Jeffrey Lacker is a former president of the Federal Reserve Bank of Richmond, where he served as its head from 2004 to 2017. Jeffrey is now a senior affiliated scholar at the Mercatus Center and is also a returning guest to the podcast. He rejoins David on Macro Musings to talk about a wide range of Fed governance issues, including the evolving nature of governance at the Fed, the increasing politicization of the central bank, its continuing relationship with Congress, and a lot more.
Read the full episode transcript:
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Jeff, welcome back to the show.
Jeffrey Lacker: My pleasure. Great to be with you, and great to be a colleague of yours.
Beckworth: Yes, it's great to have you on the Monetary Policy Project team. We're all delighted. We had you on last time on the show talking about the Richmond Fed tradition. I encourage listeners to go back and check out that program. But we now have you, we have Bob Hetzel, so I think we're going to rename part of our program [to] the Richmond Fed Wing of the Mercatus Center. Both of you are doing great work. Bob's been with us a for few years. You came on late last year, and now you're a senior affiliated scholar.
Beckworth: And we want to talk about one of the pieces you just put out. In fact, the piece you just put out, you presented at a conference we had for Bennett McCallum, who was another affiliated scholar with the Richmond Fed. So, Bennett McCallum, I'm a big fan of his. In fact, I still have that poster from the conference on my wall in the office. But great guy, rules-based, fan of nominal GDP targeting, understood credit and money issues well. And you have this great tradition at the Richmond Fed that we talked about, again, last time. And so, we are excited to continue that conversation in terms of governance today.
Lacker: Well, it's great to be part of merging these institutions with two great intellectual heritages. It was a real honor to be invited to participate in the conference honoring Bennett McCallum. When I first came to the Richmond Fed in 1989, he was a visiting scholar there, and so for the next decade or so, I got to interact with him fairly often when he was there. He used to be at UVA, and then he went to Carnegie Mellon. But, [I was] just very fond of him. He made great contributions in the '70s, '80s, and '90s to monetary economics, and even into the 2000s. But also, [he was] just a great guy to be around, with his soft southern Texas drawl and great demeanor, but also an incisive mind, and didn't hold back, so a great guy.
Beckworth: Yes, and again, I encourage listeners to go check out the conference. We'll provide links in the show notes. We also had a podcast from that conference where I chatted with Ed Nelson about some of the personal side of Bennett McCallum. It's so fascinating to learn that he was an athlete, he did a student newspaper. And I joked that it prepared him for being editor of the AEA, that he could reject articles easy, because he did that in high school. His wife was there too, she really appreciated it. It's really neat to see the personal side of prominent economists, and then also to consider all the work that they have done. And, of course, it was great to have you there and a bunch of other people. Governor Waller was there. [It] just was a great day, so I encourage folks to go back and check it out. But, you gave a presentation there that was both interesting and provocative, and so I'm excited to chat about it today.
Beckworth: The title of the policy brief that came out of that talk is, *Governance and Diversity at the Federal Reserve.* And I want to begin by reading just the first two paragraphs, and then I'll turn it over to you. It's a great motivation, great way to start things off. So, you say, "The purpose of good governance is good outcomes. From that perspective, the recent surge in inflation, and the Federal Reserve System's delayed response in 2021 and early 2022, must be central to any discussions of the future of Fed governance.”
Beckworth: “Several Fed leaders have since expressed regret regarding the delay, and a strong case can be made that the Fed's decision to hold off responding was a significant error given what they knew at the time. For example, in a 2023 Brookings Institution conference paper, authors Gauti Eggertsson and Don Kohn argue that earlier recognition by the Fed of the seriousness of the inflation surge, and an earlier response to the surge, likely would have dampened demand sooner, lessened the increase in inflation, and enabled a more gradual tightening of policy.”
Beckworth: “Many factors have been cited as contributing to the Fed's disappointing performance." And you go through and list a few, and then you say, "Could the recent evolution of Fed governance practices also have contributed to the Fed's performance? I would argue that this possibility is worth serious consideration. In particular, I would point to the change in the role of the Board of Governors at the Federal Reserve System in the search for the Federal Reserve Bank presidents, the seemingly shifting norms around public dissensions by FOMC members, and the nature of the Board's entanglement in the legislative response to the COVID-19 pandemic." So, you outline three possibilities or three ways that Fed governance could have contributed to this outcome. So, walk us through those. And let's start with that first one, the evolving governance at the Federal Reserve System. How did that play a role, do you think, in this story?
Evolving Governance at the Fed
Lacker: I start with the observation that the nature of the composition of the presidents of the Reserve Bank System now versus-- I take this benchmark, 2009, and I think things changed right then, right around the end of 2009, end of 2010. I think that you can note a distinct difference. A lot of us back then were relatively outspoken, were willing to speak in public and describe alternative perspectives on the current policy outlook, describe different points of view about where policy should go. That was, in part, kind of an outgrowth of the transparency movement that Ben Bernanke was responsible for, which I think has been a very good thing for the Federal Reserve System.
Lacker: Under Greenspan, you may recall, the committee was relatively closed. People didn't speak at all in a way that you could easily infer something about their policy views. Greenspan was deferred to as the spokesperson for the committee's views and for his views about where policy was going. His views would come out in a relatively cloaked and indirect way. But then, Bernanke came in with the natural modern economist view that transparency is better and makes for better policy and makes for better understanding of the Fed. And so he loosened the reins on us, both within the committee meeting… so that you look at the transcripts, and there's a lot more free-flowing discussion after Bernanke came in. It's not a seminar by any means, but he tolerated people expressing other views at length within the committee meetings, and it translated outside of the committee in terms of just allowing people to say what they thought in some sense.
Lacker: But something shifted in 2009, and we can talk about why that might have been. But, the other observation I have [is that] if you look at 2009, the number of presidents…. there were six or seven presidents who had-- if you looked at their CV, they had published in academic journals in the areas of monetary and macroeconomics. There were seven in 2009. Then, by the end of 2022, there were just two. Now there's just one, Williams, and he's a relatively centrist character. He's sort of inside the troika, or whatever they call it, that guides monetary policy.
Lacker: So, you have fewer voices on the committee that have the background in academic economics, I'd argue, that would give you a little more confidence in speaking your mind in the committee and a little more confidence in voicing alternative views outside. Now, that's by no means a prerequisite. You have institutions like the Kansas City Fed and the St. Louis Fed where the strong tradition of taking their independent role seriously has led to people who aren't PhD economists or not publishing in macro and monetary policy, like I said, people outside of the traditional macro background being willing to take independent stands. But it does seem to me like an indicator that might correlate with willingness to take a differing point of view in public. So, I start with that observation, that the composition of the committee has changed.
Lacker: So, in thinking about what might have brought that about… so, I was there from '04 to '07 as a president at the Richmond Fed back in '89. So, I have experience with my search, and I've seen other searches, including the one for my successor. I'm not knocking those searches, but one thing that stands out to me is that around 2010, the Board of Governors seemed to take a much stronger and more active role in the search compared to my experience and what I know [is] the experience of some other colleagues from back in the 2000s. The way I characterize it in the paper… I think this is fair, but someone can contradict me if they have other evidence.
Lacker: Back before 2010, the search involved the chair of the search committee, usually the chair of the Board of Directors of the Reserve Bank, calling and having a consultation with the chair of what's called the Bank Affairs Committee. This is the group of the governors that oversees reserve bank affairs. And the chair of the Bank Affairs Committee is the one who's generally on point to interact with the reserve banks during the searches. The reserve banks, of course, they're independent corporations, and the act says that they appoint the president and the first vice president, and the language is subject to the approval of the Board of Governors. And I think that language was interpreted as, the Board of the Reserve Bank takes the lead on the search and, towards the end of the process, checks in with the Board of Governors via the Bank Affairs Committee chair.
Lacker: Now, in theory, the reserve bank could just pick someone and send the name up, but, in general, what happened is that they got to the point where they had chosen who they wanted to appoint, but they didn't take a formal vote. They consulted, "Well, we're about to appoint this person. How would you guys feel about that?" And they get a signal back from the Board of Governors like, "Yes, this will fly," or, "No, this won't fly." In the latter case, sometimes there's a confrontation, sometimes there's negotiation, sometimes it's sent back for a redo. But it was at the end that the Board got more intimately involved. That may have varied at various times, but that's generally my impression of how the process worked.
Lacker: In contrast, now it seems like it's virtually co-management. There are very regular calls, very regular consultations. The reserve banks will send early lists of candidates that will get vetted at the Board. The Board will send in names of its own to the reserve bank search process. The Board will steer them away from certain candidates. The watchword is [that] they need to be mainstream economists. They want to screen out cranks, obviously.
Lacker: But, the question that arises is, does that emphasis on mainstream economists or mainstream policymakers, does that, in some way, filter out people that just have diverging views, legitimate alternative perspectives on the way policy is conducted? I suspect it has, and this is just a conjecture, this is what I call it in the paper. I suspect that that's led to the selection of people that, on the whole, have a stronger alignment with the Board of Governors’ views. And, in addition, less of a propensity to express dissenting views, at least outside the committee. That's my conjecture about the governance process, that it's shifted, and we can talk about why. But that's something, I think, that's happened over the last decade and a half.
Beckworth: Let's talk about why, and I'm just going to throw it out there. The politicization of the Fed, like every other federal institution, seems to be playing a role. I'm going to mention some research that was done by Carola Binder and Christina Parajon Skinner. They're both academics. They had… I think it was a law journal paper. They also had a policy brief for us, it was a derivative of that, and what they documented is that coming out of the regional banks— they looked at all of them— that an increasing share of the research is on progressive topics, so climate change, inequality, things that are important, but better addressed by Congress, in my view.
Beckworth: Congress has the tools to address those problems, but an increasing share of the research is being done on that, which, I think, complements or echoes this point you made earlier about having Federal Reserve presidents who are truly monetary economists. Now you're getting ones that, maybe that may not be their area of expertise. And so, I guess what I'm painting is a picture where you're seeing the regional Federal Reserve banks reflecting broader trends in society. Even the economic profession, those topics are topics that get you published in journals today too. Do you see something like that happening or playing a role in this change?
The Increasing Politicization of the Fed
Lacker: Yes, that could well be. I think it's a symptom of the same sort of process. The political climate around the Fed has evolved a lot in the last 50 years. There was the inflation disaster of the '70s, Volcker, there was a monetary mystique, the Fed cultivated this sort of-- one author called it the “secrets of the temple” point of view. We're technocratic experts, but we hold the cards close to our vest.
Lacker: But, in the course of the '80s and the '90s, as central banks around the world began coping with this new environment in which we're not tethered to gold, and it's all on the central bank to maintain price stability and keep inflation low and stable, central banks around the world realized that it was really valuable to have the public understand what they're trying to do, understand their commitment, and their determination to keep inflation low and stable. So, you had more and more move towards transparency over the course of the '80s and '90s. That took different forms, and it was a little halting.
Lacker: But then you had the rise of cable news in the '90s, and it was 24/7 attention to what the Fed is going to do next, and that kind of continues now. But then, in the financial crisis, the Fed undertook some very controversial, unprecedented actions in its intervention in credit markets, rescuing investors in Bear Stearns, or assisting the merger in Bear Stearns. You had Lehman Brothers. You had AIG. You had Wachovia and its merger with Wells. [You had] Citigroup. All sorts of intervention by the Fed that brought sharp political attacks from both the left and the right. You had Occupy Wall Street on the left, and you had the House Republicans carping on the Fed from the right.
Lacker: And so, the Fed was under a microscope and in a hostile political environment. In that context, having critics be able to identify people who are inside the institution expressing alternative views was very politically inconvenient for the Board of Governors in dealing with Congress, because those type of critics have a different stature than someone from the outside. They have access to the same analysis, presumably the same data. I think that's the motivating factor behind this turn towards getting more involved in the selection of reserve bank presidents. The cost it has is that the reserve banks have always been the source of useful, independent thinking and research in monetary economics. A paper by Michael Bordo and Ned Prescott— Ned Prescott's at the Cleveland Fed— but Michael Bordo, the economic historian, documented the role of the reserve banks in very important advances in monetary economics and the practice of monetary policy over the years.
Lacker: But as the Fed's gotten more attention, like corporations all over America, it has this incentive to respond in a way that heightens the demonstration of its understanding of, and concern for, the interests of a broad range of people. So, the Fed's demonstrating that it understands climate policy. It's demonstrating that it understands inequality in economic outcomes. And demonstrating that is part of cultivating a good will on the part of the electorate that I think is a response to the heightened political pressure and to the Fed undertaking really distributional fiscal policy actions when it lends in credit markets.
Beckworth: I think the reason we should think about this development and maybe be concerned about it is that it does raise questions about the Fed's independence. If the Fed continues to be politicized… and maybe what you're saying is that they have to show that they're interested in climate change. They have to show that they're interested in inequality and maybe they're just throwing a bone to the dog, keep different constituents happy. But, the problem is that we do more and more of that, and if we have swings in elections from Democrats to Republicans-- You can imagine a world where we get President Trump and he goes after the Fed for these very things and further politicizes the Fed. That's my concern is that we may be making the Fed more enabled by responding to these various constituencies in the near term, but over the long term, it might actually undermine independence of the Fed.
Beckworth: The other, I guess, thing I would bring up here is, just to play the devil's advocate, so I imagine someone on the other side would say, yes, but what about these presidents that-- They have their research staffs. So, even if they're not true monetary economists, even if they look like they're politicized, when push comes to shove, they've got smart monetary economists around them that advise them. In fact, if you go back a year or so ago, they were really focused, laser-like, on inflation. Some people joke that the Fed had one mandate a few years back because of inflation. They put aside in full employment and these other things. And so when push comes to shove, they really do act like monetary economists. How would you respond to that observation?
Lacker: I think it's a valid point to cite the strength of the reserve bank research departments, but it's up to each president to decide how he or [she] are going to use their department. What use do they make of them? How deeply do they get involved in the department? How much do they learn from them? How much time do they spend with them? I think it's just inevitably human nature that the more deeply you live and breathe the subject, the more confident you are about your assessments, confident about your ability to absorb, and evaluate, and discriminate among the advice you get from various advisors.
Lacker: If you're good, you have a department with diverse views, and they don't all tell you the same thing. So, you have to sort through things for yourself. So, I take the point, but I think that still having a background and deeply engaging in your research department are more conducive to having the confidence to express an alternative view. Of course, the other criticism is that one person's confidence is another man's hubris, but I'll leave that for a different discussion.
Beckworth: One last observation on this particular point in your essay regarding the appointment and selection of Federal Reserve presidents is that, recently, the Chicago Fed president search process, two of the governors actually voted, I believe it was, absent. When it came to the Board approving the Chicago Fed president, I believe Governor Chris Waller and Michelle Bowman, they voted absent, which, it made headlines. It was a pretty interesting development. They didn't vote against, but they didn't show their support either. How do you interpret that development?
Lacker: I think that the Chicago appointment was striking, because it was Austan Goolsbee, with a partisan policymaking background. And the Fed has a history of trying to remain as non-partisan as possible. I remember 20 years ago or so, stories coming out that one of the presidents had made a political contribution to a candidate, and it was somewhat scandalous that he'd made a political contribution to a candidate.
Lacker: The records show that hardly anyone else had, and it was kind of a part of the norms of the institution that you stayed away from signaling endorsement of one party or another, either in a senate campaign or governor, especially in the national office. So, this does seem like a watershed, crossing a red line for the Fed to countenance appointing somebody who served in one party's White House. It could turn out okay, could be fine, but it is a change in the norms, and I could understand being a bit concerned about that if I was on the Board of Governors.
Beckworth: So, the concern is that if we appoint people who are known for their political views, have been very active in policy circles, that it's going to jeopardize the Fed's independence. Because at some point in the future, again, you might have someone come to power who doesn't like what the Fed's doing, and they can point a finger at this person or that person. “Well, they're clearly on the other team, and therefore we should reconsider how the Fed operates,” and maybe rewrite the Federal Reserve Act or do something along those lines. I think that's the concern. Okay, let's move on to your second point in your essay, and that's the evolving communication norms, the public dissension by FOMC members. What is your issue there?
Evolving Communication Norms at the Fed
Lacker: I was struck towards the end of 2021. It dawned on me that you had a lot of economists outside of the Fed that were very concerned about inflation, very concerned about the delay in the Fed raising rates to fight inflation. All of a sudden, I realized that I hadn't heard any dissenting views from anybody within the FOMC, that the FOMC had been relatively quiet in public about that. And I just tried to picture what it would be like for me to be on the FOMC.
Lacker: And in 2008 and 2009, I was respectful, but not reticent, about expressing a different view about the Board and the New York Fed's credit market interventions. So, as I reflected on it, it just seemed as if the appearance was there, that the committee was sticking to the house view in public. That struck me as notable, as very different than my experience in 2009, 2010, 2011, when there was a lot of controversy about Fed policy, and a lot of us spoke out in public about it. So, it seems to me, plausible, that it's a deliberate outcome of a change in the chairman's attitude towards this.
Lacker: I described the shift from Greenspan to Bernanke. I'm guessing that Chair Powell prefers the operations and the norms of a corporate board in which maybe you dissent internally, you express different views within the committee walls, or maybe even not then, because it shows up on the transcript with a five-year lag. But then outside, you present a united front. I’m suspecting— and I don't have any evidence of this besides the observation that public dissenting views seem to have declined— but I'm suspecting that this is Powell's approach to the communication norms within the Fed.
Beckworth: Now, you're not the only person to notice this. You note in your essay that Gauti Eggertsson and Don Kohn also make this observation. Is that right?
Lacker: Yes. They wrote a great paper, a real detailed analysis of the effect of the adoption of the 2021 new Fed policy framework, and the forward guidance they dropped just a month later in September 2020, the effect of that on this delay and fighting inflation in 2021 and 2022. The last sentence of their paper, though, is… last couple of sentences [are], "The FOMC has had a very consensus-driven decision process. The committee should ask itself whether different aspects of its decisions and decision-making are allowing sufficient scope for effective challenges to the majority view." That sentence is underlined, and a number of others there as well, but I thought that was striking coming from Gauti, a very mainstream economist, and Don Kohn, a long-time Fed veteran. He started at the Kansas City Fed in 1967, went to the Board in '74, I think it was. [He] was on the Board of Governors as vice chair, very influential as a director of one of the research divisions, very much committed to the Federal Reserve System, but very, I think, bold and on target here.
Beckworth: Yes. It is pretty striking that he signed his name to that sentence.
Lacker: Let me just add something here about Don Kohn. In my experience at the Federal Reserve, he is the FOMC participant who I think paid attention to, respected, acknowledged, grappled with, understood, tried to take on Board dissenting views, with more integrity than anyone else I encountered. You would see him hear people's different views. He would audible in the committee. He wouldn't just stick to his statement. He would articulate their views. He would do this thing people talk about in marriage counseling about active listening. He would articulate, he would put it in their own words, in his own words, and he'd lean back and stare up at the ceiling as he did it. People who know Don know what I'm talking about, I think. I mean, there are plenty of economists out there who've had way more contact with him in the Board staff setting than I have. But, the integrity with which he grappled with differing views, that really stood out as I reflect on my FOMC experience. I think he deserves a lot of credit for that.
Beckworth: Alright, your final point is the evolving relationship the Federal Reserve has with Congress, tied to what they did during the pandemic. Speak to us about that.
The Evolving Relationship Between the Fed and Congress
Lacker: This goes back to a point that my late colleague Marvin Goodfriend made very forcefully in the '80s and '90s. The Fed can be thought of as doing two things. One is controlling the size of its liabilities. Its liabilities are monetary instruments, and so it supplies money to the economy. And that's monetary policy, varying the quantity of that and the way it influences interest rates. The other thing it does is it has assets. It could hold all of its assets in US government securities, and when it varies the size of its balance sheet, it just does it by varying the size of the portfolio of government securities it holds through open market operations, they're called. That's one benchmark. That would be pure monetary policy.
Lacker: But when the Fed decides to lend to a private institution— a bank, a financial institution, acquiring some credit instruments in some program or another, some facility— when it does that, it's doing something that is, really, fiscal policy. It's really different from monetary policy. Because if it expands the balance sheet, it could have expanded the balance sheet through buying Treasuries only. And if it does so by lending, it's, in some sense, doing a two-step thing of pure monetary policy by buying Treasury securities, and then, in order to implement its facility, selling Treasuries to the public and using the proceeds to make the loan. In that sense, the credit operations of the Fed are entirely separable from monetary policy.
Lacker: There's no reason the Fed has to do it and, indeed, in 2020, we saw the Treasury do some credit programs. So, there's nothing to stop those lending programs from being done by the fiscal policy authority. The difference is that if the Treasury does it, the Congress has to step in and authorize it and appropriate the money for it. If the Fed does it, it doesn't have to ask for Congress's permission. As long as it meets the lending authority it has that's left over from the old way it was founded and to do business, as long as it fits into one of those buckets of lending that it's allowed to do, yes, Congress doesn't have to go authorize it or be involved in setting it up.
Lacker: Marvin argued that credit market intervention is inherently controversial, inherently political, because it involves distributional questions. You're lowering borrowing rates for some borrowers and not for others, and this involves decisions that ought to be political and that are generally controversial, and that for the Fed to get involved with that, uses up scarce political capital that it may need and could need to defend itself and defend its monetary policy independence.
Lacker: So, his argument is that the Fed should avoid credit allocation altogether, that the Fed should have an accord with the Treasury that says, “We don't do credit policy at the Fed, you do credit policy. We do monetary policy. You leave us alone to do monetary policy and we'll leave you alone to do credit policy.” So, that sharp separation, I think, has been… It was, for me, persuasive, and for other economists as well. The warning there, though, the implicit warning about political entanglements involved in credit policy, I think, are very germane here, because in 2020, the Fed got very involved in the political deliberations involved in the fiscal rescue packages and in the design of the credit programs that the Treasury implemented and that the Fed implemented. In some instances, they were getting at cross purposes with Congress.
Lacker: Congress was writing a program and the Fed and the Treasury were writing a different program with different characteristics, different parameters. Broad brush, the Fed was urging Congress to do more on fiscal policy, and that crosses a red line that's been pretty bright in recent Fed history, and that was very surprising. Greenspan famously, virtually, never opined about fiscal policy, and Bernanke observed that too, the idea being that that's Congress's business, we don't want them taking away our monetary policy independence, so we won't comment on their business which is fiscal policy. But he raced across that line and was recommending to Nancy Pelosi that they go big, and then in 2021, they enact this last phase of stimulus programs, and they do go big, and I think, in hindsight, it's pretty clear. I think that a broad range of economists would say that they went too far.
Lacker: Now, the question that arises, did that compromise the Fed's willingness to, essentially, acknowledge that it went too far and do what the central bank needs to do when the fiscal policy authority goes too far and raise interest rates? Because the essential dynamic is that there's too much money out there being spent by people. In order to balance supply and demand, you have to get people— at least with the tools that a central bank has— you have to get people to delay spending, and the way to do that is to raise the reward for delaying spending, which is the real inflation adjusted interest rate. Instead, the Fed let the real interest rate fall to negative 5% or 6%, when it had been maybe minus 1% or 2%. You wonder whether the Fed was afraid of the optics of tightening policy just after a fiscal policy stimulus had been enacted, that the Fed had been something of a cheerleader for.
Beckworth: Those are all great points, and I want to add to those in a minute. But before I do, let me, again, play Devil's Advocate and take the Fed's side here just to be even-handed. One could say in response to that, yes, the Fed did go too far, but again, it's a byproduct of our times, the politicization of Congress, even. Congress can't do its job, therefore, the Fed is effectively stepping up to the plate. Congress is so politicized, itself, it can't come together and do things. Of course, it did pass the CARES Act and did get some things done during the crisis.
Beckworth: So one might be… just in normal time, maybe outside of the pandemic, we're putting more and more responsibility on the Fed, just because Congress doesn't seem to want to do its job. I guess the second pushback might be, yes, the Fed definitely compromised its independence during this period, but this was a war time. This was a major crisis, like maybe World War II, they did the same thing, so maybe we should view things differently. How would you respond to those pushbacks?
Lacker: The one about Congress not being able to do something seems like a weak reed to grasp here. I mean, you wouldn't want the military taking that point of view, you know?
Lacker: That we're going to go fight a war. Congress can't get its act together to declare war. So, as a general matter of constitutional democracies, you don't want to rely on the argument that technocratic agencies should step into the breach when Congress seems paralyzed. Congress being paralyzed is an artifact of just different points of view, and in a democracy, that's just something you have to deal with, this effect. But the broader point, that this was an emergency, is certainly relevant, and I take that point of view fairly. I think it was somewhat of a wartime footing that we were on in 2020, but I think that the responsible thing for the Fed was to bring its expertise to bear and say, "Hey, here's what we think. Here's how we can help the whole country respond."
Lacker: I think that the Fed has to be a participant in that, and it's part of our country's economic apparatus. So, yes, it has a role to play there. Now, credit programs are one thing. Credit programs are not monetary policy, so let's talk about them separately. On monetary policy, I think that the Fed's got to own-- If I was speaking to Congress back then, I think you'd own up that there's a lot of uncertainty here. It's April 2020, we're not quite sure how this is going to play out. Fiscal stimulus seems really warranted, but if it results in inflation, we're going to have to respond, and we're going to have to raise real interest rates.
Lacker: So, you've got to get it right. Don't go too high, don't go too low. Here, this number seems fine to us, but we could change our mind if it turns out that that was too much. I think that's a responsible approach to take. On credit policy, there, they're just implementing congressional programs. If Congress wants the Fed to lend to small businesses and not the small business administration or wants to lend to banks, and on these terms or those terms, Congress can direct us to do that as they did in the ‘30s and ‘40s. That's up to them.
Lacker: If I was a Fed chair at the time, I would've said, "No, why don't we lend you the expertise and you can set up a program like that in the Treasury. That would be just fine for us. We'll buy the bonds you issue to do that,” which is what the Fed ended up doing with those bonds anyway. So, I think there was a way for the Fed to manage its engagement, politically, in a way that preserved its monetary policy independence. And then I have to say here that I'm just conjecturing. I don't know the complete conversations that Chair Powell had behind the scenes. Maybe he did warn this way, but I suspect not, because inflation in 2021 was so unexpected. But, I think, in the future, this is going to be something on the mind of any Fed chair interacting with Congress in such an emergency situation.
Beckworth: So, one of the things that we can point to that was very interesting surrounding this conversation is the fact that the Fed has not been as vocal about fiscal deficits on the other side. In fact, Greg Ip had an article in the Wall Street Journal and it was titled, *What Can the Fed Do About Deficits? Nothing.* But, he goes on to say that the Fed was very vocal, as you just outlined, in 2020-2021, promoting it. We need it, we need it. Then, in the fall of last year, when there was a lot of concern about the deficits, the quarterly refunding deals that Treasury were doing, there was a lot of talk about term premium shooting up because of the deficits.
Beckworth: Now, some of that talk has died down as the 10-year-yield has come down some, but there was a lot of concern at that moment, and we didn't hear Chair Powell step to the mic and say, "Hey, Congress, you need to get these deficits in line." In fact, he said, "We don't speak on matters of fiscal policy." That's what he said. And Greg Ip highlighted this tension. He's very eager to speak in one direction, pro fiscal policy, but when it comes to tightening, he was very reluctant to do that. So, I do think that that is something to note. And, again, just going back to this bigger point, we want to minimize the chances of the Fed losing its independence in the future. So, we do need to be careful during these moments of crisis, even though things may be different, and we may be called on to do more than we normally would. Alright, so that's your policy brief. It's title, again, is, *Governance and Diversity t the Federal Reserve.* We'll provide a link to it in the show notes.
Beckworth: In the time we have left, Jeff, I want to go to a presentation that you gave last year at the Shadow Open Market Committee, because I think that it ties into this governance thing we've been talking about, and the title of your talk there was, *Some Questions About the Fed's Monetary Policy Operating Regime.* And as listeners of the show know, this is a real interesting issue for me. I love talking about this, so I was excited to see that you're talking about it too. So, maybe share the highlights of that, and then we can use that to talk about some of the governance issues it creates.
*Some Questions About the Fed’s Monetary Policy Operating Regime*
Lacker: It starts from the observation that the Fed now sets four interest rates. The Board of Governors sets an interest rate on reserve balances that banks hold with the Federal Reserve banks. The FOMC sets a rate on something called the overnight reverse repurchase agreement facility or repo facility. The Fed, in that facility, receives cash, lends out securities, which drains reserves from the banking system. This was adopted in the lead up to liftoff in the mid-2010s. The fear was that the Fed would raise the interest rate on reserves and other interest rates wouldn't come along. I never quite understood that fear. It was announced that, if it wasn't needed, they would wind it down, and it turned out we didn't need it. Well, lo and behold, the facility is still there.
Lacker: Third, the Fed sets the interest rate on a standing overnight repo facility, where the Fed receives a security and lends out cash that adds reserves to the banking system. It reverses it the next day or after a term. And then, the Fed still sets a target for the federal funds rate. The target is now a range, a quarter point wide. Banks, because they earn interest on reserves at the Fed, have no interest in trading reserves or no need to borrow or lend reserves, because reserve balances are so high.
Lacker: Virtually all of this trading involves government-sponsored enterprises like the Federal Home Loan Banks and Fannie and Freddie. So, they set four interest rates, and the observation is that, before the great financial crisis, we just set one interest rate. We set the target for the federal funds rate… we— I say we— I used to be at the Fed. So, the Fed set one interest rate and it directed the New York Fed to adjust the supply of bank reserves in the system. Borrowing and lending reallocated those reserves around the banking system so that banks were happy with what they held.
Lacker: And they adjusted the supply so that supply equaled demand at the overnight federal funds target. Nobody seemed to mind that repo rates and other interest rates would fluctuate around the fed funds target, as much as 10 or 20 basis points. That didn't seem to bother anyone. Nobody seemed to think we needed to set more than one interest rate to control the general level of interest rates in the economy. So, I just started to think about this question: Why do we set four interest rates? Well, if we set more than one, the spread between those two is something that the Fed seems to have an opinion about. It seems to have some judgment that it wants to control the spreads, these three spreads, between these four different interest rates, and it's not obvious why. It’s not obvious that what the market would give you, for the spreads between the interest rate on reserves and other things, is going to be problematic.
Beckworth: We were told that this system would be easier [and that] it'd be simpler to implement. If anything, it seems like it's gotten more complicated. I've had Bill Nelson on the show a few times, and he makes the same point that it hasn't been easier, it hasn't been simpler. In fact, there are now more staff employed at the New York Fed to implement this than pre-2008. And he also talks about how the system has led to a ratcheting effect on reserve demand by banks as they go on. It's not just regulations that have increased demand, but once you become comfortable with a certain level of reserves and your supervisor does, it ratchets up.
Beckworth: And this is a nice segue into some of the governance issues created by this operating system. So, it requires a large balance sheet, an ample reserve balance sheet or an abundant reserve [balance sheet], however they're framing it nowadays. It also means that the Fed is getting involved, again, in issues that could politicize it and affect the governance of the Fed. So, one thing that this system does, [is that] it effectively makes the Fed a meaningful player in determining the composition of the US federal debt. It affects duration. It plays a role that should be done by Treasury. That's one observation that I would note.
Beckworth: Also, it makes the Fed susceptible to losses on the balance sheet, and we see that right now. And in many places around the world, in advanced economies, this is a big conversation. The ECB is re-evaluating its operating framework. You've noted that the UK has a specific system in place to deal with such losses. The Swiss National Bank, they also have had big losses on their balance sheet. So, in many places, this is a big conversation, and it becomes politicized, affects governance issues. Bank regulations— I kind of touched on it already— if you have a big Fed balance sheet, banks have to hold the reserves. It affects what they hold in their balance sheets. So, it seems to be a lot of governance issues that come along with this operating system. And, again, I would just stress this point. What does it do, ultimately, to the Fed's independence, at some point down the road? Does it gradually erode it, or does it strengthen it? What are your thoughts on governance issues related to this operating system?
Governance Issues Related to the Fed’s Operating System
Lacker: I think that they're very germane. I think, also, that germane is the economic rationale for these things. It's bound to be the case that these interventions, beyond a minimalist approach to monetary policy, create winners and losers, and so on what basis is the Fed choosing winners and losers? To sketch out a really simple scheme in how it would work, imagine that the Fed just set the interest rate on reserves, it jettisoned the fed funds rate target, it shut down this repo facility, it shut down the overnight RRP facility, reverse repo facility, and it just set the interest rate on reserves. Moreover, all that it held were short-term Treasury securities, nothing but bills, bills only. And the Fed actually operated this way in the 1950s. That's what IT policy was. Now, everything else the Fed does is a variation on this. And you can ask yourself, well, relative to this simple benchmark, what value does it add?
Lacker: What value does it add for the Fed to buy longer-term Treasury securities rather than just stick to bills only, and let the market determine the relative yields on short and longer-term Treasury securities? What value does it add to intervene in the RP market on either side, either buying or selling RPs? What difference does it make for spreads? Doesn't that make some people better off? Doesn't it make some people worse off? What's the economic rationale for that? Now, the thing that you're going to hear is an analysis that involves the word, chances are, dysfunction. Now, the thing that I’d point out is that dysfunction isn't really an economic term. It's a medical term. It's something about a lack of health. I mean, in markets, things happen. So, in September of 2019, repo rates spiked on one day. Well, supply and demand drove repo rates up one day.
Lacker: Is that a malfunction or was the market responding the way you'd expect a good, efficient market to respond to some disturbance that occurred that day? And it's not at all obvious that those responses weren't relatively efficient adaptations. But, by the Fed pathologizing things like that and calling them dysfunction, anything labeled dysfunction in the Fed is implicitly an objective intervention. A market that displays dysfunction is something that, within the Fed, it's taken as gospel that if it's dysfunctioning, we can make it better. But it's never been clear to me that the Fed staff has a clear idea of the way in which we're making anything more efficient. Usually, we're intervening in a way that makes some people better off and other people worse off, and the way that I was taught about efficiency is that that doesn't change efficiency, it just makes some people better off and some people worse off.
Lacker: So, that’s the question I have about this complicated structure. What's wrong with a very simple structure with just the interest rate on reserves? Banks can hold reserves. They can operate in these other markets. They operate in the RP market on both sides. They operate in loan markets, they operate in deposit markets. It's the arbitrage and competition of the interaction— the relationship between the interest they earn on deposits that the Fed and these other interest rates— that's the thing that lets the Fed influence a broad range of interest rates. But while the Fed has a strong view on what the nominal overnight interest rate on reserves ought to be, I don't think that it has a strong analytical basis for taking a point of view on what these spreads should be.
Lacker: And I think that they should back off and let the spreads do what they do. If there's some peculiarity about how spreads behave due to some regulatory constraints— leverage ratios, for example, or the way reserves or some other assets are treated in the living will, resolution planning process or in liquidity regulation. If you think that those regulations are bollixing up the market and making the spread wrong, change the regulations. You must think that the regulations are at fault. Beyond that, I don't see any fundamental market failure going on in the markets that determine the spread. So, yes, I'm just baffled by the way the Fed thinks about these things.
Beckworth: Well, I appreciate your embrace of markets and letting them speak through price signals, but let me again provide what would probably be the other side here and get your response to it, so two things, I think. One would be, okay, let the banks be this conduit, give them the interest on reserves as the interest rate and everything else works out, but the critique might be that the problem is that all of these new regulations since 2009— Dodd-Frank, all of the Basel agreements— they have really reduced the balance sheet size of these banks and the role they can play as market makers and intermediaries, so they can't do as much as they once could. And, therefore, these other money market funds, these other entities are stepping in, and so the Fed has to be mindful because of regulations.
Beckworth: The Fed's hands are tied, to some extent, because of regulations affecting bank balance sheet capacity. And then, I think, maybe a more broad point that, maybe, captures that point is just that we live in a world with a global dollar system. We have shadow banking across the world. We have dollar markets across the world. And things can happen over there that affect dollar markets back home, and so the Fed has to have all of these other facilities open to step in, to play that role, so it's not as easy as it was in, say, 1950 or even maybe pre-2008. How would you respond to those observations?
Lacker: Well, presumably— that web of regulations around liquidity management at the large banks— presumably, they're there for a good reason, and if they're not well calibrated, recalibrate them. If they are well calibrated, [then] the price of doing business may lead to some spread between the interest rate on reserves and other market rates… rates and markets that banks interact with. But if that spreads due to some regulatory costs— It's like a marksman shooting across the wind and taking into account that, yes, the wind bends the shot a bit, so you have got to aim a little to the right and take into account that it's going to go there. So, if something adds a measure between IOER and IOR and repo rates, well, adjust IOR. Just change what you set IOR to. There's nothing you can't pull back into the policy process. So, that doesn't seem to me like a really strong argument against a simple approach.
Beckworth: Okay, well, with that, our time is up. Our guest today has been Jeff Lacker. Jeff, thank you so much for coming to the program.
Lacker: Pleasure, David.