The following transcript is from Macro Musings, a podcast series hosted by Mercatus scholar David Beckworth that explores the past, present, and future of macroeconomic policy. Subscribe on Apple Podcasts or your favorite podcast app.
David Beckworth: Welcome to Macro Musings, the podcast series where each week we pull back the curtain and take a closer look at the important macroeconomic issues of the past, present and future. I'm your host David Beckworth of the Mercatus Center. We are glad you've decided to join us.
David Beckworth: Our guest today is Michael Derby. Mike is a reporter for The Wall Street Journal who covers the Federal Reserve. Mike joins us today to discuss recent developments in Fed policy that he has been covering. Mike, welcome to the show.
Michael Derby: Thank you very much for having me.
David Beckworth: Glad to have you on. We've been reading your articles for some time now on the Wall Street Journal, and you've been doing some interesting reporting. So Mike, with all my guests, I always start the show by asking them how they got into this area. And in your case, how did you become a Fed reporter?
Michael Derby: Well, what happened was is I went to the University of Maryland's journalism school, University Maryland College Park’s journalism school. When I started going to college, I didn't really know what was going to happen. I knew I liked writing, I liked public policy, but I wasn't sure exactly what path was going to happen for me, whether or not I was even going to end up as a reporter because at the time, reporters seemed like this sort of Olympian, like I'll be lucky if I ever get there.
Michael Derby: Maryland was really, I mean, I really do owe that school a lot. They really set the program up in a way that it helped, you got good internships, they forced you to get clips. There was a class there was one class there where you were basically forced to publish 10 articles in the semester like properly published articles and if you didn't do that you pretty much, you were pretty much done for in the program. So the school forced you to get out there. It was good training. We had lots of great adjunct professors that came in to teach classes so you were being taught by people who were really out there. And so, the school definitely got me well suited and well situated to actually become a journalist.
Michael Derby: I took one economics class at University of Maryland, that's all I ever took. Before I got into this, for me, the sum total of the Federal Reserve was what's this going to do to my credit card balance. I would hear like on NPR, “oh, the Federal Reserve raise rates today and that means the prime rate did this.” And I go, “there goes my credit card up a little bit.” Other than like knowing maybe some vague stuff about Alan Greenspan, this is maybe mid to late 1990s, just really didn't have much sense of the Fed or anything like that. I traveled through Central America in the mid 90s when the peso, the economic crisis was happening in Mexico. Again, I was just completely unaware of the broader economic policy things that were going around, experiencing these things but not really knowing that much about it.
Michael Derby: So when I graduated from University of Maryland and my final internship was completed, and this is I think the summer of 1998, I did not have a job lined up. I was pretty freaked out because I did not have a job lined up. I had two job offers in front of me. One was for a small community daily newspaper that paid a pretty small amount of money. Another one was for a financial wire service that paid what at the time struck me as a pretty decent amount of money, and I did not understand what they did. But I figured I would give it a shot and if in six months it wasn't working out I could try something different.
Michael Derby: So that wire service was something called Futures World News which does not exist anymore, but we did economic indicators. We were given almost no training whatsoever. We made tons of mistakes but because we were small, you got to go to all the government departments to cover all the economic indicators, to do the jobs report. Not to be just like somewhere down helping fill out a table but actually writing the main story on the jobs report and you got to cover top officials right off the bat. And so, you just were thrown right into the mix.
David Beckworth: Sink or swim, huh?
Michael Derby: Exactly. We were given very little oversight. Like I said, we made a lot of mistakes, it was pretty embarrassing but that's how it was. And so, that company got bought out and shut down by another wire service called Bridge News. And so I was working in Washington. And at this point, I was starting to like economic policy, getting a feel for it. So we got shut down. I got offered a job to come to New York working for Bridge covering money markets. It was sort of a strange job. I was allowed to cover anything inside of a year. It was right ahead of Y2K. So a lot of Y2K stuff for the Federal Reserve, all the preparations the Fed was doing for Y2K, that all fell to me. And so, I got to, again, right off the bat, get right into sort of the nitty gritty and mechanics of monetary policy again having no direct training in it but just getting exposed to it going to the briefings at the New York Fed, all those things and learning about it and writing about it
Michael Derby: Bridge was not in a very good financial situation at the time. And so I wanted to get out of there because things didn't look great there and it actually did end up going bankrupt. I got a job at Dow Jones News where I was covering the bond market and so I got to be part of the credits team writing about Treasury movements. And the way we were situated up there, we also, we did a lot of private sector economic indicators and we also covered Fed officials that came through New York or any kind of economic policy people that came through New York. And so, at a certain point, I was given the job to be the main guy to do that. So I still kept doing markets but I just slowly started covering more and more fed things and it was primarily regional Fed officials because that's the way we were set up. So I had pretty much responsibility for all the regional Feds and again, any, say at the time if Alan Greenspan came to New York, we would be the ones to cover him as well.
Michael Derby: And so, that's sort of how I got into covering the Fed. It was all just, there was no great plan, it's just took a job, one job to another job, learned a little bit more and then in a way that's kind of here I am today, still doing it.
David Beckworth: Serendipity led you down this path and here you are. So, I got to bring this up because I follow you on Twitter. We interact on Twitter and others as well. But you are also an alternative rock band musician for many years, right? So while you were thinking about Fed, you were also jamming on the side, is that right?
Michael Derby: Well, yeah, I'd say, even now I don't have as much time for it but my great passion was actually playing and writing music. I was a bass player, I played bass in a bunch of bands and slowly got into a lot of recording, like really liked to do recording things and that got me exposed to different instruments and I ended up having a band where I played guitar. We broke up 10 years ago amicably. It was fun to do but then just career and family stuff kind of gets in the way.
Michael Derby: It gets a lot harder, trying to assemble a band is actually very difficult, to try to get people to come together especially when they're not getting paid money, it's very difficult to keep a band together. When certain other things come into your life, it just becomes, you don't have the time to deal with all that stuff. And so, that's kind of where I'm at. But still do recordings but I just haven't really, I haven't bothered to put anything out in a while.
David Beckworth: Well, I look forward to your best hits coming out one day, with some Fed back stories to them, put to music. We talked about earlier before we came on the air that Richard Clarida is a musician as well. So it's interesting to see people's hobbies. You see the professional side of them, it's interesting to see what they do in their downtime. Okay, well, let's move on to some current topics, some hot topics that you've been covering with the Wall Street Journal.
Michael Derby: Sure.
David Beckworth: I want to begin with what is increasingly a positive economic outlook, an improved economic outlook. Surprisingly probably to many people where we are today, if you look at the Atlanta GDP, the Atlanta Fed GDP Now measure, it's been in the 4% range. Things are just looking really hot. I wanted to ask since you are in contact with Fed officials, you're covering them. Are they surprised we're here? I mean, did they see themselves here maybe a year ago? Is this something that they would have expected?
Michael Derby: My sense of it is when, maybe early in the Trump administration and maybe closer to the line of or right around when they, you know, various tax cuts packages and various regulatory things happened. I don't think Fed officials expected, they expected to see small and modest bumps, I don't think they necessarily expected that growth was going to be as strong as it is. You universally see across Fed officials an expectation that this is going to be definitely a strong year of above trend growth, somewhere in the neighborhood of 3% for the year, maybe even a little bit north of that. They definitely expect or at least most of them expect growth to moderate maybe a little bit in coming years. And part of it is, at least is, I'm able to pick it up. The tax cuts and regulatory changes, they're definitely given a short term boost. Whether or not it'll give some sort of permanent upswing is still very much up in the air but this year's definitely turned out a lot better than folks have expected.
Michael Derby: Jim Bullard at the St. Louis Fed had given some remarks recently and he talked about, it's always very difficult for Fed officials to connect political things to the economy because they like to try to stay out of politics. Jim was talking about how a lot of his contacts were saying that the Trump administration and their pro-business policies, whatever that in fact actually means, just the sense that the Trump administration was pro-business, had put a lot of you know positive sentiment into the business sector and made people feel like yeah, I can take a chance, I can do this, I can try that. For me it's a little harder to actually connect that, to see how that is really the case but that's what Jim was saying that he was hearing from people. Whether I'm right, whether he's right, whether anybody's right, I mean, clearly GDP data has been very good and all it's been pretty good this year.
David Beckworth: Yeah. I think part of it one can argue is actual policy change, tax cuts, the deregulatory measures that are adding a boost the economy. But part of it I think is also psychological. To invoke the Keynesian mantra, but it's animal spirits. I think President Trump coming in just a change for many people. I know if you'll look at, for example, the National Federation of Independent Business, they're usually small medium businesses, tend to be more conservative. But man, if you look at business optimism, it is kind of shot through the roof with them. So even if it is, a lot of it may be, in their minds, it makes a difference. So if you're optimistic, if you're more positive, you may go out and do more as a business. So I think that that matters as well.
Michael Derby: I think that that was exactly what Jim was getting to, definitely a shift in sentiment and that's definitely tied to at least perceptions of what the Trump administration is trying to do.
David Beckworth: Yeah. You had an article also about Charlie Evans, the president of the Chicago Fed, where he said the economy is firing on all cylinders. I like that framing there.
Michael Derby: Yeah. Charlie Evans has had an interesting evolution because he was a guy who was definitely very, very dovish in terms of his monetary policy expectations for a long time and was definitely worried about inflation being too low. He was definitely for quite some time reluctant to embrace rate rises and was very focused on if they're going to be rate rises, they need to happen slowly. He's certainly a lot more hawkish than he used to be. His firing on all cylinders mantra has even led him in his last couple of speeches talk about how he supports the current Fed consensus that monetary policy is actually going to have to become more restrictive, moving to a stance that's restrictive of growth. This strong economy has even brought along, I mean, not all the doves are with him, but there was definitely a dove who certainly turn quite a bit more hawkish because of how things been going.
David Beckworth: Oh, absolutely. I would also note Janet Yellen in her post Fed chair role, she was interviewed recently and she too sounded a lot more hawkish than she had as the chair. So I think this kind of again goes back to the fact that the economy's been more robust, the growth has been stronger than expected. I think maybe in general, I'd like to hear your view on this, growth has been better than expected is maybe putting more pressure on the Fed to do something. They feel like they don't want to get behind. They're worried that at some point it's getting so hot, inflation is going to take off. I know there's been a large discussion about the Phillips curve and Philips curve hasn't been working, but they're still worried that it will come to life maybe.
David Beckworth: I know Jay Powell had a speech recently where he said, “I'm not worried about the Phillips curve rearing its ugly head”. But I do think in the back of their minds, this must be something they're thinking about. Your thoughts?
Michael Derby: I think that's right. The way Charlie Evans was discussing it in terms of like, it's actually, it would be a normal thing in an economy like this for the Fed to be moving towards a slightly restrictive monetary policy stance. The whole goal of this whole tightening cycle was to normalize monetary policy after the financial crisis. I think there's a greater confidence among officials that, yeah, actually, the economy is really past it and performing pretty well. And so, therefore, all these sort of crisis era, not in every way, but a lot of these crisis era ways of thinking about monetary policy, we can move past them now and we can conduct monetary policy in a more historically normal fashion.
David Beckworth: Yeah. Now, related to that, I want to touch on some stories you've been writing on these recent speeches by Jay Powell and then also the New York Fed president John Williams. We can come back to the substance of them later, but I want to focus on one of the key takeaways from their speech is that they are more dismissive of this neutral interest rate, the rate at which monetary policies, they call it R star. Both of them kind of dismissed it after being big fans for a long time, particularly john Williams. And I read one kind of cynical take on it today on Twitter, I'd like to hear your thoughts. If you pay less attention to this neutral rate R star, it may be a clever ploy because as the economy's heating up, that neutral rate is also going up. And if you're paying less attention, if you're talking less about it, it gives you cover, makes people less aware that the Fed should be raising rates faster.
David Beckworth: Do you think there's any merit to that, that maybe it's a way for the Fed to have more flexibility and not to be so constrained to raise rates as fast as they otherwise would?
Michael Derby: Well, I'll answer it this way. The way Jay Powell phrased it in his Jackson Hole speech, I understand. He talks about concepts like R star is relying on estimates of how the economy performs, estimates that have often in the past been wrong and because the estimates were wrong, it led the Fed to make policy mistakes. And so, he's placing less emphasis on these things that you kind of inherently can't know. That does give him flexibility but maybe that's just kind of a hallmark of where he's coming from.
Michael Derby: With John Williams, I think the John Williams part of it is actually a lot more interesting in that he was such a, so much of his academic work and his professional profile is around the concept of R star and calculating and knowing how to understand it. He's gone from, when he was at the San Francisco Fed in May, he said, it “shines brightly” and now last Friday, he says it's a “fuzzy blur”. John Williams is actually going to be a pretty interesting guy as the New York Fed president because I think he's going to be more, he was always very accessible at the San Francisco Fed for reporters and he's already done sit downs with reporters after speeches. So, I suspect we're going to get a chance to ask him directly soon about what his evolution was.
Michael Derby: But, in that speech where he called R star a fuzzy blur, he did mention that we're moving towards a time now where the Fed is not going to be able to provide as much explicit guidance about where interest rates are going. At some point, they might even conceivably start going back down again. And so perhaps he wants to just sort of back away from any kind of implied guidance that comes from an R star concept. And then as you also know it, Jay Powell at the most recent Fed press conference also just pointed us to the Fed's forecast, the monetary policy outlook and said that's actually a better way to get a sense of where the policy is stimulative or not and what the direction of it is.
David Beckworth: Yeah, this is all very interesting. I really do think Jay Powell's approach is a very pragmatic one. I was giving a cynical take but I do think everything I've seen of Jay Powell, he's very pragmatic, let's kind of keep an open mind, being very data dependent. But as you know, John Williams’ kind of conversion experience, from shining brightly to a fuzzy blur for the R star is really striking as you note and it will be interesting to see what has changed his thinking on that.
Michael Derby: I don't have any special insights. I think at this point it's more for people on your side to offer analysis and get a sense of why that might have happened. And like I say, I hope at some point we're going to get to ask him directly how in a relatively few short months, he went from there to where he is now. So, we'll find out. We're not done with that question yet.
David Beckworth: And to be clear, I still think R star is still going to be implicit in all the FOMC's models and it's in the background, I don't think it's completely gone away.
Michael Derby: Well, they still offer a long run Fed Funds forecast. So somehow it's in there, right?
David Beckworth: Absolutely.
Michael Derby: Yeah. While they won't describe policy as accommodative anymore, we can still look at what they think the long run Fed Funds rate is and we can see what their projections and we can still come up, like they might not describe it a certain way but we can look at it on our own and describe it based on how they're portraying it in those forecasts.
David Beckworth: I tell you what would be really interesting is if they completely remove the summary of economic projections where they have that information. Then you'd know they're really pulling back, they really want to create ambiguity.
David Beckworth: I want to move to a piece you wrote recently titled “Watch Out, There's a Fedspeak Storm Coming. Will Markets be Able to Find Direction in the Wave of Fed Chatter?” This has always been an interesting issue for me because there's always, well not always, but there's been a lot of speeches, a lot more discussion going on. But could you speak to this article and what was the point you were trying to make?
Michael Derby: Well, we go through periods where they don't talk very much at all. It's not always because of say FOMC blackout. We just go through periods where there's just, say in the summertime, things settle down and people just aren't speaking very much. Periodically, you get, I mean, just so many speeches. On the press side, it becomes very logistically challenging to cover all of them. They're not all on monetary policy. Like, for example, we've had a whole bunch of speeches today, it's Wednesday. A bunch of them are actually on banking related things, but you get these absolute surges of speeches.
Michael Derby: On one hand, it's great for transparency because you are hearing, they are out there accessible, they're talking to people, they're telling people what they think. But, it's a lot, it's a lot for people to take in. Especially in today's climate, where there's a lot of other stuff especially going on the political front, it's hard to know if it's all getting heard. In that article that you refer to, there was a, I guess it was about two years ago, a Dallas Fed research paper that talked about Fedspeak and the amount of Fedspeak that was out there. Its basic thesis was that, yeah, there can be way too much and it can muddy the message. If the Fed does have a coherent thing that they're trying to explain to markets, sometimes if you have too many people out there talking, markets aren't going to get it.
David Beckworth: Yeah. So there might be a situation where you have more noise than signal. And interestingly, just I guess this week, we learned that Jay Powell will start doing press conferences after every FOMC meeting starting in 2019. So, that's going to add to the potential sources of signal but it could also mean more noise.
Michael Derby: Well, don't you think that's actually probably even more almost a tactical thing because they've been kind of lumped into this thing for so long now in the tightening cycle where there's the expectation they can only change monetary policy at the meetings with press conferences. If you want to have a more nimble FOMC that's flexible in terms of what it can do with interest rates, at least if you have a press conference after every meeting, Jim Bullard made this argument a whole bunch of times that you actually gave yourself a lot more flexibility, you make every fed meeting eligible for something to happen if you have a press conference. I mean, just given the way markets had come to view FOMC, the quarterly meetings with press conferences. You tell me what you think about that.
David Beckworth: I think that's probably right. That's fair. But it's the question of it's more and more information. But you're right, it makes every meeting live. So anything could happen at the next meeting. It's not preordained. You're right, maybe they're boxed into a corner, they had to do it.
Michael Derby: Yeah, and I suppose another thing about Jay Powell also, on the signal to noise thing, it seems one interpretation of his career so far as that he actually is, because he's not a trained economist, he has taken a more plain spoken approach to describing policy. So, maybe he won't fall victim to boosting the noise ratio by doing it after every FOMC meeting because he's already speaking in a pretty easy to interpret and pretty easy to understand way. In that, he might be talking more, it's not necessarily going to muddy the waters too much. I don't know, that might be one way to look at it.
David Beckworth: That's true. I actually have found it refreshing, very kind of down to earth, folksy kind of your communication style. I know he mentioned that he's going to wear out the carpet on Capitol Hill, visiting, communicating, making sure things are clear to all of his constituents. He definitely is a different type of Fed chair that's for sure.
Michael Derby: I agree, yeah. We've gone from Alan Greenspan where the syntax was tortured and that old, if you think you understood what I was saying, it's been a long time, I can't remember the exact quote. But it was, you know, if you think I understood what I said, then you weren't paying close enough attention. I mean, we've gone from like a level of deliberate obfuscation to just very plain spoken where a bond trader or small business person can hear the Fed chair speak and take away a message. It's not all laden in economic jargon. It's a pretty straightforward message.
David Beckworth: Yeah, you're right. I think it's been an evolution too. I think with Bernanke and Yellen, it's been a constant improvement in communication, kind of a projection that has been put in motion and he's kind of a natural next step for the FOMC as a Fed chair.
Michael Derby: Yeah.
David Beckworth: Yeah. Well, what about this other fun topic that's been in the news. It's kind of died down maybe in the last few weeks but past few months has been pretty, I think very topical, and that is the potential inversion of the Treasury yield curve. What's going on there?
Michael Derby: Well, over the course of this year, the difference, the spread, the difference between the two and 10 year note has been growing ever closer. I think last time I checked, it was around 20, 25 basis points, which is pretty close. It's the kind of thing where one or more interest rate rises could potentially, given the way, the long end of the curve has been fairly steady and the front end of the curve has being pushed up by rate rises. So a couple more rate rises if the back end doesn't move, you could have an inversion. And you could very credibly say that the inversion was caused by the Federal Reserve. And then the problem is that almost every recession in a very long time has been preceded by an inversion of the yield curve.
Michael Derby: And so you have all these Fed officials who are absolutely on board with saying it's a meaningful indicator. But you also have a lot of them who were arguing this time is different. There's a lot of other factors happening out there and all the central bank stimulus efforts that have happened over the years of depressed long term yields. So the back end of the curve is distorted. So the yield curve doesn't necessarily mean what it's supposed to or what it historically means. So maybe an inversion doesn't mean the same thing.
Michael Derby: Then there was some interesting research from the San Francisco Fed that says the two to 10 spread is not necessarily the one you want to look at. I think it's the three month T-bill to 10 year note spread is actually a far more reliable predictor of recessions. And if you look at it that way, John Williams even noted that there's still a lot of headroom there for the Fed to act. So, yeah, you have a very interesting situation where, again we talking about Jim Bullard but he pointed out that, in the early 2000s, I guess the 2001 recession and then in Great Recession, in both cases there were inversions that Fed leaders, they said no, this isn't what it means. Bernanke in 2006 brushed off a recession for, oh, it's for other reasons, it doesn't mean what we think it means.
Michael Derby: And so, it's going to be a really interesting test of a lot of things. I mean, if the curve does invert, you'd have to believe just based on history there's a good chance of a recession but it doesn't seem like the Fed is all that worried about it. It's not a universal view because you have people like Raphael Bostic in Atlanta who's FOMC voter right now and he said he wouldn't support a rate rise that knowingly inverted the curve. But New York's John Williams talked to us in Buffalo, New York after a speech early in September and he kind of brushed it off and said, you know, an inversion in and of itself wouldn't be enough to necessarily change his monetary policy outlook.
Michael Derby: This time is different. We're going to get a test to that potentially.
David Beckworth: Yeah, and to be fair to these Fed officials who right now seem less concerned, it hasn't inverted yet, it's flattening. But the real test will be when we actually get to a completely flattened and we're on the cusp of an inversion, what do they do then. And maybe they'll change their tune at that point. I hate to keep coming back to John Williams and mentioning him. It's interesting, right? He's the one who's kind of turned on R Star and now he's turning on the yield curve inversion, which is interesting, you mentioned that San Francisco study. So his own staff put out this study that said, look, this is important. Every time it's done a great job projecting recession, it's something you got to take seriously. His former staff-
Michael Derby: But they did present it in a way that's different than the way we often, because we usually talk about twos to 10s and they were like no, you need to look at three months to 10 years. And if you do that spread, you actually find a much more benign situation because there's I think a percentage point or something like that. So that actually helps John Williams' position.
David Beckworth: There's more room to give. We have a longer way to think before invert. But what he told you there in Buffalo I guess is what's interesting is that he dismissed the outright inversion. He didn't talk about there still being room to go. Correct me if I'm wrong. He said he wouldn't be worried about an outright inversion. Is that right?
Michael Derby: If in the context of everything else looks pretty good and inversion in and of itself was not necessarily, you know, stop the presses, everything's changed. Yeah.
David Beckworth: I guess that's what's surprising. He will make that statement in light of what his own researchers said. But again, I think it's easy to say that now when we're not quite at an inversion. When we get there, they may be saying different things. The other individual of course who had something interesting to say on that was Governor Lael Brainard. She had a speech where she said, look, there's a difference between a short run neutral rate and a long run neutral rate. If the short one goes above a long run, we got to follow it, which then apply, hey, maybe we need to do an inversion. And now that also is pretty interesting coming from Fed officials.
Michael Derby: Yeah, and another pretty strong dove turning hawkish.
David Beckworth: Yeah. Now again, it does seem on many fronts like we were talking, the economy is doing really, really well. I don't see the excesses that we saw in 2006. In 2006, I remember that Bernanke his speech well. It's different this time, it's all in the term premium and that's what many of them are saying today. There's things that have emerged, demand for treasuries are still high. So it's in the term premium. It has nothing to do with the expected short rate portion of the long term Treasury. That I think is an easier sell to make today but I wouldn't want to be the one to test it. That's the takeaway from 2006, right?
Michael Derby: Well again, it's like this time is different arguments, those are challenging arguments to make because you could be very, very wrong if you are in fact wrong.
David Beckworth: Right. Because those words will come back to haunt you just like, you mentioned Bernanke's speech. It's often invoked to say, look, even the wise men like Ben Bernanke can get it wrong.
Michael Derby: He spoke to reporters recently and he gave the same message. He kind of downplayed it as well for a lot of the same reasons that you just laid out and for the reasons the other Fed officials have downplayed it.
David Beckworth: Yeah, so we just had on the show the president of the Dallas Fed, Robert Kaplan, and he made this great observation that he's not so worried about it flattening, although he'd be very mindful. He doesn't want to explicitly invert it otherwise. But he does worry that once you do invert it, you can begin to adversely affect financial intermediation, it can directly be a strain. And he's someone from Wall Street. He's seen it first-hand.
Michael Derby: Yeah, I was going to say, he's a guy you want to listen to on that because I mean, when people lament too many academics at the Fed, I mean, he's the exact opposite. I know he was at Harvard for quite a while. He was a market operator, he knows these things.
David Beckworth: Yup, absolutely. All right, let's move on now to the Fed's operating framework. Right now the Fed is using what we call a floor system and it entails the Fed maintaining a large balance sheet which actually is slowly shrinking. But long as the Fed's balance sheet is fairly large, it supports a floor system. But there's been some issues in the past few months, and you wrote an article recently on this. The article was Derby's Take, your last Derby's Take, the Fed rate range settings could see more tweaks. So tell us about that. What's going on?
Michael Derby: So back in June, so we have a, we have the Fed Fund Rate target range. And right now that's two to two and a quarter. And so the top end of that range had been defined by the interest on excess reserves rate, the rate that they paid, deposit taking, banks to place money on the Fed's books. And the floor was set by the reverse repo rate, which did the same thing but with money market funds.
Michael Derby: They were having a problem where the Fed Fund's Rate was supposed to float somewhere in the middle, but it seemed like it was persistently grinding up towards the top end of the range. So in June, they lowered the interest on, when they raised, it's hard to say it, when they raised rates they didn't raise interest on excess reserves rate as much as they normally would have. So it's now set five basis points below.
Michael Derby: I'm seeing a number of analysts reports that suggest that by the end of the year, the Fed is probably going to have to lower that spread for the Fed Funds over the interest on excess reserves rate to the top end of the Fed Funds range. They're going to have to lower it again. And I'm seeing it's been attributed to like strong treasury bill issue and some, I wish I understood the mechanics a little bit better. But apparently, because all the deficit spending that's going on right now, there's a lot of Treasury supply out there especially at the front end of the market and that's putting a lot of pressure in short term markets. So, that's forcing the Fed to do these technical tweaks. They're so technical, I personally find it hard to clearly talk them out and have them make sense. Maybe you could tell me if you think, do you think these kind of technical tweaks are meaningful to monetary policy or are they really just technical things to keep things in line, to defend this range?
David Beckworth: I think it's almost symbolic to be honest with you, because I'm not sure what is truly binding the upper bound. It's supposed to be the interest on excess reserves. So when they lower it five basis points, my question is then what's truly binding that upper bound. There have been these developments. You're absolutely right. The issuance of treasury bills has shot up and it's because of President Trump's large fiscal deficits. They've been funded to a large degree by treasury bill so you increase the supply of treasuries, that lowers their price, it increases the interest rate on treasury bills, which then spreads into the repo market through arbitrage which then affects interbank rates.
David Beckworth: So, fiscal policies effectively forcing the Fed's hand here, that's the short story. The question that I have though and I wonder is could fiscal policy really forced the Fed's hand and push it off the floor system. I don't know the answer to that. So in other words, if they continue to issue more and more debt and these repo rates continue to go up, the Fed either has to raise its target rate or it allow market rates to go above it. And in that case, it pushes the Fed back into a corridor system.
David Beckworth: That's something they said they want to talk about and that's something I'd like to ask you since you talk to these folks with your writing. Is there any sense you get of where they want to go because Fed chair Jay Powell did say we're going to have a conversation on the future of the operating system, the size of the balance sheet. Do you get a sense, are they more kind of a status quo bias to stick with the floor system unless otherwise motivated or are they truly open to considering a corridor system again?
Michael Derby: You know, it was interesting, this floor system as I understood was supposed to have been like a post crisis thing that would eventually they hoped to get back to their pre-crisis framework. That was what they had hoped. But, they've yet to make any formal declarations about what the policy regime is going to be. But they seem to becoming much more comfortable and operating in with large reserves in the system, they see there's benefits to keeping large amounts of reserves in the system. But if you keep a large amount of reserves in the system you can't go back to the old Fed Funds or just targeting the Fed Fund's Rate.
Michael Derby: So, it seems everything that they're saying, although they have not explicitly said it yet as a formal declaration. I got to believe that they're going to stick with this system. They talk about it working well. It just seems like it satisfies what they needed to do. The first shift, I can't remember exactly when was, the now retired Fed chair President William Dudley had after a speech talked about it. I was so caught off guard that he started saying, you know, basically I think this is actually what we're going to do. This is working, I think we're going to stick with it.
Michael Derby: And so, I get the sense from what they have said so far and again, they have not made a formal declaration on it but that they're probably going to keep this system. They still got a lot of questions about the balance sheet and how far it has to shrink. But yeah, I think that the floor system is going to hang around. I mean, that's going to cause some other interesting issues because the higher interest rates go, the more their profits they have to pay out in interest to banks, and so that could create some political problems. That's been talked about from time to time from some Republican Congress people. That could potentially be an even bigger problem down the road but we're not there yet. And again, it just seems like they are leaning pretty strongly to keeping the floor system.
David Beckworth: And that's my sense as well. I think it's human nature to kind of have a status quo bias. If it's working well enough, don't rock the boat, let's just keep it going the way it is. But there is as you mentioned the political economy question, the bad optics perspective of paying banks more and more, even if it's just more of an optical concern than a substance of one.
Michael Derby: Well, it is deficit implication, right? It's not a huge contribution but the Fed profits, they go back to the Treasury. They always talk about, helps with deficit reduction and so you could conceivably end up with a situation where they're paying a pretty small amount of money back to the Treasury. And so, that could create some issues for them, especially if it's perceived to be a subsidy to the bank. So that was retired Charlie Plosser from the Philadelphia Fed. He used to talk about that a lot. He really thought that, like as you mentioned, the optics were bad and were going to get worse.
David Beckworth: Yeah, and I think that could be a big issue down the road is the optics might get painful enough for them to think about it. But I guess what I find disappointing is the following, is that they're not really thinking about which operating system they would like best based on theory or based on research, based on what you know costs and benefits of a floor system versus costs and benefits of a corridor. What they're doing is they're saying, okay, we have a large balance sheet, we're slowly unwinding, we've been pretty good in signaling, it's not been disruptive. And then they say, well, what operating system is consistent with the balance sheet we have. Well right now is the floor system.
David Beckworth: And so, what I see them doing is they're going from balance sheet to which operating system works best as opposed to saying, okay, what operating system do we want and then let's adjust the balance sheet to fit it. It's a pragmatic approach. We have a big balance sheet. Let's figure out what's easy. But that's not the right way to do things. You should think through long and hard what is the best system period and then get your balance sheet. That's my take anyhow, I wish they would take that approach.
Michael Derby: Do you get the sense, you've seen speeches from John Williams at New York and also from Eric Rosengren in Boston talking about the Fed needing to create like kind of a better mechanism to formally review monetary policy like in all of its aspects. Maybe if they could get to a place where they could have a more formal unless, a more formal process to review all these questions as opposed to the ad hoc system they have now, maybe they would have a better structure to decide these sorts of things.
David Beckworth: I would love to see that, I just haven't seen it. Go ahead.
Michael Derby: It's the Fed, it's the Fed, it takes forever for, you know, it takes them forever to do anything.
David Beckworth: That's fair.
Michael Derby: All deliberations. Even the most small things, obviously, a lot of things happen quickly in the financial crisis but everything else takes forever to for them to come to a consensus on. So, give them time.
David Beckworth: Yeah. They are a big bureaucracy and like any big bureaucracy slow to change. That's understandable. Along those lines, talking about having a review, a broad review of how you do things at the Fed, you're right, John Williams has mentioned this. I remember in fact, we were both at a meeting at the Hoover Institution at Stanford back in early 2016 and John Williams was there. He mentioned this, he said, hey, I think we need to do like the Bank of Canada does, every five years or so many years, we just sit down and we reevaluate how we do things, everything from the operating system to their target. And that's why I want to kind of switch gears to is the target, the operating framework. Because Fed chair, Jay Powell, has said, look, we are going to talk about the operating system but we're also going to talk about our monetary regime, what we're doing.
David Beckworth: I wonder if you've got any sense if there's like a timetable and if there's really any genuine interest in discussing, do we go to a price level target, do we go to an inflation target with a range around it? Do we do, even my favorite a nominal GDP level target. Any energy there?
Michael Derby: I've always felt like a lot of that energy came from John Williams. He is now in a, I guess New York Fed first among equals. He's got a very different perch to argue these things from. And so, I don't know, well actually, the most recent Charlie Evan speech, … actually a lot of that speech was talking about laying out different framework and he didn't like endorse anything. It definitely seems they are thinking about it but these are some pretty big fundamental things. As we go back to it takes a long time for them to decide anything, it's going to take a, even though some of these things have been talked about for years as potentials, I don't know if there's any greater momentum. I just know they continue to talk about it and one of the guys who's talked about it a lot has now got a better perch to talk about it if he wants to so. But as in terms of like actual momentum, I don't know yet.
David Beckworth: Yeah, that's a good point. He is at the New York Fed. And to put this in perspective, this isn't in the transcripts, but we know that the Fed talked about a nominal GDP level target back in 2011. They actually talked about it, but the Fed was like, you know, it's kind of hard to switch horses midstream. We're still recovering from the crisis. And understandably they didn't do it back then. So it will be interesting to see if they're able to generate momentum, do they even have a conversation. And then secondly, to make some tweaks or major changes if possible.
Michael Derby: There's a lot of talking going on about different ways the Fed could conduct monetary policy. A lot of prominent voices are involved in it but there hasn't been really any anything to show substantive move on this. So I don't think we're any closer to having something like this happen. Maybe from the Fed's point of view, they will want to do something because it would be nice to make these decisions about how you want to conduct policy in benign economic circumstances rather than like in the middle of the crisis and having to make policy on the fly and do huge wholesale changes in your regime.
Michael Derby: There is a broad awareness that because short term interest rates are not likely to go up as much as they would have gone up historically, they seem to all be on board with the idea that coming back to near zero rates is a pretty strong likelihood. We're pretty far down the road in the business cycle. We were talking about yield curve issues. It's not implausible, something could happen. It would be a good time for them to think about this now rather than wait for too much longer. But at the same time, nothing to concrete about new thinking.
David Beckworth: Right, right. And what you were saying in other words is that I have my work cut out for me because part of what I do is this podcast, but I also do research trying to convince them. So, here's looking at you Jay Powell and John Williams and others at the Fed. I will keep pounding the drums, putting out research to hopefully keep you guys on target.
Michael Derby: Exactly.
David Beckworth: Let's move on to another interesting story that's related to all of this. And this is the interesting tale of James McAndrews and the narrow bank. Why don't you walk our listeners through it.
Michael Derby: So there is a officially albeit temporarily chartered Connecticut bank that was started by the ex New York Fed Research Director, James McAndrews. What this bank seeks to do is to, they seek to offer bank accounts to institutional customers. What they will since they are an officially, they are an official bank in the eyes of Connecticut, they plan to take that money, park at the Fed, earn the interest on excess reserves rate and then pay a return back less profits and operating expenses to their customers. The customers that would want to invest in something like this would then get a higher rate than would say the floor rate. It's not a big deal but it's a way for a lot of people to earn slightly more money on very liquid bank accounts.
Michael Derby: That's the sort of basic business model but it has a lot of implications if it were to be approved. Now, the reason why TNB is suing the New York Fed is because they have thus far not been approved. And usually it's a pretty fast quick process, but that has not happened. They have a lawsuit that details a lot of reasons why. They go through all of this, but we have not heard yet back from the Fed. The Fed has not responded to, they're actually suing the Federal Reserve Bank of New York, but the Federal Reserve Bank of New York has not responded, the board has not commented.
Michael Derby: We have the lawsuit's characterization of how the Fed's responded but we haven't actually heard from the Fed itself about how they view this. But right now, it's a lawsuit. Some scholars of these things have said that just on the merits alone that they're surprised the Fed is denying the application because it is for whatever you think of the model, it's a proper bank and it should be allowed to do what it's, it should be allowed to get this account at the Fed to do this.
David Beckworth: I don't know if you reported this or someone else did, but my understanding is the decision to deny them an account at the Federal Reserve Bank came straight from the desk of Jay Powell? Is that right?
Michael Derby: The lawsuit says that Bill Dudley when he was the president of the New York Fed and Janet Yellen when she was the chair of the Fed had nodded favorably in terms of the application but that when Jay Powell came in earlier this year, he's the one who slowed things down. That's what the lawsuit says.
David Beckworth: Okay. And the big implications would be that if this bank does get access and is a part of it, what it's doing is it's opening the Fed's balance sheet to more and more firms. I guess one of the fears at the Fed would be that it's beginning to crack in its armor where in limit, you'd have everyone having access to the Fed's balance sheet.
Michael Derby: Exactly. Any of the banks or type of financial firms that would get the lower end of the range, the overnight reverse repo rate would no longer have to bother with that. If other banks copied the TNB model, nobody would have to go to the overnight reverse repo facility or they wouldn't have to take that lower rate. They could get the interest on excess reserves rate, and in theory that could punch a hole in the whole floor system and complicate the Fed's interest rate mechanism.
Michael Derby: Although, we should also note, right now, it seems the evidence suggests that the reverse repo rate does put a floor underneath the rates, it's got very low, very few firms are actually using it and pretty much the entire year. I mean bar activity has been fairly negligible.
Michael Derby: So there's a lot this lawsuit could lead to very big things or it might not really be much of anything at all and a lot of people have commented the way short term interest rates are right now, that currently the business model might not even work for TNB. There's a lot of balls up in the air with this thing.
David Beckworth: And just to elaborate on that last point you made. The model may not work now because what we talked about earlier, all this issuance of treasury bills has pushed up overnight repo rates really, really high so that spread between interest on excess reserves and other short term rates has really narrowed which means that profit margin has narrowed. You talked to James, didn't you for this article? Did you interview him?
Michael Derby: He's quoted in the, yes.
David Beckworth: So, was he at all concerned about the narrowing of the spreads?
Michael Derby: It's tricky but that's not their issue right now. Their primary issue right now is that they feel that they are legally obligated to have this access to the Fed system and it's being turned down. That's the fight that they're having right now.
David Beckworth: Okay. I would love to get his take to see if this endeavor is even worth it if the spreads continue to compress to the point where you lose the whole profit motive. A very interesting story, one that I think it's important beyond what happens to the narrow bank business itself because, again, it opens up maybe a Pandora's box for the Fed in terms of making its balance sheet more and more accessible. I've had Morgan Ricks on the podcast and he has a proposal called Fed Accounts for Everyone. It's Morgan Ricks and several other authors. This would be a step in that direction. I know it makes Fed officials nervous and policymakers nervous because it would kind of a wholesale change in how banking is done. So that might be a concern.
Michael Derby: Yeah, I know some advocates of these Fed account, like a Fed account for everybody have talked about, everybody could bank at the Fed and everybody could get, instead of putting your money in a normal bank account and getting, I mean, whatever I'm getting on my checking account right now is basically, it doesn't count. It's nothing. But you could bank directly at the Fed and get something close to the rate that they're paying to financial market participants. One benefit of a system like that would be that monetary policy starts to bypass finicky financial markets and go straight to the people and perhaps monetary policy could be even more potent if the Fed could actually change, bring interest rate changes down to the, I don't know if the retail level is the right word, but actually down to the level of the people. And monetary policy could be more potent but it would also have the implications of potentially disintermediating the whole banking system and there are huge, huge implications.
David Beckworth: Yeah. Well, let me ask in the minutes have left about President Trump's appointments to the Board of Governors. He's had fairly conventional appointments made to the Board of Governors. Most recently, it's been Nellie Liang and he's also appointed Richard Clarida and some others to the Board of Governors. So, have those appointments been surprising to you?
Michael Derby: I think coming in there was a lot of speculation it could go other directions, people could maybe be brought that were far from the current orthodoxy of central banking. And in practice, it has just not been that way so you've actually got a Fed that's full of folks that are pretty well acquainted with how things are done and there's not any broad disagreements. And perhaps more importantly, their views are consistent with the recent history of how the Federal Reserve thinks about these things. It burnishes the status quo. It might put the fed on more of a collision course with President Trump because he's been outspoken about not liking rate rises. But by putting these people in the Fed, these very consensus minded folks, it might be a situation where President Trump can talk and complain but he's staffed the Fed up in a way that they're pretty well insulated from any criticism that he has of them.
David Beckworth: Yeah, it's been very interesting to see and surprising initially, now we've gotten used to, at least I have. He seems pretty standard. In other words, people he's appointed to the Board of Governors would be individuals that a President Romney would have been appointed in a different timeline. One person, go ahead.
Michael Derby: I was going to say like gold bugs, no like out there type of people. It's all been pretty conventional folks.
David Beckworth: Yeah, absolutely. One individual has been appointed and we've talked about him before on the show and we've wondered about him is Marvin Goodfriend. He has been appointed. He's been stuck in limbo. I know he didn't do great on his hearing before the Senate. I'm wondering if you've heard anything else about him or is he just stuck in kind of a purgatory for now?
Michael Derby: We have people down, I'm based in New York we've got people who cover Congress and are very close to that. So, I don't know anything more than you know. To the best of my understanding, it's just stalled and there's no movement one way or the other on it.
David Beckworth: Okay. Now if was stalled, is this something that like Marvin would have to withdraw himself or would president say, hey, hit the road, Jack?
Michael Derby: I'm going to say, I actually don't know the answer to that. I maybe could go back to some of the stuff that happened with other failed governors that just weren't clearly going to get through. But I honestly don't have an answer for you on that one.
David Beckworth: Okay, fair enough. Well, I believe our time is up. Our guest today has been Mike Derby. Mike, thanks so much for coming on the show.
Michael Derby: I really appreciate it. Thank you very much for having me. It was a lot of fun.
David Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.
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