Megan Greene on the Future of CBDC and How Central Banks Should Respond to Climate Change

Megan Greene is a senior fellow at the Harvard Kennedy School of Government and was formerly the global chief economist at Manulife John Hancock Asset Management. Megan is also a returning guest to the podcast and rejoins David to talk about the prospects of central bank digital currency as well as how to conduct climate change policy from a central banking angle.

Read the full episode transcript:

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

David Beckworth: Megan, welcome back to the show.

Megan Greene: Yeah, thanks for having me.

Beckworth: Well, it's great to have you back on. And last time we were talking about the TLTROs, Eric Lonergan was also on the show with you. Great show, we'll provide links to it. Encourage our listeners to go back and check it out if they haven't already. But you are also working on a book I think last time we chatted, a book on inequality. So tell us about that, remind the listeners what they can expect from your book.

Greene: Yeah, that's right. I'm looking at income and wealth inequality mostly in developed countries, within countries. And I'm looking at all of the new drivers of income and wealth inequality that you wouldn't have learned about if you learned economics 30 years ago, for example. So I'm checking out all these macro and micro drivers and coming up with possible ways to address inequality for governments, for businesses, and also for central banks where they can get involved as well.

Beckworth: Okay. And what's the expected release date, do you have that?

Greene: I don't have an exact release date. I'm almost done researching everything, and I've written more than half.

Beckworth: Okay. Well, we're looking forward to that, and you will be back on the show for sure to discuss it. Very exciting. It's always a treat to get you on. And I must tell the listeners, Megan was very generous with her time. I asked her to come on, I wanted to talk about central bank digital currency. I wanted to talk about climate change in central banking, and Megan's a perfect individual. She's very knowledgeable and very willing to participate on the show with me on this. So Megan, let's start with central bank digital currency, CBDC for short. And you had a recent column in the Financial Times titled, *Central Banks Need to Go Slow on Digital Currencies.* So walk us through that, what's happening and why should they go slow?

*Central Banks Need to Go Slow on Digital Currencies.*

Greene: Yeah. I’ve ended up being sort of an apologist, an apologist for the Fed’s foot dragging on central bank digital currency whereas most people are actually really criticizing the Fed and saying they're missing the boat. And so I'd say the consensus view is that we desperately need a central bank digital currency to address all of these different issues. And part of my argument is that there are so many different issues we're trying to address with one thing. It's not clear that this one thing is actually the best tool to use or that it will achieve what we're trying to achieve with it. I think some of the urgency for central bank digital currency really comes out of, first of all, Facebook's Libra announcement, scared the bejesus out of central banks. That's a technical term, the bejesus.

I'd say the consensus view is that we desperately need a central bank digital currency to address all of these different issues. And part of my argument is that there are so many different issues we're trying to address with one thing. It's not clear that this one thing is actually the best tool to use or that it will achieve what we're trying to achieve with it.

Greene: And then a whole host of other cryptocurrencies have really risen, we've seen it particularly during this pandemic. They've risen in volume and in value. And I think that central banks are a little bit worried that all of the traditional functions of banks, which central banks supervise will move into the private sectors. So central banks won't actually have any influence on those things like lending and deposits or credit extension. And so central banks are keen to set something up so that they don't lose control of that. I think also China is seven years on in its exploration of issuing a central bank digital currency, it's running pilot programs. And so I think there's some concern that we might lose out to China. China is a first mover. Though I should say that a few central bank digital currencies have been issued amongst really small countries in the Caribbean. But among big economies, China's a first mover.

Greene: And so there's some talk about how we could lose the US dollar as the global reserve currency if China succeeds with this. I'm not actually worried about that, I think network effects mean that we'll maintain king dollar for quite a while. So those are some of the motivations. And then also I think there is a real sense, and it's a valid one that our payment system is just not that great. It's pretty slow, particularly cross border payments, it's really expensive. And there are also concerns that not everyone has bank accounts. And so maybe a central bank digital currency could be a way of being more inclusive. So this is a veritable laundry list of things that we're trying to address with one tool and one tool only. And I think it's worth considering whether it's actually the best one. And while functionally a central bank digital currency is meant to make payments systems and services cheaper and better for more people, it might actually achieve the opposite of that if we don't design it very carefully.

Beckworth: Yeah, that's interesting. You answered my question, why are they pursuing it now? You gave this laundry list. And one way of asking this question would be, are they responding to some public demand for it? And what I'm hearing you say is it's more of a supply side driven thing, they're trying to get ahead of the game, responding to all these potential requests. Is that fair?

Greene: Yeah, I think that's fair. And I think there's been very little done on actually selling this to regular people. And I think for Joe six pack, the difference between a central bank digital currency and a regular currency that you can move around digitally is not actually that clear because from their end the effect is kind of the same. So I don't think this is a demand driven process at all, I think it's central banks trying to address a bunch of things.

I don't think this is a demand driven process at all, I think it's central banks trying to address a bunch of things.

Beckworth: Yeah. So they want to stay ahead of the game, they want to get out there before Facebook does, they're responding to pressures from China. There's advocates calling for citizens and businesses having access to the Fed’s balance sheet. So along those lines, you mentioned in your article there's different types of central bank digital currency. There's a token based, and then there's the Fed account type based. So walk us through that. And where would you come down if you had the magic wand to determine which form of CBDC there is? How would you design it? How would you choose it?

Designing An Ideal Form of CBDC

Greene: Yeah. So there are a couple of questions that we need to ask when designing a CBDC. One is whether it's just for businesses or if it's also for just regular people, so retail CBDC. And I think the general consensus is it should be for everyone. Particularly insofar as inclusiveness is the goal, then making it retail makes sense. Then there's a question about who holds the accounts really? So will people just have accounts directly at the central bank? Will I have a deposit account for CBDCs at the Fed, for example. In which case banks don't really have a role to play anymore and the intermediation that they always have. And after the global financial crisis, banks got a really bad rap. And so some people have said, "Well, that's perfect, we don't really want banks to be so powerful."

Greene: But actually there are all kinds of knock-on effects I think from basically decimating the banking sector. And if you want to do this practically, then the central bank has to pick up a whole bunch of different areas of expertise that they've never been involved in before. So they have to do all kinds of credit risk analysis. They have to get whole teams to deal in know-your-customer legislation, anti-money laundering mechanisms. So is the Fed really going to hire up all these people so that they can provide the operations on these accounts? I think that's pretty unlikely. And so more likely I think you'll end up having accounts held at regular commercial banks, but obviously it's the central bank that's providing the funds for them. And so that sort of an indirect model.

Greene: And then you can draw on the operational expertise of regular banks to manage these accounts. That has some problems too, though. So I think it's the better option, but you have to assume that if you can actually get direct central bank money, some people are going to want to do that more than having cash from a bank because banks can fail at the end of the day whereas the central bank can't really. So a CBDC is going to be fundamentally safer than your regular cash in a commercial bank. Some of the regular deposits of commercial banks are going to flee into the CBDC, into these other accounts that the banks will be managing. But that kills off commercial banks' business models because what they do is take their very stable in normal time depositor base, and they leverage it and extend loans into the real economy.

And if you want to do this practically, then the central bank has to pick up a whole bunch of different areas of expertise that they've never been involved in before...you have to assume that if you can actually get direct central bank money, some people are going to want to do that more than having cash from a bank because banks can fail at the end of the day whereas the central bank can't really. So a CBDC is going to be fundamentally safer than your regular cash in a commercial bank.

Greene: So if their deposit base is smaller and not as stable, they won't be able to lend as much. So there is a question about who's going to provide all the lending in the economy. Could it be the central bank? Well, central banks really don't want to get involved in picking winners and losers under any circumstances. So that doesn't seem like a great option. You could also say, well, then the central bank can go ahead and take the deposits that left commercial bank accounts and went into CBDCs and lend them back to the bank. So that central bank becomes a lender of first resort instead of a lender of last resort, in which case the central bank is going to have to do all kinds of risk analysis to figure out which banks they should give how many deposits. Again, the central bank doesn't really have that expertise or really want to get involved in that business.

Greene: So this is a real challenge. And if banks can't rely on their traditional business model of taking deposits and lending them out to make money, they're going to have to make money elsewhere. And so while one of the points of setting up a CBDC is for cheaper services, banks might actually make up what they're losing because of CBDCs by charging more for accounts or charging more for these services. In which case, ironically, you could end up seeing people paying more for payment services than they already are, which is the opposite of what we're trying to achieve. So I think it makes sense to have banks administer these accounts, but there are some real challenges that we're not totally sure how to get around. Then there's another question about how you authenticate with CBDC.

Greene: So you can either authenticate the CBDC itself, so you can either make sure that cash is really cash. In which case transactions can be done totally anonymously like they can with cash right now. But that has challenges because of money laundering. One of the reasons money laundering is so difficult right now is they need cash to do it in a totally untraced format. And that means you got to carry around briefcases dashed with cash, and that's cumbersome and it's easy to get busted. But if it's all digital actually, that gets rid of that impediment. So understandably central banks aren't really keen on that option for authentication, in which case you could end up authenticating the account sort of like we do with bank accounts.

Greene: But then central bank has insight into everything going on in your account. And so while we know central banks are independent in most countries, not all, but in most Western countries, and they're not the same as the government. There are real concerns for a lot of people who don't understand that distinction that this quasi government agency can see everything that they're spending and everything that they're earning. And are they going to get busted on taxes, for example, if the government has total granular details on their accounts? So if one of the goals is to include people and encourage more people to hold these bank accounts, I think a lot of people will be put off by those privacy concerns.

Beckworth: Yeah. I think you're speaking to a bigger point here, and that's our Western values both in terms of privacy but also in terms of private enterprise, letting banks be businesses and do their business and to flourish. And the concern is where we're opening up a Pandora's box potentially if we have these CBDCs, all those areas may be affected. Another one, and Megan correct me if I'm wrong here, but another one that has concerned folks is innovation. So banks have a profit motive, they have the incentive to create new products, to innovate, to bring in the latest technology. Would the central bank have that same drive, that same incentive? Would they be able to innovate like a retail bank does?

There are real concerns for a lot of people who don't understand that distinction that this quasi government agency can see everything that they're spending and everything that they're earning... I think a lot of people will be put off by those privacy concerns.

Impacts on Innovation and Real-time Payments

Greene: Yeah, they probably wouldn't. Some might say that that's a feature and not the financial innovation that got us into trouble for the global financial crisis. So some might say, "Well, it's great if banks just become service providers and aren't innovating so much." But you're right, central banks wouldn't step in to fill that gap. It would be tech companies though that can step in and fill that innovation gap. In fact, they already are to some degree. And so some of the technology behind cryptocurrencies in particular, so things like distributive ledgers, that can really help out our payment systems. So we can harness some of that even now to improve payments, particularly payments within a country, cross border payments are much more complicated. But we don't actually need a central bank digital currency to do that. It seems like there are good alternatives to a central bank digital currency, in terms of achieving what we want to achieve with CBDCs. And so I think it's worth thinking about whether we actually need this to be what we want to or whether other things might work just as well.

Beckworth: Yeah. So you mentioned in your article stablecoins, it might be one example. But in general, FinTech, FinTech providing services. And again, one of the goals is to reach the unbanked, and maybe they can do that. I've had some guests on in the past who've made the case, allow FinTechs to have a Fed master account, allow them to have access to the Fed’s balance sheet and maybe impose regulations, rules unique for them. But long as people can park their funds there in a very place, relatively cheap, that might meet the very need that they're trying to accomplish with a central bank digital currency. But interesting to see what's going to happen here.

Greene: Yeah, it could. And if we don't ... I mean, one downside of not coming up with central bank digital currencies and not extending the central bank's balance sheet to FinTech firms is that you could end up getting the opposite of what you're trying to achieve with CBDCs, which is cheaper services for more people because of market concentration. Tech is one of the areas in which we've had the most market concentration over the past couple of decades. And so you get less competition then and you end up with monopsonies essentially. And so that could actually be worse for the consumer. Generating CBDCs is a way of at least avoiding that situation.

One downside of not coming up with central bank digital currencies and not extending the central bank's balance sheet to FinTech firms is that you could end up getting the opposite of what you're trying to achieve with CBDCs, which is cheaper services for more people because of market concentration.

Beckworth: Right. So it's complicated, there's no way around it. And there's going to be winners and losers no matter what path we go down. One other quick observation and we'll move on, but I know the Fed is also by law cannot be a loss operator, it has to actually break even. So if this path of central bank digital currency incurs new costs, they have to find a way to cover those costs. And I know for example in the discussion about the FedNow account, the real-time payment system the Fed’s developing, they've had to think about costs because by law they can't just provide this service for free at no cost to the public, it actually has to recoup it. So I'm just wondering if that same consideration is also playing in the back of their minds as they think about CBDCs.

Greene: I think it is, but I think the sense is that it will be so much cheaper to do this through central banks than it is currently through commercial banks that it shouldn't be so difficult to recoup those costs. But yeah, it's definitely a concern.

Beckworth: So Megan, are there any upsides for monetary policy aside from meeting consumer needs and stuff, any implications for monetary policy if we do go down the path of the CBDC?

CBDC’s Potential Implications for Monetary Policy

Greene: Definitely. And this is something that gets a lot less attention I think in debates about CBDCs. But if we actually had these digital currencies, it opens up a whole lot of routes for central banks to engage in things they can't right now, particularly things like getting around negative rates and helicopter money drops, so to speak. So if everybody has an account either directly with the central bank or with the central bank but through a commercial bank, then the central bank has the ability to deposit money into all those accounts in a downturn. So in some ways, I know this is terrifying for every central bank, but in some ways it gives them many more powerful tools to actually address a downturn. They can also levy different interest rates if they want to on these accounts.

If we actually had these digital currencies, it opens up a whole lot of routes for central banks to engage in things they can't right now, particularly things like getting around negative rates and helicopter money drops, so...in some ways it gives them many more powerful tools to actually address a downturn.

Greene: One of the problems of negative rates is we're all operating in cash, we all have deposits in regular banks. We have negative rates and our accounts are with the central bank, they can actually cut the deposit rates into negative territory so that depositors aren't actually penalized for those negative rates. That could be a pretty powerful tool in a downturn as well. So it does open up some real opportunities. This is something that Ken Rogoff actually at Harvard has been talking a lot about, but he's been talking about the potential for using negative rates and how it's difficult to do in the way that our system is set up now. But if we weren't using cash and if the central bank had access to all of our accounts, it would be much easier to implement and could be implemented in a bigger fashion. And so it'd be much more effective than it currently would be.

Beckworth: So it would be easier to implement because we would be holding, even if we had a token-based CBDC, it would be digital, so it wouldn't be physical cash with that constraint. Is that the argument?

Greene: And the central bank has direct access to it. So even if you think about stimulus checks that the Treasury Department mailed out to people or were deposited in some cases for people, there were a whole bunch of people they couldn't actually access because they just don't have their details. And it took a while for that money to get out. But if you wanted to do that in the future, the central bank could hit the button and has access to everybody's accounts. And so it could just make that happen instantaneously, so it'd be faster and more effective.

Beckworth: So one of the things that's nice about the US dollar in physical form is all the countries overseas that have failed states, it serves as a medium of exchange for them. So think back to Zimbabwe when they had the hyperinflation in 2008 around that time and the dollar became a de facto currency, they were just using dollars. Eventually the government said, "Okay, you can do it," they didn't fight back. I wonder if we go to pure digital currency, will there always be some physical cash somewhere or will, in the case of Zimbabwe, would they start using the digital dollar themselves? It's almost like people we provide a public good to the world through the physical cash that it gets exported overseas. Any thoughts on that?

Greene: So I think we'll still continue to use regular hard cash for a long time. Might it disappear at some point? Possibly. But whether you can easily just transfer money into different countries' digital currencies or not depends on your central bank setting up a corridor with another central bank, making sure that the exchange rates are the same within and outside that corridor. And there are over 200 currencies in the world, so that's over 200 bilateral agreements that need to be, A, agreed, and B, administered. And I think that's just unworkable realistically speaking. So in theory, you could get this incredible global system. In reality, I think that's going to be really difficult. So I'm much less optimistic about central bank digital currencies really helping with cross border payments or having massive knock-on effects globally anytime soon, certainly. But I think it's just too difficult to actually administer that many different bilateral agreements.

In theory, you could get this incredible global system. In reality, I think that's going to be really difficult. So I'm much less optimistic about central bank digital currencies really helping with cross border payments or having massive knock-on effects globally anytime soon, certainly.

Beckworth: Okay. Very interesting. Again, we'll provide a link to Megan's article in the Financial Times on central bank digital currency. Let's segue now into climate change for several reasons. The first one, and we'll come back to this later, is that Fed chair Jay Powell, he's up for renomination. Potentially, he may not get the renomination, maybe someone else will. But he's up for it, and progressives have been attacking him. First it was he's soft on the regulatory front, now it's on climate change. In fact, this seems to be the growing focus of their attacks, their criticisms of him. And we'll come back to that in a bit. But it's also I think timely to discuss climate change because there was a recent UN Intergovernmental Panel on Climate Change report that came out this year. And there's a conference coming up here in October for the countries to get together and discuss the findings of this report and what they will do, next steps they will take. So Megan, maybe walk us through some of these recent developments with the UN's report in the conference coming up.

Importance and Highlights of the UN IPCC’s Recent Climate Report

Greene: Yeah. So the UN's report was the first scientific reassessment of climate change since 2013, so it had been a while. And I think the findings were more pessimistic than most people had expected. So it was a real shock, in discussing it, the head of the UN said this was code red for mankind. I mean, that's a dramatic statement. But not given what they found. The whole goal of what was agreed in 2015 when the Paris climate agreement was struck was to keep temperatures from rising too fast. So the goal was to keep temperatures from rising over two degrees Celsius. And this report found that actually unless we change things really drastically immediately, temperatures will rise by at least 3% percent Celsius. And it seems like a small change, but the implications for biodiversity, for all of our ecological systems are pretty severe. This report came out in advance of COP26, which is meant to happen in Glasgow in November, the first half of November in person at the moment, we'll see.

Greene: And it's co-chaired by the UK and Italy. But world leaders are going to get together virtually or physically and discuss how we're going to address this issue that this report has brought up. Now, a lot of countries have come up with really ambitious targets for how much they're going to cut greenhouse gas emissions. Most countries have signed on to a net zero by 2050 pledge. So they won't be generating more greenhouse gases than they're actually absorbing in different ways by 2050. Some countries have been more ambitious than others. I think at the center of COP26 is going to be a bit of an argument between developed countries and emerging market countries because the emerging market countries rightly argue, "Look, it's the developed countries that have generated all of these greenhouse gas emissions, not us. And we're getting a lot of the floods and hurricanes as a result of them, so we want to be compensated in part for having to suffer all the negative effects of their development. But also we need money in order to not increase our greenhouse gas emissions ourselves."

Greene: So a lot of it will be about climate finance. The developed countries had agreed that they would transfer a hundred billion or not a strict transfer, loan or transfer a hundred billion a year to emerging market countries by last year. And they actually hadn't hit that target. So that will be the center of a lot of the debates. I have to say as someone who's involved in COP26 and talking to a lot of the actors, the focus seems to really be on everybody's targets and how they're going to hit them. And less so on hard hitting new ideas for how we can think differently about changing everybody's behavior so we can actually achieve this. I'm a bit disappointed going into it, but hopefully things can change.

Beckworth: So Megan, that's a great overview of what's happening. Maybe just remind our listeners what COP26, the acronym, stands for just in case they want to look it up themselves.

As someone who's involved in COP26 and talking to a lot of the actors, the focus seems to really be on everybody's targets and how they're going to hit them. And less so on hard hitting new ideas for how we can think differently about changing everybody's behavior so we can actually achieve this. I'm a bit disappointed going into it, but hopefully things can change.

Greene: Yeah. So it stands for Conference of the Parties, and 26 suggests how many we've had before. So it's when world leaders get together, and it's climate focused and managed by the UN. So it's a UN process.

Beckworth: So we'll see how that goes, and that's later this year as you mentioned. So we'll be in the news, we'll be following this. Let's take this though and going into the direction of central banking, which is what we talk a lot about on this show, and you yourself have done a lot of work on. And as I mentioned, the big thing right now related to this is the renomination of Jerome Powell as Fed chairman, whether he's green enough and the Fed’s green enough. So let's just step back and think about greening of central banks in general and the pattern that's emerged. Correct me if I'm wrong here, but I'm going to start back in 2017 when the foundation was set with the Network for the Greening of the Financial System, the NGFS. It's an organization of central banks. And 2017, it starts.

Beckworth: And then we've had a number of central banks who've joined them, the Fed most recently this year joined them. It was one of the last ones to join them. And I want to read to you a finding from a survey from the BIS, it took last year, 2020. And this is what it found in the survey. It was on this issue of the greening of central banking. And it found, “a large majority of respondents noted that they do not have an explicit mandate with regards to climate related financial risks. But indicated that such risks could potentially impact the safety and soundness of individual financial institutions and could pose potential financial stability concerns for the financial system. Accordingly, these respondents viewed as appropriate to act within their existing mandates to mitigate climate related financial risk.” So what do you think about that, are central banks overreaching here? Is it reasonable to find ways into the climate change process with the existing mandates they have? What are your thoughts?

Central Banking & Climate Change

Greene: Yeah. So my thinking on this has totally changed over the past I'd say year and a half. I actually wrote a column in the Financial Times that effectively argued that central banks have no business really getting involved in climate change beyond a real supervisory role. You can always get an audience with a central banker if you want to talk about risk, financial risk and climate change. That's easy for most central bankers to swallow. The question is whether monetary policy should really be addressing climate change. That's the much less popular vision. And I actually was against it because I thought central banks have a time horizon of two, three, maybe four years where they're forecasting. And the implications of climate change are much further out than that. And so it's really difficult for them to respond to something so far out given that time horizon. I'd say the climate related events of just this summer alone take that argument out at the knees.

The question is whether monetary policy should really be addressing climate change. That's the much less popular vision.

Greene: I mean, obviously climate change is a crisis right now not 10 years from now. And so I don't think that works. And also I think most central banks feel like it's not their job to do anything about climate change in part because they also feel like it's not their job to pick winners and losers. And traditionally, it wasn't in theory. But actually if you think about what central banks do, all they do is pick winners and losers. If they hike interest rates, they benefit savers and disadvantaged borrowers. If they cut interest rates, they do the opposite, right? So they're picking winners and losers even with their most basic tool, nevermind when they decide that they're going to buy up corporate debt or high-yield bonds. In which case when the central bank announces they're going to buy something, whoever holds that thing wins, there's a clear winner there.

Greene: And so I think now that actually central banks are already picking winners and losers. And if you believe like I do that they're never going to be able to stop, they might as well be thoughtful about it and address one of the biggest crises that we're facing. And by the way, they've done this before. So the Fed, for example, stepped in and basically funded the World War II effort because it was an existential threat. They picked real winners and real losers. And so if you think climate change is as existential a threat as a war, then you can argue easily, I think, that central banks should step in again in the face of this threat.

Beckworth: Okay. So let's talk about what the Fed has done. And maybe we can come back to this issue that you bring up about how central banks are actually doing this, how you can justify what they're doing. Let's talk about what the Fed’s doing, and if it makes sense to you as they pursue a climate change agenda. So they have established two committees. They have a supervision climate committee that looks at microprudential focus. And then they have a financial stability climate committee, which is a macroprudential focus. It was interesting to learn they have two separate committees working on this. And Governor Brainard has a speech from March 2021 this year, and I thought was useful in illustrating how these two committees work differently but can compliment each other. And she gives us an example. She says, “one example is property and casualty insurance, which enables financial firms to engage in financial contracts to hedge climate related risks, while reinsurance contracts and agreements among investors can shift risk across the global financial system. As I noted earlier, some level of risk is likely to remain. A lack of transparency across participants in the financial sector could cause climate related risks to build up in hidden pockets embedding vulnerabilities that could result in cascading losses in the event of large-scale adverse weather outcomes or shocks to asset valuations.” So is that the right way to think about why a central bank should be worried about climate change, it's a threat to financial stability, or should they be thinking broader or more narrowly?

If you think climate change is as existential a threat as a war, then you can argue easily, I think, that central banks should step in again in the face of this threat.

Climate Change’s Impact on Financial Stability and Central Bank Mandates

Greene: Yeah. So that's the way that central bankers can stomach it at the moment is to think about supervision and financial stability and risk. That's the way that central bankers worldwide can engage with this topic. I actually think that they should be thinking in larger terms just because if you think about weather related catastrophes that we've had this summer alone and how they impact local economies that can impact the national economy, the implications for growth and therefore inflation are significant. So I think there's a case to be made that climate change really threatens a central bank's core mandate, which is usually around inflation, and for the Fed is also around unemployment or full employment. I don't think it's just about stranded assets and disclosure, I think that's really important and that can help us address it. But I think central bankers should think about this as threatening their ability to actually achieve their mandates.

Beckworth: So that would include price stability. You think this could actually be snuck in through the price stability part of the mandate?

Greene: I think it could, and actually it has been. For the Bank of England and the ECB in a way, they've made climate change part of their official mandate because it's related to the other mandates that they have.

Beckworth: Well, maybe tell us a little bit more about them. And what exactly have they changed and what are they going to do to meet this change?

I think there's a case to be made that climate change really threatens a central bank's core mandate, which is usually around inflation, and for the Fed is also around unemployment or full employment. I don't think it's just about stranded assets and disclosure...But I think central bankers should think about this as threatening their ability to actually achieve their mandates.

Greene: Yeah. We still don't know. Both the Bank of England and the ECB have had their mandates tweaked to include climate change pretty recently, and so we don't actually know exactly what they'll do with that. But I will say that both the Bank of England and the ECB have done more than the Fed has when it comes to climate change. So the Bank of England has been a real front runner in terms of addressing climate change that was largely under Mark Carney's tutelage. And he's now of course the climate tzar at the UN, so this has always been a pet topic for his. And the Bank of England has been really intent on corporate disclosure of climate risks. So for now it's voluntary. And about a third of companies fully comply with guidelines that were set up for disclosure for climate risk, and almost half partially comply.

Greene: But by 2022, all publicly listed companies will have to disclose their climate risk. And by 2025, privately held companies and asset management firms, insurance companies will have to disclose it as well. And so this gets to what Lael Brainard was saying in that speech that if you have disclosure on these things, then everyone can assess the risks a bit better. And so the chances of having a surprise event that results in a ton of stranded assets, for example, are much lower. So the Bank of England is further along in that. The Bank of England has also run or announced that they'll run some stress tests based on climate change scenarios. We don't have the results of them yet, I think we'll get them next year. And actually the results are going to be pretty soft.

Greene: So in a normal stress test, you see what the results are for every bank and their capital requirements off the back of those results. This won't be like that, we'll get an aggregate level of results and there won't be capital requirements off the back of it. The ECB is not far behind the Bank of England, they're also looking into disclosures, and they've also run a stress test. We don't have the example of the results yet, we should get them. I think very soon actually, it was supposed to be by late summer. And again, there won't be immediate consequences for financial services, institutions in terms of capital requirements, but at least it's a step there. The Fed’s announced that they're starting to think seriously about maybe one day having stress tests involving climate change, just to give you a sense of how far behind the Fed is on this stuff. So they have some ground to cover, but actually it doesn't mean that the Fed will be behind forever.

Greene: The Fed has, as you mentioned, has taken a bunch of steps to try to delve into climate change from a supervision perspective, from a risk perspective. But they could take on board what other central banks have been trying and leap frog. So just because the Fed is a laggard now doesn't mean it always will have to be. I think one reason the Fed has been a laggard is because they're a little bit worried about mission creep really. I think particularly this Fed chairman who after Jackson Hole just over a year ago had angry tweets from the president about his remarks is sensitive to political influence and is sensitive about the central bank's independence. I think there are concerns about the central bank delving into things that aren't really its lane traditionally because what if you get a government in place one day who says, well, if you did that, now you can do this. If you funded or subsidized climate change, now you can subsidize a wall, for example. And I think that's a real concern.

Beckworth: Okay. Well, let's look at some of the ways central banks could do even more. Right now, we're discussing the case for central banks doing actions to help fight climate change. And I want to go over a list that was provided by the Network for Greening the Financial System, again the NGFS. They had a report in March this year. And they go through, and there's three areas where they say central banks could go to the next level, they could pick up their game. One is in credit operations, one is in collateral, and one is in asset purchases. I think you've touched on some of these. But with credit operations, the interest rates you charge would be tied to how green each entity was.

I think there are concerns about the central bank delving into things that aren't really its lane traditionally because what if you get a government in place one day who says, well, if you did that, now you can do this. If you funded or subsidized climate change, now you can subsidize a wall, for example. And I think that's a real concern.

Beckworth: But to tie this back into digital currency, maybe your digital currency return would be maybe tied to how green you were. Collateral, similar thing, the haircuts, the amount of assets you can use would be tied to how green they were. And then finally, asset purchases, outright large scale asset purchases. Maybe they start buying green corporate bonds or something along those lines. So those are all areas where central banks could be more aggressive pushing the front forward and getting there. Any thoughts on those three areas?

Three Areas of Central Bank Improvement on Climate Change

Greene: Yeah. Actually, we have some experience with some of these. I should have mentioned that the ECB does accept green bonds as collateral and also is buying up green bonds. More sovereign green bonds than corporate green bonds. But some national central banks, particularly the French central bank and also the ECB are including green bonds in their asset purchases. So it's a way of providing a bit of a carrot. And I think also you can provide a stick, that's not being done yet. But we could get there whereby if you have gray assets or brown assets depending on your classification, not green assets, then you take a bigger haircut or you have to pay a higher interest rate. And the opposite of that is something that I've been proposing, I think I might've proposed it on the last podcast that I did with you with targeted long-term refinancing operations that the ECB is implementing where you have deeply negative rates that banks can borrow at from the ECB if they use the money a certain way and right now.

Greene: It was if they extended new loans onto the real economy, now it's just if they maintain their loans in the real economy. But you could actually say you can have this really negative rate, you can collect this money if you lend that money on for-green investment. And if you think about where most of our biggest CO2 emissions come from, it's from our housing stock, commercial real estate as well, it's from transportation. We haven't been able to refurbish all of that in part because there hasn't been a financial incentive to. But this would be one way to generate a massive financial incentive. Banks get paid by the ECB to do this, the ECB lends on to the end user, to you to retrofit your house so that it's got better insulation. And you might get a negative rate as well, so you might get paid for it as well under this scheme. So the ECB has the plumbing already established, so does the Bank of England. The Fed does too, it just hasn't used it at all in this way. So it would be a bigger step for the fed.

Beckworth: Well, those are all very interesting suggestions, and we'll provide links to all this material. But Megan, I got to lay my cards on the table here. I'm still with your first article on climate change, I haven't gotten to your second article yet. My heart is still in the first one. It's more out of concerns I think that many central bankers share, it's not an issue about climate change. I think climate change is a big, pressing issue, but I'm not convinced I guess that the central banks are the best agency to deal with it. I think some other federal agency that has funds allocated by Congress would probably have more legitimacy, more ability to do things.

Beckworth: But let me just go piece by piece on some suggestions, and you tell me why these are not sufficient, maybe why I need to think bigger and bolder on the climate change issue. So let's start with financial stability, why not just focus on firms in general funding with more capital, more equity, make them more robust to any shock? Climate change, war, whatever it may be. Why not just focus on enhancing financial stability overall in general and let the chips fall wherever they may be from?

Enhancing Financial Stability as an Alternative?

Greene: So I think that there are maybe two good answers to that. One is if you beef up financial stability, you could seriously curb lending activity. That could be a result or an unintended consequence, which isn't necessarily what we're going for as we're trying to come out of a downturn and is never what you're going for. So as long as they're stable enough I guess is the idea. You want to hit this perfect sweet spot where financial institutions are stable enough but still able to actually engage in lending and credit extension. So you don't want to make them hold more capital, for example, so that they're more stable, but then they've got no capital that they can lend on. That would be a drag on growth.

Greene: So I think that's one reason. And then I think another reason is that we know for sure, I have been saying myself up until six months ago climate change will be an existential threat. And someone finally corrected me and said, "What is this “will be” business? It is already here, it's here." It's not still coming down the pike as I had been saying and many others are. So given that we know that this is an immediate threat, why wouldn't we address it specifically if we've got the tools to do that? I am sympathetic to your argument for what it's worth it that there are other actors who are better placed to do this, definitely.

Greene: So fiscal authorities in theory could do a lot on this, but they haven't. And they haven't for many reasons, one could be that their electoral cycle is not that long, and so they're just not as incentivized to. Hopefully, we'll get more out of the Biden administration on the climate front, I think we will. But also given this is an immediate threat, why wouldn't we try to fire on all cylinders? So yes, the fiscal authorities should absolutely do their job on this. But if central banks can play a role, particularly in the climate finance piece, then why wouldn't we use the tools that they have at their disposal?

Yes, the fiscal authorities should absolutely do their job on this. But if central banks can play a role, particularly in the climate finance piece, then why wouldn't we use the tools that they have at their disposal?

Beckworth: That's a great reply. I'm very sympathetic to something like a National Investment Authority. I had Saule Omarova on the show, and she's proposed something like this which would be useful not just even for this, but it'd be useful during recessions in general. Last year, there's this big debate about the Fed doing credit allocation when it set up all these facilities to state governments, to businesses, to corporate bonds. It may have crossed the rubicon from liquidity to credit allocation. And there were people on the left who were making this comment. And many of them suggested what's needed is a fiscal facility that has the authority from Congress to make those kinds of credit decisions where the Fed doesn't.

Beckworth: But I take your point too though that the Fed is the only game in town many times because there aren't these agencies yet, there isn't the responsibility taken on by Congress. So the Fed is given. But that leads me into my next concern, and that is legitimacy. So Paul Tucker who you know has this great book on the political economy of central banking and government in general. And he makes the case that if a parliament or Congress wants to delegate authority to an agency over some issue, there needs to be public consensus on it. There needs to be agreement this is the direction we're going to go. So a good example would be price stability. Most people agree on the need for price stability of some form. So delegate that to the central bank.

Beckworth: Now, when you come to the environment, he would say in Europe and maybe in England there is consensus, it has to be done. So it's easy to delegate, no question. Here in the United States on the other hand, we're a very polarized country. I mean, there was a close election past two times for the president. And if we delegate that authority to the central bank, they take on more and more. It could be seen as the central bank doing mission creep and not having legitimacy to do it because half the country doesn't support what it's doing. So maybe that's one of the reasons the Fed has been slow to adopt some of these changes, just they don't feel they have the political support behind them. Do you want to respond to that observation?

Questions on Central Bank Legitimacy

Greene: Yeah. So I think it is a concern, but I also think going back to our discussion about how climate change is at the center of the Fed’s actual mandate, the Fed doesn't need more permission, I don't think. And different people have different views about this, but the Fed doesn't need a new mandate given to it by Congress if it's job is price stability and full employment and full inclusive employment. Then climate change can impinge on all of those things. So addressing climate change is part and parcel of the Fed trying to achieve what it has already been asked to achieve. So I actually think that the Fed can already do a lot of this within its mandate.

The Fed doesn't need more permission, I don't think. And different people have different views about this, but the Fed doesn't need a new mandate given to it by Congress if it's job is price stability and full employment and full inclusive employment. Then climate change can impinge on all of those things.

Greene: I know that the Fed would prefer to get permission from Congress because ultimately Congress is the Fed’s boss. So they would prefer to be told that, but then there is also this concern, well, this Congress asked us to deal with climate change, the next one has asked us to do the opposite, and we just all have whiplash at the central bank. And I think that is a real concern, I'm not sure what you can do about that. But like I said, maybe you don't need Congress's approval, maybe you just need to be working on your mandate.

Beckworth: Let me move on to another concern, and that is the politicization of the Fed, and you've already touched on this. But let's say hypothetically the Fed is given power by Congress to start buying green bonds, and it begins to do that. I could see a debate emerging over what is a green bond? How do you define a green bond? It could be something really technical, but it could be something that's fundamentally different as is nuclear energy green or not? There's a debate among climate activists whether nuclear energy, geothermal, should we include those with solar and wind? So any concern on issues like that that the Fed becomes politicized even within the framework or the big 10 of climate activists?

The Politicization of the Fed Within the Climate Debate

Greene: Yeah. So the taxonomy is the hugest issue here I think. And so you really hit the nail on the head that defining a green investment or a green bond is really difficult. The EU comes out with guidelines, they're hundreds of pages long. I don't know anyone who's actually read them, including myself. How is an investor or how is the central bank going to actually upkeep a multi hundred-page document? That's difficult. That being said, I think you've got to start somewhere. And so knowing that we're not going to have it done perfectly at the beginning doesn't mean that we shouldn't do it at all. I think we have to assume that taxonomy is always going to be an issue, but we'll probably improve along the way. This is also at the heart of the ESG movement I think as well as taxonomy, what's a green investment in a portfolio? Whose definitions are you using?

Greene: It's really difficult to come up with a truth with a capital T on that, but that doesn't mean that the movement shouldn't go anywhere. It just means we're going to have to do the best we can and work it out along the way. And so there is some opportunity for politicization, but I think that's uniform across the board that this is just a challenge for every central bank, and we kind of have to do the best that we can. There are opportunities for greenwashing, there is greenwashing absolutely. That is a shame, and hopefully that will diminish as we get better and better-

Beckworth: What is greenwashing?

There is some opportunity for politicization, but I think that's uniform across the board that this is just a challenge for every central bank, and we kind of have to do the best that we can.

Greene: So greenwashing is saying that something's green when it really isn't so much or saying that a firm is net zero when it's not actually or it only is based on this kind of particular definition that you've chosen to make it so. So that's called greenwashing, and it happens a lot. But just because it happens doesn't mean we should forget it and give up altogether. I think it just means we're going to have to accept that we're going to get better at this as we go along.

Beckworth: It's kind of like buying organic foods, sometimes those labels don't mean what they say, but you still want to try to get the organic food if you're concerned about health issues and stuff. It's a learning process. Okay, fair enough. All right, let me bring up another point, and this may seem a bit silly, but I've heard this point made. And I did a tweet recently, a reductio ad absurdum tweet illustrating this point. But how do we define existential threats? So climate change certainly seems to fit that, but this is like a long haul threat. This is a process that will take years. You used the analogy of war, which I think is a fair one. When it's war, you go all out.

Beckworth: And even last year would be a good analogy too, this pandemic was a war, a public health war. We went all out, the Fed bought up a lot of government debt, help support what was going on. But why couldn't I point to say the threat of an asteroid hitting planet earth, why don't we spend money? Alex Tabarrok is a good friend of mine, he thinks the government should spend more funds preparing for defenses for asteroids. If I had to look abroad what would be the biggest existential threat and foreign policy, maybe nuclear war with China. How do I draw the line between legitimate existential threats and just ones that are on the horizon not to worry about here and now for the Fed?

Addressing Existential Threats

Greene: I don't have a perfect answer for you, but I think you have to look at two components for all these threats. One is impact, so how bad is that existential threat? And the other is probability. And you've got to come up with some kind of calculation based on the two of them. And if probability and impact are both high, then we should probably do something about it. I don't know much about asteroids, but I don't think the chances of an asteroid hitting earth and decimating us are that high. Though if it happened, it could be really bad. But overall, that score wouldn't be that high relative to climate change where the probability is incredibly high already and the impacts also are pretty high.

Beckworth: That's a great way of thinking about it, probability in an actual impact. So maybe it'd be neat to have someone to come up with a list of existential threats with a score calculated and rank them top to bottom. That would be very useful, I think actually they have something like that. Megan, one other objection I have to tying the climate change into the Fed’s mandate and particularly price stability mandate because I've heard that several times that climate change could make things more scarce, more expensive, prices go up, which is totally true. In fact, we have seen this with the pandemic. The pandemic is also a negative supply shock. Climate change would be a big, big, negative supply shock to the global economy. Things would get scarcer and more expensive.

Beckworth: But when we think about what the Fed is aiming to do, it's aiming to stabilize trend inflation, like inflation over many, many years. And I see what we have happening now, in fact, the whole transitory versus permanent inflation story. So climate change could make things more expensive, it'd be more of a one-time bump or maybe multiple bumps. I don't think it would be a change in trend inflation or am I wrong here?

Climate Change and Trend Inflation

Greene: I think it could be a change in trend inflation, it would just take us to a different plane, I think. If you assume that climate change isn't a binary thing and that our planet is heating up by 0.1% Celsius every so often, there are different implications. Initially it's a bit harder to grow food and a bit harder to get water. And as the temperature goes up further, biodiversity falls even more, and these things get worse. I do think you end up with incremental changes and all kinds of wildfires and things like that that are supply shocks. But I do think it could put us on a different sort of plane for trend inflation as well.

And as the temperature goes up further, biodiversity falls even more, and these things get worse. I do think you end up with incremental changes and all kinds of wildfires and things like that that are supply shocks. But I do think it could put us on a different sort of plane for trend inflation as well.

Beckworth: So you're saying it'd be more than just one shock, it'd be multiple shocks each of which would cause prices to go up, and therefore it would be more than just a one-time pop, it would be a sustained growth in prices over a long period.

Greene: I think so. In so far as climate change isn't binary, it's going to be an experience unless we do something about it where things get incrementally worse.

Beckworth: Okay. So we're on this journey called climate change and how to deal with it. And we've had a great discussion today with you Megan on this and the role that central banks can play. So what would you like to see as the next steps moving forward? What should the Fed, what should the ECB, what should the Bank of England, Bank of China, what should they be doing next steps to get us to the place where we need to be?

Next Steps for Addressing Climate Change

Greene: So I think they should continue considering the financial stability side of this, but I think they should also figure out how they might provide finance to retrofit our lifestyles so that they're more sustainable. And there the central banks sort of uniquely have an easy role to play I think by saying we'll subsidize this stuff, go out and do it. And I think people would do it pretty quickly if it were subsidized. I would love to see that happen. And alongside that, I think there's a real reticence on behalf of regular people to recognize that our lifestyles have to change fundamentally if we're going to get on top of this. But if you were to provide finance to help us get there, then people might be more willing to go ahead and adopt new practices and make their houses more green and their transportation more green as well. So I think central banks could have a quick and easy role to play if they could get there.

I think they should continue considering the financial stability side of this, but I think they should also figure out how they might provide finance to retrofit our lifestyles so that they're more sustainable.

Beckworth: In the time we have left then, are you optimistic? Is the glass half full, half empty? I mean, not only central banks, the role they play, but in general technology, innovation, things that can make the world a better place on this issue. So I recently had Arthur Turrell, he used to work at the Bank of England. He's also a nuclear fusion scientist, I guess he's technically a plasma physicist. And he has a new book out, it's really great. And man, it made me very hopeful that nuclear fusion could be just around the corner. It's cleaner nuclear energy, it's also very abundant. It would solve a lot of problems if you could commercialize it. Now, we're not there yet. Any thoughts you have in closing here on whether we should be seeing the glass half full, half empty, what's the outlook?

Greene: I think those who are really optimistic about this are usually relying on new technologies to come and help us figure out how to trap carbon underground or spray the atmosphere with some sort of new chemicals that aren't bad so that it protects us from all these emissions, things like that. I'm not a scientist, I don't know enough about those technologies. I think I can't rely on those emerging, it would be great if they did, and I would be more optimistic if they did. But I think I'm more cautious. I think since those don't exist yet, we've got to do what we can with the tools that we have. I guess I'm optimistic but really worried.

Beckworth: Fair enough. Well, our time is up, our guest today has been Megan Greene. Megan, thank you so much for coming back on the show.

Greene: Always a pleasure. Thanks for having me.

Photo by David Gray via Getty Images

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David Beckworth
Calendar Date: 
Sep 20, 2021
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Libsyn Podcast ID: 
20526473
Subtitle: 
Climate change poses a unique threat to central bank mandates, and monetary policy may have a role to play in mitigating this ongoing environmental disaster.

Megan Greene and Eric Lonergan on Dual Interest Rates and the Prospects of Average Inflation Targeting

Megan Greene is a global economist and Senior Fellow at Harvard University School, and Eric Lonergan is an economist and macro fund manager at M&G Investments. Both Megan and Eric are returning guests of the show, and they re-join Macro Musings to discuss dual interest rates and the potential power it brings to central banks. Specifically, they discuss the current constraints on central banks’ toolkit, how the example of the ECB targeting TLTRO’s illustrates the potential of dual interest rates, why the concern over fiscal versus monetary policy is misunderstood, and whether the Fed’s new average inflation targeting mandate can be successfully implemented.

Read the full episode transcript:

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

David Beckworth: Megan and Eric, welcome back to the show.

Megan Greene: Thanks for having us.

Eric Lonergan: Thanks, David.

Beckworth: Yeah, it's great to get you both on. Now, Eric, you came on in early or April 2019. Megan I believe was March this year, so it's been a while since we've chatted. It's been six months or so since the pandemic has started, so how are you guys holding up?

Greene: I've just sprung myself out of the US and I'm sitting in London, so I'm doing better with a change of scenery, for sure.

Beckworth: Oh, okay. So you're both in London now?

Greene: That's right.

Lonergan: We even managed to have a socially distanced lunch over the weekend, so yeah. All is good.

Beckworth: Oh, fantastic. So you are both speaking to me from London, another testament to the wonders of the day and age we live in, where I can have conversations with people across the Atlantic. And I just did an interview with Robin Harding in Tokyo, which was great, other than the time differences. So it's fascinating to be able to talk with interesting people like you all across the world, and today we're going to talk about an article you have, it's titled “Dual Interest Rates Give Central Banks Limitless Firepower.”

Beckworth: I like that, because you're very optimistic about what central banks can still do. The premise of your piece is that the Fed and other central banks are not out of ammunition, and I love it because that really goes against the grain of much commentary, if not most commentary today. Everyone's kind of saying, "Hey, central banks have run out of ammunition," and I want to illustrate this with a piece that Greg Ip wrote from the Wall Street Journal back in March when this whole crisis was unfolding, and the title of his article is “A Misplaced Faith in the Power of Central Banks,” and I'll read the first few paragraphs.

Beckworth: It says, "Wall Street and President Trump have begged, admonished, and tweeted for the Federal Reserve to come to the economy's rescue. Tuesday morning, the Fed obliged. But their faith is likely to prove misplaced." And he goes on to say, look, we've reached the lower bound, the Fed can't do much more, it's time for fiscal policy to step in. The Fed is really on its last legs, so don't place your faith in the Fed.

Beckworth: But you guys say not so fast, right? You're pushing back against this, which is really, again, surprising, because most people who have come on the show, even, would take the other side of that position. So walk us through, why are we not at the end of the Fed and other central banks' ability to respond to the economy? You mention a number of tools they could still try, and ultimately dual interest rates, but maybe walk us through this. Why is there still more room left for central banks to respond?

Current Constraints on Central Banks' Toolkit

Greene: I would say, first of all, that fiscal policy would be great, so I'm in favor of that and would argue for that, but if it's not coming, largely because of political constraints, then I do think there is more a central bank can do.

Greene: You could do more QE, is one thing. Though now that I sit in academia, when I was in the private sector in asset management and everyone was in love with QE, they thought it had been fantastic, in academia, actually, it's widely viewed as a complete failure, and within parts of the Fed it's been viewed as either a failure or having had some fairly mixed results. So we could have more QE, but that's not necessarily a silver bullet.

Greene: We could follow in the steps of the Bank of Japan and engage in yield curve control, and up until the Fed changed its monetary policy strategy, it did seem like yield curve control was actually on the table. Investors were certainly hoping it was. One problem with yield curve control is it's really hard to stop once you start, so you're kind of stuck in forever, and we've seen that with the Bank of Japan. So that doesn't seem to be a silver bullet.

Greene: In the US in particular, we still have rates that are in positive territory, policy rates that are in positive territory, so that sets us apart from some other central banks. So in theory, we could just start cutting rates into negative territory, but there's this whole school of literature suggesting that that undermines the banking system. At a certain point, people just take their money out and stick it under the mattress, so you can only go so negative, so there's this effective lower bound beyond which you can't cut rates anymore, it actually becomes counterproductive. And the Fed has been pretty clear, they don't really want to do that. And that kind of leaves us with dual interest rates, which I'll tee up for Eric to explain.

Lonergan: Thanks, Megan. Okay, so I guess the genesis of the idea of dual interest rates, it really goes back three or four years, when the ECB announced sort of yet another program with a confusing acronym, in this occasion TLTROs, which most people on the planet don't know what they are, understandably, and not even that many economists understand what they are.

Lonergan: But effectively what these were, were funding programs but for banks. But what was innovative, in a sense, was that the funding program, it wasn't just about providing emergency liquidity, which has of course been a standard practice in terms of intervening in bank funding markets, i.e., lending to banks. But this was targeted lending, so it was actually trying to use funding of banks to provide a monetary stimulus sort of independent of the other tools of monetary policy.

Lonergan: And specifically what they did is they said, we're going to provide you with funding, I mean large scale funding, significant percentages of Eurozone GDP, contingent on you making net new loans, right? So they actually had a kind of balance sheet expansion criteria. And that is a big shift in policy, because suddenly, you move from viewing the funding side of your monetary tools as a kind of emergency liquidity to actually potentially being a source of stimulus.

Lonergan: Then, what struck me and Megan through time is they started to talk about the interest rate on this TLTRO, started to become a kind of independent discussion of the official interest rate, which is the interest rate on reserves, that's what American policy analysts would be familiar with.

Lonergan: And ultimately, at a certain point, it was striking. Well, why can't they just leave the interest rate on reserve unchanged, and just move to targeting this independent policy rate? And then all of a sudden you're freed from all of your issues and all of the problems of a lower bound and negative interest rates. And it's really as simple as that.

Lonergan: I actually think there's an element of accident in how this evolved, which is central banks have always had funding vehicles, so the Bank of England had a funding for lending, the Bank of Japan used one after Fukushima. So we've always had emergency liquidity. Somebody clever somewhere at one of these central banks thought, this could also be an independent stimulus, and then once it was out there we started to think, well, why not just keep cutting the interest rate on the funding scheme?

Greene: To be fair, when the TLTROs were first announced, they were widely viewed to be kind of emergency provision for the crap banks in Europe, so they were there for the banks that were really struggling, so they were this stimulus for them.

Greene: The point I think Eric’s just made that you can actually introduce a second interest rate. The TLTRO rate was the same as the deposit rate up until recently, actually. But they started specifying the TLTRO rate, and it made us realize, well, it doesn't actually have to be the same. So when a central bank cuts or hikes rates, they have to make allocation decisions about whether they're going to benefit savers or borrowers.

Greene: But if you actually have two rates, you can move them in different directions, and you can benefit both savers and borrowers at the same time. So that's a massive stimulus across the economy, and it gets rid of the effective lower bound, because you don't just have one rate that you're playing with. So you can go ahead and you can cut the TLTRO late, or the lending rate, really negative, so essentially the central bank is paying banks to borrow, as long as they pass the loans on to the end user, that's why it's targeted, and then the banks can go ahead and provide these loans also at negative rates if they want, so you create demand for those loans. Everybody's getting a bit of a stimulus in the process, and at the same time you don't have to penalize savers, because you can go ahead and hike that rate, you can hike the deposit rate. So you don't have to choose, in terms of allocation, you can actually benefit everyone.

If you actually have two rates, you can move them in different directions, and you can benefit both savers and borrowers at the same time. So that's a massive stimulus across the economy, and it gets rid of the effective lower bound, because you don't just have one rate that you're playing with.

Beckworth: So everyone's a winner with dual rates, which is an interesting point of this. Because as you mentioned, Megan, a lot of people do often point the finger at the central banks and say, "Oh, you're harming pensioners, you're harming savers." And I always push back against that by saying, "Hey, the neutral rates dropped. It's not really the central bank doing this, they're kind of following it down.” But what you're presenting is an even better response to that critique of low interest rates, that you still can respond to all segments of society.

Beckworth: And just to summarize what you said, you have a great line in your paper that says the ECB can target the rate at which banks can fund lending, or borrow from the ECB, independent of the rate at which the reserves are remunerated or deposited. So I want to unpack that in terms of the US. So let's say, for example, the Fed were to try this in the US, and maybe this will help some listeners, it definitely helped me think through what this is.

Beckworth: So in the case of the US, the lending rate would be to the discount window, right? The discount rate. Is that fair?

Greene: Yes.

Beckworth: So in the case of the United States, then, you would take the discount rate and lower it well below the interest on reserves. So right now, interest on reserves is .10%, so maybe you lower the discount rate to, say, -2, -3%. I'm just making numbers up here, but you would dramatically lower the discount rate. So banks could borrow at this incredible rate, but the conditions, as Eric said, is they'd have to lend into the real economy. But banks would still be able to find a place where they could earn something on their reserves and not be hurt by decreasing that interest margin. So is that a fair way to think of it in terms of the US?

Greene: Yeah, I think that's fair. It's very different from how things have been, right? The discount rate usually comes at a premium. So it would be rethinking that entirely. But that being said, in March, the Fed cut the discount rate more than it cut the Fed funds rate, to get rid of that premium. So in some ways, the Fed's sort of already taken a step toward setting up the plumbing for this.

Lonergan: Yeah, and just to clarify, because to be really clear about this, as Megan alluded to earlier, the European Central Bank, during this pandemic and crisis, they haven't reduced the IOR, right, they haven't tried to bring money market rates or the interest rate on reserves to a more negative level. They have only cut the TLTRO, right? So I think it is really important to be aware that that is effectively the channel, apart from the other programs that they're doing in terms of intervening in asset markets, but in terms of interest rates, they have elected not to continue to bring down the interest rate on reserves, but to bring the TLTRO, under certain conditions, to a lower level of interest.

Lonergan: The challenge obviously with the discount rate for the Fed would be what conditions do you attach in order to access this preferential funding, because the typical response otherwise would be, well, I can just borrow at the discount rate window and I hold reserves at the Fed and I just round tripping and it's just carried to banks. The European Central Bank has obviously thought that through very clearly, and so they've established quite rigorous conditionality.

Beckworth: Yeah, so banks wouldn't be allowed to arbitrage that difference, they would have to actually employ it in loans directed towards the real economy. So there would be conditions, but that is one of the critiques, I guess we could jump to that right now. I've seen some of the interactions on Twitter, some of the pushback is, "Well, this would quickly be arbitraged in the markets." And my response is, well, the Fed would say, "No, banks can't play this game." And then someone replied to me, "Well, what if someone else two or three levels downstream, what if they try to take the funds and arbitrage it. So how do you respond to that?

Responding to Critiques

Lonergan: First of all, I have to say, as somebody who works inside a financial institution, a regulated financial institution in Europe at the moment, I don't think, I think the culture's fundamentally changed now. I mean, most large financial institutions that would've accessed TLTROs live under the fear of their regulator. The idea that you would try to game the central bank who is your regulator, I mean, that is somebody on a mission to get into trouble, right?

Lonergan: Because the regulator in Europe has had teeth. I mean, the ECB and the European banking regulator is very, very tough. So that's the first point I would make, which is I don't think the banks are going to go out and try and game the system here. Now, there's absolutely no evidence that anyone is able to do it at the moment. The other thing that's worth bearing in mind is, of course, the quantity of reserves is determined by the central bank. No individual bank can determine how many reserves they hold. So it's often a bit of an illusion that reserves are created, and somehow I can take a loan and create reserves.

Lonergan: Well, you can't, because reserves are the function of what the private banking customers do, and it is the net result of it. So the distribution of reserves is not under the control of individual banks, it's the result of the activities in the private sector. Now, is it the case that, let's say the European Central Bank says, "Okay, we're going to provide a new round of TLTROs, and they have to be consistent with the commission's objectives that they go into sustainable energy." Is it the case that some projects that would've happened get financed? For sure. But then, the test I always put with any policy idea is, is it better or worse than your existing policy tools? The reality is, we have huge questions about the allocation of capital, and lots of challenge by just using low interest rate regimes that you might get a misallocation of capital.

Lonergan: So to me, the question here is do you want to provide stimulus, and do you have a reasonable sense that people aren't gaming the system at scale, and can you actually have a material economic impact? And on those measures, to me it's kind of unambiguously positive. At the margins, might you be substituting some kind of lending? For sure.

To me, the question here is do you want to provide stimulus, and do you have a reasonable sense that people aren't gaming the system at scale, and can you actually have a material economic impact?

Greene: Yeah, I think you get at a few other critiques that I hear about TLTROs. One is, "Well, you're just creating a misallocation of capital," so you're creating demands for loans that wouldn't otherwise exist, and sowing the seeds for the next crisis, and that might be the case. That's also the case with QE, arguably, and in the face of a deflationary spiral, those kinds of concerns tend to get moved to the back burner. So it's valid, but I think it depends on what you're facing. If you are facing a deflationary spiral, then you don't worry about that as much. So that's another critique.

Greene: I think there's another critique in terms of whether this is fiscal or monetary policy as well, because if you're providing a stimulus, should you really be doing that? Do central banks want to get into asset allocation? And the unequivocal answer is no, central banks don't want to get into asset allocation, but actually every decision a central bank makes affects asset allocation. Hiking or cutting a single rate, that affects asset allocation. So to some degree there's no way for the Fed or any other central bank to avoid this anyhow.

Greene: I would also say that the line between fiscal and monetary policy would be blurred with this, but it's already been blurred. I think we've already seen that central banks are acting more in the realm of fiscal-ish policy anyhow through this crisis, and I don't think that we're ever going back. So I think we're kind of there anyhow. And thirdly, I kind of say who cares whether it's technically fiscal or monetary policy. I mean, I think this is actually monetary policy, but if you want to say it's fiscal policy, that's okay. I mean, the Fed and other central banks are political actors, even if they're meant to be independent.

Beckworth: Yeah, well I want to come back to that question in just a minute, but one more critique that you mention in your paper, the two of you, is that some worry this might harm the balance sheets of a central bank. They might get negative equity, for example. And you guys try to explain and respond to that, but my first response is, "So what? That's what you want in a deflationary crisis," right? If the central bank takes the loss, that means it can't pull the reserves back in, it doesn't have the assets to do it, and that's exactly what generates spending, inflation.

Beckworth: Now, you want to do it in a controlled fashion, you don't want to just kind of willy-nilly and recklessly do this, but taking some kind of loss is actually the point of creating some inflation and demand for the economy, but do you want to speak to that critique?

Lonergan: I mean, I think that's a great point you're making and I couldn't agree more. I just want to make two points on this as well. I think when one thinks about the pros and cons of a policy innovation like this, you have to benchmark it against your existing policies. Right, so the hurdle here is not perfection. The hurdle here is, is this better or worse than our existing tools, more or less effective? So, for example, when people worry, I mean, as Megan alluded to, the whole issue of zombie companies or misallocations of capital because interest rates are too low, I would say it’s much better to target lending, right?

Lonergan: Keynes made the point, one of the reason Keynes said you should never raise interest rates to stop a bubble, he said is if you raise interest rates, the only investment spending that will happen is the one in the bubble sector, right? Because when you're in a bubble you think your returns are astonishing, so you don't care about the cost of capital, right? And so you can have very perverse effects. I would much rather you say, "Actually, we're going to cut interest rates now," but the funding, which is of a fixed amount, can only go, say, into fixed asset investment, right? You could exclude, so for example, the ECB excludes housing from TLTROs, which is very interesting. So arguably, TLTROs are a better way of using negative interest rates to prevent the kind of distortions in the allocation of capital or even asset price bubbles like in housing, because you can target them.

Arguably, TLTROs are a better way of using negative interest rates to prevent the kind of distortions in the allocation of capital or even asset price bubbles like in housing, because you can target them.

Lonergan: So I think that's an important point to bear in mind. Now, to the balance sheet point, you are absolutely right, and the way you put it I thought was very astute, which is you said you worry that you don't have enough assets to take back the reserves. The number of people who miss this fundamental point, because what you've described is, we can take two approaches to this. We can try and go through tortuous calculation, what is the capital and equity of the central bank? And I tell you, you and I can come up with whatever number we want, I mean that is a philosophical question. There's no accounting standards, because there's only one institution that can create reserves out of thin air, right?

Lonergan: So that's actually virtually meaningless to me in accounting terms. The simple question is, can I ever have too many reserves as a central bank? So in other words, can I ever create reserves that put me, then, out of control? So I've injected reserves into the system, and now I've lost control of monetary policy. And the first point to make here is that problem exists with all policies that we are currently operating with, right? So that problem exists with QE. In fact, it should be the result of successful QE. Because if QE is successful, the price of all of those bonds availed should fall, because in a sense, they've caused a stimulus by driving the price of them up and the yield down, so when the recovery happens, the yield should rise and the prices should fall.

Lonergan: So central banks are supposed to make a contingent loss of scale on their asset purchases. That, in effect, means, as you rightly point, the mark to market is very important, because they can't then reverse it. Let's say they then discover, "This has been too successful." Oh, but unfortunately, the price of all my assets has fallen, so I can't shrink the reserves by just selling ... So I've got exactly the same problem. But I've also got the same problem with an IOR, plain and simple, right?

Lonergan: So let's say I bought all these assets, and for sake of argument, ignore what happens to the asset price, but I've just got a problem. If I start raising IOR… the Fed funds rate, heaven forbid, in two years time was 4%, I've got negative net interest income, massive negative net interest income, because I created a huge amount of reserves. So the reality is, if you're worried about central banks' balances, you're worried about equity, if you're worried about negative net interest income, you should be really worried already and you should be stopping all of those programs, okay? That's definitely not a problem associated uniquely with dual interest rates.

Lonergan: But the final point, to me, and this is what's really interesting, and we haven't spoken about this yet, is I think tiered reserves are another fascinating and important innovation, because what they reveal to me is that you can always shrink the stock of reserves, because you don't need assets, right? So the point here is, you set an independent interest rate on required reserves, and excess reserves. Now, as soon as I have that as a tool, what I could do as a central bank in the future is I could say, "Okay, excess reserves determine money market rate," so I start raising them. But I could go into reverse on the required reserves. So if I want to shrink the stock of reserves, I'll just raise the required reserve limit and charge a negative interest rate on it, and they'll shrink.

Lonergan: The banking system, of course, will start to go backwards, because that will damage banking sector profitability very substantially, that will raise the cost of loans, cut the interest rate on deposits, and the system goes into reverse. So I personally think one needs to think about the future of central banking with these two new innovations, which is that you have targeted lending, and you have tiered reserves. And then, the issue of equity is spurious, because all that matters here is can I keep cutting the rates on funding, and can I shrink reserves if I have too many?

I personally think one needs to think about the future of central banking with these two new innovations, which is that you have targeted lending, and you have tiered reserves.

Lonergan: Apologies, I went on a bit long there, but you raised it very, very well, because you posed the problem in terms of the Fed running out of control of reserves, and I think that's a much more fruitful discussion than getting bogged down in calculations about how much capital central banks have.

Greene: This point on tiered reserves is really important as well, I think because central banks seem to be going in the opposite direction. So the Bank of England doesn't have required reserves and excess reserves, they just have reserves. And I am constantly asked, "Why does the Fed even have excess reserves? Why is it IOER? That doesn't make any sense, why wouldn't it just be IOR all the time?" So the trend seems to be in the opposite direction, but actually that would be wrong, because you'd be eliminating this useful tool.

Beckworth: This is great because I'm someone who's been a fan of corridor operation systems, the Fed has a floor, and that's kind of a popular thing now. But a tiered system is kind of a hybrid between the two, it's kind of a middle ground, and I hope we go in that direction for many of the reasons why I like a corridor system.

Beckworth: Let me go back one more time to this idea about protecting a central bank's balance sheet, because I do find it ironic, and I want to very clear to all our listeners, again, I'm not saying I'm going to go out and blow big holes in a balance sheet. This should be done in a controlled, thoughtful process for sure. But it does strike me that many central bankers sometimes care more about their balance sheet than their objective of stabilizing inflation and aggregate demand.

Beckworth: Where this really became clear to me was the Swiss National Bank, when they were pegging their currency to the Euro, they finally quit for one reason, they were afraid of losses on their balance sheet. And I was like, "Well, that's the whole point," right? That is the whole point. And I know they actually have shareholders and they've got to be concerned about some issues the Fed doesn't, but if you're so worried about your balance sheet, I think you're losing focus of what your first objective is. Again, I'm not suggesting we are reckless with the balance sheet, but we need to have a list of priorities in front of us starting with price stability, the dual mandate, stabilizing demand, and it just strikes me that sometimes central bankers get their priorities backwards.

Lonergan: The other thing I would just say here that I think is important is, and I have to do a bit of accounting in my day job, the problem is that you cannot apply conventional commercial bank accounting to a central bank. The way I look at it, it's worth reading Warren Buffett on this, when Warren Buffett, for example, talks about insurance companies, he analyzes their float. This has been a big source of his wealth generation, and he says is float really a liability or not? Because it keeps growing and it never gets called upon, right? So, in insurance terms.

Lonergan: Now, the point is if I could find the business that could literally, physically print dollars legally, what would its market cap be? I mean, how do you do a present value of that business, right? So the accounting is just, frankly, silly, right? It's just silly. We shouldn't even try to go there. They can always honor their liabilities in dollars. The only thing that matters is can they lose control of inflation or not?

Greene: Yeah, and central banks have run in the red before, the Czech National Central Bank, it's been in the red. So-called underwater central banks aren't like normal banks, so it's fine, it doesn't matter.

Beckworth: Okay, so we've gone through a number of criticisms and concerns about dual rates, one last one and we'll move on, and that is some folks say, "Well, you're just creating the supply of funding for new loans, but there's got to be demand for it." You're kind of pushing without the corresponding increase in demand, there needs to be demand and then demand and needs to move first, so how would you respond to that concern?

Greene: Well, I think you can create demand if you're offering loans at negative rates to users, and then they'd be getting paid to borrow, that could generate some demand. Do you end up making some loans that probably aren't great loans and maybe wouldn't have otherwise happened? Absolutely. So that's the misallocation of capital issue. But this, for decades economists have been saying central banks can only deal with supply issues, they can't really deal with demand issues. This is a way to deal with a demand issue.

Lonergan: Yeah, I also think, and this might happen with the ECB, I think it's probably trickier in the US context. But I would not be surprised if, and I think this is quite a clever approach, if the ECB were to link future TLTROs actually to a reduction in interest charges on existing loans. So far what they've done is they've said, you can have this, we're going to give you a negative interest rate on your funding, as long as we see evidence that you've made net new lending, so we can be convinced that you've created a stimulus, a monetary stimulus.

Lonergan: But what you could do is you could say, okay, let's say, we want your loan book, the average interest rate on your loan book to come down by 50 basis points, then you can access, or some formula. So in other words you could actually link it to a repricing of the existing loan book.

Beckworth: Yeah, that's a great suggestion. And Megan, going back to your point, I completely agree. The simple way I would summarize it is everyone has a price. At some point, you lower their interest rate enough, you said you pay people to take the loans out. At some point, if, for me, in the real world, it means the bank is going to pay me to take out a loan to get a new dishwasher, to remodel part of my house, I'll do it if they're going to pay me to do it, so you've just got to keep lowering that price until behavior responds.

Beckworth: And along those lines, you guys give specific recommendations for the ECB. You outline that right now, banks can fund lending at -1%, and reserves pay close to zero, but you say go all the way down to -4 if I read that correctly, is that right?

Lonergan: Yeah, that was based on some econometrics that Megan did I think, right?

Beckworth: Okay, Megan?

Lonergan: No, no I’m kidding.

Greene: It was just by way of example. I mean, the point being, lower it really significantly, the ECB has set up the infrastructure to do this. They've actually implemented it, but in a really timid way, and I think our point was you could do this in a much bolder way. And if you're looking at the Eurozone, which is experiencing deflation, you've got moves in the currency that means that the Eurozone's importing deflationary pressures now, this is one way to reverse that in a bolder way, so if you cut the TLTRO rate to -4% for example, but several hundred basis points more than the already do, then the effect would be even larger.

Greene: I will say, at Christine Lagarde's last press conference, she did say the take up of this TLTRO was significant and widespread and she thought that it had a major effect. So I think that there's some proof that this is working, but they should do it in a much bolder way.

Lonergan: And just to add to that, maybe, David. I look, again, in my kind of day job, if I look at say infrastructure, there's a huge amount of demand now from the investment community, which, given pension funds, given demography, of acquiring long-dated assets. If you look at something like our energy infrastructure, particularly say in Europe where a lot of end prices are regulated, so effectively regulators are determining how much the rate of return is. The real point we wanted to convey here is the private sector is typically, still in Europe, funding itself at a positive rate, it depends on their credit quality, but at a positive rate.

Lonergan: If you wanted to supercharge sustainable energy investment, if you made like five year, -4% interest rate loans available, if they cooperate with, in the European case, there is potentially more of a structure for cooperation where the guidelines of these loans could be specified by the commission, i.e. that they have to be, say, in certain, say green energy. I mean, if you said wind energy or other types of sustainable energy, where you can get a return of four or 5%. I mean, you would supercharge investment there if you suddenly made funding available at -4.

Lonergan: And it just reveals, you just suddenly realize that there's absolutely no limit here. I mean, so like, the only question is do you want to do it or not? Like, you can't say, "I can't hit my inflation target" because you clearly can. I mean, -10? And the other point that's really important in a European context, to this point about the depositors and the different interest groups, the other thing that's interesting here is one of the German constitutional court's objections to policies like QE and negative interest rates is precisely that it's placing this burden on depositors, so they are viewing them as creating a form of political tension or making decisions that are adverse. And there's been no objection, legal objections to TLTROs in the context of the Eurozone, which again is very interesting when we come out of the debate on fiscal versus monetary.

Beckworth: Okay, so it's a win-win, as you mentioned earlier, you've just been explaining, that savers benefit from this, depositors benefit from it. Everyone, borrowers and lenders, they all come out winners under this approach, so you'd think there'd be some political support for this. So how's this idea been received? You guys have both been on the case for some time now promoting this, and your most recent piece at Fox EU, so what's been the reception that you've seen from market participants to central bankers?

Greene: So the ECB's already doing it, so they’re fans. I would say the Bank of England is already doing it to some degree as well, or has done it, with its term funding scheme. If you talk to the Fed about it, they think it's an intriguing idea, but sort of give you the sense that it would be an intriguing idea if we were staring into the nuclear abyss or something, as an absolute last possible option to pull out, rather than thinking about using it a bit more proactively. And to be fair, we view the threat of deflation as a little bit less in the US than it is in Europe, our rates are a little bit higher, so maybe that's why they feel they've got more room.

Beckworth: So I guess my question, Megan, would be, though, is the ECB open to your suggestion of going even farther down with the rates? So you mention -4 as just an example, but are they open to the possibility going maybe -2, -3?

Greene: So I don't think that they're there yet, and that's why we've seen it implemented it in such a timid way. But they know the tools are there, certainly. They know that they've set this up.

Beckworth: Eric, have you heard anything from market participants, what they think about the idea?

Lonergan: The thing I'm most struck by is, and I'd be very interested to get your thoughts on it David, but my sense is there's a surprising lack of awareness. And I don't know quite whether this is by intention or not, but this was really a profound shift that the ECB has made this year. By setting the TLTRO below the interest rate on reserves, that is crossing a Rubicon. And, to be honest, I didn't expect them to do that, certainly not this quickly. But as Megan said, it was surprisingly, people just didn't realize it, because TLTROs are confusing. And so my main observation is that people are still getting their heads around it, that actually it's a very poorly understood innovation, although it's already happened.

Lonergan: And the reason I can tell that is there are certain obvious questions that the media should be posing, which is, first of all, why don't you just cut this rate a hell of a lot more? Because clearly you're not hitting your inflation target, and in Europe it's a mandate by law, that it is the mandate of the ECB. It's got a legal requirement to hit its inflation target, and it's failing. We're in a pandemic, we need much more stimulus, everybody would kind of agree that we need contingent stimulus, what aren't you discussing it openly? Why aren't economists doing calculations and working out what's the r* on a TLTRO? Why hasn't somebody gone away and modeled it, right? And then the whole debate would change, and I don't really understand why those conversations aren't happening.

Lonergan: So initially, you know the way economists work, but mostly they kind of go, "I haven't really thought about that," "Oh, that's just fiscal policy," or kind of that's a subsidy to the banks, they're going to arbitrage it. So you've had all the kind of initial instinctive and then people go away and think about it and I think suddenly sort of go, "Hang on a minute, actually, this is a big of a game-changer."

Lonergan: So that's my sense so far, and we'll see. I mean, I think were things to worsen, in the case of Europe ... Oh, one very important point I should know, and I know this because I have private conversations with them, but I have a lot of contact in Europe with German economists, and they're good friends of mine and they usually say, "Eric, whenever you start talking we kind of agree with the first 30%, and then we get a bit confused in the middle, and by the time you've finished we're like, "No way." And they said-

Greene: I feel the same way, Eric, for what it's worth.

Lonergan: Megan knows where they're coming from, right? On this occasion, I had two German economists that said, "We listened to everything you said and we were kind of still nodding in agreement." Well, because it doesn't affect savers, right? Megan and I are actually recommending that you boost savers' depositors income. So what's really intriguing to me here is that the political economy of it is actually very different.

Greene: I would highlight, though, I mean, Eric, you mention that it's a little bit opaque and nobody quite understands it, that's kind of convenient as well though, because if you look under the hood a little bit, this is a subsidy to banks, and banks were widely viewed to have caused the whole last crisis and mess, and so if Joe Six-Pack got a whiff that we were providing a subsidy to banks, even if it was being passed on to the end user in loans because it's targeted, that would be pretty unpopular. So I also think it's a shame that nobody seems to have realized this is going on, but it's also somewhat convenient politically, it allows central banks to go ahead and do this.

Beckworth: Yeah. Well, you guys are the champions of it, right? You're the two fighting the good fight and promoting this, and I honestly wouldn't have thought of this had I not spoken to the two of you. Although I will mention one previous guest on the show came on, and we talked, and after the show is recorded we started doing some more discussion and he actually came up with the same idea. He didn't realize it was being implemented in Europe, but he said, "Look, David, why don't we just lower the discount rate below the reserve rate, that way you don't deal with all these concerns from savers and pensioners?"

Beckworth: And he kind of saw the logic, he kind of stumbled on it, I was like, "Let me tell you about two people I know, Megan and Eric, they've been making the case for this for some time. In fact, they call it rocket money fuel, I mean, they say it's really a powerful tool." I guess, Megan, part of it then is just how you sell it and market it, right? You want to do it in a delicate but informative way, and correct me if I'm wrong, I mean, you guys are saying, "Look, this is something you use in emergencies," right? This is something you use in a deep recession, this is not something you would use all the time, or am I wrong on that?

Lonergan: I have mixed views on that because I think there is a much more profound debate happening about monetary policy. And I think, and if anything that, in the pandemic, that's become even clearer, which is, a single interest rate is a very, very blunt tool, and it creates all of the problems that we're aware of, which is both primarily asset price distortions, or at least runs the material risk of those, and there is a huge concern in Europe about housing markets again. I mean, if you look in Scandinavia where they have negative interest rates, they have very, very, very elevated multiples of household income on the housing market, which is certainly a major concern of financial stability.

A single interest rate is a very, very blunt tool, and it creates all of the problems that we're aware of, which is both primarily asset price distortions.

Lonergan: So I think there has been a reassessment about is it really optimal for monetary policy to have a single interest rate as the dominant lever with which you're trying to control macroeconomic demand, and could you be more astute about how you target the stimulus? And I think that's a very legitimate question. It obviously poses problems, as Megan alluded to. So how does the ECB direct lending into the sustainable energy sector, and is it its role?

Lonergan: Now, I think you can set up smart institutional arrangements whereby you can do that. Whether it's analogous to the Fed going to the Treasury and saying, "Our balance sheet's at risk, do you give us approval to do this?" Whether it's like the Bank of England did something similar, it did a funding for lending scheme into housing during the financial crisis. And I think Europe has still got ... The important point as a macroeconomist about independent central banks, I want them to control quantity and price. That is sacrosanct. The central bank must be the authority on how much money is produced and that is enshrined in constitutional law in Europe, which exceeds the power of any individual sovereign. That is incredibly difficult to change. But it is actually also under the ECB's mandate, subject to price stability and independence, and not funding governments, it tries to operate in a way that's consistent with Euro area macro policy.

Lonergan: So I think there is a potential for some inter-institutional cooperation in how you might direct these kind of, the funding stimulus.

Greene: Yeah, I would say if you asked me to come up with a perfect system, would I lead with dual interest rates? I probably wouldn't, actually, I would probably leave more in the hand of fiscal authorities who are elected specifically to make decisions about asset allocation. So I wouldn't say that this is the first best solution, I just think it's the first best solution on the planet we actually live on, where you're already seeing political pushback on additional fiscal measures. I mean, the US is the posterchild for this right now, but the UK's facing it as well. So I would say, it's not necessarily just in an emergency, but I do think if you're facing a deflationary threat, that's the time to bring it out, and it's not the best solution, but it's the best one given the world we live in.

Beckworth: Yeah, and I encourage our listeners out there who do modeling, who write serious papers about these issues, to take up Eric's challenge to come up with an r* for TLTROs, an r* for discount rates, multiple r*s, I guess in a dual interest rate system. So maybe we need to come up with a Greene-Lonergan Taylor Rule of some kind, how do you set each of the rates conditioned on some state of the economy? So I mean, part of what you've got to do is market it, right? So John Taylor did a great job marketing the Taylor Rule and the whole interest rate control idea. I mean, it was already in the literature, but you need your rule to come out and show us how it works.

Beckworth: But this is a lot of fun, and I do really encourage our listeners to read your paper. We'll provide a link to it on the webpage. I want to move slowly from that topic into another one which we touched on earlier, and that is this fine line between monetary policy and fiscal policy. We've really been going back on it through a number of our comments, but Megan, you said earlier, "What's the big deal?" Don't act like this is some true law of nature, it's a bit of a fiction, is that right? That this like we've drawn between central banking and fiscal policy?

On the Fiscal vs. Monetary Distinction

Greene: Yeah, I think that's right. And again, maybe in a perfect world, you might try to delineate them very specifically, but in reality central banks are constantly figuring out who they're going to benefit and who they're not. So in some ways they're already political actors, every decision they make is political in some way. And so they haven't been elected to make those decisions, that's fair. But I think fiscal and monetary policy has already become so incredibly blurred, and even more so in the past six months, that I don't think that should be our primary concern.

Lonergan: I'm probably a bit more pedantic than Megan. Megan is absolutely right to me in the sense that when people talk about fiscal, what they often mean is distribution, right, is better distributional consequences. And I think the reality is, really until the financial crisis, a huge amount of thought wasn't given to the distributional consequences of monetary policy, and then you have the whole issue of whether QE was contributing to inequality, and then in the European context, because they're kind of geographically distributed, they're even distributed in different countries, you have cognizance that monetary policy can put savers and borrowers in conflict.

Lonergan: But here's the thing, I think there's a really interesting area, a kind of methodological point about economics, the more I've looked at this area, is that we actually, a lot of the key terms in economics are unscientific, in the sense that they're not properly defined. In other words, we just don't define what the kind of necessary and sufficient conditions are for what constitutes fiscal and what constitutes monetary, and this is actually true of an awful lot of terms in economics. It's very interesting, they're poorly specified.

Lonergan: And we kind of leave it to intuition. I mean, I actually described a lot of what the ECB was doing to Ben Bernanke and he said, "Oh, but that's fiscal." And I said, "Ben, you have to be a bit careful, because you call it fiscal, you realize that if it's fiscal, that makes it illegal in Europe." But then I took each of his point, I said, "Why is it fiscal?" And it was really interesting, because every point he raised, I said, "But that's true when you change an IOR or when you do this with interest rates or when you do QE." And so what you actually realize, if we're honest, is none of us have given a lot of thought to what the definitions of fiscal and monetary are, and I personally think you can define them relatively clearly, particularly monetary policy, because monetary policy to me is about the creation of base money and the price of base money. So that's a theoretical definition, so that's one type of definition. You can have a legal definition and you can have an institutional definition, so you can look at precedent and just say, "Well, what did the monetary authority do in the past? Let's call that monetary. What did the fiscal authority do in the past? Let's call that fiscal."

Lonergan: Or you can go to the lawyers, and you can argue in court over what's monetary and fiscal. I have to say, on those criteria, I think this policy is much more clearly monetary, and more so than many other policies. I mean, I think QE is definitely borderline breaching the law in Europe, which is why the German constitutional court is all over it, because there are points in time where, in effect, you could be eligible for QE, but you've lost market access, and that seems to me effectively to mean the central bank's financing you, which is illegal. I think it's debatable, the institutional point you can ... So I think this is much more about the fact that economics actually is very poorly specified in terms of a lot of the key terms that we use, which is part of the reason why these problems arise.

Beckworth: Okay. So let me concede points to both of you there. We haven't defined our terms very well, Eric. Megan, maybe this is a fiction, but maybe it's a useful fiction. So let me put it this way, maybe it's been productive to create this separation so that we can have price stability. The whole famous Fed accord of 1951, for example, where the Fed eventually said, "No, we're not going to keep supporting the interest rate peg." Can we do that without this separation? Whether it's a fiction or not, can we do that? Can we have fiscal policy, for example, taking a more dominant role in macroeconomic stabilization and still preserve price stability, macroeconomic stability in the long run? Because I think the argument has been, once you do give more and more responsibilities to fiscal policy it becomes tempting and hard to control, so how would you respond to that?

Greene: So yes, we can definitely have fiscal policy play a bigger role in macroeconomic stabilization. I mean, economists have known that for a long time. It's just when politics comes into it that it's a problem. So that is the first best solution, I think, to a lot of this. But given that it's not really happening and hasn't been happening in the way it should since before the last crisis, then I think policymakers need to look for other tools.

Beckworth: Okay. Eric, did you want to add something?

Lonergan: Yeah, I totally agree with what Megan said on this. And I would reiterate, to be clear, that I'm all in favor of good fiscal policy, that's a sort of truism, and I'm not an either/or policy advisor in that sense. My view is you should do the best fiscal policy and you should do the best monetary policy, and I think we need both at the moment. To your point, though, David, I think this is incredibly important, and I think it's an area which actually, the MMT debate actually hangs on this distinction, to me. Which is, I think there's a very good reason why we have monetary and why we have fiscal policy, and the distinction hangs on the creation of base money. And the truth of the matter is, you do not have any market discipline in the creation of base money, right? So the institution that can create base money has no market discipline. It doesn't have to sell base money into the market.

Lonergan: The fiscal authority issuing bonds, or the bond financing part of the state faces a market constraint, right? That market can close, or the market sets the price. Now, the point is the constraint on the creation of reserves is inflation, and for exactly that reason, it's not a market constraint. And inflation doesn't have to be a constraint; we've had hyperinflation, right? So you can hyperinflate, and then you destroy your monetary system.

Lonergan: That is exactly why we've created independent central banks. I mean, people seem to forget this stuff, right? And that does not mean they're not democratic, of course they are, that just means they're a kind of higher order form of democratic institution, in the same way that the legal system's supposed to be independent. So they're constitutionally protected, and they're protected by a higher order form of legislation. But there is an extremely good reason why there's monetary policy and there's fiscal policy, and it actually hangs on, do we want to have a market feedback that says to politicians who take control of our treasuries, outside of emergencies, national emergencies, but in normal times, "Sorry, you're actually being irresponsible now, so yields are rising." And do we want to have a different set of constraints, which is namely an inflation target, on the central bank?

There is an extremely good reason why there's monetary policy and there's fiscal policy, and it actually hangs on, do we want to have a market feedback.

Lonergan: And that is very, very clearly set out institutional structure in Europe, and I think that's something that one has to be really, really careful about challenging.

Beckworth: Okay, well speaking of inflation, let me use that as a segue into something I've been thinking a lot about, I'm sure you have as well, and that is the Fed's new average inflation target. So I was thrilled to hear the announcement, people like us get excited about these technical changes. That's something I've been kind of championing in my own work for a long time is make up policy, and this is one manifestation of it. It didn't go as far as I would like it, but I see it as a step in the right direction, I take a glass is half full approach to it. But Megan, I want to start with you, what are your thoughts on average inflation targeting? Do you see it as being credible, as working, as maybe even getting better over time, what are your thoughts?

Prospects of Averaging Inflation Targeting

Greene: Yeah, so I think it faces a lot of challenges. We're all excited about it, but it won't change policy any time soon, right? Rates are going to be really low for the foreseeable future. But there is a credibility challenge, as you point out. Since the Fed adopted a 2% inflation target in 2012, average inflation has been just under 1.5%. So the idea that the Fed is going to overshoot in order to make up for undershooting for so long, it's a nice one, but it's not clear that the Fed can, short of implementing things like dual interest rates, in which case it absolutely can generate inflation. But short of doing something like that, it's not clear that inflation's going anywhere significantly above 2% for any period of time. So I think that's a challenge.

Since the Fed adopted a 2% inflation target in 2012, average inflation has been just under 1.5%. So the idea that the Fed is going to overshoot in order to make up for undershooting for so long, it's a nice one, but it's not clear that the Fed can, short of implementing things like dual interest rates.

Greene: I also think there's a communication challenge, so just an inflation target is complicated enough, I think Joe Six-Pack doesn't really have much sense of what that means. If you ask people what inflation is, generally they're nowhere close to what it actually is. Inflation's a really personal experience depending on what you buy, so that's fair enough, but that's already complicated enough. Now coming up with an average inflation target, I mean, just try to explain that. That's going to be really hard, and also average over what period? We don't know yet, and it seems like the Fed is committed to not working it out for a while, to give themselves quite a lot of flexibility, but is it over a business cycle? How do you explain what a business cycle is to people? I think there's just a massive communication challenge, off the back of a process that really championed communication with the man on the street, right? The whole Fed Listens initiative was to try to get input and try to communicate with regular people.

Greene: Ironically, off the back of this, they've changed their monetary policy strategy so that no one who attends Fed Listens events, other than us, would understand what the heck this actually means. So I think that's a challenge too, but the more crucial one I think is the credibility issue, and I'm just not convinced that we're going to get inflation significantly above 2% any time, for any extended period of time, to offset all the undershooting we've done.

Beckworth: Well, Megan, it's interesting you mention the listening tours. I was at one, at the board of governors, the Eccles Building, and one of the questions that came up was how do you sell that we want to raise the inflation rate temporarily to the public, to Joe Six-Pack? Or how do you say, "Hey, I'm from the Fed and I'm here to raise your inflation rate." How do you communicate that? And of course, that's one reason I'm a fan of nominal GDP targeting. You don't say that, you say, "I'm here to raise your income or sales," but yeah, I think that's a real issue. That's going to be hard to get that past Joe Six-Pack, but also politicians, right? How do you tell politicians, "We want to have higher inflation the next six months to a year?"

Beckworth: That just seems like a losing battle, so it'd be interesting to see how this unfolds. Eric, I want to switch to you on average inflation targeting. One of the things that Megan brought up is it's not well-defined. And to the extent it does work, let's say Jay Powell does get it together and does prove Megan and myself wrong, he does raise inflation, so it works out great. There's still an issue that this is not defined well, so if someone else comes along, they could do it differently, right? And it seems to me you need some clarity on those parameters on average inflation targeting for it to really work well, in addition to the credibility concern.

Lonergan: Well, I think that’s a great point and I agree with everything Megan has said. And you know, I want to be positive, so they're trying to do something helpful, and broadly it's a good idea. But there are some challenges, and one of the things that makes me nervous is that one thing I like about having, in a sense, a live target, which is actually calculated by another institution, which is the inflation rate, is that you can have some degree of confidence, if you are a member of the public, that the Fed can't game its objective. So it's all kind of hands up, now, we're all missing our inflation targets, and that's not really subject of dispute.

Lonergan: If you start calculating an average, and we know, the three of us know enough about economics and statistics that you can then start arguing, well, how do you calculate your average, as Megan alluded to, what time period do you use, to what formulas do you use, which inflation rate do you use, and you can get all sorts of possibilities, even though I have complete confidence in the technical side of the Fed's activities that they would never game it, you just become open to that kind of criticism, which is harder to do, currently.

Lonergan: So I think, yeah, there's some ... It's well-intentioned. I think broadly, having broader inflation targets or averages makes sense, but I totally agree with all of the points you guys have been making.

Beckworth: Okay, well with that, our time is up. Our guests today have been Megan Greene and Eric Lonergan. We encourage you to check out their article, it's titled “Dual Interest Rates Give Central Banks Limitless Firepower.” Thank you, Megan and Eric, for coming back on the show.

Picture by DeFodi Images via Getty Images

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David Beckworth
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Oct 5, 2020
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16269749
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With dual interest rates, central banks have the firepower they need to effectively respond to macroeconomic crises.

Megan Greene on How to Use Monetary and Fiscal Policy to Fight the Coronavirus Crisis

Megan Greene is a senior fellow at Harvard University’s Kennedy School and a senior fellow in international economics at Chatham House. Formerly, Megan was a chief economist on Wall Street and she currently has a bi-weekly column in the Financial Times on global macroeconomics. She joins the show today to talk about the coronavirus and the appropriate policy response to it as well as the future countercyclical macro policy in the United States. David and Megan also discuss the Fed’s future framework, arguments against the recent 50 basis point rate cut, and why the Fed should consider following the ECB’s lead on TLTROs as well as negative interest rates.

DISCLAIMER: This is a special episode on the economics of the coronavirus with Megan Greene that originally aired on Wednesday, March 11. We plan to run several more shows on the coronavirus over the next few weeks. Wednesday’s show with Megan was recorded late last week, and consequently some of the market data discussed is already dated. However, the core arguments and points are still very timely and important.

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. Our guest today is Megan Greene. Megan is a senior fellow at Harvard Kennedy School and a senior fellow in international economics at Chatham house. Formerly Megan was as a chief economist on Wall Street, and has a biweekly column in the Financial Times on global macroeconomics. Megan joins us today to discuss the coronavirus and the appropriate policy response to it, as well as the future of countercyclical macro policy in the United States. Megan, welcome to the show.

Megan Greene: Thanks for having me.

Beckworth: Great to have you on. I've followed your career from a far, you're on TV a lot, you're in the press. A lot of interesting things to say and you have a pretty exciting job. Again, I see you on TV, I see you at conferences. You're working on a book as well, maybe we can talk about that in a bit, but how did you get into all of this? What led you down this career path?

Greene: So my career path wasn't at all linear, I guess I'll start with that. I was a macro-biology major for most of college and at the very last minute, actually long beyond the deadline, switched to economics and politics just because I liked it better. I wasn't quite as good at it. And then I worked in investment banking as kind of a peon, nothing to do with economics. I taught at a boarding school for two years. I worked for the Prince of Liechtenstein.

Beckworth: Wow.

Greene: So nothing related to economics at all really, although I was kind of always at the cross section between politics, economics and finance in everything that I did. And I went to grad school in the UK. I was working on a PhD, actually looking at the economics of populism in Western Europe in the US, and at the time I felt like nobody cared about this topic.

Beckworth: Really? That's interesting.

Greene: I remember asking my parents like, when will this ever be relevant? When will anyone care? And like-

Beckworth: Little did you know.

Greene: Yeah, it's handy now. But I bailed out of my PhD and I ended up kind of landing in a job at the Economist Intelligence Unit. I was their Greece, Ireland, Italy and Germany expert starting in 2006. But even then I didn't know I really wanted to be an economist. I had a good economics background and I was interested in international relations in the world around me. It wasn't until I actually worked in applied economics that I realized that this is what I really love to do. And so I've always been sort of around financial services, how the markets work and how that intersects with economics and politics, but it definitely wasn't a direct path to get there.

Greene: And now I have the best job ever, I would argue, where I sit at Harvard, I'm doing a little teaching, but mainly writing a book, and I write this column with the Financial Times, and I'm a guest on podcasts. I host podcasts, I do TV, I kind of get to do whatever I want. So it's a dream, it won't last forever, but for now I'm loving it.

Beckworth: Yeah, sounds like a great gig. And I hesitate to ask this question because it may not be so, but is there a typical day in your life?

Greene: There isn't really a typical day and that's been the case for me for like over a decade now I'd say, and it's part of what happens when you're tied to a news cycle, I would say. So part of my day is figuring out what's going on and how to respond to it, but a big piece of my day now is working on my book, which is kind of taking a huge step back. I'm looking at wealth and income inequality and how the new economy is driving it. So that's not so tied to the day-to-day news. And so I'm now doing much more of jumping between what's happening right now and drawing these bigger themes and connections together.

Beckworth: So tell us the title of your book and when it will be out so listeners can go and buy a copy.

Greene: So it doesn't have a title yet actually, it has like a super nerdy academic title that will not stay, but it should out in about a year. So there's still a lot of time but it's on inequality and the new economy.

Beckworth: Okay. Well, we'll have you back on the show in about a year so you can plug the book and we can talk about the book and get listeners excited about it to go out and buy their copies. But today we will-

Greene: Perfect.

Beckworth: Focus on more immediate issues, the coronavirus, the appropriate policy response and kind of a nice segue into what monetary policy can or should do going forward. And I want to motivate this conversation by just talking about some recent developments, you know very well because you're in the midst of them and some of us have been watching from the sidelines, but the stock market has been down for a week and a half. Well, today it's back up, it's been a few days, it's gone up, but over a 10% correction in the stock market, the benchmark 10 year treasury yield fell below 1%. People were shocked by that. Oil prices down, yield curve briefly inverted again.

Beckworth: A lot of crazy things happening in financial markets, and the markets were begging for a rate cut from the Federal Reserve and some obnoxious folks like Beckworth echoed that, much to your chagrin and others, not only me, Roger Farmer, who else? David Andolfatto, there's a few of us out there who were beating the drums as well, and you pushed back politely but with certainty. Why didn't the Fed need to step in and do the rate cut that it did yesterday of 50 basis points?

Why Shouldn’t the Fed Have Conducted its Rate Cut?

Greene: So I think that first of all the Fed had no choice because the markets really backed it into a corner. But I don't think it was the right thing to do. If the Fed hadn't gone through, then the markets would have continued to throw their toys out of the stroller and we would have seen a further sell off. But I don't think it was the right thing for the Fed to do, and I don't think it has helped or will help for a couple of different reasons. I mean, the Fed has really good tools for dealing with demand side shocks in the economy. But while that might be what we end up facing, I don't think that that's how coronavirus crisis sort of has started. I think it started off much more as a supply side shock for the US economy. And as it turns out, central banks just don't really have any tools to address supply side shocks.

Greene: So the Fed can hike or cut rates, but cutting rates doesn't really address the issue of firms not getting parts to sell their goods to final customers and getting money. Cutting rates doesn't mean that people are going to go out and spend money either. It doesn't mean factory workers are going to go back to work in China and produce these parts. So it's a really blunt tool that I just don't think was really appropriate in the face of this challenge. And also rates are, were already low before this 50 basis point cut, and so the Fed is now gone and cut rates even more, which just means that we have less room to cut rates when a rate cut might actually help, so in the face of a demand side shock.

Greene: And then finally I think the Fed was really hoping that if they cut rates by more than the usual 25 basis points. So it was kind of a big amount that they did. They did it while markets were open and not during a regular meeting. So there was a lot that was really unusual about this rate cut, and I think that Fed was really hoping that they would kind of engage in this shock and awe. “We're doing something extraordinary, so everybody feel better. We're on this.” And I don't think that's how the markets took it. I think the market's kind of viewed this as, “Oh my gosh, the Fed is panicking and cutting this much in such an unusual way.” And so we ended up seeing a little bit of a sell off yesterday off the back of the rate cut. So I think for a number of reasons, cutting rates wasn't really the right way to go, but I absolutely recognize that the Fed was backed into a corner by the markets who were absolutely calling for rate cuts and who are continuing to call for rate cuts.

So I think for a number of reasons, cutting rates wasn't really the right way to go, but I absolutely recognize that the Fed was backed into a corner by the markets who were absolutely calling for rate cuts and who are continuing to call for rate cuts.

Greene: And that's not that surprising, right? There's a saying that goes that the Fed decides to hike rates and the markets decide to cut them. And investors love lower rates, that's great for asset prices. And so investors who are sitting on portfolios tend to do better when rates go low. So they're always calling for rate cuts, and I think it's no surprise that they're continuing to even though the Fed just acted pretty boldly.

Beckworth: Yeah. Let me respond to a couple of those things, and I want to go back to your analogy, I really liked it, the temper tantrum, the market threw. And it was you or someone else had a tweet or some writeup about some picture or vision of a baby screaming. So walk us through that. Why is that a good analogy of the stock market?

Greene: Because I think that the stock market has gotten really used to the so-called Powell puts and markets have broadly been going up for years now. It's been a really long recovery. And so investors have just gotten accustomed to markets moving in one direction. And what we saw was a fairly big correction relative to what we've seen over the past decade, but in the grand scheme of things, a 10% correction over a couple of days, it's not actually that hugely dramatic. I mean, the markets were already pricing in multiple rate cuts when the S&P 500 had only fallen 4%. So investors seem to be accustomed to this idea that equity markets only go up and if they go down, then the Fed has to step in and support them.

Greene: And so whenever there's a faltering in the markets, investors call for rate cuts because that's what they've been accustomed to, and the second that there is a Fed person who goes out and speaks and suggests rate cuts might come, which is what we saw before the rate cuts happened, the markets actually calmed down and rallied on Monday pretty significantly. So I think the faster you look at investors as kind of these bratty toddlers who throw all their toys out of the stroller or whenever the market starts to falter and then immediately coo and act really happy the second they get what they want, the easier it is to understand this dance that the markets and the Fed are playing.

Beckworth: Yeah. Well, I think it's a powerful analogy. Let me build upon it if I can. So this toddler does often get its way, but the problem is if it doesn't get its way, there's a lot of collateral damage that not only is the Fed backed into a corner, but panic and fear escalate. I think I agree with the points that you outlined, the Fed cannot respond to a supply shock. I completely agree with that. The Fed can't cure the sick, it can't raise the dead, it can't open padlocked factories and it can only respond to demand shocks. So maybe I was jumping the gun, maybe I'm guilty of that I’ll take that criticism.

Beckworth: But I guess my concern was we see things like the expected inflation from the bond market pointing down, oil prices down, yield curve briefly inverted. I mean, am I getting ahead of myself and reading that those are signaling demand slowdowns in the future or should I just be more patient?

Are We Facing a Demand Shock?

Greene: So I think this will turn into a demand shock eventually. I don't think we have... You cited a few indicators that suggest it might be coming. In terms of the actually economic data though we have very little, that includes any period when the coronavirus has really been a global issue. So we don't have much data yet. I think you're right that it's coming. But the idea that the Fed should cut as an insurance policy, which I think this thinking is really pervasive at the Fed that we might as well go big and in advance and then it's insurance and then we can take it out later.

Greene: I don't think that's quite right in part because I don't think the Fed will ever be able to take it out. I mean rates have only really been going in one direction for a little while. So I think we are stuck facing into the next downturn. We don't know exactly when it will be but with much less room to cut now. And that was already a problem before this 50 basis point cut but it's a bigger problem now. And I think maybe keeping your powder dry for when it would be really useful it would be great. But we aren't looking at first best solutions here I mean this is absolutely not the first best solution that the Fed should cut rates and that should be the first line of defense.

Greene: But that is the policy response that we've got. And you're right, financial conditions tightened really significantly. So in a way the Fed does have financial conditions as part of its reaction function and so could justify cutting rates that way. I just don't think that rate cuts are going to do much of anything, and so now we're going to have to go on to what would be more first best solutions having used up the second best one already.

Beckworth: It was striking about the interest rates going down you mentioned that we seem to have a ratcheting down of interest rates, not just short term but long-term ones. So the 10 year falling below 1% I mean it really, a lot of people were just awestruck by it talking about it and it's been going on for some time, a gradual decline. But the drop below 1% was kind of unexpected that it happened when it did. But it reminded me back of 2008 when we went from about 5% down to 3% or so. So we have this, it seems like at least we ratcheting down, whenever there's a crisis, the ten year gets bumped down and we don't have any kind of pull back, we're just continually marching down kind of a longward trend.

Beckworth: I had Paul Schmelzing on the show a few weeks ago and he's been doing this work on a supra secular decline and maybe we're just getting to that ultimate destination sooner because of this shock. But it is striking to see one way path for interest rates, which does make life harder for the Fed, as you said in the future.

The Downward March of Interest Rates

Greene: It does. And I think there's one kind of new quirk that's causing the long end of the yield curve to fall. And it's not really a commentary on what investors are thinking about U.S growth prospects, which is traditionally how you viewed the yield curve. So if it inverted, you'd say, well that just must mean that investors think that the U.S is going to go into recession, so it must be coming. I think there is one new quirk and that's to do with inflation and how persistently low inflation has been. And I think we still are living in this world that we've been in since the global financial crisis where the fat tail risk isn't inflation at all, it's deflation. And so if you're an equity investor and you need to hedge your investments, then actually long-term bonds are a great a hedge if you're living in this world where deflation is the fat tail risk.

I think we still are living in this world that we've been in since the global financial crisis where the fat tail risk isn't inflation at all, it's deflation.

Greene: So I think that's kind of a new quirk that's further pushing down on long-term yields. And I don't really see us escaping from that anytime soon. But I'd also say if that's what's pushing yields down, and I think it's one of many factors, but this one's kind of new. That doesn't mean that we're going to go into recession necessarily, which is often the case when you see the yield curve invert. I think this time around flight to safe assets was a much bigger piece of it. But generally the long-term of the yield curve has been really low. And I think it's partly this kind of financial quirk rather than the fact that everybody thinks we're about to face a recession.

Beckworth: Well, that's a great point. This might be the one time it's different in terms of the yield curve inversion. I think the one just prior to this, we were already kind of veering and we didn't have a recession. We got really close, but we did actually, we inverted briefly and we didn't have a recession. And I credited the Fed, the Fed actually did respond they reverse course after 2018. So maybe the Fed was a little more nimble maybe that's because we have a leader who doesn't have a PhD in economics and he's very flexible in his thinking, but it is interesting to see that kind of different story for why long-term yields might be falling.

Greene: When you mentioned really quickly that the Fed's more nimble and you're saying it that, that's a good thing we avoided a recession and it reminds me, I had a colleague who was a portfolio manager who said in kind of not disgust but in horror, like the Fed's much more like a Corvette now than it is a tanker. It used to be a tanker and so every move was really slow and kind of signposted well in advance. And now it's this Corvette and as economists, we kind of think, well that's a good thing than we avoid recessions. But for investors, having a Corvette for a central bank is actually really difficult because it's much harder to figure out what they're going to do. So that could lead to more volatility at the very least.

Beckworth: And also going back to your earlier point, a tank may have more power, it saves it for when it really needs it as opposed to a bunch of sharp turns that the Corvette may run. So let me ask this question and please push back on it. One of the things that event made me think about is the financialization of the economy. And that maybe, it's getting really hard to have a clean supply shock at all. So maybe you go back 20 years, maybe back to 1987 when there's a big stock market correction or go back to some previous event, 2001 even, I mean 2001 that's right about the time where globalization goes into hyper mode with China entering the WTO and other developments.

Beckworth: But back then maybe you could have a shock, a supply side shock and not have it reverberate around the world so painfully to the financial system. But now we are so interconnected financially it's almost impossible to disentangle those two. So it makes it harder for policy makers to react. You think there's anything to that view?

The Difficult Nature of Modern Supply Shocks

Greene: Yeah, so in terms of financial markets, I think you're right we're much more integrated now than we were before, so it's much harder to try to have some kind of containment. But I would also say that for China in particular, their financial markets aren't quite as open. We're not as linked into their financial markets as we are other kind of capitalist, open market societies. So in that sense, given this, this coronavirus has been sparked by China, has come from China.

Greene: It's worth thinking about that, that the financial markets if you have a market tank in China, it might hurt a confidence elsewhere but the actual specific direct implications of their equities falling aren't that huge on other countries. But I would say other kinds of supply side shocks, they're much easier now, and that's largely because of the globalization that you cite and kind of these global supply chains. But also because more recently, just in time, manufacturing has really come into fashion.

Greene: So it used to be that firms had pretty big inventories. And so even if you had a global supply chain your lead times before you deliver the final product to the client was pretty big anyhow and you had inventories so you could withstand it for longer. And now you've got this just in time manufacturing where you can kind of customize a product and expect to get it two days later and their inventories are really thin. And so any kind of shock to a global supply chain I think is probably much more impactful globally now than it was back even just a decade ago.

So any kind of shock to a global supply chain I think is probably much more impactful globally now than it was back even just a decade ago.

Beckworth: Yeah, those are great points. And I wonder if one silver lining from this crisis will be that businesses diversify their supply chains if there'll be some thinking along those lines.

Greene: Yeah, so I have thought like on the bright side, this would probably be worse if we hadn't had a trade war with China just in that-

Beckworth: That's a good point.

Greene: Insofar as some firms have been able to shift their supply chains, they've already done so. The downside of that is if there had been an easy or cheap option for companies in terms of getting a part that they needed, they already would have shifted it. So now we're looking at firms facing a supply side shock and actually they don't have any easy options for shifting their supply chains. So that's sort of the downside of it.

Beckworth: Yeah, it'll be interesting to see what all the fallout is from this a year from now, and I hope a year from now we will be through the worst of it. I mean, I know there's been these images of China where at the height of the crisis there you saw the pollution drop. You saw satellite pictures where there's less pollution and now we're beginning to see a little pollution pick back up, which may indicate-

Greene: You're also getting reports though that factories have been ordered to open, run their electricity. So I would say…

Beckworth: Be careful.

Greene: Take some of that with a grain of salt, it's hard to know. And it's hard to know what data you should trust.

Beckworth: Fair enough. We'll have to wait and see if we're really over the worst part of the crisis in China. Well, one of the things that's come out of this affair is that the 10 year treasury has fallen, like we talked about, it's the benchmark rate. It's the safe asset yield for the world in terms of setting other rates, and it has created problems for the Federal Reserve. So the Federal Reserve has a limited amount of interest rate space. As you mentioned they've used up some of their ammunition, they're now, I believe one in a quarter percent of ammunition left in the short end. And what happens is they'll go to the long and they'll resort to large scale asset purchases or QE if they get to the zero lower bound or the effective lower bound.

Beckworth: And so this presents problems because now there's less opportunity for them to do QE. And even ideas are on the table, like yield curve control becomes less buyable with lower long-term interest rates. So we're kind of running out of what I would consider the tools in the traditional toolbox of the Fed, and that's got to be making the Fed nervous. And you've written a lot about this, and maybe another silver lining from this crisis is that it will move forward the conversation on what to do in situations like this. So help us understand that.

How to Expand the Fed’s Toolkit

Greene: Yeah. So I think you're right. I think that things like QE and yield curve control will be much less effective if long-term rates are already low. I mean yield curve control would essentially involve the Fed selling treasuries to try to get yields up, which would be shrinking their balance sheet, which is absolutely not what they want to do in the face of a shock of any kind or a downturn. So that had been on the table, but with the ten year dropping below 1%, I don't think it's on the table anymore. I think also it's worth pointing out that the Fed really has its hands tied much more than any other Central Bank because of Dodd-Frank. So the Fed stepped in, kind of saved the US and potentially global economy following the global financial crisis, but Congress was pretty upset that all these unelected men and women were stepping in and making these important decisions. And so implemented all this legislation that really ties the Fed's hands.

Greene: So I think it's much more difficult for the Fed to get creative than for other central banks to do. But I do think that there is one option that the Fed could borrow from the ECB, and I think it could be really powerful. And I think it's actually legal and it exists somewhere else, so that's always a bonus. And that's these targeted long-term refinancing operations, so TLTROs they're called. And in Europe, basically the ECB will lend to banks and they'll lend at the deposit rate right now, which is negative. So they end up paying banks to borrow from the ECB as long as banks lend on to the real economy. And what's interesting about it is that right now the rate at which banks can borrow from the ECB is set at the deposit rate, but it doesn't have to be, it could be set at a totally different rate.

I do think that there is one option that the Fed could borrow from the ECB, and I think it could be really powerful. And I think it's actually legal and it exists somewhere else, so that's always a bonus. And that's these targeted long-term refinancing operations, so TLTROs they're called.

Greene: So they've kind of introduced a second interest rate, and that's interesting because central banks have this policy tool rates which is incredibly blunt, but they basically, for the most part, can either hike it or lower it. And depending on what they do, they have to make decisions about whether they're going to benefit borrowers or savers. They can't benefit them both at the same time, because they only have one rate that they can move up or down. And by introducing this kind of second dual interest rate in Europe, basically the ECB has created this mechanism so that they can benefit both borrowers and savers at the same time.

Greene: So let me just give you an example. So the TLRTO rate is now set of the deposit rate, but it doesn't have to be, it could be, let's say negative 200 basis points. So banks get paid 200 basis points to borrow from the ECB, but they have to lend it on to real businesses and the real economy, they can't go into kind of financial engineering buybacks, that kind of stuff, has to go to real businesses. And largely it goes to small and medium size enterprises that form the backbones in most European countries. And so they can lend on to these small businesses at let's say negative 50 basis points. So then the businesses are getting paid to borrow as well. The banks benefit from a carry trade.

Greene: You've created demand for these loans because you're paying businesses to borrow, you benefit borrowers that way. And then at the same time the ECB could hike the deposit rate into positive territory or at least up to zero, so that they're no longer penalizing savers. So they're benefiting both borrowers and savers and that's in an unambiguous stimulus across the entire economy. So that is something that's kind of new, it already exists. I don't think the ECB set it up actually to use it this way and they're not using it this way yet, but I think that they'll get there, and I think it's something the Fed can look at as well so that they can actually create this unambiguous stimulus.

Beckworth: That is very interesting, and I find it appealing because it actually speaks to an issue that many people have with negative interest rates and that is, if we do negative interest rates, you're going to destroy financial intermediation. You're going to make it hard for banks stay in business. And what you just outlined, I think, and correct me if I'm wrong, is that, banks would still have a positive spread between their funding or borrowing costs and their investing costs or lending costs this way. Is that right?

Greene: That's right. And then I think the other complaint with negative rates is that if you're a saver and you've got negative rates and your deposits are sitting in a bank and they pass those negative rates onto you, you get massively penalized. So this way you don't actually penalize savers, you just create a channel to encourage lending to businesses.

Beckworth: And the reason that banks wouldn't take those funds and deposit them at that higher rate is because they can't, they have to lend on to the real economy.

Greene: That's right. The whole thing is contingent on that rule. They have to lend it on, otherwise they don't access to that rate.

Beckworth: Well, that could be a very powerful. Yeah.

Greene: Yeah, it's not so different from the funding for lending scheme in the UK either, so it's not totally different. And so these schemes kind of exist, but the Fed's never actually gone and implemented them and no one's ever played with negative rates with them because negative rates are such a fairly recent development. And so I do think that it's a tool that we could be more creative about that's actually legal. If the ECB can agree on this, then surely any other central bank can, because it's so hard to agree on anything between all the different countries that are involved in the ECB system.

Beckworth: So has anyone at the Fed talked about it at all? Any discussions you've seen with the review going on right now?

Greene: So unfortunately I don't think this is really on the table as part of their current review. I've certainly talked to various board members and Fed presidents about it, so some people are interested, but for the actual monetary policy, strategy review, it seems like everything on the table is pretty much focused on some version of inflation targeting. And this is a totally different tool. And actually to be fair, I'm not sure that this would be a new strategy, so much as a new tool.

Beckworth: Well, they're talking about yield curve control, which is a tool that would complement like say average inflation targeting. So you could do this also with average inflation targeting.

Greene: That's right, but having negative rates in the US given the money market funds is complicated, and so it seems to be kind of a phrase you don't bring up.

Beckworth: Well it's politically toxic too. I mean, to be frank, it's not something that is very accepted in some circles. Now again, if the ten year goes down to 0% or below, we become like Japan, then maybe it's a whole different conversation, then you can bring up this point. I would go on and say we need to not only talk about the negative rates in terms of this dual rate approach, but I think they're much more effective if you do tie them to some kind of makeup policy, some kind of commitment mechanisms. We will do these until we hit some point. I think you need both of those in the quiver with your approach to monetary policy.

Greene: You know, that's fair enough, and I guess using TLTROs this way, I say it's a tool because it's not clear exactly what the goal is that it necessarily needs to be implemented to hit. So you need to choose that separately whether it's a certain percentage increase in lending, maybe that's your target, I wouldn't recommend that, I don't think any Central Bank is looking at that. It could also be inflation or average inflation price level targeting. So it could be used to hit a whole bunch of different targets.

Beckworth: Now this again takes me back to last year because I think it was in August when we last saw long-term rates go really, really low, not this low, but they were really low and people were talking about the huge stock of negative yielding bonds is like, I don't know, 13, 14 trillion, maybe more than that. We're back here now and back at that time, people were talking about, well, what do central banks do? They were talking about monetary policy, fiscal policy coordination a very awkward term, very uncomfortable area for many people to go into.

Beckworth: I think we are back at that conversation now because we're getting to the place where we may again run out of interest rate space both in the short and the long end of the yield curve. So let's go beyond what's possible legally. We've covered with you what's legally possible with the Fed. What else should the Fed look at in terms of new tools, new targets, if Congress would let them write a blank check, here you go Federal Reserve, do what you gotta do to stabilize the economy. What would you recommend they pursue?

Greene: So I wouldn't give up on legal options just yet, I think you're getting at the right idea, which is kind of coordination, which really freaks people out who are worried about the Fed's independence. But you've had monetary policy and fiscal policy coordination many times in the past and in many other countries in the past without it actually encroaching on central bank independence. So I wouldn't say that's necessarily a reason not to do it. And we have two fantastic excuses for monetary and fiscal policy coordination. One is staring us in the face right now, which is the coronavirus. So coming up with some kind of response to that not only could be a combination of monetary and fiscal policy, but absolutely should be. But then the longer term option the longer term excuse is climate change.

we have two fantastic excuses for monetary and fiscal policy coordination. One is staring us in the face right now, which is the coronavirus. So coming up with some kind of response to that not only could be a combination of monetary and fiscal policy, but absolutely should be.

Greene: So that's another opportunity where we could have monetary and fiscal policy coordination. And that conversation is only really just starting in the U.S but it has been underway with gusto in Europe for example, for a while now. So the U.S is really just waking up to this issue, but I think the ECB will end up doing much more of this sooner than the Fed will do. So those are two ways to have that kind of coordination within the legal bounds. If I didn't have to worry about what was legal at all and I had to address incredibly low inflation, incredibly low rates, and in incredibly low growth. So essentially secular stagnation, I think, then helicopter drops, that's not out of the realm of possible or useful in my view.

Greene: I mean, I think what we need to see is productive public investments, whether you think that low rates, low inflation and low growth they're a demand or a supply side problem boosting investment, both boosts productivity growth and also reduces the massive glut of savings that we have in the U.S and globally. So that would be great. So if I had a magic wand, I would certainly have that be a piece of it. But in terms of how we're going to fund all that productive public investments I do think that there's some who are worried about the deficit and debt burden and I think rightly so. And so to some degree having the central bank finance that could provide the fiscal authority with the cover, they need to do what needs to happen in order to boost growth and inflation and rates again.

Beckworth: Do you worry at all about the politicization of the central bank if we go down the path of say climate change policy?

The Issue of Central Bank Politicization

Greene: Yes. So I think as a first best option, climate change should not be down to central banks. It's not in any central bank’s mandate. Central banks conducting monetary policy, have an outlook of three years roughly, climate change is going to be an issue at some point, but probably not massively in the next three years in particular. So there's just a mismatch of incentives. So I do worry about it, but I also think that as a second best option, it's not terrible. I mean there's a clear role for central banks in climate change when it comes to regulation and supervision. So I absolutely think climate change should be involved in things like stress testing the banks. So that part of central banks insofar as regulators and supervisors are part of the central bank, and that's not the case in every country. But insofar as they are then climate change and central banks matchup.

Greene: But when it comes to monetary policy, central banks aren't a natural actor to address this challenge. That being said, if no one else is going to, then it might not be the worst thing in the world if the central banks pick it up. I do recognize we've been constantly relying on central banks to pick up everything for the past decade and that can't really last but as a second best option given the threat that climate change poses. I think it's not ideal, but it's not the worst thing in the world.

Beckworth: Well I think it's important to do it directly through Congress or directly through fiscal policy if possible too. It's something that the democratic process should consider, make it accountable. I mean my concern is if you resort to central banks doing it, it might be done in a way to get backdoor spending without kind of the appropriate appropriations process where people evaluate where health funds will get allocated. Because ultimately the end of the day there is a set amount of real resources that the government has access to. And whether you do it on balance sheet or off balance sheet, the central bank, it's still the same amount. And my concern is that you turn the Fed into a piggy bank, it becomes politicized, whatever the latest project is. Even if it's a good project, one that's it's important, like climate change, right? There might be other ones that come up, they may not be so productive. It might be a president in the future who abuses that privilege.

Greene: I totally agree with that. So as I said, it's not a first best solution at all. But I do think it's hard to argue that climate change isn't an issue and isn't something we should be doing something about. So I think you're right, central banks will be used as a backdoor of spending. And in some countries you really need that. Germany for example, refuses to come off of its black zero balanced budget when it really has the space to do so. And would benefit itself as with the rest of the year zone. So this could be a backdoor way to get around those fiscal constraints. But you're right, it gives no regard to the democratic process.

Beckworth: So we've been talking about monetary policy as a way to deal too many problems, climate change and we started off by talking how it could be used in part to deal with the coronavirus at least the spillover effects. But probably a better tool, much more effective tool is fiscal policy. And we don't see a whole lot being done there yet. So how would you advise the government to use fiscal capacity to deal with the coronavirus?

Fiscal Policy as a Response to the Coronavirus

Greene: Yeah, so it seems like the government so far was mainly just hoping we get some rate cuts from the Fed, but now that we've gotten them and they haven't really helped, I can imagine there's some scrambling going on in terms of trying to figure out how to respond to this. And of course we've had pandemics before. There are procedures in place, but I don't think we're using our old rule books so much anymore and that we should kind of go back to those and should subsidize them. So first of all, looking after our public health workers and our public health system is like pandemic 101. It's an obvious thing to do. So getting people tested for the coronavirus and not leaving them with a $1,300 bill at the end of it I think would be really important.

Greene: So certain localities have done this and New York City has announced that they're going to test for free, but I think that the government should just be funding tests for the coronavirus without having people worried about having to foot the bill at the end. Protecting healthcare workers, everyone on the front lines is really important. So you heard about firemen going into a nursing home in Seattle with no protective gear at all. And of course now it's spread significantly in Seattle. And so that should never happen. So having the government provide the funding to buy all of this gear that we need and then staffing up hospitals and healthcare centers I think will become really important. Because otherwise we just have no capacity to deal with the search. So that all helps deal with the public health side.

I think that the government should just be funding tests for the coronavirus without having people worried about having to foot the bill at the end.

Greene: But it's also a fiscal stimulus for the economy that could help. Also Medicaid is going to be pretty significantly strained as a result of this and so maybe rejigging how much the federal government pays for Medicaid versus the state so that the federal share is increased, could free up state budgets to deal with things like education. So that could also provide some relief in public health, provide a stimulus, and also allow States to focus on other things that will also be strained as a result of the coronavirus.

Greene: And then there is one thing that's really politically popular that I think absolutely see you, which is payroll tax cuts or holidays. I think that one's really likely and it just leaves people with more in their monthly paycheck. And that’s a pretty immediate stimulus people don't have to wait for that. The problem is it only works for people who have jobs. So if you have to stay home for two weeks because you're sick or because you're worried you might have the coronavirus and don't want to spread it, you could lose your job and then payroll tax cuts really aren't going to help. Or if you're retired, payroll tax cuts won't help you either. So it's something I think we'll see. But I think that it will only help so much. Boosting on safety net I think is important.

Greene: So there's a whole host of people who are on unemployment insurance or SNAP. So formerly food stamps who never really recovered from the last crisis. And I think trying to boost support for them with federal funding would be helpful as well. We could mail checks to people. And we talked about how that could be funded, it could just be deficit funded and then it's just a fiscal policy mailing checks program or it could be central bank funded. And then it would be helicopter money and helicopter drops. Hong Kong has done it on the fiscal side, so it's just deficit spending and I think that's probably better, but that would be a way to provide a stimulus to all the people who have been impacted. And then this is a really different kind of downturn from most in that we're not looking at a massive recession that could last for years like we did with the global financial crisis, right?

Beckworth: Right.

Greene: We're looking at businesses who just need to get through two quarters where they didn't have enough inventories, they can't make their sales, so they just need bridge financing for a couple of quarters. And so having the treasury department or the small business administration kind of target those firms with lending so that they can get through this kind of difficult time and these temporary disruptions I think would be really helpful in addressing the supply side of things. And then, unfortunately, there's no one in charge of all banks who can just say, you have to give grace periods on your loans. But if the different regulators could lean on banks much like China has done actually very effectively, but of course China is a central planned economy so it works a little differently there.

We're looking at businesses who just need to get through two quarters where they didn't have enough inventories, they can't make their sales, so they just need bridge financing for a couple of quarters. And so having the treasury department or the small business administration kind of target those firms with lending so that they can get through this kind of difficult time and these temporary disruptions I think would be really helpful in addressing the supply side of things.

Greene: But I think that would be really powerful if firms who are facing these supply side shocks could just get a little bit of leniency in terms of paying back their loans. That would help a lot as well. So these are all kind of fiscal policies that would cost money and would blow out our deficit more, but for what it's worth that could also raise the 10 year yield a little bit on the bright side. It's not ideal, but I think that's kind of where we are in terms of needing to put our money where our mouth is in a response and not leaving it all up to the Fed.

So these are all kind of fiscal policies that would cost money and would blow out our deficit more, but for what it's worth that could also raise the 10 year yield a little bit on the bright side. It's not ideal, but I think that's kind of where we are in terms of needing to put our money where our mouth is in a response and not leaving it all up to the Fed.

Beckworth: Those are all great suggestions, and it's interesting that you noted at the end the need to have some kind of bankruptcy plan or some plan to forestall bankruptcy for firms during this period. And JP Koning who's a blogger and is also on Twitter a lot, he found two interesting quotes from people on both sides of the political aisle. So he got a quote from Simon Wren-Lewis who's in the UK and I don’t know if you know him at all, but he's over there. He had a piece where he wrote, “If I were running the government, I would have already started having conversations with banks about not forcing firms into bankruptcy during any pandemic.”

Beckworth: Now on the right of center, you got John Cochran who also had something similar to say. He said, “We need a detailed pandemic induced financial crisis plan that forestalls bankruptcies.” So it was interesting, you got two people, right and left of center here thinking along similar lines here because this is an unusual shock, not your typical run of the mill recession.

Greene: Yeah. And while you have an unusually politicized government at the moment, facing this kind of shock could force politicians to come to some kind of agreement on the bright side.

Beckworth: Yup. You also mentioned that the 10 year treasury yield might go up if we do run big deficits. And interestingly, I was looking at a paper by Larry Summers and a co-author where they make the case that our interest rates would be even lower today had it not been for the deficits we've run over the past. And I went back and I was looking, and I took their approach and I calculated where would the ten year treasury be today, and it would be approximately between one and minus 2% if it weren't for Trump's big deficits, historically large peace-time deficits not recession deficits. And so that speaks to the point you just raised that we might actually see rates go back up if there were these programs put in place.

Greene: Yeah. The one thing I'd say is that we did have rates go up under most of Trump's presidency, so that could have been pushing up yields as well just because rates were actually rising. But I do think there are some who are concerned about deficits that usually gets priced into the term premium. And term premia seem to have completely collapsed now. So we'll see whether, if we blew out the deficit even more, if that would make a difference, it's hard to say.

Beckworth: Looking at the chart from the Summers paper, you do see as you mentioned the counterfactual ten year, it does go above zero for a little bit because of Trump's deficits, but it's still really low, it's that at point. And then where it is today, it'd be even lower, but it's kind of a, I don't know, bizarre result of the large deficits that you see rates higher than they would otherwise be and yet they're below 1%.

Greene: Yeah, that is perverse, and I do think it kind of speaks to the lower for longer argument that rates are just going to be low for a while.

Beckworth: Well, I want to go back to a topic we touched on earlier and that is the Fed’s review. It's a big review, started last year. It's going to continue to this year and they've said they'll wrap it up in June, but who knows now with the coronavirus, it might be later than that. But one of the big things they're doing is they're looking at their framework, the strategy, kind of the big picture or what should they target. They're also looking at other items, communication, the tools, but I think what a lot of people are interested in, at least I'm interested in, is what is the framework they're going to adopt and they've been pushing some kind of makeup policy. So you don't let bygones be bygones, if you missed your target, you've got to make up for it.

Beckworth: And kind of the three options on the table I think that I've seen our average inflation targeting, price level targeting and nominal GDP targeting, and of those, only average inflation targeting is really going to see the light of day. And it seems to be, that's where the momentum is. Number one, is that right? Is that what you think is going to happen? They're going to go towards average inflation targeting? Again, if you could play the benevolent dictator here, which option would you choose?

Which New Regime Will Emerge from Fed Review

Greene: So I think you're right. I think average inflation targeting is the front runner with price level targeting kind of in second place, and they're both variations on inflation targeting. So I think that's right that that's probably what will end up being chosen, but in terms of what should be chosen, I think we're all kind of wasting our time with variations on inflation targeting. Just because, it's nice to know that if the Fed undershoots inflation for a while, it's really, really dedicated to overshooting because it's baked into their framework and not just because they keep saying so, which they do. But does anybody believe that the Fed can actually get inflation above their target? It hasn't really happened in this cycle. So I do think that there's kind of a credibility issue, and of course investors and consumers need to buy that upfront.

Greene: So when the Fed says we have this, let's say average inflation target and we've had inflation of 1% and we'd like average inflation to be 2%, everybody needs to believe up front that the Fed will go for inflation of 3% and we'll allow it and welcome it. But that credibility has to be there right away before the Fed has actually had a chance to establish it, and establishing credibility only happens over time. So I think that there is a real credibility challenge with anything that is centered on inflation targeting. I do think that nominal GDP targeting is a more interesting framework. It's very rules-based as are the others, but it's even more so, and it looks at kind of the trade-off of inflation and nominal GDP to ensure that if inflation undershoots for a while, the Fed absolutely has to wait until it overshoots.

So I think that there is a real credibility challenge with anything that is centered on inflation targeting. I do think that nominal GDP targeting is a more interesting framework.

Greene: So I guess it bakes in that credibility, I think a little bit more effectively than average inflation targeting or price level targeting. But I really think as long as the Fed, and now the ECB is looking at its framework and rethinking it, it seems like they're also mainly looking at inflation targeting practices. I think that's kind of a waste of time and energy. And that we're going to end up with something very similar to what we have that's inflation target based. But I don't think it will have been worth the two years of work that the Fed’s put into it. I also think though, I mean in their defense for the Fed it's the central bank for the world's largest economy. Should the world's largest economy be the front runner going out and experimenting with new frameworks? Maybe not.

Greene: I mean the inflation target that we adopted, it was first adopted by New Zealand. That seems like a pretty great size economy to try something new and eventually other countries adopted it. So maybe it's partly just that the Fed's too big and too impactful on other economies. I mean, when the Fed sneezes, everybody else catches cold. So maybe the Fed shouldn't be out there experimenting first and a smaller economy should.

Beckworth: Yeah, I think that's a great point. Maybe we need Canada, New Zealand, maybe the U.K to try it first before the Fed follows through. But I fear the Fed is going to do just some tweaked version of what it's already doing with the claim it's going to make up for past misses. And maybe it will, I'll be pleasantly surprised, and my worry is there will be a credibility problem that prevents it. And this speaks to actually to a bigger issue I see and that is I think inflation targeting has almost been too successful in advanced economies. You look around the world and fighting the high inflation of the late 70s, early 80s was a big deal. They've come down dramatically, but they've all come down to a point where they can't seem to escape. It's almost rigidly low [and] below target inflation.

Beckworth: And I wonder if inflation targeting has created the expectation among the body politic, among leaders that low inflation is only the thing that can be tolerated and any kind of makeup policy is wrong, it's inappropriate, it's kind of an inflation targeting straight jacket they've created for themselves and it's just going to take time to change that conviction, change that belief. And that's, I guess my bigger concern is that we are in an environment we've created and it's not easy to get out of it.

Greene: Yeah, I think that makes a lot of sense. Although in the past 10 years, and in particular as you say, average inflation for the U.S depending on what metric you use. And I think it's CPI has only been like 1.4%, it's way below the 2% target. So we have gotten stuck really low and I do think that there's a credibility issue. And some people have said, "Well maybe we need to announce a new inflation target of 3% and then maybe inflation expectations will move up." My response to that is kind of why would you ever believe that the Fed could get inflation of 3% if they can't get 2%. So credibility is the currency in central bankers and I think most major developed world central banks are lacking these days when it comes to inflation. So it worries me that, that's really all that they're talking about.

So credibility is the currency in central bankers and I think most major developed world central banks are lacking these days when it comes to inflation.

Beckworth: Yeah, now I'm happy to hear you endorse nominal GDP targeting as listeners will know that's music to my ears. I'm a big fan and I know though, at the same time it's the redheaded stepchild of the Fed’s review process. So it won't be adopted anytime soon, but we continue to fight the good fight for it. And hopefully one day it is something taken seriously. And again, maybe some smaller economy will adopt it first.

Greene: Yeah. Maybe we'll get a nominal GDP targeting at the same time and get TLTROs

Beckworth: There you go.

Greene: All good ideas, just not on the table just yet.

Beckworth: A powerful combination. So Megan, you mentioned earlier that when the Fed sneezes, the rest of the world catches a cold. So you make it sound like the Fed is this kind of monetary superpower. Could you expand on that point?

The Fed as a Monetary Superpower

Greene: Yeah, I mean the Fed is the central bank for the largest economy, but it's sort of the central bank for the rest of the world in some ways. One reason is because of globalization. So trade has increased significantly and a lot of trade is invoiced in U.S dollars because the U.S dollar is the global reserve currency. So that means that any Fed policies that put any pressure on the U.S dollar then goes ahead and exerts pressures on other economies. Also related to the U.S dollar being the global reserve currency is the fact that lots of countries, particularly in emerging markets, issue debt denominated in U.S dollars. So with the Fed hikes rates and that goes ahead and affects the U.S dollar and pushes it up, then that makes it more difficult for some of these countries to go ahead and meet their debt servicing costs because they're paying in their local currency. But the debt has been issued in now more expensive dollars.

Greene: So that's also partly why, but part of it is related to kind of what's driving the long run neutral rate and there is this kind of calculation for the global R star. So the global long run neutral rate and it has gone down both in the U.S and also globally. But what a lot of research has shown, and I'm thinking of the paper in particular that Alan Taylor presented at the Jackson Hole conference last August, is that it's become increasingly difficult for a country to diverge from that global R star. And so monetary policy divergence is just getting much harder. It's much harder if you're one central bank who's hiking rates and nobody else is for you to maintain that. And that pertains to the Fed as well. The Fed was the one central bank that was hiking rates much more than any others and sure enough it ended up having to reverse course. And you could argue that's because it was so out of whack from the stance of other central banks.

Greene: So it's just much harder to be an outlier as a central bank and that applies to the Fed as well as every other central bank. So I think it's become apparent that central banks can't just pay attention to what's going on within their own national borders and that particularly is the case for the Fed, which is an interesting sort of dynamic because just as global politicians increasingly are adopting this go it alone attitude, central bankers are actually getting together and saying, you know what? We can't really do that because what we do has immediate spillovers to other parts of the world. So I think we are probably going to look at more central bank coordination going forward and actually we may already be seeing it unfold.

So I think it's become apparent that central banks can't just pay attention to what's going on within their own national borders and that particularly is the case for the Fed.

Greene: You had the G7 central bankers and finance ministers have a call and then the Fed cut rates in the face of the coronavirus. The next day the Bank of Canada cut rates. I think we'll probably see the ECB going ahead and easing next. So I do think that coordination is something that we can come to expect.

Beckworth: It's a brave new world.

Greene: That's right. Yeah, I mean I think it's a good thing that central bankers are recognizing the international spillovers because to some degree they've always been there. They're just now starting to kind of consider that and we are looking at a Fed that does look at international things more than they have in the past. I think that's a positive development.

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

Greene: Thanks so much for having me. It was really fun to chat with you, 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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People: 
David Beckworth
Calendar Date: 
Mar 16, 2020
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Libsyn Podcast ID: 
13503557
Subtitle: 
There must be a robust economic response to the coronavirus crisis, and that may require immediate coordination between monetary and fiscal policy.