Megan Greene is a senior fellow at Harvard University’s Kennedy School and a senior fellow in international economics at Chatham House. Formerly, Megan was a chief economist on Wall Street and she currently has a bi-weekly column in the Financial Times on global macroeconomics. She joins the show today to talk about the coronavirus and the appropriate policy response to it as well as the future countercyclical macro policy in the United States. David and Megan also discuss the Fed’s future framework, arguments against the recent 50 basis point rate cut, and why the Fed should consider following the ECB’s lead on TLTROs as well as negative interest rates.DISCLAIMER: This is a special episode on the economics of the coronavirus with Megan Greene that originally aired on Wednesday, March 11. We plan to run several more shows on the coronavirus over the next few weeks. Wednesday’s show with Megan was recorded late last week, and consequently some of the market data discussed is already dated. However, the core arguments and points are still very timely and important.
David Beckworth: Welcome to Macro Musings, the podcast series where each week we pull back the curtain and take a closer look at the important macroeconomic issues of the past, present, and future. I'm your host, David Beckworth of the Mercatus Center, we are glad you've decided to join us. Our guest today is Megan Greene. Megan is a senior fellow at Harvard Kennedy School and a senior fellow in international economics at Chatham house. Formerly Megan was as a chief economist on Wall Street, and has a biweekly column in the Financial Times on global macroeconomics. Megan joins us today to discuss the coronavirus and the appropriate policy response to it, as well as the future of countercyclical macro policy in the United States. Megan, welcome to the show.
Megan Greene: Thanks for having me.
Beckworth: Great to have you on. I've followed your career from a far, you're on TV a lot, you're in the press. A lot of interesting things to say and you have a pretty exciting job. Again, I see you on TV, I see you at conferences. You're working on a book as well, maybe we can talk about that in a bit, but how did you get into all of this? What led you down this career path?
Greene: So my career path wasn't at all linear, I guess I'll start with that. I was a macro-biology major for most of college and at the very last minute, actually long beyond the deadline, switched to economics and politics just because I liked it better. I wasn't quite as good at it. And then I worked in investment banking as kind of a peon, nothing to do with economics. I taught at a boarding school for two years. I worked for the Prince of Liechtenstein.
Greene: So nothing related to economics at all really, although I was kind of always at the cross section between politics, economics and finance in everything that I did. And I went to grad school in the UK. I was working on a PhD, actually looking at the economics of populism in Western Europe in the US, and at the time I felt like nobody cared about this topic.
Beckworth: Really? That's interesting.
Greene: I remember asking my parents like, when will this ever be relevant? When will anyone care? And like-
Beckworth: Little did you know.
Greene: Yeah, it's handy now. But I bailed out of my PhD and I ended up kind of landing in a job at the Economist Intelligence Unit. I was their Greece, Ireland, Italy and Germany expert starting in 2006. But even then I didn't know I really wanted to be an economist. I had a good economics background and I was interested in international relations in the world around me. It wasn't until I actually worked in applied economics that I realized that this is what I really love to do. And so I've always been sort of around financial services, how the markets work and how that intersects with economics and politics, but it definitely wasn't a direct path to get there.
Greene: And now I have the best job ever, I would argue, where I sit at Harvard, I'm doing a little teaching, but mainly writing a book, and I write this column with the Financial Times, and I'm a guest on podcasts. I host podcasts, I do TV, I kind of get to do whatever I want. So it's a dream, it won't last forever, but for now I'm loving it.
Beckworth: Yeah, sounds like a great gig. And I hesitate to ask this question because it may not be so, but is there a typical day in your life?
Greene: There isn't really a typical day and that's been the case for me for like over a decade now I'd say, and it's part of what happens when you're tied to a news cycle, I would say. So part of my day is figuring out what's going on and how to respond to it, but a big piece of my day now is working on my book, which is kind of taking a huge step back. I'm looking at wealth and income inequality and how the new economy is driving it. So that's not so tied to the day-to-day news. And so I'm now doing much more of jumping between what's happening right now and drawing these bigger themes and connections together.
Beckworth: So tell us the title of your book and when it will be out so listeners can go and buy a copy.
Greene: So it doesn't have a title yet actually, it has like a super nerdy academic title that will not stay, but it should out in about a year. So there's still a lot of time but it's on inequality and the new economy.
Beckworth: Okay. Well, we'll have you back on the show in about a year so you can plug the book and we can talk about the book and get listeners excited about it to go out and buy their copies. But today we will-
Beckworth: Focus on more immediate issues, the coronavirus, the appropriate policy response and kind of a nice segue into what monetary policy can or should do going forward. And I want to motivate this conversation by just talking about some recent developments, you know very well because you're in the midst of them and some of us have been watching from the sidelines, but the stock market has been down for a week and a half. Well, today it's back up, it's been a few days, it's gone up, but over a 10% correction in the stock market, the benchmark 10 year treasury yield fell below 1%. People were shocked by that. Oil prices down, yield curve briefly inverted again.
Beckworth: A lot of crazy things happening in financial markets, and the markets were begging for a rate cut from the Federal Reserve and some obnoxious folks like Beckworth echoed that, much to your chagrin and others, not only me, Roger Farmer, who else? David Andolfatto, there's a few of us out there who were beating the drums as well, and you pushed back politely but with certainty. Why didn't the Fed need to step in and do the rate cut that it did yesterday of 50 basis points?
Why Shouldn’t the Fed Have Conducted its Rate Cut?
Greene: So I think that first of all the Fed had no choice because the markets really backed it into a corner. But I don't think it was the right thing to do. If the Fed hadn't gone through, then the markets would have continued to throw their toys out of the stroller and we would have seen a further sell off. But I don't think it was the right thing for the Fed to do, and I don't think it has helped or will help for a couple of different reasons. I mean, the Fed has really good tools for dealing with demand side shocks in the economy. But while that might be what we end up facing, I don't think that that's how coronavirus crisis sort of has started. I think it started off much more as a supply side shock for the US economy. And as it turns out, central banks just don't really have any tools to address supply side shocks.
Greene: So the Fed can hike or cut rates, but cutting rates doesn't really address the issue of firms not getting parts to sell their goods to final customers and getting money. Cutting rates doesn't mean that people are going to go out and spend money either. It doesn't mean factory workers are going to go back to work in China and produce these parts. So it's a really blunt tool that I just don't think was really appropriate in the face of this challenge. And also rates are, were already low before this 50 basis point cut, and so the Fed is now gone and cut rates even more, which just means that we have less room to cut rates when a rate cut might actually help, so in the face of a demand side shock.
Greene: And then finally I think the Fed was really hoping that if they cut rates by more than the usual 25 basis points. So it was kind of a big amount that they did. They did it while markets were open and not during a regular meeting. So there was a lot that was really unusual about this rate cut, and I think that Fed was really hoping that they would kind of engage in this shock and awe. “We're doing something extraordinary, so everybody feel better. We're on this.” And I don't think that's how the markets took it. I think the market's kind of viewed this as, “Oh my gosh, the Fed is panicking and cutting this much in such an unusual way.” And so we ended up seeing a little bit of a sell off yesterday off the back of the rate cut. So I think for a number of reasons, cutting rates wasn't really the right way to go, but I absolutely recognize that the Fed was backed into a corner by the markets who were absolutely calling for rate cuts and who are continuing to call for rate cuts.
So I think for a number of reasons, cutting rates wasn't really the right way to go, but I absolutely recognize that the Fed was backed into a corner by the markets who were absolutely calling for rate cuts and who are continuing to call for rate cuts.
Greene: And that's not that surprising, right? There's a saying that goes that the Fed decides to hike rates and the markets decide to cut them. And investors love lower rates, that's great for asset prices. And so investors who are sitting on portfolios tend to do better when rates go low. So they're always calling for rate cuts, and I think it's no surprise that they're continuing to even though the Fed just acted pretty boldly.
Beckworth: Yeah. Let me respond to a couple of those things, and I want to go back to your analogy, I really liked it, the temper tantrum, the market threw. And it was you or someone else had a tweet or some writeup about some picture or vision of a baby screaming. So walk us through that. Why is that a good analogy of the stock market?
Greene: Because I think that the stock market has gotten really used to the so-called Powell puts and markets have broadly been going up for years now. It's been a really long recovery. And so investors have just gotten accustomed to markets moving in one direction. And what we saw was a fairly big correction relative to what we've seen over the past decade, but in the grand scheme of things, a 10% correction over a couple of days, it's not actually that hugely dramatic. I mean, the markets were already pricing in multiple rate cuts when the S&P 500 had only fallen 4%. So investors seem to be accustomed to this idea that equity markets only go up and if they go down, then the Fed has to step in and support them.
Greene: And so whenever there's a faltering in the markets, investors call for rate cuts because that's what they've been accustomed to, and the second that there is a Fed person who goes out and speaks and suggests rate cuts might come, which is what we saw before the rate cuts happened, the markets actually calmed down and rallied on Monday pretty significantly. So I think the faster you look at investors as kind of these bratty toddlers who throw all their toys out of the stroller or whenever the market starts to falter and then immediately coo and act really happy the second they get what they want, the easier it is to understand this dance that the markets and the Fed are playing.
Beckworth: Yeah. Well, I think it's a powerful analogy. Let me build upon it if I can. So this toddler does often get its way, but the problem is if it doesn't get its way, there's a lot of collateral damage that not only is the Fed backed into a corner, but panic and fear escalate. I think I agree with the points that you outlined, the Fed cannot respond to a supply shock. I completely agree with that. The Fed can't cure the sick, it can't raise the dead, it can't open padlocked factories and it can only respond to demand shocks. So maybe I was jumping the gun, maybe I'm guilty of that I’ll take that criticism.
Beckworth: But I guess my concern was we see things like the expected inflation from the bond market pointing down, oil prices down, yield curve briefly inverted. I mean, am I getting ahead of myself and reading that those are signaling demand slowdowns in the future or should I just be more patient?
Are We Facing a Demand Shock?
Greene: So I think this will turn into a demand shock eventually. I don't think we have... You cited a few indicators that suggest it might be coming. In terms of the actually economic data though we have very little, that includes any period when the coronavirus has really been a global issue. So we don't have much data yet. I think you're right that it's coming. But the idea that the Fed should cut as an insurance policy, which I think this thinking is really pervasive at the Fed that we might as well go big and in advance and then it's insurance and then we can take it out later.
Greene: I don't think that's quite right in part because I don't think the Fed will ever be able to take it out. I mean rates have only really been going in one direction for a little while. So I think we are stuck facing into the next downturn. We don't know exactly when it will be but with much less room to cut now. And that was already a problem before this 50 basis point cut but it's a bigger problem now. And I think maybe keeping your powder dry for when it would be really useful it would be great. But we aren't looking at first best solutions here I mean this is absolutely not the first best solution that the Fed should cut rates and that should be the first line of defense.
Greene: But that is the policy response that we've got. And you're right, financial conditions tightened really significantly. So in a way the Fed does have financial conditions as part of its reaction function and so could justify cutting rates that way. I just don't think that rate cuts are going to do much of anything, and so now we're going to have to go on to what would be more first best solutions having used up the second best one already.
Beckworth: It was striking about the interest rates going down you mentioned that we seem to have a ratcheting down of interest rates, not just short term but long-term ones. So the 10 year falling below 1% I mean it really, a lot of people were just awestruck by it talking about it and it's been going on for some time, a gradual decline. But the drop below 1% was kind of unexpected that it happened when it did. But it reminded me back of 2008 when we went from about 5% down to 3% or so. So we have this, it seems like at least we ratcheting down, whenever there's a crisis, the ten year gets bumped down and we don't have any kind of pull back, we're just continually marching down kind of a longward trend.
Beckworth: I had Paul Schmelzing on the show a few weeks ago and he's been doing this work on a supra secular decline and maybe we're just getting to that ultimate destination sooner because of this shock. But it is striking to see one way path for interest rates, which does make life harder for the Fed, as you said in the future.
The Downward March of Interest Rates
Greene: It does. And I think there's one kind of new quirk that's causing the long end of the yield curve to fall. And it's not really a commentary on what investors are thinking about U.S growth prospects, which is traditionally how you viewed the yield curve. So if it inverted, you'd say, well that just must mean that investors think that the U.S is going to go into recession, so it must be coming. I think there is one new quirk and that's to do with inflation and how persistently low inflation has been. And I think we still are living in this world that we've been in since the global financial crisis where the fat tail risk isn't inflation at all, it's deflation. And so if you're an equity investor and you need to hedge your investments, then actually long-term bonds are a great a hedge if you're living in this world where deflation is the fat tail risk.
I think we still are living in this world that we've been in since the global financial crisis where the fat tail risk isn't inflation at all, it's deflation.
Greene: So I think that's kind of a new quirk that's further pushing down on long-term yields. And I don't really see us escaping from that anytime soon. But I'd also say if that's what's pushing yields down, and I think it's one of many factors, but this one's kind of new. That doesn't mean that we're going to go into recession necessarily, which is often the case when you see the yield curve invert. I think this time around flight to safe assets was a much bigger piece of it. But generally the long-term of the yield curve has been really low. And I think it's partly this kind of financial quirk rather than the fact that everybody thinks we're about to face a recession.
Beckworth: Well, that's a great point. This might be the one time it's different in terms of the yield curve inversion. I think the one just prior to this, we were already kind of veering and we didn't have a recession. We got really close, but we did actually, we inverted briefly and we didn't have a recession. And I credited the Fed, the Fed actually did respond they reverse course after 2018. So maybe the Fed was a little more nimble maybe that's because we have a leader who doesn't have a PhD in economics and he's very flexible in his thinking, but it is interesting to see that kind of different story for why long-term yields might be falling.
Greene: When you mentioned really quickly that the Fed's more nimble and you're saying it that, that's a good thing we avoided a recession and it reminds me, I had a colleague who was a portfolio manager who said in kind of not disgust but in horror, like the Fed's much more like a Corvette now than it is a tanker. It used to be a tanker and so every move was really slow and kind of signposted well in advance. And now it's this Corvette and as economists, we kind of think, well that's a good thing than we avoid recessions. But for investors, having a Corvette for a central bank is actually really difficult because it's much harder to figure out what they're going to do. So that could lead to more volatility at the very least.
Beckworth: And also going back to your earlier point, a tank may have more power, it saves it for when it really needs it as opposed to a bunch of sharp turns that the Corvette may run. So let me ask this question and please push back on it. One of the things that event made me think about is the financialization of the economy. And that maybe, it's getting really hard to have a clean supply shock at all. So maybe you go back 20 years, maybe back to 1987 when there's a big stock market correction or go back to some previous event, 2001 even, I mean 2001 that's right about the time where globalization goes into hyper mode with China entering the WTO and other developments.
Beckworth: But back then maybe you could have a shock, a supply side shock and not have it reverberate around the world so painfully to the financial system. But now we are so interconnected financially it's almost impossible to disentangle those two. So it makes it harder for policy makers to react. You think there's anything to that view?
The Difficult Nature of Modern Supply Shocks
Greene: Yeah, so in terms of financial markets, I think you're right we're much more integrated now than we were before, so it's much harder to try to have some kind of containment. But I would also say that for China in particular, their financial markets aren't quite as open. We're not as linked into their financial markets as we are other kind of capitalist, open market societies. So in that sense, given this, this coronavirus has been sparked by China, has come from China.
Greene: It's worth thinking about that, that the financial markets if you have a market tank in China, it might hurt a confidence elsewhere but the actual specific direct implications of their equities falling aren't that huge on other countries. But I would say other kinds of supply side shocks, they're much easier now, and that's largely because of the globalization that you cite and kind of these global supply chains. But also because more recently, just in time, manufacturing has really come into fashion.
Greene: So it used to be that firms had pretty big inventories. And so even if you had a global supply chain your lead times before you deliver the final product to the client was pretty big anyhow and you had inventories so you could withstand it for longer. And now you've got this just in time manufacturing where you can kind of customize a product and expect to get it two days later and their inventories are really thin. And so any kind of shock to a global supply chain I think is probably much more impactful globally now than it was back even just a decade ago.
So any kind of shock to a global supply chain I think is probably much more impactful globally now than it was back even just a decade ago.
Beckworth: Yeah, those are great points. And I wonder if one silver lining from this crisis will be that businesses diversify their supply chains if there'll be some thinking along those lines.
Greene: Yeah, so I have thought like on the bright side, this would probably be worse if we hadn't had a trade war with China just in that-
Beckworth: That's a good point.
Greene: Insofar as some firms have been able to shift their supply chains, they've already done so. The downside of that is if there had been an easy or cheap option for companies in terms of getting a part that they needed, they already would have shifted it. So now we're looking at firms facing a supply side shock and actually they don't have any easy options for shifting their supply chains. So that's sort of the downside of it.
Beckworth: Yeah, it'll be interesting to see what all the fallout is from this a year from now, and I hope a year from now we will be through the worst of it. I mean, I know there's been these images of China where at the height of the crisis there you saw the pollution drop. You saw satellite pictures where there's less pollution and now we're beginning to see a little pollution pick back up, which may indicate-
Greene: You're also getting reports though that factories have been ordered to open, run their electricity. So I would say…
Beckworth: Be careful.
Greene: Take some of that with a grain of salt, it's hard to know. And it's hard to know what data you should trust.
Beckworth: Fair enough. We'll have to wait and see if we're really over the worst part of the crisis in China. Well, one of the things that's come out of this affair is that the 10 year treasury has fallen, like we talked about, it's the benchmark rate. It's the safe asset yield for the world in terms of setting other rates, and it has created problems for the Federal Reserve. So the Federal Reserve has a limited amount of interest rate space. As you mentioned they've used up some of their ammunition, they're now, I believe one in a quarter percent of ammunition left in the short end. And what happens is they'll go to the long and they'll resort to large scale asset purchases or QE if they get to the zero lower bound or the effective lower bound.
Beckworth: And so this presents problems because now there's less opportunity for them to do QE. And even ideas are on the table, like yield curve control becomes less buyable with lower long-term interest rates. So we're kind of running out of what I would consider the tools in the traditional toolbox of the Fed, and that's got to be making the Fed nervous. And you've written a lot about this, and maybe another silver lining from this crisis is that it will move forward the conversation on what to do in situations like this. So help us understand that.
How to Expand the Fed’s Toolkit
Greene: Yeah. So I think you're right. I think that things like QE and yield curve control will be much less effective if long-term rates are already low. I mean yield curve control would essentially involve the Fed selling treasuries to try to get yields up, which would be shrinking their balance sheet, which is absolutely not what they want to do in the face of a shock of any kind or a downturn. So that had been on the table, but with the ten year dropping below 1%, I don't think it's on the table anymore. I think also it's worth pointing out that the Fed really has its hands tied much more than any other Central Bank because of Dodd-Frank. So the Fed stepped in, kind of saved the US and potentially global economy following the global financial crisis, but Congress was pretty upset that all these unelected men and women were stepping in and making these important decisions. And so implemented all this legislation that really ties the Fed's hands.
Greene: So I think it's much more difficult for the Fed to get creative than for other central banks to do. But I do think that there is one option that the Fed could borrow from the ECB, and I think it could be really powerful. And I think it's actually legal and it exists somewhere else, so that's always a bonus. And that's these targeted long-term refinancing operations, so TLTROs they're called. And in Europe, basically the ECB will lend to banks and they'll lend at the deposit rate right now, which is negative. So they end up paying banks to borrow from the ECB as long as banks lend on to the real economy. And what's interesting about it is that right now the rate at which banks can borrow from the ECB is set at the deposit rate, but it doesn't have to be, it could be set at a totally different rate.
I do think that there is one option that the Fed could borrow from the ECB, and I think it could be really powerful. And I think it's actually legal and it exists somewhere else, so that's always a bonus. And that's these targeted long-term refinancing operations, so TLTROs they're called.
Greene: So they've kind of introduced a second interest rate, and that's interesting because central banks have this policy tool rates which is incredibly blunt, but they basically, for the most part, can either hike it or lower it. And depending on what they do, they have to make decisions about whether they're going to benefit borrowers or savers. They can't benefit them both at the same time, because they only have one rate that they can move up or down. And by introducing this kind of second dual interest rate in Europe, basically the ECB has created this mechanism so that they can benefit both borrowers and savers at the same time.
Greene: So let me just give you an example. So the TLRTO rate is now set of the deposit rate, but it doesn't have to be, it could be, let's say negative 200 basis points. So banks get paid 200 basis points to borrow from the ECB, but they have to lend it on to real businesses and the real economy, they can't go into kind of financial engineering buybacks, that kind of stuff, has to go to real businesses. And largely it goes to small and medium size enterprises that form the backbones in most European countries. And so they can lend on to these small businesses at let's say negative 50 basis points. So then the businesses are getting paid to borrow as well. The banks benefit from a carry trade.
Greene: You've created demand for these loans because you're paying businesses to borrow, you benefit borrowers that way. And then at the same time the ECB could hike the deposit rate into positive territory or at least up to zero, so that they're no longer penalizing savers. So they're benefiting both borrowers and savers and that's in an unambiguous stimulus across the entire economy. So that is something that's kind of new, it already exists. I don't think the ECB set it up actually to use it this way and they're not using it this way yet, but I think that they'll get there, and I think it's something the Fed can look at as well so that they can actually create this unambiguous stimulus.
Beckworth: That is very interesting, and I find it appealing because it actually speaks to an issue that many people have with negative interest rates and that is, if we do negative interest rates, you're going to destroy financial intermediation. You're going to make it hard for banks stay in business. And what you just outlined, I think, and correct me if I'm wrong, is that, banks would still have a positive spread between their funding or borrowing costs and their investing costs or lending costs this way. Is that right?
Greene: That's right. And then I think the other complaint with negative rates is that if you're a saver and you've got negative rates and your deposits are sitting in a bank and they pass those negative rates onto you, you get massively penalized. So this way you don't actually penalize savers, you just create a channel to encourage lending to businesses.
Beckworth: And the reason that banks wouldn't take those funds and deposit them at that higher rate is because they can't, they have to lend on to the real economy.
Greene: That's right. The whole thing is contingent on that rule. They have to lend it on, otherwise they don't access to that rate.
Beckworth: Well, that could be a very powerful. Yeah.
Greene: Yeah, it's not so different from the funding for lending scheme in the UK either, so it's not totally different. And so these schemes kind of exist, but the Fed's never actually gone and implemented them and no one's ever played with negative rates with them because negative rates are such a fairly recent development. And so I do think that it's a tool that we could be more creative about that's actually legal. If the ECB can agree on this, then surely any other central bank can, because it's so hard to agree on anything between all the different countries that are involved in the ECB system.
Beckworth: So has anyone at the Fed talked about it at all? Any discussions you've seen with the review going on right now?
Greene: So unfortunately I don't think this is really on the table as part of their current review. I've certainly talked to various board members and Fed presidents about it, so some people are interested, but for the actual monetary policy, strategy review, it seems like everything on the table is pretty much focused on some version of inflation targeting. And this is a totally different tool. And actually to be fair, I'm not sure that this would be a new strategy, so much as a new tool.
Beckworth: Well, they're talking about yield curve control, which is a tool that would complement like say average inflation targeting. So you could do this also with average inflation targeting.
Greene: That's right, but having negative rates in the US given the money market funds is complicated, and so it seems to be kind of a phrase you don't bring up.
Beckworth: Well it's politically toxic too. I mean, to be frank, it's not something that is very accepted in some circles. Now again, if the ten year goes down to 0% or below, we become like Japan, then maybe it's a whole different conversation, then you can bring up this point. I would go on and say we need to not only talk about the negative rates in terms of this dual rate approach, but I think they're much more effective if you do tie them to some kind of makeup policy, some kind of commitment mechanisms. We will do these until we hit some point. I think you need both of those in the quiver with your approach to monetary policy.
Greene: You know, that's fair enough, and I guess using TLTROs this way, I say it's a tool because it's not clear exactly what the goal is that it necessarily needs to be implemented to hit. So you need to choose that separately whether it's a certain percentage increase in lending, maybe that's your target, I wouldn't recommend that, I don't think any Central Bank is looking at that. It could also be inflation or average inflation price level targeting. So it could be used to hit a whole bunch of different targets.
Beckworth: Now this again takes me back to last year because I think it was in August when we last saw long-term rates go really, really low, not this low, but they were really low and people were talking about the huge stock of negative yielding bonds is like, I don't know, 13, 14 trillion, maybe more than that. We're back here now and back at that time, people were talking about, well, what do central banks do? They were talking about monetary policy, fiscal policy coordination a very awkward term, very uncomfortable area for many people to go into.
Beckworth: I think we are back at that conversation now because we're getting to the place where we may again run out of interest rate space both in the short and the long end of the yield curve. So let's go beyond what's possible legally. We've covered with you what's legally possible with the Fed. What else should the Fed look at in terms of new tools, new targets, if Congress would let them write a blank check, here you go Federal Reserve, do what you gotta do to stabilize the economy. What would you recommend they pursue?
Greene: So I wouldn't give up on legal options just yet, I think you're getting at the right idea, which is kind of coordination, which really freaks people out who are worried about the Fed's independence. But you've had monetary policy and fiscal policy coordination many times in the past and in many other countries in the past without it actually encroaching on central bank independence. So I wouldn't say that's necessarily a reason not to do it. And we have two fantastic excuses for monetary and fiscal policy coordination. One is staring us in the face right now, which is the coronavirus. So coming up with some kind of response to that not only could be a combination of monetary and fiscal policy, but absolutely should be. But then the longer term option the longer term excuse is climate change.
we have two fantastic excuses for monetary and fiscal policy coordination. One is staring us in the face right now, which is the coronavirus. So coming up with some kind of response to that not only could be a combination of monetary and fiscal policy, but absolutely should be.
Greene: So that's another opportunity where we could have monetary and fiscal policy coordination. And that conversation is only really just starting in the U.S but it has been underway with gusto in Europe for example, for a while now. So the U.S is really just waking up to this issue, but I think the ECB will end up doing much more of this sooner than the Fed will do. So those are two ways to have that kind of coordination within the legal bounds. If I didn't have to worry about what was legal at all and I had to address incredibly low inflation, incredibly low rates, and in incredibly low growth. So essentially secular stagnation, I think, then helicopter drops, that's not out of the realm of possible or useful in my view.
Greene: I mean, I think what we need to see is productive public investments, whether you think that low rates, low inflation and low growth they're a demand or a supply side problem boosting investment, both boosts productivity growth and also reduces the massive glut of savings that we have in the U.S and globally. So that would be great. So if I had a magic wand, I would certainly have that be a piece of it. But in terms of how we're going to fund all that productive public investments I do think that there's some who are worried about the deficit and debt burden and I think rightly so. And so to some degree having the central bank finance that could provide the fiscal authority with the cover, they need to do what needs to happen in order to boost growth and inflation and rates again.
Beckworth: Do you worry at all about the politicization of the central bank if we go down the path of say climate change policy?
The Issue of Central Bank Politicization
Greene: Yes. So I think as a first best option, climate change should not be down to central banks. It's not in any central bank’s mandate. Central banks conducting monetary policy, have an outlook of three years roughly, climate change is going to be an issue at some point, but probably not massively in the next three years in particular. So there's just a mismatch of incentives. So I do worry about it, but I also think that as a second best option, it's not terrible. I mean there's a clear role for central banks in climate change when it comes to regulation and supervision. So I absolutely think climate change should be involved in things like stress testing the banks. So that part of central banks insofar as regulators and supervisors are part of the central bank, and that's not the case in every country. But insofar as they are then climate change and central banks matchup.
Greene: But when it comes to monetary policy, central banks aren't a natural actor to address this challenge. That being said, if no one else is going to, then it might not be the worst thing in the world if the central banks pick it up. I do recognize we've been constantly relying on central banks to pick up everything for the past decade and that can't really last but as a second best option given the threat that climate change poses. I think it's not ideal, but it's not the worst thing in the world.
Beckworth: Well I think it's important to do it directly through Congress or directly through fiscal policy if possible too. It's something that the democratic process should consider, make it accountable. I mean my concern is if you resort to central banks doing it, it might be done in a way to get backdoor spending without kind of the appropriate appropriations process where people evaluate where health funds will get allocated. Because ultimately the end of the day there is a set amount of real resources that the government has access to. And whether you do it on balance sheet or off balance sheet, the central bank, it's still the same amount. And my concern is that you turn the Fed into a piggy bank, it becomes politicized, whatever the latest project is. Even if it's a good project, one that's it's important, like climate change, right? There might be other ones that come up, they may not be so productive. It might be a president in the future who abuses that privilege.
Greene: I totally agree with that. So as I said, it's not a first best solution at all. But I do think it's hard to argue that climate change isn't an issue and isn't something we should be doing something about. So I think you're right, central banks will be used as a backdoor of spending. And in some countries you really need that. Germany for example, refuses to come off of its black zero balanced budget when it really has the space to do so. And would benefit itself as with the rest of the year zone. So this could be a backdoor way to get around those fiscal constraints. But you're right, it gives no regard to the democratic process.
Beckworth: So we've been talking about monetary policy as a way to deal too many problems, climate change and we started off by talking how it could be used in part to deal with the coronavirus at least the spillover effects. But probably a better tool, much more effective tool is fiscal policy. And we don't see a whole lot being done there yet. So how would you advise the government to use fiscal capacity to deal with the coronavirus?
Fiscal Policy as a Response to the Coronavirus
Greene: Yeah, so it seems like the government so far was mainly just hoping we get some rate cuts from the Fed, but now that we've gotten them and they haven't really helped, I can imagine there's some scrambling going on in terms of trying to figure out how to respond to this. And of course we've had pandemics before. There are procedures in place, but I don't think we're using our old rule books so much anymore and that we should kind of go back to those and should subsidize them. So first of all, looking after our public health workers and our public health system is like pandemic 101. It's an obvious thing to do. So getting people tested for the coronavirus and not leaving them with a $1,300 bill at the end of it I think would be really important.
Greene: So certain localities have done this and New York City has announced that they're going to test for free, but I think that the government should just be funding tests for the coronavirus without having people worried about having to foot the bill at the end. Protecting healthcare workers, everyone on the front lines is really important. So you heard about firemen going into a nursing home in Seattle with no protective gear at all. And of course now it's spread significantly in Seattle. And so that should never happen. So having the government provide the funding to buy all of this gear that we need and then staffing up hospitals and healthcare centers I think will become really important. Because otherwise we just have no capacity to deal with the search. So that all helps deal with the public health side.
I think that the government should just be funding tests for the coronavirus without having people worried about having to foot the bill at the end.
Greene: But it's also a fiscal stimulus for the economy that could help. Also Medicaid is going to be pretty significantly strained as a result of this and so maybe rejigging how much the federal government pays for Medicaid versus the state so that the federal share is increased, could free up state budgets to deal with things like education. So that could also provide some relief in public health, provide a stimulus, and also allow States to focus on other things that will also be strained as a result of the coronavirus.
Greene: And then there is one thing that's really politically popular that I think absolutely see you, which is payroll tax cuts or holidays. I think that one's really likely and it just leaves people with more in their monthly paycheck. And that’s a pretty immediate stimulus people don't have to wait for that. The problem is it only works for people who have jobs. So if you have to stay home for two weeks because you're sick or because you're worried you might have the coronavirus and don't want to spread it, you could lose your job and then payroll tax cuts really aren't going to help. Or if you're retired, payroll tax cuts won't help you either. So it's something I think we'll see. But I think that it will only help so much. Boosting on safety net I think is important.
Greene: So there's a whole host of people who are on unemployment insurance or SNAP. So formerly food stamps who never really recovered from the last crisis. And I think trying to boost support for them with federal funding would be helpful as well. We could mail checks to people. And we talked about how that could be funded, it could just be deficit funded and then it's just a fiscal policy mailing checks program or it could be central bank funded. And then it would be helicopter money and helicopter drops. Hong Kong has done it on the fiscal side, so it's just deficit spending and I think that's probably better, but that would be a way to provide a stimulus to all the people who have been impacted. And then this is a really different kind of downturn from most in that we're not looking at a massive recession that could last for years like we did with the global financial crisis, right?
Greene: We're looking at businesses who just need to get through two quarters where they didn't have enough inventories, they can't make their sales, so they just need bridge financing for a couple of quarters. And so having the treasury department or the small business administration kind of target those firms with lending so that they can get through this kind of difficult time and these temporary disruptions I think would be really helpful in addressing the supply side of things. And then, unfortunately, there's no one in charge of all banks who can just say, you have to give grace periods on your loans. But if the different regulators could lean on banks much like China has done actually very effectively, but of course China is a central planned economy so it works a little differently there.
We're looking at businesses who just need to get through two quarters where they didn't have enough inventories, they can't make their sales, so they just need bridge financing for a couple of quarters. And so having the treasury department or the small business administration kind of target those firms with lending so that they can get through this kind of difficult time and these temporary disruptions I think would be really helpful in addressing the supply side of things.
Greene: But I think that would be really powerful if firms who are facing these supply side shocks could just get a little bit of leniency in terms of paying back their loans. That would help a lot as well. So these are all kind of fiscal policies that would cost money and would blow out our deficit more, but for what it's worth that could also raise the 10 year yield a little bit on the bright side. It's not ideal, but I think that's kind of where we are in terms of needing to put our money where our mouth is in a response and not leaving it all up to the Fed.
So these are all kind of fiscal policies that would cost money and would blow out our deficit more, but for what it's worth that could also raise the 10 year yield a little bit on the bright side. It's not ideal, but I think that's kind of where we are in terms of needing to put our money where our mouth is in a response and not leaving it all up to the Fed.
Beckworth: Those are all great suggestions, and it's interesting that you noted at the end the need to have some kind of bankruptcy plan or some plan to forestall bankruptcy for firms during this period. And JP Koning who's a blogger and is also on Twitter a lot, he found two interesting quotes from people on both sides of the political aisle. So he got a quote from Simon Wren-Lewis who's in the UK and I don’t know if you know him at all, but he's over there. He had a piece where he wrote, “If I were running the government, I would have already started having conversations with banks about not forcing firms into bankruptcy during any pandemic.”
Beckworth: Now on the right of center, you got John Cochran who also had something similar to say. He said, “We need a detailed pandemic induced financial crisis plan that forestalls bankruptcies.” So it was interesting, you got two people, right and left of center here thinking along similar lines here because this is an unusual shock, not your typical run of the mill recession.
Greene: Yeah. And while you have an unusually politicized government at the moment, facing this kind of shock could force politicians to come to some kind of agreement on the bright side.
Beckworth: Yup. You also mentioned that the 10 year treasury yield might go up if we do run big deficits. And interestingly, I was looking at a paper by Larry Summers and a co-author where they make the case that our interest rates would be even lower today had it not been for the deficits we've run over the past. And I went back and I was looking, and I took their approach and I calculated where would the ten year treasury be today, and it would be approximately between one and minus 2% if it weren't for Trump's big deficits, historically large peace-time deficits not recession deficits. And so that speaks to the point you just raised that we might actually see rates go back up if there were these programs put in place.
Greene: Yeah. The one thing I'd say is that we did have rates go up under most of Trump's presidency, so that could have been pushing up yields as well just because rates were actually rising. But I do think there are some who are concerned about deficits that usually gets priced into the term premium. And term premia seem to have completely collapsed now. So we'll see whether, if we blew out the deficit even more, if that would make a difference, it's hard to say.
Beckworth: Looking at the chart from the Summers paper, you do see as you mentioned the counterfactual ten year, it does go above zero for a little bit because of Trump's deficits, but it's still really low, it's that at point. And then where it is today, it'd be even lower, but it's kind of a, I don't know, bizarre result of the large deficits that you see rates higher than they would otherwise be and yet they're below 1%.
Greene: Yeah, that is perverse, and I do think it kind of speaks to the lower for longer argument that rates are just going to be low for a while.
Beckworth: Well, I want to go back to a topic we touched on earlier and that is the Fed’s review. It's a big review, started last year. It's going to continue to this year and they've said they'll wrap it up in June, but who knows now with the coronavirus, it might be later than that. But one of the big things they're doing is they're looking at their framework, the strategy, kind of the big picture or what should they target. They're also looking at other items, communication, the tools, but I think what a lot of people are interested in, at least I'm interested in, is what is the framework they're going to adopt and they've been pushing some kind of makeup policy. So you don't let bygones be bygones, if you missed your target, you've got to make up for it.
Beckworth: And kind of the three options on the table I think that I've seen our average inflation targeting, price level targeting and nominal GDP targeting, and of those, only average inflation targeting is really going to see the light of day. And it seems to be, that's where the momentum is. Number one, is that right? Is that what you think is going to happen? They're going to go towards average inflation targeting? Again, if you could play the benevolent dictator here, which option would you choose?
Which New Regime Will Emerge from Fed Review
Greene: So I think you're right. I think average inflation targeting is the front runner with price level targeting kind of in second place, and they're both variations on inflation targeting. So I think that's right that that's probably what will end up being chosen, but in terms of what should be chosen, I think we're all kind of wasting our time with variations on inflation targeting. Just because, it's nice to know that if the Fed undershoots inflation for a while, it's really, really dedicated to overshooting because it's baked into their framework and not just because they keep saying so, which they do. But does anybody believe that the Fed can actually get inflation above their target? It hasn't really happened in this cycle. So I do think that there's kind of a credibility issue, and of course investors and consumers need to buy that upfront.
Greene: So when the Fed says we have this, let's say average inflation target and we've had inflation of 1% and we'd like average inflation to be 2%, everybody needs to believe up front that the Fed will go for inflation of 3% and we'll allow it and welcome it. But that credibility has to be there right away before the Fed has actually had a chance to establish it, and establishing credibility only happens over time. So I think that there is a real credibility challenge with anything that is centered on inflation targeting. I do think that nominal GDP targeting is a more interesting framework. It's very rules-based as are the others, but it's even more so, and it looks at kind of the trade-off of inflation and nominal GDP to ensure that if inflation undershoots for a while, the Fed absolutely has to wait until it overshoots.
So I think that there is a real credibility challenge with anything that is centered on inflation targeting. I do think that nominal GDP targeting is a more interesting framework.
Greene: So I guess it bakes in that credibility, I think a little bit more effectively than average inflation targeting or price level targeting. But I really think as long as the Fed, and now the ECB is looking at its framework and rethinking it, it seems like they're also mainly looking at inflation targeting practices. I think that's kind of a waste of time and energy. And that we're going to end up with something very similar to what we have that's inflation target based. But I don't think it will have been worth the two years of work that the Fed’s put into it. I also think though, I mean in their defense for the Fed it's the central bank for the world's largest economy. Should the world's largest economy be the front runner going out and experimenting with new frameworks? Maybe not.
Greene: I mean the inflation target that we adopted, it was first adopted by New Zealand. That seems like a pretty great size economy to try something new and eventually other countries adopted it. So maybe it's partly just that the Fed's too big and too impactful on other economies. I mean, when the Fed sneezes, everybody else catches cold. So maybe the Fed shouldn't be out there experimenting first and a smaller economy should.
Beckworth: Yeah, I think that's a great point. Maybe we need Canada, New Zealand, maybe the U.K to try it first before the Fed follows through. But I fear the Fed is going to do just some tweaked version of what it's already doing with the claim it's going to make up for past misses. And maybe it will, I'll be pleasantly surprised, and my worry is there will be a credibility problem that prevents it. And this speaks to actually to a bigger issue I see and that is I think inflation targeting has almost been too successful in advanced economies. You look around the world and fighting the high inflation of the late 70s, early 80s was a big deal. They've come down dramatically, but they've all come down to a point where they can't seem to escape. It's almost rigidly low [and] below target inflation.
Beckworth: And I wonder if inflation targeting has created the expectation among the body politic, among leaders that low inflation is only the thing that can be tolerated and any kind of makeup policy is wrong, it's inappropriate, it's kind of an inflation targeting straight jacket they've created for themselves and it's just going to take time to change that conviction, change that belief. And that's, I guess my bigger concern is that we are in an environment we've created and it's not easy to get out of it.
Greene: Yeah, I think that makes a lot of sense. Although in the past 10 years, and in particular as you say, average inflation for the U.S depending on what metric you use. And I think it's CPI has only been like 1.4%, it's way below the 2% target. So we have gotten stuck really low and I do think that there's a credibility issue. And some people have said, "Well maybe we need to announce a new inflation target of 3% and then maybe inflation expectations will move up." My response to that is kind of why would you ever believe that the Fed could get inflation of 3% if they can't get 2%. So credibility is the currency in central bankers and I think most major developed world central banks are lacking these days when it comes to inflation. So it worries me that, that's really all that they're talking about.
So credibility is the currency in central bankers and I think most major developed world central banks are lacking these days when it comes to inflation.
Beckworth: Yeah, now I'm happy to hear you endorse nominal GDP targeting as listeners will know that's music to my ears. I'm a big fan and I know though, at the same time it's the redheaded stepchild of the Fed’s review process. So it won't be adopted anytime soon, but we continue to fight the good fight for it. And hopefully one day it is something taken seriously. And again, maybe some smaller economy will adopt it first.
Greene: Yeah. Maybe we'll get a nominal GDP targeting at the same time and get TLTROs
Beckworth: There you go.
Greene: All good ideas, just not on the table just yet.
Beckworth: A powerful combination. So Megan, you mentioned earlier that when the Fed sneezes, the rest of the world catches a cold. So you make it sound like the Fed is this kind of monetary superpower. Could you expand on that point?
The Fed as a Monetary Superpower
Greene: Yeah, I mean the Fed is the central bank for the largest economy, but it's sort of the central bank for the rest of the world in some ways. One reason is because of globalization. So trade has increased significantly and a lot of trade is invoiced in U.S dollars because the U.S dollar is the global reserve currency. So that means that any Fed policies that put any pressure on the U.S dollar then goes ahead and exerts pressures on other economies. Also related to the U.S dollar being the global reserve currency is the fact that lots of countries, particularly in emerging markets, issue debt denominated in U.S dollars. So with the Fed hikes rates and that goes ahead and affects the U.S dollar and pushes it up, then that makes it more difficult for some of these countries to go ahead and meet their debt servicing costs because they're paying in their local currency. But the debt has been issued in now more expensive dollars.
Greene: So that's also partly why, but part of it is related to kind of what's driving the long run neutral rate and there is this kind of calculation for the global R star. So the global long run neutral rate and it has gone down both in the U.S and also globally. But what a lot of research has shown, and I'm thinking of the paper in particular that Alan Taylor presented at the Jackson Hole conference last August, is that it's become increasingly difficult for a country to diverge from that global R star. And so monetary policy divergence is just getting much harder. It's much harder if you're one central bank who's hiking rates and nobody else is for you to maintain that. And that pertains to the Fed as well. The Fed was the one central bank that was hiking rates much more than any others and sure enough it ended up having to reverse course. And you could argue that's because it was so out of whack from the stance of other central banks.
Greene: So it's just much harder to be an outlier as a central bank and that applies to the Fed as well as every other central bank. So I think it's become apparent that central banks can't just pay attention to what's going on within their own national borders and that particularly is the case for the Fed, which is an interesting sort of dynamic because just as global politicians increasingly are adopting this go it alone attitude, central bankers are actually getting together and saying, you know what? We can't really do that because what we do has immediate spillovers to other parts of the world. So I think we are probably going to look at more central bank coordination going forward and actually we may already be seeing it unfold.
So I think it's become apparent that central banks can't just pay attention to what's going on within their own national borders and that particularly is the case for the Fed.
Greene: You had the G7 central bankers and finance ministers have a call and then the Fed cut rates in the face of the coronavirus. The next day the Bank of Canada cut rates. I think we'll probably see the ECB going ahead and easing next. So I do think that coordination is something that we can come to expect.
Beckworth: It's a brave new world.
Greene: That's right. Yeah, I mean I think it's a good thing that central bankers are recognizing the international spillovers because to some degree they've always been there. They're just now starting to kind of consider that and we are looking at a Fed that does look at international things more than they have in the past. I think that's a positive development.
Beckworth: Well with that our time is up. Our guest today has been Megan Greene. Megan, thank you so much for coming on the show.
Greene: Thanks so much for having me. It was really fun to chat with you, David.
Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app, and while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.
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