Jeffrey Lacker on What a New Fed Treasury Accord Might Look Like

Jeffrey Lacker is the former president of the Richmond Federal Reserve Bank and is a senior affiliated scholar at the Mercatus Center. Jeff returns to the show to discuss the history of the Fed Treasury Accord, the state of fiscal dominance, his five proposals for a new Fed Treasury Accord, his calls for reform around the discount window, a memorial to his friend and colleague Charlie Plosser, and much more. 

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This episode was recorded on May 20th, 2026

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: Welcome to Macro Musings, where each week we pull back the curtain and take a closer look at the most important macroeconomic issues of the past, present, and future. I am your host, David Beckworth, a senior research fellow with the Mercatus Center at George Mason University, and I’m glad you decided to join us. 

Our guest today is Jeffrey Lacker. Jeff is the former president of the Richmond Federal Reserve Bank, where he was president from 2004 to 2017. He is also a colleague of mine here at the Mercatus Center, and today we’re going to talk about the Kevin Warsh Fed, what it might mean for a new Treasury Fed Accord, and other developments in that space. Jeff, welcome back to the podcast.

Jeffrey Lacker: It’s a pleasure, David.

Beckworth: It’s great to have you on. Now, just a little while ago, we were at the Hoover Monetary Policy Conference.

Lacker: Yes, in Palo Alto. Yes, it was a great conference.

Fed Treasury Accord

Beckworth: It’s a great place. I encourage everyone who can to go there if they get a chance. One of the big things that was discussed, and definitely discussed around dinner tables, hallway conversations, is what would a new Fed Treasury Accord look like? We’re going to talk about that today because you actually had some great testimony that you did before Congress recently. In fact, you did it with our other colleague here, Tom Hoenig. You both got called before Congress and do what you do well. You testified and shared your wisdom with the people on Capitol Hill. It was also a big point of interest at the conference.

I’ll just tell one story. We were having dinner one of the evenings there. We went around the table, and each person gave their view, what they thought the new Accord would be. It was all different. Everyone had a different story. We needed to be wiser, and that’s why we got you here to help us think through that. Maybe, Jeff, you could help us first set the stage by talking about the history of the Accord because you bring this up in your testimony. Maybe start there with that.

Lacker: Sure. Yes, it’s a fascinating story. Back in 2001 at the Richmond Fed, we did a special issue of our Economic Quarterly dedicated to the Fed Accord. It was the 50th anniversary. In early 1951, the Korean War has been underway for a few months. The Fed agreed with the Treasury back in 1942 to maintain a cap on US government security yields to keep down the financing costs for World War II. That required the Fed to accumulate a lot of government securities and to intervene pretty often. After the war, things are back to normal, but the Treasury likes keeping its financing costs low.

Under Truman and World War II, we had a surge in commodity prices. Inflation was creeping up. The Fed, and the FOMC strongly believed it needed the freedom to let market interest rates rise in order to reduce inflationary pressures. Truman is a small businessman from the Midwest and strongly in favor of lower interest rates, so they got into a battle. The Treasury secretary was pressuring the Fed to keep interest rates low. There was this famous episode where Truman invited the entire FOMC, the executive committee, I think, of the FOMC, over to the White House and lectured them about the desire for lower interest rates and maintaining the yield.

The Fed officials go back to the office. One of them writes a memo to file saying, “Here’s what Truman said. We didn’t say anything. We didn’t agree or anything.” The next day, Truman calls in the press and says that the Fed agreed with me on maintaining lower interest rates and it turned out not to be true. Eccles famously, then the Fed chair, had been demoted to a mere governor by Truman’s appointment of McCabe as chair. Like Powell in the current situation, a governor who had formerly been the chair, he goes to the files, takes out the memo, leaks it to the Washington Post and the New York Times, and the president’s revealed as a liar. Imagine that.

Truman sues for peace, sends someone over from the Treasury to negotiate with the Fed. The secretary of the Treasury is in the hospital for some operation. The official that negotiates with the Fed, they agree to some conditions that the Fed can let the Treasury market float, essentially let yields rise or fall. There’s some other conditions. They’re stipulated in the minute. You can find them in the minutes of a FOMC meeting. All they released to the public was a one-line statement saying that the Treasury and the Fed are in complete accord about the government securities market. It got called the Accord.

That official on the Treasury side ends up being appointed by Truman to lead the Fed, to be the next chair of the Fed. His name is William McChesney Martin. He went on to great fame, and famously set a very independent course while he was at the Fed. The story’s told that later they encounter themselves on the street of some city. I think it might’ve been New York. Truman just looks at him and says one word, “Traitor,” and walks away.

Beckworth: That’s so interesting. There’s more to share from the story, but just right there, it speaks to the importance of certain personalities. You’ve got to have someone who’s willing to say no, right? You mentioned the one gentleman, Thomas McCabe, I think 1948 to 1951. He was pushing back against Truman.

Lacker: He was too, yes.

Beckworth: Truman says, “Oh, you’re out.” He puts his own man in, but then his own man says no. Have you ever thought about the importance of having the right person at the right time? There’s this great man theory of history, which may be an exaggeration, but these individuals, or even like Paul Volcker in the early ’80s, would history have been very different, do you think, had they not been there?

Lacker: I think there’s been a fair amount of variation over time in the beliefs of the Fed chair, their understanding of what the central bank is about, what it should do, how its actions affect the economy, how it should respond to economic shocks. Those differences in just intellectual frameworks are important. You have to have a serious constitution, some strength to get up to that position to begin with. Different chairs have approached the job differently. You have a culture in the institution as well that’s often also the choice of the Fed chair. Greenspan ran a different committee than Bernanke did, for example.

Beckworth: I remember with Paul Volcker, I’ve read the history. Also, I talked to Don Kohn on the podcast. It was intense when he raised rates, tightened policy. There’s what was it, two-by-fours and bricks were mailed to him. Truckers drove into DC. There’s even the story of someone storming into the boardroom, because security was very light back then, with a sawed-off shotgun. I can’t imagine. All of this speaks to the amazing drama you can get from central banking. Who knew central banking could be so exciting? Like a soap opera.

I guess my question, just to push this a little bit more, is had there not been a Paul Volcker, would inflation have been addressed? You could paint a story, well, part of it was Reagan did tax reform, so they’re getting more tax revenue. John Cochrane likes to say, “Oh, it’s fiscal.” Or you could tell this story. If you look at polling from this period, inflation became one of the top issues among the public. People were ready for someone to address it. Again, was it Paul because he could handle this challenge of it, or was it the circumstances that made Paul Volcker arise to the situation?

Lacker: Volcker had a great deal of fortitude, but I don’t think he could have exercised that fortitude and that strength and that determination without the political support that he knew he had in private on the Hill. Even though people would bash him in public and on the hearings were these little theatrical episodes in which congressmen felt they had to complain about monetary policy, but he had the support in private. It was pretty clear.

On the other hand, Burns had a very particular intellectual apparatus that he brought to bear, a particular set of theories. People think of that as an episode where Nixon exercised his influence over Burns, but Burns was totally on board. Ed Nelson made this point at the Hoover Conference that Burns actually believed that because of the price controls in 1971, the economy could stand very stimulative policy in ’72 without sparking inflation. He was just bringing an outdated theory to bear on things. It wasn’t a matter of independence being threatened or compromised. It was a matter of he was in place, and he happened to agree with Nixon.

Beckworth: That was interesting. You can have independence, but if you have the wrong theories in that independence, you can mess things up. Let’s go back to the ’51 Accord because you found some great quotes. Share those with us.

Lacker: It was really interesting. After Martin comes in and he’s trying to get a handle on things, the New York Fed had been intervening in the government securities market to maintain these yield caps, and they had an agreement with the Treasury to maintain orderly market conditions. The Fed in New York interpreted that pretty liberally, and they intervened pretty often. They intervened to help particular auctions go well, so they’d intervene in the pre-auction, when issued market. They’d intervene afterwards to keep the price from going under par, and the Treasury liked to pick low coupons, and so that was an active thing they ended up having to do.

At other times, they’d intervene across the curve where they saw pressure, this vague word. Martin wanted to reorient the market. He wanted there to be a free market, a market where there was the infrastructure that went along with it, so he put together a subcommittee of the FOMC in 1952, and they studied. It was a subcommittee on the government securities market, and they issued a report back to the FOMC in late ’52. In 1953, there’s a blowup between the board and New York Fed over some auction issues around May and June that went poorly. New York Fed felt it had to intervene. It was unclear their intervention was consistent with the authority they had.

It came up in hearings. The head of the New York Fed and Martin, the chair of the Board of Governors, gave speeches articulating different views, and so it went out public. There were hearings, and then as part of the hearing record, this subcommittee report was entered into the record. There’s some just great quotes that, to me, sound very familiar, and the reason they sound familiar is because the Fed intervened pretty heavily in 2020, the New York Fed in particular, to correct market dysfunction. The word these days is market dysfunction or dysfunctional markets, and it was called market functioning intervention.

It sounds exactly like orderly markets, disorderly markets back then, but there’s this great quote from Martin about how the Fed needs to step aside and let the market be free, and that that’s the path to better resilience. Can I read a little bit of this?

Beckworth: Yes, please do.

Lacker: It’s just a fascinating passage. Martin was chairing the subcommittee, so he must have been holding the pen on this. “It’s the unanimous view of the subcommittee that the Federal Open Market Committee should keep its intervention in the market to such an absolute minimum as may be consistent with its credit policy,” and by that they mean monetary policy. When they say credit, they mean monetary policy.

“This position rests not only on the fact that the system’s primary role has to do with monetary policy in the broad sense, but also because of important technical considerations related to the highly desirable development of strength in the private market for United States government obligations. The normal functioning of the market is inevitably weakened by the constant threat of intervention by the committee. In any market, the development of special institutions and arrangements that serve to provide the market with natural strength and resilience, and to give it breadth and depth, tend to be greatly inhibited by ‘official mothering,’” and he put mothering in square quotes here.

Beckworth: Mothering. That’s a new one.

Lacker: “Private market institutions of this kind are repressed particularly by the constant possibility of official actions which, by the market standards, will frequently seem and be capricious. Such actions constitute a risk that cannot reasonably be evaluated in advance and anticipated in the formulation of individual private judgments of market prospects.” He’s talking about dealers and dealer balance sheets, and that’s exactly what people talk about now when they talk about market dysfunction. That there’s some problem with dealer balance sheets that make price swings more volatile and the market less resilient.

What he’s saying here is that official mothering, meaning the threat of intervention, is what leads market participants to invest less in market making, less in dealer balance sheets. It’s been observed that, since before the Great Financial Crisis, the amount of capital devoted to dealers and the dealer balance sheet capacity has decreased since then. Well, maybe it’s not an accident because the Fed has intervened so much since the Great Financial Crisis. Maybe that’s why they’re holding out.

He makes a point of how a private dealer has to calculate what other people in the market are going to do and how they’re going to react to incoming news, and that for other market participants, he knows that they’re driven by profit and loss. He knows the basis for their calculations, but he doesn’t know what’s motivating the Fed’s intervention. It’s seemingly opaque. That opacity is the problem, and what gives rise to this issue that you have to stand away from the market for there to be the capital devoted to market-making to make it liquid and robust. Of course, what we saw, the tremendous story, Ken Garbade has documented this.

Beckworth: Yes, he has a great book on the history of the Treasury.

Lacker: Yes. He’s documented just the growth in the scale and scope of the market institutions, what’s brought us the deepest and most liquid government securities market in the world.

Beckworth: We need to officially bring back into the lexicon “official mothering.” That’s a William McChesney Martin line, official mothering. That’s fantastic. Nothing new under the sun, as the Bible says. We’re revisiting this. To be fair, I think you probably would agree with this, but correct me if I’m wrong, there are post-2008 Dodd-Frank regulations that also constrict dealers’ balance sheets. They have to fund with more capital, there’s more liquidity requirements, things that make their balance sheets less flexible, able to respond quickly. Is that a fair assessment, you think?

Lacker: Oh, there certainly is. I think the regulatory landscape has changed tremendously since the Great Financial Crisis. Before that, there was a focus on commercial banking entities that benefited from deposit insurance and an implicit assumption throughout the supervisory apparatus that nonbank activities were more market-oriented and subject to market discipline and could be left alone. As long as we police within each bank holding company, the boundary of transactions between banks and nonbank affiliates, that we could keep things safe.

The stunning thing—and Wachovia was the big watershed of this—was just the turn toward backing large banking organizations hook, line, and sinker. The distinction between bank and nonbank affiliates is meaningless now. A lot of the big banks are active in capital markets, and they’ve got dealers, government securities dealers, dealers for other markets as well. Yes, that’s brought a lot of regulation with it, but those regulations have some purpose, right? I mean, presumably, they reflect the imposition of some regulatory constraint motivated by some externality of some incentive that’s not internalized.

For example, the moral hazard that comes with being now part of a broader financial safety net that we have after the great financial crisis. If so, those represent real economic values.

Beckworth: Yes, we can debate what is the externality if it’s being properly addressed. I guess I was just thinking, on one hand, you got constrained dealer balance sheets, which you could argue maybe they need that because of what we went through with the crisis. Also, we got a government running huge primary deficits. It’s just there’s so much pressure on the Treasury market. I guess I’m just trying to paint a little more sympathetic picture. The Fed is massively intervening. I agree that its footprint with the Treasury market’s large repo market. I think there’s other side effects. We don’t have a healthy interbank market at all.

The Fed’s fund market, it’s a shadow of its former self. A lot of reasons why we can talk about, you might want to reduce the Fed’s footprint, reduce the balance sheet, and we’ll come back to this because you have some ideas on that. A lot of it also, I think, is just it’s imposed by the fact that we’ve got to finance the federal government, and it’s hard to keep up with that. I guess that is, to me, the one thing that I have concerns because I’ve, as you know, championed on this podcast, a smaller balance sheet, that even if we all agreed, even if people across the spectrum agreed, at the end of the day, we might end up back like the Fed was in the 1940s, where fiscal dominance kicks in.

Fiscal Dominance

That’s actually a nice segue to a question I was wondering about. One of the concerns you hear from people, like I’ll mention John Cochrane again, is even if the Fed does tighten, we have so much debt that it could actually generate inflation. If we get to the place where you have so much debt—

Lacker: Unpleasant arithmetic.

Beckworth: Yes, the classic fiscal dominance story, unpleasant monetary arithmetic sergeant. What are your thoughts on that? Are we close to that yet? I guess if you’re at the Fed, should the Fed keep its eyes focused on raising rates, doing its thing? At what point do they become worried that they may actually be adding stimulus by raising rates?

Lacker: Cochrane’s right about this, that it’s an oversimplification to think of the Fed as the one to whom inflation control is delegated, and that they can do that no matter what’s happening on the fiscal side. I don’t think that’s correct. I think all of the government is responsible for bringing about low inflation, and the Fed’s got a big part to play, but there are circumstances, there are deficit paths in which that’s not going to be feasible.

If you think about the Fed’s mandate, the third one, the one that no one talks about, is low and moderate longer-term interest rates, you can think of that as a mandate to ensure that the market for US Treasury securities isn’t polluted by or contaminated by unnecessary risk premia. Healthy market functioning is the way to achieve that, when a deep and broad market of participants is able to step in when prices move or when demand or supply shifts. The other perspective on this is to think about how you think a well-functioning market should respond if news arrives that changes everyone’s perspective or everyone’s expectations about what’s coming soon.

In March of 2020, when COVID hit and all the closedowns happened, what would a healthy market do? You would expect a lot of people to rationally step back from holding securities. You would expect maybe a timeout, like there was at 9/11. Let’s take a break from trading for a little while and let things sort out, then come back and trade, like equity markets closed for a week in 9/11, bond market was shut down for a week. You might expect that to be a reasonable and healthy way for the market to respond.

I think that neglecting the role of incoming information and driving these rapid price movements, neglecting that seems to pathologize government securities markets, just to pathologize things that are reasonable reactions to incoming news that’s uncertain. In the context of fiscal policy outlook, it’s entirely plausible that some news arises that shifts the views on the sustainability of US fiscal path. If that should happen, you could see US government yields rise pretty rapidly. In circumstances like that, questions would arise about the role of the Fed. Is the Fed going to declare this a market dysfunction, or are they going to recognize that there’s a legitimate reason to have a different view about longer-term yields?

Jeff’s Five Proposals

Beckworth: Let’s use that. You have your own ideas of how to address this. You actually, I believe, have five proposals in your testimony. I want to go through those in a minute. Something we heard at Hoover Monetary Policy Conference from Hanno Lustig, he’s a professor out there, he said something that Tom Hoenig often will say is, the Fed should just say no, basically.

First, he articulated there’s a difference between what the central bank views as the quality of the Treasury markets and safe assets versus what the market is showing. In fact, 30-year Treasury yield is exploding lately. We’re recording this May 20th, and it’s been rising remarkably. It is a little alarming because I’m someone who likes to cross-check monetary policy with nominal GDP. Nominal GDP and long-term Treasury yields, they tend to track each other over long horizons. We don’t want to get rapid.

That would mean aggregate demand is accelerating, which is not a good sign. Hanno Lustig says, “Well, look, just accept the fact. Don’t call it market intervention. You just let the chips fall where they are, and rates are going to have to go up because that is the reality. There’s too much stimulus, too much aggregate demand.”

Lacker: Well, I think for the Fed to back away from longer-term Treasury markets would help that. The Treasury would face the market, and the Fed would be this neutral bystander in some sense. It’s the way it ought to be. The market can tell the Treasury when it’s out of whack, when it’s unsustainable, when they have a problem. That would force some discipline on the Treasury and the Congress, the fiscal policy authorities in general. I think that’s a good thing. To have the Fed in there on a discretionary basis, that expectation of those sorts of interventions is going to cloud the market’s pricing, and it’s going to cloud interpretation of what’s happening.

Beckworth: That’s what I was going to ask you, because the Fed’s not intervening in long-term Treasuries right now. It is doing the reserve management purchase, which are T-bills. At the same time, I’ve had several people on the show talking about the expectation, almost like a put. I hate to use that term on the show. Basically, there’s an insurance view that the Fed, if push comes to shove, will step into long-term Treasury. There’s implicitly a floor. I guess that’s your point. Pull that floor away, that implicit floor.

Lacker: Well, let the Treasury stand on its own two feet in financial markets. That would be the approach. I think the Fed should back away. One element of that would be to hold as small a balance sheet as it needs.

Beckworth: This is part of your proposal, right?

Lacker: Yes.

Beckworth: Number one is reduce the Fed’s balance sheet. Tell us how.

Lacker: The Fed claims that it’s gotten to the smallest balance sheet it can consistent with the way it wants to run monetary policy. You and several people you’ve had on the show have talked about the ratchet effect. The dealers and the market infrastructure is very much a part of that ratcheting. Reserves get large. Commercial banks become accustomed to large reserve balances. They change the way they do payment processing. Dealers change the way they run their books. It becomes accommodated to a large balance sheet. Then, when it falls, short-term adjustments need to be made that maybe show up in repo spreads, for example, above the interest rate on reserves.

That’s the kind of thing that, well, the adjustment will run in reverse, but it took time to ramp up, and it’s going to take time to go the other direction. That kind of thing is what you want to aim for. You want to lay out a path, tell them how low it’s going to go, and encourage the banking system to adjust to a world where reserves are smaller. The corollary of that is why does the Fed care about the spread between repo and interest rate on reserves? It’s not obvious.

Before 2008, the Fed didn’t care a whit. Nobody talked about this spread. It fluctuated a lot on a daily basis. It went up. There were swings above and below. There were swings that seemed to be related to regulatory changes. It wasn’t a matter of policy interest. Once the Fed sets one interest rate, it should be done. The interest rate on reserves is perfectly fine. I don’t see any reason why the Fed can’t control interest rates with that one rate.

Beckworth: Let’s come back to that because that’s one of your other ideas.

Lacker: That’s another point. Yes, the balance sheet.

Beckworth: Let’s go back to the balance sheet because, Jeff, you’ve told me you’re not thrilled about some of the ideas I’ve said on this podcast. I have talked about different ways to shrink the balance sheet. As you mentioned, others like Bill Nelson, I’ve talked about this for years. Then Kevin Warsh comes along, and then we have Stephen Miran put out a paper, and then Lori Logan and Sam Schulhofer-Wohl. Almost like a menu list of different things you could do, right?

One of the ones that everyone seems to agree on, and you want to push back, so I’m going to give you the opportunity to do that, is let’s incorporate some of the liquidity regulations into the discount window tool so you can count collateral parked there toward your liquidity coverage ratio, internal liquidity stress test. You say not so fast, so tell me why.

Lacker: I think to count discount window borrowing capacity of a bank toward its liquidity coverage ratio, toward internal funding, stress test requirements, toward its resolution planning liquidity requirements, it just fundamentally misconceives the purpose of those things. Those arose, and the purpose of those is to correct the moral hazard effect of access to the discount window itself. Banks have an incentive to run themselves with less liquidity, with less contingent access to liquidity if they’re not constrained.

The problem with that is that they’re relying on the fact that the Fed will give them access to the discount window, even if they’re insolvent. That leads to excessive risk-taking. That kind of moral hazard is the fundamental bedrock feature of modern financial markets, at least in the US. Those measures, liquidity coverage ratio, resolution planning in particular, but also the funding stress test requirements, were designed to counteract the incentive to run lean on liquidity, counting on the discount window. To add the discount window is just to institutionalize the bad incentives they have from access to it.

Beckworth: Okay, a couple of things. Isn’t it not possible that you could go too far, though, in that direction? You don’t want them to go to the discount window excessively, but you create a system where they go too far the other direction. Michelle Bowman had a speech, and I think a few others, where they’re not treating this liquidity buffer, the LCR, as something to use. It becomes baked in. You’ve got to at least have that much, and then you’ve got to have liquidity for actual needs.

It’s not being used in the way that you suggest it should be used. For whatever reasons, it’s not working in practice as it’s supposed to in theory. They’re sitting on the liquidity, and then needing more liquidity. It’s one of the contributing factors to at least the story is the ratchet effect. Is it not possible that there’d be time for a tweak to this? You can swing both directions too far?

Lacker: There’s this dilemma whenever you set up a reserve requirement. It’s this classic thing that pertains to rainy day funds. When do you break the glass and say, “All right, it’s a rainy day,” to mix metaphors? This is in Bagehot too, and he doesn’t have an answer for it. He tells the Bank of England, in a crisis, lend freely. If it’s normal times, build up your reserve. He doesn’t tell the Bank of England how to know when to switch. It’s just left unsolved.

Beckworth: If Bagehot hasn’t figured it out, I guess we won’t figure it out here.

Lacker: It’s something that a private sector entity—we trust a hardware store or an auto company to manage their own liquidity buffers and to hold liquidity and decide when to use it. In the banking industry, the moral hazard is something that makes us mistrust that decision. You have these regulations that say you keep this. Then the decision to break the glass becomes one that’s negotiated between a supervisor and a banking entity. That’s a fraught thing. That’s a different kettle of fish than general orders.

Beckworth: Let’s move beyond the pendulum swung too far in the other direction, from moral hazard to stigma. I want to approach this from a different perspective because Peter Conti-Brown asked me that same question. “David, how can you be a Mercatus guy and support this ball? Aren’t you a markets guy?” I am. Here’s my other two answers. One is there’s always tradeoffs in life. Right now, I see the bigger cost or issue that the Fed’s footprint is so large. It’s huge in Treasury markets. It’s huge in repo market. We don’t have an interbank lending. We don’t have the overnight lending markets. The federal funds market is the shadow of its former self.

All those things are tied to the size of the Fed’s balance sheet. This would be one among many approaches, but if I could incorporate liquidity coverage ratio into the discount window and reduce the structural demand for reserves so I shift that demand curve closer in, and I reduce the size of the Fed’s balance sheet so the Fed has a smaller footprint, I’m making one distortionary tradeoff or maybe another one.

I’ve had like a decade of a big Fed balance sheet. The very thing we’re talking about, it’s affecting yields, all of these things. That’d be my first comment. It’s a tradeoff between that mess versus this other mess that you’re more worried about. Well, let’s do that first and I’ll come back to my second one because there’s a lot there.

Lacker: Again, the purpose of the liquidity coverage ratio is so that they have resources that mean they don’t have to go to the subsidized discount window because when they use it, it’s going to be subsidized because it’s going to be less than what they could have gotten in the market. The whole purpose of liquidity coverage ratio is to have them avoid the discount window. Having it count toward the liquidity Treasury is effectively just throwing out the liquidity coverage ratio. Deciding not to regulate as tightly liquidity positions in these financial institutions.

Beckworth: All right. Let’s go to my second response then. See if you can shoot this one down, too. Most central banks and advanced economies around the world have a very active ceiling repo facility. We have a discount window, now we have the standing repo operations. That is actively used. Banks have no hesitation to go there and use the repo market to get added settlement balances, reserves. In other words, I think the ECB is the MRO, main refinancing operations.

There’s a big movement around the world actually as these other central banks are moving away from large balance sheets. They’re all moving toward a demand-driven system is what they call it. The idea is that central banks don’t preposition reserves, but banks go to the central banks for the reserves as they need, as the economy grows, or liquidity is stressed. The point is this. There are many central banks that have more, far more active use of the equivalent of a discount window than we do. I don’t think they’re being labeled as excessive moral hazard or maybe they are. Maybe you would criticize that. Here’s my point. It seems to work abroad with other central banks that more actively use their ceiling facilities.

Lacker: I don’t think that a classical liberal at a market-oriented institution like this would hold up the ECB or the UK as paragons of market discipline. That lending has the same property as a discount window. Now, in the case of the discount window, in the early ’50s, when the Fed, during the period I was talking about, started using open market operations to do monetary policy and affect short-term interest rates like the Fed funds rate you alluded to, when it did that, the discount window became an appendage, just a vestigial appendage.

It was there from the act. In the beginning, the Federal Reserve, discount window lending was how the Fed was going to influence interest rates, but then it discovered open market operations. By the time of the Accord, the discount window is just this sideshow. The Fed restricts access to it, doesn’t want people to use it very often, and that’s the way it evolves. Then it shifts in the late ’60s and early ’70s. The Fed is asked by other bank regulators to lend to let them delay closing failed institutions so that they can find a merger partner or, in some other cases, avoid some embarrassment having to do with the circumstances around the closure.

The instances of that get larger and larger in the ’70s. In ’74, there’s Franklin National Bank. In September of ’74, all the six or seven largest central banks in the world, they decide that the home country of the bank is the one that’s responsible for lender of last resort, but this is nothing at all like what Bagehot had in mind. This is rescuing failed institutions. The precedent set lead to the growth of too big to fail. Then there’s Continental in Illinois. There’s a raft of savings and loans and smaller banks that fail in the ’80s, and the losses to the FDIC are increased by Fed lending that lets the FDIC delay closure. Same thing with FSLIC. Then it just metastasizes in 2007 and 2008.

Beckworth: You would probably be against, then, the return of a term auction facility to make the discount window more regularly used?

Lacker: I wrote a letter to my colleagues in December of 2007. I tried to steel man the case for the term auction facility, and it had to do with this issue of stigma. Stigma is a loaded term. The clinical term for it would be information revelation upon borrowing. Think about Citibank, it goes and gets $5 billion capital injection from somebody in the Middle East, and the terms are public. That’s informative because somebody had access to information and that’s how they priced it. Somebody did due diligence and that’s the price they set, that’s the price they could get.

Financial transactions, when they’re made public, reveal information about the borrower, inevitably. It’s not some weird quirky prejudice on market participants’ part. It’s not some bizarre, irrational thing. It’s a thing that comes out of an equilibrium model. It’s part of the equilibrium that when this happens, this information gets revealed and people update their priors that way.

It’s not a malfunction, or it shouldn’t be viewed as a malfunction. I went through the case. I said, “All right, let’s apply an adverse selection model here.” If you think adverse selection, which is what information revelation and that framework in that setting involves, if you think it’s adverse selection, this isn’t the facility you would design. The access was limited. You’d have to allow unlimited access because the people who are going to borrow are the ones who are the good risks. You want to get to the bad risks. I didn’t seem to be persuasive.

Beckworth: Just to be clear on this point about the Fed’s balance sheet, you don’t see, as I do, that there’s a tradeoff? You think things are still fine. 

Lacker: I wouldn’t look to incorporating the discount window into the LCR. I think that’s a way too costly measure to achieve balance sheet reduction. 

Beckworth: What steps would you take to shrink the balance sheet?

Lacker: Oh, well, I would shrink it.

Beckworth: Do you sell it off? Sell assets off?

Lacker: They have this political problem involving asset sales in that they have a very large quantity of unrealized capital losses in their portfolio, and they would have to realize those. That would require some accommodation from Congress that they’re unlikely to want to—

Beckworth: It would be a good soul cleansing experience for all.

Lacker: Right. Rolling it off is the politically expedient approach. I think rolling off the MBS should be a priority, maybe even selling those, taking some of the losses over time. They have this accounting mechanism that means that they don’t have to really ask for funds from Congress.

Beckworth: Right. The net deferred asset?

Lacker: Yes.

Beckworth: Although, it’s still implicitly happening because they’re not sending funds to Congress.

Lacker: Right. There’s infinite capacity in that account for realized capital losses.

Beckworth: I like this point you’re bringing up here because I do think more transparency about what is actually happening from a consolidated government balance perspective is useful. Overseas, the Bank of England, they actually had to go ask for capital injection from Parliament. At least it’s open, it’s public. I think that’s important.

Lacker: It makes sense because the loss to the Fed on Treasury securities that have lost value is exactly offset by the reduced value of the liability of the Treasury. It’s already accrued to taxpayers in some sense already.

Beckworth: Let’s move on to some of your other proposals. You’ve mentioned also that you would like to see Treasury should be the sole debt manager.

Lacker: I think that would be clearer than what we did in the 2010s when the FOMC was going one way, taking long-term duration out of the market, and the Treasury was at times going in the other direction. I think it should be clear to markets and everyone that after the Fed has set a short-term overnight interest rate, the interest on reserves, everything else about the Treasury market is up to the Treasury, including the maturity distribution of what’s in the hands of the public outside the Federal Reserve. I’d like to see some clarity that the Treasury manages that duration and not the Fed.

Beckworth: Should the Fed’s portfolio of assets mimic what the Treasury is issuing, so whatever the distribution is? How do you do this, I guess?

Lacker: This is what Martin pushed the committee to in 1953, which is bills only. Just hold Treasury bills, that way it’s clear to the market, the Treasury faces you guys sort it out, and that determines longer-term Treasury yields.

Beckworth: The Fed would just completely focus on T-bills and then the Treasury could come in. Whatever effect that might have on Treasury market, then the Treasury comes in and cleans it up and changes the Treasury structure.

Lacker: The Treasury has a buyback program. It can intervene in markets the way Fed does. If it has some beef about market functioning, it can act on that.

Beckworth: Keep it simple. Don’t try to mimic what the Treasury’s issuing. Just do T-bills only.

Lacker: Right. It would have the advantage of avoiding the capital losses that we experience that can be a political problem.

Beckworth: Totally. I actually have an idea. I don’t want to go over in great detail here. I think there should be a Fed-Treasury asset swap after every QE to help do QT—

Lacker: I agree.

Beckworth: —where you would get rid of all the bonds, move them to the Treasury, Treasury bills to the Fed. You lose operating losses. You also have easier ability to roll off the debt.

Lacker: My two late friends, Marvin Goodfriend and Charlie Plosser, who passed away late last year, were advocates of that, that if there’s a credit market program intervention, it goes to the Treasury right afterwards. Better, I think, is that credit programs are the responsibility of the Treasury. The Fed can execute on behalf of the Treasury just the way it conducts Treasury security auctions on behalf of the Fed.

Beckworth: That’s another part of your proposal, right?

Lacker: Yes, a credit accord. This would be a pretty ironclad commitment that if there’s an intervention in a credit market, it’s not the Fed’s responsibility. It’s something that the Treasury’s accountable for and it does under authority from Congress.

Beckworth: Okay. You have, shrinking the Fed’s balance sheet, Treasury should control the debt maturity structure, return to bills only. Of course, the return to bills only would work hand in hand with shrinking the Fed’s balance sheet. It’d be much easier to roll off T-bills if you had a large balance sheet in bonds. We mentioned credit accord would be limited to Treasury. The other one we touched on earlier, but the Fed should only have one target interest rate.

Lacker: The Fed has a target of the effective federal funds rate. The reason for that is essentially governance considerations. The interest rate on reserves is what does all the work. You mentioned before that the Fed funds market, the interbank lending market is a pale shadow of its former self. The Fed can do just fine with just setting the interest rate on reserves and going home.

The reason that the Fed in the 2010s decided to retain an effective Fed funds rate target is that the effective Fed funds rate target is set by the Federal Open Market Committee. The Board of Governors, under the law that was passed that allows the Fed to pay interest, is the one that sets the interest rate on reserves. Essentially, the FOMC didn’t trust the Board of Governors to go along with its interest rate setting. A simple one-line act of Congress could assign that authority to the FOMC to preserve the governance of monetary policy.

Beckworth: That is interesting. I did not know that. I knew that the Board actually sets the administrative rates, so a discount window, IOR—

Lacker: Remember, the discount rate is set by banks subject to the approval of the Board. It can order banks around sometimes. There’s a joint, two keys thing.

Beckworth: It is. I guess FOMC is, at least, worried that there could be some mischief.

Lacker: Some are worried, yes.

Beckworth: Okay. Very fascinating.

Lacker: I think the Fed could just set the interest rate on reserves, tell everyone that’s its policy rate. I think that the overnight RRP facility and the repo facility, the repo market of interventions, have weak justification, if any. I don’t think the Fed has really articulated why those spreads are important to manage. It looks more like the internal political economy of the money markets is driving that, the desire to give some money market participants, like funds, a leg up on banks, but have that be a discretionary Fed tool. I don’t see a reason in terms of monetary control for the Fed to be active in controlling and setting RP rates.

Beckworth: What about the ceiling? You’re going to have a ceiling rate no matter what, the discount window and the standing repo facility. You have this corridor. You would say just the bottom would be the anchor, but you’d have to calculate some spread above that for the discount window. You don’t want it to be the same.

Lacker: Maintain the discount window. There’s circumstances in which it has a reasonable use. For the RP rate, if you look before the crisis—

Beckworth: Overnight reverse repo or the standing repo?

Lacker: I would close that.

Beckworth: All of them?

Lacker: Yes. The standing repo facility, I don’t see the need for that. Before 2008, the repo market didn’t have any facility like that on either side, top to bottom. 

Beckworth: Let me play devil’s advocate here. Here’s why you would want a robust repo facility. Here’s the argument, I think. Because of what we talked about earlier, maybe you can answer this, but dealer balance sheets, because of regulations, they’re constrained.

What we see in the Treasury market, there’s less and less involvement in the Treasury market of standard banks or dealers. It’s more these high-frequency traders, it’s hedge funds, it’s nonbank financial intermediaries are playing a bigger role. If you need to get liquidity out, you’ve got to get to them as well. If your broker-dealers are clogged up, if the pipelines are, I don’t know, filled with something, they’re not getting through, you’ve got to work your way into what actually is consequential now. How do you respond to that?

Lacker: Dealers bring capital, computer systems. People enter into the market, do trades. There’s free entry. It’s regulated how much capital you have to hold for that activity if you’re doing it as part of a banking organization, but it’s not like there’s a fixed pie of dealer capacity for all time. That’s something that’s surely endogenous.

Beckworth: You’re saying you could bring in more broker-dealers?

Lacker: They could respond to price signals, if those price signals emerge. For example, if there was a lot of volatility in the repo market, you might think that would be an attractive thing to do, to arbitrage movements in the repo market.

Beckworth: I know the ECB has far more of the equivalent of broker-dealers, people who actually are primary dealers. You could do something like the ECB, have a far wider choice—

This is really fascinating. We’ll provide a link to your testimony where you go into this in great detail. I want to go, in the time that is left, to a conference that was held by the SOMC, and you were a participant there, and it’s for Charlie Plosser. You just mentioned he’s recently passed away. Tell us about Charlie Plosser, his legacy, and your thoughts about his impact.

Charlie Plosser

Lacker: Charlie was a great economist that I think is underappreciated, both as an economist and a policymaker. He joined the Shadow Open Market Committee, I believe in the ’90s, and then stepped off when he became president of Philadelphia Fed. His tenure as Philadelphia Fed president overlapped with mine in Richmond. We served on the FOMC together, and then when he stepped off the FOMC, he joined the Shadow again.

He passed away, sadly, late last year. He is probably best known in the economics world for championing something called real business cycles, real business cycle models. This was in the early ’80s when the tools of dynamic, stochastic, general equilibrium models were emerging. These were just the first models where you write down something where there’s some shock, and the natural one is productivity, there’s some savings and investment decision, there’s consumption decisions, there’s production. You just use the simplest stochastic growth model, and lo and behold, it exhibits investment and consumption fluctuations that have some resemblance to business cycles.

These were controversial. At first, they were mocked in saltwater circles, to say the least. It was clear that the right model, a true model, was going to be an extension of one of those. It emerged that over the course of the ’80s and ’90s, people worked on models where there were frictions that gave rise to a need for money and gave rise to a role for central banks in controlling monetary conditions. That avenue became what is now known as dynamic, stochastic, general equilibrium, new Keynesian models.

The important thing, though, is that those inherit all these properties of the real business cycle model. To give you a current example, there’s talk about how unexpectedly high productivity growth would be a disinflationary force. Set aside that that holds constant something about what doesn’t change when you go from low productivity growth to high productivity growth.

In those models, expected productivity growth increasing means that people feel like their real wages are going to be higher in the future, and they’re going to try and bring that forward. They’re going to try and spend it today. That means demand’s going to rise relative to supply today. Real interest rates have to rise in order to get people to want to wait and have their consumption grow at a pace that’s more in line with the growth in output. That kind of thing just flows right out of the real business cycle core of these new Keynesian models.

This debate was active in the FOMC in the late 1990s. There were some advocating, “We don’t need to raise rates, we don’t need to fear inflation because it’s going to lower costs and lower inflation that way.” My predecessor, Al Broaddus, was pointing out this insight from these real business cycle features.

Beckworth: The real rate should be going up.

Lacker: There’s a reason why if we don’t raise rates, people are going to want to spend all their good fortune today. It’s a live issue. My former colleague at the Richmond Fed, Alex Wolman, has written up a very nice piece that got posted earlier this week about the whole discussion at the FOMC.

Beckworth: That’s interesting. For sure. Real productivity gains should lead to higher real rates, which should then, in turn, affect what the Fed does if it’s going to be neutral.

Lacker: Right. What people call r-stars.

Beckworth: That’s really great. I remember him, I think, in grad school. He also did some econometric work on unit roots and stuff.

Lacker: He did. He came at it from the econometric side and made some contributions there I won’t go into.

Beckworth: I remember having to wrestle with the unit root issue and time series and his name kept coming up—Plosser. Then also, of course, we learned about him in the real business cycle literature.

Lacker: Then the other big contribution, before we wrap up, he was part of the rational expectations revolution. Clarity about monetary policy was a key principle that he talked about a lot. He was an advocate of the FOMC referencing policy rules, being as clear as possible about its reaction function, which is different from the debate about forward guidance where you say, “Oh, interest rates are going to be lower than you thought we were going to keep them.”

Bernanke, remember, came in as a champion of inflation targeting. The Fed had adopted a 2% target in the mid-’90s but hadn’t told anyone. Bernanke came in and he said about trying to get the Fed to adopt it. It stalled out in ’09. He got resistance from Capitol Hill. Then in 2010, when we were doing QE2, debating that, Jim Bullard proposed and Bernanke picked up on it, the idea that, “If we’re going to do QE2, let’s be clear that we don’t want runaway inflation and we don’t want disinflation. We want inflation and we should announce our inflation target, that it’s 2%.” He couldn’t get it over the finish line.

After that meeting, QE2 is adopted without any framework articulated. Charlie Plosser went to Ben Bernanke and said, “Let me take a crack at it. I think I can make progress.” He convened a little group of economists early in 2011, and they put together the first draft of what became the framework statement.

Beckworth: Wow. His legacy is in that consensus statement that we look at, and every five years gets reviewed?

Lacker: Yes.

Beckworth: I will encourage listeners to go back and check an earlier podcast with you where you have a great paper where you go through this history. You talk about this. You were there, and you’ve also done your research, so you’re a veteran of these fights, these debates. That was a really great conversation then, and this has been a great conversation today. Our guest today has been Jeffrey Lacker. Thank you so much for coming back on the show, Jeff.

Lacker: My pleasure. Good to see you again.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. Dive deeper into our research at mercatus.org/monetarypolicy. You can subscribe to the show on Apple Podcasts, Spotify, or your favorite podcast app. If you like this podcast, please consider giving us a rating and leaving a review. This helps other thoughtful people like you find the show. Find me on Twitter @DavidBeckworth, and follow the show @Macro_Musings.