The Federal Reserve's Role in the Economy
Todd Millay, managing director of Choate Investment Advisors, is joined by Dr. Cary Leahey, an independent economic consultant, to discuss the state of the economy and in particular, the Federal Reserve.
Todd Millay: Hi I’m Todd Millay, managing director of Choate Investment Advisors. Today I’m pleased to be joined by Dr. Cary Leahey, an independent economic consultant, who provides us with ongoing advice about the state of the economy and in particular the Federal Reserve. Cary teaches economics at Columbia University in New York and has extensive experience in the private sector and governmental roles. He was chief U.S. economist at Decision Economics, a senior economist at Deutsche Bank Securities and was the chief financial markets economist at Lehman Brothers where he served as the senior Fed watcher. He has also worked for General Motors and the White House. Cary earned his PhD from the University of Pennsylvania and is a Phi Beta Kappa graduate of Clark University. Cary, thank you so much for being with me today.
Dr. Cary Leahey: Thank you very much Todd for having me. Thank you for that very kind intro.
TM: So today we’re going to talk about the Federal Reserve or the Fed, I guess as we’ll be referring to it. And stepping back from the current crisis, there’s a lot to talk about with regard to the Fed’s role now. But I was hoping you could just start by just giving us an overview of the Federal Reserve and what role does it play in the U.S. and global economy.
CL: Well very good, thank you for that Todd. What I’d like to do is give you a little Fed 101 where I’ll talk a little about the history of the Federal Reserve and little about the institutional details, what goals the Fed has, its relationship with the other branches of government, particularly Congress and the White House, and then talk about the tools that the Fed uses to meet those mandated goals. The first thing to know is that is that the Federal Reserve, the Fed or the Board is a very interesting organization that comprises both government and the private sector. As some of you may already know, there are a number of members of the so-called open market committee, the policy rate setting committee, which are presidents of private banks, but there are governors in Washington, D.C. who actually are appointed by the President and confirmed by the Senate. So it’s important to remember that this bifurcated operating committee, this so-called FOMC includes individuals who are making economic policy for all Americans but are not directly responsible to either the president or Congress and ultimately the voter. That has created some problems with Congress which we’ll get to in a moment. But the first thing to know about the Fed is that the Fed has been around for over a hundred years, but it is only really been independent of the U.S. Treasury, which is what we call our own finance department, since 1951. In 1978, Congress in its wisdom, gave the Fed a very broad and vague mandate of what they wanted them to do. So they’ve been around for 65 years and they didn’t really have a specific mandate and the mandate mandated from Congress, which was the so-called the Humphrey-Hawkins Bill for 2 legislators, was both vague but broad. What they wanted, meaning Congress, wanted the Fed to have stable prices and maximum sustainable unemployment. Well what does that mean? What has happened is that the Fed has taken the stable prices to mean stable inflation where the goal of inflation is to be around 2%, the so-called 2% target, which was codified by Greenspan in the 1990s and made quasi-official in the last five years. Maximal sustainable unemployment is much vaguer and harder to figure out because we economists have had a terrible time trying to figure out what is the unemployment rate that would be consistent with a stable inflation rate. As it turns out that rate has been given a lot of crazy names but the latest name and the one you may have already heard of is the so-called “natural rate.” So the Fed, like many people using economics, is not as confident on what that rate is and as we’ll see later in our podcast, the fact that the Fed, particularly led by Janet Yellen and now led by Chairman Powell, has been very much willing to run the economy hot and let the natural rate decide when inflation will eventually pick up.
TM: Remind me what the tools are that the Fed is using to make this trade off. The Fed is essentially America’s central bank. It’s the bank for our banking system. What tools do they have at their disposal to strike a balance between inflation and unemployment?
CL: Well what they essentially do is they have what you might call now a four sets of tools. The first tool is the one that most people are familiar with from their Econ 101 classes. Which is changing the amount of reserves in the system that banks can use to make loans. So their changing interest rates by changing reserves. They set a policy rate the so-called “Federal Funds Rate” and they adjust reserves to get you there. One of the confusions many investors have is they think this liquidity, these reserves are being created by the Fed which is what they call money. Is they’re creating wealth out of thin air and the answer to that question is yes and no. But it’s important to remember that the Fed has to rely on banks to take those reserves, that liquidity, and make loans and once they make a loan, it’s important to remember that a loan is a debt. So it doesn’t create wealth, it allows someone that takes on the debt from the bank. The bank has made you a loan, are you going to waste that and create a business that doesn’t thrive or can you create a business that does thrive and you create wealth by creating this IOU. The second thing the Fed can do in their tools is to communicate. Now this called currently “forward guidance” but that’s been done by the Fed for many, many years where they have been trying to tell people where they think the economy ought to go. It used to be referred to as “moral suasion” but it become “forward guidance” after 2008. The Fed also makes policy statements since 1994 and they also have numerical forecasts and they finally did something I didn’t think the Fed would ever do, but starting in 2012, they had policy rates forecasts. So they are manipulating both the unemployment rate and the inflation rate by lowering rates, communicating their intentions in an effort to spark, if the economy is weak, interest-sensitive spending, like cars and homes which are interest sensitive and at the same time if the economy’s running too hot, they’ll raise rates, turn off the spigot to banks and hopefully banks will pull on the reigns, make lending more expensive and less available and slow down the economy. I will mention two other tools that they use, one that really came up after 2008. What happened is that the Fed says okay we are concerned about inflation and concerned about the economy. We had to lower rates to effectively “0” so they couldn’t lower them any more so they said “my gosh, what do our models tell us that we need to do to right the ship on the economy in 2008.” And believe it or not their model said you got to lower policy rate minus 6%, but they said we can’t do that, the rate’s already at zero. So what they did to approximate that was to combine forward guidance, which was called balance sheet expansion, which many of our podcast listeners know as quantitative earnings. So they expanded the balance sheet in a way to replicate lower rates. And then finally what they did is once again an important point to remember is the Fed is hamstrung in that they need to work with banks and they increasingly know that banks while still very important are less important than they were 10, 15, 25, 50 or 100 years ago. So they created a number of financing vehicles in 2008, many of which they brought back in just the last several months that broaden the counterparties that are engaged with the Fed at the same time, widen the collateral that they can use by loans. So the last point I want to make is, and Powell says that in speeches, all the time, is that the Fed doesn’t buy, they lend. So if they are going to lend someone they think needs help, to make that loan, the borrower has to provide some good collateral. So in many cases, the Fed with over collateralize loans in an effort to protect themselves and in many cases they end up being overly cautious and they make money just to give you a final example on all the lending that the Fed made to Bear Stearns they ended up make a very considerable profit in part because as I’m sure as many of our listeners know, the longer you can wait, the more illiquid risky assets can actually end up turning a profit. So the Fed can be a patient investor and ended up making money on assets they were forced to take over which they would have lost money if they had done it and sold them initially and they ended up making money. So those are the four ways they try to in summary effect interest-sensitive spending in an effort to either prop up the economy or slow down the economy, depending on what they are worried about.
TM: And Cary you mentioned those last two tools are relatively new innovations, they came as a consequence of 2008. They have certainly come back into play now. Can you talk about how the Fed is applying the lessons of 2008 to the current pandemic?
CL: Yes, I basically can say that there are four things the Fed did and learned from 2008. So I will use your question, which is a good one, to amplify it a bit. The first thing they learned from 2008, was to go big, go fast and to be as effective as possible. To think that the Fed pre-pandemic was predicting interest increases in 2019 and actually ended up lowering rates and at the same time abandoning a shrinking of the balance sheet and moving toward increasing the balance sheet before the pandemic. They were willing to move fast and then when the pandemic hit, they basically lowered interest rates from effectively 2 percentage points to zero in literally two weeks. I mean that has never been done in the history of the Federal Reserve. To move that big, fast and effectively. So the Fed has proven to be the most dovish Fed in history and is ready to run the economy hot until the inflation rate is above the 2% target. So I think the promise the Fed is making to us with their tools now, is they’re not going to raise rates from zero until inflation gets to 2% which could be a very long way down the road. Now to answer your question more specifically, it’s important to remember that the Fed is not only adopted almost all of the special vehicles from 2008, but have added to them and they’ve gone boldly where no one thought the Fed would ever go and let me walk you through those very quickly. The first important thing to note was that transmission process in this downturn was completely the reverse of 2008. In 2008 it was weak banks could make a strong economy weak. So the Fed was focusing on the banks, no so much on the real economy. So one of the things the Fed did in 08, and they did last, was they set up a special facility for commercial paper. What was the very first unusual thing the Fed did was beyond lowering rates to zero, is they reestablished the commercial paper facility first because the transmission was completely different. What was happening now was business was collapsing and the Fed was worried it was going to weaken the banks. So instead of the banks, in some sense, being hurt early, they’re afraid they’re going to be hurt late, so they set up the commercial paper facility. And then they did something they had never done before, first they decided in their wisdom to help the corporate bond market and they set up a facility that said if necessary we will buy corporate bonds and then they went a step further and surprised yours truly, and a number of other analysts, to set up not only purchases of high grade corporate securities, but junk bonds and then finally, the one area the Fed was least interested in getting caught up in the muck and mire of state and local finances, they agreed to provide short term financial assistance to the municipal bond market and then finally what they did is not only were the helping the big guys with commercial paper, corporate bonds, junk bonds and the like, they did set up what is known as a main-street financing facility which was trying to hit the medium-sized operation too large to tap the special funding from the governmental legislation, the so-called PPP loans for small business, there were attacking with this main street lending facility, medium-sized businesses, they are getting involved in that. But the Fed has proven to be a reliable partner to Wall Street and has proven to be concerned about not only inflation but the unemployment rate so that the Fed tremendously turned around the markets, particularly in the corporate area without actually having to buy any corporate bonds. So the very announcement effect that the Fed made that “we are willing to help the junk bond market, the corporate market, the municipal market and medium sized and small institutions if necessary” was a tremendous announcement effect, no unlike the famous 2012 statement by European Central Bank President, Mario Draghi, when he said “We will do whatever it takes to save the Euro.” As it turned out, he didn’t have to do what he said he was thinking of doing because people believe, if you’ve got the big bazooka in your pocket, you don’t necessarily have to use it.
TM: I wanted to come back to this notion of the Fed buying bonds, corporate bonds, even junk bonds you mentioned. How does that actually work? Where does the Fed get the money to do that?
CL: Well, the point to be made is the Fed is protecting itself from an initial line of losses by accepting money from the taxpayer. What happened was because of changes made in 08 through the Dodd-Frank legislation, through the Dodd-Frank legislation, the Fed cannot do a lot of stuff so to speak without the approval of Treasury and the capital that the Treasury would provide. Now, if it really is an over-the-weekend kind of situation and the Treasury can’t go to the Congress and say “will you allocate us some capital” and set up these facilities that the Fed will run, they can tap things and this is getting very “inside baseball” kind of stuff. But, they have something called the exchange stabilization fund which has up to 100 billion dollars and that can be, in a real pinch, be tapped. But as some of our listeners may know the so-called Cares Act which the third pandemic bill passed by Congress, it had various tranches of capital that were being tapped by the Fed and from there the Fed can leverage up by a factor of 8 to 10s. So, if they get 10 billion dollars of capital for a particular program from the Treasury via you and me the U.S. taxpayer, they can leverage up by a factor of 8. So in some sense they are making money not out of thin air, but out of capital provided by the taxpayers. So, if these loans were to go bust, you and me the taxpayer would be on the hook for somewhere between 10 and 12% of the loss. After that, it would be a different story. So they are getting money from the taxpayer, which they are leveraging up. So that is what the main street facility is doing and the corporate bond lending facility the junk bond lending facilities are doing.
TM: You also mentioned that the Fed has announced that it’s going to keep interest rates very low, near zero through the next couple of years. How does it do that in practice? Is that a combination of a forward guidance that you mentioned and what tools do they have available in order to make sure that interest rates remain low.
CL: Well it is true that they will use in conjunction with forward guidance and quantitative easing a way to keep rates low, but the major way they do it from day and day out is the old fashioned way of setting up reserves. Now, what that leads you to and it turned out these worries while understandable, turned out to be incorrect. Is that the Fed is creating an astounding amount of reserves and creating an astounding amount of money based on those reserves. Meaning that various measures of the so-called “Money Stock” M1, M2, M3 and whatever you want to call it have increased substantially. The worry in the market place, though Todd you didn’t ask that question directly, is that eventually those reserves could lead to an overheating the economy. But the first point I want to stress if we want to spend more time on the inflation question is, once you produce reserves, the banks produce the loans, first you have to have a stronger economy to get a higher inflation rate, unless you’re talking about the usual intricacies of the an oil price shock where you have an increase in oil prices which makes the economy weaker because you’ve taken money out of the peoples pocketbooks, but you also raise inflation. It is very important that our podcast listeners remember that if we are going to have inflation down the road, it almost always happens when the economy gets strongest. So first the economy is going to react, more lending, lower interest rates, stronger interest-sensitive spending, more business activity, and then eventually you run into capacity constraints, the economy will feel strains and you’ll get inflation. But first growth then inflation. So, it’s generating a tremendous amount of reserves to keep rates very, very low. But once again, the Fed will have to do less the more effective and how more the typical investor believes the Fed. This is the so-called “well anchored inflation expectations” argument. That if ultimately the markets says the Fed has our back, their worried about the economy, but they are also worried about inflation, then we don’t have to worry about the Fed screwing up and they may not have to increase reserves as much because people will base their activity on the announcement effect not the actual activity itself.
TM: Okay I wanted to ask you about that because after 2008 and the extraordinary Fed intervention, there were concerns that that would stoke inflation eventually and we did have eventually a strong economic recovery. But we never really had inflation, in fact inflation really didn’t get back to the Feds target. And so (a) I’m wondering why that is and (b) what lessons does that have for us this time around?
CL: Well the first answer to your question is the hardest thing for an analyst like myself to say is that “we just don’t know” and we’ve been scratching our heads on why inflation has stayed so low. Many people will laugh at us economists and we’ve been the butt of jokes for generations now. That oh, I knew what that was 35 years ago. It was because of the China effect. Now clearly low-cost imports were an important part of that. Clearly the fact that workers have less bargaining strength played a role in that. But it was very hard to figure out how the economy could get to the lowest unemployment rate in fifty years without generating very much inflation and in particular, inflation was doing what we economist thought it ought to do. Was moving to 2% and it was on its way to 2.5% and we were going to have the last laugh and then in 2018 it got to 2% and them backed off and then economy got even stronger. So that is one of the major reasons why the Fed basically waved their hands and said we just don’t know and so we need to lower rates just in case the market, which was concerned about a slowdown in the economy in 2018, they lowered rates. So the answer is we don’t have an easy answer and the Fed has basically taken what was considered an odd ball premise where you have kind of a liberal outlier among the Fed Reserve policy makers and he said, what we really ought to do is not raise rates at all, not one iota until the inflation rate is above 2% and it’s been above 2% for some time and that now is probably the mantra at the Fed and I think the Fed would be highly reluctant to raise rates right now until the inflation rate gets to 2% which I don’t think is going to happen. But there are some interesting wrinkles out there. Not necessarily related to monetary policy, which may give us more inflation than people are looking for but it won’t be necessarily because the Fed printed too much money.
TM: I wanted to come back to your inflation outlook, because I’m very interested in that, but before we get there, let’s talk for a few minutes just about what are the limits of the Feds effectiveness. Obviously, you’ve mentioned a number of very powerful tools that they have to shape the economy, but Jerome Powell was recently testifying before Congress and repeatedly asked Congress to increase fiscal support and could you talk a little bit about the role of fiscal policy versus the monetary policy that is enacted by the Federal Reserve.
CL: So why don’t I answer that in two parts, first talk about what the Fed hasn’t done and could do, what other tools they have and what are the limits of those tools and then talk a little bit about the importance of fiscal policy working in conjunction with monetary policy. First obviously the question to ask yourself if the Feds are willing to buy junk bonds, are they willing to buy equities and the answer is we don’t know. It’s highly unlikely they would do that but there is some precedence that other central banks do actually purchase equities, but that’s highly unlikely. What is more likely to happen is what is referred to esoterically as yield-curve control which says as we already discussed the Fed pins down the front end of the U.S. yield curve through the federal funds rate, but could they pin down intermediate and longer term rates and the answer is yes. They did that, when I mentioned that Fed achieved independence from the U.S. Treasury in 1951, before that, to finance the WWII indebtedness, the Federal Reserve essentially log-rolled and did what the Treasury told them to do and basically kept rates low and they pinpointed intermediate long term and short term rates. So they have experience in doing that, though clearly no one currently working at the Fed was working at the Fed in 1942 when they were doing that, but they do have experience doing that. Now effectively, it doesn’t mean a whole heck of a lot because interest rates are already at extremely low, but they can do that should they feel the need. The last point to be made which is maybe a question whose time has come and gone, is could the Fed lower interest rates below zero as they have done in a number of European economies most notably, Sweden and the answer is maybe. The big difference there is the problem with negative rates is that it can create some misallocation of resources, keep zombie companies alive that shouldn’t remain alive and finally in the U.S. because we have a highly-developed money market mutual fund industry, there is some difficulty that if interest rates were negative, would that make it impossible for money market mutual funds to maintain that so-called dollar value of their funds and could those funds become unstable. So that probably makes negative rates highly unlikely. The Fed would be a lot more comfortable doing yield curve control. Now, finally what about fiscal policy? This is extremely interesting and for a number of reasons. The first is history. Many people said, why was the Fed continuously increasing the balance sheet with quantitative easing to 2, 2 and ½, and 3. Why were they doing that? One of the major reasons why they were doing it was they had to deal with the hand they were dealt. And as some of our podcast listeners know, they may remember that many G7 economies including the U.S. adopted fiscal stringency so-called austerity measures starting at around 2010 and 2011. This happened in the United States and so as fiscal policy became tighter, the Federal Reserve in its wisdom decided they had to be looser than they would have been otherwise, so one of the reasons why we had QE2 and QE3 was that fiscal policy was becoming quite restrictive. Now finally, and this is the point from an analytical and also societal perspective that is so incredibly interesting is the Fed knows that what they are doing right now can really fight potential illiquidity in the economy, help to build a bridge to a better world six months from now. But it can’t deal with what’s surely going to happen and what investors are grappling with now, is what is the economy going to look like in 2021, 2022, and 2023? If it is significantly different, we are going to have to reallocate not only capital, but we’re going to have to allocate labor to different firms, different industries. Some industries are going to cut it. Some can’t and that reallocation process cannot be done by the Fed. It needs to be done by the firms and the workers themselves aided by fiscal policy. It can come in the form of tax credits, in can come in the form of support for R&D. All those things, that’s why when Federal Reserve Members say we can deal with liquidity problems, but we cannot deal with fundamental structural problems in the U.S. economy by keeping rates low. What they’re saying is we need to reorganize our economy and while the Fed knows the economy needs to be reorganized in the future, lower rates is not the way to get there. We need fiscal policy and a way to help reorient the economy in a cost-effective and humane way.
TM: Well finally Cary I’d like to come back to inflation. As we were discussing earlier, after 2008 and the extraordinary Fed intervention, as you mentioned, that’s when they expanded their balance sheet, that’s when they created these financing vehicles. There was a lot of concern that that would eventually result in inflation and it never happened even though we had a pretty robust economic recovery. What do you think are going to be the long-term results of this intervention and the Fed, it sounds like you said has gone even further than it did in 2008. Do you think that there is a prospect of inflation at some point?
CL: Yes, there is a prospect for inflation on a number of levels. The first is the one you’ve alluded to and it’s what people were worried about in 08 is the famous remark about inflation that it’s too much money chasing too few goods. So that could certainly happen with the actions the Fed has taken but not with a considerable lag. The second point that I’ve been making and I’m finally seeing wiser heads than mine bringing up the same point is that currently what you might call COVID walking around inflation is probably much higher than the measured inflation in the CPI which is effectively zero if not mildly negative. If seen estimates of inflation, and I know this is not a high number, but 1% compared to currently 0. And the reason for that is that goods that you and me are currently transacting and buying such as the grocery stores, those prices have gone up a lot. A lot of goods that we can’t buy like, opera tickets, or amusement park rides, those prices have gone down but they’re not effectively being purchased, so the actual inflation rate right now is higher and so many people think inflation is picking up because if you go to the grocery store it is quite impressive. Finally I’ll be a little provocative when I say that, because I think in the short run and for all the right reasons, we may get more inflation because once again if you say to yourself, that some of the lowest paid workers in our society are doing some of the most important things working on the front lines at hospitals or delivering goods or working in grocery stores, there was a feeling fifty years ago that maybe the highest paid workers in society were going to be the people doing the worst jobs. In other words, we’re going to have pay garbage men a lot of money because no one wanted to take out the garbage. And it may sound flip, but I don’t mean this to be flip at all, so if we have a society decide these people need to be rewarded because there a lot more important than we think they are, then that’s going to lead to higher wages. Now if that means that restaurant workers get paid a higher wage, is it going to lead to a world, and once again I don’t mean to be flip, but when I say that. But when I was a kid growing up in a typical middle class family in the 1950s and early 60s and I’m not being facetious when I say that, only rich people could afford to go to a fancy sit down dinner. Only rich people flew. So the kinds of things that could become very expensive, such as dining out, sit down, not stand up eating and planes may get to be a lot more expensive. Not because we’ve done anything wrong, but because those business models have to change and at the same time a lot of those workers are going to be paid more. So it may be that restaurant prices are going to have to increase substantially and so there could be some inflation, not because of necessarily monetary policy but because we in society want to pay people more and in doing so, to pay those people more, firms have to charge more. So I think inflation may surprise us and may be more a phenomenon from a rising minimum wage, but that’s for all the good reasons. Make us a better more humane society but at a higher price level and higher inflation rate to get you there.
TM: So Cary one final question. Not only are we going through a pandemic, we are also going through a lot of soul searching as a society about inequalities in our society and the Fed has been accused of being on the side of the rich and inflating asset values. Do you have a perspective on that?
CL: The Feds relationship to inequality is of two facets. The first is what most people know is that if the Fed lowers interest rates, that tends to promote higher asset values and asset values tend to help more well-to-do people than less than well-to-do people. So in some sense, the Fed policies of the last ten years are tended to make society in terms of income more unequal. However, the Fed by running the economy hot and bringing in people in low wages, particularly in the last three years from 2016 to 2019, they were actually doing the reverse and actually fostering equality because they were bringing in low wage workers. There were several years in the last five years where the biggest increases in wages were of the people on the lowest rungs of the economic ladder. So it’s important to remember that believe it or not the best antipoverty income equalizing program is to get a job. If you have a job, your chances of being in poverty are about 4%. If you don’t have a job, it’s more like 50%.
TM: Well Cary thank you so much. This has been a fascinating conversation and I really appreciate talking with you.
CL: Todd it’s been a pleasure and I hope you and our podcast listeners glean some insights if not some wisdom from our conversation.
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