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Dallas Fed chief optimistic on US, sees trade-offs for Japan

Dallas Fed chief Robert Kaplan

WASHINGTON -- The president and CEO of the Federal Reserve Bank of Dallas, one of the 12 regional Fed banks in the U.S., was relatively upbeat about U.S. economic growth when he sat down for a recent interview with The Nikkei.

But Robert Kaplan was less optimistic when discussing Japan's economic future, saying the country will eventually have to make some trade-offs.

Before taking his current job, Kaplan was a senior associate dean at Harvard Business School and a vice chairman for Goldman Sachs Group.

The interview was edited for brevity and clarity.

Q: What do you think about the condition of the U.S. economy, and what is your outlook for it?

A: Our main point on the U.S. economy is we still believe the consumer is going to remain strong in 2016. Household balance sheets have improved since the Great Recession. The job market -- employment market -- is strong. And so, all that should be a good underpinning for the consumer.

Our own view is by the time the year is over, [gross domestic product] growth will be something below 2% but approximately 2%. That would be a rebound from the first half.

The only comment I would make on the second quarter is there were some bright spots. Final demand was a bright spot. On the other hand, inventory investment was a negative.

There's no getting around the fact that U.S. growth is sluggish by historical standards. But when it's all said and done for 2016, I think it will look better by year-end than it does now. We think the third quarter will be stronger, No. 1. And, No. 2, we think it will be sufficient to continue to cause improvement in the labor market.

We look heavily here at Dallas at what we call the Dallas Trimmed Mean, which is a measure of core inflation. And by that measure, we're seeing gradual improvement, so it gives us some confidence that over the medium term, over the next two or three years, we'll slowly make some progress. But there's no getting around the fact that many forces in the world are deflationary, not inflationary.

Q: What effects will Brexit have in the short and long terms?

A: The short-term impact of Brexit ... we're worried about financial market turmoil, flight to quality, a strengthening dollar, those issues.

But on balance, I'd say [it will] probably increase the flight to quality, maybe a little lower 10-year yield, maybe a little stronger dollar than we would have had.

And then the longer-run issue is we expect there'll be somewhat weaker GDP in [the] U.K. that we'll see over the next year or two, [and] to a lesser extent in Europe. ... And we think the impact on the United States will be marginal, very manageable.

The other impact we're looking for and watching, which I don't think is likely but we have to be aware of it, is there are going to be further contagions. I don't think that's likely but I think we just have to be ... alert to it. If that were to happen, that might have some further negative ripple effects.

But if it's just the financial rebalancing in the U.K. and Europe ... it's manageable. The biggest negative will be in U.K., and we just don't know how much. That's why the Bank of England has done what they've done. But we think from a U.S. point of view and the world point of view, it will be manageable.

Q: Why do you think the U.S. economy continues to be slow so long after the 2008 financial crisis?

A: No. 1, we've had to deleverage since the crisis. And when I say deleverage, the household sector in the United States has had to deleverage. The financial sector has had to deleverage.

And by definition, if household is the bulk of this economy and they're very careful what they spend because they're trying to deleverage, that creates a headwind for GDP growth.

The good news is we're now eight years through that, so I think household balance sheets are in much better shape and the ability now to spend is much better. But we had to go through several years of deleveraging where households had to be very careful to sort of make sure their debt-to-GDP, debt-to-income was more manageable. So that was one headwind.

The second headwind is demographic. We're an aging population, and so, all things being equal, the labor force participation rate [declines]. We think some of the decline has been demographic.

But I actually think ... if you go back five or six or seven years ... I think the deleveraging, particularly of the household sector, was probably the primary factor and demographics were a secondary factor. If you sit here today, in terms of future growth, the bigger issue is demographics.

But the only other thing I'd mention is we had good growth outside the United States after the crisis, and that helped. So we were growing slowly but we had a little tailwind. We don't really have that tailwind now.

Q: The Federal Reserve released an economic outlook in June predicting two interest rate hikes this year. Is that reasonable to you now?

A: I think it is wise for me to not speculate on the number of rate increases or timing. I've found it's just not productive.

So let me ... answer you in a different way. What you see from the [Summary of Economic Projections] is expectations of growth are slowing, and you saw in the SEP that the expected number of rate hikes declined. So my view is the following:

We're making some progress. If we can grow at a little less than 2% this year, we should make some continued progress on unemployment ... and I hope we'll make continued modest progress on inflation or slow progress and be more optimistic about the medium term.

If we continue on that way, I believe that removal of some amount of accommodation is appropriate, yes. I'm probably going to avoid speculating on how much accommodation and the timing. And the reason I'm going to do that is ... as we see more data and we get more information, that will affect the timing and the magnitude.

But I believe we're approaching ... a point at which removing some amount of accommodation will be appropriate.

The other issue is ... the neutral rate. The neutral rate has declined over the last several years, which means that the Fed is not as accommodative as some people may think.

And so, while I think it's appropriate -- it will be appropriate that we remove some of that accommodation and that we move toward a more neutral stance in the future -- we're not as far away from the neutral stance as people think we are.

Q: As for the Fed's monetary policy, September is still a live meeting?

A: Well, I would actually say every Fed meeting is a live meeting, so seriously. I know some people, you know, comment to varying degrees, but, yeah, so every meeting is a live meeting.

Q: In terms of timing, it's a crucial meeting?

A: Again, I'm not going to speculate on timing of the meetings or calendar or size or anything like that. I would just say the following: We'll be watching -- I'll be watching very closely the next jobs report and looking for evidence that is consistent with my -- our -- forecast that GDP growth in the third quarter is going to bounce back, that we're going to make progress on our full employment objective and some evidence that ... over the medium term, that we can make progress on our inflation objective.

And, as we see that progress, I think it will be appropriate to remove some amount of accommodation. I just don't want to speculate publicly on the exact timing or magnitude of how we do that.

Q: The markets seem to think an interest rate hike is unlikely this year.

A: I have been in the markets myself for the past 30 years ... [I've found the] markets' expectations will change extremely quickly, based on what's happening in the economy.

It's good to watch what the markets say and pay attention to it, but I wouldn't over-read it because it's going to change. And I certainly wouldn't be guided by it. I think market expectations about what we might do are going to be quite fluid. So I wouldn't over-read or overreact to those market expectations, other than it's good to pay attention to them.

Q: You mentioned the neutral rate, a point at which a central bank's policy rate neither accelerates economic growth nor hinders it. That rate has declined in the U.S., Japan and other advanced economies. Why do you think this is happening?

A: Lower expectations of future growth. In my view, [this] is driven by a number of factors, but one of them is demographic. Every advanced economy, and Japan is a good example, is facing this aging population issue, which, unless there's a burst of productivity, it has the impact of slowing potential GDP growth. So that's one big factor that's been driving down the neutral rate.

The second big factor, among others, is there is a growing demand for safe assets globally. Some may call it a flight to quality but there's a demand for safe assets, and that drives down the neutral rate.

Some of that may be demographic, by the way ... the demographic bulge where savings rates are very high and so there's a great demand for financial assets. But we may be at a very strong level of that right now. So that's a second thing.

But whatever the reasons are, there's no question the neutral rate is trending down, and we have to think about that at the Fed because it helps us understand ... what progress are we making on unemployment? What progress are we making on inflation? And how accommodative are we? That's a third big question we always have to answer.

Q: It's maybe a tough question ...

A: Always a hard question because it's a theoretical question. There's not a public neutral rate that we get to read about in the newspaper. You can look at the 10-year Treasury or where the [Japanese government bond] trades, you won't find a neutral on the screen. We have to make ... a judgment. We infer it. We infer it based on lots of other data, but it's a judgment we still have to be thinking about.

Japan is highly leveraged, the United States is highly leveraged. And when you're highly leveraged, you're going to be very careful about doing things that would increase your debt-to-GDP.

Having said all that, I do believe there's a key role for monetary policy, but we need structural reform and fiscal policy in addition to deal with this very low growth regime that we're in.

Q: Japan has struggled to find a way out of such low growth and deflation. What do you think about the best method to overcome this?

A: So you know, I lived in Japan for five years. The logical thing you would say is Japan needs population growth. [And] if Japan doesn't get population growth, I think that's going to be a big challenge. So then it's a question of can you increase productivity in Japan? Can you do some type of debt restructuring, which gets the debt-to-GDP at a more manageable level?

But I don't think there's a lot of great examples. It's challenging if you have a declining population. ... Living in Tokyo, [people have to deal with] cramped spaces, long commutes, very expensive real estate. So how do you deal with this? How can you grow?

I assume culturally people are reticent to have more children, and culturally it's not easy to have an influx of immigration. And I know you've tried to get more women into the workforce as a way to deal with this. But I think there's no getting around the national discussion on these issues.

Because if you decide you're not going to do something on population, I think that the next issue is how do you deal with the growing debt and [the] retirement, health obligations. There has to be some way to deal with that. It will require trade-offs.

This is why I've said Japan is a good example of [how] monetary policy can play a role but ultimately these fundamental issues would need to be addressed by policies other than monetary policy.

And that's true [in the U.S.], too, and it's true in other advanced economies. There's a role for monetary policy ... but there's a role for structural reform and other policies [if we are] to reach our potential.

Q: How do you assess the Bank of Japan's negative interest rate policy?

A: The concern I have on negative rates -- again, these are tough; it's a trade-off, tough decisions -- is the negative effect it can have on the financial industry. If you have short-term borrowing, money market industry it has a negative effect on the financial system. You need a healthy financial system to grow as a country.

So I guess it's another good example where I understand why it was done and I know the currency has since appreciated, which is not what you were hoping for, but I think there are other factors at play.

But I think it reinforces to me that you need other fiscal policies and other structural policies to address these issues and that monetary policy alone cannot bear the entire burden of addressing these issues.

Q: Toyota Motor has decided to move its North American headquarters to Dallas, Texas, and many other Japanese companies have set up shop there. How do you think their presence is affecting the regional economy?

A: I mean, it's great. And, you know, the story of Texas and the 11th [Federal Reserve] District, broadly, is migration. So Toyota is in good company in that there's lots of companies and people coming here. Why? Central location. Business friendly. Regulatory climate, tax climate. Weather, maybe ... but lots of reasons. And so, I think people have been very welcoming and excited for Toyota to be here, and the fact Toyota is here -- you know, the Burlington Santa Fe Railroad after their merger came here, Amazon has built a distribution center here ... -- it's sort of the more these things happen, the more I think it encourages other people to do the same thing.

And so, I'm very optimistic about the future of this region and the state for ... many years because of this strong migration trend.

A couple of the challenges for the region have been energy and the strong dollar, but I think my guess is in 2016 we'll maybe see the worst of the energy downturn, and I'm getting more optimistic that in '17, '18 and '19, as the global oil supply demand gets into balance in '17, early '17, we'll see a little [firming of] prices, maybe slow increases ... and it won't be the headwind for Texas that it has been in '15 and '16. So I'm relatively optimistic in general about the state and the district as the headwinds from energy and a strong dollar start to stabilize, to dissipate.

Obviously, low energy prices in this country ... helped consumers, but the negative has been GDP: Energy was 13% of GDP in 2014. It's down to 6% today. That's a devastating decline. You can't get around that. That's painful. So the impressive thing is that the state continues to still -- that it's grown at all, even though slowly, but I don't expect the energy industry to shrink much further as a percentage of GDP, and I think in the years ahead maybe it will slowly recover.

Interviewed by Nikkei staff writer Takeshi Kawanami

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