Megan Greene and Eric Lonergan on Dual Interest Rates and the Prospects of Average Inflation Targeting

Megan Greene is a global economist and Senior Fellow at Harvard University School, and Eric Lonergan is an economist and macro fund manager at M&G Investments. Both Megan and Eric are returning guests of the show, and they re-join Macro Musings to discuss dual interest rates and the potential power it brings to central banks. Specifically, they discuss the current constraints on central banks’ toolkit, how the example of the ECB targeting TLTRO’s illustrates the potential of dual interest rates, why the concern over fiscal versus monetary policy is misunderstood, and whether the Fed’s new average inflation targeting mandate can be successfully implemented.

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: Megan and Eric, welcome back to the show.

Megan Greene: Thanks for having us.

Eric Lonergan: Thanks, David.

Beckworth: Yeah, it's great to get you both on. Now, Eric, you came on in early or April 2019. Megan I believe was March this year, so it's been a while since we've chatted. It's been six months or so since the pandemic has started, so how are you guys holding up?

Greene: I've just sprung myself out of the US and I'm sitting in London, so I'm doing better with a change of scenery, for sure.

Beckworth: Oh, okay. So you're both in London now?

Greene: That's right.

Lonergan: We even managed to have a socially distanced lunch over the weekend, so yeah. All is good.

Beckworth: Oh, fantastic. So you are both speaking to me from London, another testament to the wonders of the day and age we live in, where I can have conversations with people across the Atlantic. And I just did an interview with Robin Harding in Tokyo, which was great, other than the time differences. So it's fascinating to be able to talk with interesting people like you all across the world, and today we're going to talk about an article you have, it's titled “Dual Interest Rates Give Central Banks Limitless Firepower.”

Beckworth: I like that, because you're very optimistic about what central banks can still do. The premise of your piece is that the Fed and other central banks are not out of ammunition, and I love it because that really goes against the grain of much commentary, if not most commentary today. Everyone's kind of saying, "Hey, central banks have run out of ammunition," and I want to illustrate this with a piece that Greg Ip wrote from the Wall Street Journal back in March when this whole crisis was unfolding, and the title of his article is “A Misplaced Faith in the Power of Central Banks,” and I'll read the first few paragraphs.

Beckworth: It says, "Wall Street and President Trump have begged, admonished, and tweeted for the Federal Reserve to come to the economy's rescue. Tuesday morning, the Fed obliged. But their faith is likely to prove misplaced." And he goes on to say, look, we've reached the lower bound, the Fed can't do much more, it's time for fiscal policy to step in. The Fed is really on its last legs, so don't place your faith in the Fed.

Beckworth: But you guys say not so fast, right? You're pushing back against this, which is really, again, surprising, because most people who have come on the show, even, would take the other side of that position. So walk us through, why are we not at the end of the Fed and other central banks' ability to respond to the economy? You mention a number of tools they could still try, and ultimately dual interest rates, but maybe walk us through this. Why is there still more room left for central banks to respond?

Current Constraints on Central Banks' Toolkit

Greene: I would say, first of all, that fiscal policy would be great, so I'm in favor of that and would argue for that, but if it's not coming, largely because of political constraints, then I do think there is more a central bank can do.

Greene: You could do more QE, is one thing. Though now that I sit in academia, when I was in the private sector in asset management and everyone was in love with QE, they thought it had been fantastic, in academia, actually, it's widely viewed as a complete failure, and within parts of the Fed it's been viewed as either a failure or having had some fairly mixed results. So we could have more QE, but that's not necessarily a silver bullet.

Greene: We could follow in the steps of the Bank of Japan and engage in yield curve control, and up until the Fed changed its monetary policy strategy, it did seem like yield curve control was actually on the table. Investors were certainly hoping it was. One problem with yield curve control is it's really hard to stop once you start, so you're kind of stuck in forever, and we've seen that with the Bank of Japan. So that doesn't seem to be a silver bullet.

Greene: In the US in particular, we still have rates that are in positive territory, policy rates that are in positive territory, so that sets us apart from some other central banks. So in theory, we could just start cutting rates into negative territory, but there's this whole school of literature suggesting that that undermines the banking system. At a certain point, people just take their money out and stick it under the mattress, so you can only go so negative, so there's this effective lower bound beyond which you can't cut rates anymore, it actually becomes counterproductive. And the Fed has been pretty clear, they don't really want to do that. And that kind of leaves us with dual interest rates, which I'll tee up for Eric to explain.

Lonergan: Thanks, Megan. Okay, so I guess the genesis of the idea of dual interest rates, it really goes back three or four years, when the ECB announced sort of yet another program with a confusing acronym, in this occasion TLTROs, which most people on the planet don't know what they are, understandably, and not even that many economists understand what they are.

Lonergan: But effectively what these were, were funding programs but for banks. But what was innovative, in a sense, was that the funding program, it wasn't just about providing emergency liquidity, which has of course been a standard practice in terms of intervening in bank funding markets, i.e., lending to banks. But this was targeted lending, so it was actually trying to use funding of banks to provide a monetary stimulus sort of independent of the other tools of monetary policy.

Lonergan: And specifically what they did is they said, we're going to provide you with funding, I mean large scale funding, significant percentages of Eurozone GDP, contingent on you making net new loans, right? So they actually had a kind of balance sheet expansion criteria. And that is a big shift in policy, because suddenly, you move from viewing the funding side of your monetary tools as a kind of emergency liquidity to actually potentially being a source of stimulus.

Lonergan: Then, what struck me and Megan through time is they started to talk about the interest rate on this TLTRO, started to become a kind of independent discussion of the official interest rate, which is the interest rate on reserves, that's what American policy analysts would be familiar with.

Lonergan: And ultimately, at a certain point, it was striking. Well, why can't they just leave the interest rate on reserve unchanged, and just move to targeting this independent policy rate? And then all of a sudden you're freed from all of your issues and all of the problems of a lower bound and negative interest rates. And it's really as simple as that.

Lonergan: I actually think there's an element of accident in how this evolved, which is central banks have always had funding vehicles, so the Bank of England had a funding for lending, the Bank of Japan used one after Fukushima. So we've always had emergency liquidity. Somebody clever somewhere at one of these central banks thought, this could also be an independent stimulus, and then once it was out there we started to think, well, why not just keep cutting the interest rate on the funding scheme?

Greene: To be fair, when the TLTROs were first announced, they were widely viewed to be kind of emergency provision for the crap banks in Europe, so they were there for the banks that were really struggling, so they were this stimulus for them.

Greene: The point I think Eric’s just made that you can actually introduce a second interest rate. The TLTRO rate was the same as the deposit rate up until recently, actually. But they started specifying the TLTRO rate, and it made us realize, well, it doesn't actually have to be the same. So when a central bank cuts or hikes rates, they have to make allocation decisions about whether they're going to benefit savers or borrowers.

Greene: But if you actually have two rates, you can move them in different directions, and you can benefit both savers and borrowers at the same time. So that's a massive stimulus across the economy, and it gets rid of the effective lower bound, because you don't just have one rate that you're playing with. So you can go ahead and you can cut the TLTRO late, or the lending rate, really negative, so essentially the central bank is paying banks to borrow, as long as they pass the loans on to the end user, that's why it's targeted, and then the banks can go ahead and provide these loans also at negative rates if they want, so you create demand for those loans. Everybody's getting a bit of a stimulus in the process, and at the same time you don't have to penalize savers, because you can go ahead and hike that rate, you can hike the deposit rate. So you don't have to choose, in terms of allocation, you can actually benefit everyone.

If you actually have two rates, you can move them in different directions, and you can benefit both savers and borrowers at the same time. So that's a massive stimulus across the economy, and it gets rid of the effective lower bound, because you don't just have one rate that you're playing with.

Beckworth: So everyone's a winner with dual rates, which is an interesting point of this. Because as you mentioned, Megan, a lot of people do often point the finger at the central banks and say, "Oh, you're harming pensioners, you're harming savers." And I always push back against that by saying, "Hey, the neutral rates dropped. It's not really the central bank doing this, they're kind of following it down.” But what you're presenting is an even better response to that critique of low interest rates, that you still can respond to all segments of society.

Beckworth: And just to summarize what you said, you have a great line in your paper that says the ECB can target the rate at which banks can fund lending, or borrow from the ECB, independent of the rate at which the reserves are remunerated or deposited. So I want to unpack that in terms of the US. So let's say, for example, the Fed were to try this in the US, and maybe this will help some listeners, it definitely helped me think through what this is.

Beckworth: So in the case of the US, the lending rate would be to the discount window, right? The discount rate. Is that fair?

Greene: Yes.

Beckworth: So in the case of the United States, then, you would take the discount rate and lower it well below the interest on reserves. So right now, interest on reserves is .10%, so maybe you lower the discount rate to, say, -2, -3%. I'm just making numbers up here, but you would dramatically lower the discount rate. So banks could borrow at this incredible rate, but the conditions, as Eric said, is they'd have to lend into the real economy. But banks would still be able to find a place where they could earn something on their reserves and not be hurt by decreasing that interest margin. So is that a fair way to think of it in terms of the US?

Greene: Yeah, I think that's fair. It's very different from how things have been, right? The discount rate usually comes at a premium. So it would be rethinking that entirely. But that being said, in March, the Fed cut the discount rate more than it cut the Fed funds rate, to get rid of that premium. So in some ways, the Fed's sort of already taken a step toward setting up the plumbing for this.

Lonergan: Yeah, and just to clarify, because to be really clear about this, as Megan alluded to earlier, the European Central Bank, during this pandemic and crisis, they haven't reduced the IOR, right, they haven't tried to bring money market rates or the interest rate on reserves to a more negative level. They have only cut the TLTRO, right? So I think it is really important to be aware that that is effectively the channel, apart from the other programs that they're doing in terms of intervening in asset markets, but in terms of interest rates, they have elected not to continue to bring down the interest rate on reserves, but to bring the TLTRO, under certain conditions, to a lower level of interest.

Lonergan: The challenge obviously with the discount rate for the Fed would be what conditions do you attach in order to access this preferential funding, because the typical response otherwise would be, well, I can just borrow at the discount rate window and I hold reserves at the Fed and I just round tripping and it's just carried to banks. The European Central Bank has obviously thought that through very clearly, and so they've established quite rigorous conditionality.

Beckworth: Yeah, so banks wouldn't be allowed to arbitrage that difference, they would have to actually employ it in loans directed towards the real economy. So there would be conditions, but that is one of the critiques, I guess we could jump to that right now. I've seen some of the interactions on Twitter, some of the pushback is, "Well, this would quickly be arbitraged in the markets." And my response is, well, the Fed would say, "No, banks can't play this game." And then someone replied to me, "Well, what if someone else two or three levels downstream, what if they try to take the funds and arbitrage it. So how do you respond to that?

Responding to Critiques

Lonergan: First of all, I have to say, as somebody who works inside a financial institution, a regulated financial institution in Europe at the moment, I don't think, I think the culture's fundamentally changed now. I mean, most large financial institutions that would've accessed TLTROs live under the fear of their regulator. The idea that you would try to game the central bank who is your regulator, I mean, that is somebody on a mission to get into trouble, right?

Lonergan: Because the regulator in Europe has had teeth. I mean, the ECB and the European banking regulator is very, very tough. So that's the first point I would make, which is I don't think the banks are going to go out and try and game the system here. Now, there's absolutely no evidence that anyone is able to do it at the moment. The other thing that's worth bearing in mind is, of course, the quantity of reserves is determined by the central bank. No individual bank can determine how many reserves they hold. So it's often a bit of an illusion that reserves are created, and somehow I can take a loan and create reserves.

Lonergan: Well, you can't, because reserves are the function of what the private banking customers do, and it is the net result of it. So the distribution of reserves is not under the control of individual banks, it's the result of the activities in the private sector. Now, is it the case that, let's say the European Central Bank says, "Okay, we're going to provide a new round of TLTROs, and they have to be consistent with the commission's objectives that they go into sustainable energy." Is it the case that some projects that would've happened get financed? For sure. But then, the test I always put with any policy idea is, is it better or worse than your existing policy tools? The reality is, we have huge questions about the allocation of capital, and lots of challenge by just using low interest rate regimes that you might get a misallocation of capital.

Lonergan: So to me, the question here is do you want to provide stimulus, and do you have a reasonable sense that people aren't gaming the system at scale, and can you actually have a material economic impact? And on those measures, to me it's kind of unambiguously positive. At the margins, might you be substituting some kind of lending? For sure.

To me, the question here is do you want to provide stimulus, and do you have a reasonable sense that people aren't gaming the system at scale, and can you actually have a material economic impact?

Greene: Yeah, I think you get at a few other critiques that I hear about TLTROs. One is, "Well, you're just creating a misallocation of capital," so you're creating demands for loans that wouldn't otherwise exist, and sowing the seeds for the next crisis, and that might be the case. That's also the case with QE, arguably, and in the face of a deflationary spiral, those kinds of concerns tend to get moved to the back burner. So it's valid, but I think it depends on what you're facing. If you are facing a deflationary spiral, then you don't worry about that as much. So that's another critique.

Greene: I think there's another critique in terms of whether this is fiscal or monetary policy as well, because if you're providing a stimulus, should you really be doing that? Do central banks want to get into asset allocation? And the unequivocal answer is no, central banks don't want to get into asset allocation, but actually every decision a central bank makes affects asset allocation. Hiking or cutting a single rate, that affects asset allocation. So to some degree there's no way for the Fed or any other central bank to avoid this anyhow.

Greene: I would also say that the line between fiscal and monetary policy would be blurred with this, but it's already been blurred. I think we've already seen that central banks are acting more in the realm of fiscal-ish policy anyhow through this crisis, and I don't think that we're ever going back. So I think we're kind of there anyhow. And thirdly, I kind of say who cares whether it's technically fiscal or monetary policy. I mean, I think this is actually monetary policy, but if you want to say it's fiscal policy, that's okay. I mean, the Fed and other central banks are political actors, even if they're meant to be independent.

Beckworth: Yeah, well I want to come back to that question in just a minute, but one more critique that you mention in your paper, the two of you, is that some worry this might harm the balance sheets of a central bank. They might get negative equity, for example. And you guys try to explain and respond to that, but my first response is, "So what? That's what you want in a deflationary crisis," right? If the central bank takes the loss, that means it can't pull the reserves back in, it doesn't have the assets to do it, and that's exactly what generates spending, inflation.

Beckworth: Now, you want to do it in a controlled fashion, you don't want to just kind of willy-nilly and recklessly do this, but taking some kind of loss is actually the point of creating some inflation and demand for the economy, but do you want to speak to that critique?

Lonergan: I mean, I think that's a great point you're making and I couldn't agree more. I just want to make two points on this as well. I think when one thinks about the pros and cons of a policy innovation like this, you have to benchmark it against your existing policies. Right, so the hurdle here is not perfection. The hurdle here is, is this better or worse than our existing tools, more or less effective? So, for example, when people worry, I mean, as Megan alluded to, the whole issue of zombie companies or misallocations of capital because interest rates are too low, I would say it’s much better to target lending, right?

Lonergan: Keynes made the point, one of the reason Keynes said you should never raise interest rates to stop a bubble, he said is if you raise interest rates, the only investment spending that will happen is the one in the bubble sector, right? Because when you're in a bubble you think your returns are astonishing, so you don't care about the cost of capital, right? And so you can have very perverse effects. I would much rather you say, "Actually, we're going to cut interest rates now," but the funding, which is of a fixed amount, can only go, say, into fixed asset investment, right? You could exclude, so for example, the ECB excludes housing from TLTROs, which is very interesting. So arguably, TLTROs are a better way of using negative interest rates to prevent the kind of distortions in the allocation of capital or even asset price bubbles like in housing, because you can target them.

Arguably, TLTROs are a better way of using negative interest rates to prevent the kind of distortions in the allocation of capital or even asset price bubbles like in housing, because you can target them.

Lonergan: So I think that's an important point to bear in mind. Now, to the balance sheet point, you are absolutely right, and the way you put it I thought was very astute, which is you said you worry that you don't have enough assets to take back the reserves. The number of people who miss this fundamental point, because what you've described is, we can take two approaches to this. We can try and go through tortuous calculation, what is the capital and equity of the central bank? And I tell you, you and I can come up with whatever number we want, I mean that is a philosophical question. There's no accounting standards, because there's only one institution that can create reserves out of thin air, right?

Lonergan: So that's actually virtually meaningless to me in accounting terms. The simple question is, can I ever have too many reserves as a central bank? So in other words, can I ever create reserves that put me, then, out of control? So I've injected reserves into the system, and now I've lost control of monetary policy. And the first point to make here is that problem exists with all policies that we are currently operating with, right? So that problem exists with QE. In fact, it should be the result of successful QE. Because if QE is successful, the price of all of those bonds availed should fall, because in a sense, they've caused a stimulus by driving the price of them up and the yield down, so when the recovery happens, the yield should rise and the prices should fall.

Lonergan: So central banks are supposed to make a contingent loss of scale on their asset purchases. That, in effect, means, as you rightly point, the mark to market is very important, because they can't then reverse it. Let's say they then discover, "This has been too successful." Oh, but unfortunately, the price of all my assets has fallen, so I can't shrink the reserves by just selling ... So I've got exactly the same problem. But I've also got the same problem with an IOR, plain and simple, right?

Lonergan: So let's say I bought all these assets, and for sake of argument, ignore what happens to the asset price, but I've just got a problem. If I start raising IOR… the Fed funds rate, heaven forbid, in two years time was 4%, I've got negative net interest income, massive negative net interest income, because I created a huge amount of reserves. So the reality is, if you're worried about central banks' balances, you're worried about equity, if you're worried about negative net interest income, you should be really worried already and you should be stopping all of those programs, okay? That's definitely not a problem associated uniquely with dual interest rates.

Lonergan: But the final point, to me, and this is what's really interesting, and we haven't spoken about this yet, is I think tiered reserves are another fascinating and important innovation, because what they reveal to me is that you can always shrink the stock of reserves, because you don't need assets, right? So the point here is, you set an independent interest rate on required reserves, and excess reserves. Now, as soon as I have that as a tool, what I could do as a central bank in the future is I could say, "Okay, excess reserves determine money market rate," so I start raising them. But I could go into reverse on the required reserves. So if I want to shrink the stock of reserves, I'll just raise the required reserve limit and charge a negative interest rate on it, and they'll shrink.

Lonergan: The banking system, of course, will start to go backwards, because that will damage banking sector profitability very substantially, that will raise the cost of loans, cut the interest rate on deposits, and the system goes into reverse. So I personally think one needs to think about the future of central banking with these two new innovations, which is that you have targeted lending, and you have tiered reserves. And then, the issue of equity is spurious, because all that matters here is can I keep cutting the rates on funding, and can I shrink reserves if I have too many?

I personally think one needs to think about the future of central banking with these two new innovations, which is that you have targeted lending, and you have tiered reserves.

Lonergan: Apologies, I went on a bit long there, but you raised it very, very well, because you posed the problem in terms of the Fed running out of control of reserves, and I think that's a much more fruitful discussion than getting bogged down in calculations about how much capital central banks have.

Greene: This point on tiered reserves is really important as well, I think because central banks seem to be going in the opposite direction. So the Bank of England doesn't have required reserves and excess reserves, they just have reserves. And I am constantly asked, "Why does the Fed even have excess reserves? Why is it IOER? That doesn't make any sense, why wouldn't it just be IOR all the time?" So the trend seems to be in the opposite direction, but actually that would be wrong, because you'd be eliminating this useful tool.

Beckworth: This is great because I'm someone who's been a fan of corridor operation systems, the Fed has a floor, and that's kind of a popular thing now. But a tiered system is kind of a hybrid between the two, it's kind of a middle ground, and I hope we go in that direction for many of the reasons why I like a corridor system.

Beckworth: Let me go back one more time to this idea about protecting a central bank's balance sheet, because I do find it ironic, and I want to very clear to all our listeners, again, I'm not saying I'm going to go out and blow big holes in a balance sheet. This should be done in a controlled, thoughtful process for sure. But it does strike me that many central bankers sometimes care more about their balance sheet than their objective of stabilizing inflation and aggregate demand.

Beckworth: Where this really became clear to me was the Swiss National Bank, when they were pegging their currency to the Euro, they finally quit for one reason, they were afraid of losses on their balance sheet. And I was like, "Well, that's the whole point," right? That is the whole point. And I know they actually have shareholders and they've got to be concerned about some issues the Fed doesn't, but if you're so worried about your balance sheet, I think you're losing focus of what your first objective is. Again, I'm not suggesting we are reckless with the balance sheet, but we need to have a list of priorities in front of us starting with price stability, the dual mandate, stabilizing demand, and it just strikes me that sometimes central bankers get their priorities backwards.

Lonergan: The other thing I would just say here that I think is important is, and I have to do a bit of accounting in my day job, the problem is that you cannot apply conventional commercial bank accounting to a central bank. The way I look at it, it's worth reading Warren Buffett on this, when Warren Buffett, for example, talks about insurance companies, he analyzes their float. This has been a big source of his wealth generation, and he says is float really a liability or not? Because it keeps growing and it never gets called upon, right? So, in insurance terms.

Lonergan: Now, the point is if I could find the business that could literally, physically print dollars legally, what would its market cap be? I mean, how do you do a present value of that business, right? So the accounting is just, frankly, silly, right? It's just silly. We shouldn't even try to go there. They can always honor their liabilities in dollars. The only thing that matters is can they lose control of inflation or not?

Greene: Yeah, and central banks have run in the red before, the Czech National Central Bank, it's been in the red. So-called underwater central banks aren't like normal banks, so it's fine, it doesn't matter.

Beckworth: Okay, so we've gone through a number of criticisms and concerns about dual rates, one last one and we'll move on, and that is some folks say, "Well, you're just creating the supply of funding for new loans, but there's got to be demand for it." You're kind of pushing without the corresponding increase in demand, there needs to be demand and then demand and needs to move first, so how would you respond to that concern?

Greene: Well, I think you can create demand if you're offering loans at negative rates to users, and then they'd be getting paid to borrow, that could generate some demand. Do you end up making some loans that probably aren't great loans and maybe wouldn't have otherwise happened? Absolutely. So that's the misallocation of capital issue. But this, for decades economists have been saying central banks can only deal with supply issues, they can't really deal with demand issues. This is a way to deal with a demand issue.

Lonergan: Yeah, I also think, and this might happen with the ECB, I think it's probably trickier in the US context. But I would not be surprised if, and I think this is quite a clever approach, if the ECB were to link future TLTROs actually to a reduction in interest charges on existing loans. So far what they've done is they've said, you can have this, we're going to give you a negative interest rate on your funding, as long as we see evidence that you've made net new lending, so we can be convinced that you've created a stimulus, a monetary stimulus.

Lonergan: But what you could do is you could say, okay, let's say, we want your loan book, the average interest rate on your loan book to come down by 50 basis points, then you can access, or some formula. So in other words you could actually link it to a repricing of the existing loan book.

Beckworth: Yeah, that's a great suggestion. And Megan, going back to your point, I completely agree. The simple way I would summarize it is everyone has a price. At some point, you lower their interest rate enough, you said you pay people to take the loans out. At some point, if, for me, in the real world, it means the bank is going to pay me to take out a loan to get a new dishwasher, to remodel part of my house, I'll do it if they're going to pay me to do it, so you've just got to keep lowering that price until behavior responds.

Beckworth: And along those lines, you guys give specific recommendations for the ECB. You outline that right now, banks can fund lending at -1%, and reserves pay close to zero, but you say go all the way down to -4 if I read that correctly, is that right?

Lonergan: Yeah, that was based on some econometrics that Megan did I think, right?

Beckworth: Okay, Megan?

Lonergan: No, no I’m kidding.

Greene: It was just by way of example. I mean, the point being, lower it really significantly, the ECB has set up the infrastructure to do this. They've actually implemented it, but in a really timid way, and I think our point was you could do this in a much bolder way. And if you're looking at the Eurozone, which is experiencing deflation, you've got moves in the currency that means that the Eurozone's importing deflationary pressures now, this is one way to reverse that in a bolder way, so if you cut the TLTRO rate to -4% for example, but several hundred basis points more than the already do, then the effect would be even larger.

Greene: I will say, at Christine Lagarde's last press conference, she did say the take up of this TLTRO was significant and widespread and she thought that it had a major effect. So I think that there's some proof that this is working, but they should do it in a much bolder way.

Lonergan: And just to add to that, maybe, David. I look, again, in my kind of day job, if I look at say infrastructure, there's a huge amount of demand now from the investment community, which, given pension funds, given demography, of acquiring long-dated assets. If you look at something like our energy infrastructure, particularly say in Europe where a lot of end prices are regulated, so effectively regulators are determining how much the rate of return is. The real point we wanted to convey here is the private sector is typically, still in Europe, funding itself at a positive rate, it depends on their credit quality, but at a positive rate.

Lonergan: If you wanted to supercharge sustainable energy investment, if you made like five year, -4% interest rate loans available, if they cooperate with, in the European case, there is potentially more of a structure for cooperation where the guidelines of these loans could be specified by the commission, i.e. that they have to be, say, in certain, say green energy. I mean, if you said wind energy or other types of sustainable energy, where you can get a return of four or 5%. I mean, you would supercharge investment there if you suddenly made funding available at -4.

Lonergan: And it just reveals, you just suddenly realize that there's absolutely no limit here. I mean, so like, the only question is do you want to do it or not? Like, you can't say, "I can't hit my inflation target" because you clearly can. I mean, -10? And the other point that's really important in a European context, to this point about the depositors and the different interest groups, the other thing that's interesting here is one of the German constitutional court's objections to policies like QE and negative interest rates is precisely that it's placing this burden on depositors, so they are viewing them as creating a form of political tension or making decisions that are adverse. And there's been no objection, legal objections to TLTROs in the context of the Eurozone, which again is very interesting when we come out of the debate on fiscal versus monetary.

Beckworth: Okay, so it's a win-win, as you mentioned earlier, you've just been explaining, that savers benefit from this, depositors benefit from it. Everyone, borrowers and lenders, they all come out winners under this approach, so you'd think there'd be some political support for this. So how's this idea been received? You guys have both been on the case for some time now promoting this, and your most recent piece at Fox EU, so what's been the reception that you've seen from market participants to central bankers?

Greene: So the ECB's already doing it, so they’re fans. I would say the Bank of England is already doing it to some degree as well, or has done it, with its term funding scheme. If you talk to the Fed about it, they think it's an intriguing idea, but sort of give you the sense that it would be an intriguing idea if we were staring into the nuclear abyss or something, as an absolute last possible option to pull out, rather than thinking about using it a bit more proactively. And to be fair, we view the threat of deflation as a little bit less in the US than it is in Europe, our rates are a little bit higher, so maybe that's why they feel they've got more room.

Beckworth: So I guess my question, Megan, would be, though, is the ECB open to your suggestion of going even farther down with the rates? So you mention -4 as just an example, but are they open to the possibility going maybe -2, -3?

Greene: So I don't think that they're there yet, and that's why we've seen it implemented it in such a timid way. But they know the tools are there, certainly. They know that they've set this up.

Beckworth: Eric, have you heard anything from market participants, what they think about the idea?

Lonergan: The thing I'm most struck by is, and I'd be very interested to get your thoughts on it David, but my sense is there's a surprising lack of awareness. And I don't know quite whether this is by intention or not, but this was really a profound shift that the ECB has made this year. By setting the TLTRO below the interest rate on reserves, that is crossing a Rubicon. And, to be honest, I didn't expect them to do that, certainly not this quickly. But as Megan said, it was surprisingly, people just didn't realize it, because TLTROs are confusing. And so my main observation is that people are still getting their heads around it, that actually it's a very poorly understood innovation, although it's already happened.

Lonergan: And the reason I can tell that is there are certain obvious questions that the media should be posing, which is, first of all, why don't you just cut this rate a hell of a lot more? Because clearly you're not hitting your inflation target, and in Europe it's a mandate by law, that it is the mandate of the ECB. It's got a legal requirement to hit its inflation target, and it's failing. We're in a pandemic, we need much more stimulus, everybody would kind of agree that we need contingent stimulus, what aren't you discussing it openly? Why aren't economists doing calculations and working out what's the r* on a TLTRO? Why hasn't somebody gone away and modeled it, right? And then the whole debate would change, and I don't really understand why those conversations aren't happening.

Lonergan: So initially, you know the way economists work, but mostly they kind of go, "I haven't really thought about that," "Oh, that's just fiscal policy," or kind of that's a subsidy to the banks, they're going to arbitrage it. So you've had all the kind of initial instinctive and then people go away and think about it and I think suddenly sort of go, "Hang on a minute, actually, this is a big of a game-changer."

Lonergan: So that's my sense so far, and we'll see. I mean, I think were things to worsen, in the case of Europe ... Oh, one very important point I should know, and I know this because I have private conversations with them, but I have a lot of contact in Europe with German economists, and they're good friends of mine and they usually say, "Eric, whenever you start talking we kind of agree with the first 30%, and then we get a bit confused in the middle, and by the time you've finished we're like, "No way." And they said-

Greene: I feel the same way, Eric, for what it's worth.

Lonergan: Megan knows where they're coming from, right? On this occasion, I had two German economists that said, "We listened to everything you said and we were kind of still nodding in agreement." Well, because it doesn't affect savers, right? Megan and I are actually recommending that you boost savers' depositors income. So what's really intriguing to me here is that the political economy of it is actually very different.

Greene: I would highlight, though, I mean, Eric, you mention that it's a little bit opaque and nobody quite understands it, that's kind of convenient as well though, because if you look under the hood a little bit, this is a subsidy to banks, and banks were widely viewed to have caused the whole last crisis and mess, and so if Joe Six-Pack got a whiff that we were providing a subsidy to banks, even if it was being passed on to the end user in loans because it's targeted, that would be pretty unpopular. So I also think it's a shame that nobody seems to have realized this is going on, but it's also somewhat convenient politically, it allows central banks to go ahead and do this.

Beckworth: Yeah. Well, you guys are the champions of it, right? You're the two fighting the good fight and promoting this, and I honestly wouldn't have thought of this had I not spoken to the two of you. Although I will mention one previous guest on the show came on, and we talked, and after the show is recorded we started doing some more discussion and he actually came up with the same idea. He didn't realize it was being implemented in Europe, but he said, "Look, David, why don't we just lower the discount rate below the reserve rate, that way you don't deal with all these concerns from savers and pensioners?"

Beckworth: And he kind of saw the logic, he kind of stumbled on it, I was like, "Let me tell you about two people I know, Megan and Eric, they've been making the case for this for some time. In fact, they call it rocket money fuel, I mean, they say it's really a powerful tool." I guess, Megan, part of it then is just how you sell it and market it, right? You want to do it in a delicate but informative way, and correct me if I'm wrong, I mean, you guys are saying, "Look, this is something you use in emergencies," right? This is something you use in a deep recession, this is not something you would use all the time, or am I wrong on that?

Lonergan: I have mixed views on that because I think there is a much more profound debate happening about monetary policy. And I think, and if anything that, in the pandemic, that's become even clearer, which is, a single interest rate is a very, very blunt tool, and it creates all of the problems that we're aware of, which is both primarily asset price distortions, or at least runs the material risk of those, and there is a huge concern in Europe about housing markets again. I mean, if you look in Scandinavia where they have negative interest rates, they have very, very, very elevated multiples of household income on the housing market, which is certainly a major concern of financial stability.

A single interest rate is a very, very blunt tool, and it creates all of the problems that we're aware of, which is both primarily asset price distortions.

Lonergan: So I think there has been a reassessment about is it really optimal for monetary policy to have a single interest rate as the dominant lever with which you're trying to control macroeconomic demand, and could you be more astute about how you target the stimulus? And I think that's a very legitimate question. It obviously poses problems, as Megan alluded to. So how does the ECB direct lending into the sustainable energy sector, and is it its role?

Lonergan: Now, I think you can set up smart institutional arrangements whereby you can do that. Whether it's analogous to the Fed going to the Treasury and saying, "Our balance sheet's at risk, do you give us approval to do this?" Whether it's like the Bank of England did something similar, it did a funding for lending scheme into housing during the financial crisis. And I think Europe has still got ... The important point as a macroeconomist about independent central banks, I want them to control quantity and price. That is sacrosanct. The central bank must be the authority on how much money is produced and that is enshrined in constitutional law in Europe, which exceeds the power of any individual sovereign. That is incredibly difficult to change. But it is actually also under the ECB's mandate, subject to price stability and independence, and not funding governments, it tries to operate in a way that's consistent with Euro area macro policy.

Lonergan: So I think there is a potential for some inter-institutional cooperation in how you might direct these kind of, the funding stimulus.

Greene: Yeah, I would say if you asked me to come up with a perfect system, would I lead with dual interest rates? I probably wouldn't, actually, I would probably leave more in the hand of fiscal authorities who are elected specifically to make decisions about asset allocation. So I wouldn't say that this is the first best solution, I just think it's the first best solution on the planet we actually live on, where you're already seeing political pushback on additional fiscal measures. I mean, the US is the posterchild for this right now, but the UK's facing it as well. So I would say, it's not necessarily just in an emergency, but I do think if you're facing a deflationary threat, that's the time to bring it out, and it's not the best solution, but it's the best one given the world we live in.

Beckworth: Yeah, and I encourage our listeners out there who do modeling, who write serious papers about these issues, to take up Eric's challenge to come up with an r* for TLTROs, an r* for discount rates, multiple r*s, I guess in a dual interest rate system. So maybe we need to come up with a Greene-Lonergan Taylor Rule of some kind, how do you set each of the rates conditioned on some state of the economy? So I mean, part of what you've got to do is market it, right? So John Taylor did a great job marketing the Taylor Rule and the whole interest rate control idea. I mean, it was already in the literature, but you need your rule to come out and show us how it works.

Beckworth: But this is a lot of fun, and I do really encourage our listeners to read your paper. We'll provide a link to it on the webpage. I want to move slowly from that topic into another one which we touched on earlier, and that is this fine line between monetary policy and fiscal policy. We've really been going back on it through a number of our comments, but Megan, you said earlier, "What's the big deal?" Don't act like this is some true law of nature, it's a bit of a fiction, is that right? That this like we've drawn between central banking and fiscal policy?

On the Fiscal vs. Monetary Distinction

Greene: Yeah, I think that's right. And again, maybe in a perfect world, you might try to delineate them very specifically, but in reality central banks are constantly figuring out who they're going to benefit and who they're not. So in some ways they're already political actors, every decision they make is political in some way. And so they haven't been elected to make those decisions, that's fair. But I think fiscal and monetary policy has already become so incredibly blurred, and even more so in the past six months, that I don't think that should be our primary concern.

Lonergan: I'm probably a bit more pedantic than Megan. Megan is absolutely right to me in the sense that when people talk about fiscal, what they often mean is distribution, right, is better distributional consequences. And I think the reality is, really until the financial crisis, a huge amount of thought wasn't given to the distributional consequences of monetary policy, and then you have the whole issue of whether QE was contributing to inequality, and then in the European context, because they're kind of geographically distributed, they're even distributed in different countries, you have cognizance that monetary policy can put savers and borrowers in conflict.

Lonergan: But here's the thing, I think there's a really interesting area, a kind of methodological point about economics, the more I've looked at this area, is that we actually, a lot of the key terms in economics are unscientific, in the sense that they're not properly defined. In other words, we just don't define what the kind of necessary and sufficient conditions are for what constitutes fiscal and what constitutes monetary, and this is actually true of an awful lot of terms in economics. It's very interesting, they're poorly specified.

Lonergan: And we kind of leave it to intuition. I mean, I actually described a lot of what the ECB was doing to Ben Bernanke and he said, "Oh, but that's fiscal." And I said, "Ben, you have to be a bit careful, because you call it fiscal, you realize that if it's fiscal, that makes it illegal in Europe." But then I took each of his point, I said, "Why is it fiscal?" And it was really interesting, because every point he raised, I said, "But that's true when you change an IOR or when you do this with interest rates or when you do QE." And so what you actually realize, if we're honest, is none of us have given a lot of thought to what the definitions of fiscal and monetary are, and I personally think you can define them relatively clearly, particularly monetary policy, because monetary policy to me is about the creation of base money and the price of base money. So that's a theoretical definition, so that's one type of definition. You can have a legal definition and you can have an institutional definition, so you can look at precedent and just say, "Well, what did the monetary authority do in the past? Let's call that monetary. What did the fiscal authority do in the past? Let's call that fiscal."

Lonergan: Or you can go to the lawyers, and you can argue in court over what's monetary and fiscal. I have to say, on those criteria, I think this policy is much more clearly monetary, and more so than many other policies. I mean, I think QE is definitely borderline breaching the law in Europe, which is why the German constitutional court is all over it, because there are points in time where, in effect, you could be eligible for QE, but you've lost market access, and that seems to me effectively to mean the central bank's financing you, which is illegal. I think it's debatable, the institutional point you can ... So I think this is much more about the fact that economics actually is very poorly specified in terms of a lot of the key terms that we use, which is part of the reason why these problems arise.

Beckworth: Okay. So let me concede points to both of you there. We haven't defined our terms very well, Eric. Megan, maybe this is a fiction, but maybe it's a useful fiction. So let me put it this way, maybe it's been productive to create this separation so that we can have price stability. The whole famous Fed accord of 1951, for example, where the Fed eventually said, "No, we're not going to keep supporting the interest rate peg." Can we do that without this separation? Whether it's a fiction or not, can we do that? Can we have fiscal policy, for example, taking a more dominant role in macroeconomic stabilization and still preserve price stability, macroeconomic stability in the long run? Because I think the argument has been, once you do give more and more responsibilities to fiscal policy it becomes tempting and hard to control, so how would you respond to that?

Greene: So yes, we can definitely have fiscal policy play a bigger role in macroeconomic stabilization. I mean, economists have known that for a long time. It's just when politics comes into it that it's a problem. So that is the first best solution, I think, to a lot of this. But given that it's not really happening and hasn't been happening in the way it should since before the last crisis, then I think policymakers need to look for other tools.

Beckworth: Okay. Eric, did you want to add something?

Lonergan: Yeah, I totally agree with what Megan said on this. And I would reiterate, to be clear, that I'm all in favor of good fiscal policy, that's a sort of truism, and I'm not an either/or policy advisor in that sense. My view is you should do the best fiscal policy and you should do the best monetary policy, and I think we need both at the moment. To your point, though, David, I think this is incredibly important, and I think it's an area which actually, the MMT debate actually hangs on this distinction, to me. Which is, I think there's a very good reason why we have monetary and why we have fiscal policy, and the distinction hangs on the creation of base money. And the truth of the matter is, you do not have any market discipline in the creation of base money, right? So the institution that can create base money has no market discipline. It doesn't have to sell base money into the market.

Lonergan: The fiscal authority issuing bonds, or the bond financing part of the state faces a market constraint, right? That market can close, or the market sets the price. Now, the point is the constraint on the creation of reserves is inflation, and for exactly that reason, it's not a market constraint. And inflation doesn't have to be a constraint; we've had hyperinflation, right? So you can hyperinflate, and then you destroy your monetary system.

Lonergan: That is exactly why we've created independent central banks. I mean, people seem to forget this stuff, right? And that does not mean they're not democratic, of course they are, that just means they're a kind of higher order form of democratic institution, in the same way that the legal system's supposed to be independent. So they're constitutionally protected, and they're protected by a higher order form of legislation. But there is an extremely good reason why there's monetary policy and there's fiscal policy, and it actually hangs on, do we want to have a market feedback that says to politicians who take control of our treasuries, outside of emergencies, national emergencies, but in normal times, "Sorry, you're actually being irresponsible now, so yields are rising." And do we want to have a different set of constraints, which is namely an inflation target, on the central bank?

There is an extremely good reason why there's monetary policy and there's fiscal policy, and it actually hangs on, do we want to have a market feedback.

Lonergan: And that is very, very clearly set out institutional structure in Europe, and I think that's something that one has to be really, really careful about challenging.

Beckworth: Okay, well speaking of inflation, let me use that as a segue into something I've been thinking a lot about, I'm sure you have as well, and that is the Fed's new average inflation target. So I was thrilled to hear the announcement, people like us get excited about these technical changes. That's something I've been kind of championing in my own work for a long time is make up policy, and this is one manifestation of it. It didn't go as far as I would like it, but I see it as a step in the right direction, I take a glass is half full approach to it. But Megan, I want to start with you, what are your thoughts on average inflation targeting? Do you see it as being credible, as working, as maybe even getting better over time, what are your thoughts?

Prospects of Averaging Inflation Targeting

Greene: Yeah, so I think it faces a lot of challenges. We're all excited about it, but it won't change policy any time soon, right? Rates are going to be really low for the foreseeable future. But there is a credibility challenge, as you point out. Since the Fed adopted a 2% inflation target in 2012, average inflation has been just under 1.5%. So the idea that the Fed is going to overshoot in order to make up for undershooting for so long, it's a nice one, but it's not clear that the Fed can, short of implementing things like dual interest rates, in which case it absolutely can generate inflation. But short of doing something like that, it's not clear that inflation's going anywhere significantly above 2% for any period of time. So I think that's a challenge.

Since the Fed adopted a 2% inflation target in 2012, average inflation has been just under 1.5%. So the idea that the Fed is going to overshoot in order to make up for undershooting for so long, it's a nice one, but it's not clear that the Fed can, short of implementing things like dual interest rates.

Greene: I also think there's a communication challenge, so just an inflation target is complicated enough, I think Joe Six-Pack doesn't really have much sense of what that means. If you ask people what inflation is, generally they're nowhere close to what it actually is. Inflation's a really personal experience depending on what you buy, so that's fair enough, but that's already complicated enough. Now coming up with an average inflation target, I mean, just try to explain that. That's going to be really hard, and also average over what period? We don't know yet, and it seems like the Fed is committed to not working it out for a while, to give themselves quite a lot of flexibility, but is it over a business cycle? How do you explain what a business cycle is to people? I think there's just a massive communication challenge, off the back of a process that really championed communication with the man on the street, right? The whole Fed Listens initiative was to try to get input and try to communicate with regular people.

Greene: Ironically, off the back of this, they've changed their monetary policy strategy so that no one who attends Fed Listens events, other than us, would understand what the heck this actually means. So I think that's a challenge too, but the more crucial one I think is the credibility issue, and I'm just not convinced that we're going to get inflation significantly above 2% any time, for any extended period of time, to offset all the undershooting we've done.

Beckworth: Well, Megan, it's interesting you mention the listening tours. I was at one, at the board of governors, the Eccles Building, and one of the questions that came up was how do you sell that we want to raise the inflation rate temporarily to the public, to Joe Six-Pack? Or how do you say, "Hey, I'm from the Fed and I'm here to raise your inflation rate." How do you communicate that? And of course, that's one reason I'm a fan of nominal GDP targeting. You don't say that, you say, "I'm here to raise your income or sales," but yeah, I think that's a real issue. That's going to be hard to get that past Joe Six-Pack, but also politicians, right? How do you tell politicians, "We want to have higher inflation the next six months to a year?"

Beckworth: That just seems like a losing battle, so it'd be interesting to see how this unfolds. Eric, I want to switch to you on average inflation targeting. One of the things that Megan brought up is it's not well-defined. And to the extent it does work, let's say Jay Powell does get it together and does prove Megan and myself wrong, he does raise inflation, so it works out great. There's still an issue that this is not defined well, so if someone else comes along, they could do it differently, right? And it seems to me you need some clarity on those parameters on average inflation targeting for it to really work well, in addition to the credibility concern.

Lonergan: Well, I think that’s a great point and I agree with everything Megan has said. And you know, I want to be positive, so they're trying to do something helpful, and broadly it's a good idea. But there are some challenges, and one of the things that makes me nervous is that one thing I like about having, in a sense, a live target, which is actually calculated by another institution, which is the inflation rate, is that you can have some degree of confidence, if you are a member of the public, that the Fed can't game its objective. So it's all kind of hands up, now, we're all missing our inflation targets, and that's not really subject of dispute.

Lonergan: If you start calculating an average, and we know, the three of us know enough about economics and statistics that you can then start arguing, well, how do you calculate your average, as Megan alluded to, what time period do you use, to what formulas do you use, which inflation rate do you use, and you can get all sorts of possibilities, even though I have complete confidence in the technical side of the Fed's activities that they would never game it, you just become open to that kind of criticism, which is harder to do, currently.

Lonergan: So I think, yeah, there's some ... It's well-intentioned. I think broadly, having broader inflation targets or averages makes sense, but I totally agree with all of the points you guys have been making.

Beckworth: Okay, well with that, our time is up. Our guests today have been Megan Greene and Eric Lonergan. We encourage you to check out their article, it's titled “Dual Interest Rates Give Central Banks Limitless Firepower.” Thank you, Megan and Eric, for coming back on the show.

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