years ago.
Well, I actually I've gone back over look back over the last fifty years. When's the last time we got
¶ Neutral Rate, Fed Independence, and National Debt
a rally in gold like this, I think in the aftermath of the Great Recession. Remember the Great Recession, the FED took its balance sheet from eight hundred billion to four trillion, okay, and stopped and we started to run it down a little bit. In response to COVID, we went from four trillion to nine trillion, and we authorized six trillion dollars of extraordinary spending in a twenty seven
trillion dollar economy. And the GDP, the net debt to GDP went from mid seventies to over one hundred percent. When you've got leverage in the United States and to some extent in the developed world getting much higher in response to COVID. That's where people started to look at gold, bitcoin, other alternatives to paper currency because they're worried that this leveraging is just keeping going on and on and on, and so it's understandable.
Wait is it, though, Because one of the weird tensions of our current market situation is we have US stocks at all time highs, but also gold making new records almost every week. It feels like those two things are incompatible, at least in the long run. You know, maybe we could do it for a few weeks or a few months. But someone's got to be wrong here.
I spent a lot of time talking to big institutions and about asset allocation. I think, and this is our view. Also, we think there could be a re acceleration into twenty six. We think the AI boom is for real. We think we're going to get.
A lot of productivity out of AI. Okay, that is a.
Good environment for corporate earnings and for stocks. What we don't know is how successful we're going to be on bending the curve of.
Debt to GDP.
Are we going to run another two trillion dollar deficit even with tariffs?
Is it going to be higher?
And in that regard, I think people can buy stocks and buy gold and be very careful about buying the tenure and the thirty year treasury.
And I think that's kind of what we're seeing.
Actually, I want to go back to your point about sort of globalization is happening with US or without US. There's a different approach to AI diffusion out of China than there is in US. But when you go around the world, are the American providers of tech, whether it's cloud tech or whether it's Microsoft et cetera. Are they still are they gonna win? Even if the US isn't
part of that globalization wave? Will US tech still be part of the story because so much is rioting on the ongoing earnings power of seven companies.
So I'll make a general comment about US companies. Generally, a typical CEO in the United States that runs a global company has probably been to Europe in their careers seventy five times or more, and has been to Asia seventy five times, has been to China multiple times, has built relationships, and has been doing it for years. And I think that's true of tech, no doubt. Many of
the tech leaders you see are overseas regularly. Our political leaders and some of our leaders in certain governmental positions maybe have not been to China or overseas quite as much. And that's why you see during periods like this, the corporate world is continuing to chug along and build relationships globally, even though at national level we're sort of reorienting and trying to bring more to the United States and affect deglobalized.
So we've got a kind of a diachademy, and it stands in sharp relief this is the same way even a years ago where we withdrew from the Paris Climate Accord, and yet companies in the United States, to my eye, did not slow down at all in trying to build LEAD certified buildings and focus on greenhouse gas emissions and sustainability.
You talked earlier about the difference between how China and the US the corporate sphere is actually using AI. When you're looking at the US and you're looking for signs that AI is actually having a definitive needle moving impact on US productivity, what are you looking for here?
What are the signs I'm looking for adoption in a broad set of industries, because here's here's how this works. First, your company gets you to try it okay, and you adopt it. Second thing you try is various use cases based on that adoption, and then third thing you figure out which use cases work and which use cases don't work. We're kind of in that phase right now in the United States. When I say China's a little farther ahead, I think they've already tried and proven some of the use cases.
In more industry.
We'll get there too, But you'll know when we look back ten years from now.
My guess is maybe not as fast as other parts of the world.
We will have gone through all that, we'll know which use cases work, which don't, will adopt them.
We're going to get a lot more efficiencies.
There may be as many or more jobs, but they're going to shift and we're going to have to redeploy people to where the open jobs are. But we have to go through that whole cycle. And I would say we're early. We're early in that.
We just have a couple of minutes left. Here's something that's been on my mind a little bit lately that I would like your take on. How levered to the stock market is the real US economy? How much when you look around does it feel like things are dependent on these companies continuing to deliver year after year and positive asset returns.
So that's a great question.
So I would say the US is seventy five percent a serve economy. It is a very heavily consumer driven economy. This which makes our economy different from many in the world. And if you break down the consumer here, half the workers in this country, let's take an eighty eighty five million make fifty thousand dollars a year are unlikely to have financial assets, have lost twenty five percent plus purchasing power, and they're struggling to make ends meet. They're spending every
dollar they make. But if you're a business that serves them, you're seeing they're being very careful. There's another eighty eighty five million consumers tend to be I'm exaggerate, I'm generalizing fifty five and older own their home, half financial assets, and they've made a lot of money in the markets, to your point, and they're spending because they're getting wealthier.
And we've got a tale of two consumer groups. I think part of what this administration, I believe, is trying to do is help lift up this first group so that they can be more affluent and do better because right now we're very heavily dependent on this second engine based on the stock market.
All right, I'm going to sneak in one more question and go back to where we started this conversation, which is on rate cuts. I know you said a fifty basis point probably not on the table, but your your gut instinct, is this going to be the start of a rate cycle, a rate cut cycle that goes into the next year twenty twenty six or is this something that you know, maybe you got one rate cut, maybe you get two rate cuts, but it's not going to go on for much longer than that.
I think it will be. If it's a cycle, it's going to be a halting cycle. What do I mean by that cut twenty five in September? I think that's going to happen. Wipe the sleigh clean for the next six weeks. FED meets every six weeks. Wipe the sleigh clean. Make sure that you're can then still the labor market is weak, check inflation. If it's continued to be weak and inflation at least moderate, you may do another one.
Uh.
The issue I'm pointing out is I don't think we have more room to get to neutral than seventy five to one hundred basis points. So might we wind up doing two or three this year? Maybe are we going to wind up doing one hundred and fifty two hundred base points? It means you would want you would have to decide which I don't see a justification for running
¶ Globalization, AI Productivity, and Consumer Economy
a very stimulative monetary policy. And I think the FED as it's currently configured will be enormously reluctant to be below restrictive or modestly restrictive as long as inflation's running above target.
Rob Kaplan, thank you so much for doing this a lot.
Thank you so much.
So.
That was our episode with Robert Capel and recorded live on stage at the future Proof Conference. I'm Tracy Alloway and you can follow me at Tracy Alloway and.
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