Bill English is a professor at Yale University, a former senior Fed staffer, and a veteran of the Bank for International Settlements. Bill joins Macro Musings to talk about his time at the Federal Reserve, recent Fed developments, and a paper he co-authored titled, “What If the Federal Reserve Books Losses Because of Its Quantitative Easing?” David and Bill also discuss the Fed’s recent low-inflation mandate, the QE effectiveness debate, and why we should and shouldn’t be concerned about Fed balance sheet losses.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Bill, welcome to the show.
Bill English: Thanks very much, David. I'm glad to be here. I think it'll be a fun conversation.
Beckworth: Yeah. I'm glad to have you on. I've listened to you on another podcast and have been seeing your name in print quite a bit surrounding the recent Fed meetings. Before we get into all of that, including your new paper, you've had a long career at the Federal Reserve. You were at the Division of Monetary Affairs from 1992 to 2015, and then you were special advisor to the board from 2015 to 2017. You've seen a lot. You've been through a lot there. So maybe tell us a little bit about your experience at the Federal Reserve.
English: Sure. My career there was, in a sense, very simple. I arrived in the Division of Monetary Affairs as an economist. I plugged away in the division and moved up over time, senior economist, assistant director, et cetera, and ended up as director from 2010 to 2015. The division, when I arrived, was probably 60 or 70 people. When I left, it was about 140, I think. The division grew partly because of the financial crisis and the need to take on a lot of staff to address issues that were raised during and after the financial crisis. But broadly, the job involved economic research. I published some papers, but also a lot of what we called policy work, just work directly tied to the policy process, so briefing the board members, briefing the FOMC, preparing FOMC documents.
English: The job of the director, which I had for about five years, is a very interesting one. You conduct the FOMC briefing on policy alternatives. The last staff input to the policy process before the committee, as their policy discussion, was my briefing. I worked a lot on the wording of statements. That was a big part of what I did and what some of my staff did, so offering alternative language to the committee that they could then choose from, and also thinking about press conference remarks and speeches and whatever. Just a lot of communication questions ended up on my desk.
English: At that time, the Monetary Affairs director was also the secretary of the FOMC. So one of the jobs in that role, probably the biggest job, was preparing the minutes of the FOMC meetings. The minutes are, of course, a key piece of FOMC communication and, at that time, I think, particularly complicated because the committee wasn't always in agreement on what they wanted to do. So they put out a statement that was quite short, and then the minutes would be the way to express to the public, the range of views across the committee. So everybody cared a lot about, were their views captured in the minutes and so on. That was a big part of the responsibility as well.
Beckworth: When you say "those times," what times were there when there was uncertainty?
English: Well, I was director from 2010 to 2015. I would say around the QE2, in the fall of 2010, around forward guidance. Almost throughout, they were constantly thinking about their forward guidance. Around the open-ended asset purchase program in 2012 and the conditional forward guidance that they provided then. Then, as we came up to, it was time to start winding down the purchases, it was time to start thinking about raising rates, some of the most interesting discussions during my time as director were as they were beginning to lay out in a serious way their plans for how they were going to normalize, how they were going to raise rates when the time came to raise rates? There was a lot of discussion on the committee in 2014, really, about that. Then they published Principles and Plans for Normalization that then they followed when the time came.
Beckworth: So a lot of interesting things happening during that time. I'm curious, were you part of the conversation in 2011, I believe, when they were talking about their framework back then? There was discussion before they actually adopted an official inflation target. They looked at a number of different possible frameworks. Were you engaged in that?
Bill’s Engagement With the Fed’s New Framework
English: Sure. Yeah, absolutely. Ultimately, the Statement of Longer Run Goals and Monetary Policy Strategy came out in early 2012. But that discussion went back, geez, at least a year, I think. There was a lot of discussion then about, did you want to think at all about price level targeting, for example? As you probably know in models, price level targeting is pretty nifty when you're stuck at the zero bound, but it isn't quite clear that it would be as effective in practice. There was a discussion around that. Then there was a lot of discussion around what should the inflation target be, and how do you convey that information, and how do you balance that?
English: I think that one of the hard issues around that statement that came out in early 2012 was they wanted to have an inflation target. They wanted to say two percent, but on the other hand, they also didn't want to appear to be only caring about their inflation objective. They wanted to be clear that they cared also about their employment objective. But how do you convey that? Because you can't write down an unemployment objective the way you can an inflation objective. So there was a lot of discussion on, what are the right words there?
I think that one of the hard issues around that statement that came out in early 2012 was they wanted to have an inflation target. They wanted to say two percent, but on the other hand, they also didn't want to appear to be only caring about their inflation objective. They wanted to be clear that they cared also about their employment objective. But how do you convey that?
English: In the end, you may remember for a while, they used the SEP. They would say, "We can't give you a number." We look at a bunch of things to try to assess the level of maximum employment, but that will change over time. But in the SEP, the longer run normal unemployment rate is whatever it is in the SEP. That was a way of squaring. You had a number. I think people felt better at some level because there was a number for both of these things, even though they were very different numbers, in a sense.
Beckworth: Well, I imagine you watched with interest, then, the framework review in 2019 and 2020, since you've been through the first one. One of the things that struck me as interesting, and maybe as a learning experience, and I speak to myself, but I know many others as well, is when that new framework was adopted, FAIT, the Flexible Average Inflation Targeting framework, I think there was this impression that it was a symmetric average inflation targeting framework. In other words, if you went below two percent, you would catch up. Same thing on the upside. But that clearly wasn't the goal. If you look back at the statements, they're very clear. This is only from the zero lower bound. This is only below. They're not going to go above. In other words, there’s not going to be a symmetric price level target type framework. But if you go back to the statement that you mentioned, it first came out at two percent, and then I think in 2016, they modified it to say it was symmetric.
English: That's right.
Beckworth: This is my impression, correct me if I'm wrong. But people seeing that symmetric term may have naturally assumed that the new framework, FAIT, would also have some symmetry in it. It's like the next step. But it didn't. Did you catch that? I mean, I felt like maybe I was a little slow to catch onto that nuance there.
English: I caught it, for sure. I mean, the description in the statement said, "If there have been shortfalls, it'll be appropriate to overshoot a bit." Then there was a speech, I think by Rich Clarida, who spelled it out in a more specific way. So I did pick that up. I think that's a reasonable place to come out. I think the view was that when inflation goes up, you can bring it back down again. But when it goes down, you can't necessarily bring it back up again, if you're stuck at the zero bound. So, nature has an asymmetry in some sense. So policy maybe should have an asymmetry to offset that. But I agree. There seemed to be some confusion about that initially.
Beckworth: Yeah. I was part of that confusion. To be fair, I don't think we really want a price level target that's fully symmetric, because that would mean, when you have large negative supply side shocks like we've had the past few years, you would have to dial it down in a moment like that, when the economy's already weakened. So I think the asymmetric approach has appeal. Of course, you may not know this, but I'm someone who's a big fan of nominal GDP level targeting, or nominal income targeting, which solves some of the supply shock issues. I know you guys talked about that also in 2011. But let's move on to another part of your job. You worked and you led out at the Division of Monetary Affairs. There's also an office in the New York Fed, the Markets Group, that does a lot of monetary division type work. What was your relationship to them? How did you guys coordinate, talk shop, those kind of things?
English: We worked very closely together, for sure. There were daily interactions. There were regular calls, actually, twice a day, early morning and early afternoon, where the New York staff, who were very much in touch with markets and talking to market participants and so on, would report on what they were seeing. Traditionally, those discussions, the ones in the morning, at least, were also about policy implementation. A lot of discussion about what are the reserve demand factors and supply factors, and what's the open market operation today, and so on. That became moot once they moved to a big balance sheet and excess reserves and implementing policy with administered rates. But that was where that call came from. It remained because it was very important. It was very interesting to try to get a handle on what were the New York Fed people seeing and hearing.
English: The work of the desk and the work of Monetary Affairs were often overlapping. We were trying to write documents on financial conditions and financial developments, and what would policy changes do in markets? And so is the desk. I would talk with the desk manager, who's Brian Sack, and then later, Simon Potter, or Lorie Logan, who was deputy, about the work program of the desk and the work program of the Division of Monetary Affairs, each inter-meeting period, because we wanted to be sure we were communicating so that we weren't duplicating work or generating confusion for the committee. There were a lot of documents that were prepared by groups, from people from both staffs. It was a lot of interaction with the desk, for sure. That was actually, I think, a really good thing. It meant that we were more in touch with what was going on in financial markets than we could easily have been otherwise, sitting in Washington.
Beckworth: Let me ask a final question about your work at the Federal Reserve System. You were on the inside for a long time, doing fun things, sometimes challenging things. You got a lot of criticism from the outside. I'm sure you're aware of that. Did you ever have the urge to want to go public and just say, "Hey, this is how it really is, folks"? I mean, was there ever the frustration or the tension that you had to keep your mouth shut being on the inside? Now you're on the outside. You're on a podcast. You get to share your thoughts. But you spent a long time on the inside. At some point, you must have had the urge to want to say something to the public, but you couldn't.
English: From time to time. I mean, I'm not somebody who's all that eager to be out speaking in public. So, in that sense, the board's limitations on that hurt me less than it hurt some of my colleagues. But there were times when you thought, "Market participants are just misunderstanding." And it was frustrating. Sometimes somebody would give a speech, and you could work on that or something. But I remember in particular, after the taper tantrum in 2013, you may remember, on a couple of occasions after a testimony and then at press conference, Ben Bernanke said, "Pretty soon it's going to come to be time to start tapering our purchases. We'll taper slowly." Anyway, the intention was not to say anything all that dramatic, try to be roughly in line with market expectations, but provide some clarity that that was the direction things were going in.
English: The market reaction was huge. Long term rates went up a lot. There seemed to be a real confusion that this wasn't just time passing and the economy healing and the appropriate time to start winding things down, but that this was a new, hawkier Fed than they thought. For example, the expected path for the federal funds rate moved up a lot. I really did feel at that point, I wanted to go and talk to some market participants and just say, "Give me a break." I mean, with the economy recovering, at some point it was bound to happen that it'd be appropriate to start winding down purchases. At some point, it's bound to happen that it'll be appropriate to raise rates. I mean, we hope. We hope the economy continues to recover. Don't read into this that somehow this is a bunch of hawks sitting around the table. It's the same people it was last month. But, as you say, I couldn't do that.
Beckworth: Well, you were very disciplined all those years inside the Fed. It's good to have people like you doing the work of the Fed. Well, you've come on the show to discuss the Fed's balance sheet and potential losses and what it may or may not mean for Fed policy, for Treasury. But before we do that, I want to spend a little bit of time today on the most recent FOMC meeting. That was the September meeting. We're recording this the day after. This show will be played a few weeks from then, but it'll be the most recent FOMC meeting. In some sense, it was a big one. It got a lot of news coverage. As we saw, this was the third consecutive 75-basis point rate hike. Of course, there's more to come. Chair Powell was very clear about that. He will do whatever's necessary.
Beckworth: I was trying to think of a way to summarize this. What came to mind, and this was inspired by his Jackson Hole speech, is that Chair Powell was invoking his inner Paul Volcker. He's doing everything that he needs to, to make it happen. As I was thinking this, I actually came across a Bloomberg article by John Authers. It's an op-ed piece. The title of it is, *Think of Powell as Volcker's Wannabe Second Coming.* It's kind of a demeaning title, Think of Powell as Volcker's Wannabe Second Coming. It's interesting because they talk about the wording and the phrasing he used in this press conference at the end of the meeting, as well as his Jackson Hole speech.
Beckworth: He also notes someone contacted him and said this. This is from someone who emailed the author of this piece and said, "Powell said that the Fed will continue with interest rates or, in his words, 'We will keep at it.' I don't think it's a coincidence that he used the exact same phrase in his Jackson Hole address in late August. How can that be seen as a hint? Paul Volcker's memoirs are entitled Keeping At It, with the subtitle *The Quest for Sound Money and Good Governance.*" They're tying together all these links that the inner Paul Volcker is coming out with what Chair Powell is saying. I'm just wondering, from your perspective, your many years at the Fed, do you see this as a big change? I mean, for so many years, we were worried about low inflation. Now it's almost like we have a single mandate. In fact, Rich Clarida said that recently in an interview: "The Fed is effectively operating with a single, laser-like focused mandate on inflation." I mean, what are your thoughts on that development?
The Fed’s Recent Low-Inflation Mandate
English: I guess, maybe having sat inside the Fed for a long time, to me, it doesn't feel quite so exciting. It's a big change, but there has been a shift over the last year and a half, for sure. I think the first thing to emphasize is just that the outlook has been hugely uncertain. It's been hugely uncertain since the pandemic. We haven't seen a global pandemic in a big globalized economy before. Then we got fiscal policy actions that were huge and unprecedented. Understanding how they would affect the economy over time was hard. Then we got a war in Ukraine. It's just been an immensely turbulent and uncertain time.
English: What can the Fed do if it is facing tremendous uncertainty? I think the best it can do is try to balance the risks. The risks of doing too little, not providing enough support for the economy, so it stumbles. You end up as we were after the financial crisis, with just a long, slow halting recovery, versus doing too much and ending up with really high inflation. If you look at the SEPs over the last year and a half or so, what you see is the committee coming around to the view that the bigger risk is, in this case, tightening too little and ending up with a big inflation problem. But I think a year and a half ago, their bigger concern was that they don't provide enough accommodation, and the economy stumbles and ends up very weak for a long time. We have learned, alas, about how pandemics can play out and about how powerful fiscal policy is when monetary policy is keeping rates flat, and that's created problems. But again, I think what the committee would try to do is balance the risks that they face.
What can the Fed do if it is facing tremendous uncertainty? I think the best it can do is try to balance the risks. The risks of doing too little, not providing enough support for the economy...versus doing too much and ending up with really high inflation.
English: Right now, very clearly stated in the Jackson Hole speech, is that the risk they're worried about is that the economy just runs hot for longer, inflation stays really high, and it gets built into wage and price setting, and they end up in a 1970s sort of situation, where all they can do is generate a really big downturn to bring inflation down. That's such a costly outcome that I think they're focusing most of their attention on that. It's still possible, I guess, that the economy could just slow, and they could find they don't have to tighten nearly as much as they thought. But that probability seems a lot less than the probability that they can't slow the economy fast enough, and they have a really big inflation problem.
English: That's the change in tone, I think. They're just really worried that could happen. They want to emphasize that they won't let it happen. By channeling his inner Volcker, I think Powell is trying to emphasize that they really won't let that happen. So strength in the credibility of the committee to ensure everybody, "We are going to bring inflation down so that the high inflation doesn't get built into expectations and just carry on for a long time." It's tough. At this point, I think the risks are to the downside, that the economy's going to slow a lot because that's the direction they're leaning pretty hard.
Beckworth: Yes. Chair Powell was very explicit about it. He said, these are his words, "We have to get inflation behind us. I wish there were a painless way to do that. There isn't." He said a couple times this phrase that they're going to have to run the economy below trend, which I think is a euphemism for we may have to have a recession. The other interesting thing I would note from the SEP, the Summary of Economic Projections, they show an increase in the unemployment rate, going up to 4.4 or close to four and a half percent. We're at 3.7. That's a sizable increase. Usually, you don't see an increase that large without a recession. Now, they don't show a recession in their forecast. They show a slowdown in growth. But they definitely have all the indicators that suggest we could endure a recession if needed to get to the other side of the high inflation.
Beckworth: Let me ask this question. Part of the confusion last year, and I mentioned I was confused earlier about the framework, well, I was also confused about the inflation outlook myself. Like many people, the consensus, I didn't expect inflation to get as high as it did and last as long as it has. Part of it was because I think most of us saw the inflation as driven by supply side, one-off type developments that eventually would naturally work themselves out as we got to the other side of the pandemic. I think that's fair. I think there is a lot of that still in the world today. You throw in the Russian-Ukraine War on top of that, energy shortages, global supply chain problems.
Beckworth: Separate from that would be the demand pressures that have emerged from the fiscal policy, as you mentioned, and the Fed accommodating that by keeping rates low for a long time. I guess, if I had to summarize what the change in the Fed's perspective and my own is, is that we went from a realization that inflation is not just supply driven. It's also a lot of demand driven as well. They're responding to that. As I look around the world, we see other central banks also raising rates sharply as well. The ECB has had a 75-basis point rate hike. I believe the Swiss National Bank did one. Bank of England's had two 50-basis point hikes. A lot of big banks around the world are tightening. There's only a few that haven't, like the Bank of Japan.
Beckworth: My question is, though, could these other central banks be getting ahead of themselves? I think you can make the case the Fed needs to tighten very clearly. There are excess aggregate demand pressures in the US. But it strikes me that a lot of what's going on in the rest of the world is the energy shortages, supply side disturbances. Europe in particular, I think of that place. I know that the rule of thumb is you look through supply-side inflation unless you think it's going to unanchor inflation expectations. So I guess that's the fear in Europe and in other places. But do you have any thoughts on that? I mean, I think you can rationalize and understand what the Fed's doing. I find it a little bit harder to explain what many of the other central banks in advanced economies are doing.
Explaining Current Central Bank Policy Across the Globe
English: I think you got it exactly right, David. They're concerned that even though in some sense, these are supply shocks that are pushing inflation up in their jurisdictions, it's pushing inflation up a lot, and very persistently. I think they're worried that will move inflation expectations, that it will get built into wage and price setting. After all the shocks are gone, that would leave them with higher inflation than they want in perpetuity, unless they push back against it. So they're pushing back against it, both to try to dampen inflation directly by slowing their economies, but I think also partly as a protest, to demonstrate that they're not going to accept higher inflation for the long term. They really want to maintain their credibility as central banks that want and will achieve low and stable inflation. That means that at some point, they need to respond.
English: If I were at the ECB, again, I have in my mind this balancing of risks idea. They definitely have a risk that the inflation they get, it's really high, and it can start eating away at the ECB's credibility, and they could end up with a long term inflation problem. On the other hand, the real side shocks to economic activity are bigger there, too, and their economy looks weaker. The downside economic risks are also pretty big. So, for them, the balancing of risks may be a little bit less obvious than I think it is in the US, where you really have to set out to work inflation down. But they may find themselves this winter in a really difficult situation, where they have to be trading off these objectives. That's tough.
Beckworth: Do you think this is the central challenge of inflation targeting, when you get into moments like this, where you have large supply shocks, maybe ones that last a little bit longer than expected? Inflation's high, and you've got to decide this balance of risk. Do I go after inflation expectations, or do I let them self-correct, and hopefully return to normal? It strikes me that this is the central issue with inflation targeting. It's hard to know in real time what's driving inflation. You can err on one side or the other if you're not careful. There's this knowledge problem, I guess, if you could call it that.
English: I think that's right, but I guess my emphasis would be a little different. I think the reason why you have inflation targeting and an explicit numerical inflation objective is you want to fix that in people's minds, very clearly, that this is what the central bank is going to deliver over the medium term. That gives you more flexibility in the face of a big supply shock to not necessarily have to respond with tighter monetary policy, because if you've been successful as an inflation targeting central bank, you really have anchored inflation expectations near your target. So inflation doesn't go as high in the face of the shocks, and it comes back down more quickly. I think there's a lot of evidence that that's the case. This is a situation where being clear about your target and having built up a reputation for achieving your target actually is quite valuable. I think it helps. But on the other hand, as you say, if the shocks are big enough and last long enough, it doesn't help enough. You still have to respond. You still have to push back with monetary policy.
Beckworth: These central banks in Europe and other places, they're earning up their reputational credit, so to speak. Hopefully, they can use it in the future as they store up this. I mean, this is the whole credibility point. It just strikes me, though, that the ECB has had a tough run with it because 2011, two times, they raise interest rates into what I would argue is more of a supply side inflationary front. Now, moving forward, again, I think the key is, going forward, what's going to happen to the eurozone economy, what's going to happen to inflation expectations? No one really knows for sure. Will they thread that needle? Will they navigate that storm just perfectly? That just seems like a tough task ahead for them.
I think the reason why you have inflation targeting and an explicit numerical inflation objective is you want to fix that in people's minds, very clearly, that this is what the central bank is going to deliver over the medium term. That gives you more flexibility in the face of a big supply shock to not necessarily have to respond with tighter monetary policy.
English: I agree. I think it's a tough time to be a central banker all around the world at this point, I'm afraid.
Beckworth: That's why it's easy to do a podcast and be a Monday morning quarterback and talk about it.
English: It's time to be teaching central banking.
Beckworth: Yeah. There you go. Yeah.
English: Not to do it.
Beckworth: Yeah. Great time to be teaching, for sure, and to be writing papers and be thinking about this. Let's go on to the Fed's balance sheet. This is what really motivated me to get you on the show, because you had an interesting article with Don Kohn, a former colleague of yours, a former governor at the Fed, also a previous guest on the podcast. We'll provide a link to it in the show notes. The title of your paper was, *What If the Federal Reserve Books Losses Because of Its Quantitative Easing?* This was becoming an issue, and I think will probably become a more important one as we move forward. Right now, everyone's focused on the tightening cycle, quantitative tightening, but I suspect this will become more of an issue as bigger unrealized losses, maybe some net income losses, begin to occur.
Beckworth: Before we get into it, let's talk briefly about your views on quantitative easing and quantitative tightening. The standard story for those who believe QE has a big effect would be the portfolio balance channel or the signaling channel. Then those skeptics who think QE outside of, say, a crisis moment has little effect, they would invoke something called Wallace neutrality. Really, you're just swapping one government asset for the other, what's the big deal? Where do you come down on that debate?
The QE Effectiveness Debate
English: You won't be surprised to hear that I come down on the view that that QE is potentially very important. I guess the Wallace neutrality result requires, in terms of the economic theory, complete markets. I think we just don't have complete markets, so I don't think that's the right way to think about it. As Ben Bernanke once said, "It works in practice, but not in theory." That creates this tension. I guess I thought about three channels of effects myself. One is signaling, as you say. It's just the thought that if you're buying assets for the next year, people will expect you're probably not raising rates for a year, because that would be using your two policy levers in opposite directions, and that seems weird. If you commit to a big purchase program, you're committing to not raise rates for a while. If markets didn't understand that, if they thought you were going to raise rates sooner, that potentially has an effect. It pushes down expected future policy rates. It pushes down longer term interest rates.
English: A second thing is market functioning. Entering into a market that's strained and saying, "We're going to provide steady large demand in this market for quite a while," can improve market functioning a lot. If you're a market maker, you may have been antsy about taking on a position from somebody who wants to sell, because you're not quite sure who's going to buy, and what's the price that you're going to be able to sell at. Now you know the Fed's going to be there buying in quantity for a while. You feel a lot better. We saw that for sure. I mean, when the first purchases of MBS were announced back in November of 2008, MBS yields moved a ton. That, I think, was basically because that market wasn't functioning well at all. With the Fed stepping in and offering steady purchases for quite a while, market functioning improved a lot. We saw that again in the spring of 2020 when the pandemic caused big market dysfunction.
English: The third piece is the portfolio balance channel. Central banks are buying some assets. Say you're buying treasuries. You're buying long term treasuries. That pushes up their price, and that pushes down their yields. Then investors look at the now crummier yields on treasuries, and they say, "Well, maybe I'll move from treasuries to Agency MBS or to high quality corporates or something like that." You see effects on the yields of other broadly similar assets, and then probably effects on ones that aren't as similar over time. Jim Tobin, who's a famous macroeconomist here at Yale, had a story he told about throwing a rock into a pond. You throw a rock into a pond, you get a big splash and a big wave where the rock went in. Then, as it spreads out, the waves get smaller, but you get effects all across the pond.
English: I think of asset purchases of longer term treasuries and agencies as the rock going into the pond. You get big effects in those markets, but you get pretty big effects in other similar markets. Those effects affect the macroeconomy in turn. I think there are a number of reasons for thinking that these purchases can matter. Then, if you want to turn to QT for a second, when it comes to QT, it isn't clear that you're going to get a big signaling effect or a big market functioning effect. You'll still get the portfolio balance channel, but the effects are probably smaller when you turn to QT than when you were doing the QE. That's a slightly weird asymmetry, but I think it's the case. I do believe QT is still a tightening action. It still is reducing accommodation. It's tightening financial conditions. But probably nothing as much as you got when you were buying.
Beckworth: Yeah. Those are all good points. I want to go back to the one about in the moment of a crisis when the Fed steps in. I think probably most people would agree on that. QE does matter. Our market interventions do matter. They make a difference. Something I've been thinking about, it's maybe a bit of a crazy idea. I'll throw it at you since you're the former head of monetary affairs at the Fed. The Federal Reserve, over these past two years, when they stepped in, they bought up a lot of TIPS, moreso than they had in the past. I think if I remember correctly, their share jumped about to 20% of the TIPS market.
Beckworth: Normally, TIPS, which are Treasury inflation-protected securities, it's not a very liquid market. It's always had this liquidity premium. Some people discount exactly what it tells us about breakeven inflation rates and such. But I've been wondering on this very point. When the Fed steps into a market that's having liquidity problems and it becomes a market maker and the market's function, and then once again, prices reveal things, I wonder to what extent the Fed jumping in, in 2020-2021, and buying up a lot of TIPS, made the TIPS market a better market, because now there's more volume, more activity going on. Any thoughts on that? Did the Fed maybe even make things better there?
English: It's certainly possible. I guess the question is once the Fed is done buying, and now they are, and they're running things off, do other market participants feel differently about the market than they did before? I guess they might for a couple of reasons. One is that, given that there was a lot of activity in that market, maybe they invested in some infrastructure, either technical or human infrastructure, but now they've got that infrastructure, so they continue to participate in that market in a bigger way than they would've. The other is they may feel a little more comfortable playing in that market in size because they're more confident that the Fed, in the event there's some terrible situation, will step in and make sure that the market continues to function okay. There's some reduction in their perception of risk, at least tail risk, really distant tail risk, than there was before. I guess that's possible. I just don't, I'm afraid, know well enough how that market works to know if those effects are big or not.
Beckworth: Well, thanks for taking a swing at it. I've just been curious and thinking about it myself. Maybe some listener out there will do a paper on it and do some research for us. Okay, let's move on to your paper, again, the title is, *What If the Federal Reserve Books Losses Because of Its Quantitative Easing?* Maybe walk us through why would the Fed have some kind of loss on its balance sheet in the first place?
Losses on the Fed’s Balance Sheet
English: You have to remember what the Fed's balance sheet looks like. On the asset side, the Fed is holding basically a whole bunch of securities. They're holding about eight and a half trillion dollars worth of securities at the moment. They earn interest on those securities. On the liabilities side of the balance sheet, there are a few big pieces. One is currency. They don't pay any interest on that. One is the Treasury balance, which can be pretty big. The Treasury has an account at the Fed that they use as their checking account. That can be very large. There's no interest on that. But then there are reserves of banks. The Fed pays interest on the reserves of banks. There's the overnight RRP program through which the Fed takes funds basically for money market mutual funds and some government agencies and pays interest on that.
English: The Fed, it looks a little bit like a commercial bank. It has assets it's earning interest on. It has liabilities it's paying interest on. Generally, on average, the Fed's going to have pretty substantial net interest income because its securities holdings are much bigger than reserves plus overnight RRPs. So it'll, on average, get more interest income than interest expense. So, it makes money, and that money is transferred to the Treasury. There's a remittance to Treasury, and those remittances are big. They've been 50 or 100 billion dollars in recent years.
English: So then what happens if there's really high inflation and the Fed has to raise rates a lot? Well, it's going to raise the interest rate it pays on reserves. It's going to raise the interest rate it pays on overnight RRPs. Those rates go up immediately. Interest expense goes up immediately. The rate it's earning on its securities is relatively unchanged. A small fraction of those securities is turning over, but basically, they're holding a bunch of securities that have a yield, and they have the same yield tomorrow as they had yesterday.
English: When the Fed raised rates at their [last] meeting, they had the effect of reducing their net interest income. It's possible, if the Fed has to raise rates very quickly to a high level, that it ends up with a net interest expense, that interest expense is higher than interest income, and the Fed has a loss. I've done some back of the envelope calculations. I think the meeting yesterday was the point at which they probably tipped from interest income net to interest expense net. I expect, we'll see, in the fourth quarter of this year, that there'll be a net interest expense for the Fed. There will be some losses this coming quarter.
It's possible, if the Fed has to raise rates very quickly to a high level, that it ends up with a net interest expense, that interest expense is higher than interest income, and the Fed has a loss. I've done some back of the envelope calculations...I expect, we'll see, in the fourth quarter of this year, that there'll be a net interest expense for the Fed. There will be some losses this coming quarter.
Beckworth: That's in terms of current net income. The other loss, though, you can look at on the Fed's balance sheet, is an unrealized loss from mark-to-market valuation of the assets. Right?
English: Yep. That's right. There are always two ways of looking at these things. One is looking at the flows of income. That's the way I was just talking about it. But another way you can think about it is the changes in interest rates mean that the value of the assets goes down because now interest rates are higher and longer term assets are discounted more. So you can think about that in terms of the loss unrealized, in this case, on the securities, the Fed is holding. The Fed doesn't take account of that. It doesn't mark to market its securities. It does publish results for that, but it would only book that loss if it had a sale. If it realized that loss, then it would take that loss. Otherwise, it does it on a flow basis, looking at the flow of income and the flow of expenses.
Beckworth: Yeah. In fact, we should go back to that first question that you answer in your paper. The question was what would happen if Fed had a loss? In an accounting sense, what would they do to deal with it?
English: If that happened, the way this works is, as I said before, if the Fed has income, it pays that income to the Treasury in the form of a remittance. Actually, it pays its expenses, and then it pays the income to the Treasury. That would stop. There'd be no income to pay to the Treasury. The Fed would accrue a deferred asset, as it's called, which is equal to the loss that it had. The deferred asset is basically a promise. It's a promise that when the Fed returns to having positive income, it will keep some of that income. It won't pay it to the Treasury until it has offset the losses that it had. Say it had 100 billion dollars of losses. Only after it had income of 100 billion dollars would it resume paying those remittances to the Treasury.
English: The way that works is so long as the future income is big and the losses are not so big, this is fine. You just have the deferred asset for a while. You work it off with future income, and then you start remitting to the Treasury again. There isn't a big problem for the Fed in the sense that it doesn't become insolvent or whatever. But it is a problem, if you like, for the Treasury, that it's not getting remittances anymore that it was getting before.
Beckworth: The way I like to think about this, and this is a little more maybe abstract, but you can think of this current seigniorage, or you can think of the net present value of expected future seigniorage. That net present value term is effectively an asset that's on the balance sheet. This deferred asset is maybe tapping into some of that as the Fed makes it to a period of loss.
English: I think that's right. One way to think about it is if you marked everything to market on the Fed's balance sheet, you would need to mark to market the expected future value-
Beckworth: Oh, that's a good point.
English: ... of seigniorage income, which would be a big number.
English: So then, when there were losses on the securities, it might even be the case that the net present value of the future seigniorage income would go up. But in any case, you'd have a huge cushion to absorb loss.
Beckworth: Well, that would be an interesting exercise to look at, is a baseline where you mark to market everything. I guess that explains why some central banks who have had capital losses on their balance sheet are still able to function normally, because implicitly, they have this future income stream that can carry them through. In fact, let's move on to the next question. Does this have any bearing on the Fed's ability to make monetary policy?
Are Balance Sheet Losses a Cause for Concern?
English: I think the answer is really no. The Fed, even if it had significant losses, would continue to operate normally. It would implement monetary policy as it does today. It would still raise and lower the target range for the federal funds rate. It would raise and lower the administered rates that it uses to make that target range happen. There really is no implication for monetary policymaking unless the losses are just absolutely absurdly large, at which point you could imagine there being a problem down the road. But for any loss that I can think of, the Fed just keeps operating. As you say, there are central banks that have done this. They can continue to operate and implement policy.
Beckworth: Isn't part of this also the implicit guarantee of Treasury? I mean, if the Fed were to get to a point, which is unlikely, that it had huge losses, really, really big losses, Treasury would presumably step in and recapitalize the Fed, which then pushes the question, well, how solvent is the US government? We look at market interest rates. The market seems okay with what the federal government's doing right now, even though we run deficits and such. It just strikes me. It would be very hard to ever get to a point where the Fed could not conduct monetary policy, given the expected income streams coming to the federal government into the Fed itself.
English: I think that's right. I mean, in some sense, the ultimate backstop, if the Fed had trillions of dollars of losses somehow and couldn't manage them, then the Fed would have to get financing from the Treasury, from the Congress. Right? Congress would pass a budget item that would be the Federal Reserve's expenses. That's not a great outcome, but there are countries that do that, too. That's also a manageable outcome, though probably not a great one in terms of central bank independence, for example.
Beckworth: Yeah. We're a long, long ways from that. I'm just throwing that out as the hypothetical scenario. But that leads us to the next question. That is, do these losses pose a problem for Treasury and the taxpayers? You have a nice set of multiple answers to this question, but let me tee it up for you by noting I've had Andy Levin on recently. He had his paper with Bill Nelson. They're a little bit more worried about what's going on. For example, they point to the recent, I believe, quarterly report that the Fed put out on its balance sheet. There's an 850 billion dollar, I believe, unrealized lost.
Beckworth: These are your former colleagues, I should mention. You guys worked together for many years. Bill and Bill from the Division of Monetary Affairs. That must have been fun when they called Bill in the meetings. Both of you were there. But he makes the case that, look, the unrealized losses can be viewed, and I think you alluded to this earlier, as the present value of future income streams. The 850 billion unrealized loss, at some point in the future, could mean 850 billion in income loss. Let's say that's true. Why are we still not as concerned about it as they are? You list a number of reasons. Maybe walk us through them.
English: Sure. I think there are a few different reasons why that isn't necessarily a concern. The first is that QE can certainly allow the Fed to run losses in some periods if short-term rates rise rapidly. But it probably also boosts Fed profits in other periods. Fed profits, for example, were really high last year. The balance sheet was large. The Fed made 109 billion dollars that it remitted to Treasury. That's the highest level ever of remittances. Having a bigger balance sheet can mean higher income, not lower income. It depends on the relative level of short-term rates and long-term rates. To the extent that you buy some long-term securities, when short-term rates are low and short-term rates normalize, you may have lots of profits upfront, and then you may have losses later on, but the net isn't necessarily a loss. You have to think, "Over time, what does this look like?"
English: A second thing you need to think about is the Fed did QE with the intent of pushing down longer term interest rates and supporting economic growth and employment and so on. To the extent it is effective in doing those things, lower interest rates lower the interest cost of the Treasury because the Treasury's issuing new longer term obligations all the time. So the Treasury's interest bill is lower. If the economy is stronger, taxes are higher. Government spending on safety net programs are lower, so the budget deficit is smaller. So even if the Fed's narrow accounting shows a loss, the Treasury may not. They have a smaller remittance from the Fed, but they have a lower interest bill. They have higher taxes. They have lower expenses. So the Treasury may feel that this is still an improvement.
English: One way to think about this that we looked into now quite a long time ago, back in 2013, at the Fed, was what is the effect of QE on the debt-to-GDP ratio, say, 10 years from now? After all these effects are washed out, where does it leave us? The Treasury and the taxpayer are presumably worse off if the debt-to-GDP ratio is higher, and better off if the debt-to-GDP ratio is lower. What we found was in a lot of scenarios where interest rates rise fast, faster and further than expected, the Fed has significant losses, but nonetheless, the debt-to-GDP ratio is lower because of these other effects that really are pretty big and matter. Anyway, I think there are a number of other factors. What Don and I said in our piece is it's important to not look too narrowly and obsess about the Fed's slice of this. You need to look at all of the different effects of the QE on the taxpayer. Those effects may be very different than what you see for the Fed alone.
It's important to not look too narrowly and obsess about the Fed's slice of this. You need to look at all of the different effects of the QE on the taxpayer. Those effects may be very different than what you see for the Fed alone.
Beckworth: You've just mentioned an interesting point in your paper about the debt-to-GDP ratio being lower, given QE, even if rates go up. Even if we go through the kind of time we're going through right now, we could still end up, all else equal, in a better place in terms of public finance. You alluded to lower deficits, maybe a smaller debt, so a smaller denominator. But also the denominator, the nominal GDP itself could be higher if QE does its work.
English: Yep. I think that's right, though the real GDP, probably not. Out a decade, a bunch of factors that would be driving real GDP, but I'm not sure a cyclical monetary policy is one of them. But nominal GDP, I agree. You do a better job of getting the economy back toward potential, that would help get inflation back toward target. To the extent you have nominal debt that's outstanding, people aren't expecting the outcome. You have higher inflation. That would mean lower debt to GDP, for sure.
Beckworth: We've seen that, actually, this past year. It's unrelated to the QE, per se, but the inflation that we've experienced, we've actually seen debt to GDP actually drop a little bit, which is interesting, given the five trillion net addition to the public debt. Let's move on, then, to maybe another question. You've touched on it already, but let's circle back. That is, even if we don't compromise the Fed's ability to do monetary policy, even if it's not a burden for taxpayers and the Treasury, could it undermine the Fed's independence? Even though all these things are true, the appearance may not look great. We've mentioned losses. Losses might look bad to Congress. Also, part of those losses are paying out to banks and money market funds who have liabilities. You can imagine this becoming a sensitive issue as time goes on if rates stay high. How do you think about that problem?
The Issue of Central Bank Independence
English: Don and I thought this was the biggest issue. We felt like we dispatched a lot of the economic issues, but the issue of how would this play politically, and could it undermine Fed independence, I think that does concern at least me. I won't try to speak for Don. But the Fed's always controversial. Paying high interest to banks and money market mutual funds and running a loss may look bad to a lot of people on the Hill, and in the public for that matter. It is the way monetary policy is implemented. One's a short rate. One's a long rate. But still, it won't look great. With the Fed raising rates, that makes budget arithmetic harder anyway because interest expenses go up, and having, in addition to that, remittances go to zero for a few years, it just makes the budget arithmetic worse.
English: I think there is a real risk that this is politically very hard. What can the Fed do about that? I think that the best way to address this is to talk about it and be clear about it, and try to do that in advance. I remember going up when I was Director of Monetary Affairs to talk to staffers on Capitol Hill about how does this accounting work? Yes, there could be losses. Here's what that would look like. We don't think it's likely, but it could happen. The Fed has produced a number of documents that have gone through this. They had a very nice Fed's note recently where they had some different scenarios, including ones where interest rates go up to above six percent and stay there for a while, and showing, what does that mean for Fed income? What does that mean for the deferred asset? What does that mean for remittances?
English: I think that's really helpful. You want to be clear. You don't want it to be a surprise when this happens. You don't want people on Capitol Hill to say, "Oh, we didn't know that could happen. We're outraged." You want them to say, "Well, that's too bad, but we knew that was a possibility. So it's happened." I think all the Fed can do is be clear that it's a possibility and emphasize the value of QE in achieving its objectives when you're constrained by the zero bound. This has real value in terms of the Fed's mandate. Yes, there is a risk that things can work out in a way that the Fed has losses, but those aren't, in fact, a big problem. It's one of the risks that you take as a policymaker.
I think there is a real risk that this is politically very hard. What can the Fed do about that? I think that the best way to address this is to talk about it and be clear about it, and try to do that in advance.
Beckworth: Circling back to the FOMC meeting we talked about earlier, part of the challenge of thinking through this is we don't know how long rates will be high. I mean, part of the reason we're in this bind is because the Fed is raising interest rates. If you look at the FOMC's projection of interest rates under the Summary of Economic Projections, they actually have rates going back down. If you look at the real federal funds rate, it's half a percent by, I think, 2025. The nominal one's two and a half percent. So if we do end up back in that world, this won't be an issue anymore. At least, it shouldn't be.
Beckworth: I guess part of thinking about this is, well, where do we think rates are going to actually be going in the future? Maybe 2025 is too far of a horizon in political terms to think about this. But it struck me that, well, maybe this is not going to be an issue for that long. The Fed's going to tighten. Maybe we go into a recession. Rates are going to fall back down. The reason this wasn't an issue after the last rounds of QE1, QE2, QE3, is because rates were low for so long. We didn't have to deal with this situation. But now we are dealing with it because of inflation. So I guess part of the thinking of this deals with our outlook for interest rates.
English: That's right, and the expected outlook for interest rates as well. Right? Because that's what drives current long-term rates and what matters, long-term rates versus short-term rates. But yes, I mean, if the Fed ends up having to raise policy rates unexpectedly significantly further, say inflation is just a more persistent problem than they're expecting, so they end up raising rates to, I don't know, six percent, and then they have to keep them there for a couple of years or something like that, and they come down more slowly, because inflation comes down more slowly, that would make this problem worse because they would still be holding a lot of securities with low yields.
English: Now, over time, they will be running off. Securities will be maturing, and they have a cap. They let a lot of those run off. But they'll be buying some additional securities. That helps. Out a couple of years, they'll be buying probably a fair amount of treasuries, actually, once they have the new, smaller balance sheet that they want. That blunts some of these effects, but I think you're right. If they end up having to raise rates further or for longer than they currently expect, that makes these issues around Fed income more difficult.
If they end up having to raise rates further or for longer than they currently expect, that makes these issues around Fed income more difficult.
Beckworth: Well, we are running low on time. My final question to you, Bill, is this. What do you think is going to happen to interest rates? Are we going to return to a secular stagnation-type world where rates remain low? Or do you see what we've been through a permanent shift in real rates?
English: In terms of real rates, I guess I don't see any reason to think that real rates are going to be much higher, say, five or 10 years from now than they were pre-pandemic. The effects of changes in the population, the demography, that's not going to change. You can predict that way in advance. Productivity growth doesn't seem to be picking up. I just think that the underlying reasons for low real interest rates, a low R-star, if you like, are still in place.
English: Then there's an issue of, well, what happens to nominal rates? There, I guess I find it credible that the Fed will bring inflation back down to two. They've clearly staked their credibility on that, so I think they're going to have to do that. But that means nominal rates will come back down in the end to something like two and a half, or some pretty low number. It may take longer than the Fed pointed to in the SEP. I thought they had a pretty rapid disinflation, given that unemployment doesn't go that high. I'm not sure I believe things will go quite that well. But I do think they're going to get rates down, and in the end, we'll be back in a world of pretty low interest rates.
Beckworth: Yeah. I share your view, and I think markets do, too. Well, with that, our time is up. Our guest today has been Bill English. Bill, thank you so much for coming on the show.
English: Thanks very much, David. That was a lot of fun.
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