Richard Clarida on FAIT, R-Star, and the Future of the Fed’s Framework

The Fed should consider improving its strategic communication while more effectively anchoring future inflation expectations as it closes in on its next framework review period.

Richard Clarida is a well-known academic and policymaker who most recently was the Vice Chair of the Federal Reserve Board of Governors. Richard is currently a professor of economics at Columbia university and is also a managing director at PIMCO. Richard joins David on Macro Musings to talk about his academic and policy work, as well as his outlook for FAIT, the Fed’s framework review, the future of R-Star, and more.

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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: Rich, welcome to the show.

Richard Clarida: It's been a long time coming, but I'm thrilled we're doing this.

Beckworth: Oh, absolutely. This podcast itself has been key in connecting us. So, a bit of history about this podcast, one of my first guests was John Taylor, whom I worked for at Treasury many years ago. Because of that connection, he was one of the first guests to come on the show. Then, after that, he invited me to present a paper at Hoover, which was built upon some work that you had commissioned. And so, we connected at the Hoover Monetary Policy Conference in 2016, kept in touch ever since. Then, you became aware of the podcast, and here we are doing a recording.

Beckworth: Okay, let's talk about you and your work, and you've had quite the storied career. Just a quick summary of some of the things you have done, you've been a prominent contributor to New Keynesian Macro. You have five papers, with Mark Gertler and Jordi Gali, that were very influential in this literature, this New Keynesian approach. You've done work in international macro. You've also been involved in policy work for President Reagan's CEA, George W. Bush's Treasury, and most recently, as I mentioned, vice chair at the Federal Reserve. And we're here recording at PIMCO, so you're also in the private sector. So, you've had your hands on a lot of different projects, quite the accomplishment, but I want to go back to where this all began. What got you on the path to being an economist and then doing all of these things?

Richard Clarida’s Background

Clarida: Well, thank you for asking. It's actually pretty straightforward, David. In my case, I was a freshman at the University of Illinois in lovely Champaign-Urbana in 1976. I took Principles of Economics in a big lecture hall. I think there were 600 people in the class, and I was the kid with horn-rimmed glasses sitting in the front row. I had a very dynamic professor. This was in the 70s, so macro was depressing but interesting. Inflation was double digits, there were four recessions in 10 years. Bretton Woods had collapsed. What is this thing called flexible exchange rates? And I just thought, "This is what I want to be doing."

Clarida: I had grown up in an educated family in downstate Illinois in a small coal mining town. Both of my parents were educated. My father had a PhD, my mother was very educated, so I always valued education. So, more or less, then, I thought, "If I could pull this off, this is what I want to do. I want to be an economics professor who does macro. Now, that was the goal. What helped me to get on a path to have that opportunity was that I had a wonderful professor, a guy named Matt Canzoneri, who's a very respected international macroeconomist, and I took an intermediate macro class from Matt in the next year, so my sophomore year, and I did well.

Clarida: I went to his office one day and said, "Do you need a research assistant this summer?" He said, "I already have a research assistant," but I was pretty persistent, so I offered to work for free. And so, he would just give me some projects, and that increased my interest in doing macro. Then, one day, for me, he sketched out on a yellow legal pad… I said, "So, Professor Canzoneri, what do I have to do to become a-- how does one go from being a sophomore to being a macroeconomist?" He basically wrote down, "These are the courses you should take. This is what you should learn and differentiate yourself on the application".

Clarida: And I did all of that. Taking more math than was required, in particular, was important. Then, I applied to graduate school and got into some good places and ended up going straight from college to Harvard in 1979. Today, that's much less typical. The whole approach to graduate school has changed. Few people actually go right from college to graduate school anymore, but that was the norm in those days. So, I arrived at Harvard at the age of 22, and I left four years later at the age of 26, so I've been doing this a long time. 

Beckworth: Well, that's amazing. Now, I'm curious, when you went into grad school, maybe right after you finished grad school, what was your model of macro in your mind? Was it still old-school Keynesianism? Was it monetarism? How were you viewing the world back then?

Clarida: Well, in life, you want to be lucky, and you also want to have some skill and hard work. In my case, I was really lucky in the sense that Matt Canzoneri, in addition to being a really good teacher, was a freshly minted Minnesota PhD student of Sargent. So, I actually was reading Sargent and Wallace as a sophomore, or trying to read Sargent and Wallace-

Beckworth: That's hard stuff.

Clarida: -as a sophomore, and Lucas. And so part of, I think, what differentiated me in my graduate school application— which I actually went back and was able to dig up in the filing cabinets at Harvard years ago— is based upon working with Matt and reading this stuff. I basically said, "I want to do macro. I want to do rational expectations macro. And, in particular, I want to do international macro." So, that's from day one of graduate school. Now, your listeners should know that the early years of the rational expectations revolution were very contentious. It seems quaint now to mention it, but for the decade of the '80s, this tension between freshwater and saltwater was very real.

Clarida: And it could be especially challenging as a young scholar if you went to a saltwater school, but you had freshwater instincts, and that was me. Now, really, from the get-go, David, I respected, but never thought, that complete markets in macro made sense. And, as a result, in the 1980s, when I finished my PhD, and I was teaching, I was a little bit of a fish out of water, because I was doing things like what we now call Bewley models with— there are shocks and people are at corners and they can't borrow.

Clarida: Because that all seemed really realistic to me, or one of my early papers was dispensing with representative agent [macro], but trying to do life cycle permanent income with the demographics, overlapping generations of the Modigliani approach, and had a paper in the QJE, which worked through a closed-form example of that. But, again, in those days, the progress and the recognition in macro was to do complete markets macro or to do representative agent macro, and I was not really inclined to do either. Also, from day one, I was a sticky price guy. So, at some level, I was going to be having to figure out some way to jam in sticky prices.

Clarida: And, again, there was a freshwater saltwater split in those days. But just to finish up on the point, so, this is something that is luck. It was not designed. So, I've been a student of Canzoneri’s, who was a Sargent student. So, then, when I got to Harvard— my third year at Harvard— Sargent visited. He took a leave of absence from Minnesota and visited Harvard. And the remarkable thing that he did was instead of coming-- oftentimes when people go on leave, they go on leave not to teach, but to write books or to write papers, and keep their door locked. Sargent was the opposite.

Clarida: He solo taught a two-semester sequent in graduate macro, which was an elective at Harvard, which I took, and it changed my life, because it moved this away from being a concept into, how do you make this operational? And Sargent and I connected, because we had in common that his PhD student was my mentor. So, he did not ignore me, he encouraged me. When I would do things like talk about incomplete— moving away from representative agent or complete markets, he didn't discourage me. He did say that it's hard, but it wasn't like, "Don't do that."

Clarida: But I should say for your listeners, it was actually an interesting group, because there was a group of several of us who were Harvard or MIT students who went to all of Sargent's classes, used to have lunch or dinner with him, occasionally have a beer. In that group were people like Pat Kehoe and Danny Quah, Whitney Newey from MIT, and Andrei Shleifer was hanging around in those days. So, it was a really interesting time, but Tom, instead of being aloof and locked in his office to write papers, was really engaged with graduate students. So, that was also transformative, but that was just complete luck, but very important in my career.

Beckworth: Well, the stars were aligned for you. It's remarkable that he's still productive, he's still doing work.

Clarida: Exactly.

Beckworth: I hope my mind is as sharp as his when I'm his age. Now, moving forward in your academic career, I want to read an excerpt from a speech that you gave for an award— Congratulations on this award— from the Museum of American Finance, the John Whitehead Award. You had this excerpt, because you tell your story, and we'll provide a link to this biography that you have.

Beckworth: You say, "In the 1990s, as an economist trying to make a mark in academia, it was becoming increasingly clear to me that an enormous chasm existed or was opening up between academic economics and the way the real-world financial markets priced and assessed macroeconomic developments, especially those relating to monetary policy. At first, I found the state of affairs to be somewhat depressing, but also, over time, I came to believe that it represented a research opportunity, albeit a professionally risky one. It was within this context that my academic work on the science of monetary policy with Mark Gertler and Jordi Gali came to be conceived and developed." And I want to go back to that part [where] you said, "Albeit a professionally risky one." So, we'll talk about your works with Mark and Jordi in a minute, but why was it risky back then to bridge that gap?

Bridging the Gap Between Academic Economics and Real-World Markets

Clarida: Well, by that time, Mark and I had tenure. Jordi didn't, I think, or, actually, towards the middle of *Clarida, Gali, Gertler,* he got tenure. So, Jordi was a Blanchard. I should also say that, not to leave out two other influences in my life at Harvard, were Ben Friedman and Olivier Blanchard. So, I actually worked for Ben at the NBER, and Ben was my main advisor, and I learned so much from Ben, because Ben was very broad, and in particular, was not one who did not feel bound by a particular methodology or approach. So, Ben was always interested in, what is an interesting question, spend your time trying to identify an interesting question, and then figure out the methodology.

Clarida: Other people's approach is, start with the methodology and then find a question. And so, Ben supported me because, in those days, the stipends at Harvard were hard to get. And so, in my case, I supported myself by teaching principles of economics and working for Ben. Then, Olivier was the Olivier that we know today, but 40 years ago. Obviously, Olivier was, then and now, the perfect embodiment of identifying interesting questions and using just enough math to get it right, but not too much. But, by that time, I had tenure at Columbia in the mid-90s.

Clarida: In theory, what tenure is supposed to do is to free you up to do some things that could be risky. And so, it was professionally risky in the sense that when Mark, Jordi, and I started working on what became this research program, the dominant paradigm in empirical macro was vector autoregressions, in which the entire focus of the VAR approach was not to take a stand on the systematic part of the correlations, but to look at how innovations or shocks led to dynamic responses. But for your listeners, there may be some who don't know that if you have a six-variable VAR with 12 lags, you'll have 72 right-hand side variables with 72 coefficients.

Clarida: The literature in those days said, “Don't even bother trying to tell a story about those 72 coefficients. Tell a story about some linear combination of them in response to shocks.” And what both struck Gertler and I initially— and then we brought Jordi in— was that that's leaving out a lot of interesting stuff. Don't we want to think? For example, take any vector autoregression that has an interest rate in it, and that's virtually all macro vector autoregressions. You'll have, on the left-hand side will be the funds rate, and on the right-hand side will be 6 macro variables lagged 12 times. So, why is there the correlation between the funds rate and oil prices or the funds rate and the unemployment rate?

Clarida: Surely it can't be that central banks have reaction functions with 72 variables in them, and so this is when the Sargent light went off in my head, and I won't speak for Mark. I said, “Wait a minute.” The reason why, when you regress the funds rate on these 72 right-hand side variables, that they're there, is because they can be useful in forecasting things that you are interested in, which is inflation and unemployment. And, in particular, by that time, we had read the Taylor rule paper, and a light went off in my head.

Clarida: So, what if central banks either have stumbled into, or are converging to, running a systematic policy? The other thing I learned from Ben was that Ben Friedman was not a monetarist. In fact, he had an active debate with a lot of the monetarists in those days, and one of Ben's critiques was that it just doesn't make economic or other sense, if you're a policymaker, to just focus on one variable. You might care about one variable. So, Ben was always a look-at-everything guy and then using judgment and econometrics. And so, it was risky in the sense that, A, the whole rationale for the non-structural VAR approach is that macro really can't answer questions about those coefficients, so don't try.

Clarida: And then, Friedman— And up at Columbia, I still teach. I spent an entire one-tenth of the course, in essence, on Friedman's 10-page paper at his AEA address, *The Role of Monetary Policy.* But the thinking in macro [during] late '80s and early '90s was twofold. One, the central banks are creating a lot of problems, and two, they could avoid the problems if they just read Friedman ‘68 and specified a k-percent rule. So, any correlation between monetary policy and anything other than M2 growth was viewed as a policy mistake waiting to happen.

Clarida: And so, we were running against both the econometric grain and the cultural grain of thinking about monetary policy. Then, of course, in those days, we didn't really think about doing a Bayesian mode. We were actually using Sargent-Hansen cross-equation restrictions to see whether or not it actually did make sense that all of those variables were entering that reaction function. And it turned out, we found, not only in terms of reduced form but in terms of formal statistical tests, that there was incredible power of the Taylor idea, but in the context of a vector autoregression rational expectations model.

Clarida: And I still remember— just maybe an anecdote that will help on this— I still remember Mark Gertler and I were both consultants to the New York Fed in those days with Rick Mishkin, who was then the director of research. And I remember Mark and I comparing notes in a windowless conference room about a paper we were we were commissioned to write. Actually, a paper not on the Fed but on the Bundesbank called, *How the Bundesbank Conducts Monetary Policy.* It was like this “aha” moment [when] we both realized that we were both thinking the same thing, which is that we don't want to be handcuffed to just looking at the effect of shocks on the economy. We want to say something about the systematic part of monetary policy. And so, that was a choice, and we were we were early in that. Then, what happened when we brought Jordi on board is, Jordi not only appreciated the idea and the motivation, but also saw, very quickly, a way to do it very econometrically elegantly with GMM. So, that was also a real advance. So, more long-winded than you want, but-

Beckworth: No, it's great to hear that story. Let me just mention three of your papers. You have more with the two other co-authors you mentioned, but you have a 1999 Journal of Economic Literature paper, *The Science of Monetary Policy: A New Keynesian Perspective,* which is a nice summary of the literature that you've just said, so we'll provide a link to that. Also, the 2000 QJE paper *Monetary Policy Rules and Macroeconomic Stability: Evidence And Some Theory.* And I believe that's the one where you look at pre and post-Volcker regimes.

Beckworth: I remember, as a grad student, reading that like, “Ah, these are different regimes." Then, you have a 1998 European Economic Review paper, *Monetary Policy Rules in Practice: Some International Evidence,* where you look at G3 and the E3. G3 being Germany, Japan, and the US, and then E3, UK, France, and Italy. But coming out of all of those papers, was your research agenda, with these gentlemen— Is that where we get the three equation New Keynesian model? Is that where it all came together and [where] it's common now?

Clarida: Well, by the end of the '90s, it was definitely something that people were picking up on, so I would cite several influences. So, my good friend and my Columbia colleague, Mike Woodford, was then in the early days of writing his magnum opus, which came out in 2003, but the chapters of that were circulating. Actually, Jordi was on top of that before I was. There's a very important paper by Bernanke and Woodford, [in] '97, about putting Taylor rules in a macro model and looking at robustness, forward-looking versus backward-looking.

Clarida: Lars Svensson was starting to put policy rules systematically into macro models. Also, at the time, King and Marvin Goodfriend were also going down the same path. So, what we were early on, or perhaps one of the first to do, was to really take a stand on the whole quantity versus rate instrument approach, because there were some of those early papers that did New Keynesian models but with money demand equations and money supply.

Clarida: So, we were really the first to say, "Okay, you've only got three equations. One's going to be an Euler equation. One's going to be a Phillips curve, and the third equation is going to be a Taylor rule." Because at that point, in Woodford's book, it was not yet out, and, in fact, Woodford was actually looking at doing full commitment, optimal policy under commitment, where you typically will not get a Taylor rule as the outcome. And at that point, I don't think Lars' work had fully been ported into the Euler equation, New Keynesian Phillips curve. So, we were very early in that and certainly, at the time, we were doing it. So, we certainly knew of this work, but this work, at least the versions that we saw, had not yet taken a stand that the third equation would be a Taylor rule equation.

Beckworth: Okay, but you were very seminal in the New Keynesian literature for sure. We don't want to let that go unrecognized. Well, I want to talk about, in a minute, your work on international macro. I want to come back to that, but I want to go back to your policy work. So, you worked for the Reagan CEA, Council of Economic Advisers, which is pretty interesting. Then, also, at Treasury, I think we just barely missed each other.

Clarida: Literally by a week probably, because I left in May of '03, and you arrived in June.

Beckworth: In fact, it was interesting. I got my PhD, and John Taylor was actively recruiting PhDs at the time, in International Affairs. It was a great experience working under him. You also were probably best known now, recently, as the vice chair of the Federal Reserve System, so a very important role. Tell us about those roles you've played in the policy world and how they may have influenced your thinking.

Richard’s Journey Through the Policy World

Clarida: Well, we'll go chronologically. So, when I was an assistant professor at Yale, I got a phone call out of the blue one day from Michael Mussa. Now, Mike and I had never met, but as an international macro person, I had read all of his papers, and Mike called me because, when Mike had gone to the CEA to be a member of the CEA, the CEA typically is a lean operation, and the staff turns over every year or two. So, they're always looking to bring in new staff. And, really, the tradition at the CEA going back 60, 75 years is [that] a lot of their staff are PhD economists who are somewhat early in their careers.

Clarida: Although, in my case, I was only 28, and I'd only been an assistant professor for two years, which is probably a little bit early in the CEA domain. And so, Mike hired me, in essence, to be his right-hand person. So, whatever Mike was working on, I was working on, and so I got the bug immediately. It's neat to be in the old executive office building, and you're out to the elevator and you see the president.

Beckworth: So, you saw Reagan?

Clarida: Oh, my goodness. In fact, when we're done, I've got a picture shaking his hand in the Oval Office.

Beckworth: Oh, yes, I've got to see that.

Clarida: Yes. So, I got the bug. And it seemed interesting, David, that among the issues I was working on with Mike, then, it's going to sound like complete déjà vu. The more things change, the more they stay the same. So, among the things we were working on was the overvalued dollar, and this was right after the Plaza Accord. The interesting thing that any student of history knows, but someone who's not a student of history maybe doesn't know, is that the Reagan administration was not a free trade administration. There was a lot of interventionist trade policy and voluntary export restraints, in particular. There were a lot of tariff actions and the like.

Clarida: So, part of what I learned was a difference between the textbook, the rhetoric, and the reality. That was an important lesson, because you'd think, "Reagan's a free trader," well, aspirationally, maybe. Then, also, there was a very important tax reform act that passed in those days, which was a real bipartisan [bill], so shocking. Today, you would never get a bipartisan tax bill. It was a bipartisan revenue-neutral bill that had a grand bargain. You cut the top rate from 70 to 28 on income, but you basically get rid of a lot of exemptions and deductions. So, lower rate, broader base, and then also substantial corporate tax reform.

Clarida: The last immigration reform that's passed in the US, [was] passed in the Reagan administration. So, I got the bug, and a lot of economists who are academics don't like the fact that when you're in a policy job, oftentimes your objective is to get 90% on the way to the ultimate answer in a week, as opposed to getting 100% of the way to the ultimate answer in three years, but I actually liked that. And Mike was an incredible mentor, brilliant, incredibly funny, and taught me a lot of lessons, which I mentioned in that acceptance speech.

Clarida: But then, I returned to academia, went to Columbia, [was a] professor, was department chairman, and then I had another opportunity to go to Washington in the George H.W. Bush Treasury, working as Assistant Secretary for Economic Policy. That's, essentially, the chief economic advisor to the Treasury Secretary, very eventful period. My first day on the job was September 11th, 2001. The US economy went into a brief recession, [and then a] jobless recovery. Also, [there was] important tax legislation. The thing that I'll mention here, David, that was both fun and a little bit ahead of its time, is that I had been reading some of the research work by Stock and Watson on what we now call nowcasting.

Clarida: In fact, I think even before it was published, it was just in working paper form. And when I got to Treasury, then-Secretary Paul O'Neill said to me, and I'm paraphrasing now, but it was more or less he was saying, "Look, I used to be the CEO of Alcoa, and every day I would have a computer to monitor and I'd have a printout of all of our production and all of the activity in 50 countries around the world where we have aluminum operations. Now, I come to the Treasury, and my only access to data is stuff coming out with a three-month lag on GDP. We've got to be able to do a better job of keeping our pulse on the economy than looking at the published data."

Clarida: Then, I said, "Wait, Stock and Watson are smart guys. They have this thing called nowcasting." So, I had a group of folks who worked for me, and, of course, it was all hands on deck after September 11th. So, I said to him, "Let's get some nowcasting up and running." Nobody was doing it in Washington. In fact, they got it up and running in two or three months. By today's standards, [that’s] not particularly sophisticated, but a back-of-the-envelope, rough and ready, Stock and Watson-approved nowcast model. So, our first big out-of-sample test was to do the nowcast for Q4 2001 GDP. And because September 11th had happened, and everybody was depressed, Wall Street consensus was very gloomy.

Clarida: You can go back and look at the numbers, but I think those numbers come out the third week of January of 2022, and I think that the Wall Street consensus for Q4 2021 was something like minus four, minus six. Our nowcast was basically saying zero flat, and the original number came in within a tenth of the nowcast, which was the best call we had, but it was our first call. So, at that point, then, Secretary O'Neill is really proud of what his team is doing. It's this new thing. Instead of waiting to get the data, we're telling you, in real time, what it is. So, that increased my profile within Treasury and in Washington.

Clarida: I will say that at O'Neill's recommendation, I did go over, and I briefed, shall we say, senior officials at the Fed— I won't mention their names— and they were skeptical. The initial reaction at the Fed in '01 '02 is, “We don't need to do nowcasting, because we have the beige book.” Our response was, "Well, the beige book is invaluable, but maybe you can augment the beige book." Of course, now, the Fed is a world leader in nowcasting, but it was not in '01, so that was interesting. Anyway, so then, after two years there, I then returned to Columbia, and also then had opportunities to begin advising investment firms.

Clarida: Three years later, I joined PIMCO, and I'm still at PIMCO. I obviously resigned, but I have come back since my Fed days. Then, as you mentioned, then, in 2018, I had the opportunity to serve as Fed vice chair during what was really, David, a very eventful four years. I arrived in September of 2018, so I was there for the final hikes in that rate hike cycle. One thing that was interesting, personally, to me, was that one of the things I'd worked on at PIMCO in 2014 was this idea that there would be a new neutral destination for the funds rate in the next liftoff cycle.

Clarida: And, at that point, I was really influenced by Laubach and Williams. I said, "Look, the Taylor rule says the real rate is two, so the destination funds rate should be four." And the Fed and the dots [are] saying that the real rate is two and the destination funds rate is four. But if I just look at the bond market data and I look at Laubach-Williams, I don't think we want to be running the US economy at a 4% or 5% funds rate. We can't even get inflation to two with a 0% funds rate. So, at the time that Bill Gross and I wrote the essay on the new neutral [in] May of 2014, we were definitely early or first in that call. So, it was interesting to me to actually get to the Fed and realize, once we got the funds rate up to 2.5% in December of 2018— so, basically, a 2% target and then a 0.5% equilibrium real rate— that's more or less where the economy was.

Clarida: In fact, if anything, inflation started to fall a little bit in 2019. Also, Chair Powell asked me to oversee the Fed's framework review, which we'll probably want to talk about at some point. I was also the chair of the communications subcommittee, so thinking about forward guidance, thinking about the SEP. Then, of course, after March of 2020, it was all hands on deck for the pandemic collapse and the rest. So, it makes me dizzy to think about those years--

Beckworth: Yes, you had a lot.

Clarida: -but certainly a very fascinating time to have the privilege to serve.

Beckworth: So, I didn't realize [that] you were not only seminal in New Keynesian macro, but also in nowcasting.

Clarida: Not in terms of methodology, but in terms of applying it in a real-world setting.

Beckworth: That's amazing, though, that, back then, that it was even put to use.

Clarida: In fact, just to verify that, there's a Barron's article that was written, I think, in March of 2002, about, “Clarida's team at Treasury brings nowcasting to government.”

Beckworth: There you go. It's in print.

Clarida: It's in Barron’s.

Beckworth: It's in print. So, let's talk just briefly about your time at the Fed. I want to move on to talk about FAIT and R-Star and a few other things before we get to the end of the show. But what is it like in the Eccles Building? I came and actually visited you, but it's got to be surreal, maybe at first. You walk in, and these are the hallowed halls of, really, global monetary policy, given the number of countries that either peg or have debt in dollars. You effectively set monetary policy for a large portion of the world. Did that weigh on your shoulders? Did that thought cross your mind as you go in there, "Wow, I'm in here"?

Clarida: Well, I will just be candid with you. It was the professional thrill of a lifetime. My first FOMC meeting, I get chills thinking about. I'd been a student of the Fed since college, but to actually have the privilege to be selected to be a member of that committee and vice chair— and it was also very special to me, because Jay Powell was a new chair, and I was a new vice chair. He and I didn't know each other, but from the instant we met— I have to ask Jay— but I think we were a really good team.

Clarida: Jay wanted someone who had some, I think, academic credibility and gravitas in terms of thinking about the framework. He wanted someone he could trust, and it was very clear to me that when you're vice chair, you have both a privilege and responsibility. The privilege is that you're a member of the troika, and you get to help think about, not only the agenda for a particular Fed meeting, but, really, about the arc and the plan for the year and also interface with the research staff. But there's also a responsibility.

Clarida: The responsibility is that, once a decision is made, it's my job to advocate and to explain it, and I did that without reservation. It helped that virtually all of the time we were on the same page, but the point is— in fact, people used to ask me similar questions when they would visit me in my office. And, again, I was there for nearly four years, and the first two years were pre-pandemic, and then the last two years, roughly, were post-pandemic.

Clarida: The first two years were a lot more fun than the second two years, but, certainly, in the first half of my term, we were in the Eccles Building, which, for your listeners, is the original Fed building. There's now a second one across the street, the Martin building, and a third that's under renovation, as well as office space around DC, but there is a lot of history in that building. Not only was it a thrill to attend my first meeting, [but] every day, walking in was a thrill. The other thing about the Powell Fed in the pre-pandemic days is [that] it was a very collegial place.

Clarida: All of the governors are right along a hallway, so, there was Jay Powell's office, and then 30 feet down the hall was Governor Brainard, and then 20 feet down the hall was Vice Chair Quarles. Then, my office is right next to Vice Chair Quarles. So, we all had an open-door policy. Now, we didn't abuse it, but if Jay needed to see me about something, he would just walk in. At the end of the day, we would oftentimes compare notes. Randy Quarles and I had worked together in the W. Bush Treasury. Actually, Randy worked for John Taylor, and our offices were next to each other. And I had known Lael since her graduate school days, and then later on, Miki Bowman and Chris Waller. So, it was a very collegial place. The governors used to have lunch every three weeks or so. So, I loved it. 

Clarida: In fact, I didn't finish my story. So, I used to be asked by people what it was like to have been a Fed watcher and now be Fed vice chair, and I would paraphrase the classic quote attributed to Lou Gehrig. “I consider myself the luckiest, but I would say, not the luckiest Yankee on the planet.” I consider myself the luckiest macroeconomist on the planet. So, it was very special.

Beckworth: So, we had Randy Quarles on, and he told an amazing story [about] how he kept tripping the security alarm system at his desk. So, I'll encourage listeners to go back and check it out, but he developed a reputation for pulling in the SWAT team at the Fed. I want to mention just briefly, and then we need to move on, that you also were a musician. You're probably the only Fed official to have their own album out, as I checked, 13 songs, 38 minutes. I understand you and Powell would play guitar together for special events at the Fed, but let's move forward to FAIT, flexible average inflation targeting. My sense of it all— again, that you had the Fed Framework Review, 2018-2019, and then you also gave speeches after it was announced. You were kind of the intellectual architect of FAIT. In your speeches, for example, you talked about Bernanke's temporary price level target. Maybe just share some insights about that journey.

Constructing the Fed’s FAIT Framework

Clarida: Okay, so, literally, before I arrived at the Fed, the day that I got confirmed by the US Senate in August of 2018, I got a congratulatory phone call from Jay Powell. The second thing he said after congratulations is, "You can't get down here fast enough, and on day one, I want you to start helping me think about our framework." So, Jay had a priority that the Fed do this, and he entrusted the oversight of that to me. Now, a couple of things about the framework review, this was not a Rich Clarida or a Jay Powell cramdown.

Clarida: Indeed, one of the things that made it both, I think, worthy, but very logistically intensive, is that it was a system-wide effort with, I think, no fewer than a dozen staff workstreams allocated across the entire system, all of which are now online. So, all of the staff research that went into it is now available. I think, at five or six consecutive FOMC meetings, we had briefings on the framework, and there was also a Fed Listens component. So, part of the Powell framework was not only for the Fed to be listening to academics and market participants but be listening to everyday Americans about the relevance of the dual mandate to them. And there were a lot of skeptics on Fed Listens.

Clarida: Certainly, I remember Fed reporters, for background, had some pretty negative things to say about it, which were reflecting what they were hearing from folks. And even within the system, there was a little bit of nervousness, and that's why it was important. We had some early Fed Listens events that Neel Kashkari and others organized to show proof of concept, and then it became a winner. I should also mention that, internally, in essence, the co-head of the project was Thomas Laubach, because Thomas was the head of monetary affairs staff at the Fed. Thomas was the one who was the liaison with all of the district banks in coordinating all of that research, and, also, through his work with Williams, really an intellectual inspiration for a lot of it.

Beckworth: So, FAIT was, I guess, announced in Powell's speech in August of 2020, but formerly September 2020, it was--

Clarida: So, here's the timeline. The last meeting that I had at the Fed before the pandemic arrived in the US was a meeting with the chair, John Williams, and a handful of other people, in which we were beginning to discuss whether or not we should begin to move towards a vote on the new framework in the spring of 2020, perhaps at the May or the June meeting. So, we were quite close. In fact, we were at the point where John, Jay, and I were in broad agreement about where we thought we wanted to end up, and that was ready to go. So, there is a misperception, which is understandable, that the new framework, basically, was just called out out of desperation because of the pandemic. But as the archival records will show, what became the new framework was, basically, where we were in January and early February of-

Beckworth: So, had the pandemic not happened, it would have been announced much sooner.

Clarida: Oh, yes.

Beckworth: Oh, that's very interesting.

Clarida: Oh, sure. Oh, yes. In fact, I vividly remember, at the New York Monetary Policy Forum in 2020, John and I were both there in my hotel room. I think Jay was on the phone, and then we were writing out notes about what this thing would become, the framework statement. So, yes, it had not been vetted at the committee, and that was going to take several meetings, but in terms of the initial template for discussion, that was January, early February of 2020.

Beckworth: Okay, so, let's talk about it and what's happened, because a lot of people today might associate it unfairly with the high inflation. So, what is your assessment now that we're looking back a few years and we have a record to evaluate things?

Evaluating the Results of the FAIT Framework

Clarida: Well, maybe it would be helpful just for me to give my concise take on what FAIT is and what it's not. First of all, flexible average inflation targeting is the way that we use to describe the framework that we adopted formally in August of 2020 at the virtual Jackson Hole meeting, since it was done virtually in August of 2020. I, and, I think, the committee always thought of FAIT as an evolution, not a revolution, of existing practice.

Clarida: The first thing that FAIT did is that it recognized that we and the global economy had been in a world, really for a decade after the global financial crisis, in which the effective lower bound on policy was a binding constraint. In the US, it was a zero lower bound. In Europe, the ECB went slightly negative. But the idea is [that] if there's a deficiency of aggregate demand relative to supply, to reflate the economy, you need an accommodative policy. But policy’s accommodation is limited if there is a lower bound on the policy rate. And people can say, "Well, that sounds like a great theory."

Clarida: Well, the evidence was that rates had been at zero from December of '08 until December of 2015, and core inflation was 1.5%, and in Europe, it was even lower. I have the exact quote here, so I didn't misjudge it. "The committee judges [that] the downward risk to employment and inflation have increased, because the committee is likely to be constrained by the effective lower bound." So, that was the motivation for the refinement.

Clarida: Secondly, FAIT reaffirmed that the goal of policy is a 2% inflation rate. And, indeed, there was a lot of commentary during the review, and some criticism, when I publicly said that on our framework review, everything is on the table except the number two. The ultimate answer is going to be an inflation target of 2% and, obviously, there's a whole discussion about twos. The number two is, T-O-O, too low. But, essentially, early on in my conversations with Jay, we agreed that since our problem had been that zero rates had not been able to move inflation up to two, that it wouldn't solve the problem to say, "You know what, inflation's been below two for most of the last 10 years, and we're going to solve that problem by raising the inflation target to three." That just didn't click to us.

Clarida: The next thing that we did in the framework is that we inserted something that had been implicit in the framework, but that we elevated in importance. We said, "The committee judges that longer-term inflation expectations are well anchored at 2% if it seeks to achieve inflation that averages 2%." In other words, everyone who does inflation targeting says that one of the goals of inflation targeting is to keep inflation expectations anchored at target. We went a step further and said that the way to keep inflation expectations anchored at target is, on average, to deliver 2% inflation. In other words, if the target is two but inflation every year is 1.5 or 1, at some point you have to acknowledge that expectations may not stay anchored at two. Then, finally, what does all of this mean for policy? 

Clarida: And here was the key sentence: The committee judges that “Following periods when inflation has been running persistently below 2%, appropriate policy will likely aim to achieve inflation moderately above 2% for some time." So, the acknowledgment that appropriate policy could actually seek an overshoot was in response to the problem of inflation being below 2% and as an instrument to bring about the ultimate goal, which is keeping inflation expectations anchored at two. So, one of my colleagues on the committee, when I got there early on, said, "Rich, you should know that, within the Fed, we view this long-run statement of goals as quasi-constitutional.”

Clarida: “It doesn't spell out the detail and the menu of how we do policy, but it does spell out our principles and our goals." And so, then, that is now announced in August of 2020. The question is, okay, well, if this is the new framework, then how is the Powell Fed going to try to achieve these goals? And it was at the September 2020 meeting that, with two dissents, the committee laid out some very, very specific forward guidance. And I won't quote [for] you, but, roughly, what we said is— Now, remember, it's September of 2020. There are no vaccines. Millions of people have died. The unemployment rate had been running at 14%.

Clarida: GDP in the second quarter of 2020 collapsed at a 30% annual pace. And I remind you and your listeners that, in 2020, we had a huge public health catastrophe. We had a huge shock to the economy's aggregate supply, because people weren't going to work. You're not going to produce widgets if nobody goes to the widget factory. And we had an unprecedented dose of support to aggregate demand through the CARES Act, the fiscal package that was $2.5 trillion. The Powell Fed was all in, rates cut to zero, large quantitative easing, liquidity support, backstop to support the credit markets.

Clarida: So, what happened in 2020? An enormous shock to aggregate supply, an enormous shock to aggregate demand, and inflation fell by 1%. So, what we had observed going into that September 2020 meeting is that we've seen a lot of big shocks. We don't like where we are in the economy and, right now, inflation's falling. And so, it was in that context that we said, "Look, it is our expectation now that to keep inflation expectations well anchored, we will not begin to hike rates until inflation has returned to 2%, and until, in our judgment, we've achieved maximum employment."

Clarida: Now, technically this is what monetary economists call a “[threshold-based] forward guidance.” That is, you say, "I'm not going to even begin to do anything until these thresholds are met." There were other policy options available to us. One, which would've been a version of Bernanke's temporary price level targeting, where a central bank simply says, "When I've been at the zero bound, inflation's too low. I'm not going to lift off until inflation gets to target," and that's the Bernanke template. And after that point, you then just basically revert to a Taylor-type rule.

Clarida: Another approach, which the committee itself lays out in its policy rules box— and, David, you and I have discussed the value of that box, and I will point out that it's now back in the monetary policy report. The monetary policy report box, since July of 2022, has included, in addition to the classic Taylor rule, something called a shortfalls Taylor rule, which is just a Taylor rule, [but] the only difference is that if the unemployment rate is too high, that's a reason to lower rates. If the unemployment rate is too low, you just shut that down, and you only raise rates because inflation is too high.

Clarida: And so, we could have implemented the new framework with a shortfalls rule. So, the key point here is that, in my mind— and, I think, in the committee's mind— we distinguished between the framework and the goals and the implementation of the framework through forward guidance. We also offered— we, because I was, then, there— The committee also offered forward guidance in December of 2020 that we would not even begin to taper the pace of QE until we had made substantial further progress towards our goals. Now, that, again, was a policy choice. We could have simply said, "We'll let you know meeting to meeting on the balance sheet. We're not making any promises."

Clarida: Another set of guidance that we offered to markets was that we would not begin to raise rates until we had ended QE. We also said that we will not end QE at one meeting, we'll taper QE first. So, there was a lot of forward guidance offered between September of 2020 and December of 2020 that would later factor into the committee's decision to delay liftoff until March of 2022, even though the policy rules were all signaling that liftoff would be appropriate by the third quarter of 2021. That's the other important point. The Fed has its critics. Many of the Fed's critics oftentimes don't bother to offer a counterfactual. They just say that they didn't like what the Powell Fed did with all of that bad advice from Vice Chair Clarida, but they don't offer a counterfactual.

Clarida: In particular, the legitimate real-time counterfactuals, which would be rules-based, without any guidance, would have probably indicated liftoff at the September of '21 meeting. The committee, in the end, lifted off in March of 2022. So, criticism of the Fed is, really, what would the last four years have looked like if liftoff had been in September of 2021 versus March of 2022? The other thing I would point out [is that] David Papellwho some of your listeners note, has done really fine work, in which he does a legitimate counterfactual calculation that he updates every FOMC meeting.

Clarida: Which is what various policy rules, inertial and non-inertial, would have indicated using the data available to the Fed at the time and using the Fed's own SEP projections. Those also show a liftoff that would have occurred in the fall of 2021. But, importantly, they show that, although the Powell Fed didn't begin to lift off until March of 2022, it actually got to that Taylor rule path pretty quickly by the fourth quarter of 2022. So, that's my own concise take on both the framework, the motivation, and the implementation.

Beckworth: That's a good point, that even if you had followed a rule religiously, it would have been just a few months difference. It wouldn't have been some earth-shattering difference. The other thing [is], it sounds like you're saying that there's a difference between FAIT on paper [versus] how it's executed, and those two things need to be kept distinct.

Clarida: Well, I think, here, the quasi-constitutional analogy is a good one. The Constitution, for example, says Congress passes laws, and the executive branch executes the laws and signs the bills. It doesn't tell you what to put in the Commerce Department bill or how much money to allocate to the Defense Department, or it doesn't tell you about what tariffs should be. So, the framework itself is broad enough, because it's focused on goals and destinations, to be consistent with a range of implementation.

Clarida: The other thing I should point out, again, because I have to remind myself— because you and I have had a lot of conversations about this— that I've not had conversations with your listeners. The most important thing to remember about the lessons learned from the inflation surge post-pandemic is that it was very similar across countries, across implementation, and across policy strategies. So, single mandate inflation targeters, like the Bank of England, inflation was too high. Single mandate inflation targeters, for the Eurozone, inflation was too high.

Clarida: Inflation was too high in Switzerland. It was too high in Australia. It was too high in Canada. Moreover, with the exception of the SNB and the Norwegian Central Bank, all of the other advanced economy inflation targeters also chose to fall behind the curve, in that they did not begin to hike rates until core inflation in their country had moved well above target. So, it was something about initial conditions— inflation had been too low for a decade— about the magnitude and complexity of the shocks, because they impacted both supply and demand, that led central banks to do very similar things and to have very similar liftoffs, very similar inflation history, and now very similar disinflation.

Clarida: So, I think and I predict that, with the passage of time, scholars will look back on this period and they will not think that it revealed very much about inflation targeting versus flexible average inflation targeting versus single mandate versus dual mandate. They think it will reveal something about the initial conditions and the magnitude and the complexity of the shocks. And, knock on wood, this is, I think, where they will end up if, as I expect, central banks will get inflation into the twos and keep inflation expectations anchored there.

Beckworth: That's a great point for those who want to point to FAIT. How do they explain the rest of the world, which did not have FAIT? Well, let's look forward to the next Fed framework review, which is starting later this year. What would you recommend and what would you hope they do, if anything, to the framework?

The Future of the Fed’s Framework

Clarida: So, I think that most of the important lessons learned are lessons about the choice and the implementation of what Ben Bernanke has called the new tools of monetary policy, so, rates, forward guidance, and [the] balance sheet. I think there are some important lessons learned about all three of those. In terms of the actual framework statement itself, I think that the recognition that anchoring inflation expectations at target is important, and the recognition that central banks will help to keep inflation expectations anchored if they actually deliver inflation that averages 2%.

Clarida: So, I would not see any need for what is actually paragraph 4 in the statement to change. I think that the committee could explain, in a committee statement as opposed to individual speeches, what it thinks shortfalls means. The record will show that I gave 12 speeches in which I said what Rich Clarida thinks shortfalls means, but it could be helpful if there's actually an FOMC statement. I think shortfalls is just shortfalls. The committee has a view about what full employment is. The committee knows that there are standard error bands around that, and the way the Fed balances off its dual mandate with uncertainty about the natural rate is to form a view on the natural rate. If the unemployment rate is above the natural rate, then that's a factor in keeping rates low or cutting rates. If the unemployment rate falls below the current estimate of the natural rate, that's not a reason to hike if there's no inflation. I think it's that simple.

Clarida: Maximum employment is the level of employment consistent with keeping inflation on target at 2%. Then, as I said, I think that the interesting thing for the committee will be what's in the second paragraph and whether or not, looking ahead, the committee judges, "That it's likely that the zero lower bound is likely to be a constraint on policy in the future and that there are downside risks to employment and inflation." The world, in some respects, looks different than it did five years ago, and so the committee might want to think about whether or not that risk is as elevated as it appeared at the time.

Beckworth: Okay, in the time we have left, I want to circle back to some of your international work.

Clarida: Yes.

Beckworth: And, in particular, you had a paper in 2015 that dealt with R-Star, or this neutral rate which you just referenced, in the context of FAIT and why it's important to take a global perspective, and use that to motivate a question: Where do you think R-Star is going? Are we forever leaving behind that world of low R-Star or are we going to return to it?

The Future of R-Star

Clarida: Okay, well, first of all, I'll do a little public service here, which is something, David, you and I have discussed, and I've discussed with people, but I'm not in print on this and so, even better than being in print, I'll get it on your podcast, and then maybe I'll write an article.

Beckworth: Absolutely.

Clarida: I think, in discussions of R-star, it is critically important to distinguish whether or not one is thinking about the riskless real yield on a 30-year bond or the riskless real yield on a three-month T-bill. What's the difference? The difference is what economists call the term premium. And I'm of the view that there is reason to believe that the equilibrium real yield on a 10-year bond or a 30-year mortgage, looking ahead, may be higher than it was in the decade after the global financial crisis, but not necessarily because I think the federal funds rate that is consistent with keeping inflation at 2%, once it gets there, has necessarily risen by as much.

Clarida: In other words, I think we could be in a world with steeper yield curves once we get inflation to 2%, but not necessarily all that much of a higher riskless policy rate. That will be an empirical question, because we're not at 2%. The other thing I want to say is that some of the discussion— not on your podcast— but some of the discussion of this issue, it's certainly confusing. It could be confused, because it points to market pricing that markets are not pricing in the funds rate getting all the way down to the Fed's long-run dots.

Clarida: And that is true, but that could simply be because markets think inflation is going to be sticky and that, for the next several years, the policy rate is going to have to be above neutral. So, where I am now is in a spot where I think that we could well be in a world— and, of course, I need to state the most relevant reason why 10 and 30-year bond yields may be higher than they were— is that there's a lot more Treasury debt that financial markets have to hold. When I served as Assistant Treasury Secretary in 2001-2003, the debt-to-GDP ratio in the U.S. was 39%. It's now 100-plus percent.

Clarida: Reinhart and Rogoff wrote a classic book in which they pointed out that, historically, there's no magic number, but, historically, once you get debt-to-GDP above 100%, bad things happen. And so, unless you think that the Fed, on an ongoing basis, is going to be doing unlimited QE to, basically, peg bond yields, then I think the way that the Treasury market will clear is with a higher term premium. Obviously, in addition, another factor that could push up longer-term yields is infrastructure investment and subsidies to climate transition and all of the rest.

Clarida: But I think the important point is that you want to distinguish between where you think long-term bond yields are ending up and where you think the fed funds rate is ending up. And so, I'm in the camp that, for now, thinks that the fed funds rate, once we get inflation to 2%, will still be a lot lower than it was pre-GFC. It may be somewhat higher than it was when I was at the Powell Fed, and we got the funds rate right up to 2.4%. But most of my focus is where I think bond yields are going to end up, and that could well be higher.

Beckworth: Okay, with that, our time is up. Our guest today has been Rich Clarida. Rich, thank you so much for coming on the program.

Clarida: Thank you.

About Macro Musings

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