We saw the turn in domestic demand about the second quarter of last year before we saw the tax cuts hit. Tax cuts exacerbated the rebound in demand. But there was still this hesitancy. The feeling was "Fool me once, shame on you; fool me twice, shame on me." You know, it's a "Show Me" economy. I want to see my order books backed up before I'm going to really commit to hiring.

In the first quarter of this year, somewhere around January, we started to see a dramatic shift among our clientele, particularly in the heavy manufacturing sector that had been so hard hit, where all of a sudden they were saying, "You know what? Our order books are filling up."

And if you look at things like the Institute for Supply Management survey and orders in general, they have been trending up for more than a year. (See Chart 2.) They were all at such low levels that it took a while to feel good about it. Remember, the benchmark was the bubble of the late 1990s.

Chart 2

[D]

Now we're to the point where order books are filling up to the degree that they actually have to bring new production capacity online.

We've also got some shortages of raw materials and steel bottlenecks and things like that all starting to come into play. It's interesting to me that this year, after facing deflation screams by a lot of our industrial Midwest clientele a year ago, they're now saying, "Your inflation figures are too low. We're going to have inflation through the roof."

And they have to understand: they're important, but they're not the only sector in the economy. The reason we didn't have widespread deflation then is the same reason why we're not going to have a sharp, widespread acceleration in inflation now just because we're experiencing raw materials prices going up. But it is an interesting issue, how much the situation has changed.

Now we're on the heels of record profits and record cash flow. As lenders, we'd like for there to be more interest in borrowing, but the bottom line is that we can finance a pretty strong recovery and investment in this country without much of a pickup in business borrowing.

Large corporations have restructured their balance sheets much like consumers did. They're cleaned up, they're ready to go, and they've got access to easy credit in many ways, from equity markets right through to the debt markets, which are much deeper than they were just a year ago. We've been seeing a recovery in business investment since the second quarter of last year, but what's interesting is seeing it broaden in 2004.

The first phase of it was sort of a high-tech reinvestment boom. We were replacing computers that we had bought for 1999 through Y2K. Service on them had expired, and even though the computers still ran just fine, we had to replace them because the leases had expired and things like that. They've got a very short shelf life. It's almost impossible to call a computer a durable good given how quickly they get replaced these days.

On the other side of it, we're now seeing the heavy truck sector coming back extremely strong, going from about a 150,000 run-rate last year to an estimated 250,000 this year. The heavy truck sector is one of those great lead industries in the manufacturing sector, because you need trucks to move stuff around. Whether it be retail goods or anything else that needs to be moved in this economy, you need trucks to do it.

So, clearly, order backlogs are building. We're hearing from our companies that shipments are picking up in the 15 to 20 percent range, but orders are picking up in the 30 to 40 percent range. We also have exceedingly tight inventories. That provides a little extra momentum—even if you didn't have demand, you'd have to replenish inventories a little bit. But with demand growing, you also are more willing to hold higher inventories. And so we're set up well on momentum.

"You know, it's a 'Show Me' economy. I want to see my order books backed up before I'm going to really commit to hiring."

D. Swonk

In terms of global demand, that's been picking up a little bit as well. The export situation has been improving slowly, in part due to the decline in the dollar. The situation abroad, although not terrific, is no longer deteriorating. And all of that is adding to a much brighter outlook for the U.S. economy.

You always have to be careful that you don't bite the hand that feeds you. People complain about the deficits we run with China, but with the rest of the world, China doesn't run very much of a deficit. In fact, with much of the world, they run surpluses. Part of the reason is that China has supported the economies of the rest of Asia that are many of our big buyers. So you want to be careful about saying that China is a problem, because if you knock China out, all of a sudden you knock out many of your developing countries in Asia. One of the reasons Japan is coming back is because China has been a big buyer of its goods.

In an election year, you often hear sound-bite solutions to complex problems. But I think you have to be very cautious not to look for sound-bite answers to complex problems. And the issue on trade is rather complex, but we're all better off with free trade than with protectionism.

Before we move to policy issues, I wanted to follow up on commercial loans. We've seen them decline at FDIC-insured institutions for 12 consecutive quarters. The decline has been led or dominated by large banks that make loans to large corporate borrowers.

You cited some of the fundamentals that are back, and you also cited some of the factors that are restraining borrowing, including access to the capital markets. Give us, on balance, your outlook for when that number will turn positive again. How much of a recovery in C&I [commercial and industrial] loan volumes do you see later this year?

I think we still probably have got a very soft first half of the year through June or so, but as we get into the second half of the year, there are a couple of factors that may be pushing up commercial lending. First, the underlying fundamentals for investment activity are improving, which is the number one thing to look at. But cash flow will also remain strong, although year-on-year profit gains are going to be tougher to get the comparisons on, because we're already coming off an extremely good quarter.

"I think you have to be very cautious not to look for sound-bite answers to complex problems."

D. Swonk

So by the end of the year, instead of a 30 percent year-over-year gain, we'll be looking at more like 18 percent, which is still spectacular. But all of a sudden, if you start investing, you'll be using some of that cash flow.

The other issue is that capital markets have gotten a lot deeper. Equity markets have gotten deeper. But I think as the fear of rates going up increases, there will be some rush to lock in to some kind of borrowing. So there will be an opportunity in the second half of the year for banks to step up and say, "Here's your chance, guys. This is it on low rates."

We have had a Fed that's been very restrained, very willing to be patient, and we have a lot of liquidity. There is not a lot of risk out there, and C&I loan growth should help strengthen the economy in the second half of the year. We expect it to accelerate into the fourth quarter. Many people have criticized us for having C&I loan growth pegged at around 4 percent in the first quarter and saying we're way too low—and now everyone's revised down to us, so I'd love to be surprised now. By the end of the year, I think we are looking at 5 percent growth.

One of the reasons is that the ability to fully expense certain types of capital expenditures will expire at the end of this year, and many of our capital equipment producers are already saying, "Yeah, we need to think about it—we'll get to that in the second half." So it sets up a second half of the year surge in many of the kinds of purchases that require C&I loan growth as well.

In terms of timing, we may end up borrowing a bit of investment activity from the beginning of 2005, but it could set up for a very nice second half of this year. I caution people, though, that if they get a really great fourth quarter, to take it with a grain of salt—they may want to average it with the first quarter, because it could simply reflect people slipping in under the change in the tax law.

Another experiment that will show that tax policy affects behavior.

That's right. It does affect behavior.

You touched on something else also. There is an interesting debate that we see developing with regard to inflation. Some have said that the commodity price increases we've seen recently are a harbinger of a wider price inflation that will be a replay of what we saw in the 1970s. Others say no, it's different this time—we have essentially a deflationary global economy, which makes inflation a very remote concern at this stage. What is your outlook for inflation, and what does it imply for Fed policy?

I guess there is no real black and white to inflation this year. I think one of the greatest issues in inflation is that we've got some of these temporary bottlenecks in raw material price increases and we've found ourselves in a high-productivity environment, so we've been very, very able to absorb a lot of that shock. Commodity prices are only one piece of a very complex inflationary puzzle.

More important, and maybe more subtle, than that is that many of the deflationary factors that people were really concerned about have disappeared. And that could, in turn, lead to some concerns going forward about inflation.

My own view is that we could get some relief on oil prices—and that takes a lot of the pressure out of the equation. At prices this high you tend to get lots of cheating at OPEC, and we may already see that kind of activity picking up. And that's great, because we'd like to see oil prices come down a bit.

In my view, we are in an environment where deflationary pressures are abating, unveiling some of the underlying inflationary pressures in this economy, which are not overwhelming but certainly are there.

I believe we have now reached a point of price stability. If you look at the underlying core inflation numbers, whether it be the Personal Consumption Expenditures Core Index or the Consumer Price Index, we've seen a stabilization. We no longer have disinflation, prices are no longer falling, so we're stabilizing. The question is, when is inflation going to move up? Well, inflation is inertial, so we should expect it to move up slowly, but we should also expect it to move up.

There are two issues there. One is that the Fed certainly feels it has a little bit of wiggle room to allow inflation to move up. That may be a case of "Be careful what you wish for." If you get price stability, do you really want to be there? The other issue, though, is once you start chasing inflation, you have to play catch-up, and we're starting with a Fed funds rate that is extremely accommodative.

Ideally, the Fed would like to have a gradual increase in rates that the markets can adjust to. Nobody wants disorderly change; they want it all to be very orderly. Also ideally, I think, with the stronger employment numbers, seeing the Fed move up by the end of this year to 1.5 percent in the Fed funds rate would be welcome news, because it would set the stage for a more gradual pickup in rates over the course of the next couple years. Now, "gradual" is a relative term. I've got the Fed funds rate close to 4 percent by the end of 2005!

Four times where it is now.

Exactly. And that is a lot of heavy lifting for the Fed to do in an orderly way. And, you know, the question is whether they will be able to do it in an orderly way.

Many people are saying that we need to be more preemptive, but this is a Fed that says no, we need to be more reactive. I think we need about three-quarters of a million to a million in employment gains before the Fed feels comfortable moving, so we're not there yet. It'll be volatile in the next couple of months, but you can certainly envision the Fed statements beginning to express a balance of risks to inflation as they gradually start to take the security out of the system. It will start out gradual, but in 2005 it could be much more aggressive.

And the Fed will prepare the markets for that. They've already begun to say, "Rates are going to go up, you know they're going to go up—OK, guys?" Just when will depend on how strong the economy is. When the rates do go up, we like to see it be nice and orderly and gradual. But how many times do we really get our wish in that way? Life usually has a lot more surprises in it. My concern is that there will be a much less orderly rise in rates in 2005.

The real challenge for the Fed will be to manage the bond market so that it doesn't go too far in the other direction. Because clearly, the bond market went too far in accommodation in thinking that deflation or disinflation was forever in the prices of bond deals, which is sort of silly, and the bond markets can change pretty quickly—and quick changes are hard.

Do you get the impression that we are at the end of a 20-year cycle of disinflation with short-term interest rates at a 45-year low, and that we are turning a corner? That's a very uncertain place to be, as evidenced by the bond market's reaction last summer. They weren't quite sure whether to turn that corner.

There were a number of factors behind the bond market reaction, but yes, there is no question there is uncertainty. The interesting thing is that, for the most part, most traders in the bond market have been in a bull market their whole lives, and that lack of experience is something that you worry about, because we are at a turning point. The Fed is coming out and saying, "Eventually we're going to have to raise rates, guys. You know that, right? We're patient, but patient doesn't mean no rate increases."

Inflation is stabilizing, and if the economy improves, even if inflation didn't accelerate, you'd still have to raise rates so you wouldn't have to worry about it later on.

The Fed is also firing these warning shots, saying that if we get into structural federal budget deficits again, along with current account deficits, and we get dollar depreciation—that may eventually work into prices. These are all things we have to worry about. So we can't take it in a vacuum. And the problem is, like I said earlier, people's natural tendency is to take the most recent past and forecast the future. The most recent past often sets the stage. And the fact that we're at 45-year lows should tell you something—it's not sustainable. So prepare yourself.

The problem is, it's very difficult to time. What you have to do is be ready to move as soon as the market moves, which means you're not going to get the market low, and you won't be able to fully hedge yourself, as a lending institution, against higher rates. However, it is probably a good time to go ahead and start hedging, because once rates begin to move upward, it will probably be part of a long process, not a short-term adjustment.

I'm interested in your views on the current account deficit and the dollar. Here again, there seem to be opposing views, although the reality is probably in the middle. One view is that the United States is spending beyond its means, which could result in an unstable dollar—a collapse scenario for the dollar. Another school of thought sees the U.S. current account deficit as structural and not unrelated to the fact that many countries and firms around the world really depend on exports to the United States, so there's a long-term structural global imbalance. Is either view accurate? And how does a half-trillion-dollar current account deficit ultimately resolve itself?

Well, first, we do have a structural trade deficit—the rest of the world relies on us because we rely on the rest of the world for our goods. We are the most efficient economy in the world, and we have the highest capacity to consume and invest of anyone in the world. So all else being equal, given purchasing power parity or anything you want to throw in there, we would be running a structural current account deficit, importing more than we're exporting, because we have this insatiable demand that is allowed in this country because of the freedom and depth of our capital markets.

"It is probably a good time to go ahead and start hedging, because once rates begin to move upward, it will probably be part of a long process, not a short-term adjustment."

D. Swonk

The last time we had a merchandise trade surplus was right after the recession in the 1990s. At that time, we had everything possible going to help the current account: weak demand here, strong demand abroad, and a weak dollar.

We had foreign contributions for the war then, too.

Yes, so that was an extraordinary period of time. And to get back to that kind of balance, that's a heck of a lot to ask of the world and us. It would take a recession here to do it, along with an extraordinarily weak dollar reminiscent of its plunge in the late 1980s and early 1990s.

This time we've had a reasonable, orderly decline in the dollar. In the near term, I think there is actually room for stabilization in the next year or so, and maybe even some appreciation, as we start to get into a situation where rates are rising in the U.S. and world economies are improving as well. Going forward, we should continue to do better than the rest of the world, and in a higher rate environment that just tends to favor cash flows into the U.S. We'll also continue to see a better return on capital for a while. And that should be favorable to the dollar, to at least keep it stabilized given the counterpressures or crosscurrents of a large current account deficit.

The other issue is that the dollar alone can't do the heavy lifting. It's a very crude tool given that many of the countries that we have trade deficit problems with do not have floating currency. China is only one example. And, frankly, even if the dollar depreciated 40 percent against China and they moved to a basket of currencies, that wouldn't change—in fact, it's still cheaper to produce in China than it is here.

The larger issue over time is going to be very difficult for us. I think we'll get some cyclical improvement in federal deficits, which will take some pressure off so we can deal with some fundamental problems in the federal budget deficit that no one really wants to deal with, because they hurt. It's painful. And you need almost a crisis type of situation like we had in the early 1990s when the balanced budget accord was pushed through to actually deal with things like the federal budget deficit.

My fear is that the persistence of the twin deficits (federal budget and current account), even with momentary improvements, is going to cause an enormous amount of pressure on the dollar over the next five to ten years. What we could be talking about is dethroning the U.S. dollar over time as the world reserve currency. I think no one has really thought about what that means, moving to a basket of currencies where the euro is one player in that basket, the dollar is one player in that basket, and perhaps the yen is another player in that basket. Having the dollar as the reserve currency has been another reason why we have been able to afford the luxury of carrying such a large amount of debt as a share of GDP, unlike any other economy in the world. People say it's just the depth of our capital market. Well, who's to say other countries that are reforming are not going to have depth to their capital markets also?

I think we're running a large risk of losing that status as the world's gold reserve, sort of a gold currency. It's not real gold, but it is the reserve currency of the world. In fact, gold ore is traded in dollars. Europe has not had to pay higher oil prices because it is the dollar that has depreciated.

But on the other side of it, the dollar's status as a reserve currency has afforded us lower interest rates and more debt than any other country in the world would be allowed to carry—it really is extraordinary. What we are doing is walking into a world where I think you could see a very substantial collapse in the dollar in the next five to ten years if we don't do some things to improve that and, as a result, lose some of our status as a world reserve currency.

That would be a very different world for us to deal with. We would have to deal with the same kind of consequences as many of our trading partners when they go into debt. And we would be expected, like firms and individuals and the rest of the world, to make an attempt to pay back our debts. That's something we're not entirely used to in this country.

So it's a structural change. And that gets into my role at the bank, looking at the world and what could go wrong, what could go right—no matter what could change. How do you position yourself for that change when it comes? Be aware, this is where the potholes are and this is where the opportunities are. Every change is an opportunity, as long as you anticipate it.

It's very difficult to anticipate these regime changes, waking up in a different world where the dollar is no longer king.

Right. But it is better to be thinking about them now than to let them sneak up on you.

That leads to the next question, which relates to your role at the bank. I would like you to discuss the role of point forecasts versus the type of analysis you just described, which is a scenario analysis. Which is more important in terms of the usefulness in decision making, risk management, that sort of thing? Or do both have a role?

The market requires point forecasts. You have to remember what economics is at the end of the day—it's the study of collective human behavior. It's not this magic black box of numbers that we spew out for markets to move by on a daily basis, and it's one of the main reasons that I don't work on the trading floor.

I think that fundamentals always dominate, and, over time, economics is most powerful over a two- to five-year horizon. For planning purposes and risk management, economics is most useful in identifying which industries are really going to boom if we're positioning the bank this way and which industries we need to worry about. It's more powerful in all those ways, picking winners and losers, than saying the Fed will move a quarter-point on this date. The reality is that we know the Fed is going to move within the next 18 months. But by how much is it going to move? We can guess with a reasonable amount of certainty, but the reality is that it is more important to know that we are shifting, that we are at a turning point, and to know how to position yourself for that turning point as it comes.

"Every change is an opportunity, as long as you anticipate it."

D. Swonk

In terms of my role at the bank, I've done risk management, I've done the equivalent to ALCO [asset-liability committee] and those kinds of committees. But more often than not, economists get asked the wrong questions. I think the role of an economist is to help define the questions so that they can be answered in a meaningful way, rather than let the market determine the questions in a less meaningful way. I think we spend too much time on point estimates, although they're important, and that's where the articles are written and that's where brand equity can be generated in answering those questions.

The reality in terms of adding value to your company is to help strategically, and economics is just incredibly well suited for that. That's where, especially for lenders, you need to understand where strength in consumer borrowing is going to be—which is very, very strong in traditional areas—but you need to price the risk, you don't just ride the wave. That's a really important thing to be calling. It's important to call that heavy manufacturers are going to be coming back, and don't write off and leave behind all these great customers you've had a relationship with because they're not coming back at that particular moment. Obviously, you want to be selective, but you want your institution to be there for them, because they are going to make it back.

"You have to remember what economics is at the end of the day—it's the study of collective human behavior. It's not this magic black box of numbers..."

D. Swonk

So my view is that you add a lot more by identifying structural change and using the power of economics in terms of what it really tells us about collective human behavior, the decisions that are being made out there, and the repercussions of the decisions you make, rather than just focusing on the point estimates.

With that said, every point estimate of the economy should reflect a story. Far too often, you'll see forecasts that aren't consistent. We all have our different theories and our own model that points out what is consistent and what is not. If we're not going to be consistent at some point, we're saying that history is changing. Are we willing to make that bet, theoretically? Is the world really changing, or is it we're just wrong on our point estimates? You want a consistency in your point estimates where someone can read the forecast and see a story—for instance, that the consumer sector is moving from being the leading sector to holding its own, but is no longer the driver of the U.S. economy, or that investment is moving from being a drag on growth to a booming sector in both traditional as well as high-tech equipment. Those are consistency issues, and there are stories in the numbers.

I teach MBAs, and their final project is to be a stock analyst and value a company. I teach them the economics of it, and what I teach them is, "Don't worry so much about what every word of a Fed statement says. Worry about where things are going from here, and what the story in the forecast is." If you are going to write about your company in the context of the economy, you better have your logic consistent. Even if you don't agree with me about what the macro picture says about the individual winners and losers—and all are tied, inherently, it goes in both directions—you had better understand what you are saying. Everybody has their own sound-bite answers, and everyone wants to hang onto that, but that's not really a part of strategy, and that does not represent long-term understanding.

At the end of the day, we focus so much on quarter-to-quarter movements, day-to-day movements in the market, and, frankly, is that where the press comes? Absolutely. And that's where brand equity can be generated, and the role that I play as a face for the bank. But I always say that's the icing on the cake—I still have to bake the cake. And the baking of the cake is to understand what all the inconsistencies are in the longer run and the structural changes that are emerging. Because you can have someone coming to you and saying, "You made an interesting point—you didn't just talk about employment. You made another point about that that was something that caught my attention." And that's what you want to do, to make people get an "Aha," and give them a toolbox to understand the world going forward.

You impressed people at the FDIC when you spoke to our November 2002 economic roundtable.¹ A lot of people at the FDIC, especially those who are not economists, said, "Diane's the first economist who I really understood. She tied her story to things that were tangible to me." The story behind the numbers is something that you really bring across.

I am very much an applied economist, and, believing in that, my job is that of an economic translator. I take what really brilliant people say and try to make it make sense in the real world. So they make me look really smart. That part about being an economic translator, you have to take out all that academic stuff and say, "This is what it really means for you." That's part of the job for an economist in any company. Everything I have done is useless if I'm not helping someone to think, and I have not helped them to understand their world in a better way. Communication, at the end of the day, is the only way to do that.

I don't like to invoke my privilege in being a woman, but it's not always been an advantage in my profession to be a woman. I've learned to make lemonade out of lemons on this issue, and I think I have more latitude in making economics real and interweaving, talking about my children as an illustration, because what we tend to forget is that economics is about the thousands of decisions that we make every single day, whether we are going to spend time enjoying our children, for example, and not make money during that period of time.

That's a base decision of human behavior. Most of us work to live, we don't live to work. I love what I do with a passion, and I understand that everything we do is economic, but at the end of the day, it is important to be able to relate that to people so they can understand it more in their own world. We all understand economics—we all do it all the time. My challenge is to get people to be aware of how they're making decisions and how those decisions influence the rest of the world.

You have been very generous with your time and your willingness to talk through all these issues with us and to bring your own personal experiences to it.

It's been my pleasure. It really is. I mean, this is what it's all about, to get people to think a little differently than they have. This is what I do.

Mary Ledwin Bean provided editorial assistance for this article. Photographs are also by Ms. Bean.

In Person Profile: Diane Swonk Diane Swonk is Director of Economics, Chief Economist, and Senior Vice President at Bank One Corporation in Chicago, where she manages the bank's Corporate Economics Group, and is a Clinical Professor for DePaul University's MBA program. She recently published her first book, The Passionate Economist: Finding the Power and Humanity Behind the Numbers. Ms. Swonk began her career with First Chicago Corporation. She is a national economic consultant and appears regularly on television and in major financial publications. She served on the Board of the National Association for Business Economics (NABE) and the Finance Committee for the Executive Club of Chicago and is a director of the Illinois Economic Education Association. She was named "Business Leader of the Year" by the YWCA of Metropolitan Chicago and an NABE Fellow for her outstanding contributions to business economics. Ms. Swonk was one of the Wall Street Journal's "Star Forecasters," was named "Top Woman in Finance in Chicago" by Today's Chicago Woman, and was just named one of the most influential women in business by the Chicago Sun-Times. Ms. Swonk earned her master's in economics with honors from the University of Michigan and her MBA with honors from the University of Chicago.