Randal Quarles on Inflation, Balance Sheet Reduction, Financial Stability, and the Future of the Fed

Randal Quarles is the executive chairman of the Cynosure Group and the former Vice Chair of Supervision for the Federal Reserve Board of Governors. Randy also served as an official in the US Department of Treasury, and he joins Macro Musings to talk about his time at the Federal Reserve and his thoughts on current issues facing the institution. David and Randy also discuss how the Fed fell behind the curve on inflation, how he sees the balance sheet reduction process playing out, the central bank’s shifting focus toward climate change, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Randy, welcome to the show.

Randal Quarles: Thanks for having me. Great to be here.

Beckworth: It's great to have you on, and I must give full disclosure. I worked for you at Treasury many, many years ago. That's where I first met you. And that's a great segue into a question I have for you. Tell us about your career path. How did you get into public policy? You were at Treasury two times, is that right? And then you were at the Federal Reserve. So walk us through that trajectory and how you got there.

Quarles: Well, so I started out, back in the Coolidge administration, as a lawyer and worked for a law firm in New York called Davis Polk, which was and is probably the premier financial services law firm, maybe along with Sullivan & Cromwell, in the country. [They] represented J.P. Morgan and Morgan Stanley and then a variety of other financial services firms. That was the expertise that I was developing, were on financial policy issues, financial legal issues. And when the Treasury in Bush 41, the Brady Treasury, was putting together a team to work on kind of the policy response, the broader policy response, the long-term policy response to the sort of fragilities that had been revealed in the savings and loan crisis, they put together a team that consisted of a senior academic, Bob Glauber; a kind of mid-level investment banker, who was Jay Powell; a Hill staffer, senior Hill staffer, who was John Dugan. And they needed about a sixth-year associate expert in the law and financial institutions. And they cast out to the usual suspect firms in New York and picked me.

Quarles: So I went down to the Treasury for a few years in Bush 41. And then, once you've done that, you kind of get on a list. And I enjoyed the work very much. I went back to my law firm after that, but when the Bush 43 administration came in and Paul O'Neill was asking Brady, "Whom should I bring back from the old group?" and they brought me back, I served in a variety of different posts in the Bush 43 Treasuries, for all three Treasury secretaries. And then I was even more on a list, so that when the Trump administration was looking for someone to fill the vice chair post, I was on that list.

Beckworth: It's interesting that you and Jay Powell spent two times together at Treasury and at the Fed. So was it like an old reunion when you got back together?

Quarles: Yeah, we became good friends, and stayed good friends for all of those 30 years. I mean, when you look at our resumes, they appear to overlap more than they actually do because Jay was also an associate at Davis Polk, and I was an associate at Davis Polk. We both were in the Brady Treasury. He was a partner at Carlyle. I was a partner Carlyle. We were at the Fed then at the same time, he as chair and I was vice chair. But we really, until our time at the Fed, had only been in the same place at the same time for those two and a half years in the Brady Treasury. We just had very similar careers. And we're very good friends.

Beckworth: Yeah. I read the Nick Timiraos book, which they highlight some of this relationship and the going back and forth, and really fascinating to read. And I'm going to use it as segue into another question I have for you, Randy. And that is, what is the typical day like for a vice chair of supervision at the Federal Reserve? Now, I know there's probably no typical day. Maybe I can make this a little bit easier by saying the typical day prior to the pandemic, so prior to February 2020. What would you do? Is there a routine? I mean, walk us through that.

A Typical Day at the Fed for a Vice Chair

Quarles: I don't know that there was necessarily a routine. One of the appealing things about public service at the Fed, compared to, say, my time at the Treasury, and I loved my time at the Treasury, but the Fed has the resources, and the time, and the focus on a limited enough range of responsibilities that you can really think deeply and rely on deep staff research in executing those responsibilities. At the Treasury, you have to respond so much faster across a much broader range of responsibilities, and you have a kind of explicitly political aspect to your responses. I mean, you're working for the president and part of the political administration. And the Fed really is much more of a temple. It's not exactly 50 hours of reading a week, but it is much more kind of reflective, and you have the opportunity for deeper analysis than in many other sorts of public policy responsibilities.

One of the appealing things about public service at the Fed, compared to, say, my time at the Treasury, and I loved my time at the Treasury, but the Fed has the resources, and the time, and the focus on a limited enough range of responsibilities that you can really think deeply and rely on deep staff research in executing those responsibilities.

Beckworth: So, in your position specifically as vice chair, you had both to vote on monetary policy, which I can imagine takes a lot of time and deliberation, as well as being a regulator. You also served on the FSB. So, I mean, you did a lot of different things. Your plate was full. And I just can imagine you had to manage your time carefully to work through all those different responsibilities.

Quarles: Yeah, particularly taking on the chairmanship of the FSB. I'd like to say that yes, half my time was devoted to monetary policy, half to regulatory policy, and half to the FSB. So it did make for some long days. But again, in each of those responsibilities, there was an ethos of kind of deep analysis, and reflection, and getting to the right answer that was quite satisfying.

Beckworth: Yeah. So you had a fun time there. And you told a great story at a conference I would love you to share with our audience. So you commuted, is that right? You actually lived in Utah part-time and lived in DC part-time.

Quarles: Yeah. During my last stint at the Treasury and then as a partner at Carlyle, we'd lived in Washington. And our kids had been raised there up until sort of their mid-teenage years, early teenage years. And then we moved back to Utah, which is home for us in a deep sort of way. And I had started my own firm out here. So when they asked me to come back and serve in the Fed post, my family said, "Well, we just moved back out here. And we like Washington, but we don't want to move again." My kids had just settled after the move. So I commuted and took the last flight in from Salt Lake City into Washington on Sunday night, which gets into Dulles at about midnight.

Beckworth: Wow.

Quarles: And it's something I'm very glad is over. But it meant that during the week, I was essentially a bachelor. I tried to get back and work out of the Fed office in Salt Lake City on Fridays. That worked maybe once or twice a month. So for the week, until I went home for the weekend, I was just alone in Washington and tended to work much later than Fed governors typically work, in the building at least.

Beckworth: Yeah. So tell us your story. You have a great story that you use to illustrate, actually, the Fed's commitment to price stability. So finish it up with the implication for price stability, but walk us through this amazing story you had of your nighttime work.

Quarles: So being there, not having a family, I would work late at night. The Fed outfits each of the governors' offices, although no one had told me this, with a panic button that's under your desk. And so... may have been the first week I was there, certainly very early on... I'm working late at night, typing something out and maybe jiggling my knee a bit, excited about what I'm doing, and I pushed the panic button. Had no idea I'd pushed the panic button because I didn't know it was there. It doesn't make a sound in the room in case whoever's holding you hostage, they don't know that help is on the way.

Beckworth: Right. Right.

Quarles: So this has never happened before, and the security was never perfectly aware. They just weren't used to having somebody on the governor's hallway at 10 o'clock at night. So this team of security folks with rifles and the helmets and the visors comes running into my office, and we just sort of stare at each other for a bit. And then they say, "Well, you pushed the panic button." And I say, "What panic button?" I had no idea. So then they explain. Everything's fine. And you would think that that is the sort of thing that would only happen once, and I would then be very careful not to push the panic button. But no, it happened more times than you could possibly imagine that I would just get so absorbed in whatever I was doing at 9:30 or 10:00 at night, and my leg would start to jiggle, and I'd push the panic button. So eventually they stopped responding. They just stopped coming. So if only the terrorists had known that was the time to attack…

Beckworth: Nice.

Quarles: ... the Fed because they weren’t going to respond to an alarm. And eventually they moved the panic button to an entirely separate part of the office, which defeated the purpose, I suppose, but was easier on everyone's nerves. But before they did that, they hired a new security guard, as one does. And the alarm went off, and he goes, "Oh, my gosh, we got the panic button in Governor Quarles's office." They said, "Well, you go save Governor Quarles. Yeah. We'll take care of the folks down here at the gate." And so he comes running in. Of course, by this time I realize what's happened and said, "Oh, I'm so sorry to have disturbed you. I pushed the panic button."

Quarles: But this young security guard was something of an art aficionado as well, and so he then was interested in the art that was on the walls of the office. And the Fed gives the governors a choice of art to decorate your office. It's not a valuable collection. It's a nice enough collection, but it's not from the Smithsonian. But one of the things that I had chosen to put on my walls was actually painted by Arthur Burns. It was an abstract painting. For policy folks who have turned to painting, George W. Bush is a much better painter than Arthur Burns. But I had it on my wall as sort of a memento mori of, "Don't do this." Not the painting, but what Arthur Burns stood for at the Fed.

Quarles: So as we're going around, and I'm explaining, "Well, this painting, this is a chalk portrait of Marriner Eccles, and this is a chalk portrait of Carter Glass," and explaining to the young security guard the history and so forth, we get to Arthur Burns. And I say, "Now, this was painted by Arthur Burns," and I'm getting ready to explain to him who Arthur Burns was and why it's on the wall, and kind of bringing this young, new member of the Fed family under the tent. But before I can explain any of that, all I say is that this is by Arthur Burns, and the security guard says, "Oh, my gosh, that's the guy that let inflation get out of control."

Quarles: As you said, it's a story that I sometimes tell to sort of give an indication of the commitment of the institution to controlling inflation, when people say, "Will this Federal Reserve really have the stomach to control inflation and see the unemployment rate rise and the economy be reined in?" And the answer is, the one great sin at the Federal Reserve that is on everyone's mind, from Jay Powell's to the brand-new security guard, is that you don't let inflation get out of control. My young colleague had no idea what the unemployment rate was in 1972, had no idea what the oil price was in 1972, had no idea what the political situation was in 1972, but he knew that Arthur Burns let inflation get out of control, and was a hiss and a byword in the building half a century later. This FOMC is not going to become those people.

It's a story that I sometimes tell to sort of give an indication of the commitment of the institution to controlling inflation, when people say, 'Will this Federal Reserve really have the stomach to control inflation and see the unemployment rate rise and the economy be reined in?' And the answer is, the one great sin at the Federal Reserve that is on everyone's mind, from Jay Powell's to the brand-new security guard, is that you don't let inflation get out of control.

Beckworth: What a story, and what a standard that security guard sets for the next hires. "Do you know your monetary history? If so, you are hired." Hopefully he's not the one interviewing, because that'd be very high standard. Randy, you're also known, during your time as vice chair, for your humor and erudition in your speeches. So let me give a few examples of this. In your speeches, even the titles are very clever and eloquent. So your departing speech, December 2nd, 2021, the title is *Between the Hither and the Farther Shore: Thoughts on Unfinished Business.* And this was quite the speech. And let me read near the end of paragraph here. And you may have to help me on some of the pronunciation here.

Beckworth: But you state, "I am told that Dan Tarullo's final speech as a Fed governor was 26 pages long, and this one is only 25, consistent with my relentless quest to improve the Fed's efficiency and simplicity. Yet even at this Mahabharatan length, I have only hit the highlights of what my successor will need to address." So you use big words, very eloquent. Another speech, October 20th, 2021. The title is *How Long Is Too Long? How High Is Too High? Managing Recent Inflation Developments Within the FOMC's Monetary Policy Framework.* October 5th, 2021, another speech, *Goodbye to All That: The End of LIBOR.* And then, another great one for someone my age, June 28th, 2021, *Parachute Pants and Central Bank Money.* So, I'm old enough to understand parachute pants. What a great title. So what's behind this, your humor, your clever use of words? Tell us the motivation, the background.

Quarles: Oh, I don't know. I don't know, other than that these topics are... which, obviously, the folks who are listening to this podcast appreciate because they're into these topics... They're quite important. In many ways, the history of the United States can be interpreted as responses to many of these financial policy issues. Certainly been a critical thread in the history of the country. But they're often little understood and viewed as esoteric and maybe un-understandable. And I think that if you make your discussion of them a little warmer and a little less clinical, that that can help convey that.

Quarles: Now, it was a great burden on the public affairs folks at the Fed, who were always seeking to tone me down. The public affairs person who was kind of principally responsible for my area, a guy named Eric Kollig, wonderful public servant, became a really good friend. Our politics were quite different. He had a wonderful understanding of the press and how to get your message across. I guess his fundamental message to me always was, "Randy, nobody wants a funny Federal Reserve governor, and B, you're not that funny. So tone it down." And that was almost always good advice. So if you'd seen the first drafts of many of those speeches, you would realize that they were all improved by being toned down a bit.

Beckworth: Well, let me ask one final question about your time as vice chair. Did you listen to any podcast, and would one of them happen to be Macro Musings?

These topics... They're quite important. In many ways, the history of the United States can be interpreted as responses to many of these financial policy issues. Certainly been a critical thread in the history of the country. But they're often little understood and viewed as esoteric and maybe un-understandable. And I think that if you make your discussion of them a little warmer and a little less clinical, that that can help convey that.

Quarles: I did indeed. I was a regular listener and am a regular listener.

Beckworth: Well, thank you. Good to hear. Good to hear that in the halls of the Eccles Building, you might hear Macro Musings being played. Well, let's move on, then, to some substantive issues, and let's go to probably the most pressing one right now. And that is inflation. And at that conference where you shared that incredible story about the security guard at the Federal Reserve building, a big part of the discussion was the inflation and how did the Fed fall behind the curve. And right now, the Fed seems to be getting ahead. It's really tightening. It's talking up more rate hikes. But what is your sense of what happened last year, and coming into this year, that the Fed seemed to fall behind the curve on inflation?

How Did the Fed Fall Behind the Curve on Inflation?

Quarles: So, let me begin by saying that while I do think that we fell somewhat behind the curve [on inflation], I don't think we’re either irrecoverably or dramatically behind the curve. So, consider a year ago. Inflation had started manifesting in the spring, starting above 3% in April, I guess. By the beginning of June, it was 5%. I think that was CPI inflation rather than PCE inflation, but still. But when you looked at the basket that we use to measure inflation, there was really only one element in it that was showing significant inflationary pressure, and that was used car prices. That's a whole separate topic, the degree to which kind of headline inflation numbers can confuse certainly public discussion and really even policy discussion because they can be driven by kind of eccentricities in a single element.

Quarles: When I arrived at the Fed, inflation was unusually low, was printing unusually low, because the spring before I arrived, all the cell phone companies had moved to unlimited data plans, and that dropped what people were paying for cell phone coverage significantly. But it was one thing. It was not a trend. It was not really affecting inflation, but it dropped the aggregate inflation number significantly. And you just had to kind of wait for that to roll out of the trailing 12 months. And as soon as it did, inflation popped back up to more what we were targeting. So in this case, it was just the opposite effect. Because of the computer chip shortage, driven by well-documented and expected supply chain disruptions, new cars were difficult to produce because they're basically rolling computers these days. So if you wanted a car, you had to buy a used car. And used car prices over the previous two months had gone up by 25%, and that drove the aggregate annualized inflation number to print at 5%. But it was just one thing, and that was being driven, obviously, by sort of COVID events.

Quarles: And in that sort of a circumstance, I think the right response was, "Well, the Federal Reserve can't produce more computer chips, and raising interest rates in order to constrain aggregate demand so that the demand for used cars fits within the current supply of used cars would be insanity." So given the information that we had, given what was a very logical narrative of expected inflation from supply chain disruption, the right response was to say, "Well, we shouldn't begin yet in trying to constrain this inflation." Now, by the fall, by September, it was clear. It was clear to many of us on the FOMC, many observers, you now had kind of comprehensive, very broad-based price increases across the basket of goods that we use to measure inflation. And you had various measures of supply in the economy that were at pre-COVID readings or above.

While I do think that we fell somewhat behind the curve [on inflation], I don't think we’re either irrecoverably or dramatically behind the curve.

Quarles: The one that I kind of liked to focus on was the measure of throughput at the ports, because that was a story that all last summer people were saying, "People haven't come back to work because of COVID. And so there are these bottlenecks at the ports because you can't get the goods unloaded, and that's constraining supply of imported goods in the country." But by September, it was clear that through the US ports, especially the port of Los Angeles, was at and above pre-COVID levels, and you still had all these bottlenecks because you had much more demand trying to bring goods through the ports than could be satisfied by the pre-COVID level of supply. And by the end of the year, the ports had broken records for the amount of throughput, and you still had this backlog.

Quarles: And that was just one data point among many. The supply disruption element of the inflationary dynamics was not non-existent, but it was not what was predominant. What was predominant was that we had overstimulated demand, and many of us had expected that there would be a certain amount of that. I certainly had not predicted the degree to which the overstimulation of demand would result in this sort of inflation. But the good news there, of course, is that's something that the Fed can respond to. Interest rate policy ought to be very effective in responding to inflation, if that's the primary driver, as I think that it is the primary driver. And that was clear in the fall.

Quarles: So then the final element of your question is, "Okay, well, that was clear in the fall to many, if not to everyone. So why didn't the Fed move in the fall?" And was that a function, in particular, that's often raised? Larry Summers raises the point. Is that a function of the Fed's monetary policy framework that was adopted in August of 2020, that I've described as the dis-relevant element of it being, "Wait until you see the whites of their eyes," as opposed to responding at the first signal of developments in the economy that one would think might be accompanied by future inflation? Wait until you see the inflation in order to respond. I don't think that that's what drove the lack of response in the fall. I think it's the wrong conclusion to believe that the monetary policy framework in general, or even that element of it, is mistaken.

Quarles: This is maybe an eccentric belief. I don't think that it's universally shared or even widely shared on the FOMC. But my belief is that it's a separate element of the Fed religion that resulted in not moving in the fall, and it became clear that it was time to pivot to withdrawing accommodation, and it's a long-standing kind of Fed principle that you shouldn't step on the gas and the brake at the same time; meaning that you shouldn't be raising interest rates at the same time as you are still increasing the size of the balance sheet. And so we had decided that we needed to taper the balance sheet purchases. The lesson of the taper tantrum under Bernanke was that you've got to telegraph that well in advance. You've got to do that gradually, in order to avoid disrupting markets. And you have to have completed that before you can start raising interest rates so that you're not doing two conflicting things. So that was the sequencing.

The supply disruption element of the inflationary dynamics was not non-existent, but it was not what was predominant. What was predominant was that we had overstimulated demand, and many of us had expected that there would be a certain amount of that. I certainly had not predicted the degree to which the overstimulation of demand would result in this sort of inflation.

Quarles: With the benefit of hindsight, I think it's now clear that in circumstances such as obtained in the fall, where you had inflation printing at such a high level, unemployment that had fallen significantly below what we thought was an inflationary level, a clearly overheated demand, and the relative power, if you will, of interest rate policy versus balance sheet policy, I think that in those circumstances, for a limited period of time, to have said, "Yes, tapering the balance sheet has to happen over an extended period of time to avoid disrupting markets, but we're going to begin raising interest rates even before that taper is complete because now is the time to move more aggressively in the response to inflation," I think that would've been wise.

Quarles: I'm a pilot, and I would often bore the FOMC with my analogies to flying. And one of the first thing you learn when you're a pilot is that you should always turn the rudder and the ailerons in sync so that the plane is moving in a smooth and coordinated turn when you're turning. And if you move the rudder and the ailerons in different directions, the plane will start to sink out of the sky. So usually that's a mistake, but there are occasions, like when you're trying to land the plane and you're a little too high over the runway, where you actually do that. You move the rudder and the ailerons in different directions so the plane slips into the right glide path, and then you re-coordinate and land. And I think that last fall would've been a time for the Fed to slip policy down onto the right glide path by beginning to raise interest rates even before the balance sheet taper was complete.

Beckworth: Do you think the FOMC now is committed to returning to 2%, or would they be willing to, say, stop at 3% if it meant avoiding a really steep recession? I mean, are they committed to the 2% inflation target? Because some people have said, "Why not just raise the inflation target at 3%? An opportunistic time to deal with the fact that we might have a zero lower-bound environment in the future. Let's stop at 3." Where do you think they fall on that?

My belief is that it's a separate element of the Fed religion that resulted in not moving in the fall, and it became clear that it was time to pivot to withdrawing accommodation, and it's a long-standing kind of Fed principle that you shouldn't step on the gas and the brake at the same time.

Quarles: So, certainly, if I were on the FOMC, my view would be, well, A, I think that a 3% target is too high. I was fine with but not intellectually deeply committed to a 2% target. Paul Volcker, great hero of monetary policy, never understood the 2% target. “We should be aiming for zero. Why are we aiming for 2%?” But I think to do that in this environment really would undermine your long-term credibility. If you've said, "We will maintain 2%," there's a whole separate discussion. Should it be 3? Should it be 4? I think some former Fed officials have argued... many economists... I don't think a majority, but many economists have argued that the inflation target ought to be higher. But if in this context, you say, "Okay, well, we can't meet that target. So we're going to define a target that we can meet," you really undermine your credibility for the future target. So how do you know that the next time that you need to bring inflation down to 3, you're not going to say, "That's actually too hard. Let's make it 4"? So I think that the Fed is sort of stuck, even if it were becoming committed to the view that 3% were the right inflation target. And I see no evidence of their becoming committed to that view and no reason for them to be so. But even if they were, you sort of have to get this under control first, and then you can say, "Let's think about whether that was the right target."

Beckworth: Yeah. I agree with that completely. I think credibility is the key issue here, and you don't want to compromise that, particularly in a period like when we're in right now, where there are questions about the Fed's commitment to inflation. Let me move to the Fed's balance sheet, since you touched on that. So right now it's close to $9 trillion. There was an annual report that came out from the New York Fed on open market operations, and they projected it to get down to $6 trillion. What is your sense of how small it will get?

Randal’s Sense of Balance Sheet Reduction

Quarles: So, my sense of how far the Fed's balance sheet ought to shrink has changed quite a bit, or certainly materially, during my time on the Fed board. I arrived generally committed to the position of a lot of folks who wear my general political jersey, that post-2008, the balance sheet had bloated unnecessarily, and it was really important to get it back almost to the pre-2008 level. It became clear, I mean, the minute I walked in the door, that that wasn't really a possible answer, because the Fed's balance sheet is driven by the demand for its liabilities, and currency alone was at 1.4 trillion, I think, when I walked in the door, and it had been at 700 billion when I left the Treasury in 2006. And I had thought, with all the digitization of the financial system that was going on, that surely there would be probably a little less currency outstanding, rather than twice as much currency outstanding when I came back into the official sector.

I think that last fall would've been a time for the Fed to slip policy down onto the right glide path by beginning to raise interest rates even before the balance sheet taper was complete.

Quarles: And then the demand for reserves that's being driven in part by the changing operational framework for monetary policy, the floor system, in part by the changing liquidity requirements for the banking sector, so significantly greater demand for reserves in the system. It's just going to be a larger balance sheet. And I don't believe that, looking at it purely as a financial matter, that that has that many consequences. I think the Fed's balance sheet can be as big as it needs to be. It can be any almost arbitrary number, and that doesn't have the financial consequences for the system that I feared or thought before 2017.

Quarles: What I do worry about is that a balance sheet of that size, certainly relative to GDP, becomes an attractive nuisance. For the listeners who are lawyers, they'll all know what that means, which is in your first year of law school, in tort class, you learn that a property owner can be liable for allowing to remain on his property a dangerous instrumentality, even though it's completely on your own property and someone to would have to trespass to get to it, if that feature is irresistibly attractive to people of immature judgment, such as children and congressmen.

Quarles: And so I worry not about the financial consequences of a very large Fed balance sheet, but about the potential political attractiveness of a pool of assets that large for political objectives, whether that's accelerating a green transition, as they are doing in Europe, or whether that's building a border wall, which was never suggested, but surely someone could think about that. I mean, politicians, if they see a pool of assets that big relative to needs and GDP, will certainly have ideas as to how to use that. That is a reason to try to shrink it as much as possible, but it's never going to get back to 700 billion, and 6 trillion may be as small as it can go.

Beckworth: So, you mentioned the role that regulation plays in this, and you had several speeches on the liquidity coverage ratio. That creates demand for these high-quality liquid assets, treasuries and reserves. And since the pandemic, when the large-scale asset purchase program vastly expanded the Fed's balance sheet, then the other kind of big regulatory... constraint's the right word... but regulatory impediment was the supplemental leverage ratio. That became a binding constraint. And as you've noted in your speeches... and I've had other guests, Bill Nelson, on the show before... it was never meant to be a binding constraint. When it was first written, the expectation was the Fed's balance sheet would be relatively small, even if larger than 2008. But now we get to a crisis when it's really, really large, and all these reserves make it a binding constraint. So I know right now, it's under consideration. It's being possibly tweaked like it was during the pandemic. Assume that it does get tweaked. Between that tweak and the standing repo facility, do you think that makes the transition to a somewhat smaller balance sheet easier, more likely?

It's just going to be a larger balance sheet. And I don't believe that, looking at it purely as a financial matter, that that has that many consequences. I think the Fed's balance sheet can be as big as it needs to be. It can be any almost arbitrary number, and that doesn't have the financial consequences for the system that I feared or thought before 2017.

Quarles: I just don't know that there's going to be that much appetite at the Fed for a materially smaller balance sheet. After September of 2019, when... So, the Fed then had been following the view of, "The balance sheet needs to be as small as possible, but not smaller. And we don't know exactly what that size is. But we'll see it when we kind of reach a kink in the demand curve as we begin to shrink reserves and shrink the size of the balance sheet. At some point, we'll see kind of a developing of a slope in the demand curve, and we'll know that we're there. And then we'll kind of expand it back out a little bit." The disruption in September of 2019 as we were shrinking the balance sheet was significant enough that I think the general view on the FOMC became, "We don't want to ever get that close again" and movement away from the view of, "Let's shrink it until we're absolutely as close to that kink as possible." It was, "Well, let's just make sure we've got plenty of cushion before that ever happens again."

Quarles: I worry a little bit about that because of my concern about the attractiveness of a very large balance sheet, particularly since, post-COVID, we're now dealing with a balance sheet that's materially larger than the one that we were talking about in the discussion in September of 2019. I do think that one of the drivers of that disruption in 2019 was our, not so much liquidity regulation, but liquidity supervisory policy, which put a pretty heavy thumb on the side of the scale of preferring reserves over Treasury securities in satisfying your liquidity obligations. And with that heavy of a demand for reserves, it meant that people weren't going to jump into the Treasury repo market in the way that we expected that they would in order to kind of equalize that quickly, because they valued reserves much more heavily than they valued treasuries in satisfying what, from a regulatory purpose, are... Those are viewed as the same thing. They will both equally well satisfy your regulatory obligation to maintain high-quality liquid assets.

Quarles: But from a supervisory point of view, if you needed intraday liquidity, given the fact that it still takes a day to settle Treasury securities, you need reserves to handle that. You need actual cash. And so the banks heavily preferred that. So I think if one were to address that, and the Fed has gone a reasonable way towards addressing that supervisory preference for reserves over treasuries, that you could try again to get closer to that kink without the sorts of disruptions that we saw in September. But I don't think that the Fed's going to have the stomach for it.

Beckworth: Okay. So, we've been talking about monetary policy. Let's go to the other part of your job, and that's the chief bank regulator. You also oversee financial stability. So let's talk about that for a few minutes here. One of the remarkable things that happened in 2020, that came out of that, is the banking system went through it relatively unscathed. It was relatively robust to what happened. And I know you have argued that's because, look, we had ample capital buffers and liquidity taken care of, coming into the crisis. Some critics would say, "Yeah, yeah, yeah, but fiscal policy kind of really provided a lot of income to the economy." And you have a rebuttal to that. Talk about the stress test. So walk us through your rebuttal to that critique.

Given the fact that it still takes a day to settle Treasury securities, you need reserves to handle that. You need actual cash. And so the banks heavily preferred that. So I think if one were to address that, and the Fed has gone a reasonable way towards addressing that supervisory preference for reserves over treasuries, that you could try again to get closer to that kink without the sorts of disruptions that we saw in September. But I don't think that the Fed's going to have the stomach for it.

Randal’s Response to the Fiscal Policy Critique: Stress Tests

Quarles: Yeah. I mean, so, it's inarguable that the actual outcome for the financial system was heavily driven by the level of fiscal support to the real economy, so that the losses that one might have expected to roll up into the financial system from closing down businesses, administratively, never happened. So yes, that is true, but we didn't know that it was going to be true. In the first months of the COVID event, we were in the middle of running stress tests, of running the annual stress test at that time. And many jurisdictions in the world, sort of as that happened, said, "We're going to stop running stress tests. It's just impossible to do it. We're just going to circle the wagons around the banking system. We're going to prevent any distributions out of the banking system of any sort. They have to stop paying dividends. And then, when we get to the other side, we'll see how the dust has settled."

Quarles: In the US, we took a different approach, which was to ramp up the real-time stress testing and analysis of the system. So in addition to the annual stress test that we were running, we ran three simultaneous sensitivity analyses as part of that stress test, to say, "If the world evolves in this way, how will the banking system evolve? If losses roll up in this fashion into the system, how will they evolve?" And in each of those sensitivity analyses, the banks, they were hit hard, but there was no financial crisis in our analysis of, "Given the potential developments that we're seeing here, how would the banking system evolve?" We then continued to run additional stress tests during the ensuing year, assuming in each case that at each point that we ran the test, that we devised the scenarios, there was no additional fiscal support than had already been provided. "And how will the banking system evolve?" So we ran, over the course of that single year, seven stress tests of one fashion or another, assuming in each case no additional fiscal support from where we were.

Quarles: And in the initial four tests, the tests plus three sensitivity analyses, that was no federal support at all… the amount of capital and liquidity in the banking system preserved the system well. It did what it was supposed to do. I certainly understand where people are coming from who are saying, "Well, that wasn't a real test." Thank heavens it wasn't a real test, from the point of view of the financial system. But we were testing the system rigorously throughout to say, "How does our framework work? How would it work in this case?" And I think it's inarguable that the resiliency of the banking system was sufficient.

Beckworth: So, just to recap, what you're saying is you did stress test throughout this period, even before all that fiscal support had arrived. And therefore you could do the scenario analysis, "Well, what if there were no more fiscal support?" And you found that the banks would survive and make it through that. Let me go to a different area, Randy, and that is shadow banking. And you worked on the FSB on this issue. I know you worked on the money market funds, a big part of this. But what is your thought to critics, who often say what the Fed did during the pandemic was needed, it was important, but all those liquidity facilities, all they're really doing is further entrenching shadow banking and the global dollar funding market? How do you respond to that?

Responding to the Shadow Banking Critique and Randal’s Work with FSB

Quarles: So, a few things about shadow banking, or non-bank financial intermediation, as we worked hard to try to ingrain as the terminology of choice. Post-2008, there was not as rigorous, or extensive, or effective amendment to the regulation of the non-bank system as there was of the banking system, for a whole variety of reasons. There was some, and some of that proved actually counterproductive. The changes to liquidity regulation of prime money market funds, for example, was actually counterproductive in the COVID event because it simply set the point at which there would be a run on all money market funds higher than it would've been before because as soon as you reached that irreducible level of liquidity that the regulations required, and you had to start imposing fees or dropping gates, everybody would run from all funds. And so that was the wrong answer. It seems so evident, with hindsight, that that would've been the wrong answer, you kind of figure, "Who was thinking that up?"

I certainly understand where people are coming from who are saying, 'Well, that wasn't a real test.' Thank heavens it wasn't a real test, from the point of view of the financial system. But we were testing the system rigorously throughout to say, 'How does our framework work? How would it work in this case?' And I think it's inarguable that the resiliency of the banking system was sufficient.

Quarles: So there is a lot of work, in my view, that should be done in creating the right regulatory framework around the resiliency of the non-bank sector. That is not, however, a cloning of the bank regulatory requirements, because the banking system is a different system. It is possible to look at the behemoth organizations that are at the center of all the interconnections and networks of the banking system, and focus your regulation around kind of making those fortresses of resilience, and have a more resilient banking system. The non-bank system, you would look in vain for those sorts of behemoth central nodes, so it's much more fragmented. You're much more looking at activities. If I had a clear solution to the right framework for macroprudential regulation of the non-bank system, I'd happily provide it to you. I don't. I think there's a lot of work that has to be done there.

Quarles: The two things I would say are exactly that. It hasn't been done, to the effectiveness and efficiency of that system, and it can't be done by simply cloning bank regulation and applying it to it. It would be a lot of work and thought that has to be done. During the COVID event, though, that was where the Fed's intervention was really most necessary, was with respect to fragilities and weaknesses that we saw on the non-banking side, as opposed to anything we thought was going to happen on the banking side.

Beckworth: So tell us about your work on money market funds with FSB. You did address that particular part of shadow banking system.

Quarles: Yeah. So, we began with money market funds. What the FSB did was kind of create a number of options of policy responses that might be different, depending on how money market funds, with a role that they play in a particular local financial system or domestic financial system, but that would kind of create disincentives to run from the holders of interest in money market funds, as opposed to incentives to run, whether those are pricing incentives, swing pricing, other sorts of supervisory or regulatory incentives. The theme across all of them, though, was to kind of create structural disincentives to run, as opposed to regulatorily minimum standards for liquid assets that have to be held, because we discovered that just accelerated rather than delayed the problem.

Quarles: I still think that even with the work that we did at the FSB, even if all of those proposals were implemented, I think that's still a fragile system. The problem we're running into is that the tight constraints that we have put, particularly leveraged capital requirements, on the banking system are driving deposits out of the banking system. They do not want the assets that they would keep in order to hold that level of deposits, because of the capital costs that we put on those liquid assets that would be required to back those deposits. So we're pushing deposits out of what is now the most resilient part of the financial system, the banking system, and pushing it into a much less resilient part of the system, money market funds.

It is possible to look at the behemoth organizations that are at the center of all the interconnections and networks of the banking system, and focus your regulation around kind of making those fortresses of resilience, and have a more resilient banking system...If I had a clear solution to the right framework for macroprudential regulation of the non-bank system, I'd happily provide it to you. I don't. I think there's a lot of work that has to be done there.

Quarles: So I think that a comprehensive approach to thinking about resiliency of the whole system can't only look at money market funds and the regulation of money market funds, or the regulation of non-bank system as well, although I think there's a lot of work to be done there. It should also look at what incentives are we creating for activity to be pushed out of the banking system into the non-banking system, when we might actually prefer that it stay in the banking system, but we've created regulations that drive it out.

Beckworth: Okay. One last question for you, Randy, before I let you go. And I appreciate the time you have given us today. This is one question with kind of two embedded in it, so it's going to be maybe a little bit longer. And this deals with climate change. So, listeners of the show will know that I'm a little less convinced that the Fed should be delving into this area than many believe it should be. And here is my reason. I believe climate change is a real issue, and I believe it should be addressed by Congress empowering agencies to deal with it. But the Fed itself doesn't have a legal mandate, per se, to deal with this, unless you interpret it under financial stability or some other part of its existing mandate. And I would take the more general approach that if climate change is a threat to banking system, then why not take an approach where you just require more capital or whatever's needed to withstand that shock?

Beckworth: So we've seen a number of developments over the past few years that could be risks to the banking system... trade wars, pandemics... and there's all kinds of tail events out there. Asteroids, solar flares, things that can knock out our grid. I mean, are we going to stress test for all of those or just for climate change? So that'll be my first question or first part of the question. Why does the Fed focus in on climate change and not these other risks? And then, the follow-up would be, given the recent Supreme Court case of West Virginia versus the EPA, will that have any bearing on what the Fed can even do with climate change?

I think that a comprehensive approach to thinking about resiliency of the whole system can't only look at money market funds and the regulation of money market funds, or the regulation of non-bank system...It should also look at what incentives are we creating for activity to be pushed out of the banking system into the non-banking system, when we might actually prefer that it stay in the banking system, but we've created regulations that drive it out.

Addressing the Fed’s Focus and Jurisdiction on Climate Change

Quarles: So, those are interesting questions. With respect to should the Fed be looking at climate change, again, I took some heat from folks who generally agreed with the approach that I took to regulation and supervision generally, because I do think that that is an appropriate issue for the Fed to analyze, particularly given that you have a lot of academics, policymakers, people who engage on these issues who are saying that this is a critical threat to the financial system, that, we should engage with that, and not to the detriment of anything else that we should engage at, but that is part of thinking, "What risks might there be to the financial system?" That's something we should have an answer to.

Quarles: Now, I think that a dispassionate analysis of that question is that climate change is not much of a risk to the financial system. And it's hard to see how it can be. And I say that as someone... I live in a solar-powered house. I drive an electric car. I'm maybe not as apocalyptic as many about the global or social implications of climate change. But even if you are, they evolve over such a long period of time, and exposures in the financial system turn over so rapidly that the financial system will adjust.

Quarles: So, I live in Utah. Skiing's big industry here. It's big recreation. I'm a big skier. Banks here that have a loan out to a ski resort, well, in 30 years, a ski resort may be much less profitable. One can take that into account, but nobody makes a loan to a ski resort for 30 years. You make a loan to a ski resort for three years or a year. And in that time, there's going to be little difference between the profitability of the ski resort at the time you made the loan versus the time the loan is rolling over. And as it rolls over, you evaluate then. "Well, what's the situation?” That's a homely example, but multiply that by thousands through the financial system.

With respect to should the Fed be looking at climate change...I do think that that is an appropriate issue for the Fed to analyze, particularly given that you have a lot of academics, policymakers, people who engage on these issues who are saying that this is a critical threat to the financial system.

Quarles: The likelihood that climate change is a stability-threatening event for the financial system seems quite small, even if you accept, as I partially accept, that it is a serious issue that we should be taking reasonable measures to address. So I think it's something that the Fed should look at so that it can give that answer. Right? I don't think that the outcome of a dispassionate analysis of the issue is that now we need to add to the stress test, a special climate stress test that will result in increases in capital for the financial system against the threats of the evolution of climate. That doesn't make any sense.

Beckworth: Okay. What about the Supreme Court case? Does it have any bearing?

Quarles: Yeah. So, the Supreme Court case, obviously I think that's hugely important for the banking regulators generally. That will play out over the course of the next decade. Plus the earlier Supreme Court decision this year about the SEC's administrative judges and the circumstances in that. I think the evolution of the Court's restraining of administrative discretion, under administrative law, that has happened in those two cases, and that clearly is on the agenda of the courts going forward, is going to be hugely important for the Fed.

Quarles: I think that the Fed, not only through regulation, but the banking agencies through supervision, which is something that the courts have rarely dealt with and that many people, even those deeply steeped in administrative law, really only have a limited awareness of the role of supervision in the banking system and the quite consequential policy decisions that are made and affected through supervision rather than regulation, some of which have major consequences. The compliance of that with the framework of administrative law is not clear at all, I think. I think that it can be made to be, but I think that the courts sort of will be bringing the Fed up short. The Fed will have to change its method of operation, and regulation, and supervision significantly in light of not just these two recent decisions but what's clearly going to be the interpretive framework of the courts for the Administrative Procedure Act and administrative law generally going forward. That's going to be a sea change for the Fed.

Beckworth: Okay. Well, with that, our time is up. Our guest today has been Randy Quarles. Randy, thank you so much for coming on the show.

Quarles: Thank you for having me. It's been a great pleasure.

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