Aug 15, 2022

Jeffrey Lacker on the Past, Present, and Future of Federal Reserve Policy

The former President of the Richmond Fed explains the history of the Fed’s inflation target and how the Fed’s next framework review will be a great opportunity to clarify the parameters of the flexible average inflation target.
David Beckworth Senior Research Fellow , Jeffrey Lacker

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Jeffrey Lacker is a former president of the Federal Reserve Bank of Richmond, where he served as its head from 2004 to 2017, and more recently served as a distinguished professor of economics at the Virginia Commonwealth University School of Business through 2022. Currently, Jeff serves on the Shadow Open Market Committee. He joins David on Macro Musings to discuss the traditions of the Richmond Fed, the history of the Federal Reserve’s implicit inflation target prior to 2012, the two percent inflation target the Fed formalized in 2012, the more recent transition to an average inflation target, what the Fed should consider during its next comprehensive framework review, and much 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: Jeff, welcome to the show.

Jeffrey Lacker: My pleasure. Great to be here, David.

Beckworth: Great to have you on and I've had the pleasure of interacting with you at some of the Cato monetary policy conferences and some other conferences, as well. Our paths have crossed, so it's a real treat to get you on. You are a veteran of the Federal Reserve System almost 30 years, so you have a lot of wisdom to share with listeners on this show. You know our audience loves this, eats this up, Jeff, so it's a real treat to get you on. And one thing I want to talk to you about is the Richmond Fed. We hear a lot about the Board of Governors. In fact, we've recently had several guests on who were at the Board of Governors. Randy Quarles, Ellen Meade, and that's great and fascinating, but it's great to hear what happens at the regional banks. You were the President at the Richmond Fed and you also worked there several decades before then, so let me begin with this question. What is unique or what was unique about the Richmond Fed? Is there a Richmond Fed tradition?

The Richmond Fed Tradition

Lacker: I think there is. You have to realize back before the '70s, most of the reserve bank research arms were essentially business economics. Business analysts following local economic conditions. Crops out in the Midwest, manufacturing down in the Carolinas, that kind of thing. And in the '70s the Fed came under attack for its monetary policy and I think a lot of economists started paying closer attention to the Fed, and I think the system responded by building up their economic expertise, and that showed up at the reserve banks at different times and places.

Lacker: St Louis was kind of the pioneer in the '60s with monetarists that were doing great empirical work. Minneapolis is sort of the flagship of that crew that in the '70s was working with people like Tom Sargent, and Neil Wallace, and Chris Simms, and Ed Prescott, that really were spearheading the revolution in macroeconomics in the '70s. Minneapolis had more big name all-stars than the Richmond Fed, but Richmond had some very good economists and also started beefing up its economic expertise in the '70s and '80s. Bob Hetzel, who you've had on your show, it's been a while, but came in the mid '70s, a Milton Friedman student. Tom Humphrey was there, an expert in classical British economic thought and monetary history. Marvin Goodfriend was exceptional, hired late '70s. And Mike Dotsey, and I could mention others, as well.

Lacker: What I think distinguished [the Richmond Fed] in my experience was that they pushed really hard on the practical policy implications of advances in macro and monetary economics, what it meant for actual policy implementation, for actual policy decisions, for deliberations at the FOMC meeting every meeting. For example, the rational expectations revolution focused attention I think usefully on credibility, on the state of expectations about the Fed's commitment to low inflation, and that's a perspective that my predecessors, Bob Black and then Al Broaddus, brought to the FOMC repeatedly, were sort of focused on that. The new classical synthesis, as Marvin Goodfriend and Bob King liked to think of it, mostly called the New Keynesian synthesis these days, was an effort to sort of embed the rational expectations, a real business cycle framework, and sort of expand it to cases where there's some stickiness in nominal quantities like wages and prices. But in that, there's this core real business cycle model in which real interest rates fluctuate over time, even if you have perfect monetary stability, if you have perfect price stability.

What I think distinguished [the Richmond Fed] in my experience was that they pushed really hard on the practical policy implications of advances in macro and monetary economics, what it meant for actual policy implementation, for actual policy decisions, for deliberations at the FOMC meeting every meeting.

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Lacker: And what that teaches you for policy is that the interest rate the Fed set has to track the real interest rate in the economy. And that's a perspective that the Richmond Fed brought to the fore and pushed hard on. The appreciation for monetary history was deep at the Richmond Fed, and I think that led to an appreciation of the fragility of the Fed's political position. I mean, I think if you look back at the '60s and '70s and see the blunders the Fed made, the blunders that were made on inflation, they all stem from a political vulnerability. And an appreciation for the tenuousness of the Fed's credibility I think was what led many at the Richmond Fed to take a fairly hard line on credit allocation, on the Fed's involvement in credit markets, and attempts to direct credit to particular sectors or particular borrowers. And the idea is that the Fed needs to conserve its political capital for the benefit of its credibility for preserving price stability and that getting involved in things that are tangential to monetary policy but involve distributional disputes potentially, or controversies, is something the Fed should avoid. That's another thing that comes out of that tradition for me.

Beckworth: It sounds like an exciting place to work during that time. Now, you mentioned a number of prominent economists. Marvin Goodfriend, Bob Hetzel, Robert King. Now, was Bennett McCallum also affiliated with you guys?

Lacker: Yeah. We had, like Minneapolis and other reserve banks, developed a small collection of visiting scholars, so Bennett McCallum was at the University of Virginia in the '80s. Later went to Carnegie Mellon. He was a stalwart of our lunch table. Spent several weeks a year there. Bob King was at Virginia for a time, was at the University of Rochester. Now he's at Boston University. And we've had a slew of others, as well, listed on the website there.

Beckworth: I bring up Bennett McCallum because he's a bit of a hero to me, Jeff, and you probably know why. He's a big nominal GDP targeting guy. He did it long before it was cool or maybe I should say back when it was originally cool in the '80s, but it was great to have him, to read his work, and he too was a part of the Shadow Open Market Committee. Had some interesting papers he wrote there, so that's fascinating that he was a part of that tradition. Now, you mentioned Bob Hetzel. He's actually an affiliated scholar with our monetary policy program here at the Mercatus Center, and I asked him this similar question. What's the Richmond Fed tradition? So, I'm going to read a few things off that he said and maybe you respond to them as I do them, so I'll go one by one with you here. He said on this first point, and you kind of alluded to this, but he claims the Richmond Fed was the first regional Fed bank in which the research staff actively interacted with the bank president to prepare FOMC statements.

Lacker: I'll take Bob's word on that. He's more voluminously knowledgeable about early Fed practice around the reserve banks. I do know that from my time at the bank in the '90s and later, and comparing notes to other research departments, that our preparation process at least at that time was on the very intensive end. Involved deliberations, and work over the weekend, and just very long sessions stretching into the night doing some wordsmithing on the President's statement. My understanding is that other reserve banks at the time... I don't know, maybe some do this now still. The President kind of writes something up and gives people a look at it and it's a little less grueling a process. But we had some really intense sessions kind of going over the details of what Al was going to say at the meeting.

Beckworth: You were very prepared walking into the FOMC. Another claim Bob makes is that Richmond was willing to serve as a counterweight to the board. He goes on to say “next to the St Louis Fed, Richmond was the most important bank opposing Chairman Burns.”

Lacker: Yeah, so I think that was true historically back in the '70s when Burns was chair. I think more broadly, the Richmond Fed kind of cultivated a willingness to hold up to critical examination things the board would say. Not take them hook, line, and sinker at the face value, but just scrutinize them and see if there's a different point of view that's worth considering. Yeah. I'd call that part of the Richmond tradition.

Beckworth: Well, I'm going to jump to an item on the end of his list which is related to that, and he claims the Richmond never allowed the board to censor its publications, and I know Bob Hetzel himself has been very critical of the Fed, and he was able to publish his journal. In fact, he wrote a book criticizing the 2008 Fed response, so I'm assuming you agree with that, as well.

Lacker: Yeah. It is the case that the Richmond Fed resisted board staff attempts to censor or suppress publications. Now, there are times where the publication came out in a different format, in a different way, and if we talk about the Bailout Barometer later I can give you an example of that.

Beckworth: Oh yeah. We definitely want to get to that because that's a really fascinating metric. And he mentioned some other items that you already touched on. The Richmond Fed was opposed to credit allocation policy. He also mentioned the Richmond Fed supported the idea of a rule, which I think goes back to your talk about time consistency and expectations. Yes. So, a lot of interesting things. I'm going to end on this one and use this as a segue into the next part of our program, but he also mentioned Richmond Fed was the first regional bank to support an inflation target. So, you have a paper in the Cato Journal and it's titled “A Look Back at the Consensus Statement.” I want to use that as a motivation to talk about the adoption of the inflation target explicitly in 2012.  Let me ask this to get things going. Even before 2012, were you gunning for an explicit inflation target to get things going?

The Explicit 2% Inflation Target

Lacker: Yeah. I think so. Marvin Goodfriend was the champion and I wholeheartedly agreed that the Fed ought to announce its objective with regard to inflation. The mandate that we're under from Congress directs us to achieve price stability among a couple of other things we can talk about, but it seemed to us that it was a no brainer that the Fed should articulate numerically what that involved, what it would look like. When you go back in the record and the transcripts you find there was discussion in the mid-'90s, when we got inflation down, the Fed got inflation down to around 2% or 3% depending on how you measure it. CPI or PCE. There was two episodes where there were debates at the FOMC that Greenspan organized and held in order for the committee to discuss its views about legislation that was in Congress that would give us a price stability mandate.

Lacker: And as part of those debates, the first was in January '95 and the second was in July of '96. In the second of those debates, Al Broaddus, the Richmond Fed president, was up against Janet Yellen, who was then at the Board of Governors, and the expectation was that she would take sort of a dovish view against an announced inflation target and Al would take a hard line in favor of an inflation target of zero. Well, it turned out that in the debate they both agreed, and they agreed that the Fed should hold the line, not let it go back above 3% again, and that over time it should work the inflation rate down to 2%. And they go around the table and almost everyone agrees with that, and so Greenspan's faced with this kind of majority that wants an inflation target of 2%. So, he consents. He sort of acknowledges that. But he says, "Don't let this get out of this room." So, the Fed from '96 on had essentially a secret. The FOMC had a secret 2% inflation target. And so, the rest of the struggle to get to 2012 is how are we going to announce, how is the Fed going to announce it? What's it going to announce as its inflation target? And that's where the drama comes in.

Beckworth: That is so interesting because there's been a number of studies that have gone back and tried to estimate what the implicit inflation target was during this time. For example, Peter Ireland has a paper where he shows the Fed began targeting something near 2% in the mid-'90s, which is what you just said, and I've seen a more recent paper, and the name escapes me and the authors, but I'll find it and put it in the show notes, but the paper went back and looked at the transcripts, kind of like what you're suggesting, and is able to quantify based on what they were saying what these targets were for each person. And it was pretty surprising. Again, you see this kind of consensus emerge in the '90s around 2%. Let me step back before we get a little further into the 2012 discussion and decision. In your mind, why 2%? If you recall, Alan Greenspan was kind of vague on the number, right? He wanted it low enough so people didn't think about inflation. In your view, why 2%?

Lacker: That's a really good question. What Greenspan used to say, just as an aside, is 0% inflation properly measured, but he was just a deep student of statistical methodology and was well aware of the work of Michael Boskin and others on the biases in the Consumer Price Index, and the personal consumption expenditure price index, as well. So, I think that was his kind of out, that measurement error let us target 1% or 2% inflation. I think that something in the 1% to 2% band gives you a little margin for measurement error. There's of course the zero-bound constraint that would lead you to tilt upward a little bit. But you know, you don't want to go far above that, and I don't think it's been demonstrated that it's within a central bank's control to really maintain inflation at a higher rate at a steady pace. I think the variability becomes a little bit different at higher paces. But yeah, I'd put it at one and a half was what I was advocating in the mid-2000s. I thought that was reasonable and allowed for measurement error, and so that's about where I ended up.

Beckworth: Yeah, so I recall the discussions from Boston study where they pointed out this measurement problem, and just in case our listeners aren't clear, the argument is that there's substitution effects. There's different problems in measuring prices so the actual price might be lower. What role, though, did say the wave of inflation targeting that started in New Zealand, went to the U.K., Canada before the US, did that have any role? Because they adopted I think 2% as well. Was there kind of like, "Well, we have this measurement problem. We have everybody else doing it, so why not 2%?"

Lacker: Yeah. I think that those examples were germane. If everyone else had adopted inflation targets of zero, I think that would have been influential. It would have raised questions. Well, why can't you do zero too? But I think sort of the uniform desire to do that, to go to 2%, all those examples, those were also examples of clarity too, importantly.

Beckworth: Right.

Lacker: I'll mention something. In the '90s debate about the level of inflation, the reason to stay away from 2% was to build in a little buffer for nominal wage processes. And the idea is that a firm can let real wages for people go down without cutting the nominal wage explicitly, and so a little bit of inflation provides a little grease in the wheels of the labor market. The idea is that if you had a lower inflation rate, then people whose real wages sort of ought to go down, their kind of equilibrium was for them to go down, would face firms having to make them mad by cutting their nominal salary. So, there's like a little kink in people's utility function at nominal wage gain of zero. But then, of course, after Japan, the debate shifted to focus on the zero-bound issue, and the idea that it's really costly to hit it, and be constrained by it, and you want to be constrained by it less over the cycle, so you want a steady state average inflation in turn.

Beckworth: That's interesting, your sticky wage story there. Basically, another motivation is some money illusion. People don't really see it. And it's so true because I recall when I was working at the universities, many years you'd go without a pay raise, and faculty were okay with that, but man, lo' and behold, if you ever dare suggest a pay cut it would be just a disaster across campus. It's definitely a way to lower the real wage. One last thing I want to mention before we get deep into 2012 is you pointed out that it's maybe hard for central banks to target stable inflation that's high, because in theory you could write a model down where as long as it's high, stable, and predictable, people price it into their decision making, their contracts, it'll be a wash. But in practice, it doesn't seem to be that way.

Beckworth: What's interesting is in the current context we're in how inflation has become such an important political issue. It's the number one issue in polls. And the BIS had a recent annual report, and they had this economic part of the report, and they look at inflation, and they had a really fascinating section where they looked at advanced economies and they showed as inflation goes up how wide spread are the increases. So, how common is the increase across all the individual relative prices? Dispersion, yes. And they showed around 5% you get this dispersion really takes off. It explodes. So, I wonder if like at 5% people become really cognizant of the price level, of the cost of living, and maybe below that they're a little less worried about it.

Lacker: Yeah. Well, the traditional literature on this is that people don't change prices every day, unless you get to hyperinflation, and then they do, and it's a pain in the neck. But in the usual world we live in you pay attention every so often. You reexamine your prices and you adjust prices. And so, they come in these discrete increments. Maybe once a year. Maybe if inflation's faster or costs are changing in your industry, maybe every quarter or more often than that, but at a higher inflation rate you have this sort of sawtooth pattern to your nominal price. The dispersion of the relative price increases, as well, and those relative price dispersions lead to distortion. You have people doing business trying to figure out, all right, what's this going to cost me? One week the price can go up a bunch and so you get this disjointed noise that seeps into economic decisions and makes it harder to do business, makes it harder to make good decisions about resource allocation. That's kind of the thing that gums up the works when inflation rises. And that's a perfectly anticipated sort of inflation that's at a steady rate. And so, that sets aside just the erosion of the purchasing power of money, what it does to financial contracts that were written before inflation rose and things like that.

Beckworth: Okay. Let's move to 2012. And let me begin by asking you how long did this process take to officially adopt a 2% target?

Lacker: Six years. Bernanke was nominated in late 2005 and at his hearings it was going in widely known that he had been a strong advocate of an explicit inflation target. In fact, he and three other people co-authored a book in 1999 that laid out a very strong case for inflation targeting. Well, there were Democrats and Republicans, and some particularly on the Democratic side, they were strong proponents of the maximum employment part of the Fed's so-called dual mandate, and so he was on the defensive about whether he would pursue an inflation target, and if so what that would mean for the employment part of the mandate. And he was very defensive. He said, "If we adopt a target I'll consult with Congress and it won't be a change in the way the Fed does its business."

Lacker: In 2006, he takes office and second meeting, March, he commissions Don Kohn to lead a subcommittee to look into doing this, and there's some resistance at first. And it has to do with would this devalue the perception of the Fed's commitment to maximum employment. And so, they try some kind of compromise half measures. That's when they started forecasting, everyone submitting economic projections and publishing the Fed's economic projections. So, they were doing that for years for the current year and the next year, so they added another year, like a third year, so this would be like adding 2024, and they were hoping that everyone would have the same inflation forecast for that and they could just say, "Well, that's our target."

Lacker: That did not turn out to be the case, so they added this fourth column, the long run. After all the shocks have died out under appropriate monetary policy, what are these variables that the Fed forecasts going to be? And they were hoping everyone's long run forecast for inflation would be the same. And that turned out to not be the case either. There were people from one and a half and up to two. And that shifted around as you got economic shocks and stuff, so that wasn't satisfactory and they realized that they didn't really have it. But it was still on hold for a while.

Lacker: In 2009, the new administration comes in. Bernanke consults with the economic folks in the White House. I'm going to drop the name Summers, Romer, and can't remember the third name, but consults with them. Comes back to the Fed and says they're reluctant to spend any political capital on this. And so, they cautioned us to proceed carefully and pay attention to what it means for the employment mandate. Bernanke then had a conversation with Barney Frank on the Hill and said he was opposed, and you had new members on the board. You had Dan Tarullo who was opposed to it and ended up abstaining and not voting for it in the end. So, there was resistance from some in the committee, but some outside the committee, as well.

Lacker: It was sort of put on the back burner for a while. But then in 2011, we started leading up to QE2, and Bernanke wanted to pair it with an inflation target. It was going to be a big “shock and awe” thing. But he was worried about deflation which is why he wanted QE2, but he was also worried that it would spark an increase in inflation expectations, too. He wanted to reassure everybody we didn't want a big burst of inflation, so he wanted to announce an inflation target paired with the QE2. Well, the inflation target part fell by the wayside when QE2 was announced, and that happened in late 2010. In the aftermath of that, the beginning of 2011, an ad hoc group of reserve bank presidents got together. Charlie Plosser organized the group. It was Jim Bullard, Charlie Evans, Narayana Kocherlakota, and Eric Rosengren. It included a couple of doves and a couple of more hawkish members, so it was a good diverse balanced group. And they crafted a statement and Charlie Plosser brought it to Ben Bernanke in the middle of the year. He said, "Well, all right. Let me circulate this and see." And so, he circulated it at the board. Later that year, there was a kerfuffle about date-based forward guidance. In August, the Fed adopted guidance based on a date as opposed to using sort of adjectives. And in the debate about that at the August meeting, Yellen introduces the idea of an unemployment rate threshold guidance instead of date-based guidance. But the immediate thing that people responded with was, "Hey, look. For us to put an unemployment rate number in the statement when we haven't said anything about our inflation target seems backwards since no one thinks we can control the unemployment rate the way we can control the inflation rate."

Lacker: Evans gave a speech in September in public touting that, but it was just problematic until we had an announced inflation target. And I think that was the real impetus for actually finally getting it over the hump. So, there was a special topics meeting, November FOMC meeting. There was a discussion. There was a sort of a show of hands, a straw poll, and it was 11 to 3 in favor. And so, Janet Yellen was directed to go craft a statement, negotiate a statement everyone can support. And she finally comes back and in the December meeting we learned that Dan Tarullo will abstain, but everyone else is going to be on board with this. And then it came out in January of 2012. And we can talk about the particulars of it in the current framework, but that's how the process went. Pretty fascinating back and forth.

Beckworth: Yeah. There's a long history there with Bernanke being appointed all the way up to the January 2012 decision. Now, in 2016 I believe they changed some of the language on that to include “symmetric inflation target.” I believe that's the term they added. Because you know, there were several years where the inflation was... Three, two, one. There were several years where inflation was running below the 2%, maybe 30, 40 basis points, and so they wanted to make it very clear that this was a symmetric target. What was your expectation and understanding in 2012 as to what this 2% inflation target actually meant and how it would be implemented?

Lacker: I certainly thought it was a symmetric target. I don't know anyone who didn't. The claim has been made, sort of a straw man has been put up there, the claim that there's this risk of people thinking that 2% is a ceiling and not the center of our target. And I just think that's preposterous. I don't know of anybody who ever said that in the FOMC, advocated 2% as a ceiling. I don't know of anybody who ever advocated that in public. And I just don't think that was a realistic thing, but I think the symmetry was put in there to attempt to counter that. It's important to recognize the interesting thing about the whole decision process is that up until the very end most people favored a target range.

Lacker: Most FOMC participants wanted a range of like 1% to 2%, 1.5% to 2.5%, 1% to 3%, or something like that. A lot of other central banks had target ranges. But at the last minute it was made a point target and I think the reason is that if inflation was running under two then, a point target made it a more dovish thing to announce that you had a target of two, because it meant, "Oh, we have a rationale for some more stimulus." The thing that the committee never really grappled with is the question, if you're going to have a point target, how close is close enough? And that's the thing that you can see people squabble about it in the transcripts in the 2010s. 1.7, three tenths of a percentage point below inflation. You ask yourself, all right, what would various people say if it ran 2.3% for a few years? Actually, we actually know, because it did from 2004 to 2007. The core inflation rate averaged two and a quarter. Headline was closer to three, over 2.9.

Most FOMC participants wanted a range of like 1% to 2%, 1.5% to 2.5%, 1% to 3%, or something like that. A lot of other central banks had target ranges. But at the last minute it was made a point target and I think the reason is that if inflation was running under two then, a point target made it a more dovish thing to announce that you had a target of two, because it meant, "Oh, we have a rationale for some more stimulus." The thing that the committee never really grappled with is the question, if you're going to have a point target, how close is close enough?

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Lacker: And a couple people complained. I mean, I was complaining about the time inflation was too high. Thought we shouldn't stop in '06. Probably a mistake in hindsight. But then it just struck me as implausible that the people who were complaining loudly about 1.7 were likely to complain just as loudly about 2.3. You can see some evidence of people talking their book in some sense on that. But they never really answered that question. So, markets were left unclear about whether 1.7 was close enough. I'd argue it's pretty close. I mean, given measurement error and all we know about the vagaries of inflation setting and policy setting, that it would have been helpful if we'd clarified, "All right, 1.5 to 2.5, that's fine. That's close enough for us."

Beckworth: Yeah. I like the idea of a range myself. I was just talking to somebody affiliated with the Bank of Canada and they just recently had a new framework review they did last year, I believe, and they still maintain this 1% to 3% range, so it was interesting to hear you say that you guys were pretty close to adopting something similar to that, and I wonder how the conversation would have been different the past decade, the decade prior to the pandemic, had that been the case. Less worry, less concern about drifting below 2%.

Beckworth: Well, let's move to then the new framework, which was also recently adopted in the US. The average inflation targeting framework. And I have to confess that I misunderstood it at first. I had it in my mind a symmetric average inflation target, because there's a lot of discussions about average inflation targeting leading up to this decision, and a lot of people said, "Oh, it's just a special case of price level targeting." But in fact, it's not. It's an asymmetric price level target, I guess you could call it, where they only do make up policy from below 2%. If they go over 2%, they're not going to correct for that, and that became very clear. Jay Powell was asked questions about this at the press conference and just going back myself and reading the speeches leading up to it, and senior Fed officials, they were all very clear about what this was about.

Beckworth: Vice Chair Rich Clarida, when he was in that position, had several speeches where he said this is an asymmetric average inflation target, so I see now that I misread that. But I think a lot of people did too. They suspected this was going to be symmetric. And one of my reasons I think this impression was out there was also that that statement of being a symmetric inflation target being introduced in 2016, and so you might just kind of naturally assume that the new inflation target's also going to be symmetric on both sides, but it wasn't. Any event, enough of me. I want to hear your sense of that framework and maybe you can also give us some thoughts on where you think the Fed should go in the next review, which is coming up in a few years.

The Average Inflation Target

Lacker: It's a really good question. The whole makeup strategy sort of begs the question of why not get inflation up to 2% now, just 2%? So, the makeup strategy presumes that the Fed can engineer if inflation's been running at say 1.7 for five years, it can engineer inflation up to 2.3 for a few years to make it up. Well, if you could do that, why not just get inflation up to 2%? Why can't you just do that? It wasn't obvious that announcing that you're going to try for 2.2 or 2.3 for a while was going to help you get up to two, and it just wasn't clear at all that an announcement alone on that front would help. When they could, if they want to, engineer 2% inflation. They could try and do that. But it just begs the question what's holding them back on that.

Lacker: I think the biggest challenge for a revision of the statement is the way it handles employment. The maximum employment part of the original statement was kind of a mess. And thankfully in the revision that they released, they deleted this problematic piece, so the original statement, there was a paragraph about employment at the top. It said that maximum employment is determined by forces outside the Federal Reserve's control, therefore we can't have a target for it. Then it said, by the way, the forecasts in the summary of economic projections have a long run unemployment rate in them. And it sort of invited you, it sort of coaxed you into thinking of those at the same thing, but they weren't because some of us wouldn't agree to the statement if they were equating the SEP long run forecast of unemployment to maximum unemployment.

Lacker: And some of us objected strenuously to the idea of putting a numerical value for unemployment rate target in that statement. So, it sort of slipped in there in the back door in a very fuzzy and very confusing way. I think the biggest problem with maximum employment is just what it means. I think that there's a vestige around the Federal Reserve of thinking about it in the way that it was thought about in the 1960s, as a level of full employment, but I think what we know now, understanding stochastic growth models, understanding models in which technologies, shocks affect the economy in very diverse ways, is that what's maximum in the long run, where you can get in the long run, is very different from maximum employment next week, or next month, or next quarter. And I think that the focus on this very smooth, fixed, sort of from outside the model level of unemployment that corresponds to maximum employment has been a mistake and has misled the Fed on several occasions, including last year.

Lacker: If you look at the stochastic growth models we have, models of economies hit by shocks with frictions in labor markets and various other markets that make them realistic, I think what comes out of that is that a non-inflationary maximum employment is something that's affected by virtually every shock in the economy. And so, in 2011, the unemployment rate corresponding to maximum employment was probably pretty high. Probably 8% or 9%. And it came down over time as the people naturally overcame search frictions, naturally adapted to new labor markets, new technologies, new areas of growth, and the like.

The biggest problem with maximum employment is just what it means. I think that there's a vestige around the Federal Reserve of thinking about it in the way that it was thought about in the 1960s, as a level of full employment, but I think what we know now, understanding stochastic growth models, understanding models in which technologies, shocks affect the economy in very diverse ways, is that what's maximum in the long run, where you can get in the long run, is very different from maximum employment next week, or next month, or next quarter. And I think that the focus on this very smooth, fixed, sort of from outside the model level of unemployment that corresponds to maximum employment has been a mistake and has misled the Fed on several occasions, including last year.

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Lacker: But you know, to ask yourself what's the maximum level of employment we can reach without inflation next quarter sort of answers the question. Yeah, you're not going to do that well. And I think that the Fed's focus on the labor force participation rate from before the COVID shock and thinking that we could get back to that, I think it misled the Fed in early 2021. I think it led the Fed to believe that the inflation they were seeing was a random blip and that resource utilization wasn't that high. But I digress.

Beckworth: No, this is fascinating stuff, and we're discussing maximum employment, and you're kind of stressing this emphasis the Fed has on maximum employment as some kind of long run equilibrium value when in fact it might be dynamic, changing over time, so let me throw another dimension to this out there, and that is in the new framework they also changed the reaction function that's implicit in it from one being symmetric around maximum employment to shortfalls from maximum employment, which I thought was a pretty big deal. In my mind, the first thing I thought when I saw that was maybe Milton Friedman's plucking model or something like that. But I was wondering what your take was when you saw that. They only want to look at shortfalls.

Lacker: Yeah. That's a really good question. And it goes just to the heart of how we understand labor markets functioning. In the standard models with economic variables that fluctuate around trends, it's natural to think of unemployment as bouncing above and below trend. But if you look at unemployment, it falls gradually. It just keeps falling, and falling, and falling, and maybe it flattens out a little bit, and then there's a recession and it rises a lot, and then it falls gradually. And Robert Hall and Marianna Kudlyak, who – Marianna used to be at the Richmond Fed – have documented that the rate at which it falls is pretty steady across business cycles. And so, we're not in this world where unemployment rate blips up, comes down again, blips down, blips up, blips down. It's this steady process of it falling over time.

Lacker: And you know, if you think for a minute about labor market search frictions, it's easy to picture why that might happen. That's a world where we're kind of close to the natural rate all the way down that curve that falls down there. I wrestled with this when we were first asked for long run projections for the unemployment rate, and I'm thinking, "Well, if that's the way the world works, what's the long run? Is it the average over time? Or is it the low point you get to?" This raises a puzzle for the Fed when the unemployment rate gets down to 3.5% and a couple of years ago, they were saying that the neutral rate, sort of the long run max, the rate corresponding to maximum employment, was 5%. Then unemployment rate got below their maximum rate and they kept that longer run forecast up there and sort of begging the question, what are we doing below that? Is that bad or good? And so, I think that using this language sort of solves that optical problem for them, but I think the deeper conceptual problem they have is that the SEP’s projection for the unemployment rate doesn't clearly conform to the best possible understanding of how labor markets work.

Beckworth: Going into the next review, what do you think they will consider and what do you wish they would consider?

I think that the Fed's focus on the labor force participation rate from before the COVID shock and thinking that we could get back to that, I think it misled the Fed in early 2021. I think it led the Fed to believe that the inflation they were seeing was a random blip and that resource utilization wasn't that high.

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The Fed’s Next Framework Review

Lacker: That's a really good question. I think the thing they need to do is clarify what maximum employment means over time. I think this finesse is hard to sustain and it leads to a lot of confusion. And I think even internally, a lot of people think of maximum employment as that old NAIRU idea of like a fixed level of the unemployment rate that doesn't vary over the business cycle, when in fact the employment you can get in a way that's not inflationary is something that fluctuates with just about all business cycle conditions that you could think of.

Lacker: I think that I'd like to see them back away from a point target because a point target just gives everyone, anyone, on both sides, an argument to push for policy one way or another. And you know, it's not obvious that 1.7 is that terrible an inflation rate to have had over the last 10 years, and it's not clear we could have done much better for people's real lives economically to run policy in a way to have gotten something much better. So, I think a range would be good, but the one thing I don't think they should do is even consider changing the 2% center point for their target. Because I think once you ring that bell and change it once, well, then you've sent a precedent for moving it up or down that it'll take decades to outgrow, and outlive, and put in the past.  I think they should be really hesitant to move away from a 2% inflation target. That's for sure.

Beckworth: Yeah. We've talked about that on this show quite a bit recently because there have been calls by some observers for the Fed to opportunistically adopt a 3% target, or 4% target, and you know, there's been conversations in the past that the Fed should do this because we're going to be stuck at the lower bound much more going forward. But it would definitely be a big strike against their credibility if they did it in this moment. Even 2024, we might still be coming down from inflation, from the highs, so it would look really awkward if they did that, but it struck me in talking with you if they adopted a range, say they did 1% to 3% like the Bank of Canada, maybe inflation's at two and a half, 3%, but they could say, "Hey, we have a range. 1% to 3%."  It just maybe takes off the pressure a little bit, but it also provides some guardrails for where the inflation should be and allow it to drift down maybe at a gradual pace. They don't have to accelerate it, make it disinflationary at a really rapid pace. What would be your guardrails? 1% to 3% or something smaller?

Lacker: I think 1% to 3% would be workable. I think one and a half to two and a half would be workable and probably preferable. I think the argument against it has always been that people might think we're indifferent in there, but I don't think that has to be the case. You can tell them. People can understand that you're trying to get it to two but that you're going to view performance as reasonably satisfactory if on a year-to-year basis we're within one and a half to two and a half percent. I think people will understand that.

Beckworth: Very nice. So, something that you've worked on in the past is the Fed doing credit policy. You and Marvin Goodfriend have worked on this. You've worked on when should the Fed step in and be a backup of last resorts, a lender of last resorts, and the Fed, as you know, did a lot during the pandemic. 2020. In fact, you can go back to 2008. It opened up a lot of facilities, we call liquidity facilities, to help out not just the banking system but also the shadow banking system, and during the most recent one they also opened up credit facilities. So, main street lending facilities, and there's just been a lot of calls for the Fed to expand what it is doing. I want to break that apart and let's first start with the liquidity facilities and then we'll move to the credit facilities. Do you think the Fed is doing too much with liquidity facilities? You mentioned earlier in this show this barometer at the Richmond Fed. Tell us about that and maybe we can use it as a segue into liquidity facilities.

I think that I'd like to see them back away from a point target because a point target just gives everyone, anyone, on both sides, an argument to push for policy one way or another...I think a range would be good, but the one thing I don't think they should do is even consider changing the 2% center point for their target. Because I think once you ring that bell and change it once, well, then you've sent a precedent for moving it up or down that it'll take decades to outgrow, and outlive, and put in the past.

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Evaluating the Fed’s Growing Footprint

Lacker: We were concerned, and like a lot of economists were in the '90s, thinking about the bailouts of the '80s, and '70s, and wanted to know, all right, if somebody's looking at that history, what would they think across the financial sector about who's going to benefit from a government bailout and who isn't? And so, I asked two economists, John Weinberg and John Walter, to lay out all the debt issued in the financial sector, the financial sector, so like bank liabilities, pension funds and the like, and chart out which ones benefit from a perceived safety net of government guarantee. So, there's deposit insurance, there's the pension benefit guarantee corporation that are explicit. But then there's implicit guarantees that you could do if you set a really conservative standard for what's been rescued in the past by way of not formally insured liability.

Lacker: So, for example, many bank depositors are rescued even though they don't have deposit insurance if there's deposits above a certain size. And many bank liabilities are covered. So, I had them measure this. This was in the year 2000, so they did it for the year 1999, and what they found out was that about something like 45% of financial sector liabilities were benefited from an explicit or implicit government guarantee, either on the basis of the law or on the basis of precedents set, and we took a fairly conservative approach to that. So, after the precedent set in the recession of 2008, 2009, that number shot up to over 60%, so about 60% of the US financial sector liabilities benefit from an arguably perceived government guarantee, and that struck us as a big number.

Beckworth: Are they still maintaining that barometer?

Lacker: Yeah. Actually, they stopped after 2016, after I left.

Beckworth: Oh, I would love to see it today.

Lacker: They don't seem as interested anymore.

Beckworth: Yeah, so let me run this by you, and I think the implication for this Bailout Barometer is huge, but the Fed stepped in in 2020, and understandable in the near term something had to be done because there was this dash for cash, markets were collapsing. The treasury market itself was under stress. But the Fed's backstopping of shadow banking, or what I would call global dollar funding markets, it was all the liquidity facilities we'd used in 2008, plus some new ones, plus the dollar swap lines were expanded. There was also the new repo facility for foreign financial government organizations, FIMA, that could step in. So, if I look at all those entities and I say those are implicit liabilities, man, the Fed's balance sheet just blows up. I mean, it's huge.

Beckworth: It's conceivable that it's much broader than just even domestic financial liabilities because there's a lot of dollar creation occurring outside the US, a lot of dollar liabilities outside the US. Let me put as my question to you, and I've put this to many others, how do we deal with this? I think it makes sense the Fed responded in the moments, but all that's doing as you've argued in many pieces is that it's creating the incentive for more dollar liability creation overseas. You call it moral hazard. Maybe an optimistic view would be it's the Fed has increased the elasticity of a global dollar system. Banks are more able to make dollars and not worry about runs on them. It's like FDIC but for shadow banking across the globe.  How do we, as regulators in the US, deal with the growth of global dollar funding markets and then having to step in when there's a panic?

Lacker: Yeah. The problem that's entailed is just the open ended and ambiguous nature of the entire edifice. It's widely perceived that large banks in the United States are too big to fail, and what I explicitly mean by that is that it's widely believed that their creditors will be rescued in the event of distress on their parts. That sense, that creditors will be protected in the event of distress, spreads now in a broad range of financial intermediaries and a broad range of markets. Every precedent the Fed sets, when it's a new one, expands the range of those intermediaries that are viewed as implicitly backed by the tendency of the Federal Reserve and others to intervene.

Lacker: But the Fed has never made those implicit commitments clear. Back in the '80s, the phrase was constructive ambiguity, so the Fed would reserve the right to intervene to rescue uninsured claimants on financial institutions, like banks, but it wouldn't say when, or where, what the criteria was, what the dividing line was. It liked to preserve some ambiguity in order to kind of preserve the deniability that they're just backstopping everything. And so, Bear Stearns was a great example of this. In the event the policymaker is sitting there with the possibility of letting them go and letting some creditors of Bear Stearns, say, suffer some inconveniences if their liabilities aren't guaranteed, or covered, or made whole immediately, if they suffer some inconvenience then that's going to spread because these institutions are viewed as probably backed, but maybe not for sure. Market perception of that probability is going to sink to zero for some institutions.

Lacker: But on the other hand, if you back them, then the probability perceived rises to one, and for policymakers it's always going to be more attractive to extend the safety net in an extreme event. And so, you get this steady creep outwards in the range of the safety net, but an unwillingness of policymakers to actually commit and be explicit about who's in and who's out. So, you have this uncertain boundary and at the boundaries people are going to be testing it, and people are going to be kind of gambling on whether, all right, are we going to get covered? Are we going to get rescued? And the Fed seems to just expand the boundary every time.  This time, in 2020, we saw corporate intervention in the corporate debt market, which was viewed as beyond the pale back in 2008, 2009. But that dynamic doesn't seem wise and doesn't seem conducive to the most effective and efficient financial markets. And it all stems back from the inability of the Fed, this off balance sheet financial intermediary sponsored by the US, created by the US government, to commit to boundaries around the institutions that it'll rescue with credit policy.

Beckworth: So, what can be done? What practical steps could the Fed take? Again, I understand where the Fed's coming from. It wants to preserve dollar funding in the moment of stress. But it has this effect that you mentioned. The boundaries keep getting pushed farther and farther out. They keep getting tested. It reminds me of my kids. They'll test my boundaries. The Fed's being tested too. So, what practical steps do you take? What time consistent steps can one take to prevent that growth?

The problem that's entailed is just the open ended and ambiguous nature of the entire edifice. It's widely perceived that large banks in the United States are too big to fail, and what I explicitly mean by that is that it's widely believed that their creditors will be rescued in the event of distress on their parts. That sense, that creditors will be protected in the event of distress, spreads now in a broad range of financial intermediaries and a broad range of markets. Every precedent the Fed sets, when it's a new one, expands the range of those intermediaries that are viewed as implicitly backed by the tendency of the Federal Reserve and others to intervene.

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Lacker: I think that the most valuable thing would be to set up boundaries. And, hope is not lost. If you look at the example of hedge funds, LTCM was rescued in 1998, but by the early 2000s the Fed and other regulators had sent a clear message that the hedge fund industry was beyond the pale and not going to be rescued explicitly, so LTCM in 1998 wasn't an explicit rescue, but the New York Fed leaned on a lot of big banks to come to their aid. So, I think that shift you saw lead to a change in the way hedge funds funded themselves, and they now have gates and provisions that severely limit their vulnerability to anything of a sort of run-like behavior. And I think that's an illustration of what happens if you could set a firm boundary around the federal safety net. And I think clarity around that boundary and I think that a commitment to respecting that boundary is important to financial stability. I think the benefits of hedge funds for improving financial market efficiency seem to be apparent. I mean, it seems to be worthwhile to have that kind of a channel for financial intermediation, but just because there's some financial intermediation going on doesn't mean you need a federal guarantee, either implicit or explicit.

Beckworth: Okay, so that's the liquidity facilities. In the time we have left, let's spend a little more time on the credit facilities. By credit facilities, I guess I would include the bond facility. Now, some would argue it's liquidity, as well, but clearly, like you said, it's going beyond the pale if you had asked someone in 2008. But I think a more clear example would be like the main street lending facility, or the municipal facility, and I know you and Marvin Goodfriend have written on even the Fed holding this GSE securities, agency securities, so what are your thoughts on what seems to be a creeping movement toward credit policy?

Lacker: Yeah, so it's gathered steam. Seems to be advancing at a pace faster than you would characterize as creeping these days. I think [Fed credit policy] not a good thing for the way our economy is evolving. I think what's essential about central banks is price stability and the stability of the monetary system, and for that you need the Fed to control a monetary instrument, and I think doing anything else with their balance sheet beyond holding very short-term treasury securities is an intervention in markets that's going to have winners and losers, and is not something that ought to be part of the Federal Reserve's remit. I think that the rationale for Fed intervention in credit markets has been incredibly weak and I think it's not been good for the way our economic system has evolved.

Lacker: I think that it's encouraged borrowing via short-term liabilities because short-term liabilities, demandable liabilities are what give rise to intervention, and so they kind of elicit an implicit insurance from the central bank. So, you've got this undergirding to the whole system of short-term liabilities that in essence substitutes short-term investment over long-term investments and has distorted the shape and tenor of our financial system as a result. And I think it's not good for the Fed to get tangled up in picking which sectors it's going to support and which sectors it's not going to support. And I think what they do is hide the extent to which they are picking winners and losers.

Lacker: I mean, you can see how it makes visible, "Oh yes, we're supporting this sector by lowering their borrowing costs." But behind the curtain is the fact that if they didn't support that sector, if they bought just short-term treasuries instead, there's other sectors that didn't get support that should have lower borrowing costs. So, when they support a sector they're driving up borrowing costs for other sectors if they're having any effect at all. And I think that sense of favoring some sectors over others is something a central bank shouldn't be in. I think that the effects of short-term turmoil in financial markets are greatly exaggerated. But I think that the Fed has stumbled into conveying a sense of broad responsibility for dampening financial market volatility and I think they've done that without a strong analytical sense of what volatility ought to be dampened by their actions and what volatility shouldn't be dampened by their actions, and I think they're at sea.

Beckworth: And I wish Congress would do more here. I wonder sometimes if the Fed does more, including expanding into credit allocation, because Congress is not doing its job. Congress should find some other federal agency to do some of this work during crisis. I would also mention to our listeners that we didn't have time today to get into it but Jeff has a new working paper out titled “Money Market Fund Reform: Dealing with the Fundamental Problem.” We'll have a link to that. I wish we could have spent more time on financial stability with you, Jeff, because that's one of your areas of expertise, but thank you so much for coming on the show today. It's been a real treat.

Lacker: Thank you. My pleasure.

Photo by Win McNamee via Getty Images

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