Northern Trust’s chief economist weighs in on the health of the economy, the direction of interest rates and inflation, and current conditions in real estate.
Today we’ll chat with Carl Tannenbaum, chief economist for Northern Trust. In his role, Carl prepares the bank’s official economic outlook and participates in forecast surveys. He is a member of Northern Trust’s investment policy committee, its capital committee, and its asset/liability management committee. Prior to joining Northern Trust, Carl spent four years leading the Federal Reserve’s risk section. He was deeply involved in the central bank’s response to the 2008 financial crisis. Carl began his career in banking at LaSalle Bank/ABN AMRO, serving for more than 20 years as the organization’s chief economist and head of balance sheet management. Carl holds an MBA and a BA in finance and economics from the University of Chicago.
Background
Economic Outlook, Inflation, and Tariffs
“The Final Descent,” by Carl Tannenbaum, Ryan James Boyle, and Vaibhav Tandon, Northerntrust.com, July 16, 2024.
“Trust the Process,” by Carl Tannenbaum, Ryan James Boyle, and Vaibhav Tandon, Northerntrust.com, June 13, 2024.
“The Value of Economic Data,” by Carl Tannenbaum, Northerntrust.com, July 19, 2024.
“The Truth About Tariffs,” by Carl Tannenbaum, Northerntrust.com, July 3, 2024.
“A New Round of Tariffs,” by Carl Tannenbaum, Northerntrust.com, May 24, 2024.
“Inflation Has a Perception Problem,” by Carl Tannenbaum, Northerntrust.com, June 21, 2024.
“Aftershocks,” The View From Here With Carl Tannenbaum, Northerntrust.com, March 11, 2024.
The Fed and National Debt
Federal Reserve Bank of Chicago’s Spotlight on Childcare and the Labor Market
“Debt Matters,” The View From Here With Carl Tannenbaum, Northerntrust.com, Jan. 9, 2024.
Real Estate, Banking, and AI
“Out of Office,” The View From Here With Carl Tannenbaum, Northerntrust.com, April 1, 2024.
“Banking: Back in the News,” by Carl Tannenbaum, Northerntrust.com, Feb. 16, 2024.
“Shedding Light on Private Credit,” by Carl Tannenbaum, Northerntrust.com, May 17, 2024.
“Empowering AI,” The View From Here With Carl Tannenbaum, Northerntrust.com, July 24, 2024.
“Automation and Anxiety,” by Carl Tannenbaum, Northerntrust.com, July 12, 2024.
“Augmented Intelligence,” The View From Here With Carl Tannenbaum, Northerntrust.com, June 27, 2023.
Other
“Last Mile: What It Means in Reaching Customers,” by Adam Hayes, Investopedia.com, Sept. 11, 2023.
Committee for a Responsible Federal Budget
Dan Lefkovitz: Hi and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Lefkovitz: Today we’ll chat with Carl Tannenbaum, chief economist for Northern Trust. In his role, Carl prepares the bank’s official economic outlook and participates in forecast surveys. He is a member of Northern Trust’s investment policy committee, its capital committee, and its asset/liability management committee. Prior to joining Northern Trust, Carl spent four years leading the Federal Reserve’s risk section. He was deeply involved in the central bank’s response to the 2008 financial crisis. Carl began his career in banking at LaSalle Bank/ABN AMRO, serving for more than 20 years as the organization’s chief economist and head of balance sheet management. Carl holds an MBA and a BA in finance and economics from the University of Chicago.
Carl, thanks so much for joining us in The Long View.
Carl Tannenbaum: Delighted to be with you. Looking forward to the conversation.
Lefkovitz: Well, we’re obviously talking to you in the midst of an election year, not short on drama. Maybe you can tell us generally how you factor in politics, how you think about policy implications, and how they impact your economic outlook.
Tannenbaum: We’re certainly following the major economic issues that surround the 2024 American election. Those include policies on trade, immigration, taxes, and spending, climate change, and others. As we try and assess, one of our models at Northern Trust is that we can’t predict, so we do try and prepare. And so, we’re looking at both sides of all of those questions. As we speak today, at least the polling numbers are leaning in the direction of the Republicans. Much could change between now and election day. And so, we focus a little bit more attention on some of the movements that may come from that outcome.
First in the area of trade, it seems like either side will probably sustain or even extend the level of trade restriction, tariffs, quotas, and other anticompetitive things that will curtail international trade. China will certainly be a primary target for that. That has a series of implications. Certainly, we’re going to have to find sourcing for some of the things that we’re getting from China that will be subject to the more severe of the restrictions. I also put out a piece to our clients, just as a primer to refresh everyone’s understanding about how tariffs work. China does not pay the tariffs that are levied against it. They’re paid by exporters and ultimately, as the evidence seems to suggest, passed along to consumers. And so there may be objectives down the road that are important, but in the short term, tariffs and trade restrictions can certainly add to the rate of inflation.
Immigration is a topic that has challenged politicians for the better part of 25 years. The question of how many, what kind, over what time interval, under what conditions is one that deserves good national debate. As I talked to fellow economists and also the US Chamber of Commerce and its members, zero is the wrong answer. I think the United States historically has benefited from some level of immigration, both to fill in the ranks of a labor force that does have an aging component to it. And then we’ve also been blessed over the decades and centuries with newcomers from overseas who end up being innovators and drive our economy forward in the right direction. So, it’s a fancy way of saying skilled and unskilled labor.
Certainly, the two sides are a bit different. The question has been raised to a higher level because of the levels of immigration we’ve had just in the last 18 months. I think we do need to come up with a sensible set of guidelines. If we reverse too much, I do think that it could again add to inflation. We’re just beginning to see a leveling out in labor market sizes for certain professions like caregiving, agriculture, leisure, and hospitality and immigration has certainly helped there. And there are some who would propose that we move in the other direction and begin excusing or deporting some who are here without appropriate documentation. And that also would have an important impact on industry. So that’s just a sampling of the number of issues that are involved. I know we’ll probably get to a handful of others during the course of the questioning this morning.
Benz: Definitely. That’s a wonderful overview, and you’ve referenced a lot of different areas. I just wanted to follow up on the tariff point because your piece that you referenced was quite negative on tariffs. Can you expand on why you think that a Trump tariff policy, for example, would be a negative for the economy at large?
Tannenbaum: The basic thesis is that globalization, as it’s been practiced over most of the past 30 years, has had a number of benefits among them being a greater choice for consumers, in general lower prices, keener competition that has made our domestic industries better. It has created a certain number of jobs, while certainly has also placed others in some question. And so, I think the studies that I’ve seen and respect that are impartial have found general gains. I think an important qualifier is that free trade is not always fair trade. And some of the measures taken really by administrations of both stripes over the course of the last decade have been intended to restore a level playing field to some of the areas where things had gotten out of balance.
Again, I point out that that certainly may be a worthwhile goal. But as we reverse the convenience and access to, let’s say, products from China, the alternatives to those products are going to be more expensive and, in some cases, more scarce and continuing to import from China with a tariff regime is going to be more expensive. The evidence is certainly quite clear that when importers face tariffs, they pass them along. I think the data are that the average cost to the average American household of the current tariffs is about $600 per year. And obviously, that’s money that comes out of our household budget. So, I think economists are somewhat unanimous on the basics, but then divided a little bit on how actually these should be implemented and what the long-term results might be.
Lefkovitz: Well, you referenced inflation and employment. We are recording this in the third quarter of 2024, and the Fed has yet to cut interest rates. You obviously have a unique perspective having worked for the Fed, but the market was expecting six interest-rate cuts coming into the year. What do you think economists underrated or missed?
Tannenbaum: Well, this is a question that my senior leadership has been asking me all year. Frankly, I’ve been under some pressure as they’ve been under the impression that lower rates would be very helpful. And anytime we have any slippage in any of our portfolios, the economist is the one who gets the blame. So sadly, this may be my last opportunity of appearing with you on your podcast.
I will say that we were certainly not among the group that was expecting such an extensive and aggressive set of interest-rate cuts from the Fed. I think coming into the year, we had thought that they would wait until June and then move in a measured way after that. The market was certainly expecting a lot more. And what the market missed, I think, was first inflation did prove to be stickier than most of us thought. We had a nice decline in the rate of inflation in the second half of 2023. And I think people were expecting, some were expecting anyway, that it would continue. But we saw that there were areas of the price picture that were going to have what we’ve called the “last mile problem.” In other words, getting all the way down to a level consistent with 2% was going to be harder. And those are housing. We created a little bit of a housing boom, but with low rates during the pandemic era. And so house prices have gone up and so rents often follow suit. I mentioned earlier that we’ve had a lot of newcomers to the country who need places to live. That’s also kept upward pressure on rents. And so, the cost of shelter, which is the biggest part of the Consumer Price Index and other inflation indexes, continues to increase at a year-over-year pace of more than 5%.
The second area is basic services where shortages of labor, which I mentioned are getting better, but still there are shortages. Those prices have continued to escalate at nearly a 4% annual clip. And we’ll need to see additional progress on both of those for the Fed to feel comfortable, eventually lowering interest rates. As we visit today, the news through the spring and the summer has gotten quite a bit better. Fed officials are sounding a little bit more contented and confident. And so, the market is set up for the first Fed cut in September, and I would tend to agree that that is a likely outcome. The market, though, is expecting the Fed to be very aggressive after that.
I’m still a bit cautious. And the reason is, is that inflation is still on a core basis, the way that the Fed looks at it at about 3% year over year. And the target is 2%. I’ve been asked frequently whether the Fed would declare victory if they got close enough. And frankly, the answer is no. Having worked at the Fed, the seriousness with which the Federal Reserve takes its 2% inflation target is something that markets often understate. The Fed believes that that level is consistent with long-term investment performance, economic growth, job creation, and many other positive things. They also feel that they’ve made a commitment to get inflation to that level and abandoning it when they haven’t reached it would be a shock, frankly, to their credibility. So, for all of those who are wondering whether the Fed might change its inflation target or hedge a little bit, I just don’t see that to be the case.
Benz: You referenced a lot of important subtopics there that we want to go back to. But we want to reference your Fed experience. Having worked at the Fed, what do you think observers misunderstand about the organization and how it operates?
Tannenbaum: That’s a long list, to be very honest with you. And I’ll be candid that having followed the Fed and monetary policy for decades before joining them, there was a lot that surprised me when I got inside the walls.
Let me just give you a sampling. The Fed is a big organization and monetary policy is only one of its facets. Certainly, people are familiar with the fact that it does bank supervision. But while it oversees individual institutions, it also feels like it is the safeguard of the stability of the financial system more broadly. And so, some of the inquiries they make and the decisions they take are aimed not necessarily at ensuring that no banks will fail, but more broadly, that the financial system will continue to perform well. And having joined the Fed in the spring of 2008, and certainly some of my partners here at Northern Trust based on that timing field that I caused the financial crisis. But instead, I found myself right in the middle of it. And many of the decisions taken by the Fed at that time were really aimed at making sure the financial system continued to operate to support the American economy as controversial as some of those changes were.
The Fed is also still very engaged in the payment system. They facilitate payments, still clear checks, are at the forefront of technology that’s helping payments become more efficient and fast. The Fed does a huge amount of work in community affairs. They look at a series of economic topics and try and bring smart people together to form intelligent policy. Austan Goolsbee, the current Fed president here in Chicago, called together a conference on daycare, which you might not think is a top economic issue, but it’s a huge issue for labor force participation, upward mobility, standards of living for a lot of families. And so, the Fed wants to be a nexus of good conversation on topics like that.
And then going back to what I said earlier about monetary policy, there is some feeling that the Fed somehow has policies of convenience. But the dedication that the Fed has to their mission is something that gets into those that work there very, very deeply. And I was quite surprised at how quickly the goal of facilitating a financial system and a set of economic conditions that are conducive to long-term economic performance got into me personally. It was very, very powerful. The four years that I was there were among the highlights of my career.
Lefkovitz: So, Carl, you referenced that “last mile problem” and the Fed’s seriousness with which it takes its goal of bringing inflation to 2%. Why do you think that the interest-rate hikes that we saw, the most dramatic in a generation, why do you think that they have not slowed the economy and brought down inflation to the extent that the economic textbooks maybe would have predicted?
Tannenbaum: There are several factors that explain an apparent delay in the effectiveness of monetary policy. The first fall into the category of borrowers locking in the rates on their debt. You may remember that thanks to the easing that was done in 2020 and 2021, you have a number of Americans who have home mortgage rates of less than 4%. Perhaps you’re one of them. And if you are, I suspect that your plans to move may be on a long-term hold. But the data are that while the mortgage rates in the marketplace have gone up, the mortgage payments made by households have not budged a lot. And so that has blunted to a certain degree the impact of higher rates on things like the housing industry.
Secondly, partly under the blanket of a Fed guarantee in 2020, a lot of corporations, even those with not the highest ratings, were able to issue long-term debt at very favorable interest rates. And those don’t really begin rolling over until the early part of next year. So, corporations have not had to face the high level of current market rates. And then finally, consumers also really were able to curtail their borrowing when they were receiving pandemic stimulus checks. And it’s only been in the last 12 months that we’ve seen, for example, credit card balances get back to levels that they held prior to the pandemic. So, you do gradually see households paying that higher interest rate, and that should have a bit more of a headwind effect on economic activity.
Finally, for those who don’t have debt, the higher interest rate has added to their incomes. Those who are invested in, let’s say, cash or variable-rate bank products are getting much more in interest, and that’s contributed to their spending. So, in some sense, there’s an element of demand stimulation that’s associated with monetary policy that is often overlooked. All of that said, as time goes on, I believe that the moves that the Fed has made will become more noticeable and potent. And they’re factoring that into their decision as they contemplate whether the time is right for a pairing back just a little bit.
Benz: You’ve referenced the housing market a couple of times. New homebuyers have obviously been quite affected by the higher mortgage rates, and renters, as you referenced, have also been impacted. Can you discuss that, and also discuss the implications for the broader economy of what’s going on with the housing market?
Tannenbaum: The housing market is a central one. It’s among the bigger industries that we have in the United States, and so the events there are magnified on the national stage. I will say that it is very difficult for those who are first-time homebuyers to access the properties that others might have been able to buy in years past. Measures of affordability, which combine the house price with the interest rate are not exactly at friendly levels right now. Part of that, going back to an earlier comment, is that you have a lot of people who are homeowners that are not putting their homes on the market at the same pace that they ordinarily would because of their low mortgage rates, as some call it, house lock. And instead, they’re adding on to their homes if they have need for extra space and not turning them over to the market. At other price points, we have failed in the United States to build enough housing stock, especially at the, what I would call, the entry level, where we need both owner rentals, owner units, and rental units. So much of the development in the multifamily space—and sorry, that’s apartment buildings for those who aren’t economic geeks. We just have not built enough, which have price points, let’s say of, I don’t know, $1,000, $1,500 a month, which would be accessible to people who are just starting their careers or who want to make sure that they’re trying to save for a home later on. And so, construction has really not been what we might have expected.
A variety of reasons for that. Certainly, zoning and permitting, getting areas to allow additional home construction is not the easiest thing to do. During the pandemic, when we weren’t building a whole lot, we drove quite a number of people out of the skilled trades. And so, we do have shortages of contractors and plumbers and electricians and alike. So, I think this is something that deserves a fairly healthy discussion at a national level so that we can develop a set of policies that will keep supply and demand in this area in balance. And after all, we do have huge mortgage agencies and housing agencies at the federal level that should be in a good position to help us get to that objective.
Lefkovitz: Wanted to get your take on the inverted yield curve. Why do you think it hasn’t predicted a recession? Do you think it’s broken as an indicator?
Tannenbaum: I have to confess, I’ve never been a huge fan of the yield curve as an economic indicator. People have noted that the yield curve has inverted prior to almost all of the 10 recent recessions that we’ve had. But there’s not a lot of causality there. And the yield curve doesn’t exactly invert, and then three months later we have a recession. In some cases, those lags are very long. If I’m not mistaken, the recession that we had as part of the global financial crisis in 2008, the yield curve had inverted almost two years prior without incident.
And so, as a leading indicator, the fact that those time lags are so long and potentially variable, I think really diminishes its value in the absence of other evidence. And this time around, we’ve had an inverted curve for a very long period of time. The degree of inversion actually has come down quite a lot in the last 12 months. And the thing I’ve been noting to our clients is that an inverted yield curve merely suggests that interest rates tomorrow are going to be lower than they are today. And that is a scenario that’s consistent with a soft landing, as well as consistent with a recession. The way that people use the yield curve as an indicator doesn’t have the nuance to know the difference between the two. So as with so many other things in economics, I counsel not just relying on one indicator, but looking at a variety in order to get closer to the truth.
Benz: You referenced that you were not at all alone in forecasting a series of rate cuts this year and earlier rate cuts than we’ve had. So, I’m wondering if reflecting on your career, can you think of another time when the conventional wisdom was so wrong as it was coming into 2024 about the direction of rate cuts?
Tannenbaum: At the outset, I would say it’s probably a blessing for those of you who are listening that this is audio only so that you can’t see what a career in economics has done to me. I had the pleasure of visiting with some of our new hires here at the Northern Trust. We bring in very smart young people as part of our training program, and many of them are very interested in economics. And I had to give them the warning that getting too close to the topic can be damaging to your hairline.
Anyway, I think one of the reflections that I offer them though is that the rules in economics are not immutable. We are dealing with social sciences. And paradigms change. Tastes change, in some cases gradually and some cases suddenly. We will have shocks that occur that throw off what we thought we knew about supply, demand, and equilibrium. Policy regimes change. And so, if you’re going to do this, you have to be very adaptable. And all of us use models, but one of the bromides that I stress to my partners in my group is that the skill in using models sometimes is knowing when to turn them off. And so, in the context of what we’ve gone through since 2020, the pandemic was one of the bigger shocks that we’ve had to both supply and demand in a very long time. And frankly, it’s not a surprise that some of the models or understandings that we had developed prior to the pandemic have really been called into a significant question.
The supply shocks, I’m sure everybody is familiar with. First, it was the supply chain interruptions, which made it very difficult to get goods from overseas. Those blessedly have largely cured, although I will note that global shipping costs have been under some pressure from the conflict that we have sadly in the Middle East of late. The other side was the labor market. We did have a toll taken by the disease itself in leading people to retire early. Some are still struggling with long covid and symptoms that limit their ability to work. Also, we had to close the borders to even legal immigration during the worst of the pandemic to safeguard the public health. And so that created shocks to the provision of services in the labor market.
We’re not quite back to normal on any of those fronts, and so identities are having to reflect the fact that we’re just not dealing with the same action and reaction. And so, the Federal Reserve certainly was not alone in being surprised when inflation raged in 2021 and 2022. Their use of the word transitory was one I’m sure that they regret, and the chairman retired that term after a suitable distance. And chastened by that, frankly, is I think one of the reasons why they’ve held rates higher for longer and that they want to make trebly sure that they reached their destination. So that’s just, I think, a short list of the many shocks I think that have come through. Obviously, geopolitical things have occurred.
So, let me just say this. To some, this is very frustrating, and economists are made to look silly for their forecasts not coming true. But if you’re doing your job right, it’s not just about the base case, everybody. You have to look at contingencies and what ifs, which is what we do a lot of here at Northern Trust. And I actually find—while it’s frustrating—it’s very interesting trying to solve the puzzle of what might happen and then illustrating the range of things that could occur as opposed to putting all of your chips on one number.
Lefkovitz: Well, you talked about some of the effects of the pandemic that seem to have dissipated. But the commercial real estate market seems to be an area that maybe is permanently impacted. How are you assessing the risks in the commercial real estate market?
Tannenbaum: I think hybrid work is, believe it or not, even though it’s been the order of the day for a while is still something that we’re getting used to. I’ll leave aside the issues for leadership and development, which you can save for another podcast, but let’s get to office space. So certainly, it’s no secret that office vacancy has mushroomed and could even escalate further. The evidence that we have on office attendance largely comes from a company called Castle Systems that monitors badge swipes entering buildings. By that measure, we have reached peak return to office and that level is only about half to 60% depending on the city of what it was prior to covid 19. As a result, tenants are trying to rationalize their office space. Landlords are desperately trying to keep their space full, and it’s really roiled that side of the commercial real estate market.
One of the things I do like to offer as perspective is when I read an article about commercial real estate, I do want to remind everybody that there are four main categories. One is industrial, and a lot of that is distribution centers and more recently data centers. And the rental rates on data centers are going through the roof because of the needs of artificial intelligence. So that sector is doing very well. We talked a little while ago about multifamily construction. There, certainly, there’s no issue with rents and vacancy. Retail commercial real estate is another category. Certainly, we’ve gone through the transition to online purchasing, but that largely has run its course, and retail occupancy and rents are holding up fairly well. So, I do like to make sure everybody focuses just on the office subset of CRE when they’re thinking about that topic.
Then if you double-click down further, you find that the median office building is not a 50-story chrome and glass edifice in a city center. There are a lot of smaller structures that are still highly occupied, and rents are firm. So, moving those to the side, you really face with a handful of very large properties. And then you’re wondering who is going to hold the bag when the property is revalued. As many of you know, loans on those properties usually roll over every five years, and that next round of rollovers is going to be uncomfortable. The question is, do investors own the building? If so, they’ll have to negotiate a haircut, some of which investors will take, and some of which the landlord will take. And if they’re a bank, it’s the same process. Is the landlord going to put in more equity in order to keep hold of the property, or is the bank going to have to take a loss? And I think the answer is going to be some of each.
It’s been written up that the banking system itself might be at some systemic risk from office real estate. I think that’s probably an exaggeration. And the reason is, is that this has been an accident, frankly, happening in slow motion. Because the loan rollovers don’t happen all at once, banking companies have had the opportunity and certainly have been encouraged by their overseers to put plenty of reserves aside for when the day of reckoning comes. And so, while this will be uncomfortable for some smaller regional banks, I certainly don’t think it’s going to cause a run on the banking system.
Benz: We wanted to stick with that, because when you worked at the Fed, you spent a lot of time studying the health of the financial system. We did have some bank failures last year, Silicon Valley Bank, First Republic, but it wasn’t a contagion. Are there risks that you’re monitoring within the financial system? You just mentioned the commercial real estate area, but any other risky spots that you’re looking at and concerned about?
Tannenbaum: Well, the shock to the system that we had last year, what is it they say that whatever doesn’t kill you makes you stronger? Certainly, the attention that the surviving companies are paying to the issues raised by Silicon Valley Bank, which are you need to understand what changing interest rates can do to your profitability, and also just recognize that if your name is painted adversely in the media, you are subject to very rapid withdrawals of money. So, a lot of other firms certainly have been taking a harder look at their positions there encouraged by the regulators. And so, I wouldn’t list those two topics necessarily as being high on the list.
Certainly, I think one of the areas that shows up frequently in financial stability reports is what is known as private credit. So private credit is essentially other pools of money typically managed by private equity firms, which are available to make loans to individuals and small companies. That sector has been growing very, very quickly. There are now an estimated $1.5 trillion of private credit loans outstanding in the United States and that number is growing. We wrote a long piece on this. Certainly, adherents of the industry point out that this makes capital available, in some cases at lower rates and with fewer restrictions, to companies and individuals that need it. It’s being guided by a lot of very experienced credit underwriters, some of whom used to work for banks and now have moved over to work for nonbanks. The thing that worries me and frankly worries the Fed, the European Central Bank, and the Bank of England is that that structure has not been tested by a broad credit downturn. And the thing that makes you a little bit nervous is like other areas of private capital, there isn’t a lot of transparency around what’s going on there. We have to guess at what the volumes are. We certainly have no details on the credit quality of the underlying loans. And so, it’s hard to anticipate what impact that might have more broadly. Certainly, some of those funds do have credit lines from banks largely for contingency, but they could be drawn on and create some contagion elements if there was ever a more difficult situation. And so, I think the Fed among others is trying very hard to learn a lot more about how those dominos are lined up so that we can make sure that if set in motion there’s a little bit of a break so it doesn’t bring down more of the financial system.
Lefkovitz: And from your perspective, Carl, are there certain indicators that you’re monitoring that would be cause for concern if they’re flashing red?
Tannenbaum: Yeah, nothing that’s flashing red for me at the moment. Everything seems to be settling into soft-landing territory. I will say though that the financial conditions, broadly speaking, are pretty easy. And by financial conditions, that’s an umbrella term for how easy is it for firms and individuals to get capital and how expensive is it? And as we take a look at some of the market-based measures, credit spreads, the amount that corporations are paying to borrow above the rate that the Treasury is paying to borrow, those are very, very skinny. It makes you wonder whether things are priced for perfection. We’ve been watching some of the evidence on bank-lending standards, which had gotten very tight, but now they’re getting just a little bit easier. And so, I want to make sure that the things don’t get overexuberant there. And then the markets have been incredibly strong, as I’m sure you know, with very low levels of equity volatility. And as just a dumb economist thinking about what might happen and the risks geopolitically, and certainly that the uncertainty surrounding the November balloting, one would think that you’d have a normal level of volatility. And yet investors do seem to be very, very consistently excited about prospects for earnings in equities. So, I’m just hoping we’re setting ourselves up for a correction.
Benz: I wanted to follow up on the geopolitical-risk point. Beyond the upcoming US election, which we’ve talked about, risk seems pretty high right now. We have wars raging, tensions running high across the globe, elections in many major markets this year, not just the US. So how do you think about geopolitical risk and incorporate it into your thinking about the economy?
Tannenbaum: The first answer to your question is 24/7. Very often when I meet with people, I ask what’s keeping them up at night. And for me, it’s a long list. Economists are paid to worry. We can find a dark cloud behind almost any silver lining. The profession also attracts people who aren’t happy unless they’re unhappy about something. So, as I begin my homily here, take that as background.
But I think the broad trends are concerning here. Beginning in the early 1980s, a tone was set to expand global commerce. Trade pacts were signed. Walls were brought down. And as a result, there was a geometric increase in the fraction of global output that was traded across borders. As I noted earlier, I think this had a variety of favorable impacts, not universally. We probably need to do a better job of understanding and managing the downsides of free trade. But one of the upsides was that associated with economic cooperation was diplomatic cooperation. And so, under the heading of new global order, we had a period of relative peace, with the Balkan Wars of the 1990s, a notable exception. And there was a feeling that we could handle bad actors collectively because we did so much business with one another.
And then the 2008 financial crisis revealed the downside of some of those investment in economic linkages. Losses were taken worldwide on a crisis that originated with poorly underwritten mortgage credit here in the United States. The economic recovery from that episode was very, very slow. And certainly, in Europe, they had a hard time coming out of it. And they had their own debt crises in the years subsequent to 2008. During that time, we began to hear voices around the world asking questions of whether so much global interaction was a good thing. At about that time, we started seeing the slow but then more rapid increase in the number of tariffs and trade restrictions. Electorally, voices started to gain the ascendance early in 2016, which was a watershed year for this with the Brexit vote and our own election results that began to accelerate, not just the number of trade restrictions, but then also the weakening of global organizations like the World Trade Organization and the International Monetary Fund. It was designed to keep the international peace, at least from an economic perspective. And then also, it’s not my main area of expertise, but I don’t think I’m speaking out of school and suggesting that global collaboration on security, on climate, on other things is not what it used to be. And I think that there’s a link between the economic deglobalization and geopolitical unrest. And there’s statistics that bear that out.
While the conflicts that we have raging now have roots that go back decades, or in some cases centuries, the fact that they’re happening today, I think, is a reflection that global collaboration is not what it used to be. And that raises a host of possibilities where sudden events or bad actors can step forward and disrupt not just markets but our lives. And it’s absorbing a lot more attention than it used to.
Lefkovitz: Certainly, a lot of risks out there. On the opportunity side, or perhaps a risk as well, you referenced AI earlier in conjunction with commercial real estate. We wouldn’t be a podcast if we didn’t talk about AI. How are you thinking about AI and its long-term impacts on the economy?
Tannenbaum: Well, we’re thinking a lot about it here at Northern Trust, both generally and also in understanding how it can benefit our clients. Obviously, we’re doing that with the highest level of concern for safety and cybersecurity. But for societies at large, I think this is a very, very significant trend. I’m naturally a cynic. We’ve seen a number of developments during my working lifetime that people have described as transformational that were less than that. But I think this one has legs. And as people talk about it in the same breath as railroads and electrification, I’m not sure that they’re engaging in hyperbole. If you’ve played around with it, if you’ve read any of the commentary surrounding it, the potential that it has to raise productivity, standards of living, economic growth to a degree that would make our debts more sustainable, I think is very possible. The specific applications are already with us. Let’s not forget that AI is a big umbrella. People throw the term around a lot, but it can mean everything from natural language processing to some of the things that we’ve had for a while now with machine learning and the automated testing of new vaccines or architectural designs that are enabling those to come together with greater speed and quality. I believe we’re just scratching the surface there. And I’m excited about the possibilities.
I would just add a few cautions or caveats. One of the other bromides that I tell my modelers is that the best of models is undone by the worst of data. And so, as we use AI and its kin, we need to make sure that the data that it’s trained on is of the highest quality because otherwise we’re going to get bad answers. Secondly, AI can have biases. And so, we do need to make sure that the push that it requires to get going is done in a manner that doesn’t lead us to conclusions that are not broadly applicable or beneficial. Third, AI has certain natural limitations. It’s going to place an additional demand on the power grid that I’m not sure that everybody fully understands. It is a power hog at the moment. And while people are working on algorithms that are a little bit gentler on processing time, speeds, and temperatures, that may be a while in coming. And so, if you take a look at how much power companies are getting ready for the surge in demand of the fact that data centers themselves are trying to secure dedicated supply, and Bill Gates, among others, has been out suggesting that we bring small-scale nuclear generation into the picture in order to meet those demands. That’s certainly going to be a limiter that we’re going to have to manage well. I made the comment to clients earlier this year that we have two mega trends in economics—AI and climate change—that in some ways are running headlong into one another.
And then there’s a cybersecurity question. Certainly, there are examples already where AI has been used to crack codes or emulate human behavior in a way that compromises security. I think that just raises the temperature and the vigilance that has to be employed by all who are using AI and signed on to the interconnectedness that makes our economy go. But while some think it’s a scourge, I don’t think it’s going to go away. Attempts to slow it down, I think, are going to prove fruitless. And so, I think our objective is to try and use it to our maximal advantage and then manage any of the downsides.
Benz: I’m curious, are you using AI at all in your work today? And what do you think are the implications of AI for the type of work that you do?
Tannenbaum: In economics, there are a number of applications. Getting data together is a snap. It takes a while to come up with a library of websites that you can go to and strip information we have services. But if I want a time series of the American unemployment rate and I go into one of the platforms, it comes right up. If I want it to write a summary paragraph of recent trends, it can certainly get you started on that. This is all experimentation. There are some other applications to other areas here at Northern Trust that I’m not at liberty to discuss. But it’s really incredible, the things that we’re learning, the speed that we’re gaining, the service that we’re enhancing, and we’re just scratching the surface. So, the neat thing for those of us who have been around for a while is that you’re always on the prowl for something that can really excite you and get your motor running. And for me, I’m at 90 RPM.
Lefkovitz: And following up on the other mega trend that you mentioned, climate change, a lot of investors are trying to figure out how this impacts their portfolios. How are you thinking about climate change and its risks and opportunities?
Tannenbaum: And here, I don’t intend to delve into the climate science or what’s causing it. The data are that we’ve had a long string of the hottest air and water temperatures in a very long time. There does seem to be sufficient data that suggests the risk, at very least, that human activity is causing this. And even if you aren’t fully convinced by the science, the risk that it’s right—and some would say that’s a fairly high likelihood—has already gotten insurance companies and others really reacting to this in the present day.
So, the first thing I say is that the impacts of climate change are not things that will evolve over time. They’re here today. The incidence of an expense of severe weather activity certainly is on the rise. In some parts of our country today, it’s incredibly difficult to buy property insurance. I think we’re only heading further in that direction. If you carry out some of the possibilities over the longer term, you will find areas of the world where it will be very difficult to grow basic foodstuffs. Projections on crop prices could be very, very high. You could have people who are farmers who are unable to remain living where they are, and they’re going to be migrating, in some cases, a disorderly way in order to find new places to farm or new places to live. The consequences that we’ll have in terms of temperature, I think, will make it very difficult for certain areas of the world to remain habitable. We already have shortages of potable water in many parts of the world that is only going to get worse.
So, I think the best approach for investors is really to understand the risks and the outcomes that might come to pass on their specific industries or specific shares. Also, I think it’s important if you’re an investor to understand from the companies that you own exactly how they’re looking at climate change and preparing for it, whatever your views on how fast this will occur, why it’s happening, being prepared for an eventuality, I think, is very good practice for both companies and investors.
Benz: Sticking with risks, debt in the US has been climbing. You say the US is on a dangerous fiscal trajectory. Maybe you could talk about why and what are the implications of an elevated debt/GDP ratio, which is something we’ve been hearing people warn about for quite a few years now.
Tannenbaum: We sure have. I remember one of the most popular written pieces that I ever produced bemoaned the high level of national debt. I wrote it on the occasion of the birth of my youngest daughter, who at that time was a cute 6-month-old. I worried that she would grow up in a world where her taxes would be very high, there wouldn’t be the opportunity for her to enjoy the standard of living that mom and dad had. I read back on that recently, and it was quaint because she is now in her mid-20s. The national debt is 6 times what it was back then, and people are still saying the same things.
There are those who have said persistently that debt does not matter. I am not one of those. The costs of borrowing are impinging on the national budget to a greater and greater degree. It’s growing as a fraction of national expenditures. It’s making it less comfortable to keep up spending on even basic entitlement programs like Social Security and Medicare. It’s creating a real problem for the Congress as they try and hammer things out.
That said, we got here. What is it Hemingway said about going bankrupt: first it happened slowly, and then all at once? We had a surplus for the last time in our country in the year 2000, and those who are of a certain age will remember that the worry that Alan Greenspan had that we might end up retiring all of the national debt, and then it would be very hard for the Fed to conduct monetary policy. Well, he needn’t have worried because shortly afterward we’ve had kind of a back and forth between tax cuts and spending increases. Here so far this century, we’ve had four administrations, two Democratic, two Republicans. We’ve had mixed Congresses for most of that history and so, the notion that one side or the other is fully responsible for where we are.
But the Committee for a Responsible Federal Budget, I highly recommend their stuff. It’s nonpartial, and they really call out some of the perversions. I think one of the points of mistake is so many programs are advertised as paying for themselves and the evidence says that they never do, spending or tax cuts. And so, we’ve gotten to the point now where our debt is 100% of our GDP and could be twice that level by the middle of this century.
The good news is that financing it by and large has not been a problem other than the higher cost. The bad news is that one never knows when a tipping point is reached where international investors will say that they’ve not only had enough of our Treasuries, but they’ve had enough of the political dysfunction that periodically comes up and asks the question of whether the debt will be repaid. And I should note that our current debt-ceiling accord will expire shortly after the beginning of next year. So, whoever is seated in whatever seats in January is going to have to go back through that process that we’ve seen altogether too often where the world is watching, whether the United States and our currency are still worth investing into the same degree. So maybe not tomorrow, maybe not soon, but sometime in the rest of our lives, I think we’re going to get to a very uncomfortable point. And so, when I go to Washington, I urge policymakers to try and stay as far away from that brink as we possibly can.
Lefkovitz: While you referenced longer-term threats to the dollar’s reserve currency status, but putting that aside, the dollar has been very, very strong versus a lot of major world currencies for some time now. Do you see that changing?
Tannenbaum: I don’t. And one of the basic things that we should all recognize is that currencies are graded on the curve. And so even though we’re not handling our nation’s finances, other areas of the world are maybe even having a rougher go of it. And I often ask, what is the alternative to the dollar? And most of the leading alternatives actually have weakened reputationally. The euro area has been struggling. Several of their economies have been bumping along in recession, having a heck of a time convening new policies on the budget. They’ve had a very bifurcated set of elections this year that are going to make consensus hard to reach. The United Kingdom just had a big change of government.
The other leading economy in the world, of course, is China. And we’d be here for another hour if I attempted to enumerate the number of severe challenges that they have aside from the fact that their currency, the renminbi, is not freely convertible and therefore probably not a great candidate as an international medium of exchange. And so, as a result, most of the measures that we look at that gauge the strength of a currency, how much of foreign reserves around the World Central Bank reserves are denominated in the dollar, which year of international transactions are dollar-based? When countries and companies borrow in currencies other than their own, what is their leading alternative? And the dollar comes up at the top of those lists and probably has lengthened its lead. So, I just hope that that’s not taken as an excuse for inaction. But right now, we’re just not facing the consequences that one might think for running such big debt and deficits.
Benz: You’ve mentioned a lot of different aspects of the economy, which obviously affect the world that we’re all living in. But how should a conversation like the one we’ve just had influence how people approach their portfolios, if at all? How should they approach economic information like this and potentially incorporate or not incorporate into their portfolios’ positioning?
Tannenbaum: So, what I’ve been advising our clients is make sure that your peripheral vision is active. Beware of convenient narratives, always ask good questions. During most of my career, the presumed wisdom has not always been correct. And portfolios need to be constructed so that they’re nimble. We always advise at Northern that we’re really not after the flavor of the month, the hot stock of the day. Your investments are there for a purpose. They’re there to meet your objectives over the longer term. And so, before you even start portfolio construction, think about what you’re trying to do. Understand your risk appetite. And if you stick to that, you’ll have investment cycles that go back and forth. But in a long run, it should be a strategy that ensures that you’re where you are financially. So that’s the organization’s anthem on how to incorporate changing circumstances into investment strategy.
Lefkovitz: Well, Carl, I’m afraid we’re out of time. But thank you so much for joining us on The Long View and sharing your insights today.
Tannenbaum: It was my pleasure. Thanks for the conversation.
Benz: Thank you so much, Carl.
Lefkovitz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And at @Christine_Benz on X or Christine Benz on LinkedIn.
Lefkovitz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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