Dec 21, 2020

Jeanna Smialek on the Year-End Review of 2020 Financial Markets, the Fed, and US Monetary Policy

Looking ahead at 2021, the role of the Fed’s balance sheet within this crisis remains an open question for policymakers.
David Beckworth Senior Research Fellow , Jeanna Smialek

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.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Jeanna, welcome to the show.

Jeanna Smialek: Thanks for having me.

Beckworth: Great to have you on. We've been following your work. You've been incredibly busy this year. What a year to be a reporter on The Fed, right?

Smialek: It has been quite a year. It has been pretty nuts.

Beckworth: Yeah. I imagine the way you do your work has changed. In the past, I imagine you would do sit-down interviews with Fed officials, you'd go to conferences. How has your work changed as a result of the pandemic?

Smialek: Yeah. Pretty hugely. I think like you said, a lot of what happens in monetary economics happens via conference. So as a reporter, it's really been a bummer not to get to go and chat with economists on the sidelines and talk to officials and see them in their natural habitat. A lot more Zoom interviews, as I'm sure everybody who listens to this has been experiencing, certainly a lot more phone calls instead of in-person meetings. It's just been wildly different. I do think the one thing that is nice and has shifted a bit is I feel like people are at home and bored, so everybody is much more willing to talk to reporters than they usually are.

Beckworth: Nice.

Smialek: People don't seem to take the same objection to being called randomly on a weekend than they used to. Or at least that's my perception. I could be wrong there. Maybe they're still annoyed and I'm just not picking up on that.

Beckworth: Yeah. As the reporter on the Fed for the paper of record for the US, do you have access to Jay Powell, to Randy Quarles? I mean, do you have a direct line to the big man?

Smialek: I'm a good reporter, I can't tell you that.

Beckworth: Okay.

Smialek: We don't disclose our sources. But I think you can tell from our reporting, we talk to a little bit of everybody, which is good, because I think we're always trying to get the most realistic view possible about The Fed. As your listeners I'm sure are conscious of, it's a committee, these decisions are made by a lot of different people. We try and make sure we're talking to all the officials.

Beckworth: Okay. I've been watching you as well as other FOMC reporters during the FOMC press conferences. So that's the one manifestation of the changes we've seen, and it's the Zoom screen, you got 15 faces on there trying to coordinate, chair Jay Powell, the questions are being asked. I'm sure it's been fun for you. It's been fun for us to watch as well as it all unfolds. Tell us a little bit about yourself. How did you get into the Fed beat? I mean, it was that your original dream and vision to become a New York Times reporter for The Federal Reserve?

Smialek: No. Definitely not. I knew I wanted to be a journalist. I went to journalism school, University of North Carolina at Chapel Hill. I actually wanted to be a foreign correspondent. I wanted to do something international. But when I was in college, I studied abroad in China through the scholarship program called Phillips Ambassadors. The Phillips, the folks who endow it insist that the students who do that program have to take business classes, it's a requirement for the scholarship, and I'm trying to pay for college. I was like, "Yeah, I'll take some business classes." I just discovered that I totally loved it. Ended up at Bloomberg, followed all that new interest at Bloomberg and Bloomberg put me on an economic speed which ended up turning into a Fed beat, and here we are. I stuck with it. I've never really done anything but economics in journalism. I've been covering the Fed for about seven years now. And now I'm at The Times.

Beckworth: Yeah. You've been covering some really technical issues too. You covered the facilities, which we'll talk about later that were reintroduced this year. Some of them introduced for the first time this year. The policies ideas like r-star, all this technical econ speak that most people fly over their heads, you've had the master that, you've done a great job. You have to portray it to a wide audience via The New York Times. I know it's been a fun and challenging but yet rewarding job for you. Again, as I mentioned earlier, you're on today because this is going to be one of our year-end episodes where we recap some of the highlights. Then this one in particular, we want to talk about US monetary policy during 2020. I think it's important though, to understand this year to not only understand the pandemic, but also what led up to this year.

Beckworth: I want to in particular, look at the previous tightening cycle. 2015 and 2018, what happened in 2019 leading up to this particular year. I want to go all the way back to 2015, if you don't mind and talk about that first rate hike. We've come off of the last crisis. We've had a large balance sheet. We've had many years, Janet Yellen becomes Fed chair. As soon as she was appointed, the Fed started talking about rate hikes, rate hikes. It wasn't until the end of 2015, they actually did it, but you saw evidence of those rate hikes in markets. The dollar got strong, Fed fund futures went up. Many would argue, I wasn't one of them, that had a bearing on that emerging market crisis during that time, the oil prices and what your colleague Neil Irwin called the mini recession or the manufacturing recession of 2015, 2016. But in any event, there was this rate hike that started in 2015. You could argue it implicitly started beforehand because of all the rate hike talk. What was the story behind that? Why were they so eager to raise rates? What do you think was happening back then?

Recent History of Rate Hikes

Smialek: Yeah, I think to really understand that you even have to go back a little bit before 2015. The reason for that is a lot changed in that inner crisis period that I think it was really momentous. One thing that changed is in 2012, the Fed formally adopted a 2% inflation target. Prior to that, they had implicitly been targeting 2% inflation, but they hadn't officially told us that that's what they were doing. They formally adopt the target. They start doing press conferences. Ben Bernanke ushered in the era of post-meeting press conferences. They're just talking to the public a lot more. They're being a lot more transparent about what they're doing, why they're doing it, et cetera, which is important I think to your point in that the tightening can start before the tightening actually starts. Monetary policy has become an open mouth activity to a large degree.

Smialek: I think that's important context to understand. We get to 2015, unemployment is dropping pretty quickly, the economy is starting to feel a little bit better, it doesn't feel completely better, but things are looking up, and the Fed is starting to get a little bit concerned that in its framework, the Phillips curve framework is the one that is operative at the moment. As unemployment sinks lower and lower, as the labor market gets closer and closer to full employment, people are going to start lifting wages, we're going to start seeing some prices bubbling up a little bit, and we might see slightly higher inflation. And they take this idea that policy works with long and variable lags, it takes a long time for an interest rate increase to play out through the economy.

Smialek: They get this feeling that they need to start getting ahead of the game, catching up to the fact that inflation is going to start rising. In this context, it's very important to understand that the Fed thinks of interest rates relative to where they ought to be to keep the economy totally stable. It doesn't think it's going to necessarily slow down the economy dramatically just with one rate hike, because it still feels that monetary policy is going to be "easy" after a couple of rate hikes. It thinks that it's probably eight or nine hikes away from tight monetary policy. The idea basically is these things work on a lag and we got to get going at some point in time. That's where we are in 2015. They don't think we're at full employment, inflation is clearly still below 2%, but they feel like they need to get going or else they're going to get behind the curve.

The idea basically is these things work on a lag and we got to get going at some point in time. That's where we are in 2015. They don't think we're at full employment, inflation is clearly still below 2%, but they feel like they need to get going or else they're going to get behind the curve.

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Beckworth: Yeah, those are all good points. As you were talking, I was reminded, 2014, at least part of the year was a boom year because I remember there was rapid growth. People were getting excited. It was like, "Oh, finally, we're going to have this big boom." It didn't materialize by the end of the year, but it's easy to understand why the Fed did get worked up, did get worried. You forget the emphasis, like you just mentioned, on the preemptive rate hikes, which has changed now with this new framework we'll talk about later, but preemptive was the name of the game. That's the way you did policy because of the lags that you talked about. They went ahead and they did them and then they waited another year for the second rate hike, is that correct?

Smialek: Yeah, that is correct. I think it's important to note that the economy was doing better, things were feeling better, but it was clear that there were still a lot of people on the labor market sidelines at the time. We knew unemployment was falling and there was certainly a contingent at the Fed that felt that we should just basically be keeping an eye on that headline unemployment figure and that was the important number to watch. But there was also a contingent at the Fed led, I think by Janet Yellen, now going to be the Treasury Secretary assuming she's confirmed, but I think led by Janet Yellen, there was this idea that maybe headline unemployment was not the number to watch, participation was showing some signs of maybe stabilizing after years of decline. Participation just to define it, is the share of people who are either working or looking for jobs.

Smialek: It's the people who are active in the labor market. It was showing signs of stabilizing after years of decline. There were some positive things happening. I think there was this idea that the economy's wobbling a little bit, maybe we can go a little bit further on the unemployment rate than we thought we previously could have without touching off crazy inflation. Given that latitude and given the fact that the economy is not coming in as strong as we thought maybe we should hold off. Yeah, they waited a full year and they got a lot of criticism for it at the time, as I'm sure you remember. Now they get criticism from the other side because people say maybe they went a little too early and a little too hard.

Beckworth: Yeah, you can't please everybody. That's for sure. You bring up a good point that not everyone was convinced the rate hikes were warranted at the time. I was one of those voices. But most people, if I recall correctly and correct me if I'm wrong, most people were for the rate hikes. Most people were like, "Come on, why haven't we had rate hikes already?" A lot of discussion about how the Fed was harming savers and retirees. In some camps, the Fed was artificially keeping rates low, but like The Fed, I completely agreed, rates weren't low relative to where they should be relative to this r-star term, the equilibrium rate. But nonetheless, there was a lot of pressure to do things back then. Is that a fair assessment at least lot of political inside, outside the Fed pressure?

Smialek: That is completely fair assessment. I think if you read back through congressional testimony at the time, Senate and House Republicans were pressuring Janet Yellen like crazy. There's quite a clear record here.

Beckworth: Yeah. Some of the criticisms now of what they did back then. Looking back... Again, I'm guilty of saying, "See, I told you so. We shouldn't have raised the rates so quickly back then," but I do think it would have been hard for anyone not to raise rates back then. I think there's just so much pressure. It was hard for Janet Yellen. It would've been hard for... You put anybody in that role. I just wonder how easy it would have been to hold off and done what the dubs wanted to do during that time.

Smialek: Yeah. It's hard to rewrite history. I think we can see that they were under a lot of pressure, like I said, just by looking back at the record and certainly having lived it and been at those hearings, it was a very tense period. I think it was playing out in the context of the post financial crisis era. The Fed was still coming under a lot of scrutiny for the things that had it done in 2009 to help the banks, to save the economy. They felt like they had done what they needed to do, but they were still clearly paying the political price for that. I think that context was really important. I think they were afraid of continued political attack. I'm sure they would not use the word afraid, but I will.

Smialek: I think there was a lot of concern at the time. It is worth saying that there were dubs, like you said, who were clearly against these rate hikes. I think Lael Brainard is the one that probably most famously questioning of these policies at the time. She gave a couple of speeches basically laying out why she thought maybe this wasn't the best idea, but then she eventually voted for it. She did not dissent against the rate hikes, or at least the 2015 rate hikes, she didn't dissent. It was a big question, will she, won't she. And she didn't. But it was a fraught decision, I think. But yeah, it would've been hard for them to resist the pressure. I think you're right there.

Beckworth: Yeah. I'll just mention. George Selgin has a new paper out on this very issue. We'll provide the link to it. He goes into great detail. We won't for the sake of time go into the detail that he does, but it's an interesting episode to look at nonetheless and just to see what can we learn from that moment. Lael Brainard, I really appreciated her speeches that time. I believe maybe it was after the 2015 hike, but she also, as I recall, talked about how the rate hikes, the shrinking of the dollar were having these repercussions throughout the world and the international dimension and how that international dimension was coming back to bite us in the rear in the US economy, which we saw again, the manufacturing slowdown. We didn't have the problems with China during this time, but you could tie it back to that.

Beckworth: Okay. We have the initial rate hikes December 2015, 25 basis points. In terms of Janet Yellen's tenure, we see five rate hikes for exactly 125 basis points. She is chair until February 2018, and then chair Powell comes in, he does another four rate hikes for 100 basis points. That brings us to 2018. Of course, I believe the end of 2017, we start to see the balance sheet began shrinking, QT as they call it, quantitative tightening. But the interesting story here I think is the rate hike story and what they were thinking. You've touched on this and alluded to this, and I want to just go through some of the mysteries or questions or challenges during this previous cycle, because I think it has a bearing on what happened this year. There were several of them.

Beckworth: One of the big ones, as I recall, is the low inflation mystery during this time. I actually have a paper I never finished, but I went to databases and it was just getting a number count of all the articles on low inflation with the terms like conundrum, puzzle, mystery, and there's a bunch of them. And you see that they begin to peak during this period. What was the Fed thinking? There were a lot of stories during this time from the FOMC officials as well as others. In fact, there were conferences, as I recall, on this low inflation puzzle during this time. There are a number of stories that were given. I'm just wondering, what is your sense of the most important conclusions they drew from this period or what they took away as the reasons for the low inflation?

Recent History of Low Inflation

Smialek: Yeah. I would say that this is a who done it that we still haven't solved. I don't think that there is a really clear consensus around why inflation is low. You'll know better than I will, but clearly economists have their favorite theories. They are not always consistent. I think there's one school of thought that says the Fed went too early, the Fed did not try hard enough to get inflation higher. I think there's one school of thought that says inflation expectations are just anchored. People know that inflation is going to be low and stable, and so inflation is low and stable and we're slipping lower and lower because people are expecting lower and lower inflation. This becomes a self-fulfilling prophecy. It's the opposite of what happened in the 1960s in the United States.

Smialek: I think that's one theory that I think there's an idea that globalization and technological change have killed inflation. That's certainly the view that folks like the Dallas Fed take. I think there are all these different narratives, but the unambiguous truth is that inflation has been low. It has not gone up. It does not seem to be responding particularly well to this Phillips curve framework that we talked about earlier. It's not obvious how you get it back up. I do think that the Fed has increasingly coalesced around the idea that expectations do matter, and they're clearly part of this story. And so the solution is that we need to get those expectations back up a little. They have clearly been slipping across a number of indicators. We need to convince people that inflation is coming back at some point in time, so that it doesn't continue to slip lower and lower, as we've seen in places like Japan.

The Fed has increasingly coalesced around the idea that expectations do matter, and they're clearly part of this story. And so the solution is that we need to get those expectations back up a little. They have clearly been slipping across a number of indicators.

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Beckworth: Yeah. One of the great moments from this period, this discussion on the low inflation mystery for me at least, was Neel Kashkari when he wrote his Medium posts, and he did one where he called the Phillips curve faith-based religion or faith-based economics. It was great. He mentioned it's a compelling story. He thought it was a compelling story, but it just wasn't working and to follow it, it was a faith based thing. There's no data. You have your faith and you have your empirical evidence, and empirical evidence says this is not working, but everyone's still just out of habit, most people were doing it. They wanted to fall back on this Phillips curve, but it really quit working, which leads to the second, maybe puzzle or mystery of this period or question. It's really closely related.

Beckworth: This is the decline in all the star measures. Jay Powell had a great speech, I really liked it; navigating by the stars. I believe it was 2018, Jackson Hole meeting. But it was really interesting to see the Fed’s estimates of the natural rate of unemployment, the speed limit on the economy, so to speak, decline over the years, which was one way to get around the fact that the Phillips curve wasn't working well, maybe we just don't have the right numbers plugged in, so it keeps going down. I just want to cite the numbers here. In June 2013, the u-star. They started keeping track of this with the summary of economic projections, long run estimate of the unemployment rate, it was at 5.6%. By December 2019, it 4.1, quite a change.

Beckworth: I know Adam Ozimek makes this point over and over again, if you take their number, 4.1 at the end of this period, and you plug it into the model back in 2014, 2015, 2016, they shouldn't have raised rates, if you take their most up-to-date number of what they thought was the sustainable unemployment rate. Then of course, there are star fell too. It fell from about 4% down to 2.5 by 2019. Jay Powell had this speech that spoke to this, the challenge of keeping track of these stars, these unobservables. Do you think his speech was hugely consequential, was it, you think, a catalyst behind the review? What do you think were the long lasting impacts?

Smialek: I think his speech was consequential, as Fed speeches often are, as a statement of the consensus that was beginning to develop at the time. What I mean by that is I think at that time, by way of context, it's important to note that for years, Fed officials had been talking about this idea that unemployment might just be permanently a little bit higher, that u-star variable, the level of unemployment the economy can sustain before inflation starts rocketing higher. It had increased for various structural reasons. They'd also been talking about this idea that r-star, the neutral interest rate that the economy can sustain before you start choking off growth, that r-star had increased. There's this idea that it was going to be... at the time when people were talking about short-term r-star, this idea that you could temporarily boost it up by having a higher potential growth, especially in the context of fiscal spending and the tax cuts. People were talking a lot about the short run r-star increasing.

Smialek: But I think experienced just hadn't borne that out. They were starting to have a little bit more modesty around what these star variables really meant and how well you could predict them. The most famous models that talk about these star variables, a Laubach-Williams, Holston model in particular, I think, it's pretty backward looking. It's basically taking a bunch of variables that already exist in the economy and using them to say like, "Here's where the neutral rate is." I think there was beginning to be this idea that we've been hiking interest rates trying to hit neutral, trying to hit this star variable that we've projected, but do we want it too slavishly follow that, because we don't really know where these numbers are, and clearly we don't, we've been revising them for years.

Smialek: I think Powell put a fine point on it. I think he was ahead of the committee and saying, "Guys, we need to revise our expectations and we need to be a little bit clear that we don't have super, super precise ideas of these variables." I think he came out and said it pretty loudly in that speech. But I think it was a conversation that was shaping up at the time. I think it's something, as you said, that has been wildly consequential in the time since, and certainly was the impetus for this entire framework review in which the Fed has really examined itself and said, "How are we setting policy? Why are we setting it this way? And how do we get inflation back to 2% on a sustainable basis? How do we stop missing this goal in a low rate world?"

Smialek: Really, I think this is an existential crisis for the Fed in some ways. I think David, you and I have talked about this before, but there's this real problem that they're facing down, which is if inflation slips slower, they're increasingly not going to be able to get it back up, because their tool includes inflation. So if inflation is a lot lower, they can't cut interest rates as much, you can't accommodate the economy as much, and you can ever get inflation back up. This is a real problem for them. I think they've increasingly grappled with that.

I think this is an existential crisis for the Fed in some ways...there's this real problem that they're facing down, which is if inflation slips slower, they're increasingly not going to be able to get it back up.

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Beckworth: Okay. It was a question that was being forced upon them by the reality of the experience as you said. But you said Jay Powell was ahead of the pack, so to speak. I wonder if it was because he was a lawyer, not an economist, this point's been made before that he comes in without all the baggage of the PhD training. Do you think that's a fair point or has that been overstated?

Smialek: I think this is clearly a point that people make a lot. I think it may be a slight overstatement. And the reason I say that is because I think clearly if you read the footnotes of that... I'm a big footnote nerd, I like footnotes a lot. If you read the footnotes of that speech, he's synthesizing the information well, that's clearly the lawyer in him, but he's keying off of some of the cutting edge economic research. I think that there's a lot to be said for having a fresh set of eyes cast over it, but he wasn't existing completely independent of the PhD economists. They weren't all totally useless as it pertains to this conversation. To that point, I think that actually a big influence at the time had been that r-star model I mentioned earlier, the Laubach-Holston-Williams model, I think that came out in 2017 and that was, I think, really the first moment that contingent within the Fed were saying publicly and loudly, "Hey, interest rates have fallen lower and they're not going to go back up."

Smialek: I think that 2017 paper was a big step along the way toward Powell giving the speech saying like, "These star variables, they're uncertain, they might be moving. We need to worry about them." I think it was all kind of a progression.

Beckworth: Okay. As someone who's closely attuned to The Fed, the Fed officials, what they're thinking, did this realization force them to rely more on other measures of r-star? You mentioned the Laubach-Williams measure, well-known, but a lot of people have problems with that. If you look at their r-star measures, as you said, it just seems to move slowly, seems to be lagging. They also have an output gap measure that's estimated as part of this exercise, which seems wildly inaccurate compared to other measures and what's happening on the ground. I'm wondering, do you see or did you see Fed officials move more towards, say, market measures like the implied five-year, five-year forward measure from real measures like tips or some other measure of r-star?

Smialek: They will tell you this, so I'm not unveiling the secrets of the temple here, but they clearly look at a variety of measures. They don't just look at Laubach-Williams. I think they do look at market-based measures, they, I think have several of their own forecasting tools. Then I think they also just look at what's happening in the real economy. Some of this is just... and I think this is the thing that gets lost in these conversations. We talk about economics and all these Mathew terms and with our models, but a lot of this is throwing spaghetti at the wall. I think they did watch what happened during that hiking cycle and see, was the economy responding? Was it responding as our models would have predicted? Was it responding the way we would've just expected in our heads? I think a lot of this was just trial and error. They saw how things responded to their moves.

Smialek: Importantly, I think, as you mentioned earlier, and I think you just can't overstate it, they watched telemarketers responded to what they were saying and how the economy responded to what they were saying, because that was, in many cases, just as important as what they were actually doing.

Beckworth: Okay. The other big question from this period, and we need to move on to the current year because that is the main reason we brought you on, but this is fascinating. I spent a whole show on this period, but the other big question that comes up during this time is what will be the operating framework they decided to stick with? 2008, by default, they effectively went to a floor or abundant reserve system and they had to make a decision; do we stick with this or do we go back to a corridor, which you probably know, I'm a fan of a over corridor, symmetric corridor, George Selgin is too, but it seems like the world is moving towards these floor systems, not just the US, The Fed, but the ECB, other big central banks in advanced economies. But this review came up on this question, right?

Beckworth: I think, as you mentioned, part of the conversation was informed by this realization that r-star is going low, that really some of their hands are tied partly behind their backs, so what did we do? But was this conversation really a big conversation? Because my impression was, it didn't last that long. It was the end of one year. I believe it was January 2019, they voted officially to move to the budget reserve. It was just a few meetings before that. I might be mistaken. Did they have a long, long discussion or was it more of a modest one?

Smialek: I think that this was not a wildly controversial decision at the end of the day inside The Fed. I think maybe the reason for that is the abundant reserve system is just a little easier to use. You don't think of central banking as being a user-friendly exercise, but in this case, I think that that was an important consideration. Corridor systems are hard. You have to constantly be operating in markets. It requires some guesswork. Whereas abundant reserves systems, the floor system is a little bit more automatic. I think there was clearly a conversation about this. This was a thing they debated, it was a decision they had to make, but-

Beckworth: It was an easy choice for them.

Smialek: At the end of the day, it was a fairly easy choice. Then I think markets drove their hand a little bit on this one as well.

Beckworth: Yeah. That leads us to September 2019, the big repo crisis, which again, now it looks small in comparison to what we went through in March of this year, but back then they had this mini crisis, which the Fed had to change course and go in big and reverse, the shrinking of its balance sheet. The way I look at it, and I know others disagree with me on this, but the Fed had a corridor system, it officially made it so in early of 2019, but it was also trying to shrink its balance sheet is as small as it could while still being abundant reserve. It was trying to get down. It still wanted to have abundant reserves, but with as few reserves as possible, if I can state it that way, but they went a little too far by accident.

Beckworth: They kept shrinking the balance sheet. At the same time, treasury was pulling reserves out because of... it was selling auctioning securities and collecting corporate tax revenues. September 2019, they tripped and went beyond that threshold where it effectively put them into a corridor system, even though they still had a lot of reserves, but I don't want to get too much in the weeds, but they learned their lesson, like you said, and they said, "Okay, we need to be more careful and keep lots of reserves in the system." Here we are today and the few of us who still like corridor systems, we're holding out hopes that maybe in a decade or so, we'll get back to one. Canada was our last hope, but Canada, their balance sheet blew up during this year as well.

Beckworth: There's a few places. I talked recently to the central bank governor of the Philippines. They have a corridor operating system, but anyhow, another time we'll have a conversation about that. Let's come to 2020, this amazing year, painful, crazy year. I want to be clear, we are recording this on December 11th. There is a meeting next week, the last meeting of the year. We are talking... This show will air after that meeting has happened. We'll kind of forecast what's going to happen at that meeting, but we're trying to take stock of this year, 2020, all the things that have happened and make sense of it.

Beckworth: Again, this has been a great year for you. I will mention, I meant to mention this earlier, because it's such an intense year, you've been in the trenches, you've been on the front lines. You have a great book that you're writing about all this. Is that right?

Smialek: Yeah. It's convenient that we just had this conversation about the history, because the book is actually a little bit more sweeping than just this year. It's about the post-Greenspan Fed. It talks a little bit about Bernanke and Yellen, and then heavily concentrates on this year. The narrative structure is very much focused on this year.

Beckworth: You've written a lot this year on the facilities and what the Fed’s done. I want to get to that in a bit, but maybe we should start off our discussion on this year by just taking stock of where we were in January. Now, my great memories of January, I went to the American Economic Association meetings in San Diego. It was sunny, it was beautiful. Things were looking great. Was the Fed in a sweet spot during that time?

Optimism Going into 2020

Smialek: Yeah, I would say. I think it's worth bearing in mind, just what a crazy 2019 they had just come through. We thought that 2019 was the craziest year that was ever going to happen to the Fed because they had entered 2019, rewind end of 2018, they do their final rate hike, chair Powell kind of indicates that maybe they'll do more maybe at the press conference. He didn't really say that, but markets took it that way. Markets go haywire. The President reportedly considered firing Jay Powell. That news breaks over Christmas. The markets are melting down because of that as well. 2018 is terrible. He has to come out and reverse himself early in 2019 in an interview with my colleague Neil Irwin, and basically say, "No, we're not hiking rates essentially. We are going to be really patient. We're chill."

Smialek: He comes out in 2019, puts market's minds at ease. They get through the first half of 2019, and President Trump is just tweeting about Jay Powell constantly. He calls him an enemy. He compares him to Xi Jinping. He calls the Fed officials bone heads. [2019] was a crazy year, [the Fed’s] under constant attack. The trade war is happening. The economy is looking a little wishy-washy. The Fed ends up cutting rates three times because they're worried about the trade war and they're worried about the economic situation devolving. Three rate hikes that nobody was expecting going into the year. It's just a nuts year.

[2019] was a crazy year, [the Fed’s] under constant attack. The trade war is happening. The economy is looking a little wishy-washy. The Fed ends up cutting rates three times because they're worried about the trade war and they're worried about the economic situation devolving.

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Smialek: It's finally over. They think they recalibrated policy. President Trump has stopped tweeting about Jay Powell so much. Everything seems like it's kind of looking up. The Fed is ready for a victory lap. And then we have 2020.

Beckworth: Yeah. Hey, thank you for bringing those events. I skipped over those. But yeah, that was a great time, I should say, great from my perspective as a Fed watcher, but not so great from inside The Fed. But yeah, it brings back also the memory of the yield curve inversion talk, if you recall. There were some fed officials who were perfectly fine with the yield curve inverting. I remember John Williams like, "Ah, bah humbug. What's the big deal if it's the fundamentals." Even Lael Brainard had a speech where it was surprising where she's like, "Let things go." I actually made a t-shirt, Jeanna, about this time, and I just want to bring it up because it's no longer relevant or anything, but put the seal, the Fed on my t-shirt, probably inappropriate without copyright permission.

Beckworth: Then I put a little saying that says, "We have the nerve to invert the curve." Because there was this kind of a surprise like, "Man, you guys are willing to go all out and invoke a recession. You're willing to let that happen?" But as you mentioned, they changed direction the next year. In fact, we were both at the Jackson Hole conference in 2019. One of those moments where president Trump was really just going off. I remember Jay Powell was giving his speech and I can't remember what his speech was about to be honest, but I do remember what was being tweeted at the very time. Most of us had our heads down looking at our phones, not at Jay Powell, because that's when he was comparing the Jay Powell to the president of China and asking who was America's worst enemy. Very shocking.

Beckworth: You're like, "What did Jay Powell say?" "I don't know, but this is what President Trump just said about him." That was a very memorable a year. I am glad you brought that up. But early 2020. Getting back to the 2020, things are looking great. If there hadn't been this pandemic, so some other earth 2 history, we sail through. Unemployment was 3.5%. Yes, inflation was still lower than their target, but it seemed like we'd finally gotten close to full employment level. Did you get any sense of jubilee celebration at the Fed like, "Ah, look, we've hit the sweet spot. We're doing things right. Finally, a good year is in store for us."

Smialek: I think it was so cool at the start a 2020, end of 2019. I travel with the Fed a lot. I go places with them. For years we have been going places and they would give these speeches about how the economy was improving and it just felt like it was kind of ringing hollow. The people were like, "Unemployment's kind of still high here. It may feel great in Washington DC and New York, but it doesn't feel fantastic here." Then I think something changed at the end of 2019. You would go to places that would still be having economic problems, there would still clearly be issues, but people were really hopeful.

Smialek: I went to an event up in Connecticut with Chair Powell in Novak last November. I remember, it was this community that was pretty diverse. There clearly been some bad times there, there were a lot of empty storefronts, et cetera, but there was also a new manufacturing plant and people were getting jobs. People were getting trained and things were really feeling like they were looking up. I think you could certainly see that in the data. Folks were getting pulled back into the labor market. Prime age participation was improving for everybody, but men, really. Younger men weren't doing so great, but most people were. People were doing a lot better.

Smialek: I think the Fed was feeling great about the fact that inflation was still low and unemployment was still falling because instead of just worrying about inflation, they felt like they could test that labor market. [The Fed was] setting up for this great experiment where they were going to see how low unemployment could go before inflation shot up higher. Then they never got to check it out. We did not get to it. It was the experiment that could have been that didn't get to play out.

[The Fed was] setting up for this great experiment where they were going to see how low unemployment could go before inflation shot up higher. Then they never got to check it out. We did not get to it.

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Beckworth: Yeah, it was such a wonderful time and what could have been. Sad that it happened, but life is what it is. Pandemic gets to US and very crazy times in February and March, and the Fed really gets active. Let's talk about what the Fed did. I'm going to just list some of the items, maybe you can talk us through them, what it did during this time. First thing it did is it cut rate. How quickly did it cut rates?

Fed’s Policy Response to COVID

Smialek: It cut rates fast, I think in the grand sweep of history. I think this will be remembered as a very proactive Fed because they started cutting rates the first week of March. Most people were not taking the pandemic seriously as a risk at that point, and when I say most people, I mean most policymakers. A lot of Washington was still like, "Is this an issue for us? We don't know if this is an issue for us." But the Fed was cutting rates. That seemed like a big deal. I remember at the time there were a lot of analysts notes asking, "Are they being too reactive? Monetary policy is not the right tool to deal with a pandemic, et cetera, et cetera." But they went ahead and did it, and then markets went absolutely haywire for the next two weeks.

Smialek: On March 15th, they cut rates to zero and they rolled out massive QE, and they quickly went on to roll out a bunch of other emergency policies. It was a pretty quick turnaround. March was frantic.

Beckworth: Yeah, basically all the rate hikes they had done over the past years since 2015, they reversed in a few weeks. They went from 2.5 back down to zero to quarter percent range. Now, I actually wrote a piece, an op-ed. I was supporting those rate cuts. I got blow backed. After the first one, I got blow back from people like, "Ah, Beckworth, you're just encouraging the Fed to respond to the stock market, the market signals." I even got an email from a senior staffer at the board of governors who's like, "You shouldn't be writing..." He was not happy with my cheering on what he thought might be too quick of a reaction.

Beckworth: But nonetheless, I think it was born out that those were appropriate. Quick rate cuts. Then we move to the QE that you mentioned. Just to put things in perspective, in January 2020, the Fed’s balance sheet was just over $4 trillion. Now it's over $7 trillion, about a $3 trillion increase over this period. We see treasuries going up. Treasuries are still being purchased every month. The Fed also continues to intervene in the repo markets to keep the money markets functioning appropriately. We got massive QE going on. Tell us about in terms of QE, what were some of the things the Fed did differently this time compared to the previous crises?

Smialek: I think one thing that's really important to note that actually I find... and I'm sure this is not something that is true of your listeners, but I find that it happens when I'm talking to other people, is it seems to be the case that a lot of America has forgotten we had a financial crisis in March or that we almost did. We did, it was a disaster. March was horrible. The treasury markets were completely melting down. I think that's the context in which we have to understand this QE program. Flashback to March, the markets are just not functioning. Everyone is running into cash. People are selling everything they're holding and trying to get cash, which is fine. That's what happens in a crisis, except the problem is that all of the market infrastructure starts seizing.

Smialek: Things are not moving. It turns out that the reason that nothing is moving is the treasuries are not moving, the very backbone of financial markets, off the run treasuries, slightly older treasury securities, you can't sell them. There just are no buyers. There are plenty of sellers, no buyers, which is insane because even in the depths of the financial crisis, this did not happen, not to this extent at any rate. The rate strategists I'm talking to are panicking, traders were panicking as much as traders ever panic. They don't really panic. They are a pretty stoic bunch. March is just completely insane. The Fed steps in, they try and do repo. They're offering these short term overnight term loans to try and get things moving. It's not working. Nobody's there.

Smialek: The take-up is the take ups big, but things are still totally not playing out. The Fed has been buying a little bit, doing a mini Not-QE program, famously Not-QE program, buying some bonds as a way of trying to fix the problems that we had seen back in September. Lorie Logan and her staff at the New York Fed pull forward all of those purchases. They just basically do a Not-QE program of their own. They pull forward everything they're authorized just to get us through to that Sunday meeting. The Fed authorizes a bunch of purchases as it revamped its QE program. On March 15th, that doesn't work. Markets are still a mess the following week. They're buying huge quantities of bonds by historical context and markets are still a disaster.

Smialek: What we see is the Fed rolls out an unlimited QE program. They say, "We will buy as much as is needed, basically. We will buy everything just to try and get these markets to work again." That works. That is the thing that ultimately saved us from a real financial crisis back in March. I mean, we were in a financial crisis, but it saved us from a protractive one. That's basically what happened. Then the QE program that has followed has been much more regimented, I think, than that open-ended QE, initially sounded like it might be, and has increasingly shifted toward being about accommodating the economy, which I think is much more of the kind of QE that we're familiar with here in the US and the one that most people think of when they hear that the Fed is doing these large scale asset purchases. That shift has happened gradually over time. We're clearly no longer at a point where markets might melt down at any moment, but they're still buying huge quantities of bonds.

Beckworth: Yeah, it is easy to forget how crazy it got in March. It was very turbulent. It seemed like an eons ago. So many things have happened in 2020, it's hard to remember that far back sometimes. Now, there's been a lot of discussion on what to do to prevent something like that from happening again. How do you repair the treasury market? It is striking. People typically rush into treasuries, but in this case it was so bad. It wasn't good enough that it had go to the next level, which was pure cash. Is the Fed talking about something they would like to have done in terms of preventing this from happening, like the proposal for standing repo facility? I know Darrel Duffie at Stanford's proposed more central clearing of treasuries. Do you think there's anything that has traction that's likely that we see happen in the future as a response to this crisis?

What has the Fed Learned?

Smialek: I think they are still very much at the analytical phase of this, trying to understand what happened. I still don't think there's a clear consensus on what exactly broke here. The FSB has put out its report, the BIS the Bank for International Settlements has put out its report. I think that the Fed board has been clearly very engaged in trying to figure out what happened. I think basically the consensus is everybody was selling and things broke as a result, and money market funds were a problem, hedge fund relative value trades were an exacerbator, but not the cause. There have been all of these inter-playing theories about what exactly went wrong. I think that at the end of the day, they have to figure that out with some precision before they're going to be able to figure out how to fix it.

Smialek: I think there's consensus that we need some money market reform because clearly the gating mechanisms that they installed after the financial crisis actually exacerbated the problem instead of fixing it in this go around. I think there's pretty wide bipartisan across the regulators consensus that something there needs to change. I think there's some consensus that hedge fund leverage was an issue, but no consensus over what to do with that, because they think that hedge funds play an important role in intermediation. I'm not sure how that changes. I just don't think there's like a clear consensus around what role the Fed’s balance sheet has to play in all of this. Randy Quarles allowed, but then quickly walked back, that it's possible that the balance sheet is just going to have to be permanently much larger, the Fed is going to have to be active in these markets because the infrastructure is not going to be robust during times of crisis.

I think there's consensus that we need some money market reform because clearly the gating mechanisms that they installed after the financial crisis actually exacerbated the problem instead of fixing it in this go around... I just don't think there's like a clear consensus around what role the Fed’s balance sheet has to play in all of this.

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Smialek: Then he was quickly like, "No, I don't mean that. We should just be buying constantly." But that is clearly not with what he was trying to say. But I do think these are open questions and I don't think they have clear answers yet. I think it's going to take more time.

Beckworth: Well, is it safe to say that one option that's not widely endorsed is this whole thing that Randy Quarles was just talking about that you don't want to rely on the Fed’s balance sheet every time, you want some other option. Is there a consensus around that?

Smialek: I don't know. I don't think we are there yet, just because honestly, I think, like I've mentioned earlier, so many of these decisions will have to be made by committee. The presidents probably wouldn't have a vote on an issue like that because I think of this would fall into the realm of regulation, which means it's a board matter. But I think that clearly they're all going to weigh in. I don't think that we've heard enough of them weigh in because I think we're still at the diagnostic phase. I think this is like a TBD big story for 2021. I think it's going to be really interesting to watch what happens here.

Beckworth: It's still an open question. All right. Well, let's talk about the facilities that were introduced during this time. Some of these were introduced in the previous financial crisis, but there were some new ones as well. You've done a lot of reporting on this. I mean, this is like your bread and butter the past few months, and what has happened with them since then, but I don't know if we want to go through all of them, but I like to at least create two buckets. I know there's different ways to do this, but I'd look at a liquidity facility bucket and then a credit facility bucket. I get this from Lev Menand who has a great paper on these facilities. Liquidity facility bucket is one where you have things like the commercial paper funding, primary dealer credit facility, money market fund, liquidity facility, all these things that are there to really support the quiddity that the functioning of the financial system, keep it running and going.

Beckworth: I would go more broad than that and say it is to keep the shadow banking system going around the world because the dollar swap lines would also fall under that. The Fed really massively intervened on a scale larger than the previous crisis. And it was important to keep what would have been a great financial crisis from emerging. It did a good job. Then you go to the credit facilities, which you get into probably the more controversial ones, and correct me if I'm wrong on this, but this seems to be the area where there's more debate, both from the right and the left.

Beckworth: The right was like, "You guys are intervening in credit markets." The left would say, "You're not going far enough into credit markets. We need more help." Where you have the corporate credit facilities, primary, secondary, as well as the municipal facilities and the main street facilities. Where do we stand on those now? And what is your takeaway? If you had some key points about these, where do you see this all headed?

The Fed’s New Facilities

Smialek: Yeah. Just to bring us up to the current moment. I think the way that Lev separates these out in the way that you just laid it out is a really good way to think about it. The more novel facilities were backed up by this $500 billion pot of money that Congress appropriated in the Cares Act, the big pandemic response package. They handed 454 billion of that specifically to treasury for these five facilities. Secretary Mnuchin set up these facilities. One of them was from the crisis. It was a rehash, something that we had done in the crisis called the telth, which is basically meant to help securitize markets to keep functioning. The other ones were all new. There were two that buy corporate bonds, only one of those ended up being used, but it ended up being pretty important.

Smialek: There was one that does main street lending, small and mid-sized businesses via banks. Then there's one that does municipal, state and local bond issues, and buys those. All of them were set up with backstopy terms. They weren't meant to be used as just like, "And you get money, and you get money." These were not the Oprah car version of Fed facility. But they were very much meant to be used if private markets were not working, if they weren't kicking in. But secretary Mnuchin midway through November announced that he was going be bringing them all to a close at the end of the year because he believed that that is what Congress had intended. Then he asked the pet to please give back all the money. The Fed said, "Okay, here is your money, so you can have it back."

Smialek: Now those have all come to a close and there are real questions about whether they would be able to be restarted at the same scale come next year. That's where we are now. There's a huge legal debate over whether... there's not a huge legal debate over whether Mnuchin had to do this. He says he had to do this, but most outside lawyers you talk to will say he probably didn't have to do this. He chose to do this. He absolutely could do this. He had the legal authority to do it. But there will be a huge debate, I think next year, if they want to get this money back and then re-inject into the facilities, that's going to be wildly contentious. It's going to be interesting.

Smialek: There's still money in the old ESF. The old pot of money that the treasury had to potentially back up these facilities, there's still money in there, so they could restart them just with that. Anyway. That's our mark to market. These controversial facilities are no longer going to be running after December 31st. I think the big question going forward and the big conversation we're about to have is, were they a good idea? Should they continue to exist? And should they be more generous if they do?

Smialek: I think if you talk to folks on the left, their idea is basically the Fed is meant to support the economy and the Fed is happy to step in and help all of these market players when things are going badly and has helped them. If you look at where markets are, has helped them fairly enormously, why is it not helping main street? Why isn't it doing more for these entities in need? I think that's that side. I think on the right, those folks are saying, "the Fed is a lender of last resort. It is supposed to follow this old dictum that says, 'I'm here to fill in liquidity needs, but I'm not here to make markets. It's not supposed to stand in for private players, and it's too invasive of role for the Fed to play for them to be really active in credit markets.'"

Smialek: That's certainly like Senator Pat Toomey from Pennsylvania who is likely to be chair of the Senate banking committee. That's certainly his view. He's been a big player in this conversation. I think this is going to be again, unresolved issues for 2021. I think this is going to be a massive conversation. There is huge amount of daylight between the two sides. I don't think these are easy questions with easy answers.

Beckworth: If things do get weaker in terms of the economy, if we do have... even though vaccines on the horizon for most people, there's a slowdown this winter. These facilities may be something that's worth looking at again if things deteriorate pretty fast, and the question is whether we can use them or not. This is part of, I guess, the question for 2021, do we use them again? Let me ask this question. Do you think there's a big takeaway in terms of Fed independence because they have used these facilities? The fact that the Fed should do more, should change the criteria for the use of the facilities, should go places that hasn't gone before. Does the Fed worry about that? Does the Fed worry that maybe it's opened a Pandora's box and maybe asked to do more in the future?

Smialek: I think that's an interesting question. I should point out for listeners, if things get worse this winter and these facilities need to be restarted in January, it is certainly the case that they can restart them. There is probably about 50 billion that they can use in that Exchange Stabilization Fund. You can restart them at a pretty big scale. What you can't do is make the terms a lot better. A lot of Democrats on the Hill had been looking at the municipal liquidity facility in particular and saying like, "Hey, let's make that look a little bit more attractive, and then we can use it as sort of a backstop or backup option in the event that fiscal support isn't forthcoming." That option is probably more or less off the table now. Just so listeners know that.

Smialek: I do think it's an interesting question how this affects their independence and their place in pandemic and economic relief history. I don't know where they're going to come down on that. They clearly chose to implement these facilities. This is a place that they thought they had to go. This is going to be one of those things that gets to how they view their role and whether they think it was appropriate and whether they are worried about how far they've gone. I think that's going to be determined a lot by what comes next.

Beckworth: Okay. One other comment about these facilities and we'll move on, our time is running short here, but the Lev Menand’s of the world, the Morgan Rick’s of the world, one thing that they would advocate... in fact, there's others too, I'd throw in other individuals, but they've been very vocal is they believe that there should be an explicit fiscal facility doing what these credit facilities were attempting to do. In other words, there should be some facility out there that would help the states, that would help main street, and it would be funded and it'd be for emergency use only. I'm not seeing or hearing much talk about that now. My impression is and suspicion is that's not going to get much traction after this crisis. Is that fair or are people talking about it?

Smialek: I think there's some really interesting questions around stuff like this, because the Fed actually has fairly broad authority to use these facilities and to do a lot of... I'm sure listeners are familiar with 14 2B because it's been in the news a bit, but the Fed could just go out and buy state and local bonds. They have these broad authorities as I think you're alluding to. The issue is that they're a central bank, should a central bank be exercising that kind of authority? Because it essentially ends up becoming a game of potentially picking winners and losers. I think those are big questions that we're still going to be asking in the next year. Just as was the case with the market meltdown question, I just don't know that we have a consensus yet, because I just don't know that we got all the information yet. It's a slow deliberative body. They like to take a step back, look at what happened, look at how things worked and then make their decisions.

Beckworth: Okay. Well, you've already alluded to what's going to be a big issue this next year; could be the discussion of the Fed’s role, the Treasury's role, next year, big discussion about that, but something that strikes me is a big discussion... and we'll end on this note because our time is about up and that is, do you think the Fed’s new framework will be really tested this next year? Here's the reason I make this argument or raise this question, that is, if we have a boom this next year, many are arguing that there's going to be this pent up demand, it's going to explode, we're going to have life go back to normal. All those vacations and service sector activity has been missing will be there. And the economy is going to heat up. It's going to grow really rapidly.

Beckworth: And as a result, there's going to be some inflationary pressures that will emerge. Will the Fed commit to its low rates for a long period or will it hike rates? Will it stick with its commitment to get the average inflation rate up and keep rates low? Will it see through what I think will be ultimately a temporary inflation blip, but if there is one in 2021, will the Fed be able to see through it? I think that's an important question. Do you see it as a big question, as something that you'll be covering and we'll be talking about a lot next year or not?

Smialek: I think it's certainly something that we'll be talking about a lot next year. I think the Fed probably is going to point to its commitment every time it gets asked about this. They said they're going to do it. They have to follow through or else no one's ever going to believe them again. I don't think this is going to be a huge open question in their minds. But I think the commentary is clearly going to come at them from all directions. I've been seeing a lot of folks, the techno optimists are back. People are saying like, "Oh, hey, maybe productivity is about to surge." There's certainly a concern that inflation is going to surge. There's also concern among some people that inflation is going to plummet. I think they're going to be facing a lot of pressure from a lot of different camps.

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

Smialek: Thank you for having me.

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