Joseph Gagnon on Central Banks’ Ability to Fight the Next Recession

Joseph Gagnon is a senior fellow at the Peterson Institute for International Economics and formerly, a senior staffer at the Federal Reserve Board of Governors. Joseph is also a returning guest to Macro Musings. He joins the show today to discuss his recent policy brief titled, “Are Central Banks Out of Ammunition to Fight a Recession? Not quite.” Specifically, David and Joseph discuss the variety of monetary policy tools available to central banks to combat the next recession (with special emphasis on the Federal Reserve, European Central Bank, and Bank of Japan). Joseph also makes the case that the ECB should adopt a formal review of its monetary policy framework.

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

David Beckworth: Our guest today is Joe Gagnon. Joe is a senior fellow at the Peterson Institute for International Economics and formerly was a senior staffer at the Federal Reserve Board of Governors. Joe is also a returning guest of the show, so be sure to check out his previous appearances. Today, Joe joins us to discuss his recent policy brief titled, “Are Central Banks Out of Ammunition to Fight a Recession? Not quite.” Joe, welcome back to the show.

Joe Gagnon: Thanks for having me, David.

Beckworth: Thanks for coming back on. Well, the answer to your question is in the title of your essay. So we can stop right there, but we don't want to do that. We want to dig in deep because you have some interesting insights in your paper, but I want to begin by asking why write this policy brief now?

Gagnon: Oh well, I just think there's certainly... I'm not saying there's going to be a recession in the next year or two, no one knows, but the odds of a recession are 15 to 20% in a given year, and that’s significant chance of recession next two or three years. And looking at where interest rates are, so low already, you got to wonder how much lower could they go and what are the options for central banks?

Beckworth: Yeah, and we're going to work our way into this paper, but I want to give the punchline now. The punchline is the Fed has some room or scope, as you say in the paper, whereas the ECB and bank of Japan, they don't look so hot. They're a little more troubling. But we're going to work our way through all the different tools and options they have, and currently the Fed has some space and scope. I guess my fear is maybe by the time the recession gets here, that scope will be even more diminished.

Beckworth: I firmly believe, and you can push back on this, but I really believe that rates are going to continue on a secular decline, including long-term rates. If a recession happens in a year or two, the 10-year yield could be a lot lower than it is today. Then you're really like hoping for some kind of innovation for monetary policy or fiscal policy combination to help us in the recession. I think it's a very timely paper because we are in a position where it looks like central banks are increasingly facing limited ammunition as you talk about in the paper.

Beckworth: Okay. So you begin first with the tools that are available, interest rates are low. So your section is titled “Monetary Tools When Interest Rates Are Low.” And the first option on the table is negative interest rates. So talk us through that.

Negative Interest Rates

Gagnon: Well, negative interest rates had been used now in Europe and Japan, although in Japan not very much, but in Switzerland, a country that's used it the most, the marginal deposit rate of the Swiss National Bank, that is what commercial banks in Switzerland earn on their accounts at the Swiss National Bank, the marginal rate on the next dollar deposits is minus .75%.

Gagnon: However, every bank that's doing this or almost every bank that's doing this, I think Riksbank hasn't done it yet, but other central banks are doing this, have instituted these tiers of accounts so that a certain amount of deposits at central bank get a zero rate. And then the negative rate only hits the excess. So that's sort of to... The reason is to give... It's really a subsidy to the banks to offset the fact that no bank anywhere has imposed negative rates on small account holders, small deposits. And many haven't even imposed negative rates on large deposits, although some are starting to.

Gagnon: And so if you are earning a negative rate on your assets and you can't put a negative rate on your liabilities, your margins are squeezed and people complain that this is hurting banks’ profitability, making it harder for them to land. It's counterproductive. It actually robs the policy of some of its stimulus. So to offset that partially, they're doing this sort of subsidy to banks, the intramarginal subsidy, which is interesting. And that's what makes me think that there isn't much room to go further.

Beckworth: Okay. Politically, is that the story, more than theoretically or economically?

Gagnon: I think it's both political and theoretical because I think we have this theory result that says that it's not... You can put $100 bills in a safe and you get a zero rate of return, so why would you lend to anyone ... Now, that was theory and now we've learned in the real world there are these frictions and costs and actually putting dollar bills in a safe has some costs.

Gagnon: The electronic money that we use these days for payments, payrolls, et cetera, is more convenient. And so for businesses to switch to paying their employees in cash would actually be rather costly and there'd be more security risks, et cetera, et cetera. So that cost of using cash allows us to get away with a negative rate on the more convenient asset. But it's limited.

Beckworth: It's limited. Okay. All right. So it's limited both theoretically, because we still have physical cash. At some point, if the rates get low enough people will substitute into cash, but politically banks are getting harmed and it's just a bad selling point. I think most people don't understand it.

Gagnon: People react very asymmetrically to this. I mean, even sophisticated people, I'd get an investment newsletter, I won't say from whom, who is just outraged at the thought that he could have a negative rate on his deposits, and yet if inflation were higher than the normal interest rate, he wouldn't have complained the same way. Why would you not say the same thing about inflation that you're saying? And he would say, “Well, I don't like inflation either,” but I think they say that these negative rates are an abomination. It's something that they wouldn't say about a 3% inflation rate.

Beckworth: Right. Now there is, I think confusion over it, and I think maybe it's partly our fault, the Fed’s fault, central banks’, the educator's fault, because we always say, “Hey, central banks are adjusting rates. ” And it gets the message off that the central banks control all rates all the time, when in fact it's global flow of funds that determine rates ultimately. In fact, the Fed tends to follow that more than sets it. So it's hard to communicate. Look, maybe you're part of the reason rates are going down. We're saving a lot.

Beckworth: But in any event, I agree, it's tough to sell. The Miles Kimball’s of the world, they would say, well it just hasn't been tried yet. I mean, all true believers in any case will say it just hasn't been tried hard enough if you believe in socialism, but it hasn't really been tried. If you believe in negative rates, it really hasn't been tried. Is there any hope that it will really be tried? Because like Miles Kimball would say, “Yeah I agree currency is a problem but we'll disconnect the link between physical cash and electronic money and therefore we won't have this problem.  It just hasn't been tried.

Gagnon: I think that's going nowhere because that is just a silly idea to disconnect physical cash and real cash and just enormously complicated and confusing to anyone. I think that's a nonstarter. But I think that what might happen is where Sweden is coming, where in Sweden, cash has been used less and less in stores and a lot of stores don't accept cash anymore. Everyone has a bank account, everyone has mobile phone payment technology. The problem is, it's being near the zero bound is kind of making that transition problematic. It'd be better to make that transition while we were above the zero bound, and then get rid of cash and then when we hit the zero bound it would be possible to do these things, and maybe we'll get there.

Gagnon: But I think it's more of a… I could see it happening as a technology-driven outcome. Everyone had that technology and everyone realized there was no need for cash. In fact cash was dirty and cumbersome, whatever, then we could move to this world, and I think that would happen.

Gagnon: But I think the question is going to be what do privacy rights people say about this? They don't like this because electronic money leaves a trail and they don't want that. Cash doesn't leave a trail.

In Sweden, cash has been used less and less in stores and a lot of stores don't accept cash anymore. Everyone has a bank account, everyone has mobile phone payment technology. The problem is, it's being near the zero bound is kind of making that transition problematic. It'd be better to make that transition while we were above the zero bound.

Beckworth: I'm playing devil's advocate there. To be clear I'm not advocating socialism either.

Gagnon: I would like that. Look, I'm absolutely… This would be the best outcome if we could get rid of cash and deal with privacy concerns and deal with people who don't have bank accounts in terms of the inclusion, financial inclusion issues. It would be the better outcome because I think frankly negative rates would be a better way to deal with this problem, and the hysteria about it would subside when people realize, well, it isn't bad.

Beckworth: Well, I had a guest on the show who made the case that you could actually do digital cash, central bank, digital cash, and still maintain privacy. But at this point, I think it's probably still a ways to go before he could get to that point. But if you could somehow reconcile privacy and digital cash widespread use.

Gagnon: That will be likely. It will be likely. But I don't think it's happening in the next day.

Beckworth: So negative rates are kind of off the table. At least nothing below the effective lower bound. And in fact, what is your estimate of the effective lower bound?

Gagnon: Well, so we say in the paper that cuts in these marginal rates down to minus half a percent seem to be fully effective, almost as effective as cut rates above zero. And we can give full credit to that. There's this research out there that suggests as you go deeper and deeper below zero then the harms pile up and there's this concept of a reversal rate.

Gagnon: I don't know if I fully buy it. Markus Brunnermeier at Princeton claims that in the Euro area that rates about minus one, that if the ECB went below minus one it would actually be more harmful than helpful. And of course this is a continuous process so that means that the last few cuts when you get to one.

Beckworth: Nonlinear.

Gagnon: Yeah. And so we say well we stop at minus 0.5 because we don't think… We think it's safe to say that the benefits are good up to there. After that maybe you could get a little bit more Switzerland .75. Maybe it's still a little more you could do. Side effects start overwhelming to good effects at some point. And we know the cash constraint is there at some point. We don't know where that is.

Gagnon: And if you hit it and people start wholesale switching into cash, that's kind of a tipping point that you don't want to cross because then getting them to come back is difficult and then they're not sensitive to the interest rate you're charging. You just don't want to get to that world.

Beckworth: Yeah. Fair enough. Okay. So negative interest rates are not a big part of the toolkit. They're part of the toolkit but not going to be the big guns here. So for…

Gagnon: Although we say they're more powerful than the Fed thinks, which we'll come to, I think.

Beckworth: Yeah. So we're going to work our way through the tools and then talk about each country specifically. In fact I have a question related to that, whether the Fed actually will ever use negative interest rates. But let's hold off on that for a minute. Okay. Forward guidance is the next tool.

Forward Guidance

Gagnon: Yeah. We don't develop much basis for guidance because I actually think that forward guidance is going to become more routine and it's actually superseded by QE. Whatever forward guidance can't do then QE comes and does. Making forward guidance credible over super long horizons I think is… I don't find it persuasive. I just don't think forward guidance is all that important. Forward guidance does a little bit, but we're in need of bigger tools.

Making forward guidance credible over super long horizons I think is… I don't find it persuasive. I just don't think forward guidance is all that important. Forward guidance does a little bit, but we're in need of bigger tools.

Beckworth: Well, let me ask this question. So when I think of forward guidance, kind of a practical meaningful way to do it would be to do level targeting because level targeting creates the… Of course the level of target itself has to be credible, but let's take that as given. A level target would give you that kind of makeup, that commitment to keeping rates lower for longer or injections being permanent. So wouldn't that be one way of thinking about forward guidance, to keep a level target?

Gagnon: That's another reason to not give it because we actually talk about raising inflation expectations, which including through tools like this. So that's right. That's a type of forward guidance. I think in theory these things work great. I think the question is, especially if you'd make this change when you're not achieving your target.

Beckworth: Fair enough.

Gagnon: You're not going to look at that and say, “Are you crazy? You can't even hit your target. How are you possibly going to-”

Beckworth: If you can hit 2%, why would you hit 3 or 4%?

Gagnon: Yeah. So I think you'd really want to have this be instituted long before the recession hit and people understand how it works and then when the recession hits years later, then it would help. And I agree with that. We organized this paper more like what if a recession hits next year before everyone has a chance to really understand this?

Beckworth: And I think also the type of forward guidance you probably more likely to see with what we saw last time where the Fed would say, “We're going to keep rates low until some certain period.” Okay, let's go to quantitative easing. This is kind of like your baby here. I mean, you are well known. Your paper has been cited thousands of times. You helped create quantitative easing in some format. I mean, obviously more people than you in part of the story, but you're well-known for QE. So tell us about QE.

Quantitative Easing

Gagnon: Well, QE in fact is what the Fed is going to put most of its bets on. In other words, if you listen to what Fed officials are saying, they really think that QE is going to save them. And I actually agree that it's maybe the single most important tool they have, but I don't think it's going to be enough because they haven't… I don't think they've thought clearly the limits of QE. So I think QE works by altering the portfolio that investors hold and changing the risk premium, the premiums that they hold.

If you listen to what Fed officials are saying, they really think that QE is going to save them. And I actually agree that it's maybe the single most important tool they have, but I don't think it's going to be enough.

Gagnon: Some investors want long-term returns. So investors want short-term returns. As you change the balance of long-term and short-term assets, you shift the market against some investors and in favor of other investors, and that moves the term premium from positive to negative and all this. And I understand that. But it's not unlimited because there is a lower bound to the long-term rate. And there's two ways of thinking of it. One is, well you could hold a hundred dollar bill for 30 years and you'd get a guaranteed yield of zero.

Gagnon: So if a hundred dollars bill is like a 30-year bond in that sense with a fixed coupon of zero. So why would you hold a 30-year bond at a deeply negative rate when you could get zero, right? But I think there's another bound that people haven't thought about, which is… Because that bound might be somewhere quite a ways below zero because of convenience and safety because electronic money might be… But I think there's another bound that's even higher, closer to zero and this is it.

Gagnon: If the Fed, or central bank, says that the lower bound and at short rate is zero, which the Fed is sort of saying lately, right? They're saying that we don't think we do negative rates, although they don't totally rule it out, but they say we don't. If they totally ruled it out, if they said, “We'll never have negative short rates,” then I argue that, we argue actually that no bond can have a lower rate than that. Because think about it, if you know with certainty that no short rate will go below zero forever, then you would never hold a bond with a negative rate because it would always be dominated in every state of nature by a series of short rates.

Beckworth: Right.

Gagnon: So that raises the lower bound on the bonds to zero. And if anything, it must be a little above zero because there's only the chance of higher rate, never a lower rate when you're at zero. So then that means you can only make capital losses on the bond. It's a one way bet. So then the rates got to be even a little higher to make room for some two-way bet. So the Fed has not fully understood that yet

Beckworth: Okay. So…

Gagnon: And that's why the Fed needs to use negative rates.

Beckworth: So that it can make the QE more powerful.

Gagnon: Because they can make QE more powerful. If you show that you will put the short-term rate negative, then the lower bound and the bond goes down.

Beckworth: That's interesting.

Gagnon: And then your QE actually has some bite.

Beckworth: Yeah. Well, I mean, the thing I've been thinking about lately is that the long-term yields are marching down across the advanced economies. It's the safe asset shortage. And I think these are structural reasons, structural developments in the background that have caused this. So demographics, the country, the world is growing fast in terms of an income, but not the capacity to produce safe assets. The new regulations after the crisis. All these things are going to be with us for some time. They're not going to go away. So in my view, I see rates continuing to fall.

Gagnon: You're very pessimistic.

Beckworth: Well, I don't see them going up. And in fact one of your former colleagues still at the Fed, Kiley, Michael Kiley.

Gagnon: Michael Kylie, yeah.

Beckworth: He has a paper out just recently where he estimates… The term he uses is long run equilibrium, real equilibrium rate is minus 1%.

Beckworth: Which if I translate that into a 10-year treasury though in 2% inflation target that gets the 10-year treasury up to a 1%. So if he's right, then the 10-year a year… In some point, the near term is going to sell down around 1%, which really eats away a lot of room and you kind of get at this in your paper.

Gagnon: I think you're right. If he's right, and if you're right, then I think there's even less room for the Fed then we said. But we started from where we are now. So there's a bit more room because the treasury at 1.7 or 1.8.

Beckworth: I mean that's what you say in this paper. And to be fair to what you say here, there is still space currently, but I'm thinking about in say two years of recession hits and that 10-year has gone down that low. So as long as there's a safe asset shortage problem, there's going to be these other problems, and given the Fed’s unwillingness to think below zero, there are going to be problems. But I want to come back to QE and its effectiveness. So you've written extensively on this beyond your initial famous co-authored paper. And in fact you gave a talk last year at the Cato monetary policy conference. I was there too. I think a fair summary of the literature you've written this and other reviews and others have written this, is that QE did lower long-term yields. And then the case of the US a little over a hundred basis points, kind of the cumulative effect. A little over a hundred, I think 120, maybe 150.

Gagnon:  125, something like that.

Beckworth: 125, okay.

Gagnon: A hundred to 125.

Beckworth: Yeah.

Gagnon: All the QE programs.

Beckworth: Yeah. All cumulative like over the QE 1 to QE 3. And there's, I think a fair consensus. There's a few dissenters out there and you've addressed them. But I'd say most people would agree with that conclusion. Where there's been less agreement is the actual effect on the real economy or the economic outcomes. It's kind of mixed. And you can make the case it did have an effect or look at the counterfactual. Well, if they didn't do QE, it could be even far worse, right?

Beckworth: But I found it interesting that in your paper last year, it came out actually this year, but you gave a talk last year, is that you yourself acknowledged that QE didn't deliver the oomph, the economic growth that you had hoped for. Maybe I'm characterizing you wrong, so push back, but in the paper, I believe you make the case that maybe QE just wasn't tried early enough and aggressive enough. Had they done that, you would've seen more oomph, more economic recovery.

Gagnon: Sure. There's several little things maybe that add to one big thing. I think the biggest thing is that the Fed was timid and didn't do as much as its own modeling said it should have in the beginning.

I think the biggest thing is that the Fed was timid and didn't do as much as its own modeling said it should have in the beginning.

Beckworth: Okay.

Gagnon: If you under-power your policy and then you get an underpowered recovery, you shouldn't be surprised. But they did it because of the uncertainty and the newness and novelty. It was sort of scary. The headline numbers are big even if they actually aren't… Don't mean what people think they mean, trillions of dollars. But it's not like spending trillions of dollars.

Beckworth: Right.

Gagnon: So that was unfortunate. But little things like the whole breakdown of the mortgage market, banks being afraid to make mortgages because they started to fear the Fannie and Freddie would toughen their criteria excessively. They went from way too lax to too tight on terms of lending criteria. So all the MBS purchases the Fed made didn't stimulate as much mortgage refinancing as you might've expected, but that was a structural problem that reflected regulation, and I don't know what. But it was the biggest unforced error of the Obama administration. In my view, they should replace the head of the guy regulating Fannie and Freddie and told them, “You've over done it.” But they didn't do that.

Gagnon: So I'm trying to think what else there was. I mean, there is this issue, and I think maybe you're leading up to it or something, which it isn't just… You had to think carefully when you say that the QE lowers long-term bond yields. There's a really interesting paper that just came out by this guy Ramin Toloui, which-

Beckworth: Treasury.

Gagnon: Used to be at Treasury and is now at Stanford. And he points out that, “Look, if your QE policy succeeds in getting people thinking the climate is going to grow again and inflation won't fall as low as you thought, and raises inflation expectations back up to where they should be, then bond yields should come back as people realize that.” So in other words, the skeptics who point to the fact that bond yields rose oftentimes towards the end of these QE programs is not a bad thing. It's a good thing.

Beckworth: You'd want that.

Gagnon: You want that. It's a sign that it's working.

Beckworth: Right, exactly.

Gagnon: So when we say QE lowers bond yields, you have to be careful. What we mean is QE lowers bond yields relative to other factors like explaining expectations and growth expectations at all the other things. And when those kick in, then bond yields rise again. And that's a good thing.

Beckworth: I agree with that. I guess my biggest critique of QE is that it wasn't done right. Not that you shouldn't have tried it. And you know this, I've said this before to you, QE should've been tied to a level target. That to me is the biggest, and I think that's the criticism, like Michael Woodford and Gauti Eggertsson… Their irrelevance results, the Neil Wallace critique is that it's like an inflation target tied to QE, won't be anywhere near as powerful as QE tied to a level target. Anyways that's been my critique. But with that said...

Gagnon: I think certainly, the theory behind that is very strong and it's correct. And I think although it may... We don't totally agree. I'd go a long way in your direction saying the Fed was way too complacent about the massive slowdown in output and inflation and should have had some more ketchup than it did, which is going partway towards here.

Beckworth: Yeah, absolutely. Okay. Well, let's move on to the next tool. The next tool is foreign exchange intervention. So is that on the table for the big central banks?

Foreign Exchange Intervention

Gagnon: I don't think so. I think we should just skip that one.

Beckworth: Okay.

Gagnon: I have a lot to say about it.

Beckworth: I guess the one that comes to mind would be Swiss National Bank and they tried to peg to the Euro. They bought up a lot of everything under the sun almost. You can almost imagine them buying up the whole planet. It seemed like it was a losing battle for them, but that didn't really work.

Gagnon: I wouldn't say it didn't work.

Beckworth: Well, they eventually dropped the peg, right?

Gagnon: Yeah. But they continued to resist appreciation, and I think it had effects, although it's a pretty darn expensive way to get those effects, but that's what they did. I mean, let's not do it because in a global recession, this is the pure beggar thy neighbor policy we really don't want to talk about it.

Beckworth: Yeah. Well, I guess the thing that always puzzled me about the Swiss National Bank experience, and I had a reporter on from the Wall Street Journal who covers Switzerland. He's actually over there. And he highlighted this point that the Swiss National Bank would take losses on their balance sheet. But for me I was like, wasn't that the point? Given you want it to be orderly and kind of systematic and kind of well thought ahead of time, but the whole point is if you take a loss on your balance sheet that's inflationary and the Swiss were worried about taking a loss. It would hit them. That's what kind of puzzled me.

Gagnon: I'm with you.

Beckworth: Okay, let's move on. Again, it's not really something on the table. We don't expect the Fed, although President... Our previous show, folks, go back and listen to this. We actually talked about this. President Trump has toyed with the idea.

Gagnon: Well, that's true.

Beckworth: If there's a President Warren, maybe there'll be some more toying with that idea going forward.

Gagnon: We'd have a real currency war then.

Beckworth: Yeah. But in any event, in the absence of those unlikely outcomes in terms of actually foreign exchange intervention. Let's move on to another tool which would be raising inflation expectations.

Raising Inflation Expectations

Gagnon:  And this goes into your type of rules where we want to level target, where a level target is one of these ways of saying we're going to make up this low inflation period with high inflation later. That's how it works. And in theory it's like, makes a lot of sense. It's exactly what you want to do. I just think that if you don't start this until after the recession has hit and you're already underperforming, it's not credible.

It's exactly what you want to do. I just think that if you don't start this until after the recession has hit and you're already underperforming, it's not credible.

Beckworth: It's not credible. I know, I agree. And it's not even credible right now before because we can't hit 2%. I guess the question is not hitting the target. Is it that reflected choice preference of the Fed or is that just the Fed can't hit it? It needs fiscal health, it needs something else. I like to think the former is the case. I once did a photoshop job where I took Neel Kashkari and plastered him 12 time around the board table. I said imagine a clone of Neel Kashkari since 2015. They probably wouldn't have raised rates. And that being the case would inflation have been different today? And I think it would have. I don't know, maybe not enough, but I want to believe that made a difference.

Gagnon: Well, if they had been doing some strategy like that already iN place, they wouldn't have been raising rates as you said. And in hindsight, even with the strategy they had raising rates was a mistake because it turned out there was less inflationary pressure that they expected.

Beckworth: Yeah. And they admitted. I mean, Jay Powell admitted.

Gagnon: They admitted. Look, I was kind of ambivalent when they started this raising rates where I thought, "Well, I don't see the rush." But on the other hand it looks to me you're not crazy. But now in hindsight, I think it was a mistake.

Beckworth: Well, let me ask you about a rule that that speaks to forward guidance, this is something we've been covering, and this is a monetary policy rule called a Reifschneider-Williams rule and it's one of these rules. It's like a Taylor rule, but it says if you can't actually hit the prescribed value for the federal funds rate, like a zero lower bound experience, then you have to make up for it afterwards. And what's interesting, if you look at this Reifschneider-Williams rule, so one of the coauthors is John Williams who's a New York Fed and he's been, I think relatively hawkish.

Beckworth: He's not following his own rule, but if you look at the rule, it's still at zero. It's still at 0% even today. And the reason I know this is because the Board of Governors has a webpage. They list monetary policy rules and they have the Reifschneider-Williams rule. They call it the ELB rule, but if you read the footnotes, it's based off... And it's still like... I'm pretty sure the last time I checked, which was sometime this past month, it's still at 0%. Now, this show may be played in 2020 so I'm talking about late 2019 here. But no one at the Board... Now, I would probably imagine myself would have thought this far out. You'd still have rates that's zero. And it would be hard to do. I mean, I think politically it'd be hard to explain that.

Gagnon: Yeah, exactly. I think the length that we've been at the zero bound especially we would have been if we had stayed at the zero bound as we probably should have is in 10 years. 10 years of zero rates. I mean who would've guessed? And I was one that wanted to do more at the time, but I never believed it would turn out this...

Beckworth: Take this long.

Gagnon: No one did.

Beckworth: Okay. Final tool on the table I believe is outright transfers or helicopter money. So going to happen?

Helicopter Money

Gagnon: No. The Fed cannot do this. The Fed is very limited. The Federal Reserve Act is written in a very, almost un-American way because usually in America you can do anything unless you're told you're not, you can't do it. But in the Federal Reserve Act it's like no, you can only do these things. That's what the Federal Reserve Act says. You can do only these things. And just giving away money is not one of them. So the Fed cannot do it. But the ECB, European Central Bank and the Bank of Japan, if you read their charters, they have clauses in the charters that specifically say that if you need to achieve your price stability mandate and they both say essentially the same thing, if you need to achieve your price stability mandate, because they have one prime mandate, which is price stability, but they're allowed to define it.

Gagnon: While in Japan it's now 2%, in Europe, the ECB has chosen to define it as close to 2%. If you are not achieving that mandate and you're running out of things to do in Europe with a two thirds majority, if you've got a two thirds majority on the governing council, you can do anything. Literally anything except lend directly to a government. You cannot literally...

Beckworth: Interesting.

Gagnon: In the primary market, you cannot buy government bonds directly from a government. You have to buy them in a secondary market. But otherwise you can do anything you want. You can give cash out to people. You can do whatever. It doesn't enumerate the things you could do. It just says anything else needed to achieve your mandate. That's incredible. And the Bank of Japan says if you get the prime minister's approval, you can do anything else needed to achieve your mandate. And actually they've been using that to buy equity at 1% a year, 1% of GDP a year of equity in the Bank of Japan. They could do more. They've got the prime minister's approval to do that. And so that's an option they have. And they could do helicopter money under... I mean these statutes are-

Beckworth: That is amazing. It actually gives more meaning to the term Abenomics. As the prime minister is literally signing off on buying equity in theory could do helicopter drops. So they could do helicopter drops. The Fed cannot. Not on the table. But again, this takes me to the place where say, there's a recession in two years and a 10-year yield is much lower than today, short end. Maybe the Fed's cut rates a couple of 50 more basis points. It almost seems like we'll be forced into a corner, although there will have to be some form of fiscal policy at use, whether it's Congress, the Washington Center for Equitable Growth and the Brookings Institution's book on increasing the automatic stabilizers, which I think is a great idea. A very systematic rules-based, increasing automatic stabilizers.

Beckworth: But that probably won't happen either. So my fear is we'll get to a point where it will be make it up as we go along in the heat of the battle fiscal policy, which won't be very effective. So any event, okay, those are the tools. Let's look at the actual scope. All right? So there's the tools these central banks could use. The question is where do they stand and how much oomph do they have? How much ammunition do they have? So let's start with the United States. And this is something interesting that I didn't know before I read your paper. Several things I didn't know.

Is the Fed Out of Ammunition?

Beckworth: But this one I think was really striking. So in past recessions, you basically have from the past, two kind of moderate recessions, but the federal funds rate declines 5.3 percentage points. So I've heard that 500 basis points decline is kind of average. In addition to what was interesting and new is the 10-year yield decline is just over two percentage points as well, 2.2. So we need to see that happen for a normal kind of moderate mild recession to have a healthy recovery out of it. And the question is can the Fed do that?

Gagnon: And our answer is yes, barely.

Beckworth: Barely.

Gagnon: They can do that, starting from where we are now. If they go to negative rates, if they go to put the fed funds rate, which is about 1.6 now, and they push it down to minus half percent. That's over two percentage point drop in a policy rate. That would bring the bond deal down some automatically. And then though they could use forward guidance and QE to push yields further all the way out, which we think for the 10-year we could go as low as minus 0.3%. This is based on what's happened already with Europe. German and Dutch bonds, and Swiss and Swedish bond.

Gagnon: So that would lower long-term yields quite a bit more to their lower bound. That is worth, if you use the Fed’s model of the economy and you translate how much is that worth? It's worth another three percentage points caught in the fed funds rate in terms of how much it stimulates economy. So you add that up with the two that they could do. They cut the fed funds rate to two and then the bond yield goes down some. And then you use QE and forward guidance to push the bond yield down all the way rest. And then that's worth another three. So two plus three is five. So it would be 5.2 is what we got.

Beckworth: So pretty close.

Gagnon: Which is almost exactly what they did in the 1990 recession and in the 2001 recession.

Beckworth: All right. So if a recession comes pretty soon, we're in good condition. If it's a mild recession I guess-

Gagnon: If it's a mild to moderate, those are slightly less than average recessions, but close to average recessions.

Beckworth: I guess looking out, I don't see any reason to believe otherwise. It would be severe. I mean, it's not like a highly over-leveraged economy like there was in 2008. I think if we do have a recession it would probably be more along those lines. So that's fair. So it sounds perverse, but if we're going to have a recession, please happen soon. Actually, that sounds horrible. I mean, let me take that back.

Beckworth: We'll leave that on the show for the sake of our listeners. You can cringe at that. But I don't want any recession. I mean, point blank recessions are horrible, but the implications of your analysis is the sooner we have it, the better in terms of being able to handle it.

Gagnon: I'm not sure I fully buy your assumption that the longer we wait, the worse it will be. I suppose you're right that the longer you wait, the chances of more imbalances piling, more financial shenanigans piling up or something that it causes to be, but it's not obvious to me that's necessarily the case. It's a possibility.

Beckworth: You're hopeful that this secular decline in rates, it's going to taper or going to...

Gagnon: Yeah. I must convince that way there's much further to go, but I could be wrong.

Beckworth: Okay. All right. Tell you what, Joe we'll come back in a few years and see. Hopefully no recession and we'll see what the yields are. Okay. What about European Union or the Eurozone? Where do they stand, the ECB?

Is the ECB Out of Ammunition?

Gagnon: So if you look at the German bond yields, if you think that's a safe asset, they're basically at the zero bound. I mean, basically bond yields are minus a half percent. It's pretty much all the way out. I think the 10-year bond is minus .4, which is incredibly low. So I don't see any room. And there's some questions about whether there's some... There's almost nobody holding German bonds anymore unless there's a gun to their head. Basically, the certain regulators for certain things require the certain financial institutions hold some bonds. Why it has to be Germany? I don't know. But anyway, there's, a sense that no one's holding because most German bonds are hauled above ECB or by foreign central banks as reserves and so there's almost no private sector agent who's not a regulated entity holding German bonds anymore.

Beckworth: Really?

Gagnon: Yeah. So you wonder is that really a market rate or what does that mean?

Beckworth: What about the Swiss? I mean, the Swiss also have really low rates.

Gagnon: I don't know. Yeah. They don't have a lot of big government bond market and don't forget in Germany, they have a surplus so the German bonds are shrinking.

Beckworth: That's fascinating because people have been saying, "Hey, the Germans need to run bigger fiscal deficits, issue more bonds." It would alleviate some of the pressure on the safe asset challenge. But what you're saying is maybe people would want to buy them, which if that's the case, then that puts more weight back on the US to issue the debt for the world.

Gagnon: No, I think people would want to buy German bonds. It's just that if there were more of them then.

Beckworth: Of course that's where the yields will come up.

Gagnon: The yield will come up and then people would come in.

Beckworth: That's fair.

Gagnon: The thing is fine, but I think the thing... So what we point out is that while the Germans are those lower bound, but Italy… Italian yields are a one and a half percent higher than German yields and the ECB could buy Italian bonds and push their yields down to the German level. And French yields are at three-tenths or four-tenths percent higher. So they could push all these spreads down to German levels. If you think that the benefits are proportional to each country share of GDP and you weighed up by bond, all the deal can come down, it's worth maybe a percentage point cut in policy rate if they were to do this. But there's legal questions whether they could do this. There's all kinds of... I don't want to get into it, but can they buy in disproportionate shares or if they had to keep buying German bonds in proportion to Italian bonds, would they run out of bonds to buy? What would happen?

Beckworth: Yeah. And a lot of legal questions.

Gagnon: So there's much room there and certainly nothing that's not controversial and that then leaves basically helicopter money. And in Japan it's a little different in Japan because they don't have these spread across country spread things. It's just one country, one JDB market. But they have only pushed the policy rate to minus .1. They could push that down to minus .5 and then the bond yield, which is also only around minus .1 could come down further if they want to. But again, it's four-tenths of the short end and three four-tenths of the long end. The total is maybe worth a percentage point. Not much room.

Beckworth: Chump change, huh.

Gagnon: And I don't see that people are really... I mean, I think people are saying that this isn't much, but I know people have seen in central banks explaining what they're going to do... They don't seem to be engaging with the limitedness of this scope. You know what I mean? They've asked the Bank of Japan, what would you do if you need to? Well, they said, "Well, we could lower short rates a bit more negative." But they don't engage with the fact that the room is just tiny compared to normal times. So what would they do in a recession? They haven't communicated to markets what they would do.

Beckworth: Yeah. That kind of the overarching theme of your paper here is there's really limited space around the world. I mean the US is a little bit more, but even the US compared to previous recessions, previous experiences is very limited going forward into this. This should be a wake-up call, right?

Gagnon: Yeah. That's the point of our paper is to say, "Look guys, you can't keep acting as if you..." They keep saying we could ease if we needed to, we could ease if we needed to, but there is not much there. Face up to it. Make contingency plans.

That's the point of our paper is to say, "Look guys, you can't keep acting as if you..." They keep saying we could ease if we needed to, we could ease if we needed to, but there is not much there. Face up to it. Make contingency plans.

Beckworth: So I guess the question would be then, will they resort to helicopter money? Will they adopt the level target? Will they be more radical? Things like that.

Gagnon: So I just talked to people from Japan both in government and outside government and all the talk in Japan is lowering the inflation target, not raising it because you can't.

Beckworth: Oh, wow.

Gagnon: And I think that's just a disaster. It would be a disaster. And the IMF came out in the article for consultation with Japan and said, "Maybe they might want to consider inflation range," which I think implicitly they had in mind something like one to three but they didn't say. But the idea would be again to ratify under achievement, which is just the wrong way to go. It's just frustrating.

Beckworth: That is, I think, a big deal because as you know if you say, "Okay, let's change it from 2 to 1% or create a range which allows us to drift to 1%, you erode credibility." And once you do that, then why not drift from 1 to 0%?

Gagnon: They argue that it's the opposite. They argue that since you aren't achieving two, you've lost your credibility. So if you'll gain it back, if you lower the target because then it's like... I think that's just backward reasoning. It doesn't confront the fact that you're making the zero bound worse.

Beckworth: Yeah. I've read some pieces where some prominent, I think German politicians were like, "Well, let's just lower and flush and target 1% because that's what we're actually hitting. Which again, on the surface that seems reasonable, but then you think about it. Well man, if they do 1%, why not lower to half a percent, 0% if things don't go... It's not credible. At least a poor long-term planning decisions for businesses and the economy. And then the zero lower bound problem as well.

Beckworth: So these are real challenges that lay ahead for central banks and the Fed happens at being at a slightly better place. I had a market analyst on previously, Jim Bianco and he said in the US, we should be happy. We have the highest yields in the world. We complain... He's talking about investors. Now, they complain about the low yield on safe bonds and stuff. But they should be grateful. Look around the world. I mean, we're at a much better spot even though it's low.

Beckworth: But going forward, this is going to be a real problem for policy. So Joe, we've been talking about your policy brief titled, “Are Central Banks Out of Ammunition to Fight a Recession? Not quite.” We've covered a lot of ground. Any closing thoughts on this piece we haven't touched yet?

Gagnon: Yeah, there's one other point that we make and I find it... It's really surprising to me that a short paper makes so many different points. But one point that we didn't cover is that raising the inflation target, either directly or indirectly, if you were doing a nominal GDP target through a higher path or nominal GDP, say going from 4% to 5% growth path, it gives the Fed more power, more ammunition than anyone has pointed out as far as I can see.

Gagnon: The standard way of looking that is to say, "Well, sticking with the inflation sort of rule, if inflation target is two when we raise it to three, and then all interest rates will go up by 1% and then the Fed would have..." Once you get to steady state and you're there, when the recession hits, interest rates would be 1% higher, and the Fed would have 1% more room to cut.

Gagnon: And so when you say it that way, it doesn't sound all that powerful, right? Well, they got one more percent, but they only had a couple, and that's not enough. It helps, but it's not enough. But it's better than that. Because you're also 1% farther away from the lower bound on the bond yields. And when you've lowered the Fed funds, that extra 1%, you won't have lowered the bond yield all the way to its lower bound yet. You'll have that much more room to do QE before it hits its lower bound.

One point that we didn't cover is that raising the inflation target, either directly or indirectly, if you were doing a nominal GDP target through a higher path or nominal GDP, say going from 4% to 5% growth path, it gives the Fed more power, more ammunition than anyone has pointed out as far as I can see.

Beckworth: That's a good point.

Gagnon: And we estimate using the Fed's model. That means that each percent you raise the inflation target, you give the Fed two and a half percent effective ammunition, because not only in the short rate but also through QE.

Beckworth: Okay, that's a great point. You're right, I haven't seen that anywhere else is that most people when they talk about raising the inflation target, they're thinking about how it affects the zero lower bound on short-term rates. But your point is it also has a bearing on long-term rates because you've changed the trend path, the long run inflation outlook and therefore the 10-year treasury would pop up by that. That increases as well. And therefore more policy space. You can find short end and long end. It's a richer story. So that's a great point and something definitely to think about.

Beckworth: Well Joe, we have a few minutes left and this has been great. Again, I encourage our listeners to take a look at this. We'll link this policy brief and it was written with Christopher Collins and I recognize him as well. You guys co-wrote this together. But you have another co-written piece and this is titled, “Priorities for Review of the ECB's Monetary Policy Strategy.” So tell us what was this piece about?

Gagnon: Oh, so let me start since you mentioned my coauthor in the first piece, and I should have mentioned him earlier too. And he is also co-author on this new piece, Christopher Collins, who I work with at the Peterson Institute. He also used to work in the Federal Reserve System.

Beckworth: Okay.

Gagnon: And our third colleague on this one, Jérémie Cohen-Setton, who's a research fellow at the Peterson Institute. And so the three of us wrote this and what it was is the European parliament has these regular monetary dialogues in it. It's two or three times a year. And as part of their sort of oversight of the monetary policy and ECB in Europe and the topic... They put out a call for papers, and so we submitted a paper which they accepted and the topic this time was should the ECB review its monetary policy strategy, and how… What should it look at? And so we wrote a paper advising them on what the ECB should do.

Beckworth: Yeah. And so you give three motivations for doing this review. So you're encouraging the ECB to do what the Fed is doing now: review its overall framework, tools, strategy. And the Bank of Canada of course set the precedent for everybody because they've been doing it every five years for some time. I want to read your three reasons for doing this. So first you say the decline in the neutral rate of interest. So low policy rates, low interest rates in general motivate this reconsideration. We just got done talking about that with your previous piece.

Beckworth: Secondly, you mentioned the ECB is particularly well positioned to improve its toolkit given the flexibility embedded in this mandate, and we touched on that earlier as well. We can do things the Fed can’t do. So it's a chance to explore the flexibility of the options it has.

Beckworth: Third, you say some conclusions of the ECB's 2003 review needs further improvements. So you talk about the inflation target, maybe it could be worded a little bit better and we'll get to that in a minute. So you give three motivations for the ECB to sit down and have a hard review of what it does. I'm going to add a fourth one to your list, Joe, and that is the ECB screwed up so bad in 2011 raising your rates twice and I'll put 2008 as well. It raised rates once. But it really, I think that the worst job during the great recession period of any central bank.

Beckworth: No one's perfect, the Fed wasn't perfect. I mean, everyone makes mistakes. We're all human. But to me it's unconscionable what they did in raising rates in 2011. They're barely out of the great recession and it was a mess. So I think if they're being sober and honest with themselves, they would say, "Look, we made some mistakes. How can we avoid making those same mistakes going forward?" So that's my two cents worth. And I know you couldn't put that in the piece that's going to be submitted to the ECB, so I'm doing it for you here.

Gagnon: Well, I agree with you. Those are egregious mistakes and at the time many of us pointed them out. So it never occurred to me to think, well, in the policy review, in terms of a structure and a framework of your policy, one topic should be don't make mistakes because I think those are mistakes even in the framework that they had.

Beckworth: Yeah.

Gagnon: That's a good point. I mean, maybe they should institute some way of putting in their framework something that would alert them to a possibility.

Beckworth: Listeners will get tired of hearing this speech from me, but the problem in 2011 and in 2008 is that they were lured by the siren call of high inflation, temporarily higher. And some of it was supply shocks from commodity prices. Some of it was, I think it's a tax law, tax changes, but these were all temporary supply side shocks that drove up inflation, which in theory central bankers should see through, but they can't. It's hard. I'm not saying I would be any better at it unless I have a framework, a structure in place that disciplines me, and you know where I'm going with this, Joe, something like nominal GDP targeting. But that's not on the table. I mean, I know already that's not going to happen at the ECB. But with that said to maybe having a truly flexible inflation target where you're not so worried about the brink...

Gagnon: I think they are moving that way, man. They used to say 10 years ago they would tell us, "Look, in the US inflation goes back to core," and that's why you look at core. But in Europe a core goes back to headline. And they claimed that they had statistical evidence to prove that. And maybe there was some truth at some point in the past, but that's not the way it's behaved since then. I think they're finally catching on.

Beckworth: Okay. So with my soapbox part of the discussion over here, tell us what are the recommendations and points that you raise in this piece?

Priorities for Review of ECB’s Monetary Policy Framework

Gagnon: Well, we think there are two urgent things that the ECB should do, although I like your point about “don't do stupid stuff.” I think Barack Obama said something like that at one point. But anyway, we focused on sort of main structural things that are easy to explain. And one was that, "Look, they're targeting something below two, it’s just too low." If you actually look, they did have a review in 2003 that was the first review and it's been 15 years since the 16 years since they did that. But in their first review, they went in where the target was said to be any inflation less than two and implicitly zero to two. And then they changed that to suddenly to take zero out of the range and to make it something that was around but just below two.

Beckworth: Okay.

Gagnon: And there's been some dispute as to how symmetric that was, whether it's really one to two or one to two and a half or what. But they definitely took out zero to one. And they said we chose a number just below two because our guess is that, that will mean it will almost never be at a zero bound. And that's high enough to avoid the zero bound problem. They literally said that.

Beckworth: Wow.

Gagnon: So now we can go back and say we were wrong. And if that wasn't high enough to avoid the zero bound then we really must raise it now. I think that's one point we made. And so we say they should make it three and make it clearly symmetric around three, and a simple number. We point out that in the 30 years before Germany joined the Eurozone, German inflation averaged three and a half percent and it was widely considered to be very successful.

Beckworth: Yeah, that's right.

Gagnon: Why should they be so worried about when three and a half was widely viewed as...

Beckworth: Germany is like the poster child for inflation control. Like during the 1970s you compare US to Germany, Germany didn't have a high inflation that we had. So if it's good enough for them, it should be good enough for ACP.

Gagnon: You’d think. So that's one point. And then the other point is we think that the point that we just made about the working paper, we discussed that really what the current tool of interest rate policy and QE they have no more ammunition. So they really need to develop another tool to be ready when the next recession hits. And probably that should be helicopter money.

They really need to develop another tool to be ready when the next recession hits. And probably that should be helicopter money.

Beckworth: All right. And that again is legally feasible, right?

Gagnon: With a two thirds majority that policy is allowed.

Beckworth: Okay. All right. And I guess if you get into recession, times get hard, you might get that two-third majority.

Gagnon: You might.

Beckworth: Because there's no fiscal policy, real fiscal policy options. So the only game in town is monetary policy.

Gagnon: I actually think this is especially beneficial in Europe precisely because fiscal coordination is so impossible there, and it's so controversial. There've been trying to figure out all the other countries. Every other country practically wants Germany to have around fiscal deficit. They have a fiscal surplus now and Jérémie doesn't want to because until recently it's felt like its economy was strong and didn't need it. And so this is the main problem, right? You're in a monetary union and the conditions are different and no country wants to do something that's not in its own interest just to help out its neighbors.

Gagnon: And then there are all these restrictions on other countries who need it doing more because they're already having fiscal deficits. So it's the best. And this sort of cuts through that, and also I think might light a fire under the politicians. If the ECB did this and it was seen as successful and got around these fiscal stability growth pack restrictions, it might be hugely popular, and then might force the politicians to say, "Well, we need to come up with some centralized fiscal macro response tool to take it back,” because politicians might like extra to have it themselves. But to cut through the gridlock in Europe. And the problem is that the ECB isn't set up to do this right now. I mean, they don't have a list of every resident or citizen or who they could mail checks to.

Beckworth: Logistics would be tough.

Gagnon: Logistics would be tough, but it's not insurmountable and there are options, but they need to get the groundwork ready.

Beckworth: Yeah. And that's what your paper is for. So do you foresee the ECB doing a review along these lines?

Gagnon: Sadly, no.

Beckworth: But that's the point of your paper is to kind of push them in that direction, right?

Gagnon: Yeah. Our viewers are welcome to look at this, European parliament website where our paper is and I think there's... I'm not sure how we can tell them to find it.

Beckworth: We have a link, and we'll provide a link to it on the show.

Gagnon: Okay.

Beckworth: So definitely. And it's also on your website too.

Gagnon: It's on my website, but what I wanted to say along with our paper are, I think, three other papers that also talk about this. And I must say I was deeply disappointed when I read those papers.

Beckworth: Okay.

Gagnon: They are just woefully unambitious and fall short of a task.

Beckworth: Maybe we shouldn't link to those other papers then.

Gagnon: I think it's pretty... I don't know what to say. I mean the lack of... I don't want to say imagination, but just...

Beckworth: Content with...

Gagnon: The complacency.

Beckworth: Yeah, the complacency.

Gagnon: The complacency that's in those papers is shocking.

Beckworth: All right. So that's why you say you're not terribly hopeful this will happen anytime soon, but this is what should happen.

Gagnon: Yeah.

Beckworth: And maybe given time they'll say, "Hey, the Bank of Canada is doing the review. The Fed is doing the review. Let's do the review. I mean, Gagnon, his buddies encouraged us. Maybe we should take it seriously." So I mean the one thing is-

Gagnon: There's a bit of complacency here. I mean, I think the Fed is certainly... People are trumpeting that they're doing this review and what a great thing it is and I fully support it. But even the Fed is a little too complacent.

Beckworth: Well, I know there's people at the Board of Governors and other regional Fed banks listening, but I think my views are very clear that I've been a little disappointed with the review too. I think it's useful and I'm glad it started, and Jay Powell indicated at last press conferences it's going to continue. In one of the last few press conferences, it will probably continue like the Bank of Canada, which I think it's a great, great, great to hear. My fear is coming out of this, we're going to see average inflation targeting and it's going to be just a minor tweak to what we have. It's not going to be average inflation targeting with real teeth.

Beckworth: And again, that may be the reality given politics. You can't be too radical in making changes given Congress and everything else. But back to the ECB, I mean it's been remarkable in my view that the Euro has lasted as long as it has. So I was wrong. I thought it was going to break up, I don't know, 2011-2012. I thought, "Oh, these days are numbered." I was wrong. And it has persisted, and maybe eventually they will take to heart your suggestion for review and make the world a better place.

Gagnon: Maybe.

Beckworth: Maybe. Okay. Well with that, our time is up. Our guest today has been Joe Gagnon. Joe, thanks again for coming on the show.

Gagnon: You're welcome.