Matthew Raskin on Treasury Market Stability, Interest Rates, and the Fed’s Balance Sheet

Increased central clearing and use of the Standing Repo Facility are just a few ways to improve the liquidity and stability of the Treasury market.

Matthew Raskin is the US head of rates research at Deutsche Bank and was formerly a senior staff member of the Federal Reserve System. Matthew joins David on Macro Musings to talk about interest rates, QE, QT, and the Federal Reserve’s balance sheet. David and Matthew also discuss the inside story behind the Fed’s shift in operating system, Matthew’s framework for long-term interest rates, how to improve the liquidity and stability of the Treasury market, 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: Matt, thank you for joining us.

Matthew Raskin: Thanks for having me, David. It's a pleasure to be here.

Beckworth: Well, it's great to have you on, and I've had several of your friends from the Federal Reserve on. I've had Joe Gagnon. I've had Brian Sack. In fact, the three of you, plus Julie Remache, authored a very influential article on large-scale asset purchases. It got published in the International Journal of Central Banking and the title is, *The Financial Market Effects of the Federal Reserve's Asset Purchases,* over 1,000 citations. You also had a New York Fed version, also with 1,000 citations. That's a pretty amazing paper. As I mentioned to you earlier, that's the kind of paper that gets you promoted from associate to full professor at many universities, because all of those amazing citations, so it's neat to finally meet one of the other authors on the paper.

Raskin: Yes, it's great to be here, as I said.

Beckworth: So, you have spent a lot of time at the Federal Reserve. How many years were you at the Federal Reserve?

Raskin: I was at the Fed for 15 years. I left about a year ago but was there for 15 years.

Beckworth: So start with your journey there at the markets group, because that's where you started, in 2007?

Raskin: I joined the markets group in 2007. I'd been doing my PhD in economics at Johns Hopkins, and I joined the markets group of the New York Fed. The markets group is responsible for many things. It manages the discount window on behalf of the second district, the New York District. It provides investment services to foreign central banks like custodying their dollar assets. I think it's most associated with the open market trading desk. The open market desk, which is where I worked for the bulk of my time there, is responsible for operations to implement monetary policy, managing the Fed’s portfolio, and market analysis to support the Fed's monetary policy and financial stability objectives.

Raskin: I had a variety of different roles during my 15 years there, both domestically and internationally focused. Most of my work was centered on analysis or managing analysis, although I did have some oversight responsibility for operations. For example, I spent a couple of years in a group called Foreign Exchange and Global Markets where I was responsible for analysis of foreign financial markets and foreign central banks, but also management of the Fed’s liquidity swap lines and their foreign exchange intervention readiness.

Raskin: Over my last several years there, I worked as an advisor to the SOMA Manager. At the time, that was Lorie Logan, and Lorie has since gone on to be the President of the Dallas Fed, and much of my focus working with Lorie was on briefing the FOMC on financial markets and desk operations. If you go to the FOMC minutes, the first section of those is a summary of the briefing that SOMA manager gives to the committee on markets and operations, so I worked with Lorie to put that together. As part of that process, we would meet with the committee's leadership, Chair Powell, Vice Chair Clarida, and then Brainard at the time along with New York Fed President John Williams, to brief them heading into the meetings on what was going on in financial markets, what markets were expecting in terms of Fed policy, and to think about how markets might interpret and react to different policy communications and policy actions.

Beckworth: You mentioned Lorie Logan, who's been a past guest on the show, and now, as you mentioned, President of the Dallas Fed. She gave an amazing speech recently, and we'll come back to that, on the floor system, as well as this point about the Standing Repo Facility and how to make it more effective. But, since you were advising her right before you left, did you get to work on some of the new facilities that were introduced in the past few years? I'm thinking of the FIMA repo account and the Standing Repo Facility. Were you involved in some of that deliberation?

Raskin: Yes, I was there, obviously, through the COVID episode, when the Fed launched a whole host of facilities including, initially, the FIMA Repo Facility, which was introduced on a temporary basis, and then it was made permanent in 2021. In my role, I was involved in the design of those facilities, and then played a large role in discussing, with the committee, the motivation for those facilities, how we thought they'd work, and what impact we expected them to have. I was certainly closely working with Lorie and others across the group as those facilities were being put together.

Beckworth: Very fascinating. We also had on the show, a while back, Steven Kamin, who I believe is also involved. You guys probably work together, crossed paths, in these discussions.

Raskin: Yeah, so Steve was the head of international finance at the Board for a long while.

Beckworth: Okay, so you were there during the COVID period, so an exciting time. It's stressful too, I should say, but it's always great to have the experience of being there in the heat of battle, things are happening, innovations are occurring. You saw all of the innovations in 2020, but if we go back to when you first started, 2007, that's also great timing. You show up just in time for the great financial crisis, or some call it the Great Recession. And I want to bring something up that’s particularly historical about that period, and that is the change in the Fed’s operating system from a corridor to a floor system, from a scarce reserve to an ample reserve system. I'm dying to hear your inside story of how that unfolded and what it was like to be behind the scenes when that big change was taking place.

The Inside Story of the Fed’s Change in Operating System

Raskin: I think that change was really a consequence of the policies that the Fed put into place during the global financial crisis. In late 2008, as the failure of Lehman and then the intensification of the global financial crisis was coming about, the Fed moved its overnight interest rate, the fed funds target, down to zero. Then, in order to provide additional stimulus to the US economy, [it] announced what we've all come to be quite comfortable and familiar with in the decade and a half since, but at the time was relatively new— certainly new for the US— which was large-scale asset purchases.

Raskin: It used an expansion of its balance sheet, through purchases of agency mortgage-backed securities, agency debt securities, and then US Treasury securities on a very large scale, with the goal of bringing long-term interest rates down and easing broader financial conditions, once they could no longer do that by further reducing their overnight interest rate, because it had already been brought to the zero lower bound. Then, as a result of those policies, the size of the Fed's balance sheet grew to be very large, and so the Fed was in a world where it was no longer feasible to implement monetary policy once they wanted to move off the lower bound, by reducing the level of reserves in the banking system back to a level that was sufficiently low that they could exercise control over overnight interest rates by doing active open market operations.

Raskin: If you think about the policy implementation regime that was in place prior to the global financial crisis, that was a world where there were very little reserves, excess reserves in the system. The way the Fed hit its target for the Fed funds rate was by doing active open market operations. It would go that in and do repo operations or reverse repo operations that would bring the level of reserves in the banking system to where they needed to be in order for the market to clear at the target rate that the committee had set.

Raskin: Once they'd done asset purchases on such a large scale and the size of the balance sheet, the Fed's balance sheet, had grown so large, there were so many reserves in the system that they faced basically two options. One was to try to drain those reserves and get back into a world of scarce reserves, where again, they'd be doing active open market operations in order to hit the target for the funds rate, or to live in a floor system and to control the level of overnight interest rates by the setting of administered rates. That's the interest that they pay on excess reserves that banks hold, and then a little bit later, it was the overnight reverse repo facility and the rate that they pay on that facility. Since then, the Fed has been in the floor system, and it's a very different system for operating monetary policy.

Beckworth: So, the Bank of Canada also expanded its balance sheet during the 2008-2010 period. It also hit the zero lower bound. In fact, I think one can say a corridor system collapses into a floor system by default when you hit the zero lower bound, you have to expand the balance sheet because the policy instrument, the rate hits zero. But Canada actually shrunk back down. They actually returned to a corridor system, where we stayed on the floor system. I guess the best understanding I can have, one of the reasons for this, is that we introduced a lot of regulations that may have increased the structural demand for reserves, so from Dodd-Frank to all the Basel rules. Is that a fair interpretation? Are there other things you would add to that?

Raskin: I think that's a part of it. I think another piece was an expectation that with the neutral level of short-term interest rates, or R-star, having fallen over recent decades, the Fed was in a world where if in normal times, the level of the overnight interest rate is relatively low and sufficiently close to zero, when the Fed wants to provide accommodation or needs to provide accommodation, it only has so much scope to do that by reducing overnight interest rates. Maybe the judgment in that world of a low R-star where the effective lower bound would be a binding constraint with increasing frequency, the Fed would need to provide accommodation by expanding the balance sheet.

Raskin: The natural counterpart to that, in terms of implementing monetary policy, was to remain in a floor system where, again, you can control overnight interest rates by the setting of the interest that you pay banks on their excess reserves, and the interest rate that you pay on other liabilities. I think the judgment was just that this was the most effective and efficient monetary policy implementation regime in light of that low level of neutral interest rates and propensity to hit the effective lower bound as the Fed needed to provide stimulus.

Beckworth: I like how you frame that. Another way of saying it is, the balance sheet size was endogenous to the realities of the world around, right? We're hitting the zero lower bound, so the Fed had to expand its balance sheet. I want to use that as a segue back to the 2020s. In the 2020s, a lot of interesting details, but I want to step back and look at what I think is a big-picture point from that. And that is, all of these facilities that the Fed introduced, we talked about FIMA, Standing Repo Facility, but there are a lot of other ones, corporate bonds, the same ones we used in 2008 as well, commercial paper, money market fund facilities.

Beckworth: In my mind, one thing they did that was very important is, they're responding to the stress of global dollar markets, not just the US, but global dollar markets. And something I've been thinking about is, is the Fed kind of forced? Forced may be too strong, but it's endogenously responding to the fact that there is this growing market of dollars around the world, whether it's corporate bonds, repo, or people holding Treasuries, and the Fed has to respond if it wants to preserve that global dollar system and, in turn, keep financial stability at home.

Preserving the Global Dollar System

Raskin: I would agree with that. I think another way to put it is that global dollar funding markets are interconnected, and so if there are pressures that emerge in offshore dollar funding markets, those present risks that they spill back over into domestic money markets, and adversely affect the transmission of credit and the Fed's ability to achieve their monetary policy and financial stability objectives. You mentioned the whole host, the alphabet soup of facilities that was either introduced or brought back in some form or fashion during COVID. Another key one in this context was the expansion, on a temporary basis, of the Fed's dollar swap line. There is a standing swap line network comprised of five other central banks, but during the COVID episode where, again, there were these strains in global dollar funding markets that were putting, at risk, the Fed's ability to achieve its domestic dual mandate objectives, there was a massive expansion in central banks that had access to dollar swap lines.

Raskin: That was done on a temporary basis, but then as we talked about before, there was the introduction on a temporary basis, at least initially, of the FIMA Repo Facility, which is a way that the Fed can lend dollars against Treasury collateral to foreign central banks who are custodying those assets at the New York Fed, and then that facility was made permanent in 2021. So, I do think there's a very real sense in which we have these interconnected dollar funding markets, and stresses that emerge in offshore markets can spill back over into domestic markets, and so the Fed, I think, was looking to put in place facilities to address that potential.

Beckworth: Yes, and I'll mention one other guest we've had on here, Bob McCauley. He used to work at the BIS. He made an argument that the reason the Fed stepped into corporate bond markets for the first time, and many people were like, "Oh, what is the Fed doing? Has it crossed the red line? Is it doing too much?" He argued, "No, the Fed is again responding to global dollar market pressures." A lot of overseas companies have issued bonds in dollar denominations and just like it had to intervene in commercial paper, it had to intervene in the corporate bond markets, and he expects it to continue to be an issue going forward.

Raskin: Yes, that's interesting. I have not previously associated the credit facilities— there were two corporate credit facilities that were launched in 2020. One was for the primary market, and a second for the secondary market. My recollection is that those credit facilities were only buying bonds or ETFs of US-domiciled companies, but of course, in the same vein that we're talking about spillovers and linkages in dollar funding markets globally, I think that's certainly true in global credit markets. So I think it was part of this broad set of facilities that were put in place, again, with the goal of helping to ensure the continued flow of credit domestically. And, again, just given these global linkages between markets, there are these important spillovers.

Beckworth: Yes, he actually argued that the Fed got lucky because it was only buying US corporate securities or ETFs, and that in the future, it may need to actually intentionally go beyond that, but that’s another conversation for another time. Circling back to your career, so you spent a lot of time at the Federal Reserve, at the New York Fed. You were also at the Board of Governors. Tell us a little bit more about that time.

Matthew’s Journey from the Fed System to Deutsche Bank

Raskin: As I said, I joined the New York Fed in 2007. The board is a key stakeholder for the Fed, for the markets group, for the open market desk. There's very close collaboration between New York and the board on a whole host of issues related to policy implementation and operations, but also market analysis. And so, I had the opportunity in 2012, 2013 to do an ensconcement. I went down to the Board of Governors for about 18 months and worked in the Division of Monetary Affairs. You've had a number of guests from MA, Monetary Affairs, on your program as you alluded to before, so Bill English, Bill Nelson, Brian Sack, Joe Gagnon, all of them worked at one point in Monetary Affairs.

Raskin: During my time down there, I was covering US interest rate markets, US inflation markets, and Fed Policy expectations, and doing a mix of policy work, so briefings for the governors, working on minutes to the FOMC meetings or the monetary policy report, and then also had the opportunity to be doing my own research on those topics. The thing that was really great for me about that experience was the relationships. As I mentioned, the board and New York worked very closely together, and so those relationships, understanding the cadence of work at the board, how things generally worked down there, and getting to know the people well, I think those relationships and that experience really served me very well during my time back in New York and since.

Beckworth: Sounds like an amazing journey you've been on. Tell us about Deutsche Bank. What are you doing there?

Raskin: At Deutsche Bank, I am the US head of interest rate research. I lead a team here that's responsible for analysis and forecasting of US interest rate markets. We cover Treasury markets, both nominal and inflation-indexed bonds, inflation markets, so things like inflation swaps, interest rate futures that are linked to Fed policy, swap spreads, interest rate options. So, we're doing analysis around those markets and forecasting those. Of course, Fed policy is central to all of that, so I think my 15 years at the Federal Reserve has served me well in my current role.

Raskin: I think in many ways, the work I do here at Deutsche Bank is similar to the work that I was doing at the Fed, but with a different audience and a different focus. At the Fed, my audience was senior staff and policymakers, and my objective was to help them make informed decisions about monetary policy and financial stability. Here, I work with clients who are making decisions about asset allocation and portfolio management, or trades, and they're really investors at various types of financial institutions, so at banks, asset managers, hedge funds, pensions, insurers, sovereign wealth funds, but also corporate clients. Again, producing written analysis, meeting with clients, and advising them around issues related to their portfolio management and asset allocation.

Beckworth: Let's use that to move on to the current state of interest rates in the US and around the world. As our listeners know, the Fed rapidly increased its target rate, it's now at 5.25% to 5.5%. Just recently, the 10-year Treasury bumped up against 5%, it's now down a little bit, 4.6% or so, but a big swing in long-term rates, they have gone up rapidly. And one of the big questions or debates out there is, why? And I want to kick that off by first asking you, what is your theory or framework for thinking about these long-term rates?

Matthew’s Framework for Long-term Interest Rates

Raskin: Yes, so my framework for thinking about longer-term interest rates… I guess I would describe it as the expectations theory with time-varying risk premia. What I mean by that is, I think of term interest rates on default-free instruments. So, I'm thinking about US Treasuries as a function of two things: one is expectations for the path of short-term interest rates over the life of the bond, and two is a risk premia or term premia, which is an excess expected yield over and above that expected short-rate path, which is compensation that investors get for bearing interest rate risk in a longer-term bond.

Raskin: I think that's a fairly common way to decompose longer-term interest rates as reflected in the immense focus on term structure models, things like the Kim-Wright model or the ACM model, which are two models that have been produced and are maintained by Fed staff that break down longer-term interest rates into these two components: expectations, and term premia. As I think about it, though, and try to make sense of market developments, I actually think it's helpful to break that expectations piece down further into two pieces, one of which is expectations for the long-run neutral policy rate.

Raskin: That's the short-term interest rate that will prevail when the economy is in equilibrium. In a nominal space, I think of that as a function of expectations for R-star or the neutral real rate, and expectations for longer-run inflation, which should be a function of the Fed's inflation goal. Now, that real piece, that R-star-neutral real rate, is not something that's controlled by the Fed. I think that's a function of fundamentals like productivity growth, demographics, and other things that alter the balance between savings and investment. That's one piece of the expectations component.

Raskin: I think the other is expectations for interest rates over the cycle, so over the next few years, and the extent to which interest rates will deviate from that long-run neutral level. And so, I do think the Fed controls that, but with constraints that depend on its goals, but they decide how to trade off their inflation and unemployment objective. Clearly, we're in an environment now, where I think of the next couple of years, the Fed's policy rate, the fed funds rate, is expected to be above that longer-run neutral level. Those three things together, I think expectations for long-run neutral, expectations for the Fed policy cycle, and then term premia, for me, at least, are a useful framework in thinking about moves in longer-term interest rates, and I think I found them quite useful in applying to what we've seen over recent months in terms of the big moves in rates.

Beckworth: Well, go ahead and decompose the recent moves into those three groups.

Raskin: Yes. I think, a part of what we've seen over recent months—and let me just start by saying, as you noted, we've seen very big moves in interest rates, very big increases in interest rates, over recent months, and what people refer to as a bear steepening of the curve, which means that the curve is steepening at the same time that interest rates, both at the front-end and the long-end, are moving higher. And so, in trying to understand what's driven that, I think a piece of that has been a reassessment of the Fed policy cycle. So, I think just given the strength we've seen in the real data as well as in the inflation data, there has been some reassessment of the path of the fed funds rate over the next couple of years and, in particular, pricing out of cuts in 2024 and 2025.

Raskin: But, the moves in interest rates have been much more pronounced in longer-term yields, and in far forward rates, things like five-year, five-year rates and beyond, and in the framework that I just outlined, those are not a function of expectations for where policy will be over the next couple of years, but are instead reflecting either a reassessment of long-run neutral, so where the Fed will get back to with its policy rate on the other side of the cycle, or a reassessment of an increase in term premia. And It's very difficult to distinguish those two things.

Raskin: I think there's good reasons to think that both of those may have risen some. I think, again, just given the strength we've seen in the economy, against a backdrop where the Fed has hiked over five percentage points, that has led many investors to reassess what that long-run level of neutral interest rates is, and maybe mark that up a little bit. And we're seeing, I think, more discussion from the FOMC and from policymakers themselves about the idea that R-star may be higher than we come to believe coming into the COVID episode. But I think for me, the real big driver of the recent increases in interest rates has been a repricing in term premia, and in particular real term premia.

Raskin: If you look at breakevens, so these are measures of expectations for inflation at different horizons that you can derive from the yields on nominal bonds and inflation index bonds, those breakevens have been pretty steady through this big repricing in longer-term interest rates. I would argue remarkably steady just given the magnitude of the moves that we've seen. That's telling me that it really hasn't been a reassessment about longer-run inflation or inflation risks that's been the big driver of the move, and instead it has been a repricing in real-term premia.

Raskin: As I think about that, I think we started from a place where term premia just looked like they were very low by historical standards and relative to fundamentals that I think drive it. The term structure models I mentioned earlier all had longer-dated term premia stuck in this very low range that we’d fall into in the second half of the last decade, even as things like inflation uncertainty, the correlation between bond and equity returns, and an outlook for supply were all, I think, pointing in the direction of higher premia. And so, I think we had a bunch of developments over the course of the summer that were putting a spotlight, in particular, on the outlook for supply, but against a backdrop where premia just looked like they were too low, and overdue for a repricing. And I think those developments, which we can talk about, put a spotlight on the outlook for supply against a backdrop where premia look too low, and we just got this repricing.

Beckworth: Yes. There's so much there, so fascinating. Let's unpack some of that. So, two things you noted: one is, some in the market are reevaluating where long-run R-star should be given the resilience of the economy, so that's bumped up a little bit. You've also noted that the term premia has probably gone up as well. And you said there's a repricing of where it should be. Is that due in part to the uncertainty of budget deficits, or just that we had it wrong the past decade?

Term Premia Repricing and Budget Deficits

Raskin: In my view, it's a combination of those things, but I do think there have been a number of developments in recent months that have put a spotlight, in particular, on the outlook for supply and for budget deficits. We are on track this year to run a deficit of around 7% of nominal GDP with the unemployment rate below 4%. That is a huge historical outlier. Then, you had, in late July, the Treasury, who on a quarterly basis announce how they're going to finance the deficit and what they expect that the borrowing needs to be for the current and next quarter.

Raskin: In late July, you had Treasury announce a bigger borrowing need and an earlier increase in the size of its coupon auctions that I think maybe many were expecting. Chair Powell, in his July FOMC press conference, talked about the prospects that the Fed’s QT, or quantitative tightening, could continue alongside interest rate cuts if those interest rate cuts are coming in a soft landing scenario. And then you had a few auctions over the course of October that had big tails. In other words, the clearing price on those auctions was below what people were expecting heading into them. I think these developments together were, again, just putting a spotlight on an outlook for deficits and outlook for supply that suggested that term premia were just below where they needed to be to compensate investors for that rise in supply.

Beckworth: That all makes a lot of sense to me. The one question I have, Matt, is that breakevens haven't budged. In fact, they show inflation expectations well anchored, and yet bond traders are apparently a little concerned about the increase in supply and budget deficits. I guess the tension I see is, and this all makes sense, they see the uncertainty, the huge auctions, but it's not translated into higher inflation expectations. Am I missing something there or do those not necessarily track? In other words, if there's going to be big budget deficits going forward, why not see, also, a repricing of expected inflation in the future?

Raskin: I think part of that is an expectation that the Fed, with their policy and short-term interest rates in particular, would offset any inflationary impact that might come from those bigger budget deficits and from looser fiscal policy. But it still leaves investors needing to absorb more duration risk, more interest rate risk in their portfolios that might otherwise have been the case. In my view of the world, as compensation for bearing that additional duration or interest rate risk, they require a higher excess expected return or term premium.

Beckworth: That makes a lot of sense. The Fed is still credible, no threat of fiscal dominance, but there will be an extra fee compensation to manage the bigger supply.

Raskin: Yeah, and if I can just interject quickly, I think it's very much in line with the model in the paper that you mentioned at the outset, the paper with Joe, Brian, and Julie, which was a paper that was looking at the financial market effects of the Fed's large-scale asset purchases, but if you think about the theory, there are different channels through which those purchases can affect bond yields, but I think a big one is the supply channel, and what people often refer to as the portfolio balance channel, where by adjusting the amount of duration risk that is held by private investors, the Fed can actually reduce term premia. In other words, when it buys a bunch of longer-term Treasury securities and finances those purchases by issuing overnight liabilities in the form of bank reserves, it is drawing duration risk out of private portfolios and putting them onto the Fed's balance sheet. As a result of holding less duration or interest rate risk than it would have otherwise, it will accept a lower compensation in the form of lower term premia to bear that risk.

Beckworth: So, Matt, something else I love to follow [in the] Treasury market, and it's tied to what we've been talking about, and there have been a number of challenges in the Treasury market, as you know, both from your work at the Fed, also at Deutsche Bank, and there have been a number of calls to reform it or to make it more effective, everything from more central clearing, to fixing the Standing Repo Facility, to removing reserves from supplemental leverage ratio. I'm just wondering, what are your thoughts on how to improve the liquidity and stability of the Treasury market?

Improving the Liquidity and Stability of the Treasury Market

Raskin: This is obviously a big question for policymakers. We actually have the inter-agency working group, which is the Board, New York Fed, Treasury, SEC, and CFTC, holding their annual conference on the Treasury market this week. There are a number of initiatives that have been put in place or announced, all designed to increase the resilience of the Treasury market. I think a big one that's been in focus over the past year is a proposal that the SEC has to mandate central clearing of cash, Treasury securities, and Treasury repo. There's also a number of initiatives around increased transparency and data in the Treasury market.

Raskin: What I want to pick up on is, I think, implicit in your question, was the Standing Repo Facility and whether there are steps that need to be taken in order to improve that or make that more effective as a potential backstop. Maybe it helps to start by backing up and remembering why the Standing Repo Facility was put in place. I think a lot of it has to do with the blowout in repo market funding that we saw in September of 2019 and the Fed's interventions during that episode, as well as during the early parts of COVID, to do repo on a very large scale in order to provide liquidity to the markets.

Raskin: I think the Standing Repo Facility basically automates those operations. What it does is take what were discretionary operations to provide repo in a very large scale to the markets, and it turns that into a standing facility that does that on an automatic basis. I do think that should help to provide a backstop to markets and prevent another blowout of the sort that we saw in repo markets in September of 2019. I think the Fed… there's a lot of focus on the Standing Repo Facility in the context of the Fed's QT and its balance sheet runoff plans.

Raskin: And I do think the Fed— and we've heard this from policymakers— is comfortable seeing temporary usage of the Standing Repo Facility if they get to a place where reserves in the financial system, in the banking system, maybe get to too low a level, and the Standing Repo Facility would help to prevent that low level of reserves and pressures that it might create in the repo market from moving overnight interest rates outside of the Fed's target range. But I don't think the Fed is looking to use the Standing Repo Facility strategically as a way to run their balance sheet down much more aggressively than they otherwise would.

Raskin: I think more generally on that point, because we haven't had a chance to talk about it yet, I do think the Fed is going to be much more cautious in managing QT and the balance sheet reduction now than it was in 2019 partly because of the experience in 2019, and the pressures that we saw in repo markets in September of that year, and the fed funds rate moved outside of the Fed's target range. That was the first time that the Fed was reducing its balance sheet, doing so-called balance sheet normalization, and I think there was a desire, at that point, to get the balance sheet down to the very minimum levels that would be needed in the Fed's floor system. I think with the benefit of that in hindsight, the Fed's going to be more cautious in managing down the balance sheet this time. I don't think they have the same institutional inclination to explore the very minimum levels of reserves that are needed in the financial system. And I think you see this more conservative approach reflected in their guidance.

Raskin: If you look at the principles for balance sheet runoff that the Fed put out last spring, there are subtle changes in those principles relative to what was in place during the last round of balance sheet runoff, that are reflective of the Fed's increased caution in managing down the balance sheet this time. But to come back to the question of the SRF, I do think it's important that the SRF is in place, because it does mean that, if for whatever reason reserves in the banking system do temporarily get to too low of a level, you have the Standing Repo Facility there as a backstop that for, at least, a short period of time, that would help to prevent repo rates and other overnight rates from moving outside of the target range.

Beckworth: So Matt, another issue related to the Standing Repo Facility is the number of counterparties that are a part of it, and some worry it is not enough, but maybe it's also a function of the fact that it probably would be used more during a crisis than during normal times. Nonetheless, your former colleague, Lorie Logan, has recently suggested that the Fed incorporate central clearing into the Standing Repo Facility. Two questions: what would that mean, what would it look like? Then two, how would it improve the facility?

Incorporating Central Clearing Into the Standing Repo Facility

Raskin: The Standing Repo Facility counterparties are, one, the primary dealers who are the Fed's counterparties in all of its open market operations, and two, banks who have signed up for the SRF, so banks need to explicitly sign up for the Standing Repo Facility. It is an untested facility, but as I mentioned before, I think it automates the operations that the Fed did during 2019 and COVID, to provide repo funding on a very large scale. I think, though, one challenge around that relatively limited set of counterparties is it means that in order for the liquidity that the Fed provides through the SRF to make its way to other investors who don't have direct access, that funding needs to be intermediated by dealers. In other words, the dealers would need to borrow funds from the Fed, and then lend those funds on to their counterparties, who may be the counterparties that need the funding.

Raskin: Now, what that means for dealers is that it increases their leverage ratio, and if the leverage ratio is a binding constraint, or dealers are just worried about the implications of increasing their leverage ratio and the possibility that it could become a binding constraint, they may be less willing to use the Standing Repo Facility to on-led those funds to where they're needed in the financial system. I think what Lorie mentioned a few weeks back was the possibility that the SRF could be centrally cleared, and what that would mean is it would allow dealers who are receiving funding from the SRF to net that funding against the on-lending that they would do, and it would reduce the balance sheet implications of using the Standing Repo Facility, and make it a more effective facility for the Fed.

Beckworth: Well, that sounds very promising. Let's move on to the current interest rate environment, what's going to happen next. We've been on pause or on hold for a few meetings here, and there's all of this debate about another 25 basis points. I know you find that a little frustrating or very narrow because it creates a false sense of precision, or what is your issue with that focus on that 25 basis point hike?

The Current Interest Rate Environment: To Hike or Not to Hike?

Raskin: I think that's right. Most likely, the Fed is done hiking, but the data has been strong. We had a close to 5% GDP growth number for the third quarter. We've seen strength in retail sales. We saw the last CPI inflation report come out on the elevated side, and in particular, some of the stickier, more persistent components came in above expectations. If not for the tighter financial conditions that we've seen, related to that rise in longer-term interest rates that we were talking about before, it's quite likely the Fed would've hiked at their meeting a couple of weeks ago.

Raskin: Against that backdrop… although, as I said, I think they're most likely done hiking, it's not hard to imagine a scenario where we get some further upside inflation surprises and maybe an easing back in financial conditions, a reversal of some of the tightening that we've seen over recent months, which means the Fed needs to hike more. Now in that scenario, as you're suggesting, I do find this debate around whether they're done or have 25 basis points more to go, to be too narrow. If you think about the December FOMC meeting or Q1 of next year, that's a world where the Fed will have been on hold since July, it will have hiked once in the last seven months.

Raskin: And so I think it's quite likely that it will either look at that point like they've done enough, or possibly even too much in terms of monetary policy tightening, or that they've got a decent amount more to do. In other words, this notion that they'll decide after having been on hold for that long, that they've got more hiking to do, but it's exactly 25 basis points, that's enough to deliver to get the job done, it just seems overly fine-tuned to me. They have to stop hiking somewhere and at some point, so there's always a choice about whether to do that last 25 basis points or not. But, I think that’s different in an environment where the momentum has you hiking, and then you deliver that last one and stop, relative to a world where you've been on hold for a fairly long time, and decide you've got more to do. Again, that just seems like it's too narrow a debate, given what we'll likely be looking at come December, or the first quarter of next year.

Beckworth: So when you're thinking about these issues, what the Fed's going to do in the future, its rates, do you use Taylor rules or inertial Taylor rules, plot in their own SEP values, and see if we're going according to a certain framework or reaction function, do you find that useful or not?

Raskin: I do, actually. I find that to be quite a useful benchmark. In fact, I put out a piece on Friday that did that. It looked at the SEP projections for next year, so inflation, unemployment and the longer-run unemployment and fed funds rate, and put those through a Taylor ‘93 rule and a balanced approaches rule, which puts more weight on the unemployment rate gap. Those are two rules that the Fed includes in their monetary policy report. They consult those rules in their policy-setting process, but they certainly don't follow them mechanically.

Raskin: But if you plug the inflation and unemployment projections from the SEP into those rules, they would generally be calling for a much more aggressive pace of cuts next year than the Fed has in its own projections and more aggressive than the market is currently pricing now. I think one way to interpret that is that the Fed views the short-run level of R-star as being elevated, that maybe there are these headwinds to the economy related to residual household excess savings from the fiscal transfers during COVID, or other factors that mean that, over the near term, the neutral level of short-term interest rates is higher than it might otherwise be.

Raskin: That can maybe help to explain why the SEP projections for the funds rate next year are materially above what would be implied by those policy rules. As I said, they don't follow those rules mechanically, they certainly didn't follow them over 2021 and into 2022, and if you look historically, there have been periods where they've deviated quite materially from the prescriptions of those rules. But I do find that to be a helpful benchmark, at least, to begin to make sense of what we see both in terms of the Fed's projections and in market pricing.

Beckworth: Well, that's great to hear. We just had David Papell on from the University of Houston and he's real big on Taylor rules, and he has a paper he's been updating every quarter with the new SEPs, he and told a very similar story to what you just told about the rate cuts next year in the Taylor rule versus what the market and the Fed's doing. Alright, Matt, I have one thing left I want to cover with you. This is something very near and dear to my heart and that is the Fed's framework, or FAIT, flexible average inflation targeting framework. I'm sure this is important in your work at Deutsche Bank, because it has implications about the path of interest rates going forward.

Beckworth: But this past week, Chair Powell had a speech at the IMF and he talked about some of the issues he's dealt with during this inflation surge period. I'm just going to mention two, the speech is longer than this, but he mentioned, "In real-time, it's quite hard to distinguish the difference between inflation caused by supply shocks versus demand shocks." And this is important because he notes that the standard thinking is that you see through inflation caused by supply shocks. If a pandemic hits, there's global supply chain disturbances, inflation goes up, you don't want to tighten in response to that because you're adding salt to the wound, it's not going to help. But if it's inflation caused by excess demand, then you do want to step in and intervene. He said, "Look, in practice, that's very difficult to know the difference between the two."

Beckworth: He also went on to say something which was very interesting to me, that even with supply-side inflation, so even if you could distinguish the two, that view that you want to always look through supply-side inflation may not always be wise. This is something you would hear in an emerging market, because they would respond to supply-side inflation because of credibility concerns, and that was his point, is even if it is supply-side-driven inflation, you might find that if there's enough supply shocks, it could actually affect expectations. Then he concludes by saying that we're going to have a framework review, but I'm wondering what you think that all means for the framework review. Are they going to tweak FAIT, do something a little different, a more humble approach, what do you think's happening there?

Supply Shocks and Predictions for the Fed’s Next Framework Review

Raskin: Yes, let me start on the comments about supply shocks, and then come to the framework. I found Chair Powell's remarks unsurprising just given the environment. I think the Fed is still dealing with inflation that is meaningfully above their target. Supply-side developments were an important component in that, and there are also a number of geopolitical developments now that could potentially lead to sharp energy price increases. So, yes, the classic central bank playbook is to look through a supply shock as long as it's transitory. But again, in this environment, coming through period of such elevated inflation, it's trickier for the Fed to do. They're understandably focused on the risk that if headline inflation comes in high enough for long enough, that can spill over into core inflation, and more troublingly, into inflation expectations.

Raskin: We have a Fed that has been talking about the risks to over versus under-tightening as becoming more balanced over time, but I still believe, from a perspective of their risk preferences, they would prefer to over rather than under-tighten with the understanding that they can always ease back if they overdo it. But if they underdo it, they run this risk that inflation becomes more entrenched than inflation expectations become unanchored, and it makes, ultimately, their job of bringing inflation back to 2% much more difficult.

Raskin: I'm not surprised that in this environment, the chair is talking about how to respond to supply shocks in a way that looks different from the central bank playbook that we've become accustomed to over recent decades. Turning to the framework review, maybe to just start with a few reflections on the 2020 review, it was a big deal. They made some big changes to the framework in 2020. I think the backdrop for that, which we talked about earlier, was this notion that R-star, the neutral level of real short-term interest rates, had fallen over recent decades and that that raised the likelihood that the Fed would be hitting the effective lower bound.

Raskin: That created a context in which they judged that make-up strategies, things like average inflation targeting, could be beneficial, so that was obviously one big change they made. Another big change that has been less in focus was on the employment side of their mandate. They went from talking about addressing deviations in employment from maximum employment to focusing on shortfalls from maximum employment. What that meant is that it built in an asymmetry in the way the Fed would be responding to developments in the labor market on the employment side.

Raskin: In particular, if they thought that the unemployment rate was too low, they wouldn't respond to that by tightening, but if the unemployment rate got too high and above what they judged to be its natural level, they would respond by easing. I actually think we're in a world where that asymmetry that was embedded in the 2020 framework is gone at this point, because the Fed is now talking about, and I think understandably talking about in this environment, that labor market strength could be one potential reason that they might need to hike more. I think that makes sense in this environment just given the potential inflationary implications of a tight labor market, but I don't think it's in line with the framework that they rolled out in 2020. Coming more directly to your question in terms of what to expect for the next one, that review will kick off next year, it will come to completion in 2025. I think what happens depends a whole lot on what we see over the next year and a half.

Raskin: Are they back to 2% inflation and sustainably back to 2% inflation? Does it look like those challenges around the effective lower bound are not as pronounced as they once were? Maybe because people have reassessed what long-run neutral is, and in fact, long-run neutral might be higher than we have come to believe. I think in that world, if they judge that R-star is higher than they thought, and they have sufficient conviction around that, it's possible that they could take average inflation targeting out of the framework in 2025.

Raskin: Otherwise, I would expect only incremental change around the policy framework and strategy. I think they're likely to be maybe a bit more conservative this time given that I don't think AIT was necessarily the reason that we saw the big burst in inflation, but I think that maybe the implementation around that, they'll have judged what the benefit of hindsight could have been done differently. So I do think, maybe, they're going to be more conservative in terms of unveiling a wholesale revision to the framework than they were in 2020.

Raskin: The thing I get asked about a lot is on the inflation target, whether they will keep the 2% inflation target or make changes to that. My answer is always that they can't make any changes to that until they get back to it on a sustainable basis. It's possible that come 2025, if we're back at 2%, or very close to it and have been for some time, that they could… I could imagine them making some adjustments to the inflation target and, in particular, adopting maybe a target range centered on 2%. So something like a 50 basis point range from 1.75% to 2.25%, or maybe, and I have a little bit less conviction around this, even putting in place a target of 2 to 2.5%.

Raskin: And the reason for that, I think, is they spent a long time and, in fact, unveiled a new framework that was motivated by this persistent undershoot of their 2% inflation objective, but that undershoot was on the order of 30 basis points. And so with the experience of the last several years, that undershoot looks quaint. A framework that maybe puts less focus and has them less focused on responding to an undershoot of that magnitude, I think, could be something that we see in 2025. Again, I think it's entirely dependent on them having achieved that objective because, if not for that, they'd worry about the credibility effects of raising the inflation target, or even just changing the inflation target, in a world where they had not yet come back and hit it.

Beckworth: So we have to wait and see what happens to inflation, but this has been a very fascinating conversation, Matt. Thank you so much for coming on the program.

Mathew: Thanks so much for having me, David. I appreciate it.

About Macro Musings

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