Angel Ubide on Getting Central Banks Out of Their Comfort Zones

Central banks are risk averse, and here’s how to balance prudence with a proper amount of risk taking.

Angel Ubide is a Managing Director at Goldman Sachs and formerly was a Senior Fellow at the Peterson Institute for International Economics. Angel joins the Macro Musings podcast to discuss his new book ‘The Paradox of Risk: Leaving the Monetary Policy Comfort Zone.’ Angel argues that the Federal Reserve has become too afraid to take risks when implementing new policies. Instead, he offers alternative proposals aimed to move monetary policy out of its comfort zone. David and Angel also discuss the Eurozone crisis, the ECB, and using more effective communication, accountability, and greater transparency to minimize biases within monetary policy

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: Angel, welcome to the show.

Angel Ubide: It's a pleasure to be here.

Beckworth: It's great to have you. One, it's a great book to read, especially for folks like me who enjoy macro and money. But before we get into your book, I would like to know how did you get into macroeconomics?

Ubide: Well, study economics at the university, went to do a PhD in economics in Florence, Italy. It's a great place to spend four years with a full scholarship doing macro at the European University Institute. And then I was recruited by the IMF, so I came to the city, worked at the firm for five years, did both program countries and surveillance. And then I moved to work in the market. I work in a couple of hedge funds for 15 years and now at Goldman.

Beckworth: Okay. And you also spent time at Peterson Institute for international economics as a scholar there. You've had kind of an interesting journey. You kind of have your ear to the ground, what's going on in the marketplace. You're a practitioner and not just an academic and theoretician. And what I found fascinating reading your book is that many times people in the marketplace, individuals who are financial industry, many times I find people in the finance industry often make claims that academics find incredulous such as the Fed is artificially lowering interest rates or the Fed is the cause of all bubbles or, you know, kind of … But you didn't, you don't have those.

Beckworth: You have much more nuance, I think pretty standard macro view. Yet you're also someone who's in industry. I found it interesting that your views are very informed, balanced, nuanced. What do you attribute that to?

Ubide:  So that was one of the, I think one of the reasons I wanted to write a book, right? I mean, first was to document everything that has happened and put my reflections on it. Then it was sort of try to translate markets for academics and try to translate the academia for the markets, and then put those two things together for policy makers and for central bankers. Part of what I've been doing over these years, as you say, I've been working in the market, but I had a research agenda at the Peterson and other places, and I have participated in a lot of policy conferences and academic conferences. And I think the interesting thing about this book, at least that's what I hope is that it's at the intersection of this triangle, which is the academia, the policy making and the markets and sort of try to educate everybody there and try to get to a better place.

Prudence and Risk Taking

Beckworth: Yeah, this is definitely a book that people of the American Economic Association meetings would read and find interesting, and it's also a book that practitioners on Wall Street would enjoy reading. I think it was a great read. If you had been someone who fell asleep, went to amnesia in 2007 and just woke up this book is a great summary of what has happened. It gets into all the debates, gets into issues about the bond purchasing program, negative interest rates, forward guidance. It's a nice thorough documentation, not just to the US but the world. Let's get into it. The title of your book is The Paradox of Risk: Leaving the Monetary Policy Comfort Zone. What does that mean?

Ubide:  One of the things I tried to convey, and it goes back to what I was saying about trying to educate people at both sides of the aisle, is that there is this view out there among policy makers that you are a conservative policy maker if you minimize the amount of risk that you take. And being conservative makes you wise. And the point I try to make there is that that point is not necessarily true. A policy maker needs to be prudent, and being prudent means assessing the situation and taking the right amount of risk, not the minimum amount of risk. Because if you don't take enough risk, you could make the situation riskier.

Ubide:  And that is the quote that opens the book that is taken from Machiavelli, right, “All course of action are risky, so prudence is not in avoiding danger, but in calculating risk and acting decisively.” And so that is the point I try to make. It applies to monetary policy in normal times, but especially in crisis situations, but it also applies to economic policy in general. If there is an insufficiency of demand and if there is a recession, it doesn't make sense that the government goes in an austerity drive, because you may be thinking you are reducing the risks you are taking by being a conservative, but what you are doing is making the economy more fragile.

Beckworth: Yeah, that's what struck me, is you argue very eloquent in the book that Central Banks had a hard time going outside their comfort zone. And by nature maybe almost they're risk averse. They need to take bold actions, but like you said, it's not in their nature, their DNA to do that. And you gave some really good clear examples. Central Banks, they had a task to respond to the crisis and some things that were very bold but collectively they were very timid in how they applied those bold new actions. You know, the large scale asset purchases are bold in many ways, but in other ways they were still a slave to low inflation.

Beckworth: They were handcuffed by low inflation. And this is something I've definitely have been thinking about too, is no matter what they did, negative interest rates, large scale asset purchases, bigger large scale asset purchases, forward guidance, they were still hamstrung by their views that we can't have temporary overshoots and inflation and we can't tolerate anything. And so we see inflation being persistently low. Your argument is that caution really had a cost, right?

Ubide:  It was excessive, especially at the beginning. Now, people would say there is a learning curve. Fine, I take that. But I think there is an issue that we are hostage of our recent past. And so when you think about, you know, is the power of narratives and this is something that you can see it in the markets a lot, right? Markets are doing by narratives, when there is a story out there, everybody sort of chasing that story. And one of the things we saw is that what was the narrative that got us into the crisis? It was excessive debt and it was excessive risk taking.

Ubide:  And so it was a little bit anti-natural for policy makers to say, to solve a crisis that in principle was driven by excessive debt and excessive risk taking then I have to take myself more risk or a government, I need to think about doing a [inaudible 00:07:39] cyclical fiscal policy that it involves increasing my deficit and increasing my debt. And so there is an inertia there. What is that Central Banks have been thinking the last 40 years is the inflation of the ‘70s.

Beckworth: Yeah.

Ubide:  For them, they only thing that was in their mind is to make sure that inflation didn't go up. And so again, it goes back to the paradox of risk, rather than making an assessment, assuming the past didn't exist and say, what is my main risk today? My main risk today is that inflation is too low, so I act accordingly. They couldn't get rid of the fear that inflation could just snap higher if they were going to buy bonds. And I think it's this tension that has been quite interesting over the last several years.

Beckworth: Yeah, so the risk breeds more risk because of the way they responded to it.

Ubide:  If it's not properly managed, so if you're a portfolio manager, you are basically evaluating a situation and taking the right risks. I think policy makers should be acting in exactly the same way.

Beckworth: Yeah. It's interesting you brought up an example in the book that speaks to this, that we pushed for a lot of reforms on banks and the financial system. Banks need to fund with more capital. They need to be more careful, more regulated, whatever your solution is. There's been a lot of push towards making sure banks, commercial banks are doing a better job, better insulated from shocks, but Central Banks themselves haven't been as eager to embrace change. And so it's almost like we're putting all the heavy lifting on the private banking system and less responsibility, less accountability back to the Central Banks.

Ubide:  I mean this is … maybe I'm jumping a little bit too far ahead, but this is a great example, right? When we think about, we have us commercial banks and the financial sector in general to raise capital and tighten the regulatory and supervisory standards so that they can withstand another shock similar to the one we had in 2008, that's perfectly fine. Then when I suggest, for example, we should be raising our inflation target so that we can withstand a recession similar to the one of 2008 they said, “No, we don't want to take that risk.” There is a little bit of an asymmetry, right? We want to get the financial sector ready for a shock of the size that came after Leeman. Now, we don't want to have our policy frameworks ready to address a situation similar to that one. And I think there is a bit of an asymmetry there. Yes,

ECB Policy During the Great Recession

Beckworth: No, I completely agree. In fact, I hold a view that is controversial. I think Central Bank policy, the ECB in particular you mentioned in your book had a lot of responsibility in making things worse in Europe. I mean, we can talk about banking crisis, but sometimes the shock coming to them wasn't just debt it was bad policy. The ECB raising rates twice in 2011, I mean, raising rates in 2008, no matter what condition the banking system was in, those shocks only worsened them, right? And so you've got to get good monetary policy in place in addition to the other fixes you want to apply.

Ubide:  Absolutely. And I think we need to make sure, and I know this is wishful thinking, but that monetary policy really can operate without the pressure of politics, right? I mean, a key reason why the ECB did monetary policy the way it did, which was first only focusing on liquidity provision and interest rates, and only much later on buying government bonds, it was mostly politics, right? Because a lot of the arguments that were made at the beginning that QE was illegal, it was not allowed by the master treaty and by the ECB’s status. Obviously we’re seeing now that there were not true.

Beckworth: Right, we’re doing it now.

Ubide:  It would have been a very different decade if the ECB in 2008 or 2009 had started doing QE the same way that the Fed and the Bank of England did it. And all the arguments back then, “But the ECB cannot do it because it doesn't have Eurobonds or it's a monetary union and all that. Obviously they are not true in hindsight because they are doing QE now.

Beckworth: Right. Yeah, you mentioned in the book that one of the biggest reasons the ECB got politicized was Germany and that the Germans themselves are some of the biggest advocates of an independent Central Bank, right? The Bundesbank was this gold standard of central banking and they wanted to uphold this. In one hand they preach, you've got to have an independent Central Bank. On the other hand, they were some of the most adamant critics. They filed lawsuits. The rhetoric from the finance minister and government was very much against the ECB. There is a, you mentioned this irony that Germany was politicized in the ECB at the same time talking about we need an independent Central Bank.

Ubide:  Exactly. I think it's a bit sad, right? I mean, when you look back, the constant attacks on the ECB coming from the German academia, I'm part of the political establishment, I think are quite … they are very negative. They are very harmful. They have dented the credibility of the ECB in the eyes of the German public opinion. When you watch the press conferences that the ECB holds with every meeting, you can just see the tone of the questions coming from the German journalists and how they are so different from the tone of the questions coming from all of the other journalists. And so it is a bit of an antagonistic approach that the German public opinion has versus the ECB. And that's not healthy. It makes the ECB less effective and it just creates an environment that is more politicized. Politicizing this sense of basically everybody questioning what the Central Bank is doing and whether there is a second agenda or anything like that. And that's not good.

Beckworth: Well, we're on the ECB and we're getting ahead of ourselves, but we're on this conversation and you've worked in Europe and know it very well. This credibility problem between the German public and the ECB, do you think this may cause problems in the future? I mean, can the Eurozone survive with this type of German sentiment?

Ubide:  No, I think in the end the outcome has been quite good given the difficulties, right? Despite this opposition, despite the lawsuit, despite the dissents, the ECB, when it finally got to put the right policy framework in place, which was essentially at the end of 2014 when they cut rates to negative levels and they did this big QE program, they have managed to put in place a very aggressive monetary easing. And so they have managed to generate a very strong recovery, which now we can call it expansion in the Eurozone of which German is benefiting a lot obviously. That's why they have such a low level of unemployment. And they have managed to essentially put the euro area in the right course.

Ubide:  Now, I think the other thing that is important is that as I was saying, yes there were lawsuits, there were questions about the legality of a lot of these instruments but now we know that there is no question about the legality of those instruments. If it has to happen again it will become much more natural that it happened. It was painful. It was difficult. I think we are in a better place that many of us thought we were going to be just three or four years ago. And the ECB, the current leadership deserves a lot of credit for that. And then the question is to think about the future, what does the ECB and the policy framework, but also the policy framework in the euro area needs to do in order to make sure that the next time things are not so complicated.

Beckworth: Do the Germans recognize the contribution the ECB has made with its programs? In other words, you mentioned the economy is taking off … not taking, it's warming up in Europe, it's doing better because of these programs. Are Germans willing to give credit to the ECB and therefore embrace it more?

Ubide:  I think at the margin, but some of the bad habits, to call them like that, persist. For example, inflation is only 1%. It has been 1% the last three or four years. And there is an important part of the German public opinion that is calling for an end to QE, for an increase in interest rates because they think that rates are abnormal. And what I say, and it goes back to one of the things I mentioned in the book, they shouldn't focus on the instrument, they should focus on the objective. And the objective is inflation close by below 2% and the ECB is not there yet. There is no reason for any change in policy simply because you think that zero rates are abnormal or that by imbalance is abnormal.

Ubide:  They should continue to focus on the objective. There is still that sort of lingering issue, but I think slowly the ECB has been quite good at explaining what they are doing.

Beckworth: Slowly it's becoming normal to have the ECB do these things even for the Germans?

Ubide:  I hope so. That's one of my recommendations. Again, I hope I'm not jumping too far. It's one of the recommendations in my book. We should call all these instruments … we should stop calling these things unconventional, everything is conventional.

Beckworth: That's a good point, right. Over time it does become normal. What is normal? And this is the new normal. Going back to your point, the first chapter and the title of the book, The Paradox or Risks, you mentioned Central Banks and the struggles they went through and how they may have heighten the risk by not being appropriately at least immediately. You also mentioned fiscal policy, and one of the points you raised in the book is that this narrative, this thinking that got them in the trouble could be really illustrated with debt to GDP ratios, or you look at debt to GDP and is it a cause or a consequence, right?

Beckworth: And so yes, if a country is running excessive amount of debt and you go into the crisis with massive debt to GDP, that's one thing. But for me, these countries like Spain for example, that the GDP shut up after the crisis or because of the crisis. And so you’ve got a view that as a symptom as opposed to the cause. You need to be careful, right? But you mentioned people … One of the things you mentioned in the book I found also illuminating is that many public officials said, “I don't want to be the next Greece.”

Ubide:  Yup.

Beckworth: I remember that in the US, apparently in Europe is a big thing too. But Greece kind of confirmed everyone's worst fears, the Germans in particular, but even in America. And so no one wanted to be the next Greece, so they just started looking at debt to GDP is crossing 90% or whatever the threshold is, even if it's driven by a cyclical change as opposed to a structural change.

Ubide:  It is, again, it’s the power of narratives. In some sense, one of the things I also want to develop with the book is the behavioral biases that we have in public policy, in economic policy and that is one. You see Greece, Greece becomes the anchoring of everything else. Nobody wants to be like Greece, when it doesn't make any sense to have that fear. Imagine Australia, why should Australia worry about being the next Greece. But I know that everybody was going into the G20 meetings and everybody was saying, “I want to do a fiscal adjustment program, because I want to be seen as fiscally disciplined.”

Ubide:  And that was the anchoring effect of everything having started with Greece. Imagine everything having started with the banking crisis, for example, rather than a fiscal crisis. I can imagine that everybody would have been looking at its own banking sector and trying to make sure they were tightening the banks. And so this is something that is interesting because these behavioral biases, they create bad decisions in financial markets, but they also create bad decisions in policy makers. Think about Reinhart Rogoff, 90% threshold. It became an anchor. It was the wrong anchor, because it triggered a lot of behaviors, including here in the congress, right? And a lot of issues about the sequester and about the other things that then we have seen that made little economic sense.

Beckworth: Yeah, no, I agree with that. And I think while debt is important and it can exacerbate a crisis, I do think policy is just as important. I mean, I take a strong view on that, that monetary policy really was an important part of this crisis. I think for example, the Fed, and you don't stress this as much in your book, because it's more my view that the Fed set on its hands from April 2008 to October, a 2% seems low and it did cut a lot. But when it set on its hands, it was signaling, it was concerned about inflation, it was talking up inflation fears. And the market's reacting, okay, that means they're tightening and implicitly they want to tighten.

Beckworth: And one thing I've mentioned before in this show is if you look at Fed fund futures like a year in advance, they start rising to the first half of 2008 because the Fed’s, you know, and by June the Fed fund future rate one year in advance is three and a half percent. I mean, so that I believe is very destructive. I do think there would have been a recession no matter what. But I do think the Fed definitely did not help things and maybe made it worse. And the ECB’s case clearly it made things worse. I do agree, I mean … and the reason I bring this up is your understanding of what caused the crisis, what was the main contributor to the crisis is going to shape your narrative of it. And the popular narrative may be right, maybe wrong, but it's going to shape policy whether for better or for worse.

Ubide:  Exactly. I mean, I always say that the most persistent effect of a crisis is the consensus about what drove the crisis, right? Because that's going to drive all the policy actions after the fact. And if the consensus on what created the crisis is wrong, we are going to adopt a lot of bad policies. And so that's very important. And that's again, I go to the power of narratives. It is then very difficult to dislodge these narratives. And so we need to be very careful when we say, “Well, this is what happened. It was all a debt crisis.” Well, if it's a debt crisis, we are going to try to reduce that. And if we all reduce that at the same time, we are going to end up in the wrong place.

Beckworth: Yeah. Your book has come out about a decade after the crisis started, so I mean, I think this is part of the conversation that’s going to be had, right? We're going to have people taking 10 year anniversary looks and probably for a long time on we'll be trying to … what was really, because the Milton Friedman's classic book came out in the ‘60s, which really made us reevaluate, or caused a great depression, right, which was 1930, 30 years later before people really got the narrative right. I agree, this narrative point you raised is a very important one.

The Leadup to the 2008 Crisis

Beckworth: Okay. Let's move on to your second chapter where you get into the background of the crisis and you know, call it confirmation bias, but I really love what you said in this part. Because there are several things you bring out, but one of them is the importance of the 1970s in shaping the response of Central Banks to the crisis. Speak to that.

Ubide:  I mean it was, if you think about it, the ‘60s was a happy time and then all of a sudden we spend 20 years with high inflation. And you get to Volker and Volker had to do a change in the framework in order to essentially start bringing down inflation. And so that took us over a 20 year journey after that that converge into the development of inflation targeting regimes. And then we got the Great Moderation. Now, the Great Moderation, we still don't know how much for slack, how much was good policies, but we all loved it. And so you get to 2007, and then you say, “Oh, the most important thing here is to preserve the hard-earned credibility of monetary policy, having to stabilize inflation at 2%.” But we only look to the upside. We don't look to the downside.

Ubide:  One of the reasons we didn't look to the downside is because we thought that the problems that Japan was facing is because they didn't do the right things. Not because we thought that they put in place policies but they just didn't work, it’s because we thought, they just didn't know what they were doing. And I think one of the things we have learned in the last 10 years is that Japan have been doing everything that it was supposed to do. It wasn't just doing enough, but it was doing everything. Japan has been 10 years ahead of everybody. But now what we are realizing is that it's much more difficult to increase inflation when it goes down than to reduce inflation when it goes up.

Ubide:  And why is that? Because from the point of view of taking risk, a Central Bank will never hesitate to show toughness in creating a recession to slow down inflation. But it seems that it's more difficult for a Central Bank to show toughness in taking a lot of risk to boost risk-taking an activity. It seems that it's easier for a Central Bank to put rates, say at five and hold them there until inflation comes down, than to put rates at zero and hold them there and the inflation goes up. And it’s this asymmetry that I find fascinating and I think it's one of the things we have discovered in the last 10 years. And that's what again, I go back to the issue of you need to take the right amount of risk.

Ubide:  I had to spent the last few years debating with journalist and others when they said there is too much liquidity around. I said, “No, there is not too much liquidity. There is liquidity,” or “The rates are too low.” I said, “No, rates are low, they are not too low,” because look at inflation. You are not achieving your inflation target, so it cannot be that rates are too low but they feel too low.

Beckworth: It just seems unnatural-

Ubide:  Exactly. And so we need to go against those things, so some things that feel unnatural and that's what I got to, we need to eliminate the stigma of some of these things. Because if we keep the stigma, we are going to continue to think that it feels wrong. And many times what feels wrong is the right thing to do.

Beckworth: Well, and that's what's interesting, as you mentioned, it helps us better appreciate what Japan was going through. It wasn't just that they were ignorant, it's just that they're dealing with these behavioral bias, whatever you want to call these, cognitive biases that limit us from doing the right thing and thinking clearly. And I agree. I think higher inflation, it can get it. It just doesn't have the desire to do it, because it's fearful. It's very risk averse. And the thing is, I can understand it at some level. If I talk to my friends who are not an economist, I often get the, “Man, the Feds are just stealing from savers. The Feds are artificially lowering rates. Beckworth, how can you condone this?”

Beckworth: I’m like, “No, you're the ones causing the rates to be low.” I mean it's … the desire to savings is higher than it's been an investment's low. The truth is the Fed is just trying to follow what you guys are doing. But that's a harder message to sell. What they see is this big powerful institution lowering rates. And for them it seems … what's natural is 4% or 5% rates. I agree, it's been humbling, but it also seems challenging. What do we do to really shape this narrative? I mean, you're making a very bold effort here, the book, but I feel like it's like I've got to convince my friend who's not an economist and a person who votes for Congress and all of them as well, that it's more complicated than just...

Ubide:  I mean, there is a lot of education in fact that it's needed, right? Because again, we started the crisis by thinking this was going to last six months. I mean, you were saying before that the Fed in the summer of 2008, some people were thinking about raising rates. The ECB did get to raise rates. Some people in Washington were considering whether they were also going to raise rates. There were those instincts. Remember, in 2009, 2010 Bernanke already gave the exit principles. That was six years, too early.

Beckworth: Yes. He was a little too early.

Ubide:  But that was the point, right, they we're worried that without communicating that they could exit, that people were not going to agree with their entering. And now it's completely different, because now we are trying to say, especially take the ECB that is still has a lot of work to do. That is, listen, trust me, I'm going to do whatever I need to do. I'll think about the exit when the time comes. It's a different mindset that we have today because of what we have learned with respect to what we had in 2007, 2008. There is a lot more education that needs to come out of this.

Beckworth: Yeah. Maybe your point earlier that now that we've seen it, been through it, it might be easier next time to tolerate a little more boldness. But I do want to go back to this point, you know, in inflation fears were big. I have a paper write … one of the things I did is I collected some survey data on biggest fears and inflation becomes, and a part of that was due to commodity prices going up in 2008, but even in … This survey, I looked at even 2009 inflation … people were highly concerned and inflation actually bumps up a little bit in 2009 over 2008. And what's striking about that is by 2009, it's pretty clear we're in a deep recession, even headline inflation, even deflation, people are still concerned.

Beckworth: And I think the reason they're concerned is because it seems so scary, right? I mean, you had this huge QE1, was very radical, president Obama's fiscal stimulus seemed really … Everything seemed different and radical and scaring. And then they were very concerned about inflation. Going back to your point, they were thinking about the 1970s again.

Ubide:  And they were thinking in terms of quantities, right? Which is something that has created, I think a lot of misunderstand, because we define QE as the amount of bonds that we bought. And so people saw this massive increase in the balance sheet of the Fed. And so those who still believe in monetarism they said, “This is going to translate into a lot of inflation.” Now, what people didn't understand at the time, and it hasn't been properly explained, is that the moment we started paying interest on excess reserves, the link between the balance sheet of the Fed and any measure of money is broken. And the link of any measure of money and inflation had already been broken that previous 20,30 years, right? But what we got is that the Fed very quickly put in place a mechanism that allowed them to run any monetary policy with any size of a balance sheet.

Ubide:  But that was sort of lost in the noise. We were talking about 10,000 other different things. And so one part of the economics profession was still thinking about money is here and money will eventually create inflation. And it has been a question of, okay, but what about Japan? But Japan was different. Now what we are saying is that Japan wasn’t different. Monetary policy operates via risk taking and via risk-free interest rates and quantities don't really matter. And I think that's one thing we have learned.

Could the Fed Have Used Interest and Excess Reserves Differently?

Beckworth: Let me ask you this question then. Do you think the Fed could have used interest and excess reserves differently to have helped stimulate the economy? I mean, what you're implying is all those bank reserves are created basically sterilize in consequential, no effect on inflation. Well, why not do what the ECB did and maybe make it negative? Why not-

Ubide:  Well that depends a lot on the specifics of each financial sector. And I think there was a discussion and there was a conclusion that given the structure of money market funds, the structure of treasury markets and all that, it wasn't, you know, the risk reward to put it like that of going negative wasn't that appealing. The same conclusion was reached in the UK. A different conclusion was reached in the area of Japan. It's very idiosyncratic..

Beckworth: Yeah. Maybe I'm wrong here, but it seems like this goes back to your earlier point though. They are more worried about preserving the money market fund than they were about a full recovery.

Ubide:  Fair enough,

Beckworth: Which means like, look, there's some kind of trade off you’re weighing, some kind of-

Ubide:  Fair enough. But you know, we did have a little money market fund crisis.

Beckworth: We did, and they were belled out and they were … Look, and I'll be fair, in real time all of this is much more complicated than you and me here. But … and I know also like 2000 … I criticized 2008, but in 2008 GDP numbers weren't showing it. But the thing is there were other signals in 2008, very clear that something was … break evens were dropping. There's a lot of things that were … asset prices were screaming, wake up Fed, something bad is about to happen. I want to just stress the 1970s. This is maybe my hobby horse, but I really think that it has created this … It's an unwarranted fear of inflation. It wasn't bad experience, but it's not typical. And there was a paper last year by Malmendier [inaudible], Making of Hawks and Doves, an NBER Working Paper

Beckworth: And what they go through and document is that those individuals who lived through the 1970s and are now on the FOMC, they were older and aware versus people who are really young during that period, maybe less aware who are now on the FOMC. That the younger folks are less worried about the 1970. The older ones are more … so for example, let’s put a face to this. Neel Kashkari he's not that concerned, but he doesn't … he sees the undershooting as a problem. But like both Ben Bernanke, Janet Yellen have expressed concerns. We don't want to go back to the 1970s, so an older generation is more bias, more worried, younger generation. This might be a generational thing.

Ubide:  Listen, I mean, one way I like to think about this is that risk management is an exercise in imagination. And so in some sense you are hostage to your experience and the patterns that you have seen. You see that in markets all the time, right? Some people say, markets did X during this period and they are going to replicate it, and so their period, because it sort of looks similar. And I think for policy makers is the same thing. Policy makers come to the picture, and that's what I say it's so difficult … it's so important to get rid of the biases because you need to come to the table with a fresh mind and say, “Give me my best information, the best analytics, and let's think about it regardless of my own personal biases.”

Ubide:  And I think it's what you say, that people who lived through the ‘70s and especially those who were instrumental in bringing inflation down and in creating the inflation tolerating regimes, they own that. Going back to behavioral economics is the endowment effect. And when you own something, you value it higher. Now, if you have lived basically your professional life the last 20 years, all you know is the great moderation and the undershooting of inflation. And so for you the main risk obviously then inflation is too low, because the ‘70s is something that is in the textbooks but you don't really experience it. And I think that's the issue. And that is why it's important to have people from different age-

Beckworth: A diverse representation.

Ubide:  … codes in the committees. And then it's really important to have processes in place that try to minimize these biases when you are making policy decisions. And that's why I insist all the time, it has to be goal oriented monetary policy. Because put the goal there and constantly try to focus on it.

Beckworth: Yeah, that’s a good point.

Ubide:  So, that chart that you saw of the darts with the bullseye and all the dots down there, exactly. When you are doing inflation targeting properly and you are at 2%, you should have hits all around two, not only below two.

Beckworth: Yeah, we'll put that chart on our website. This is a chart of the target where there's someone shooting guns and as Angel said, and a true inflation target, there should be just as many shots above as below the target. But what we're seeing from the ECB from the Fed is they're persistently below. We'll make sure to get that chart online so you guys can enjoy it too. This cognitive shortcoming is … I like what you said, you're a hostage to your imagination, which is sometimes shackled by what you've lived through. And so you mentioned one solution to be, to have diversity of ages on the FOMC. But sometimes that's not possible. Oftentimes you get older more … You mentioned processes, what kind of processes could you introduce FOMC so they're not just thinking 1970s? Is there something you could actually do?

Ubide:  I mean, one thing, the more, for example, I've been thinking about this and I keep on changing my mind every now and then, but if you are forced to publishing your forecast, then your forecast is there. You have a reputational cost. If you don't meet your forecasts and if you know your mandate is to hit some target, then you are constantly being challenged or judged by your peers. That is quite important, for example. There are other issues of our process, for example, the issue of change in the inflation target. You could have a process whereby you have to review your inflation target every three years or every five years, like the Bank of Canada does. Why? Because it forces you to do it.

Ubide:  If you don't have a process like that, you may not want to do it. It's politically inconvenient and it's not the right time. You have a process, you have to do it. And this is, again, I'm going back to my experience, a portfolio manager in markets. The way you try to overcome your biases is putting processes in place that essentially tried to keep you in the right place. And so transparency and again more communication of that type I think is the kind of thing that can help you overcome the biases.

Beckworth:  That's interesting. Again, going back to the point about we expect banks to be behaved better now. We impose tighter capital restrictions, but Central Banks have yet to maybe fully account for the biases that lead them down these paths.

Ubide:  I think they are working on that. I think here at the Fed for example, this debate on changing the policy framework is starting, is becoming more public and that's quite good. There has been conference that the Peterson, [inaudible]. There are going to be more events about that. This is going to generate a public discussion. Then you have the minutes, you have the speeches, you have a lot of things there that is going to be very difficult for them not to be subject to a lot of public scrutiny at some point if they decide to do something or not to do something.

Beckworth: What about the idea of a Central Banker’s wage or employment status being tied to hitting the target? New Zealand, this was supposed to happen, never has actually happened, but the head governor in Bank of New Zealand in theory could lose his or her job if he didn't hit his target over the business cycle. I know that it never actually has it been … that levers never been pulled, but do you think that'd be one way to get around the bias.

Ubide:  Maybe a little bit too harsh, because it could create short term [inaudibl], right? The same way we complain about firms trying to meet the quarterly targets and that affecting behavior. I mean, Central Bankers have their terms and if they don't do a job I imagine they don't get reappointed, and they put their reputation on the line. I don't think Central Bankers like to be criticized in the media and the rest. I think the important thing is that there is an open discussion and that there is a transparent, back and forth. And that the scrutiny is not simply the Central Bank governor or president going to the Congress and having a back and forth with the senators about something that may be completely unrelated. Should also be with the community, the economies, the general public and be more open.

Beckworth: Okay.

Ubide:  And if you are more open then you are going to be more transparent and more subject to feedback.

Beckworth: Okay. Just to recap your chapter on the background, we got the ‘70s, create this kind of mental bias, this shackle to your experience. The great moderation, you also mentioned it was from some people formative in the sense that they thought that was normal, small business cycles. You mentioned, if you came to view the great moderation as normal you couldn't imagine a great recession ever happening. Therefore, you would never need to respond aggressively, so there's another compounding bias. Then you also switch gears and focus specifically on the ECB. They had other issues the Fed didn't have.

Beckworth: They were an experiment, they were very careful, almost built so that fiscal dominance wasn't a part. The Germans wanted to make sure those people on the periphery didn't drop their debts off. Also, you mentioned that in the Eurozone that any kind of convergence, any changes in real exchange rates had to come through. Internal devaluation is not through changing price levels.

Ubide:  That's very important, because it goes back again to the anchoring effect, right? The European policy makers spent the best portion of the first decade, of the century worrying about competitiveness, divergence real exchange rate diverging. And so when the crisis hit, the first thing that they did was to say, “You see, I told you.” That was the reason. The reason was that Spain had another value, real effective exchange rate, Greece too, Ireland too, others too. And so the solution was not demand policies. The solution was a structural reform to regain competitiveness. And you know who had been one of those who had been banging this drum was there.

Ubide:  And so part of the reason I think why the initial approach to the crisis in Europe was to think it was mostly stricter and that there was no need for a counter cyclical demand policies, if you want, that most of the work needed to be done from stricter policies was this one. Now, what we have seen with time is that Spain, for example, has completely compressed a current account deficit that was 10% of GDP to now being imbalance without necessarily having the help of the exchange rate and having gone through, I would say very mild adjustment in prices and in wages. Now, when I say mild, I need to be careful because yes, wages have been either flat or even negative at some point. But when you think about the amount of adjustment that it was thought it was going to be needed, it has been quite a small.

Ubide:  I think what we have learned is that the obsession with competitiveness was overdone, and that the euro area economies have been way more resilient that what it was thought it was going to be the case.

Beckworth:         Yeah. And you mentioned in your book, I mean just going back again to the big theme, The Paradox of Risk, some banks being afraid to leave their comfort zone. As you just mentioned, initial experience confirmed their prior of … it's always structural problem and you mentioned Bayesian prior here for the leaders of the Eurozone, European Union as it's structural, that's the first issue. I think, and you would probably agree, there are structural problems, but that immediate shock was a demand, a cyclical one that required. But when they saw elevated real exchange rates in the periphery, like, “Ah ha, how do you fix those?” You fix them through structural changes.

One-size-fits-all Monetary Policy in the Eurozone

Beckworth: Let me ask something about the Eurozone while we're on that. One of the takes I've had on the Eurozone crisis other than it may never have been of more currency or in the first place, but put that to the side, let’s assume that that's not an issue, is that when you take a one size fits all monetary policy to very different economies that don't have all the shock absorbers, labor mobility, fiscal transfers, this is almost bound to create some kind of problems. For example, in the early part of the Eurozone's experience, Germany was really sluggish. Who's the ECB going to adjust its rate to the average, but the average is weighed down by Germany.

Beckworth: So rates were roughly appropriate, like a Taylor Rule perspective, roughly appropriate for Germany, but they were way too easy for Ireland, and for Spain, for Portugal, and that helped fuel the boom. Then you go into the crisis, rates are still roughly appropriate for Germany, but they're way too tight for the periphery and that makes things worse. I mean, in some ways is this something we can … maybe your answer is we have seen some adjustments so that there is more internal migration or more price flexibility?

Ubide:  I think two points, right? You say it absolutely right that monetary policy is not enough for the euro area to have an optimal growth path, because there are going to be cyclical divergences and so you are going to need something else. And the something else is fiscal policy. And so the debate today is should you have a euro area fiscal policy or should you have something that compliments a national fiscal policy so you can address these kinds of issues? I think that that's the first part. Now, the second point, and I think the positive one is that we have seen that there has been a lot of adjustment that has happened without necessarily requiring hiring your own currency. There has been a lot of labor mobility.

Ubide:  Now, labor mobility is just different. I think there was a lot of obsession in the euro area at the beginning that labor mobility had to be from one country to the other. What we saw during the boom was a lot of external migration coming into the Eurozone. And a lot of that external migration then left. And so the adjustment in terms of labor mobility also happened, but it happened in a different way. I mean, that's the case of Spain. Spain had one of the fastest population growth in the world in the 2000s, but it was all basically Latin-American immigrants. All of a sudden population in Spain went up a lot. A lot of those left.

Ubide:  And so we had part of that. The same thing with Eastern Europe, so Germany basically enjoys an infinite supply of labor that comes from Eastern Europe. That goes back and forth. There are different ways in which the economy has adapted. Again, it remains suboptimal. It is still needs, in my opinion, a European fiscal policy, especially because the stability and growth pact and the fiscal compact are asymmetric. They can force countries to tighten policy, but they cannot force countries to loosen it once they are inside the 3% range. And so you get the policy framework that is in some sense deflationary.

Ubide:  Because if the euro area as a whole needs a fiscal expansion, but none of the countries volunteers to do it, then you don't get it. And so there are these issues, but I think that the end result on the euro area is that this idea that the UK is a safe asset because it has its own currency, but Spain is not safe because it doesn't have its own currency. I think we have we have seen that does not necessarily true.

Beckworth: That's interesting. So you're saying the typical thinking, my thinking of the lack of labor mobility is I'm thinking, well, people from Spain aren’t moving to Germany or people from Greece. But what you're saying is there's other labor mobility. There's international labor mobility, so from Latin-America to Spain in and out, and then in and out of Germany. That’s very fascinating. In some ways what you're suggesting is the euro zone is maybe moving, inching closer to an optimal currency area. On the margin it's becoming an endogenous currency or?

Ubide:  Let's say it’s a better currency area.

Beckworth: It’s a better currency area.

Ubide:  And the currency areas are endogenous, I believe. And I think it has shown that it can work as one. But it still needs improvement. I think that's very clear and very important.

Beckworth: Yeah, so there's room for improvement, but what you're saying is people are so dedicated at this project that by sheer will, this thing is moving a little bit closer to being an optimal currency area. Let's go to your proposals. I encourage listeners to look at the rest of the material in the book. I haven't done justice to it. Angel has several proposals moving forward that will move monetary policy out of its comfort zone and make it flexible and adaptable to any shock that comes. Tell us about them.

Ubide:  Basically the point I make is yes, monetary policy has worked but it could have done better, and we can get better prepared for the next recession. And so what do we need? And I think we need action in several areas. One is to increase our inflation target. And as I said before, we need more room to cut rates. And the way you achieve more room to cut rates is by hitting the recession with a higher inflation rate. That also obviously would have probably higher nominal rates, and so there is more room to cut rates. I think we need to … I'll focus more on dual mandates and that's very clear in the case of the Fed, but in other Central Banks it’s not.

Ubide:  If you have a situation where there is hysteresis and where there is very flat Phillips curves, it's very important that Central Banks test the limits of growth. Because if you don't test the limits of growth, you could get stuck in a situation where potential growth is low, not because it's strictly low, but there has been a shock, hysteresis has created a situation in which the weakness in demand becomes weakness in supply. And if you don't correct that, then it becomes paramount in weakness in supply. A way to think about it, and I think that applies for example, to the Fed now, is don't worry about the unemployment rate being too low.

Ubide:  You keep on pushing until you get your inflation rate where you want it to be, because what do you know about where the [inaudible 00:48:23] is? After all, we don't know. The third point is that I think Central Bank should get ready to carry large balance sheets and to be ready to buy all types of assets. It's not obvious that the best policy is to buy only the safest asset. And why do I say that? Because when you buy bonds, you are counting on the private sector to do the portfolio rebalancing. And sometimes the private sector doesn't want to do the portfolio rebalancing, so you may be better off rather than buying a lot of bonds. You could also buy some riskier assets.

Ubide:  On that, the ECB, for example, has done a good job. They've been buying corporate bonds and so they have been addressing the risk premium that was too high rather than just going into one and then hoping that the rest is going to work. And if this requires some kind of arrangement between the governments and the Central Bank about future recapitalization in case of losses, then so be it. But I think that's quite important. And fourth point I make is that forward guidance is going to be, already it has been a very important part of the policy toolkit, but it should be used in a cyclically adjusted manner.

Ubide:  In other words, what is forward guidance? Forward guidance at the end of the day is the Central Bank telling you more or less about what it’s going to do. Now, when the Central Bank tells you a lot about what it’s going to do, what happens is that it's taking more risk, because it's committing. And that's important when there is a lot of risk-aversion in the market. There is a lot of risk aversion. I want somebody to save the day. That should be the Central Bank telling you, “Listen, don't worry. I will do whatever it takes to put the economy back on track and to put inflation back on track.”

Ubide:  Now, that need changes with the cycle. There could be moments which are exactly the mirror image of that. That is when the economy is doing very well, inflation is high and risk taking is elevated. That's the moment when you want the Central Bank to sort of take risks out of the system. How did you do it? Telling very little about what you are going to do. Yes, of course you developed your reaction function and all that, but you don't telegraph when you are going to raise rates, so you don't telegraph how much you are going to do. Because the main reason why people put current rates on is the certainty about the policy path.

Beckworth: Okay.

Ubide:  It’s not just the level of rates, it’s the certainty. If you tell me rates are going to go up 25 basis points a quarter over the next three years and I know that with certainty, that's heaven.

Beckworth: You can use that, yeah.

Ubide:  Because then I can price that perfectly. If you simply tell me rates may go from one to three or higher and I don't know when, then I cannot be as safe and I cannot take the same amount of risk. You can use policy, you can use forward guidance to manage risk taking. And then the final point is communication. And I said it before, I think we have to stop calling these policies unconventional. There is no unconventional policies and there is no exit. There is tightening and there is easing of policy, and all the instruments are possible and all the instruments should be accepted. And if we do that, then we have something that is much more robust to all the shocks.

Ubide:  Because if we are in a situation where inflation is too high, we know how to do it. But awareness situation when inflation is too low we need to keep pushing demand for an extended period of time, we need to be as effective as we can. And this is what I think is the way to do it. The one final point I would make is, I suggest to raise the inflation target. And people say, “Well, it's not going to work because we cannot inflation from where it is to 2%. How is it going to work?” Well, what we should do is the process of opportunistic reflection. What is opportunistic reflation? It’s the mirror image of what we did in the last 30 years, that was the opportunistic disinflation.

Ubide:  So you take a couple of cycles, but the way we went down from the inflation of the ‘70s to 2% it was over three or four cycles in which Central Banks always tighten policy in such a way that they would start the next cycle with inflation below where they enter, so it's like going down the stairs. What I'm proposing is the same thing. In this cycle we try to overshoot our inflation targets because we need to stabilize inflation expectations. Then once we have overshot those inflation targets, then we start discussing moving the inflation target higher. And then we can do it again at the next cycle, and then we’re in an inflation target of around three to 4% depending on the economies. But that would give us enough room to be able to cut real rates as needed.

Beckworth: You know, so the Bank of Israel in the crisis, which is a very interesting experience, they acted aggressively. Stanley Fisher was the head back then, and their experience in the great recession was very mild, and what you saw was even the real GDP collapsed. They allowed inflation to shoot up. I think they had a one to 3% range for their inflation. It shot temporarily to 5% so it … I mean, that was more of a short term reflation, but what that did is it kept nominal demand stable. And that mitigated the severity of the great recession. But they were open to thinking outside of the box.

Ubide:  If you think about it, the Bank of England did the same thing. The Bank of England is the only Central Bank of the major Central Banks today where inflation expectations are higher than they were pre-crisis. And one of the reasons is that the Bank of England tolerated those big swings in inflation. Remember, the Bank of England was doing QE with inflation close to 5%. The Bank of England was strictly symmetric and they had several price level shocks driven mostly by the depreciation of the currency, but also by VAT increases. And they simply accommodated them because they thought that our inflation target these over the medium term. And to be a tool, you need some periods above, some periods below. And that means that today the credibility of the 2% target in England is very, very solid. It's much more than here in the US where inflation has been below 2% since the middle of 2008 with the exception of four months.

Beckworth: No, and I think that speaks … the case of England speaks to the importance of seeing through supply shocks, right?

Ubide:  Exactly.

Beckworth:You have this tax increase. It's a one-time supply shock. It's going to raise prices temporarily. You see through it. I like what you're saying. I want to throw you a curve ball here maybe or throw something back at you. Your points are … and I largely agree with them when an … Your five steps, one was a program of opportunistic reflation or I think what you really mean is symmetry. And if you could go below you go back up, you kind of make sure that you're symmetrically your inflation, dual mandates. Three was be able to use all tools, balance sheet included. Four was cyclically adjust forward guidance. Five is an improved communication. Well, I'm going to suggest something that does almost all of those except for number three that use all tools.

Beckworth: But I'm going to suggest that a nominal GDP level target can incorporate all of those. If you're doing, and this could be true to some extent for a price level target as well, but nominal GDP level target, you're going to have that, like I said with Israel, that nominal income was relatively stable. Dual mandates implicitly embedded in a nominal GDP target, cyclically adjust forward guidance. If you know the level with return to a level, it has implicitly built into it at the right time to be doing forward guidance. And then another thing of course about nominal GDP targeting like over price level targeting is that it allows supply shocks. It tolerates changes in prices because of the supply shock. What is your take on nominal GDP level targeting?

Ubide:  I mean I can say, it’s one of the options that are being proposed in addition to price level targeting. I make two points, I think. One is some people are offering as a way of not increasing the inflation target. And I don't have a strong sense of why increasing an inflation target is so bad. But the problem I have with nominal GDP level targeting is that first of all communicating it is quite complicated, right? Because GDP, especially in this country gets revised many times. And so what you are trying to tell people is I am telling you that starting from today I'm going to generate a nominal GDP level over the next three years, so facts. But that takes will have to change because in six months my base will have changed.

Ubide:  And so it creates a little bit of a complication in terms of communicating with the public whether the Central Bank is being successful or not or how do you do wage bargaining when you don't know if inflation is going to be one or three or five? Because the problem with nominal GDP targeting is that-

Beckworth: It tolerates-

Ubide:  It tolerates a much wider range, if you want, of potential inflation movements, right? To me it’s the kind of thing that you can achieve the same outcome without necessarily doing that framework with a flexible inflation targeting regime, which has a dual mandate. But at least I would prefer to keep the GDP part separated from the inflation part. And then as I said, to me more GDP is better than less GDP. Another problem you would have with nominal GDP targeting is that you are sort of capping your upside in terms of growth. What if you have a positive supply shock? And then you have a positive supply shock and you can get more GDP, but you are very slow at recognizing that you are having a positive supply shock.

Ubide:  And so your inflation keeps on going because there is some inertia and then your GDP starts accelerating. Do you want to cap that? Not necessarily. If you are doing an inflation targeting with a sort of dual mandate, yeah, GDP is going, but for as long as your inflation is not getting out of control, then you have to let it go. It's a bit what I was saying about the [inaudible 00:58:26]. I think what we are going to discover in this cycle is that probably the [inaudible 00:58:30] is much lower than we thought. And we are only going to figure out that exposed.

Beckworth: Your big issue is then measurement issues, so daily revisions and then what do you do with positive supply shocks?

Ubide:  Yeah, and I think it's a bit too restrictive. I would rather have the flexibility of having a dual mandate where you can separate both. And as I said, if I redefine in a maximizing growth subject to prices stability, then I think I give more opportunity to positive supply shocks to develop.

Beckworth: Yeah. Well, do you want to hear what a response to that would be?

Ubide:  Yes, of course.

Beckworth: Okay. I would say on the first, on the data revisions that can be an issue, but I think what you'd want to do is probably target a forecast to get around. And so I have a paper with Josh Hendrickson where we show that the Fed's forecast of current quarter of nominal GDP actually is stationary, so on average they don't miss it even though the revisions may be. But that was still, as you say, it'd be kind of a change in approach. The other thing tied to that though, I think is selling it to the public. And I think there you'd have to say, “Look, we're aiming to stabilize your nominal wage growth or your dollar income growth.” That's what it would be.

Beckworth: And I admit that it would be a change in from trying to stabilize prices. We're going from stabilizing prices to income, so no doubt I'm marketing communication job. But I think that's something that I would at least would like to pursue, anyhow. On the potential real GDP issue, I see that actually as a virtue versus as a bug in the following sense; when you'd have the Fed target nominal GDP, you're saying, “Look, you don't need to worry about what potential real GDP is. Just keep nominal demand stable.” If real GDP goes up, you're going to tolerate a little mild disinflation, but you're not capping real … you think of it as capping real GDP? I view it as you're allowing real GDP to go wherever you want and you're allowing inflation to be the absorber or the adjustment [crosstalk 01:00:38]-

Ubide:  Well, if you can do that, yes. But I don't know if you can do that.

Beckworth: Well, I hope you could do that. Broader prices would adjust and it'd definitely be a change in approach for sure. My vision would be, for example, you keep nominal wages stable and effectively stabilized nominal wages, but the real wage could still change because of the price level. But we're getting in the weeds a little too much. I think we very much agree on the spirit of this. I mean, Frederick Michigan at that last conference, I think maybe it's nice compromise between what both of us are saying here. He wants to have an inflation, maybe 2%, but with maybe a, I think one to 3% range. This really resonated with me when someone told me, it might be useful just to say, “Look, we're going to go from one to three.”

Beckworth: Just saying the guard rails are at one and three would maybe politically make it easier to overshoot once in a while. As opposed if two is your target, you go over that, you know, Congress might have your head, so.

Ubide:  I think one way, I mean, near term that this could be solved is exactly that. Everybody criticizes the ECB a lot, but the ECB’s prices stability definition is close but below 2% over the medium term. And I think what's missing in the Fed’s long-term objectives of policy is to define prices stability as inflation as 2% over the medium term or over the cycle or on average or something like that. Because I think right now they feel constrained that 2% is sort of 2% at all times, which is the way it was defined for the Bank of England. And I think the way you would give the flexibility to the Fed is by defining it over the cycle or over the medium term or something equivalent.

Ubide:  And that point then, the FOMC could say, yeah, we've been below, so on average or over the medium term we need to spend some time below, some time above and then be able to explicitly forecast inflation above 2%, which I think is what's missing today.

Beckworth: Okay. Well, this has been a great conversation. Our guest today has been Angel Ubide. Thank you so much for being on the show.

Ubide:  My pleasure. It's been great.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.