Dallas Fed President Robert Kaplan spoke with The Wall Street Journal reporters and editors in Washington on Tuesday, July 16, 2019. He discussed his outlook for the economy and interest rates in an environment of heightened policy uncertainty. Here is a partial transcript of the interview, lightly edited for clarity and length.

WSJ: What has changed for you in the outlook since May 1?

ROBERT KAPLAN: So I'll back up a little bit. For those who follow what I've been saying, all through 2018 we've been saying at the Dallas Fed, growth was going to slow in 2019, all through the year. And the reason primarily we said that is fiscal stimulus was going to wane, and it is waning. And if you asked me on April 30, a little bit of the surprise so far in the year for me was growth was stronger, actually, than I might have expected.

Then you had the situation with China, which had some effect. But the thing that I think, talking to businesses, which I do regularly, extensively -- the thing that had a significant effect was the threatened tariffs on Mexico. And I have lots and lots of businesses in my district who basically took me through -- they literally said, let me tell you the dollar cost to our business of this if this were to happen, and I was surprised -- substantial in terms of logistics, supply chains, increased costs. Even though it didn't happen, though, the threat of it and the significance of that -- I had thought it might dissipate more. It hasn't dissipated that much in that most businesses I talk to regularly are basically saying to me, I think trade uncertainties is just going to be a feature of the outlook. And even though there are trade deals, most of them say we thought (the United States-Mexico-Canada Agreement) was done, OK? It was done. I know it hasn't been ratified by Congress, but we assume it's done. It shows even if there are trade agreements you're going to have these skirmishes and threats, and for us it could have a material impact on our business.

So what's most business assuming? It doesn't mean -- they're not cutting back. But pretty much across the board they're giving me examples of, and some of these capex projects we're thinking about, we're saying, let's just slow this down. Let's wait. So it's had some chilling effect on that. A lot of companies are already trying to diversify their supply chains and logistics.

So roll forward to since May 1. Our forecast at the Dallas Fed went from the one I just described to you to being more in the neighborhood of 2%-2.25% with we think -- if you would have asked me three or four weeks ago I'd say probably the risks are to that maybe to the downside because of these uncertainties and, related to that, global growth decelerating. If you ask me today -- and I've said it to you in a couple interviews -- let's just take a little more time. Let's just see. Let's just see what's going to happen.

We're actually feeling a little more firm about -- you know, 2%-2.25% is a reasonable base case for 2019. I had been worried that if these uncertainties and the impact on business was severe enough, maybe you're going to start growing below potential. I don't -- we're not seeing that, at least at this point, and I don't see that in the outlook. We think growth is going to be 2%-2.25% by our measure. That's at or above potential. It means the job market's going to tighten. And so I'd say growth isn't what it might have been, but we think it's going to be solid.

When I say all that, things can change quickly. And I'm watching very carefully because I'm worried global growth, no question, is decelerating. Manufacturing sector is weaker. Shipments, they're weaker.

WSJ: Can we drill down a little bit on business investment? You said it's had a chilling effect, but you also sounded like you weren't sure if it's actually causing companies to cut back. So is business investment, in your mind, slowing because of trade uncertainties? What's happening with business investment?

MR. KAPLAN: They're basically saying to me, listen, the good news is the consumer's strong. 70% of (gross domestic product) is the consumer. Consumer's solid. But what they're saying is we're conscious of the fact we're later in the cycle and people saw some deceleration in their own businesses just between May 1 and today. And so they're just saying let's just be more cautious, and that's what I hear from businesses -- on a project we're thinking about, let's just be a little bit more cautious.

We just did look in our Dallas Fed survey of about 350, 400 companies, which we just looked at the results last week what we just got back. And what's an example? I think something like 25% or 30% of the respondents said that this uncertainty is having some negative effect on capex. Another 20%, 25% said no change.

WSJ: And how does that compare to previous surveys?

MR. KAPLAN: That's a little weaker. It's a little unusual.

What I'm trying to say is when I say things are stabilizing, I don't hear businesses telling me they're cutting back. They're just saying they're being more cautious. A lot of the businesses we talk to are -- there's an aspect of their business that's domestic, many of them, but some of them are global, and they're just being a little bit more careful. I think it's more like a little bit of a dull headache than a -- than something where they're expecting a severe.

So I look at that, and this is a good example of something based on my conversations, surveys, data obviously. I saw retail sales came out this morning, was solid. That doesn't surprise us. That's consistent with what I'm saying. But we'll keep watching and it's subject to revision. And I am concerned if global growth got weak enough it could spill over in the United States.

The second (factor) is inflation. And again, for those who follow the Dallas Fed, we've been writing for now three years, done two conferences on it. We've been saying for three years we have expected inflation to be muted. Why? There's a cyclical component to inflation which has to do with the tight labor market, and then there's a structural component of inflation. And we spent a lot of time emphasizing structural means. Technology, technology-enabled disruption, and to a lesser extent globalization are taking away pricing power and limiting the pricing power of businesses.

And the trend is businesses two years ago that I used to talk to that had pricing power I talk to today, they don't have pricing power. It's spreading. It's intensifying. And so it's not that inflation -- the cyclical elements are dead. They're not, but they're being muted. I assure you, if people have wage costs they would like to pass them on into prices. Just in many industries they can't. So what are they doing? They are trying to deal with the margin erosion. A lot of them are dealing with it by more investment in technology. I have these conversations everywhere I go: We're investing more in technology to try to manage our costs.

And for some businesses that are public, they're also masking some of this by share repurchase. So they have some margin pressure, but they're doing some financial engineering to continue to grow earnings per share. But even with that -- you may notice S&P earnings are flat. Even with sizable share repurchase, that's telling you that there's margin pressure.

The only other comment I'd say which is -- that is a sensitive, tricky one, it's also possible -- and I hear this from a number of industries -- that a very low cost to capital is actually accelerating these structural forces. Why? Because it allows more and more of these platform companies to be funded having little or no gross margin in some cases, but very large market caps. And so you just have to keep in mind that much -- some of this disruption -- not all, but some of it -- is a little bit of a product of or is facilitated by very low cost to capital.

Then there's the third consideration when I go into this meeting, and this one is for me significant. And that's just the market -- the level of market-determined rates.

WSJ: The yield curve?

MR. KAPLAN: Yield curve, yes. And when I say market-determined rates, U.S. yield curve and rates globally, OK? And when I've talked to you before I've said to you many, many times and repeated I need to see an inversion of some size and some duration. I'm starting to see some duration. This has been going on for a while. And this issue has really become more pronounced since May 1. So I think these issues we just talked about in number one are starting to -- I'm starting to see reflected in the yield curve. I mean, sluggish outlook for U.S. growth, sluggish outlook for global growth, and it's having an impact on market-determined rates. I'm sensitive to how much of that -- these rates are being determined by central bank policy, but I think some of it is indicative of outlook for economic growth.

WSJ: I just think a lot of it is being driven by (European Central Bank). I mean, the Bund --

MR. KAPLAN: Some of it.

WSJ: The Bund seems to be driving the global bond market. I mean, the Germans' yield curve, negative out to 10 years --

MR. KAPLAN: Some of it is.

WSJ: There's a real scramble for --

MR. KAPLAN: And when the ECB just recently announced prospective measures, it's having some effect, I agree. I think that's not 100% of the effect, though. I think some of it is --

WSJ: But doesn't that -- I mean, shouldn't it make you somewhat circumspect about the inflation value of our yield curve?

MR. KAPLAN: It does. It does. I factor this in. When we talk about this it's always a factor in my thinking, is that there's a substantial amount of global liquidity and central bank liquidity that's having some effect.

Having said that, my own -- this is a judgment, and we won't even know the answer to this in hindsight. But my judgment is some of it has to do with, I think, skepticism about outlook for growth. And in particular I think you've seen a -- if you go to April 30 and look at market-determined rates versus today, yes, some of the change has been a new pronouncement from the ECB. Before you ever got to that you saw, again, this threat of tariffs. The China issue plus the threat on Mexico you saw some move. And I'm observing this, and I'm talking to people who make duration decisions to try to get their thoughts.

WSJ: But if the threats have diminished, then what's actually --

MR. KAPLAN: So my attitude on the curve is you never do know, but ... let's just take a little more time, thinking that if the outlook for growth stabilizes and you get a retail sales report like today, maybe the curve will reassert itself. And so all this is a way of -- that's the third factor I'm thinking of.

So what's the outlook for growth, inflation, and market-determined level of rates versus where the fed-funds rate is set? Because on the third one, if I thought this was going to be persistent, and I think it's -- I'm starting to think it's more persistent -- this third issue would make you consider at least a tactical adjustment. Not a change in strategy, not the beginning of a rate-cutting cycle, but it would make you at least think about a tactical adjustment in the fed-funds rate. And I mentioned the word "tactical," means modest, restrained, a limited move basically on the premise that as we sit here today maybe the fed-funds rate is a little bit out of kilter with market-determined rates. I'm open-minded to at least arguments on that subject.

The first two arguments (around trade uncertainty and inflation) are less persuasive to me than the third one, and the third one also makes me think -- but you always are thinking at all times in this job, maybe I'm wrong, maybe I'm wrong, maybe I'm wrong. And then I look at the curve, one of these things is going to resolve. Either growth is going to turn out to be more stable and stronger than people think, and I would assume eventually the curve will adjust, or it could be the curve is foreshadowing something where we're just -- even though growth is solid now there's going to be some weakening, and the curve is foreshadowing that. I don't know the answer.

WSJ: So that raises a question of how urgent is it to deal with that third factor. Is that something you can wait and see how it plays out? Or do you say, well, when this thing bursts, bad things happen --

MR. KAPLAN: That's one of the issues I expect we're going to be debating and I plan to debate in this upcoming meeting in whatever it is, two-and-a-half weeks, two weeks.

WSJ: You say we have financial conditions that are pretty available, a lot of liquidity --

MR. KAPLAN: Robust.

WSJ: Robust, OK. Relatively strong economy, still growing above potential.

MR. KAPLAN: Yeah.

WSJ: And here you're potentially easing into this. Do you worry that you're going to look back a few years from now and feel you overdid it and you set off another bubble?

MR. KAPLAN: I've said this probably 50 times in written essays and I just said it -- monetary policy accommodation is not free. And so I weigh every decision against the cost. And why do I say it's not free? It creates excesses and imbalances. It can create distortions.

What's an example of one of those excesses? We have a historically high level of corporate debt right now. I think it is fueled by very low rates. And so history has shown as these excesses and imbalances build, at some point we actually have to deal with them, and they can be very painful and difficult to deal with. So, yeah, it is a factor I'm always thinking about, yes.

Listen, we knew that weaning off monetary policy stimulus and stimulus generally was going to be challenging. And I just think you have to be concerned with the impacts on excesses, imbalances, and distortions of accommodation. And so for me I take it very seriously when using that.

And that was also a factor, to your point, in approaching neutral, wherever neutral is. It was a factor over the last three years in my thinking that it would be healthier for the U.S. economy to be gravitating toward a neutral policy setting if we could get there. That was one of the factors in my thinking.

WSJ: In the last (Summary of Economic Projections), did you project a flat or a lower path?

MR. KAPLAN: Flat.

WSJ: It sounds like you've changed since the June meeting.

MR. KAPLAN: Well, not yet, and I don't have to do another SEP until September. When you get two-and-a-half weeks in front of the next meeting, I think at this stage I'm going to probably save my arguments. I'll have an open mind going into the meeting. I've been saying leading up to this we should take more time, we should turn over a few more cards. I was hopeful in saying that on the third point that we'd see some improvement in the relationship between the fed-funds rate and market-determined rates. On the economic side I've seen a little stabilization. So it's a bit of a -- that waiting has produced a little bit for me of a mixed bag, and I'll go into the meeting with an open mind and ready to debate these issues.

WSJ: If the chairman wants to go toward a rate cut, you'll follow?

MR. KAPLAN: I'm not going to comment on that, but I'm going in with an open mind. But again, the key thing I'd say, if we're going to make an adjustment for me it would be tactical, not a change in strategy. I still believe in the balanced approach that we articulate in our monetary policy framework, which says when you have an overshoot on one objective and an undershoot on another, you balance the two. That is our framework. I'm still an adherent to that framework.

WSJ: Take us deeper into your thinking on corporate debt. Are you seeing financial leverage that could be risky in a changing environment? Are you seeing changes in corporate behavior as being driven by corporate debt?

MR. KAPLAN: So the good news is 10 years ago the issue was the lenders were overleveraged. Today it's not perfect and there are some issues with the shadow system, et cetera -- you know, I've taken a hard look at CLOs and others -- but I'd say lenders by and large, if we just stop the clock right here, I'd say the banking sector and financial sector is in much better shape. Not perfect, but in better shape. And I think we should continue with tough capital requirements and stress testing.

The issue today is corporate debt. So the household sector over the last 10 years has actually deleveraged. Not perfect, again, but better. And so the household sector has not grown. Its incomes have improved, job market, so that's good. Government sector is a lot more leveraged. Come back to that. And the corporate sector is historically highly leveraged.

So why is this happening? One is the cost of debt is historically low. You have this lack of pricing power I just talked about earlier where you've got -- it's tougher to grow margins. And what businesses are doing is more aggressively using share repurchase and financial engineering to help grow earnings per share. And you've got the rise in activism. It's no accident you have a rise in activism. And the playbook from a lot of the activists is either, leverage up and buy back your stock, or do some other transaction that usually involves debt. So when debt costs are this low, it's hard to resist for companies to use debt to grow earnings per share or do other transactions -- merger activity and others -- particularly when it's more difficult to get organic growth and grow your margins.

And so in response you're seeing a tripling in BBB debt, literally tripling, and you are seeing a pretty healthy, dramatic rise in leveraged loans and in high-yield debt. I caution to say, if we stop the music right now none of this creates, in my opinion, a systemic risk. But I do believe the reason it's worth calling out is in a downturn, if we slow more than we're slowing, it will be an amplifier to the slowing. And why is it an amplifier? It means that as revenues and profits slow, an increasing percentage of profits will have to go to servicing debt and are less likely to be able to go to investing in the business, and it will help amplify a slowing. And at this stage that's where we are. And I would like to see us cull it out because it has the potential with cost of capital to slow to get worse.

WSJ: The corporate sector doesn't reach a point where it says, you know what, it's getting tough to service this debt, we have to cut back on our investment?

MR. KAPLAN: It will match -- if you start to see a greater slowing in the economy than what we're seeing. So if we continue to grow at or above potential, this is manageable. If you start to see a greater slowing, which eventually we will have a more severe downturn, I don't know when, but sometime in the future -- at that point, for those businesses that have a significant amount of debt, it may impede their ability to -- they're going to have a greater percentage of their cash flow used on debt service.

Now, when you combine the corporate debt with the government debt, it's fair to say that the economy is a lot more interest-sensitive than it was. And the reason we're not screaming about it is the cost of debt is very, very low. And the prospects are the cost of debt is going to stay very, very low. But that's an example of one excess that you worry about. Also, listen, if debt costs and the return on savings is very, very low, it just incentivizes people to take more risk, to over-allocate the risk assets.

That was appropriate 10 years ago when we were coming out of the severe downturn. I think at this stage in the cycle it's probably not the kind of behavior -- you would like people to be a little bit more moderate at this stage in the cycle.

WSJ: So if you're recalibrating monetary policy, and this year, where people thought policy was going to get tighter but now it may in fact get easier, at a time when regulatory policy has been getting tighter but has more recently been getting easier --

MR. KAPLAN: You're talking about financial regulatory?

WSJ: Yeah. Would it be appropriate, if you're going to recalibrate monetary policy, to also change the direction in which regulatory policy has been traveling?

MR. KAPLAN: So I am one that has said, and pretty consistently, that certainly for the big banks -- for small, mid-sized banks, I think streamline is appropriate. They don't present a systemic risk. They're important in their communities and serving their communities. But for the big banks, yeah, I am an advocate that we should be keeping, at this stage in the cycle, very tough capital requirements and stress testing. And I would be loath to actions that would dilute that.

WSJ: And do you think the Board is moving too far?

MR. KAPLAN: I think each individual step I understand the rationale for it. I just -- let me leave it at -- and I'm obviously having conversations. I don't think we're hurting the U.S. economy at all by keeping very tough capital requirements and stress testing for the big banks.

WSJ: I want to go back to your point about market-determined rates, because one of the criticisms you hear right now about where it sounds like the Fed might be moving is that it's being bullied by the bond market that it's following market signals too much. What's your response to that?

MR. KAPLAN: It pays to pay attention to the markets and to observe what they might be saying. But we should not be overreading or overreacting what's going on in these markets. I pay attention, particularly what's going on in terms of credit spreads, credit availability, what's happening with the yield curve. But I take it a little bit, understanding that markets can change on a dime. And sometimes they can change in reaction to prospects for economic conditions and they change in reaction to comments from central bankers. And I have to take that into account.

WSJ: Do you think you're at a place where the markets are so expecting a policy move that you would be tightening conditions now if you did not follow through on those?

MR. KAPLAN: I'm not going to comment. I'll leave that to others to comment on. I've been watching these markets carefully for most of my adult life. And I've been watching the curve, as you know. And I watch it intently every day. And it strikes me that this inversion, and elements of it, have been -- are starting to become more persistent. And I think a factor is central bank policy. But I also do believe -- and this is a judgment; you'll never know the answer -- I believe my own judgment is some of this is in reaction to prospects for economic growth. I think there's some economic signaling, but also I can't discern precisely which is which.

And so one of the reasons I've been advocating, leading up to this, let's take more time, is I didn't want to contribute to what might be the central bank-determined impacts to this. But I also think some of this is economic. I do. And the reason I do is when I look at companies -- or, countries around the world, I look at Germany what's going on, I look at certain sectors, I look at what's going on for prospects for economic growth, economic uncertainty. I think you're seeing some of that reflected in the bond market.

WSJ: They used to call this the looking in the mirror problem. You look at the bond market, and you're seeing the bond market, and you're seeing yourself as you're looking at it.

MR. KAPLAN: Well, that's what you got to be careful of. I call it the echo chamber.

WSJ: I want to ask about tactics, because you referred to the possible rate cut as something that would be modest, restrained, limited.

MR. KAPLAN: If we do it at all, yes, it should be.

WSJ: So, define that. Is that just one move?

MR. KAPLAN: I'm not going to speculate here. And I told you, in my SEP, I had zero. But let me leave it this way: It should be limited, and it should be restrained. And we should be patient, in my view, in the intervals as we do it.

(END) Dow Jones Newswires

July 16, 2019 15:36 ET (19:36 GMT)

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