Robert Kaplan on the FOMC, the Dallas Fed, and the Lessons from the Great Recession

Although the Fed currently uses a floor style operating system, the future of the central bank’s balance sheet may dictate if that system changes.

Rob Kaplan is the President and CEO of the Federal Reserve Bank of Dallas. Previously, he was a professor and associate dean at Harvard Business School, and a vice chairman at Goldman Sachs. Rob joins the Macro Musings podcast to talk about his career, the Dallas Fed, and U.S. monetary policy.

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: Rob, welcome to the show.

Robert Kaplan:  Thanks. Good to be here, David.

Beckworth: It's a real treat to have you on. With all my guests, I always start off by asking them how did they get into economics and to macro, and in your case, the Federal Reserve. What was your career path that led you to the Fed?

Kaplan: I was an investment banker for 23 years, as you know, at Goldman Sachs, and then I actually took a leave of absence to teach leadership at Harvard Business School. I enjoyed it so much I went back to the firm and I formally resigned, and then wound up staying at Harvard for close to 10 years, first as an instructor, then as a professor, then a senior associate dean. What happened was, in 2015, the Dallas Fed was doing a search for a new CEO, and I got a phone call from one of the board members and asked me whether I'd consider doing this. I thought about it, came down and talked to them, and they offered me the job relatively quickly. I guess it was sort of a circuitous route, but I always wanted to do public service, and when the opportunity to come to the Fed came up, I jumped on it and thought it was a great way to do public service.

Beckworth: I read in your bio you grew up in Kansas. Is that correct?

Kaplan: I did, yes.

Beckworth: All the way from Kansas to the halls of power at the Federal Reserve.

Kaplan: Yes, something like that. Yes.

Beckworth: I mentioned Kansas because I was born in Kansas as well. We had a previous guest on, Brad Setser who's from Kansas. We had a lot of recent Kansas guests, which is great. You've written a lot of interesting books on leadership, self‑growth. You were the dean at the Harvard Business school, so you know management, personal development. I'm curious because you have a unique perspective on that at the Federal Reserve. How do you view the Fed through the lens of your business and management skills?

Kaplan: First of all, I'd say institutions in this country and in the world generally, but certainly in the United States, are very critical. It's very important that our institutions work effectively. Having a strong institutional framework allows people to innovate, run businesses, do all the other things that we do freely because our institutions are strong. I think the Fed is one of those important institutions in the United States. Historically, the leadership of the Fed has been, not wholly, but heavily comprised of PhD economists. I'm one of the few business people around the table, but we do have a few of them. I think in terms of leadership of this institution having a mix of PhD economists, as well as people who've been in the business word and in the private sector or other walks of life, I think that diversity of backgrounds is very valuable and makes for better leadership.

Kaplan: There's a whole range of things going on at the Fed that the Fed uses me on, on how to make sure that whatever it is we're doing. We do monetary policy, we do research, we do supervision of the banks in the United States. We oversee payments. We're an operator and we do treasury services, cash management and all those things. I think the things I've learned as a business person in terms of adding value that's distinctive, setting priorities, figuring out where you're out of alignment, getting into alignment, I brought all those practices to the Fed, and I think they're all applicable here.

Beckworth: All right. Very interesting. I'm curious. What is it like in a typical day in the life of a Federal Reserve president? You're at the Dallas Fed. What does your typical day begin like and end with?

Kaplan: Well, it's fair to say that at any moment in the day, I've already got in the back of my mind trying to understand what's going on in the economy in Texas, New Mexico, Louisiana, and the economy in the United States as well as the economy globally. I'd say at all times in this job, when I'm talking to business leaders, I'm talking to other leaders, I'm talking to economists, I'm always spending part of my time trying to figure out what's going on in the economy and what's the outlook. I probably spend, on a typical day, I'm talking to our research people.

Kaplan: I'm probably talking to 30 CEOs a month, so I'm doing several calls a day that are scheduled. There are some management aspects of this job. I chair budgeting for the Fed spending stewardship. I'm spending time on that. Then probably a whole range of other people, leadership, and management issues in managing the 1300 people at the Dallas Fed and also being involved in managing a lot of the activities we've got going on in the Federal Reserve System generally. It's a mix of those things on any given day. Then, a good part of my time, I'm out in the community speaking and also learning about what's going on in the economy.

Beckworth: You've got a full plate there, juggling a lot of different responsibilities. You mentioned the part about staying informed about the US economy. I'm curious, in addition to your in‑house advisors, your economists that you turn to, where do you like to go for news market analysis? Is there favorite newspapers, magazines, news shows that you like to turn to?

Kaplan: I look at everything. It starts with when I get up in the morning, I'm probably watching the same cable news shows everybody else is on CNBC and Bloomberg and others. I'm reading The Times, The Wall Street Journal, and the FT every single morning. I'm watching the Dow Jones' wire or Bloomberg during the day for news stories. I'm also watching the markets. That pattern I probably follow every single day. Then, I'm talking, as I said, to people in industry, CEOs about what are trends that are going on that I might not be reading about in the paper or seeing in the markets. Based on all that, I'm trying to form a pretty good picture of what I think is going on out there and what's likely to happen in the future.

Beckworth: That's a pretty big volume of news absorptions.

Kaplan: I'm consuming a lot. I'm used to it. I've done it for my whole career. I'm consuming a lot every day. That's deliberate.

Beckworth: I'm curious, one of the new facets or mediums for getting news is Twitter. There's a lot of interesting conversations that go there in real time. It's kind of a news wire for some folks, but it's also conversation platform for others. I know some Fed officials look. Some participate. Do you see any value in Twitter for your job?

Kaplan: I'll just tell you when I was a professor at Harvard, I used Twitter to post speeches I gave and articles I wrote. I seldom made a comment on it. I usually just posted something I did or an interview I did, and I use it the same way at the Fed. I think for me it's a good distribution method where if I speak or if I write something, we put it on Twitter. I probably personally don't use it to converse with people because it's too limiting. In this job, I think a sound bite that short may not lend itself to the kind of work that I'm doing.

Beckworth: Right. It has a potential to blow up. I want to ask about FOMC meetings. Can you walk us through what it's like to prepare, to get on the plane, when you're actually in the conversation at the FOMC? What is it like?

Kaplan: In a way, I'm always preparing for FOMC because of my work in trying to understand the economy and thinking about monetary policy. I'd say, formally, we usually start our formal preparation for the FOMC about two, two and a half weeks before the meeting. We have a process here that I work on with our research department where they're preparing briefings on the local economy, the national economy, international, a number of then specific topics like what's going on in the financial sector, banks, etc. They're working on that. At the same time, I'm making a number of outward calls to a range of business leaders, community leaders, some economists, some people in the markets just to try to understand what their insight is as to what's going on now.

Kaplan: That all comes to a head at the end of the week right before FOMC where I'll make notes then on what I think I want to say at the FOMC in terms of my analysis of the economy. Also, I will have worked with our research department here to debate what the appropriate path is for monetary policy. Then, I'll write some notes on Friday before to jot down my views. I'll get to DC on Monday. We'll usually have committee meetings on Monday among the Fed bank presidents and the governors. Then we'll start the FOMC on Tuesday. I'd say everyone around the table has their own process. One thing we all have in common, I think we get to that table, we're all extremely well‑prepared and spend a substantial amount of time preparing, which makes it a very valuable process.

Beckworth: Do you bring staff with you? Do they get to sit around the table when you're at the table? I mean, behind the table.

Kaplan: I always bring usually our chief economist or some senior economist from the bank. Sometimes we rotate it. Like a lot of things at the Fed and the FOMC, it's pretty choreographed. There's a seat that's been the seat for the President of the Dallas Fed, which has been our seat for a long, long time around the table. Then around the outside of the table, there's an assigned seat for the economist that comes from the Dallas Fed. They will always sit in that seat.

Beckworth: Is that by chance Evan Koenig? Does he get to go on those trips?

Kaplan: It's Evan or it's now Mark Giannoni. One thing we've tried to do is rotate our senior economists, so that they have a chance to see what goes on at FOMC. I think it's a great experience, and so we're trying to make sure our senior people get exposure to that.

Beckworth: Okay. When you're in the FOMC and you're discussing what to do next, let's say there's a disagreement. Maybe the majority wants to move one direction and someone else is dissenting. They think another direction's appropriate. How are such disagreements handled?

Kaplan: I would say that here at the Dallas Fed and also at the FOMC, I'm hopeful that there'll be disagreements. What we all come prepared to do is independently give our views. Sometimes, our views around the table at the FOMC are the same, similar. Sometimes, we disagree. When we disagree, we discuss why we disagree and debate it. I think that's the most valuable part of the process. I think I'd be disappointed if there is too much agreement around the table. I think it's very important. I think we have a culture at the FOMC where a disagreement is welcome and encouraged. What we do though is debate it out. We all learn from it. We all reserve the right to be persuaded or to change our minds. I think that's one of the big values of the FOMC process.

Beckworth: There is this perception though that when the final vote is cast, that's it good to maybe to some extent put on a unified front. Is that true? Even if you disagree, you vote because you want to send a clear signal. I know there's been dissents. Is there ever the time where maybe you said, "Okay, I'll vote now, but maybe I have some misgivings about it."

Kaplan: Here's my approach. I'm probably representative. On any one decision, I may either have great conviction and feel very strongly. My job, by the way, before the FOMC meeting is, in my opinion, to share those views with others around the table and then ultimately, the week before with the chairperson, either Janet Yellen or Jay Powell. If I disagree with where we're going, I'm going to work hard to try to convince them of my position. They're going to debate back. By the time I've walked into the meeting, I've already expressed my views. To the extent I had disagreement, I have expressed them. If I have strong enough conviction, I would not be averse at all to dissenting. Turns out so far, I have not. I come from a business background, and what I learned in business is you don't wait till the meeting to disagree. In the lead‑up, you give your views. Sometimes in my experience here, I've been able to persuade others around the table to moderate their views. Sometimes I've disagreed. Through their arguments, they persuaded me I should moderate my views.

Kaplan: I would say for me, I have not worried too much about presenting a united front after we leave the meeting. I've been very free. I think most around the table feel very free to express their view, including if they're uncomfortable or disagree with certain aspects of what we're doing. I think that's a very positive thing. We're pretty transparent. We do a Summary of Economic Projections, so‑called dot plot. We submit our views on what the outlook is for GDP growth, unemployment, what we think the appropriate range is for the Fed funds rate. There's some consensus, there's a median, but there's outliers. I think when we leave the meeting, I certainly do feel free to explain why I might be an outlier on certain things. I think that's very positive. It's very transparent. No, I don't say anything publicly that I wouldn't say privately in the meeting.

Beckworth: Very interesting. There's some discussion that goes on before the actual meeting. Everyone knows where the other participants are coming from. You say that's an important part of the process.

Kaplan: I think so. Listen to Fed presidents, we're getting together frequently apart from FOMC because we're doing work on other operating aspects of the Fed. We work on a bunch of committees. It's not unusual that if I have a different view on what the neutral rate is or the outlook for the economy or some other issue, including regulatory issue, I'll call a few other presidents and bat it around. I've called governors in the past and batted it around. I think this group, I was about to say cohesive and collegial. This group works very well I think together as a group. Even though there's new participants, some people are retiring. New participants are rolling in. I think there's a culture that we work together very, very well. We independently express our own views and do our own independent work, but we also learn from each other and listen to each other.

Beckworth: Very interesting. One of the areas you just mentioned is the regulatory front, the part of your responsibility dealing with bank regulation. There's also the state banker charters. State of Texas has its own bank regulators. I'm wondering, how do you interact with them or does the Board of Governors interact more with them than you?

Kaplan: We are involved in supervising the banks, for example, in the state of Texas. In the lingo, supervision is a "delegated" function, in that the big policy decisions are ultimately made at the Board of Governors, but that doesn't keep us from having extensive discussions about them. Then our job in the districts is to implement these policies. We do a lot of the work we do in coordination with the Board of Governors. I would say this is a shared activity with different aspects of it being delegated to one party or the other.

Beckworth: Let's move on to the actual stance on monetary policy, the decisions that have recently been made. Just this September, the FOMC met. It raised another 25 basis points. It looks like there's going to be some more going forward. If you calculate them all in, the ones next year, the ones still remaining this year, it could put the target rate, interest rate, in the low to mid 3% range. I'm curious if you're comfortable with that destination.

Kaplan: Here's what I've said publicly. This is a good example, maybe, of what we were talking about earlier. Each of us is part of submitting our views, but each of us separately articulates what we submitted. Let me explain. I have said that my own judgment is we're meeting our dual mandate right now, meaning full employment. We are at or past full employment in the United States, in my view. That doesn't mean there isn't some more labor slack. There might be, but I think we probably are meeting our full employment mandate. I wouldn't have said that two or three years ago, but I would say it today. We are also meeting our price stability objective, in my view. We have a stated objective of a 2% medium‑term PCE target. Right now, based on all the work that we're doing at the Dallas Fed, we believe we're meeting that 2% objective. My own view is when you're meeting your dual mandate, it's appropriate to be adjusting the stance of monetary policy to something closer to at least a neutral stance.

Kaplan: Neutral means, we've been accommodative at the Fed for the last, literally, eight or nine years. I think we're getting to the point now where I think the economy no longer needs the Federal Reserve to be accommodative. This would be akin to, I'm not suggesting we put our foot on the brakes, but I do think we should be, at least at the Fed, taking our foot off the accelerator. My own assertion is neutral. There's disagreement, I think that's appropriate, around the table. My own best guess as to what the neutral rate is probably revolves around something in the range of two and a half to two and three‑quarters, but I would emphasize that's inherently imprecise. It could be a little higher than two and three‑quarters. It could be a little lower. What I've submitted in the dot plot probably calls for us to get to a destination where maybe the ultimate rate we get to is closer to two and three‑quarters to three percent. Some are higher. Some are lower in that submission, but that's the neighborhood as to where I am.

Beckworth: You'd be a little bit lower than the median that we now see in the Summary of Economic projections.

Kaplan: It depends on which year. I'll let you refer to it. What I've said is I'm comfortable with one additional raise in December. I'm comfortable and I think my base case is that we would raise at least a couple of times next yet. If you did that, that would get us in the range of two and three‑quarters to three percent. We're two to two and a quarter right now. If we raised once more in December and then twice more next year, that would get us in the range of two and three‑quarters to three percent. I, so far, do not have a view that we should go beyond that. I might change my mind by the time we get to next spring or summer and articulate a view that we need to do more, but at this juncture, I'm not ready to make that judgment.

Beckworth: Sure. That makes sense. You know what's interesting? You mentioned the neutral rate. What is the value? There's differing views upon it. It was interesting just these past few days, past week or so, Fed Chair Jay Powell is, I don't want to say distanced himself, but he's definitely recognized there's ambiguity surrounding the estimate of it. They're moving targets. They're hard to pin down. Then President of the New York Fed, John Williams, had a speech where he came out and just said, "Look, we have to be less focused on this R‑star, this neutral rate measure." After it being so important, it seems like, for the past few years, he's downplaying its importance.

Kaplan: I'll give you my own interpretation. I think it might be a little different than the premise of your question. What I would say and what I have said is we ought to be recognizing, and we have all along, that the neutral rate is inherently uncertain in the same way our best judgment on the full employment rate is inherently uncertain, okay?

Beckworth: Mm-hmm (affirmative).

Kaplan: It's not like I can look at the 10‑year Treasury and I can see a rate. The neutral rate is, by its nature, in a range and has some ambiguity. I think we're wise to recognize that. Having said that, that doesn't mean we don't still have to make a judgment about it. In the same way when you're approaching an intersection and you've got your foot on either the brake or the accelerator, you've got to make a judgment about how fast you're going and what your rate of speed needs to be as you approach that intersection. You know what I mean?

Beckworth: That's a good analogy-

Kaplan: Understanding that it's not an exact science. I think it's appropriate to caution that these estimates are uncertain and that as a result... I'll let John Williams and Jay Powell speak for themselves, but what I take our comments to mean is as a result, in our statement, I don't think it's useful at this point to be commenting on whether or not we're accommodative. I think it was useful for the last eight or nine years. I think it's less useful now. I think the other thing that's worth commenting on, as we get toward our best estimate of neutral, there's going to be a little bit more uncertainty, which is another way of saying I think when you're highly accommodative, I think it's clear that you should be raising the Fed funds rate and moving toward neutral. As you get toward neutral, given the neutral estimate is got a band around it, is uncertain, you have to realize it's not going to be an exact science. It's going to be imprecise. We should just recognize that. I think that's the way I would frame this.

Beckworth: That's fair enough. That seems reasonable. Also, I think it's maybe a little early to dismiss the R‑star completely because it's still going to be in all the models, implicitly in all the Phillips curve thinking. It's still there. It's just you guys are being more nuanced, as you just suggested, with it.

Kaplan: I would say to you I don't foresee a time where I'm going to dispense with trying to think about R‑star. I think it's an integral part of monetary policy. Having said that, I'm never going to attach undue precision to that. I'm always going to be very aware and always emphasize, this is highly precise. It's subject to revision. We might move our estimate up or down of R‑star. Let's just put it in context.

Beckworth: Along those lines, do you have any concerns about inverting the yield curve?

Kaplan: Yeah. I would say two things on that. Number one, in terms of when I look at the yield curve today, what I see, and I'm speaking as somebody who spent a good part of my career in the markets, the one and the two‑year Treasury, I think, pretty heavily reflect what the Fed has said it's going to do on the Fed funds rate. In other words, we've been pretty transparent. I think you see a lot of what we said reflected in the one and the two‑year rates. Good example of what I just said is, we raised the Fed funds rate last week. I don't think you saw the one or two‑year Treasury rate move at all, or they did not move it in response to that, which tells me it's in the market. The 10‑year Treasury is another matter.

Kaplan: The 10‑year Treasury is not as heavily determined by the Fed because we set the short rate. It's heavily determined by supply‑demand factors, and it's market‑determined. I think the 10‑year Treasury is telling me that there's a lot of global liquidity, which keeps down the 10‑year rate and the 30‑year rate. It also tells me that expectations of future growth are somewhat sluggish. The curve is flattening as a result of that. I do believe that's it's very important to pay attention to the curve. I, for one, would not want to knowingly invert the US Treasury curve. I wouldn't. Others might disagree with me. Here's why I wouldn't want to do it. For me, one, yes, historically, it's been a pretty good forward indicator of future recession, but for me the bigger issue is if you have an inverted yield curve, I mean if it's materially inverted and inverted for an extended period of time, what that means is financial intermediaries. Lenders, their business is to borrow short and lend long.

Kaplan: If they cannot borrow short and lend long and make a spread because of an inversion... In other words, you get paid more to take shorter risk than longer risk. I think that, ultimately, in my experience, is going to have an impact on tightening financial conditions. It doesn't surprise me that historically when there's been an inversion, it usually has lead to tightening financial conditions, ultimately, and a slowing in the economy, if it persists. That's why I think it's worth continuing to pay attention to and not discounting. Flattening might be fine, but if you actually have an inversion, a material inversion for an extended period of time, I, for one, would view that as something I'm going to watch very, very carefully. That'll be a factor in my decision‑making.

Beckworth: That's a great point. The yield curve can go from being a predictive tool to an actual causal agent for financial intermediation, if the inversion is big enough, as you suggested. Let's move on then to some other interesting topics. These are bigger questions as the Fed moves forward this year and next year. There's two I have in mind. The first one is the future of the Fed's operating system. Right now, the Fed, with this large balance sheet, is running a floor system, but if the Fed's balance sheet were to continue to shrink, the bank reserves continue to get smaller and smaller, at some point, if this was left unchecked, the Fed would be pushed back into a corridor system like they had before 2008. I think it would be a little bit different because you would still have interest on excess reserves, but it would be more of a corridor system. Alternatively, the Fed could stay with the floor system, end that run‑off of the balance sheet. Do you have a view of which operating system you would prefer to see in the future?

Kaplan: I think this is an example of something where I think it just pays to have an open mind. We're running down, gradually, the Fed's balance sheet. I'm watching very carefully how the markets are reacting to that. I'm watching very carefully the mechanic on how the Fed funds rate is set. We're making, I think, ongoing judgments and trying to assess and learn from this process about how much reserves are actually needed in the financial system. I think it's a little too soon to judge. My guess is we're going to wind up, ultimately, with a continuation of the current system of a floor system, but I've got an open mind on that. I'm not sure I see a scenario where reserves decline enough and our balance sheet runs down enough where we return to the old corridor system, but I'm open‑minded. The most important thing between now and over the next months and years is just to be learning from what we're seeing and trying to make an assessment as to how much reserves are needed and what the appropriate system is.

Beckworth: You view this issue from, let's see what size of balance sheet makes the most sense, and then what's the implications for the operating system, as opposed to, what operating system would I like. Then find the balance sheet that fits it. Is that fair?

Kaplan: Yes, that's very fair. That's absolutely right.

Beckworth: Okay. All right. You're not pre‑set on an operating system. You more want to see what amount of reserves do you think the system needs and go from there.

Kaplan: Right. Like a lot of things, we should be adapting our approach to what the needs are of the financial system.

Beckworth: Okay. All right, so the second big point of conversation, one that's near and dear to my heart, and the reason I mention Evan Koenig, because I know it's near and dear to his heart, is the actual monetary regime. Right now, the Fed has an inflation target, has a dual mandate, as you mentioned, but also it's an inflation target. There's been a lot of discussion about, should we look at something different, a price level target, a temporary price level target, a nominal GDP level target, that would be my one I would check, or maybe even inflation targeting with a range, like 1% to 3%. I know Evan is a fan of nominal GDP targeting, at least he has been. I'm wondering what your thoughts are. If you could reset the system... I know part of the problem is it takes time to change an institution, change market expectations. If you had a clean slate, what regime would you pick?

Kaplan: You're right. Getting from here to there, if we're going to make changes, is a very tricky thing because we've conditioned the markets and the public to expect a certain type of framework and reaction function from us. Having said that, I do think it's a healthy thing. I do believe we should be stepping back and re‑reviewing our regime. I think we should be doing that in the future on some regular basis, but I think that's a healthy thing. I'm hopeful that we'll be doing that at the Federal Reserve. Of all these approaches, and obviously, I live here in Dallas with Evan, the nominal GDP targeting has a lot of appeal in that it takes into account inflation. It takes into account growth. The other thing is we are a very highly leveraged country. It's nominal GDP that services our debt.

Beckworth: That's right.

Kaplan: In other words, you need to generate nominal GDP to service the debt. There are some challenges though with this approach and others, which I actually would like to see us debate. What's an example? How to explain nominal GDP targeting, in that there's a catch‑up mechanism in nominal GDP targeting, and a lot of other aspects that I think are not going to be easy to communicate. The good news about the current framework is it's relatively straightforward to communicate.

Beckworth: That's fair.

Kaplan: My main objective, I don't have a conclusion, I would like to see us have a formal review, look at all these different options. The other comment, people have asked me, "Would you like to raise the inflation target?" So far, I'm open to examining that, but so far, I'd be reluctant, in that, we set a 2% inflation target. We've been running, famously, behind it for many years. We're not, right now, meeting it, and I'm a little hesitant to want to further change that target, especially at this stage in the economic cycle. Also, it brings into question if you change the target, do you have the tools to achieve that target? While we've got a lot of cyclical inflation pressure right now, I think a lot of forces out there right now are in fact deflationary: globalization, automation. My main thing, again, that's a long‑winded way of saying, I don't have a conclusion on these things. Probably nominal GDP targeting would be at the top of my list, but I'd like to see all these various approaches examined, debated, and a good process to be reviewing this.

Beckworth: Do you think the other members of the FOMC are as open as you are to these alternative approaches?

Kaplan: As a practice, I normally don't try to speak for the whole committee, but you've seen, I think, a number of statements from others around the table that have expressed an openness. I think that includes Presidents and Governors. I'm hopeful that this is something we should do, even if the end of it, we make no changes at all. I just think the process... Listen, I come from the corporate sector and the business sector and I'm accustomed to re‑reviewing your governance, your frameworks, your approaches, and doing that on some regular basis, I think that's a healthy thing. I started this conversation about the importance of institutions in this country. I think one of the things that preserves and builds institutions and confidence in institutions is an observed willingness to re‑examine how we do things and update those things.

Beckworth: All right. Fair enough. This is about the 10‑year anniversary of the financial crisis. As a member of the Federal Reserve, I wonder what your thoughts are on the lessons from this crisis.

Kaplan: There's a number of them, but the most important, for me, is probably two things. Number one, before 2008 or so, the Fed did not have, we did not have stress testing of the big banks. In particular, what I mean is we looked at capital. We looked at other features. I've learned, by formerly being a banker, capital alone may not tell you that much unless you stress‑test it. What we learned out of the crisis is there were a whole series of derivatives, contingent liabilities, tail risk, credit default swaps being an example of that. I don't think the Fed recognized the degree of leverage in the system because we didn't run stress tests. I want to make sure, going forward from here, we can re‑review capital requirements, regulations for small and mid‑size banks. I think it is very critical that we keep very tough capital requirements and stress‑testing for our big banks. Second lesson is, as much as we do a good job on the banks, a lot of the financial risk in the system is in the non‑bank financials. It's away from the banking system. It's in the so‑called shadow financial system.

Kaplan: I think what we learned in the crisis was we don't have great visibility on the shadow system. A lot of the worst practices which helped lead to the crisis, including writing an excessive amount of credit default swaps, happened not in the banks, but in the non‑bank financials. I'm a little concerned, as I sit here today, to make sure that we monitor, and it won't be at the Fed because we don't have oversight on non‑bank financials, but I think our other institutions and oversight groups, SEC and others, need to be watching very carefully the non‑bank financials. We've learned historically a lot of the excesses and leverage, including in derivative form, can build out in non‑bank financials. I'm not worried so much about the risks we see. I'm worried about the risks that we don't see. That's what the lesson is for me, one of the big lessons of the financial crisis, that we were running far more risk than we were recognizing, and I want to make sure that doesn't happen again.

Beckworth: Okay. I actually lived in Texas during this period. I remember getting a mortgage in late 2007. It was fairly easy. One of the takeaways I got at least from the state of Texas is they had regulations in place that prevented some of the excesses or the worst parts of the housing boom from getting into Texas. My understanding is at least from the housing boom‑bust in the '80s, in the oil‑related boom‑bust cycle there, Texas put in place some laws, for example, that prevented one from getting a 120% mortgage. I've wondered if there's any lessons there.

Kaplan: Of course. I think what we also learned is in 2006, which was a good year in the United States, right?

Beckworth: Yeah.

Kaplan: If you look at the household sector in this country, the household sector was extremely leveraged. Meaning if you took household debt divided by gross domestic product for the households, there was a very high degree of leverage. The reason we didn't notice it is if you looked at household debt relative to asset values, it actually didn't look excessive, back to home prices. What the housing crisis exposed is a lot of households were dramatically over‑leveraged, but they were comforted by the fact that there were easy mortgage conditions and home prices were very high.

Kaplan: Obviously, I don't need to remind people when the housing sector collapsed, all of a sudden, the household sector, it was clear, were very highly leveraged, and they've spent the last eight or nine years deleveraging. I think one of the lessons also, which relates to mortgage availability and so on, was we've got to watch the health of the household sector. Even with that, the aggressiveness on mortgage offerings were probably the tip of the iceberg. It's all the securitizations upon securitizations upon securitizations of those mortgage obligations, which magnified those excesses. If we didn't have all the securitizations on top of this aggressive mortgage lending, it still would have been painful, but it wouldn't have been anywhere near as painful as what ultimately happened.

Beckworth: This goes back to the point you made earlier about nominal GDP targeting. Again, in a different world, a counterfactual world where we did have a nominal GDP level targeted, this would have made that crash a whole lot nicer or less severe.

Kaplan: Truthfully, I wasn't at the Fed. I've been at the Fed only three years. I actually probably have a slightly different take. I think there's a number of things we do at the Fed. One of them is monetary policy, but another big one is macro-prudential policy. I think if you don't have good macro-prudential policy, it's very difficult to run a sensible... It makes monetary policy harder. I think we need to do both. You could debate, and I've been part of those debates, to question monetary policy leading up to the crisis, approaches for monetary policy. I think if you don't have good macro-prudential policy for, again, stress testing, monitoring of the non‑bank financials, I think it makes it very hard to avoid instability.

Beckworth: That's a fair point, but if you did have those imbalances build up, let's say, for the sake of argument, you did have that leverage. I think the point you made earlier is that a nominal income target, a nominal GDP target that would make the unwinding of that leverage much more manageable. Is that fair?

Kaplan: Listen, what I've learned is, if the household sector gets over‑leveraged, you've got to accept it's going to take a number of years for households to deleverage. They're not like companies, who can sell assets, raise equity, restructure, restructure their debt. Households can't do that. I think the trick is a little bit of prevention. I think we want to get into a situation where we monitor the household sector more carefully and try to take steps to maybe moderate excessive debt growth at the household sector relative to income.

Beckworth: One last question in the time we have left. You mentioned earlier the fact that inflation, for a good part of the past decade, undershot the 2% target. There was an explicit target after 2012, implicitly was there beforehand. I wonder, what is your explanation for why inflation tended to fall below target for so long?

Kaplan: My own view is that there were a number of headwinds which were deflationary. One, the household deleveraging created a headwind for GDP growth. Secondly, automation and to some extent globalization also have changed the balance of power, where pricing power of businesses today is much, much more limited than what it was even 15 years ago. What do I mean by that? The consumer right now has, in the palm of his or her hand, more computing power today than most companies did 25 years ago. That has changed the power balance between the consumer and business. I talk to lots and lots of businesses, where they just do not have pricing power because consumers now much more easily, technology‑enabled, are able to shop for lower price, greater convenience.

Kaplan: There's a whole series of disruptive entrants into businesses and disruptive technologies for existing businesses that create greater transparency, limit pricing power, and limit competition. I think those forces are not going away. If anything, they're accelerating. Those forces of automation and globalization are probably deflationary, so my own view is I think we've seen a little bit of that over the last 10 years. I think you can also argue maybe the Fed's done a good job in anchoring inflation expectations, but I think there are structural changes in the economy, in the United States and globally, which may mute inflation, haven't muted inflation and will mute it in the years to come.

Beckworth: Okay. Well, on that note, our time is up. Our guest today has been Rob Kaplan. Rob, thank you for coming on the show.

Kaplan: Thank you, David. Good to talk to you, sir.

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.