May 17–18, 2021
Policy Session 1: Is the Monetary Policy Toolkit Adequate to Meet Future Challenges?
The limited scope for reducing policy rates over the last decade has induced central banks to place increased reliance on balance sheet policy, which raises a variety of underexplored topics.
Paula Tkac: Hi there, and welcome back. I'm Paula Tkac, the associate research director at the Atlanta Fed. Our next panel will explore the provocative question: Is the monetary policy toolkit adequate to meet future challenges?
Before we begin, I'd like to remind our attendees to please continue the discussion after the panel session by following the link to the breakout rooms that's in your invitation.
Now, I'd like to introduce our moderator, Julia Coronado. Julia is founder and president of MacroPolicy Perspectives, and I'm sure many of you are very familiar with her from her many contributions as a commentator and Fed watcher in the financial media. Julia has deep experience, expertise, and passion for all things macroeconomic and monetary policy, and we are very excited to have her lead our next discussion.
Take it away, Julia.
Julia Coronado: Thank you, Paula. Glad to be honored and happy to be part of this event. I wish we were in Amelia Island. I think I can speak for all of the participants. It's my pleasure now to introduce an excellent panel to tackle the big questions you just outlined. I think as President Bostic noted, you select people who are not reticent in sharing their views, and I think that is certainly true for every member of this panel you are about to enjoy. I will give brief introductions to three people that don't really need introductions.
Willem Buiter has been an academic professor of economics at Yale. He's been a member of the MPC at the Bank of England. He's been chief economist at Citi Group...;so, a long and storied career, is with us.
Joe Gagnon, who is a former senior staffer at the Federal Reserve Board. His research has really been part of establishing the intellectual foundations that have driven the evolution of Fed policy in recent years, at a critical time, is also with us.
Simon Potter, who was the head of the Markets Group at the New York Fed and the manager of the System Open Market Accounts. He ran the balance sheet at the New York Fed and also helped establish not just intellectual foundations but really operationalizing the Fed's policies and balancing the costs and benefits from each of the approaches that the Fed was developing in real time. An important contributor to the new frontier of monetary policy, and that is balance sheet policy.
I have given the three opinionated panelists a set of questions so that they might prepare remarks that are both informative and in the interest of time we get to hear from everybody in a balanced way. We're going to start with a near-term view of the world, which is that much more interesting in light of the April data that vice chair Clarida discussed in a previous panel: a downward surprise to employment, upward surprise to inflation.
Of course, the mantra of any good central banker, or central bank watcher, is "one month does not make a trend," but let's look into our crystal balls first and start with: What is the outlook for the economy, and importantly, for inflation? What are the underpinnings of your outlook? That is, is it fiscal policy that's the primary driver of your outlook? Is it bottlenecks and supply chain constraints? Is it longer-term secular forces, or all of the above? And then, what monetary policy accompanies that outlook?
We're going to start with Joe. Would you like to give us your views on the outlook?
Joseph Gagnon: Yes. Thanks, Julia. I'm looking at inflation this year being above 2 percent, as Raphael and Rich just said in the last panel. We know the reasons are some bounce back from an unusually low inflation last year, as well as some bottlenecks, as are still lingering restrictions in the economy, and getting people back to work. Where I differ is going forward. I think most forecasters are saying that inflation will fall back to around 2 percent next year. I actually think it will rise further to 3 percent, or a little above 3 percent, next year, and the reason is that the economy is going to be very strong. In my view, we are on the cusp of the biggest economic boom of our lifetimes, and the reason is we've had the biggest fiscal deficits since World War II.
If you add in the extra saving that piled up last year above the normal trend, plus the additional fiscal spending this year, we've got 20 percent of GDP in extra spending capacity over what we would normally have, and that has been damped. The multiplier is low so far, it's not all being spent, but as the vaccines work, and I believe they're working better than even hoped for, I think we're going to see people being willing to come out and be more active in the economy, and more opening of the economy. By Labor Day, I expect we'll be fully open. I don't think most forecasters have priced that in, and that would point towards a somewhat higher multiplier, although still not super high.
The other thing is, the Fed's going to keep rates low. If you look at what the capacity of the economy is to absorb that spending, output gap, if every one of those 8 million people gets rehired, output would be 4 percent higher. We can go above that, surely, but the 10-20 percent spending boom is just going to clearly raise inflationary pressures, which isn't a bad thing, and I don't think we should get too alarmed about it.
Then turning to monetary policy, I would say I don't expect any rate hike this year. Everything is sort of going as expected. I do think by fall we might get some taper talk, and then maybe sometime next year the Fed might start to taper. Whether the Fed raises rates or not next year depends. Probably they will, under my outlook, because I think inflation will be obviously not receding by early next year.
But here's my main point, I would strongly urge the Fed to take this opportunity of a rising inflation rate to raise its inflation target. The zero lower bound, the inability of monetary policy everywhere to push rates much below zero, has been far more damaging than anybody thought 20 or 30 years ago when we were heading to 2 percent inflation targets.
If you look back 20 years ago, the literature on optimal inflation was not very strong, something in the range of 2 to 4 or 5 percent, seemed like a reasonable range for inflation. We settled on 2 percent. If you thought 2 percent was the right number back then, the fall and the neutral rates that we've seen, and it was in Rich Clarida's chart. Those of you who did see the charts this morning, it was in Rich Clarida's chart, the neutral rate's fallen more than 2 percentage points over the past 20 years. Rich's coauthor, Jordi Gali, had a nice paper that says that if you thought 2 percent was optimal back then, 20 years ago, you should raise the target 1 percent for every 1 percent fall in the neutral rate. Which means if 2 percent was optimal 20 years ago, 4 percent is optimal now.
And 4 percent shouldn't scare us, because 4 percent is what Paul Volcker achieved back in the '80s. He was lauded for conquering inflation, and he only got it down to 4 percent. I think a number of 3 to 4 percent shouldn't scare people, and it will give the Fed much more room to get a better economic outcome.
Coronado: Thank you, Joe. So just a quick follow up before I move on to Willem, and that is, you expect the Fed to not taper until next year, but then to raise rates in the same year, so maybe to act with a bit of a sense of urgency to conquer inflation. In your view, that sounds like it might be a policy mistake if they do that?
Gagnon: I would hope they would not be in a rush to do that. I would rather see them accept a bit more inflation. They will have to raise rates eventually, but I would not rush to do that. I would rather say, "Look, we are actually not in a good place. We need to get a higher inflation, actually, more long-term, to get us in a better place."
Coronado: Thank you. It's interesting, you say 3 to 4 percent. That echoes the words used by a newly minted Governor Waller in his most recent appearance.
Willem, would you like to give us your outlook for the economy, for inflation, and for monetary policy?
Willem Buiter: Thank you. It's an honor and a pleasure to be here. I see inflation this year around 3 percent, coming down to 2½ to 3 percent for 2022, and then to 2 to 2½ percent beyond that for the next five years or so. I believe that will be supported by a monetary policy which begins to be restrictive at the very end of this year. I agree with the previous speaker that we are likely to have some taper talk by the end of the year, and actual tapering starting early next year. I also expect rate hikes in 2022.
The economy this year is roaring away. That unprecedented fiscal, mainly fiscal, or for market demand, stimulus is reinforced in terms of its price effects by adverse supply consequences of COVID-19, and indeed, of some of the employment benefit measures they've taken, which have adversely affected labor supply in parts of the economy this year, and will continue to do so until they are revoked by September.
I do not believe that raising the inflation rate target is the solution to our problems. Yes, you have the zero lower bound problem. but as I will argue later, the way to address that is to abolish the effective lower bound and to make sure that seriously negative interest rates can be implemented. But I'll talk about that later. Thank you.
Coronado: Thank you, Willem. Just to clarify again, you expect the Fed to also raise interest rates in 2022?
Buiter: Yes, definitely.
Coronado: This is a very hawkish panel that we are establishing here. Simon, would you like to provide us with your outlook?
Simon Potter: Glad to be here. I guess forecasting is pretty hard to do. and you can do it frequently, or you can be humble. If you look over the last few years, I think it's good to be humble. One of the things I've been trying to work out is, what is the state of inflation in the U.S.? We saw a very high reading on core and total inflation for April. The Fed spent a lot of time trying to measure what underlying inflation could be, and there's a number of ways you can do that.
You can use something like the median CPI the Cleveland Fed has, and that's trying to capture where the center of the inflation distribution is. If we look at that, it's running at 2.1 percent, so well below core CPI. You could also use the trend mean. Instead of just looking at the center, it throws out the tails, that's running at 2.4 percent, so nothing looks unusual there. I could look at two-year inflation CPI, just over 2 percent. There's a model from the New York Fed called the underlying inflation gauge. That's running 2.7-2.9 percent, not that different from 2011, or 2008.
I'm not seeing anything, without knowing about the pandemic fiscal policy savings, that unusual. There's a sticky price measure that the Atlanta Fed has. That's also running at 2.4 percent. I think it's easy to make statements right now, given what we've just seen about what inflation might look like over the next year or two. The outcome-based policy the Fed has gives them a lot of freedom to look at those outcomes. Because we're not good at forecasting inflation, at least in the near term, we should look at those outcomes.
Now, if you ask me, "Where's inflation going to be in 2024 or 2025?" I'd be much more confident in saying, "I'm going to stand with my forecast at 2 percent for that, on the measure that the Fed uses."
Coronado: Excellent. And the monetary policy that you expect to accompany this forecast?
Potter: Well, it's outcome-based, so if you tell me the outcomes then I could tell you what the monetary policy would be. But I believe the FOMC has been pretty clear that it's actually looking at realized outcomes and not using forecasts, and the assumption there is inflation expectations remain well-anchored. I don't see any evidence yet that they're not well-anchored.
Coronado: Your assessment of the various measures of inflation is that it's pretty sanguine, that you would expect inflation centered on 2 percent, roughly speaking. So therefore, my guess is you're maybe not as hawkish as the other panelists in anticipating that a rate hike is likely in 2022?
Potter: Well, none of us are making these choices, so we're neither hawks or doves. If you ask me to forecast, it's pretty hard to forecast in the short run. of the long run, the central distribution, with a wide range around it, is going to be around the central bank's inflation goal. There's a lot of literature in forecasting that looks at this, that further out the central bank will apply policy in the correct way, and there's nothing we've seen recently, particularly the size of the shock. So used car prices were a large part of what we saw. It's not going to be the case that used car prices increase eight percentage points more than new car prices for much longer, because then we'd all be buying new cars because they'd be cheaper than used cars.
Coronado: Excellent. Let's move on to the heart of the topic that was assigned to us, which is: Does monetary policy possess the toolkit to achieve its desired outcomes? Let me start with you, Simon, or stay with you, and ask how does balance sheet policy fit into your worldview? What do you make of the ongoing use of quantitative easing, and the expanded use globally? It's become the go-to marginal tool of support in a recession, and what do you think are the channels and the risks and maybe the unintended consequences? And lastly, are there other policy levers that you think that the Fed should be considering now for the next cycle?
Potter: I might not cover all that in the three minutes I have. When I was still at the Fed, I worked with Frank Smets and led a working group that the BIS put together, looking at these unconventional monetary policy tools. We looked at four of them. One of them was lowering the effect of the lower bound, which I think Willem's going to talk about, and we looked at balance sheet policies. There are two types of balance sheet policies. There are balance sheet policies where you buy assets, and there's balance sheet policy where you lend, and we saw both of those being used a lot over the last year.
I think that was innovation by the Fed in the market-based system that we had, in terms of the type of assets they were prepared to lend against from non-banks. and that was almost as effective as the Mario Draghi "butterfly" speech, in terms of how much balance sheet expansion was required. There's definitely an aspect of this latent power of the central bank, and central expectations around the good equilibrium.
We've seen many more central banks, at the zero lower bound, and most of them have adopted, in that position (as we discussed earlier), the decision to buy assets. Those purchases can vary depending on the central bank mandates, but one of the things that's been interesting is less concern than there was 10 years ago about market functioning, partly because we started this period with very poor market functioning, so there was a need for the central bank to come in and buy assets to make the markets function better. But I think the central banks have adapted reasonably well and understood how to buy in size reasonably quickly.
The fourth component, there are two balance sheets, and there's the effective lower bound that we looked at, is forward guidance. And there, I think central banks have innovated a lot. They have moved to state-based or outcome-based guidance, and you've seen this across a number of central banks. That is the glue that puts all the other policy pieces together. The Fed, I think it was particularly interesting that going into this period, they were thinking about what their overall framework was. This was a debate: How much of this is tools, versus the whole framework?
So the U.S., in some sense, was lucky that the Fed had had that strategic review ready to go pretty soon after the crisis started, which backs up the outcome-based guidance that the Fed has, which is similar to other central banks, but it's within a framework which is more established.
Coronado: And what about the other tools. Do you think that this is a sufficient tool kit, and that the innovation is on the margin that you described in terms of using that balance sheet policy in ever more creative ways, depending on the circumstances? Or do you think there are other tools that the Fed should consider?
Potter: One of the big differences relative to when we did this work, looking at the central bank toolkit, is a lot of the assumption there was that fiscal policy would not be supported, and the big news last year was how powerfully that fiscal policy tool was used. I don't know whether that was specific to COVID, or a more general type of change in how we think of the use of fiscal policy. You and I have both worked on tools that sort of combine monetary and fiscal policy. Clearly, trying to study what these transfers mean, that we've used in the U.S. and other countries, outside of an environment where you've shut down a lot of the supply side, would be helpful to see if they are a good complement to other policy tools.
Coronado: Excellent. Moving to Joe, what is your view in terms of the balance sheet policy, something again that you've helped establish a framework for thinking about? What are your thoughts here in terms of what role it plays and how it might evolve going forward, and are there other policy levers that are needed?
Gagnon: I think there are other policy levers needed. As Simon knows, I agree with what Simon said just now wholeheartedly. I think central banks have been very creative in using the balance sheet, and all the naysayers who pointed out all kinds of problems that this would cause, I don't see the problems having materialized, and I'm not very worried about them.
As Simon said, there are different ways of using these tools and different channels through which they can operate. I think of monetary policy as like pouring water into irrigating a field or something, and if one channel is blocked the water can rise and flow into other channels,(and I think it is effective.
The issue, it seems to me, is if we limit balance sheet policy to debt instruments, one option would be to use equity in real estate and other types of real assets, and that could work. But if we're limited, as we have been so far, to debt instruments as bonds and lending, even subsidized lending, I think in Europe, in Japan, they have basically run close to the limit of what they can do. The U.S. has not, and I think QE could work further in the U.S. if it had to. I think in Europe and Japan, we see they're close to the limit, at least, if they limit themselves to debt and they don't subsidize the debt so much that the central bank is losing money, in which case it's like a fiscal policy.
Basically, I don't think quantitative easing in debt instruments can lower bond yields lower than the lower bound on the policy rate. Whatever the market thinks the lower bound on the policy rate is, is the lower bound on the bond yield. I have a paper with a colleague, Olivier Jeanne, where we showed that theoretically, and there's a lot of empirical evidence that that is the case.
This is what worries me, because unless we're willing to do truly unusual quantitative easing balance sheet policies, like buying equity and real estate, which have no upper limit on how the price could rise, then you're left with fiscal policy, or raising the inflation target. This is, again, why I think analyzing balance sheet policy and the limits of balance sheet policy leads me to say, "We need to have a higher inflation target."
Coronado: But the inflation target needs to be achieved through the use of monetary policy tools and fiscal policy tools of course, but we don't always have those in cooperation. For example, last cycle fiscal policy went the other direction. You still think that the balance sheet is the appropriate margin for exploration, should we need to achieve that inflation target, correct?
Gagnon: Absolutely, that's correct. I think that's right. I think, though, that we should take advantage of the fiscal policy that's really helping us now, because if we can get a bit more inflation then it becomes credible that the Fed could raise its inflation target and it could all work. It might be hard if we didn't have fiscal policy helping us.
Coronado: Thank you, Joe. Before we turn to Willem for his views on balance sheet policy and other policy tools, let me just remind attendees that you can submit a question. We will start taking questions at the top of the hour, so please feel free. We already have a couple, so please enter your questions and we will provide time for those questions.
Willem, I know you have some different views on balance sheet policy and the right margin to explore for new policy instruments in a world of low interest rates. Can you let us know what your thoughts are here?
Buiter: Over the COVID period, the size of the Fed balance sheet has increased from roughly $4.3 trillion to just about $8 trillion. We can't repeat that too often, so I think serious consideration should be given to abolishing the effective lower bound and acquiring the capacity to set the short-term policy rates, and all other interest rates in principle, at deeply negative levels.
This can be done in three ways. One, abolish cash. Second, tax currency, which could include Mankiw's currency lottery based on serial numbers, with the unlucky winners becoming worthless. Third, introduce a variable exchange rate between currency and negative interest-bearing deposits and depreciate currency vis-à-vis the negative interest-bearing deposits.
This could be combined, but need not be, with the creation of a central bank digital currency, which could provide a universally available, high value-added deposit. If you don't want to do this, at least make use of the interstate space there is and get the federal funds target rate down to minus-50 or minus-75 basis points. right? That would mean getting rid of the remaining constant net asset value money market funds, but so be it.
I think a very important dimension of what the Fed has been doing has been the external and international dimension, also emphasized by Rich Clarida. In March 2020, three major international corporation-enhancing measures were undertaken by the Fed. First, it enhanced the provision of U.S. dollar liquidity, between the "big six" players. Second, it established temporary U.S. dollar liquidity arrangement swap lines with nine other central banks, including some EM central banks. Third, it created this often-temporary FIMA Repo Facility to help support the smooth functioning of financial markets, including the U.S. Treasury market.
Now, these facilities have been extended to September 30, 2021, but I would give consideration to them all being made permanent. They would only be used in times of crises, but it should be there on a permanent basis so we don't have to wait for their creation.
Finally, I want to emphasize the financial stability role of the Fed, which is not reflected adequately by what happened to the size of its balance sheet. It was more about the composition of its balance sheet. I'm going to talk about the lender of last resort, and market maker of last resort, actions of the Fed. As part of its policies to promote financial stability, the Fed created or recreated nine new facilities. Five of these were money market of last resort facilities, Commercial Paper Funding Facility, the Secondary Market Corporate Credit Facility, the Primary Market Corporate Credit Facility, the Municipal Liquidity Facility, and the Main Street Lending Program, but all five of these have been terminated already.
In addition, the Fed created, or increased the scale and scope of, its lending of last resort operations by creating four or recreating four new lender of last resort facilities, the Primary Dealer Credit Facility, the Money Market Mutual Fund Liquidity Facility, the Term Asset-Backed Securities Loan Facility, and the Paycheck Protection Program Liquidity Facility. The only one of these four that still exists, is active, is the Paycheck Protection Program Liquidity Facility. I again would like to give consideration to making these lender of last resort and market maker of last resort facilities permanent. They would still only be used in terms of crisis, but would be available when necessary, on demand, without delay, and they would really enhance the effectiveness of the Fed's financial stability operations.
Coronado: Thank you. I'd like to follow up just with a couple of questions on your thoughts there. Do you think, with the dollar being the reserve currency, and with the structure of the U.S. financial system as it is, do you think negative interest rates or the elimination of cash is feasible logistically? Is it desirable? Is it feasible politically? It seems to me that there might be a lot of unintended consequences of trying to remove cash with the U.S. dollar.
Buiter: Well, first of all, you don't have to remove cash to abolish the ELB, right? You can do it through a variable exchange rate between currency and interest-bearing deposits. But yes, if you go the "abolition of cash" route, which I would actually favor, because the main purpose of cash, apart from helping the financially unsophisticated, is to support crime. It is feasible, it is desirable, and there's no reason to wait.
Coronado: Can I ask, Simon, what are your thoughts on this? I want your perspective in here because of your particular expertise. What are your thoughts on the feasibility of negative interest rates in the U.S.?
Potter: I think cash is used for lots of different things. It's one of the greatest inventions of all time, so we shouldn't just get rid of it. I think there are other choices here. In terms of the question that you precisely asked, I don't quite understand how a financial system works when I borrow some money but then the person who's loaned me the money is sending me the coupon payments on that, but this is one of the things about how a deeply negative system would work.
I think in Denmark, there is some evidence that mortgage rates went negative, but of course, you bundle in principal payments then, so the flow is still in the right way. If people have an idea of how that financial system would work, I think it would be good to write it down and think hard about what the incentive problems are, what the monitoring problems are. That hasn't been done, to my knowledge, because most of the models just assume there's an interest rate which drives consumption or investment, there's no financial system.
Coronado: Joe, can I ask you to chime in? You didn't opine on negative rates being a desirable tool. is there a reason, in your view, that that's not on the front burner, or shouldn't be?
Gagnon: I agree with Willem that in some ideal, theoretically, that is the right way to go. But I guess I share Simon's concern about just how socially practical it is to either eliminate cash or tax cash. The political salesmanship involved just strikes me as onerous. Let me, if I might toot your horn, Julia. You and Simon have a nice paper that is related.
Coronado: Please. Toot away.
Gagnon: I believe it's on the Peterson website, in fact. Simon can correct me, I thought it came out on our website, about how the people have central bank digital currency in the U.S., and it seems to me that would be one way to go further and make this happen, if they could abolish cash because everyone had this digital currency and was able to use it. Then we could have negative rates.
And I'd have to say, Simon raises a good point about, "Well, but have we thought carefully about the incentive structures of financial instruments in such a world?" And I haven't. I guess as a macroeconomist, I always thought negative rates would work and that's all there is to it. I'm sort of with Willem on that, but it seems to me your paper is a lead-in to a kind of world where that might work.
Coronado: Well, thank you for tooting the horn. We appreciate that. But Simon, in our proposal, we didn't envision going cashless or even using it as a means to achieve the feasibility of negative interest rates. Rather, we thought, which at the time garnered a lot of pushback, but we thought that universal digital accounts could be a way to, within a particular structure that is sanctioned by Congress, deliver cash directly to consumers in a crisis or a recession once particular thresholds are reached for such action. And that in doing so, potentially it would be a more efficient form of monetary policy, that you would have less of the unintended consequences.
I would say, Willem raised the issue of financial stability. With balance sheet policy, for example, the corporate credit facility, we achieved great market reaction without spending very much money at all, on the one hand. On the other hand, there is some concern that we have more seriously undermined risk management in financial markets or encouraged some moral hazard there. I think one of our proposals was if you get money directly to consumers, and that's certainly what we're doing on the fiscal policy side, maybe what you achieve is more effective macro insurance overall.
Before we move on to the next round of questions, what is your view, let me just stay with you, Joe, on some of the financial stability implications of the balance sheet frontier? What, if anything, do you worry about there?
Gagnon: I'm probably the wrong person to ask that question, Julia, because I have never found those financial stability worries credible to me. I just don't see that there has been, but I'm sure someone who worries about them a lot has come up with clever reasons why we should still worry about them.
Coronado: Simon, do you have any thoughts there?
Potter: The incentives in the financial system will change based on what actions that the Fed takes, and clearly some of the actions they took were quite far along the spectrum you'd expect a central bank to do. Why did they take them? Because it was critical to keep credit flowing at that time to the large corporations in the U.S. and smaller ones. I don't think our proposal was really part of that debate because we shut everything down and you had to find a way of making sure that things didn't rust or scar or whatever you want to say in that period. The Fed, from my viewpoint, was particularly worried, given the market-based system that we have, that it was very vulnerable unless a backstop was put in place.
And it did turn out to be a backstop. I'm unaware right now of any compelling story about moral hazard in terms of how corporates will look at how they fund themselves moving forward. That's always going to be a difficult issue of where that line is. Clearly the line was crossed in March 2020, where the central bank needed to take that action.
Coronado: Agreed. Let's move along to the next round of questions that we had all prepared before we turn to the Q&A, which is now populating from the attendees. The theme of this conference, there seems to be a theme running through it of the international dimension of monetary policy, particularly with regard to the Fed, and I thought vice chair Clarida's remarks were an excellent way of getting that established, and what are the dimensions of integration, and what are the feedback loops back and forth between Fed policy and global financial markets and vice versa.
I'm going to start with you, Willem. What is the international dimension to your outlook? Do you see the global economy in a synchronized recovery, or do you see there are some asynchronous dynamics developing? How do the Fed's policies integrate with that outlook, the more global outlook) And what are some of the risks? What are the implications of, if there are asynchronicities, what are the implications for interest rates and exchange rates, and currency and capital flows, from these global dynamics?
Buiter: Among the advanced economies, and China, we have what I would call a synchronized global recovery at the moment. We've entered that state. It's not equally exuberant everywhere. The U.S. clearly is foaming at the mouth. There's 6½ percent plus growth likely this year. But even in the euro area and in the UK, we are likely to see something in the high 4 percent or 5 percent territory. China, 8 percent plus, and all that. It's a different story in many emerging markets and developing economies, which have not been able to use the combined monetary fiscal stimulus that has jogged the U.S. and other advanced economies along once the shock of the COVID-19 crisis hit.
These economies are, and will continue to be, in bad shape, piggybacking a bit on the global recovery, but badly in need of domestic fiscal monetary stimulus as well as imported recovery. Imported from the U.S., and the rest of the advanced economies. The U.S. is the key global player here. It drives the global business cycle to a greater extent than any other central bank, in my view, and so in its decisions to start tightening and unwinding, ideally it would allow for the fact that this is going to affect the global financial cycle, to wit the emerging markets and poorer developing countries.
Yes, the U.S. is the key player, will remain the key player, and hopefully will go easy when it decides to tighten, because of the external repercussions of any tightening decisions it may be undertaking.
Coronado: I'm trying to square that with the thought that they might start raising interest rates next year. You don't think that that could be potentially destabilizing to global markets or the broader global recovery?
Buiter: Oh, yes. I'm worried about it, yes.
Coronado: So, like Joe you think they're going to do it, but you are worried that that might not be the right policy decision.
Buiter: U.S. monetary policy is different by domestic inflation and employment considerations, but it allows for external repercussions to the extent that they feed back onto the U.S. economy. The U.S. doesn't have a global mandate, and I wish it did. Since it has global tools, it should have a global mandate, but it doesn't. And so, we're likely to see some damage inflicted on the global recovery by what I consider to be a globally slightly premature U.S. policy tightening starting late 2021 and getting going in earnest in 2022.
Coronado: Despite the fact that we have the vice chair very articulately laying out these global feedbacks, you feel like they're not going to factor them in in setting policy?
Buiter: Not sufficiently. They may factor them in to the extent that there is feedback onto the U.S. economy. I mean, there are good global economies. But their objective function, simply, is local, national.
Coronado: Fair enough. Simon, what's your perspective of the global backdrop through the prism of capital flows and market stability, and its feedbacks onto the economy?
Potter: If you look at the last cycle, I do think that international developments had an impact on Fed policy. You can see that in 2015 and 2016, when China slowed down, and the rest of the world did. Definitely Brexit, that vice chair Clarida brought up, was a concern for a long time. And if you look at 2019, when the Fed cut rates 75 basis points before we knew anything about COVID, there was clearly a viewpoint that we needed a more robust global growth picture for the U.S. to be meeting the mandates that they had on inflation and on maximum employment.
What's happened since then is, we've had a really big shock. The IMF looked at this and, remarkably, I believe, they think the U.S. in a year or so's time will be above the trend growth that it was going to have before COVID hit. That is not true of other countries. In particular, in the emerging market world, we know that COVID is not under control, the vaccines are not widespread, and they've acquired a lot of debt. Now, maybe they would have liked to have acquired more debt over this period. That's something Willem pointed out, that the U.S. and other countries were lucky in terms of the capacity to risk share, but it's still a debt burden.
That's going to be a problem if we don't see very strong growth in the advanced world. One way for this to work out well is for strong growth in the advanced world and in China, which will pull up those other countries. The other choice is that there will be a drag on growth, not in the short run when we have fiscal policy, the savings in the U.S., but in the longer run when we're trying to decide where is global growth going to settle. I think vice chair Clarida pointed out this big fall in the global neutral rate of interest. That is not a positive viewpoint about where growth is going to be as we get to 2023, '24, '25.
Coronado: Thank you, Simon. And Joe, what are your thoughts here on the global dimension? I'd like to particularly kind of prod your view on U.S. inflation dynamics. Simon touched on the drop in the global neutral rate. We've also seen a lot of synchronizing of global inflation dynamics. How does that feed into your view of the overheating of inflation, or the higher run rate of inflation? What are your views on the global dynamics, and the outlook in general?
Gagnon: Sure. Let's start by repeating, but perhaps with a bit more emphasis, what Willem and Simon just said, which is that the U.S. is just a big outlier this year. If you look at the fiscal response to COVID last year, the U.S. was number one. A few other countries were close, though. But as a group the advanced economies were way ahead of the emerging markets, and that is an important feature.
This year, the U.S. is all by itself in having a massive repeat fiscal stimulus. No other country is doing that, so the U.S. is just going to be way ahead of everyone else in the recovery. It's being ramped up further by the fact that the U.S. is relatively ahead on vaccinations. Only a few countries are equal, or ahead of us, and also, we have more effective vaccines than the countries that are ahead of us who have somewhat less-effective vaccines.
I think this combines to damp down the pandemic faster in the U.S. and more convincingly, and just further accelerating the U.S. lead. Emerging markets are way behind. We need to do a lot more. The most important thing we can do is to send all the surplus vaccines we're about to have quickly to the emerging markets so they can catch up. That's the most important thing we should do.
Let me just say that, in terms of how this is going to play out in inflation, I think inflation can be very different across countries based on each country's own dynamics. I know there are some international spillovers, but I think they're not large enough to offset the basic fact that U.S. inflation will be higher than anywhere else.
What I think is going to happen is when the Fed starts to respond, and depending how it responds, the dollar is going to rise. Now, if the Fed actually were to raise the inflation target, that would actually damp that a bit, which would be good. But the dollar is going to rise. We're going to have a big increase in our trade deficit. Forecasters are already seeing it, and I'm betting that forecasters are still underestimating that, but even the forecasters are seeing that. That's going to really help the rest of the world a lot. Once again, the U.S. is going to be the engine of growth for the world. We've seen that story many times. It's about to happen again, probably with a strong dollar, but even without a strong dollar, to some extent it will be true.
And then, because I have to say something controversial in every single question, let me end with the following thought. I think it's great if the U.S. helps emerging markets, both with vaccines and with imports from them. But I do wonder, given the massive rise in U.S. government debt, which is supporting all this spending, is it politically sustainable forever, to the extent that a lot of this doesn't flow to poor countries, but flows to wealthy countries or China? So, think Germany, think China. How politically sustainable is it for us to basically borrow or mortgage our children's future to support jobs in Germany and China?
Coronado: "Mortgage our children's future." That's nice and provocative, and I appreciate a macroeconomist who's willing to actually think about political economy issues, because certainly those are far more important than we generally like to admit.
Your point is well taken. I agree we're on the aggressive side for the deficit, the drag from trade, and basically the exporting of stimulus. But in the past, which is different from last cycle, when the U.S. has taken that leadership role in the global recovery, it has also been a dampening effect on inflation, which is why I had asked the question.
It's sort of a matter of degree, I guess, in terms of the size of the stimulus and the speed of the spending of the excess savings that have been generated, and how much inflation that comes off of that.
Gagnon: If I could just point out quickly. I think about 15 or 20 percent of the spending in the U.S., 20 percent or so will be met at the margin from imports, and that's enough to really affect the rest of the world a lot. But I would say 75 percent or so is met domestically, which is plenty to cause inflation.
Coronado: There are many reasonable forecasts in these uncharted waters we are in. I'm going to start folding in some of these questions that are coming up. There are a few that are on inflation, and inflation and policy tools. I think, Joe, you made the point that Volcker was lauded for getting to 4 percent inflation. The question is, it's different to come at 4 percent inflation from above than to go to 4 percent from below. The psychology of that might be very different, and more destabilizing. How do you view that?
Gagnon: It's a worry, and it requires really good communication skills from the Federal Reserve to constantly stress that the Fed will not tolerate, and is not mandated to allow, high inflation. But just to say that high inflation, 3 percent or possibly 4 percent, 4 percent would be the limit, I would say, that you can do this...;maybe 3 percent, but somewhere in that range, is not really high inflation, and it's not going to really be that noticeable to people that it's all that different from before. But it will make enough difference for the lower bound, in my estimation, to matter and to be worth having. How you thread that needle in terms of communication, I grant you it's difficult, but I don't think we should be dissuaded from doing the right policy just because it's difficult.
Coronado: I wholeheartedly agree. In fact, you could argue that it's being put to the test right now. The fact that two extremely knowledgeable and seasoned macroeconomists and central bank watchers like you and Willem expect the Fed to raise interest rates next year, despite that probably not being consistent with their average inflation targeting desire, shows that they still probably have some work to do on the communication front.
Willem, what are your thoughts in terms of the psychology or the risks of coming at inflation from below and rising to 3 percent or 4 percent on a sustained basis? I mean, we're already there on a spot basis, but what if we get there on a core basis? Do you worry about, say, some inflation expectations getting unanchored, and businesses and consumers getting into an inflationary mindset?
Buiter: It would be quite an increase if we go to 4 percent, right? Because remember, we haven't been at 2 percent. We've been well below 2 percent for a number of years. So I think it would be a major triumph of communication skills of a casual, empirical interpretation of what's going on if the Fed managed to convince markets that the new target is say, 3 percent or even 4 percent but they are serious about not letting it run beyond that, that this is not a return to the '70s, the pre-Volcker days. This is your new normal, with modest but stable inflation of around 3 percent. We've had a major communication triumph.
Coronado: Simon, do you have views here in terms of the inflation expectations channel, and how vulnerable it might be?
Potter: I'll just start out with stable prices is the mandate the Fed has. I think it's a stretch to use a zero lower bound to say 4 percent inflation is consistent with stable prices. Two percent inflation, as measured, is much more consistent with that. I think Volcker and Greenspan's view about inflation ("you don't really have to think about it") is the situation we've been in for a while. The reason the central banks had to think about it is a neutral rate of interest fell.
If the ways of moving up that neutral real rate of interest, they'd be preferred over all of these, on what inflation expectations tell us, I think there's financial markets, there's professional forecasters, and there's households and firms. Definitely, we're seeing in all those measures, they've moved up. The Federal Reserve Board staff has come up with a nice measure of trying to integrate all of those. If you look at some of the analysis on Wall Street, which is a higher frequency than the Board staff are producing this, they've clearly moved back to the level on this common index where they were in 2014.
Is that a high level of inflation expectations? No. If you refer to this earlier period, where I don't think Volcker was necessarily happy with the 4 percent, the inflation expectations were much higher. There's a really big break in the early '90s when the Fed basically kept on having inflation falling, and it cemented in this level of inflation where you didn't have to take it into account. That is different from the current situation, where we are reopening the $22 trillion U.S. economy. There are lots of shocks, in the Suez Canal, semiconductors, rental cars. Prices are supposed to move in the short run, to reflect these differences in supply and demand for individual goods. That could be price falls or price increases. It has nothing to do with inflation over the long run.
Coronado: Yes, that's a great framing for this. I actually was thinking about that with the conversation between president Bostic and vice chair Clarida. We've changed the philosophy and strategy of macro policy, both fiscal and monetary policy, to err on the side of doing more earlier rather than fine-tuning or calibrating to exactly how much you need. Err on the side of providing more stimulus than maybe you need, to jumpstart the recovery and get it going. What did we expect exactly to happen from that? It seems like the natural consequence is, as president Bostic pointed out, economics 101, macroeconomics 101, is demand moves faster than supply.
You have this inflationary impulse that's different from the prior recoveries, where we were worried about inflation first and foremost, and so we erred on the side of doing too little, and we had this sort of malaise, this kind of lingering slow recovery that had these ripple effects through inflation and inflation expectations to the downside. It was the whole intent to push it to the upside, and now we're seeing that. So perhaps this is exactly what we want, and there are no problems. This is good.
Let me keep going with some of the audience questions. One of the questions, and I think this is a trickier one, is that inflation...;the Fed has a new broad-based and inclusive employment mandate, and yet things like inflation, higher inflation, and/or quantitative easing and balance sheet policy that works through financial conditions and supports asset prices, tend to exacerbate inequalities. I know that the Fed's response to that has been, "But the primary focus is, if we get a long recovery that is strong enough and sustained enough, we know we'll see narrowing of labor market disparities," which we did see last cycle.
How do you balance those things, actually? Balance sheet policy does, by definition, work mostly through financial conditions, and we have seen just tremendous and deepening disparities in the distribution of wealth. How should the Fed square that circle?
Willem, do you want to start with that?
Buiter: It's clear that the aggressive balance sheet policies that we've seen since the start of the COVID-19 crisis have exacerbated inequality because there's been a massive concentration of wealth, especially at the very high end. That, I think, is something that is hard to do anything about except through fiscal measures, basically the tax-transfer mechanism. But expansionary monetary policy of all kinds, including the ones undertaken at the moment, do boost employment, and to the extent that it boosts the employment of marginal workers can actually reduce certain forms of inequality.
The Fed should not have, I think, an equality objective per se on par with maximum employment and price stability. But if it can, without damaging its fundamental target, address especially employment-related inequalities, it should do so, and it is doing so. For the rest, we're going to have to go the fiscal route. It's the only way to deal with the inequality consequences of this, and any other, driving mechanism.
Coronado: To paraphrase, you're saying that yes, it does have that unintended consequence, but the alternative would be to not pursue aggressively a strong recovery, that would be worse, and inevitably we need to look to fiscal policy to narrow those inequalities. Is that fair?
Buiter: The Fed targets aggregate employment and output, and inflation. This has implications for inequality, which where possible, it can address by modulating its policies. but for the rest, it has to rely on other financial and fiscal instruments to deal with it, yes.
Coronado: Thank you. Joe, do you have any thoughts there?
Gagnon: Yes, actually I do. I've thought about this. I have three points I would make. One is, I think the inequality we're talking about isn't so much rich versus poor as old rich versus young rich. If you already have assets and the Fed starts buying them, you get wealthier and you get a windfall. But if you're a wealthy high earner who has to save for his or her retirement, you're getting a very low rate of return on your savings for your retirement and you're hurt. And it's kind of an "old role versus young."
The poor are really kind of neutral in all this, because they don't have a lot of financial assets either way, and if anything, they're net borrowers so they get actually easier terms to borrow which is a good thing for them. The second point is that it's not clear to me how much is driven by QE versus the fact that the equilibrium real rate of interest has fallen, and that's exogeneous, the central banks can't control it. In a world in which the equilibrium interest rates are lower, that's going to raise asset prices. Central banks have really no choice in this thing.
And the final point I would make, and it sort of actually feeds in with what Willem just said, is I think it does point towards fiscal-type policies as being more important because they can help boost the economy in a way that isn't tilted towards certain classes of people, or at least classes of people who don't need help, and it can be aimed at people who do need help. I think that sort of raises that point.
Now, if you wanted central banks to be involved, then I would again point to your paper with Simon where you talked about how central banks could get involved in sending cash to people who need it, or everyone equally. And I like that idea. I think central banks should get a little bit of fiscal responsibility in that regard, under very limited conditions, very limited, only at the zero bound, only if you're failing to meet the target, and only if the treasury secretary or finance minister signs off on it. But in that case, yes. Helicopter money, or the type you talked about, absolutely.
Coronado: Thank you for that. I'm very sympathetic to the notion that fiscal policy is the primary lever for addressing these issues. At the same time, we all talked about monetary policy being out of ammunition going into this crisis. and yet what we learned was that it is incredibly powerful and innovative, and so why don't we think more creatively about what it can look like, a little bit more outside of the box, and be proactive about that, along all of the dimensions that policy has an influence? Rather than just saying, "Oh, it should be fiscal policy."
Buiter: Can I just make one comment?
Buiter: I would strongly object to the central bank engaging in a direct fiscal role, making transfer payments. It is a different matter for the treasury to use the central bank, if it has a CBDC, to transfer money to intended recipients in a very detailed and structured way, but that would still be a fiscal decision. You cannot have the first order independent fiscal capacity in the central bank, that would be a bridge too far for me.
Coronado: For you, but not for me. Simon, did you want to join in here?
Potter: Let's look back at history. If we're sitting there in 1929 and someone said to you, "The Fed could intervene and the Great Depression won't happen, but those stinking rich people are going to be a little bit richer," I think most people would have taken that trade off back then. What I do think the Fed has done with the new framework is recognize that maximum employment is not just one number. It has a broadness to it that's very important.
If you don't have that broadness, then you're more likely to tighten at the point where inequality, the big reducer, is for many people a good job in the labor market. And to reduce inequality, I think one thing the Fed can do is have this broader definition of what maximum employment is. There's a lot of evidence from the U.S. labor market that that does equalize, over time, the impact of some of the other features we have in the U.S. One of the reasons the U.S. is doing better than other countries is it is more flexible, it is more dynamic, it uses more of a market-based system.
For the central bank, which is just there to try and make society a better place, having this broader definition of maximum employment helps. But central banks who don't have a maximum employment mandate, I think it's harder to explain that trade-off.
Coronado: Oh, I completely agree. Actually, one of the most popular questions from the participants is around housing, and that kind of brings this all together a little bit, in a way. We've seen an acyclically strong housing market. Part of that is supported by monetary policy, both through low interest rates, but also the liquidity that restarted mortgage bond markets certainly helped ensure that some of that liquidity was available. What we're seeing is that for people with access to credit, which tend to be people that have jobs and maybe good credit scores, they're able to buy homes, and we're seeing a tremendous bidding up of home prices. Do you think that that's desirable?
More pragmatically, when the Fed does start tapering do you see them maybe taking a strategic approach of tapering first in mortgages, just to sort of ease some of the support that is being directed into the housing market in particular? Simon, I'll start with you. Do you expect there to be a different strategy, and how do you see this support for housing in the broader framework?
Potter: There are a lot of housing markets in the U.S. They've gotten hit by some common shocks. One is that people wanted more space, and they didn't necessarily have to live as close to their work, so that's going to affect house prices. That's just a structural shift, it's going to mean they're higher. The second one is mortgage rates got really low in the U.S., and there are two things that drove that. One is the policy rate of the Fed. The second is the QE of the Fed, both the Treasuries and the mortgages.
Both of them affect financial conditions more broadly. I don't think the Fed should be in the role of trying to pick out a particular mortgage rate. What it should be trying to do is keep financial conditions easy. So in terms of the discussion you had, when the Fed gets to the point that it wants to slow the increase in the assets that they hold, they're going to have to look at a number of issues to do with market functioning and how to explain things. My experience is, explaining something simple is easier than explaining something complicated, where you're trying to hit a very precise target with a blunt tool.
Coronado: Essentially, you're saying that trying to do something that is targeted at the mortgage market or mortgage market conditions would be undesirable, or at least challenging from a broader communication standpoint, that when you're talking about balance sheet policy, simple is the best practice?
Potter: The Fed controls the interest on reserves rate exactly, the overnight RRP rate, and the discount window rates. It doesn't control these other market room rates. They're influenced by lots of different things, and they're particularly influenced by people getting confused about what the Fed's trying to do. Having clarity and simple policies is often easier than trying to target somebody.
Coronado: Joe, do you have any views here in terms of what the role of monetary policy is with regard to the housing market right now, and how that affects or should affect their balance sheet strategy or communication going forward?
Gagnon: No, I think Simon said it well. I was just thinking in the Great Recession back in 2008 and 2009, when we were buying MBS the first time, I remember thinking how mortgages were one of the most effective things the Fed could do in those circumstances, and I still feel that way. But you're reversing the question and saying, "Well, when it's time to tighten, what does that mean?" And I don't know that it has strong applications. I think Simon's right, that simplicity is best.
I would only say just a complete digression, which is just this all highlights that the real difficulty in this country is restrictive zoning laws that prohibit building enough housing for people. It is a first order problem that the Fed really cannot tackle.
Coronado: Not only the Fed, not even fiscal policy can easily tackle it when it's all happening at the local level. Agreed. Willem, do you have any thoughts there on mortgages versus Treasuries, and how house price inflation fits into the Fed's...;
Buiter: Just very, very briefly. It is clear that expansionary, highly expansive, monetary policy means low interest rates, means stronger house prices. We're just going to have to live with that, that's what expansive monetary policy does. But why the Fed routinely purchases mortgage-backed securities, even now, is a complete mystery to me. I would buy, for regular outright open-market purchases, I would buy U.S. Treasuries and broad-based ETFs tied to an equity or corporate bonds. I would not target mortgage-backed securities of any kind, commercial or residential. I think there is something strange about this U.S. obsession with the housing market and the central bank, through that particular channel, and I would abolish it.
Coronado: I knew I could get a few provocative soundbites out of you. The Fed should be buying corporate and equity ETFs, and not mortgage bonds. That definitely...;
Buiter: The Bank does.
Gagnon: May I?
Coronado: Yes, please jump in.
Gagnon: Willem, as I'm sure you know, the Fed is limited in what it can buy by the Federal Reserve Act, which I think is unfortunate. Among the major central banks, the Fed has the most restrictions on its behavior of any central bank I know of, and I think that's unfortunate. But it does lead me to wonder, and I wonder if Willem or Simon have any views, you could argue that maybe the correct asset on the balance sheet of any central bank is the market portfolio of all securities. That would be the neutral balance sheet. You expand the balance sheet when you need to ease, and then you shrink the balance sheet when...;and maybe that is the way one could conduct central banking, it seems to me. It's worth thinking about.
Coronado: I would love to hear your thoughts, Simon, on that.
Potter: Well, buying equity is different from buying a U.S. Treasury security, or a mortgage one. You're the owner of that company, so I think that's not an ideal asset to have. Being a bond holder when the private sector could default or not meet some of the requirements on that bond, you're also involved. The central banks who have done those types of purchases have to deal with a range of issues, which I don't think central banks are necessarily well-designed to do. I think another definition of "market neutral" is one where it's a debt instrument where you're never going to get control, or it's a debt instrument, obviously with equity you have control.
And then there's an argument, maybe in the U.S., because the mortgages are guaranteed, that it's OK to have them. It's a controversial thing for the Fed. The Fed had rules preventing purchases. That was changed in 2008, and it is one of the most effective ways of doing QE that other countries don't have. If we go to Australia, which has innovated massively over the last year, there was a great speech that Guy Debelle made two weeks ago, they chose the three-year point for the yield curve targeting because that had the biggest effect on housing. And obviously they have a hot housing market there, but again, you want some "harmless" in asset markets because the other choice is a depression.
Coronado: Is coldness. Yes.
Potter: That's not a great place to be. The housing channel, because it's an asset that's widely held in many of these countries, is one of the powerful ways to get financial conditions through. You can do it in the U.S. by buying these mortgage bonds. That has a direct effect on mortgage rates. In Australia, we do it at three-year point. In the UK, where Willem used to be on the policy committee, I think bank rate helps pretty well there.
Coronado: Yes, because in both Australia and England, there's much more use of variable rates so those shorter-term interest rates do translate much more directly. And so arguably the Fed has to do MBS, because that's how you affect the U.S. housing market.
There are some questions from the audience, and some of this discussion lends itself to, Joe, it sounds like you would be open-minded to almost sort of a sovereign wealth fund-type approach for the U.S. There are some proposals out there, like the Fed has expanded its balance sheet. It's pretty much telegraphed that it's not going to seek to shrink it as an objective, but rather let the economy grow into it, seems to be the communication we're getting from the Fed, that there won't be a desire this time around to sell bonds so much as just stop buying them and let the economy grow into it.
If this is the world we're in, where the Fed is much more of an active market participant, do we need to think about these balance sheet policies more holistically? This is an issue, for example, right now in the TIPS market. You've got the Fed buying TIPS, you've got the Treasury making issuance decisions with regard to TIPS, and the combination is influencing market measures of inflation expectations in ways that make it very hard to say that's a clean read of actual inflation expectations. So Joe, is this the Gagnon proposal for a sovereign wealth fund?
Gagnon: We've certainly seen a lot of countries act that way, and so we wouldn't be alone by any means. But I think every country has its own unique circumstances. Simon raised the issue of control, a central bank doesn't want to have control over private companies or the negotiation in a default of a bond, and I don't know what the right answer to that is, except to say that I think you'd want some kind of neutrality imposed on the Fed so it doesn't play favorites, and that's why I say the market portfolio. But I don't know how to deal with, if you actually get control of particular companies, what you do. In the Bank of Japan, they do it through exchange traded funds so there's one step removed from the equity, but I don't know...;yes, I haven't really thought about that carefully.
In terms of what you raised, Julia, I don't know. I wish the Fed had more powers that other central banks have. I feel the fact that the Fed can only buy Treasuries and government agency-backed MBS is actually a limit, a serious limit, on what the Fed can do, and I think that's unfortunate.
Coronado: Willem, you have the look of somebody who wants to chime in.
Buiter: No, it's just interesting, this notion of the Fed buying a market portfolio. It would, of course, mean that it takes a significant amount of credit risk on the balance sheet.
Coronado: Which is Simon's point, yes.
Buiter: We'd have to think about whether they should have to come therefore, with some kind of guarantee or fiscal backstop from the Treasury. For the five money market of last resort, market maker of last resort, and lender of last resort operations that the Fed created for flexibility purposes, many of them, most of them, had fiscal backstops of this type.
It can be done, therefore. It can be legislated at very short notice, and it is something that I think we should keep under consideration, that a broad-based set of market operations by the Fed, with a fiscal guarantee of some kind, might be the way to go.
Gagnon: Can I just add, one little point is some people think, including me, but my former colleague Angel Ubide has also written on this, that one way to talk about the channel monetary policy is taking risk on or off the market. That's not a normal channel we think of, but this sort of market portfolio aspect would enable the Fed to take risk off the market and give a risk-free asset when times are tough, and then when times are good reverse that operation. It has some logic to it.
Coronado: Simon, I'd like to hear your thoughts here, arguably, when you're starting to get into the duration-buying channel, that is exactly what you're doing, right? And so, we're already there. It's just, how do you maybe make this more standing and permanent, and as market-neutral as possible? Simon, did you want to...?
Potter: I don't think you need to be active in open market operations in the way that's been described here unless you are at the zero lower bound where you should be using your interest rate tool. If you are at the zero lower bound, what's the most effective way of using the balance sheet? You can take out duration risk, you can have a portfolio balance effect, you can have the old standard QE effect of more reserves in our system, or in the U.S. you can have the prepayment channel through the mortgages, so the Fed doesn't hedge. You see, a lot of the purchases that they do on mortgages are really just to replace the paydowns, and that's been a pretty effective way of sustaining the stance of policy.
I'm not aware of a really good story that you want to have the market portfolio, and it's going to be very difficult to do that across central banks. The country with the most market-based system would be the U.S., so you could argue that you need it there. The country, though, where you don't have big capital markets, you'd go through the banking system.
I think what Willem was talking about is when the market-based system doesn't work that well, as we saw in March 2020, what's the right stance of the central bank? Well, that's more trying to stabilize markets than adding impetus to the monetary policy stance. And there, that's really for the Federal Reserve Board, under their 13(3) authority, and we saw that used in an extensive way. I don't think there's a big argument for opening up the Federal Reserve Act again, given what we saw the Fed was able to do in March 2020.
Coronado: Taking this a step further, a related question is how should the Fed be involved, if at all, in the issue of climate change? So far, the most obvious channel is, at least from a supervisory standpoint, ensuring that the banking system is monitoring and pricing the risks that come from climate change. Is there a role through balance sheet policy for the Fed to play in sort of "green finance?"
Willem, let me start with you since you have a skeptical and global eye on things.
Buiter: Well, I think it is not the mandate of the central bank to engage in "green financing," so it has to change the mandate first in order to do so. Would it be desirable to do so? This would actually tell them to actively purchase, together with U.S. Treasuries, "green" securities issued by appropriate private issuers. I'm doubtful, I must say. I think I would put these kinds of jobs...;they're going to be done in the fiscal or regulatory sphere, but not the monetary policy sphere.
Gagnon: Yes, I would agree. What central banks have the staffing for, what they're good at, is two things. One is macro stabilization, understanding the macro economy (locally and globally), and how it affects their mandate of employment and inflation. But the other thing, in some central banks, is financial stability, especially the banking system. This is kind of neither, except as you said, Julia, narrowly in terms of supervising the banks and their risks to climate.
Otherwise, it doesn't involve anything that central banks have expertise on, or any particular or unique tool for. This is what treasury finance ministries should do if needed, I guess. Not that I would be opposed to it strongly, but it really doesn't strike me as an obvious place to put that authority.
Buiter: As a regulator, of course, central banks have to look at all the risks on the balance sheet, including climate risk. I think that's a serious matter, but it is different from engaging in open market operations involving "green" bonds.
Coronado: Simon, your thoughts?
Potter: If the Fed was actively buying corporate bonds in open market operations, as the ECB and the Bank of England was, then this is one of the considerations you'd have to take into account. The remit of the Bank of England has been changed to take that into account. The ECB is moving in that way. The way they've been buying is through an index, usually, and they're trying to be representative with some sense of what would have the most impact, what would affect employment in the UK.
I don't think it's a big deal to slightly change that and say you've got a preference in your index for buying ESG-type bonds. In some sense, if you think that's a risk that you're trying to mitigate, it's the same as trying to mitigate the risk of a buying a bond which is going to affect employment in the U.S. when you're in the UK.
I don't think that part of it is controversial. The safety and soundness of the financial system is definitely not controversial, because central banks and supervisors, that's what they're there for.
Coronado: Right, and supervisory policy therefore would be...;
Potter: But of course, to say that "you should take into account" is not saying how it should be done, and you can have lots of different discussions or disagreement about what the actual risk is, as you can do about other risks.
Coronado: Although the Fed has the powerful position of being able to define exactly how you should be, and in what way you should be, pricing and reserving for those risks.
We are out of time. I would like to thank all three panelists, fabulous discussion, it did not disappoint. I hope it didn't disappoint president Bostic, who was not looking for reticence and I don't think we delivered reticence. I'm going to hand it back to you, president Bostic, and thank you very much for bringing all of us and making us part of this conference.
Raphael Bostic: Thank you very much, Julia, and thank you to the panelists. To answer your question: no, you did not disappoint. This was actually a very, very good, engaging, and provocative panel. Just thinking about the morning, what I heard right from the beginning was a consensus that the next 8-12 months are going to be very strong from an economics perspective in this country, but that's where the consensus ended in terms of, what does this mean and how should we think about it, and what are the implications for where our policies should go. Lots of different thoughts and perspectives, and things that I definitely needed to think about.
In listening to the panel in particular, thinking hard about how we should think about the different adjustment speeds of the demand side versus supply side of the economy, and what sorts of measures or metrics might we want to focus on to get a sense about whether things are permanent or more transitory in nature, and that's something that I will definitely take away from their conversation.
I just really enjoyed the extended discussion about the strategies of doing monetary policy, and how you execute it. Whether we think about a sovereign wealth fund or issues of central bank control, making a lot of the facilities that we did through the pandemic and the Great Financial Crisis permanent, these are all really interesting questions, but one thing that they all get to and touch upon is the local politics and the political economy of the situation.
That was mentioned a number of times, but for every central bank they are really constrained by the politics of their country and what sorts of authorities they're going to be allowed to have. As we move forward, if we're going to consider some of these, we are definitely going to need to bring in the policy side. Then, I also very much enjoyed the conversation on inequality, very, very broad set of considerations in terms of rich versus poor, but also rich in different ways, and the differences between people who are rich in different ways and the assets they have.
So, very thought provoking. I'm not going to abolish anything quite yet, coming out of that panel, but definitely I appreciate the candor and the directness. I hope you out in the audience enjoyed this conversation as well, and I would just advise you, we've got another day coming, and tomorrow should be equally direct and pointed as we have one of the nation's leading and most outspoken economic thinkers, Larry Summers, who's going to be on the program. He's going to offer some opening remarks, and then have a conversation with one of the most direct and pointed people on my staff, our research director, Dave Altig. That will prove to be a really interesting conversation, I assure you.
We will also hear from another one of my colleagues, the president from the Dallas Fed, Rob Kaplan, who will moderate a discussion on the dollar's role in global financial markets. If you've seen Rob talk, you know he's also someone who says exactly what he thinks. It will prove to be an interesting discussion, and a great panel.
I want to thank you all for being here for day one of the 2021 Financial Markets Conference, and I look forward to seeing you tomorrow.