Roberto Perli is a partner and the head of global policy at Cornerstone Macro and is formerly a senior staffer at the Federal Reserve Board of Governors. Roberto joins Macro Musings to discuss the Fed’s new average inflation targeting framework and what it means for monetary policy, markets, and the economy going forward. Specifically, David and Roberto also discuss the current vague nature of FOMC forward guidance, the challenges and credibility concerns of AIT, and how to further improve the Fed’s framework in the future.
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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: Roberto, welcome to the show.
Roberto Perli: Thank you, thank you very much. And thank you for having me, it's a pleasure to be here.
Beckworth: It's great to have you on. You are a true, bonafide Fed watcher. You used to be at the Fed, you do it for a living now. And if people aren't following you on Twitter, I recommend they do. You get some of his free research, there's a paid part as well, but he shares a lot of great information online. I love every Thursday, you give the balance sheet updates. I really appreciate those. You let us know what's happened, so we don't have to dig into it ourselves.
Beckworth: I was following for a while, closely there, the dollar swap lines, but kind of gave up on it, and you've given me the updates as they come to you every week. So, thank you Roberto. And thank you for all your other great insights on the Fed. And I'm really excited today to talk about the new framework because you may know this, but I'm a big fan of makeup policy. Particularly, I'm a fan of nominal GDP level targeting, all of my listeners get tired of me talking about it, so we won't talk about that today. We'll set that to the side and talk about average inflation targeting. And you have a great perspective because you've been inside the Fed, you're a senior staffer there, you know what they think. Maybe you can help us understand why they chose this path. But before we get into all of that, tell us a little bit about yourself. How did you get into macroeconomics? Why this career? And how did you end up where you are?
Perli: Well, I'm originally from Italy. In Italy, unlike here, when you choose to go to college or university, you have to pick your major immediately. It's not that you can “fool around”, for a couple of years and then decide. You have to pick one immediately and it's really hard, right? Straight out of high school, to pick the right one. I think I got lucky and I picked economics, which actually turned out that it was really interesting. So, I started economics, and then I graduated after some uncertain beginnings. I graduated well. And as the time passed, I became interested in really, academic economics and tried to study economics more deeply than I did in Italy. And so I applied to doctorate programs in the U.K. and the U.S. and I was very fortunate to be admitted to New York University, where I was working with one of my idols at the time, it was Jess Benhabib, on self-fulfilling prophecies, which is a very abstract subject, of which I got tired after a couple of years.
Perli: But as you know, in academia it's very hard to change subjects on the fly, and so at the same time I also became very interested in monetary policy. And so I was offered the position at the Fed, which I enthusiastically took in monetary affairs, which is a department that does all the monetary policy work for the board, the FOMC. And so I learned a lot. I learned a whole lot over there. It was a, I think a good experience. Certainly preferable, from my perspective, from the academic experience that I had before that, teaching at the University of Pennsylvania for a few years.
Perli: So I stayed with the Fed for about nine or 10 years, and then always you get the question of, "Do I really want to retire at the Fed?" Cause there is the distribution of tenure at the Fed scheduled by [inaudible]. So either you leave after a certain number of years or you stay there until you retire. So it was just right there at the cusp, I decided it was a good thing to try something different. And so I joined another Wall Street firm, ISI, for a couple of years, and then 2013 with Andy Laperriere and Nancy Lazar, my two partners, we started Cornerstone Macro. And we're still in business, doing well, and so we're very happy to be there. Cornerstone Macro does a lot of things, from economics, policy strategy, technical, energy, all sort of research. My key is obviously, I focus on monetary policy and interest rates.
Beckworth: Okay. Well, it's been great to meet you on Twitter, so you're another person that I've been acquainted with because of Twitter, so thanks Twitter for making our contact and providing great content from Roberto. But I want to move with you onto average inflation targeting, this new framework that was introduced. So Jay Powell had his big speech at the virtual Jackson Hole as you know... introduced the Fed's version of makeup policy, as one way to put it. There have been a lot of talk about this, review's been on for a year. But in broad terms, without getting too much into details, but in broad terms, how would you explain this to someone as being different from what they had before? What's the big directional move the Fed made in this decision?
Moving Towards an Average Inflation Targeting Regime
Perli: Well, I think there are two really big moves. One is certainly the makeup aspect, right? So inflation has been below target for so long, right? So if you look at the plot of inflation, any measure of inflation you want, or in particular let's say... just use PCE, core PCE, that is the Fed's favorite measure of underlying inflation. So since 2008, since the Great Financial Crisis, it has been almost constantly below two percent, right? And sometimes quite a bit below two percent. And so that's bad, right? Because inflation expectations, which is what really matters for setting nominal rate and many other things, are largely, or at least in some part, are adaptive. So you look back, say, "What's inflation going to be tomorrow?" You look back, and say, "Well, it was one and a half percent last year and it's going to be one and a half percent next year as well." And so that's bad because it pushes, it constrains the so-called nominal neutral rate even closer to zero, right?
Perli: So, and that's a problem because if the nominal neutral rate is too close to zero, then the Fed cannot raise the federal funds rate too far away from zero. Every time the Fed goes over neutral, it restrains the economy and it runs the risk of a recession or something... or unnecessarily diminishing growth rate, or even pushing the growth rate to negative territory. So it's very risky to do that, so we don't want that. And so, it's good, right, to try to push up inflation expectations by committing to say, "Okay, we have been under two percent for a long time, now we want to be above two percent for at least a period of time." So I think that's the reason why they try to lift the nominal neutral rate away from zero as much as possible in order, just to put it very simple, right? So if nothing is done, where we end up is the same place where Japan has ended up maybe a couple of decades ago. Where Europe arguably has ended up a few years ago, so we're next, right? So that's not good, so we need to try whatever we can, the Fed needs to try to do whatever it can to prevent that. And so there's this kind of a makeup aspect of the new policy.
Perli: Now, the second important change is the fact that there was this maybe subtle, but maybe not, a shift in language. Before, the Fed was saying "Hey, we care about deviation of unemployment from the the natural rate of employment." And now, the Fed says, "Well, we care about instead, shortfalls from maximum employment." So that's important, right? So essentially this says, "So we want, first of all, maximize employment, but we're not going to raise rates preemptively if the unemployment rate gets too close to NAIRU, we're not going to raise rates preemptively because we want maximum employment. We're not satisfied with NAIRU."
Perli: And so the implication of this is the following, say okay, if there is no inflation in excess of two percent, or maybe there is no inflation in excess of a little bit above two percent, because we want this overshooting, why in the world should be raise rates at all, right? So essentially, this is a recognition of number one, the fact that the Phillips curve has been as flat as the proverbial pancake for the last, at least 20 years, and so there's no sense in being proactive with respect to inflation, and second, I think there's already a realization that there are many reasons, look there are many reasons that lead to inequality, right? And maybe income inequality is a small portion because wealth inequality is probably the biggest portion, but by preventing the unemployment rate for going as low as it could in the name of preventing some non-existent inflation, the Fed probably has contributed in the past, a little bit, to income inequality. And so income inequality is bad for a host of reasons, so I think the Fed realized, "We can do something in that respect as well." So long story short, I think it's a big change and it's probably a welcome change, at least from my perspective.
By preventing the unemployment rate for going as low as it could in the name of preventing some non-existent inflation, the Fed probably has contributed in the past, a little bit, to income inequality.
Beckworth: Yeah, I like it too, and I think it's a first step in the direction I'd like it to go, but I like your point. So one is, to avoid the zero lower bound problems, to get the policy rate high enough so the Fed has some kind of wiggle room, but I like your second point too though, that the other subtle change is to let labor markets run hot so that we get full employment, and we were so close to that near the beginning of this year, and then we've lost all of it.
Beckworth: My friend Karl Smith has said, "We haven't fully tried capitalism until we really run the economy hot and everyone gets back to work and we see these improvements for many people across different levels." So those are the two changes, the makeup element that will hopefully raise the nominal interest rates that the Fed targets, as well as a slightly different approach to how it deals with full employment. Now, that's the broad view. Let's dig in a little deeper into some of the specifics here because there has been some confusion, there's been some uncertainties of what this actually means, and let me just give you two headlines to highlight this. So there's a Bloomberg headline on September 22nd, and this was about Charles Evans, the president of the Chicago Fed.
Beckworth: The headline says, *Evans Says Fed Plan Allows Hike Before Inflation Average is Two Percent.* So, that implies, at least from the headline reading, that the Fed may actually increase interest rates before they get the average up to two percent. Now, there is actually a reasonable interpretation of what he said, dealing with lags and stuff, but just the headline itself was very confusing based on what they just said they wanted to do, was get the average up. Well then the next day, the Vice-Chair, Rich Clarida comes out and has a talk, and then the Bloomberg headline for him says, *Fed’s Clarida Says Months Above Two Percent Needed for Liftoff.* So, you're getting these different voices, and maybe Evans meant the same thing that Clarida did, just in a subtle way. But there seems to be a lot of confusion there, and let me read to you a small bit from the September FOMC meeting, and maybe you can help me sort this out and help our listeners figure out what's missing, what needs to be defined here.
Beckworth: But they went on to explain the statements, some of the parameters of this new average inflation targets, so let me read what they say here. It says, "The committee seeks to achieve maximum employment and inflation at the rate of two percent over the longer run. With inflation running persistently below the longer-run goal, the committee will aim to achieve moderately above two percent for some time so that average inflation, two percent, over time, and longer-term inflation expectations remain well-anchored at two percent."
Beckworth: Alright, so there's three things there that aren't defined. They say first, they aim to have inflation moderately above two percent, what does that mean? And then they say for some time, what does that mean? And then inflation averages two percent over time, what does that mean? So you have these windows, how long does average inflation cover, and then how fast will you do the makeup period, right? And these things are very vague and undefined, and let me ask you this. Is that a feature or a bug? Is that maybe something they want, or is it just maybe a by-product of having the committee make a decision? Or do you think they really would like to better define those parameters?
The Vague Nature of FOMC Forward Guidance
Perli: I would say all of the above, with maybe a little bit less weight on the latter, right, but it's certainly... look, they do want flexibility. The Fed, any central bank wants flexibility. They hate to tie their own hands in advance, so we don't know, right? We can forecast the future but we don't know exactly what's going to happen, and so we want to have flexibility to address whatever situation we'll run into. So that's legitimate. Also, for sure, there is a committee management aspect in there, right? Because it's 17 FOMC members and probably at the very minimum there are at least 34 different opinions on what the language will be, the threshold should be, so I think the more vague the language is, the better the chance that you will have a general agreement. And even with this vague language, we got to this [inaudible] last time.
They hate to tie their own hands in advance...We can forecast the future but we don't know exactly what's going to happen, and so we want to have flexibility to address whatever situation we'll run into. So that's legitimate.
Perli: So there's that. Look, ideally it would be nice to specify some threshold but I think it's, for two reasons, it's complicated and so that's the way they did it. Is it bad or is it good? Look, I think it's good for them for sure. I think it's obviously it's less good for observers, for market participants, for normal people right? That have to interpret what the Fed is up to. And the fact, as you mentioned earlier, that we heard this barrage of speeches of FOMC officials and sometimes, one will say one thing seemingly and the other guy is saying something different so that doesn't help, right? That is a direct product of the lack of clarity, it's open to interpretation and different people can have different interpretations. And maybe Evans, as you mentioned, he didn't speak particularly clearly, I doubt that Evans wanted to be hawkish, right?
Perli: But at the same time, look, you have to be aware, right? That when you speak maybe you can be taken out of context. When you said the most perfect thing in the world, but taken out of context. It doesn't come out right, so you have to be aware of that. And so when that happens, luckily, there is more than one FOMC official, right? So you can always send out someone else, maybe of a slightly higher ranking if you want to use, or Vice Chairman of the board, send him out and send the record straight and say, "Hey no, we're not going to lift interest rates before inflation gets to two percent or even a little bit above two percent". So in other words, I think what Clarida was trying to say, "It's not the time to have doubts or to communicate doubts, you just need to sound unified, and maybe we're not perfectly unified and maybe there are different opinions, but it's very important, crucial, for the success, which we all want, the success of this policy, that we sound unified and so I may go out and set the record straight." Which he did. I think in fact, I mean to his credit Evans did the same the next day, right, and so I think he recognized that he muddled the water a little bit.
Beckworth: Yeah. Well, thank you Vice Chair Clarida for helping us see things better. So there's a committee dimension for sure to this, right? You've got many people and you've got to get them all together and to agree to a statement, agree to a new framework altogether. So there's going to be some ambiguity on the margins of what this means. But let me throw out another theory here. So given there's the whole committee consideration, but maybe they're using this as a way to move towards something like Ben Bernanke's 'Temporary Price Level-Targeting'.
Beckworth: I've called this the poor man's version of Bernanke's Temporary Price Level Targeting because with an average inflation target, it really gives you a lot of flexibility to do all kinds of things. You can ignore some periods altogether, you can define how you're average is going to be constructed, and in Bernanke's Temporary Price Level Target, if you read his ideas behind it, he has some language for the FOMC that isn't that different than what the FOMC actually chose for the average inflation target. But his idea is you only do makeup at the zero lower balance of big, strong demand shock be one condition. And secondly he made the point, you want to avoid tightening when you have negative supply shocks that might temporarily raise inflation. And so he paints a picture of and an approach that's flexible and I'm just wondering if average inflation targeting is just a kind of version of that, that's easier in terms of a first step, walking towards that goal. What do you think?
AIT as a Poor Man’s Price Level Targeting Regime
Perli: Yeah. Well I, look, I completely agree that what this is effectively a temporary price level-targeting, even a price level-targeting framework right? Look, I think it's hard to explain to the public what price level-targeting does and why especially we want to do it. I think it's a lot easier to do what they did, which is to say, "Hey guys, nothing has changed. We're inflation targeters and we are inflation targeted. Two percent it was and two percent it still is. Only on our edge, right? So we're going to be under it, a little under, we're going to be a above, but still the framework is the same. Reality's not, right? It's different but it's a lot easier, politically and even just from a point of view of pure explanation to the public is to use something like this, right? And so I think the consequence are the same, right? Because look, you say temporary price level-targeting, well I would say temporarily, at least, the Fed has a higher inflation rate right now, right, which is exactly what you need to re-establish the price level. So it is the same, very close. So it's the same thing done a little bit, I don't know, though I should say maybe obscure in some of the details, right? In the interest of clarity and minimizing political problems.
Beckworth: Yeah, for sure. It is easy to market to congress and the public to say, "Hey, we haven't changed things that much" while at the same time opening the door for them to do changes that lead to makeup policy and or significant... Let me ask one other question about their September statement. They noted in their Summary of Economic Projections that they don't expect to hit their inflation target. Two percent, let alone their average, as far out as 2023. So we're getting close to four years out. So if they have an average, that implies at least loosely, another four years of above target. You're getting close to a decade of this window. Now again, maybe I shouldn't read too much into these inflation forecasts. But you know technically these forecasts are, "conditioned on appropriate monetary policy". So if I take it seriously or literally, it's telling me this is going to be a pretty long average window. But what are your thoughts on that?
Perli: Well, so yeah, forecasts are subject to change of course, right? But listen, as you said, by 2023 there is no overshooting. Maybe we make it to two percent, they say today. And then how long of a period of overshooting do you want Clarida to talk about, months? It seems a little bit too short, right?
Beckworth: Right, for four years of undershooting I mean if you start now, it seems like you've got a lot of work to do right?
Perli: Yeah. I mean look I wouldn't say, if you were to take this literally and say we haven't been systematically above two percent since 2008... So it's 12 years plus another four.
Beckworth: Right, you don't want to do that far back right.
Perli: You don't want to go that far back so, I think my view is that at the very minimum I would say you want a year of inflation over two percent. And quite possibly quite a bit longer than that. And so sitting here from the perspective of today, which is what matters by the way for interest rates today, is okay, we know if the Fed tells us that the best case knowing no overshooting since 2023, so no rate hikes in 2023, then at least one year of overshooting, hopefully that will be 2024. Right, so generally 2024 inflation magically goes over two percent, and so we leave it there for another year. And then, given what we know today, the earliest right, we can expect an interest rate hike, is the year 2025. But, quite possibly actually well beyond that, right? So yeah, we're staring at a long time of zero rates. Look, last time it was seven years, right? December 2008 to December 2015. Hopefully we'll be short of this time but okay, you can probably tell I have my doubts.
I think my view is that at the very minimum I would say you want a year of inflation over two percent. And quite possibly quite a bit longer than that.
Beckworth: Right. Well how would you like to see this framework improve? So if you could play economic dictator for a day and define everything, how would you firm up the framework?
How to Improve the Fed's Framework
Perli: Well, so they told us a lot of things right? Maybe they… but they told us a lot of things. So we want higher inflation, we want maximum employment; which is good right? So what they haven't told us is how. That's the problem, right?
Perli: It was hard enough again for a committee management perspective to tell us, to agree on what they want. How to get there is even more complicated. But that's crucial, right? Especially if you want investors or market participants, which are fundamental to the transmission of monetary policy to the real economy, you want to these guys to lift the inflation expectations. And right now they haven't at all, right. And I think they can be forgiven, again because the Fed hasn't said exactly how it plans to achieve higher inflation.
Perli: Look, we can all guess, sit here and guess, and I'm very happy to do it. But I think that the tools are going to be, forward guidance, already done, right? So number two, asset purchases, which they're already doing and I think they will do even more going forward for a long time. And then we'll review curve control on the back-burner, I don't think it's dead by any stretch of the imagination. Certainly it's not going to happen tomorrow but if needed, it's there. So the problem with all this... so there's negative rates which I don't think we're going to get there. I don't think there's any appetite for negatives rates, but it's there. The problem though, with all these ideas, with all these tools, is that they don't do the same thing.
Perli: If you think about it all this stuff we just mentioned is aimed at keeping rates, although they're already low, even lower. That's all this stuff does. So, why do we want to do that? Why we want to do that for many reasons but why particularly is okay, we want to communicate to the central bank, we want to say, "Okay, the households and businesses borrow today instead of tomorrow, while rates are low because it's convenient to do so". And so if you do that, you transfer growth from the future to the present. That's what we want. The problem is that rates are already low and importantly, expected to stay low, right? And so this trickle down won’t really work very well. And so the power of all these tools that we just mentioned is not what it used to be.
Perli: So Powell is right. I think any central bank will tell you, "We have a lot of tools", right? So yes, it's true. It's just that the power of these tools is very weak, right? And so that's a little bit of the problem. I think that Fed is facing what other central banks are facing as well.
Beckworth: Well, let me again push you on this point. You're economic ruler for a year, what would you do to the Fed to make it more powerful? I mean, would you give it some temporary fiscal facilities? Give it helicopter drops? Give it negative rates? How would you push the central bank? And I know this is not your day job to speculate on this stuff. And it may be highly unlikely but if you could design an optimal Fed in this environment of zero low bound constraints, how would it be different?
Perli: Oh, look. I think that the first problem that anybody that wants to do that faces is that the Federal Reserve Act, the law right? So there's not much that can do in the normal course of business, can either buy treasuries or MBS so that's it, pretty much right? Or shorten munis, but I don't want to do that for other reasons and so that's it. Even so, we saw this day since March, the Fed has been buying corporate bonds, muni bonds, been lended to small businesses, so doing a lot of good things but those things cannot be used in the normal course of business. Those are so called 13(3) facilities that require unusual and exigent circumstances which basically means a crisis of some sort. Right now we are in one so we can use them.
Perli: But hopefully soon, the virus will be brought under control and then the Fed cannot use those tools anymore, unless the law changes. So there are proposals out there and Yellen and Bernanke are among the most prominent, right? That are advocating for Congress to give the Fed the ability to buy corporate bonds in addition to treasuries and MBS. It's good, I think that will have the additional benefit of compressing corporate spreads, not that corporate spreads, not that they need to be compressed a lot because they are already very low, so even that wouldn't, probably in the current circumstances, make a ton of difference.
Perli: Look, you bring up other more creative possibilities like helicopter drops. Helicopter drops has kind of a bad reputation right, imagine this, the central bank giving money to everybody. But listen, I think those are ideas that are really delicate, right? For obvious reasons. The central bank is independent so when you start talking about interaction with the central bank with political authorities, the risk is that independence gets lost, right? And so that's always an issue that the Fed and anybody else really has to consider very carefully before going that route. The same time though you can say, "Hey what's really happening today?" Right, so what has the Fed been doing since COVID hit? Well it’s put in place all this facilities, what are these facilities?" Facilities basically took money that Congress appropriated and leveraged it, right? The Fed has bought very little but potentially can buy a lot. That's the power of this policy right? So this is an example of an interaction between Congress and the Fed; the political side of Washington and the Fed. And so far it's working really well, right? So very little purchases but incredible effect on financial markets.
Perli: I think there is one facility that's not working is the Main Street program; could work a lot better because of design issues. But look, you can argue we are already in a world where the Fed and the other side of Washington are cooperating. And so far there haven't been any particularly pernicious consequences of Fed independence. So maybe we are setting the blueprint for the future. So I regard this as a good experiment in what modern-day policy could be, should we find a lot of problems. So distancing ourselves from the zero bound, bringing up inflation and so on.
But look, you can argue we are already in a world where the Fed and the other side of Washington are cooperating. And so far there haven't been any particularly pernicious consequences of Fed independence. So maybe we are setting the blueprint for the future. So I regard this as a good experiment in what modern-day policy could be, should we find a lot of problems.
Beckworth: Well Roberto I'm happy you're so sanguine about the Fed's program since the COVID crisis. I worry a little bit about the corporate credit facilities, the temporary emergency ones. To me, I worry about independence that these things have created political pressure, right? Why are you buying from certain corporations, not others? Why don't you go more aggressively into state's municipalities? I mean, it seems like on one hand you've opened a Pandora's Box, right? If you could go into this market, why not go into all markets? The Fed is having the effect, whether it likes it or not, on big corporations but not on small businesses because its hands are tied by the law, by the Federal Reserve Act. So, do you not worry about independence concerns from that angle?
Perli: No, yeah, I do worry about independence. What I'm saying is that, so far it seems that both sides have respected each other's prerogatives, right? I haven't heard Congress really putting undue pressure on the Fed. Of course Congress puts pressure on the Fed all the time, it does it every day, even before COVID. But it's not something that I would classify as particularly stronger than usual. And then I think the Fed has been very scared in offsetting whatever undue pressure it was under, especially from the administration earlier on. So I think that so far things are going well.
Beckworth: So far so good.
Perli: Yeah, so far so good. But as I said before, you do have to worry about independence, right? So I think we're headed towards a future where more corporations will be needed because again these traditional tools that the Fed has don't work very well. So we need to do something different and doing something different invariably I think involves more politicization of the Fed. So good subject to study, to think about hard and this is probably a good time to be thinking about it.
Beckworth: Yeah. Well let's circle back to average inflation targeting. So we've highlighted what it is, some of the ambiguity surrounding it, some of the parameters are not well-defined, how long is the average window, how quickly is it made up. Let's talk about challenges to it moving forward. So do you see any credibility concerns, any reasons to worry that it might be undermined and completely lose its effectiveness because of structural reasons in its design moving forward?
Challenges and Credibility Concerns of Average Inflation Targeting
Perli: Oh, I mean, a couple of scenarios I can think of where this framework becomes non-credible. And one is that in spite of the Fed saying we want higher inflation, inflation doesn't come up. Because this is, I think, the base case, unfortunately because inflation is not just... low inflation is not just a U.S. problem, it's a problem that the whole world has with few exceptions. And certainly the developed world. And that tells you that maybe low inflation is a structural problem which the central bank is not well-equipped to deal with. They can deal with cyclical problems, maybe, but structural problems... so that's one possibility. Another possibility is exactly the opposite, right. So for some fortuitous reasons the Fed changed the framework right the day before inflation starts going out of control, so that Fed loses even more credibility in that scenario but I think the risk of the latter is pretty low. Of course, call me next month…
Low inflation is not just a U.S. problem, it's a problem that the whole world has with few exceptions. And certainly the developed world. And that tells you that maybe low inflation is a structural problem which the central bank is not well-equipped to deal with.
Beckworth: Yeah, something crazy happens. Yeah that's a good point, so the Fed introduces a new framework and the goal is to get average inflation rate up and it fails to do that. Well that further undermines or further adds to the weight of the Fed's problem over the past decade. Here's a concern I have though, let's say the Fed is able to get inflation up. And just a little bit, not runaway inflation, up to four percent maybe, some makeup inflation maybe to be precise. So the Fed’s catching up for the year or two that you've outlined earlier, that's a tough sell in my view.
Beckworth: You've got to go to Congress, you've got to go to people and say, "Hey, we're from the Federal Reserve and we're here to help you with higher inflation. Trust me, it's a good thing". That to me has got to be one of the hardest sells to make by an economic policy maker and that's one reason I'm a big nominal GDP targeting fan. I think it's easier to say, "Hey, we're here to increase sales," or "We're here to increase incomes". But they can't say that, they've got to say, "Hey we're here to increase inflation". And I worry that when they come to that challenge, that's going to be a tough test to pass.
Perli: Yeah, look I think that's just one reason why 16 year overshooting window is probably not going to happen. That's why Clarida was talking about months, even I talk about maybe a year, maybe a little longer. But so not going to be too long precisely because yeah it's really hard to justify higher inflation and I think we heard that clearly from the advance that the Fed had with a variety of groups, right? So the concerns of the civil society call it, was that higher inflation hurts the weaker segment of the population first right? So yeah I completely agree with you, it's hard to explain, to justify, especially if it's sustained for a long time.
Perli: Yeah I think the Fed gave itself an out in the framework... or actually the FOMC, couple of weeks ago when they said that one of the conditions to raise rates to see inflation in the forecast, in the Fed's forecast, established above two percent for enough time. So what matters is not necessarily just the actual inflation, it's also the forecast. Fed can say, "Okay, we are at two and a half percent which is a little bit too high but don't worry about it, we see inflation coming down next year and so we still don't do anything". So there are a few outs built into the system, but I agree just going out there and explaining why you want higher inflation is, I think a challenge.
Beckworth: Let me bring up another possible issue that you've highlighted, and that is future FOMC members may disagree on the definition of average inflation targeting, right? So Richard Clarida, Jay Powell, they have their understanding of what average inflation targeting is but because it is so vague right now... there's the Powell doctrine let’s call it that. But in a few years... in fact let's take the horizons in summary of economic projects okay. Let's say they actually come true, four years out we finally get or we see inflation going up and someone else is the chair at the Fed, there's different governors. Does that not make it tough as well to continue this policy? This is a time and consistency problem, kind of in reverse. Do you worry about that possibility?
Perli: Yeah well look, time and consistency is an old and real problem that any central bank or any, I guess, decision maker has. I think what they did here, it's not that they just got together and FOMC said, "Well today we decide to do this". They thought for almost two years, right? So since October 2018 until Jackson Hole end of August, and they wrote down the result of this policy review in this long-run statement, long-run goals and policy strategies, right? So that's, people like to call it the constitution of the Fed, right. So it's a lot harder to change that than to change a FOMC decision made in one day. So I think that's an important point and yes, right, so the personnel can change but the most important things obviously in 2022, Jay Powell is up; his term's up. So we'll see what happens. But maybe someone else comes in.
Perli: But suppose right, so someone else comes in and has completely different ideas. Well, it will have an awfully hard time persuading the rest of the committee to renege on this constitution that they just approved a couple months ago, two years before at that point, right? And so I think that the hurdle for changing this is high. However, Powell and the FOMC right, gave the future generations of policy makers an out. They said we're going to revise this constitution every five years.
Perli: Because things can change, right? So it's reasonable to do that. But at least for the next five years, I mean I don't think anything's going to change, no matter what, who is going to be in charge.
Beckworth: That's a great point. It's in the long-run statement of goals, which is this document, this almost sacred document at the FOMC. But also I mean the Fed itself is a conservative institution, it doesn’t quickly change, it's not like a sports car you can cut corners. It's like a big ship that takes a long time to turn around. That's a great point. I hadn't thought about that. So even if there are different perspectives in the future, it will take time to bring them on board.
Perli: No, I would say it takes time to do everything. Maybe that's a bad thing but in some cases actually there are some advantages that...
Beckworth: You don't want to be moved with the winds of change all the time, you want to have some steady as we go to the course of monetary policy. Well let's take this framework and what we know about it and what we've discussed about it, and apply it to what it actually means for the markets, for the economy today. So you had a Twitter thread that was really interesting that was titled 'Three common Fed impressions that are wrong'. So I think the framework ties into this as well as what the Fed is doing. And let me read the three Fed impressions that are wrong. I'm going to read them out and then you can comment on them.
Beckworth: So number one is the Fed will start hiking relatively soon, the Fed policy will be on hold just because rates are on hold, and Fed policy is equally ineffective for economy and markets. So those are the three I believe false impressions that people have about the Fed, and you responded to those. So can you respond here to them too?
Responding to Three False Fed Impressions
Perli: Sure. So this is an experience that what I wrote is based on my interactions with our clients, of course, or even looking at discussions on Twitter as well or in the media in general. But there is substantial contingent of people, investors, who seems to expect the Fed to raise rates in 2021, 22, 23. Actually we did a survey of our clients and a good 47% had rate hikes in 2023 or earlier. Fed says no.
Perli: And of course you can ask the question how much time do these people spend thinking about their answers or... there's lots of reasons, right? Maybe they have a much more optimistic view of the economy than we do or the Fed does. But nonetheless they are there, they are out there, right? And so these people actually trade in the market and if you look at, okay rates are low, that's fine, but if you look at some corners of the market you see signs that maybe rates are not as low as they could be in the absence of these doubts, right?
Perli: For example, if you look at options on Fed fund futures or even dollar futures, you see that there are people out there that are betting on early or fast tightening on the part of the Fed, in spite of the Fed saying no. So that's why I think a stronger forward guidance, so maybe yield curve control could probably help the Fed. That's out there. So I think, as we discussed earlier, the probability of that happening is not zero, but I think is low, all right? So that's one.
I think a stronger forward guidance, so maybe yield curve control could probably help the Fed.
Perli: So the other one is... so the Fed policy is equally ineffective for the economy and markets. So as we said before, Fed policy, I wouldn't call it ineffective for the economy but less effective than it used to be, right. So diminishing returns, rates are already low and so, not as effective as before. But from a point of view of the market, the Fed can just push markets around just like it did ten years ago, 20 years ago, right? So the impact of Fed decision on a national market is always the same as it was since transmission from markets to the real economy is different. But impact on market is what it is so there is a tendency on a part of some investors say, "Oh, the Fed is out of the picture and it's not going to do anything, so it's going to be ineffective". Maybe economically but certainly not market-wise, so let's pay attention.
Perli: And then I think that also covers my second - my third, sorry - point. So yeah, I think as I said, there are still some misperceptions out there. I think that the Fed would love to correct and I think they are trying because these last two week I think was the highest concentration of Fed speeches in how many years? So they're going out there and trying to evangelize the masses here but think they still have a little bit more work to do.
Beckworth: Trying to get them on board to the new framework and what it means for rates and forward guidance and everything else. Well this leads me to a final area I want to cover in the time we have left in the show today, and that is the question of who ultimately determines real interest rates? What actually determines long-term real yields in the economy? And I think we have the same view on this, but it's just worth discussing because I get into this discussion with lots of financial journalists and I take a very different view. I'll call it the BIS view, Bank of International Settlements, they've a got a view which has, I think truth in it but then it gets away from what I think are the ultimate drivers. And the view is that the Fed really can set the entire yield curve and do so indefinitely. And I take the view, I think you too, that the Fed may temporarily peg a rate, in fact it can peg rates, but if it cares about price stability then it's a slave to the fundamentals.
Beckworth: The fundamentals ultimately will drive real yields over long periods of time to the extent that the Fed cares about price stability And so when it comes to questions like forward guidance, is the Fed really setting the forward guidance or are markets anticipating weak growth in the future? And this is really an identification problem, in what we call macro, but I'm interested to hear your thoughts on this, because I know you've commented on this question too before on Twitter. I'd like to get your feedback on it.
The Determination of Interest Rates in the Economy
Perli: Yeah, so look I think the answer to the question [of] who sets the long term interest rates… the answer is not the central bank. There's just no way... it's the other way around. Market for economic forces set interest rates, right. So there is such a thing as this neutral interest rate, which is determining the very high level to what's the neutral rate of interest is the equilibrium between savings and investment, right? So if you have an excess savings or investment, the neutral rate goes down, right? It's just the price of that market and there's more supply than demand then the price goes down. Which is what has been happening for a long time now, right? So maybe it's not all U.S. savings that flow into the U.S. economy, but that's what's been happening. And the reasons are demographic in nature, the reasons are productivity, that's not what it used to be, potential growth is not what is used to be. There are many structural reasons. That's what has pushed this neutral, real neutral rate, down.
I think the answer to the question [of] who sets the long term interest rates… the answer is not the central bank. There's just no way... it's the other way around.
Perli: On top of that we have inflation expectations that have diminished because of structural reasons, again, because of the inability of the Fed and any other central banks to generate inflation of late. So inflation expectations slowly have trended down. So lower real rate, and lower inflation expectations, equal lower nominal neutral rate. And that's it. And so if you, central bank, try to go over neutral, try to raise rates, push rates, above neutral, all sorts of bad things happen. So you cannot do that, you're constrained by reality, right? So it's not the Fed that, or the ECB or the BOJ that capriciously decide, "Well okay, we want rates low because we decided so".
Perli: They're doing that because they have nothing else to do. They cannot do anything else without creating damage to the economy. So I think it's fundamental to understand, and I hear it, I hear opinions of the country every day, and markets talk and my clients but that's what it is. And so central banks just follow... the job of the central bank is to manage the deck of cards that they've been handed to right? So that's what they're doing. Unfortunately the cards are not that good these days.
Beckworth: I agree with that. It's just you hear a lot of commentary today that kind of disavows the savings investment framework. You hear a lot of people kind of dismiss it out of hand. I mean, there's this debate, what really drives industries, is it a liquidity preference theory kind of the Keynes, which I think is a good story for the short-run but meeting the long-run is the desired savings of our investment. And a lot of people have a hard time with that, they freak out, they must have an allergic reaction to it. But to me, I like to call it the fundamentals. You call it the structures, the fundamentals of the economy, ultimately are driving R star, the real rate.
Beckworth: And like you said, the Fed can't raise rates above reality. I like that, you have the constraint of reality. The question is though, can the Fed keep rates low forever? You hear for example, MMT would like to see the Fed peg rates at zero across the entire yield curve; just to peg it there and keep it there. And, well that might be possible in the near term and at some point that amounts to supporting fiscal policy. At some point you think you would see inflation take off and then the Fed would then raise rates. Which again in my minds is the Fed’s coming to reality, if to the extent that they care about price stability.
Perli: Yeah. Look, I think the answer is no. You cannot keep interest rates at a certain level for a long time, unless of course the circumstances warrant that. With what’s happening today, we're not that far from zero. We're pretty darn close. And so for now it's good, it’s not the Fed’s reality. But look you could in the future. So suppose the economy improves and market wants to push rates up, you could, certainly keep them artificially at zero, the cost to that is the explosion on your balance sheet, right? So you have to buy everything in sight, just like the Fed had to do at the end of World War II when the Fed was pegging the rate to three eighths of a percent and the ten year rate about two percent, I remember right. And the market said "Okay, we're out of the woods. Now things look good and we want to push rates higher." The Fed kept them at the target level but the balance sheet ballooned, right? And so you can do that but that's the downside and do you really want to have a balance sheet multiple times of your GDP.
I think the answer is no. You cannot keep interest rates at a certain level for a long time, unless of course the circumstances warrant that.
Perli: Or do you want inflation? That's right. Which by the way it is exactly why the Fed got out of that World War II framework. And after big discussion of course with Treasury, which led eventually to the Treasury Fed Accord. So that basically set the stage for Fed independence. But yeah, it's...
Beckworth: Well you want a little bit of that right? I mean, the whole idea of yield curve control is you get a little bit of that nominal growth but not too much.
Perli: So I think a yield curve control becomes useful when... so, remember 2013? So, 2013, the minutes of the, I think March or April, March FOMC meeting, talked about tapering, [inaudible] the minutes or few people do it so that kind of went unnoticed. And then one nice day, Bernanke goes in front of Congress and said, "We're going to taper these things sooner or later" and that's when people said, "Oh no". He grabbed people's attention, right? And people said, "Okay, so these guys are going to taper QE sooner than we thought, it must mean that they're going to raise rates sooner than we thought", right? And so people conflated term premiums with expected rates, and interested rates ballooned up. So that was bad, you don't want that to happen. And so yield curve control I think would be useful in this type of situation, right?
Perli: But at the same time when it really comes the time to raise rates you have to unwind yield curve control, you cannot keep it in place forever otherwise again, the cost is your balance sheet just goes through the roof. So I think that's part of the reason why the Fed is careful about yield curve control because it's easy to get in, and we know, we understand that it's beneficial. Getting out is a little bit tricky.
Beckworth: I've had some previous guests on that say the hardest part is getting out of yield curve control when the economy needs to heat up and you want to pull the plug, you have all kinds of issues that emerge. Alright, one more question. I said that that was the last one, one more question though. I want to end on this because it's related to low-rates as well as the Fed's new framework which is projecting rates at zero next four years or so. And that is financial stability. What do these low-rates mean for financial stability? Because you, I imagine, face many different clients and people who have strong views about what the Fed is doing with low-rates, and so give us your thoughts on that.
Low Rates and Financial Stability
Perli: So, financial stability I think is an important issue. Now, it's not the level of rates that worries me right because again the level of rates is what it should be. It's not the Fed that's keeping them there it's the economy. And so if rates are low it's because the economy dictates that way, that doesn't pose particular financial stability problems, right? So to me, that's one important point to make.
Perli: I think the risk to financial stability comes from somewhere else, right? So for example, look what happened... what day did the S&P 500 bottom? Or corporate spread peaked? It was March 23rd. What happened on March 23rd? Well, Powell came out and said, "Hey guys, we're going to stand ready to buy everything in sight. Corporate, munis, small business, even junk bonds, and even leverage loans… so anything. We're going to touch all corners, literally, of the debt market. There is nothing that can escape us. We're going to do that." And so, in spite of the Fed having bought very little across all these facilities, doesn't matter. It's not how much the Fed buys, it's the message.
Perli: The message is, we stand behind you guys and if things go wrong, we're going to get you out of trouble. So that's where the financial stability issue comes from. Look, I'm the first one to tell you what the Fed did on March 23rd was necessary. If they hadn't done it, it would have been just as big a disaster as the financial crisis. So it was necessary to do it, and maybe it was unsavory to buy junk bonds and all these things and I understand but that was not the time to worry about these types of issues.
It's not how much the Fed buys, it's the message. The message is, we stand behind you guys and if things go wrong, we're going to get you out of trouble. So that's where the financial stability issue comes from.
Perli: So that was necessary because that gives confidence, gives willingness, to investors to take on risks; perhaps too much risk with respect to what the so called fundamentals warrant, right? So for example, we at Cornerstone Macro thanks to my colleague Benson Durham, we are able to provide some valuations for asset prices so let's say, stock prices. Stock prices are significantly over-valued at this stage, relative to this concept of fundamentals based on forecasts, consensus work, it's not ours; consensus work for growth, inflation, and a variety of other things.
Perli: And the reason we cannot prove it but the reason most likely is the fact that the Fed has provided this "put", right? So that's what... asset prices are higher than they should be because of this. So I think in the short-term that's a good thing, necessary. The long-term, either an adjustment happens or at some point it will happen anyway. So I think that's a little bit, a delicate issue. Far from me saying that we're going to jump off a cliff tomorrow, a surprise that will collapse but I don't think they will. But it's something to think about. It's the consequences of doing good today, maybe you don't do as good tomorrow.
Beckworth: Yep. Well on that note, our time is up. Our guest today has been Roberto Perli. Roberto, thank you so much for coming on this show.
Perli: No, thank you very much it was a pleasure to be here. I always watch your podcast, it's always terrific so thank you for inviting me.
Photo by Olivier Douliery