We attended the recent Schwab Impact 2018 Conference in Washington, D.C. A highlight of the meeting was the interview with Janet Yellen, the former Federal Reserve Chairwoman. In her conversation, she discussed a wide range of topics important to investors.

THE U.S ECONOMY IS IN GOOD SHAPE 
Janet Yellen noted that despite the recent stock market correction, the U.S. economy overall is in good shape. GDP growth hit 3.5% in the third quarter, or 3% annualized. She believes the U.S. economic expansion will extend through 2019, making it the longest expansion in the country’s history. Unemployment remains low. There are more job openings than people to fill them with the 3.7% unemployment rate at the lowest level in 50 years. 

She expects growth of the U.S. economy will slow next year to 2% to 3% with the unemployment rate falling even further and inflation in the range of 2.1% to 2.2%. She thinks 2% GDP growth is consistent with stable employment levels. Productivity and/or the labor market would need to increase for 3% GDP growth to be sustainable. 

LOW INTEREST RATES 
Given tight labor markets and strong growth, the Federal Reserve is taking its foot off the accelerator by gradually raising interest rates. The Fed has hiked interest rates three times this year and is expected to increase rates once more in December. Janet Yellen agrees that more interest rate increases are needed. Yellen remarked, “At this point, a couple more interest rate increases are necessary to stabilize growth at a sustainable pace and stabilize the labor market so it doesn’t overheat.” While inflation measures have hovered around 2%, monetary policy acts with long lags. Therefore, the central bank has to head off inflation expectations before they become embedded.

While President Trump has said that the Fed “has gone crazy” by raising rates so much, Janet Yellen disagreed by pointing out that financial conditions remain accommodative. She said that real interest rates (nominal interest rates less inflation) today are essentially zero. She expects the federal funds rate will average around 3% over the next 10 years, which translates into a real (inflation-adjusted) rate of 1%. 

“The normal level of real rates is likely to be low and stay low,” Yellen forecast. She stated real interest rates historically were around 2%, but most economists believe the average level of rates is trending downward due to an aging population, slow productivity growth and high demand for safe assets not only in the U.S. but in other developed nations. 

NEXT RECESSION?
Janet Yellen does not see a recession imminent. However, if the Fed tightens too much and fiscal policy turns to restraint, she put the odds of a recession occurring in 2020 at slightly greater than one in five. If it does occur, she predicts the recession would be mild, explaining it doesn’t have to be a “deep, terrible recession.”

TRADE TENSIONS
Questioned about the impact of tariffs, Yellen answered that tariffs could boost inflation by 0.1% or 0.2%. However, the uncertainty created by trade tensions may inhibit corporate investment and consumer spending, which ultimately could lead tariffs to be more deflationary than inflationary. If trade tensions escalate with China, she did not envision China using their vast U.S. Treasury bond holdings as a weapon. Since China needs U.S. Treasuries to manage their exchange rates, she conveyed, “It would hurt China more than the U.S.”

NATIONAL DEBT AND A MAGIC WAND
Janet Yellen believes the United States is taking on too much debt. National debt is 77% of gross domestic product. With the population aging and the costs of entitlements (Social Security, Medicare and Medicaid) expected to rise from 10.5% of GDP to 15% of GDP over time, the U.S. is on an unsustainable debt path. Asked how to fix the problem, Janet Yellen proclaimed, “If I had a magic wand, I would raise taxes and cut retirement spending.” 

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