Note: This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.

JULY 19, 2010

SPEAKERS: TOM KEENE, BLOOMBERG NEWS; THOMAS GALLAGHER, SENIOR MANAGING DIRECTOR, ISI POLICY RESEARCH; KEN PREWITT, BLOOMBERG NEWS

TOM KEENE, BLOOMBERG NEWS: Right now, Tom Gallagher joining us from Washington. Tom, good morning.

THOMAS GALLAGHER, SENIOR MANAGING DIRECTOR, ISI POLICY RESEARCH : Hi, Tom, thanks for having me on.

KEENE: We just had on Neil Barofsky, Inspector General of TARP. Is this it the new Washington? Is this going to stick, this idea of transparency where Inspector General's are running around making reports?

GALLAGHER: Well, I didn't hear your interview with him, but -

KEENE: Sure.

GALLAGHER: - it's certainly part of the new environment, the financial reregulation bill that passed last week that's going to be signed by the President this week. It gives a lot of new powers to Washington and so I think whenever you get to an expansion to the role of government, then people like Inspector's General are going to have more time.

KEENE: I want to talk about in your always eclectic note, you look at the VAT tax. We've had a number of shows on the VAT tax. You suggest, I believe that it's really going to be a tough slog to get a VAT tax through.

GALLAGHER: I have a hard time getting past the always eclectic part. But I think it's going to be very difficult in anything close to this environment to get a VAT tax through. And to get it through, if it does happen, I think first you have to have some kind of market feedback, you know some signal from the market - you know most likely a spike in interest rates that can't really be attributed to economic growth that's going to be signal to Washington that they got to get their house in order.

And if you do a VAT, then it's probably not a small VAT. It's not an add- on, where you just have a VAT that more or less plugs the hole. I think it's got to be bigger VAT that would be able to take other - take income taxpayers off the tax rolls. You see what I'm saying? So if you needed to plug that 2 percent hole, you would have a 2 percent VAT, you'd have a 6 percent VAT and use the excess to reduce taxes for other people. But I think we're a long way from a political and economic context where that's going to be feasible.

PREWITT: Well, aren't we getting almost to the point where half households don't pay income tax anyway?

GALLAGHER: That's -

KEN PREWITT, BLOOMBERG NEWS: I mean it's up around 47 percent or so.

GALLAGHER: I was just going to say, I think the number's 47 percent. The number of households that pay no income or payroll tax is only 13 percent. So a lot of people pay the payroll tax, but you know if you're a worker, you pay in the payroll tax. So I think the share of people, share of households that pay some form of Federal tax is actually pretty high.

PREWITT: What - is Mr. Bernanke going to have any surprises for us this week when he goes to Capitol Hill? What are you going to be listening for?

GALLAGHER: Well, yes, I think that we're all going to be focused on how much the Fed has changed its economic forecast, even since its June FMOC meeting. We know we got an important data point. The June employment report after that forecast was put together, most of the data points since then have been more negative. So I think you know A, we'll want to see how much he might have personally downgraded his expectations for the economic outlook.

And then B, under what conditions would the Fed consider some more easing. Not kind of the small steps that have been reported in the papers, you know a cut in the interest and excess reserves rate or rolling over MBS purchases instead of reinvested the MBS as they mature. Not small things like that, but genuine quantitative easing. I think those are the two things that we'll be looking for. What's his personal assessment of the economic outlook, how much has that changed and under what conditions would they consider some genuine - more genuine easing.

And I put that in the context, and I think what's clearly bothering the markets now is change in demand. You've got the - there's been a falloff in demand stimulated a little bit by Europe and then now by the weaker data in the U.S. and so the real question is how's the Fed going to respond to that?

KEENE: And the rate of change of that. I was just floored by that amendment of macroeconomic advisors from a three handle down to a two handle. It was so abrupt. What is your team saying about the abrupt news of the last eight weeks? What is Ms. Lazar and Mr. Hyman saying about that?

GALLAGHER: Ed and Nancy, Ed Hyman and Nancy Lazar have downgraded their forecasts quite a bit. We've got a 2 percent growth forecast for the second quarter. I don't know if you could call it a forecast, with you (ph) predicting the last quarter, but you know what I mean.

KEENE: Sure.

GALLAGHER: That's 2 percent also. Also, just the diffusion index that ISI looks at, just the data, have they been stronger or weaker. That's really coming down pretty sharply.

KEENE: Yes.

GALLAGHER: So you know, this is I think the economy in the last couple of months has clearly hit - is it just a soft patch? If that's what it is, how long does it last? Will it require some kind of a policy response? Those are all the things that we're grappling with.

KEENE: Is the policy response filtered in here? And I don't mean it's a major coefficient, but this idea of all this legislation, the uncertainty that Ken and I have seen in small business surveys. How do you factor in the new-new of Washington legislation?

GALLAGHER: Well, it's done more on a subjective basis.

KEENE: Yes. GALLAGHER: I think that - I think that as I look at it, I think you can't write it off. You can't say it's having no impact because there's some new regulations and regulations have costs and they clearly will have some kind of an impact. But in terms of explaining the data trend that we were just talking about, I think it has to be put as a pretty low factor. You know what really changed in May and June, those were the two employment reports, where private sector job creation was really disappointing.

It seems to be triggered first by Europe, you know the - how Europe's policy response was swinging toward fiscal austerity and then second, just by weaker demand in the U.S. So you know it's hard to point to some new level of uncertainty over regulations that took effect in May and June. So I don't want - I'm not saying it's unimportant, but I think what's bothering the markets right now is it's a lack of aggregate demand.

PREWITT: Well, you know in the meantime, we have this story in Politico this morning that the massive expansion of government has basically guaranteed a robust job market for policy professionals, regulators, contractors for years to come. The housing market boosted by the large number of high income earners in the area, meaning the Washington D.C. area is booming right along and the political poll asks Washington elites and then the rest of the country the same question; are we heading in the right direction? The answer -

(TECHNICAL DIFFICULTY)

GALLAGHER: I'm not sure what it's supposed to sum up. I think that the public attitude is driven - is very much a coincident indicator. So with unemployment at 9.5 percent, I think that the public will always regard the direction as not - you know as we're moving in the wrong direction. I think that any poll you want to look at, whether it's confidence of the President, even confidence in the government, well generally even confidence in Governors is highly correlated with perceptions of the macro economy. And until you get some progress on that, I think the public at large is going to be disappointed in the current policy mix and therefore in incumbent politicians.

KEENE: Right. We're going to come back with Tom Gallagher.

(BREAK)

KEENE: And we continue with Tom Gallagher of ISI. Tom, I mentioned Greg Mankiw looking at the median duration chart of unemployment. It's become my favorite chart, just trying to figure out when do we see a reversal. You've written up unemployment benefits, the President to speak at ten-thirty this morning. Give us the anecdotal of the politicians in Washington as they look at just this wall of structural unemployment.

GALLAGHER: You know, Tom, I actually - I just called it up here when I heard you mention it. I've seen this before. I hadn't - but it's been a while since I've seen it.

KEENE: Yes.

GALLAGHER: I didn't realize this just continued to spike up -

KEENE: It's like five deviations.

GALLAGHER: What is especially striking is comparing this to the '81, '82 recession that ran about six quarters. It was a pretty severe one, not as severe as the one we just went through, but it got up to what looks like about 12 weeks there, it's about 25 weeks now. I mean it's - it's substantially higher. So I agree with you, it's an eye-catcher in terms of the state of the economy here.

I don't know that this has penetrated the political debate to be honest with you, very much. And I think especially given that the deficit politics has trumped unemployment politics here in the current debate that Democrats can't get to the sixty votes in the Senate to extend the unemployment insurance benefits until the new West Virginia Senator's been sworn in. So I think that tells you that this hasn't really penetrated the politics or it's not as important as not passing legislation that raises the deficit.

PREWITT: Well, is that clear-cut. I mean either extend unemployment benefits or not? I mean isn't there some more going on there?

GALLAGHER: Well, that's - it's - it hasn't - politically that's been the case, that they've lapsed because it hasn't been extended and I think this week with the new West Virginia Senator, that's going to change. So they will pass that extension. So there won't be too much of a lapse in benefits for those that fell off the roles. But I think this speaks to a broader point. You know earlier we were talking about that what's bothering the market is lack of demand and the Fed isn't inclined to do anything about it now. So you turn to fiscal policy and right now we've got - you know basically a politically equilibrium here.

Congress doesn't want to pass legislation that either raises or lowers the deficit, which is probably the worst of both worlds. And I think that's where we are now and that's what I think the markets are reflecting is that you got a soft patch. Could be - could go on for a while and policy's not really - neither monetary nor fiscal's in a position to do much about it.

KEENE: Tom, just in the one minute that we've got left with you, just remarkable as we go to the first Tuesday of November. Do you suggest that the President will be active in the election? Where does that stand now? Is he going to dive right in on Labor Day and become very active?

GALLAGHER: Of course, I think that's the traditional role of presidents. He'll do that when the time comes. Obviously, there was a lot of criticism from House Democrats about not doing enough. KEENE: Yes.

GALLAGHER: I'm sure that will poke a response and I'm sure that he'll be very active on the campaign trail. I mean what first term president wasn't active on behalf of his party in the midterm.

KEENE: Even with the criticism. Tom Gallagher, thank you so much, from ISI with perspective on Washington and our political economy.

END OF TRANSCRIPT

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