Thomas Hoenig is a former vice chair of the FDIC, former president of the Kansas City Federal Reserve Bank, and is currently a distinguished senior fellow at the Mercatus Center at George Mason University. Tom’s research has focused on the long-term impact of the politicization of financial services, as well as the effects of government grant privileges on market performance. Tom joins David on Macro Musings to talk about COVID-19, the Fed's response to its economic impact, and the current state of banking in the United States.
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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: Tom, welcome back to the show.
Tom Hoenig: Well, thank you. It's good to be back. I look forward to the conversation.
Beckworth: Well, it's great to have you as a colleague. I feel very privileged to have you as a colleague. Now, we both commute to Arlington, so we're not always there at the same time, but it's great when we are, because I can walk down the hall, and there's Tom Hoenig with his door open, former president of the Kansas City Fed former FDIC vice chair, and he's willing to entertain David Beckworth and his crazy ideas. Well, I love it. I can go badger you with some of my notions, and Scott Sumner is my other colleague. It's been a great place to work, to have people like you around. I just feel real privileged that you're a part of my Mercatus.
Hoenig: Thank you. It's a privilege for me to work with Mercatus, and with you in particular, I've had a good time.
Beckworth: Well, it's been fun. It's been a lot of fun, for sure. Now, before we get into the meat of our discussion today, I'm just curious, what has the crisis meant for you and your personal lock? You've been locked down in Kansas City?
Hoenig: I have been locked down since early March. Here, like it is in most places, a lot of the malls are closed and restaurants are closed. Just now in Kansas city, we're beginning to open up a little bit, but very slowly as there are still a lot of cases out there, although declining, and we keep our fingers crossed, but we'll see how this evolves.
Beckworth: Okay. I imagine your well set up, you've got an office at home there you can work. You're finding that you're able to be productive at home as well as in the office.
Hoenig: I hope so. I think so.
Beckworth: Yeah, oh absolutely. Yeah, for sure. It's been great though, to be in a position where we can still work. I know many people aren't as fortunate as us. So we have great jobs and we're able to continue work. In fact, I would say we are striking while the iron is hot. This is an opportune time for people like you, Tom, to weigh in and give us wisdom and what should be done with policy. Let's segue into that. As the way to think about it with you, you have this really amazing career, storied career. You started at the Kansas City Fed in the early '70s. In fact, from 1973 to '91, you were doing bank supervision. As we talked about on the last show, you overlapped with Don Khon who became a governor, vice chair, I believe of the board of governors. So you guys overlapped there. And then in '91 to 2011, you were the president, is that right?
Hoenig: That is correct, 20 years.
Beckworth: 20 years at the Kansas City Fed. Part of that, you had a lot of responsibility, and I encourage our listeners to go back and listen to that show. You go through some of what you did, is more than just doing monetary policy and bank regulation. It was managing and organization, and sometimes you have to make tough decisions like all CEOs have to. That's really fascinating to hear that side of the job. After that, you became the vice chair of the FDIC from 2012 to 2018, where you help implement Dodd-Frank, and you really worked hard to get banks to fund with more capital. I know they never got to the point where you wanted them to be, but you worked hard, and that was your goal. I'm wondering, coming into this crisis, how did you feel about banks? Were banks better prepared? Was there any progress made coming into this crisis so that banks could better withstand a shock like COVID-19?
Bank Prepardness Leading up to COVID-19
Hoenig: I think there was progress made. I think the banks, especially some of the larger banks, found themselves, as a result of the efforts of the regulatory authorities and themselves, and I think their own boards having had a very bad experience in 2008 and '09, that they did improve their capital positions. As I've said before, not as much as I would have liked, but better than perhaps they would have liked or more than they would have liked. So, they did come into this a little better prepared for the shock and still the stress that is ahead of them because we're, in this quarter, really taking the real hits that are coming with a shrinkage of the economy, and how they fare through this quarter, I think will be very telling is in terms of the outlook for the future and how well prepared they are to help rebuild that future.
Beckworth: Is there a small chance that many of these big banks, while they're solvent now, might become insolvent if this drags on long enough?
Hoenig: Well, anything that drags on long enough can threaten solvency. I'm of the view at the moment that, given all the support that has come from both the government in terms of fiscal policy and the Fed in terms of liquidity and support policies, lending policies, that the economy will begin to turn in the third quarter and build from there, and therefore allow the banks to number one, absorb the losses that are almost certainly there, but then to turn forward and begin to help in the recovery. I don't expect major insolvencies because I think the economy will turn in the third quarter, but they are going to feel pressure, and I hope and expect at the moment that they are better prepared to deal with that pressure now than they were in 2008 and '09.
Beckworth: Okay. That's great to hear. And one of the critiques that you often hear about these big banks right now during the crisis is the dividends they're making, and sometimes also share buybacks, but is there an urgency for banks to quit doing dividends during this time? I think, is it Neel Kashkari? Who called for banks, president of the Minneapolis Federal Reserve Bank called for them to increase their capital cushion, and this is one way they could do that. What are your thoughts on that?
Hoenig: No, well, first of all, I would acknowledge that some of them, the larger ones, have ceased buying back their own stock, and that helps with those capital, and that's a plus. That does leave dividends though, and it does leave some of the elements in terms of the executive management's bonus programs. I would say that they are part of the judge, but I would encourage them to delay dividends or cease dividends temporarily. There are some benefits. People say it's not enough to make a difference, but I think perhaps it is enough to matter. I personally think that. I've got two or three reasons for that. Number one, they do have to absorb some losses, and the better capitalized you are, the better able you are to absorb those losses without causing people to become anxious. That is the stockholders and the public more generally, so it strengthens your balance sheet.
Hoenig: Number two, because you are better capitalized, you're able to work with your borrowers more liberally, that is to give the borrower more time to see the recovery come and to help provide concessions to them to get through this. That really is I think, an important dimension for the banks to have in mind as they proceed through this crisis period. Finally, I do expect we will see a recovery start in the third quarter and beyond, and having a stronger capital base actually provides a better base for lending. Because remember, for every dollar of capital they retain, there's approximately $15 of loans that they can make. Your leverage off of that, given the capital requirements and their capital level, can be quite helpful to the economy, to businesses and to the recovery. I would encourage them to at least consider very seriously as they see this quarter evolve.
I do expect we will see a recovery start in the third quarter and beyond, and having a stronger capital base actually provides a better base for lending. Because remember, for every dollar of capital they retain, there's approximately $15 of loans that they can make. Your leverage off of that, given the capital requirements and their capital level, can be quite helpful to the economy.
Beckworth: That's a great point. I hadn't thought of that. The bigger their capital cushion going into recovery, the better position they are to extend loans moving forward. That's what we need to get the economy up and running again.
Hoenig: Actually, following the last crisis of 2008 and '09, the banks who were better capitalized were able to support the lending programs more readily than the banks who were on the margin. You would expect that and it proved to be the case. So, here we have another opportunity to maybe make a difference by having a better capital base.
Beckworth: Interesting. Very interesting. Just to maybe recap on some of the numbers coming into this crisis, and I know averaging across very different types of banks is a crude approximation, but how much capital did banks fund with? What was the percent? Was it 5%? How big did they get on average?
Hoenig: Well, the thing you have to remember is there's various ways to measure capital, and most of the banks use a so-called tier one capital ratio, which takes their equity to their risk weighted capital, the risk weighted assets, rather. That gives you a number of anywhere from 10% to 12% or higher. But that, I think is misleading because it takes a lot of their balance sheet and says, this is a lower risk and so you don't have to hold capital against you. If you normalize that and look at the leverage ratio, that is the tangible capital, that is that amount of capital that can absorb loss against their total assets, the average is around 6.5%, maybe between 6.5% and 7%. That's for the largest banks. For the regional and smaller banks, it's between 8% and 10%. During the last crisis in 2008, those numbers were probably closer to 3.5% for the largest bank. You can see they are better capitalized, but still the largest are less well capitalized than the regionals and the smaller banks, but it's still an improvement.
Beckworth: It is. Now, where would you place that number in an ideal world? If you could wave a magic wand, you were the capital dictator of America, where would you put those numbers?
Hoenig: I would have those numbers for the largest banks, as I've said in the past, be at a minimum of 10%. I say that for a couple reasons. Number one, before you had all the safety nets in place of the markets and the banks themselves understood that to have between 10% and 15% was really where they want it to be and should be, and we also found in some of the research, even some of the research more recently than the Mercatus folks have done, that 15% gives you a much greater staying power for a very serious downturn. My number of 10% is kind of a compromised number in a sense, but it is, I think, a level that would give them pretty good staying power through any crisis and then help rebuild for the recovery.
Beckworth: Okay. Banks are in a much better position, and fortunately we're not experiencing the same type of crisis as we did in 2008, which lasted longer than we think this crisis will last, also, had these long lasting effects with a slow recovery, and some would argue hysteresis. It took time for markets to heal. Hopefully, this is very deep and very sharp, and hopefully, as you mentioned, we can have a rebound start soon. Though I'm sure there's going to be some small businesses that never come back. Some relationships that are destroyed that will never recover, but hopefully, we'll have some kind of robust recovery here in the third quarter, fourth quarter of this year and we can get things going again, and ultimately, banks will be able to do what they're meant to do, financial intermediation in our economy.
Hoenig: I hope so as well. It depends a lot on how quickly the virus can be brought under control and how much confidence people have with restarting their lives. I don't know the answer to that. I don't think anyone does. So, we are in limbo as far as that issue is concerned, but I think most people assume that we are going to begin to re-engage with the economy in this third quarter.
Beckworth: Yeah. We see different states, different localities opening up different stages. It'll be interesting to see what happens, like state of Georgia, where I'm from originally, opened up pretty early, and it'd be interesting to follow and see what happens there. Because I do think you're right, even as the states open up, one of the concerns will be people themselves, not the governments, but people, will they be more risk averse? Will they be willing to go out and engage in commerce to trade, to travel, to spend, to live life normally if they're still nervous about the virus? It's more than just governments given the green light. It's about us engaging as consumers and businesses.
Beckworth: Okay. Well, let's move on to what the Fed has done for the economy. We've touched a little bit, I guess, in terms of what it's doing for banks, but let's really dig in deep here and talk about the Fed's response to the crisis because you are a former member of the FOMC, so you have a great perspective on this. You saw this from the inside in 2008, 2009. You have really a great perspective to bear on this as well, as from someone who regulated banks at the FDIC. I'm going to categorize what the Fed has done into three areas or three buckets. All right? The first one's going to be the Fed's response to the crisis, what I call traditional monetary policy. The second one, I would call liquidity response or liquidity facilities, trying to make sure the banking system and what some would call the shadow banking system is still standing and enabled to do their job. Finally, credit facilities. It's the new area of the Fed has gone into this time around trying to prop up the real economy with these really novel and new lending facilities. Let's work our way through those three different buckets and just get your feedback, your perspective on them as we do so. Let's start with traditional monetary policy.
Beckworth: What we've seen the Fed do there is, it's lowered rates to zero, or zero to 0.25, but basically we got to the zero lower bound. According to chair, Powell, and he speaks on behalf of the FOMC saying, no one there wants to go negative. We've reached the lower bound for interest rates, number one. Number two, they have gone on unlimited QE. They will buy as much as they need, I guess, to get to where they're going. One thing that's not been very clear is where they're going in terms of what's the end goal of the QE purchases. I think it'd be nice to tie that to something. Maybe their end goal is hitting 2% inflation, some measure of full employment, but they've done that. Of course, they've promoted forward guidance by sending out signals. They'll be doing this as long as they need to, but I guess, if I had to summarize, it would be risk cut to zero, unlimited QE. They haven't opted for negative rates. They haven't really opted for yield curve control yet, or any other, or helicopter drops, or anything else really radical, are stuck with their traditional tool set. I say traditional. Traditional since 2008 QE in interest rates. I'm just wondering, have they done what's appropriate in your view in terms of traditional monetary policy?
Liquidity Support and Traditional Monetary Policy
Hoenig: I think they have done what is appropriate, given the circumstances and the economy they are in. I don't think any chairman could, given the precedent that had already been set and the needs of the economy would have done anything differently than this FOMC has done. Certainly, I would have been in agreement with it because what you're doing is you're not just supporting the so-called shadow market at all. You're trying to provide confidence that there is always going to be enough liquidity to allow markets to function, but whether those markets were too far extended, whether they were less cautious than they should have been, for the moment, that is not the issue. The issue is we are where we are, and how do you make sure there's enough liquidity to assure confidence in the economy so that it doesn't collapse upon itself?
Hoenig: Going to zero was probably a very easy call, expanding and re-introducing QE was probably a very easy call. Extending it then further, that is the ability to create money to a broader set of uses, including direct lending, that may have been a more difficult call, but given the circumstances and the fact that this was an outside event, a virus, I think they were able to get over that hurdle and do all that they felt, that is the committee felt was necessary to provide confidence in the economy and prevent it from collapsing. I think those are not easy choices in some sense, but in another sense, they're very rational choices.
The issue is we are where we are, and how do you make sure there's enough liquidity to assure confidence in the economy so that it doesn't collapse upon itself? Going to zero was probably a very easy call, expanding and re-introducing QE was probably a very easy call.
Beckworth: They have been very aggressive with the traditional part of monetary policy, and you're supportive of what they've done. I know going into this, that you had some reservations on what they were doing with like the repo market, but they stepped in. For example, in March, and maybe this is where we move into our discussion of the liquidity facilities buckets, so let's leave traditional monetary policy and talk about what they're doing in terms of supporting the financial system, which I think most observers would agree that it fits the definition of some kind of lender of last resort, or I think Perry Mehrling calls it market maker of last resort. But they've been massively intervening in the shadow banking system starting with the repo operations. They're investing over a trillion dollars in overnight repo, another trillion in one month to three months out. They've also, as you know reopened up some of the facilities they used in 2008, including the primary dealer credit facility, the money market funds liquidity facility, the commercial paper facilities, all of those are to keep this measure, this institutional form of money rolling over, keeping it alive and well so that liquidity in the financial system is still functioning.
Beckworth: My understanding is the changes they made to Dodd-Frank under 13(3) coming out of the last crisis, really specifies that they can only set up facilities to that end. That when they do these facilities, they have to be directed to providing liquidity to the financial system. So you can argue, make a reasonable argument that's what they've done with these facilities. It does beg the question though, is there a better way to deal with all of this activity that's outside the traditional banking system? In other words, the Fed can reach traditional banking needs to the discount window and its facilities that it was designed, but the shadow banking system, so all of this institutional money assets, the repos, commercial paper, all of that is outside the normal channels through which the Fed operates, so it has to set up these special facilities. I'm just wondering if you think there's a way to better manage that or have a full-time facility set up to deal with them or just rewrite regulation. I guess this goes back to your discussion of banking. There is a lot of money creation occurring outside of banks. Do you have any thoughts on how we, as a country, should approach it, should engage with it, should regulate it?
Hoenig: Well, that's a pretty big question.
Beckworth: Yeah, that's a huge question. I know.
Hoenig: But let me start by a technical item, and that's the 13(3). Dodd-Frank changed it, but not really. They have to go to the Treasury to get permission to engage in this. The Secretary of Treasury is a political appointee. It's highly unlikely that the Secretary of Treasury would ever say no to the Fed on that request. It's more formality than substance there. That's not an issue for me. I know it is for some, but not for me. The second is, what we've done over time, that is what the Fed has done over time is enable the financial system to lever up to ever greater degrees because it has maintained low interest rates for an extended period of times starting before the last crisis, following the recession of 2000 and moving forward.
Hoenig: You've encouraged this leverage and you've encouraged the use of short term inclines to fund longer term assets among groups other than just commercial banks. That's done. That's money market mutual funds and other institutions. I think, you've set that up. That's it now. So, when you get a crisis, normally when you weren't so leveraged, these so-called shadow banks would have lines of credit with commercial banks who had then a line to the Fed and you would address these liquidity issues through the banking system. The banking system is not equipped to do that any longer.
When you get a crisis, normally when you weren't so leveraged, these so-called shadow banks would have lines of credit with commercial banks who had then a line to the Fed and you would address these liquidity issues through the banking system. The banking system is not equipped to do that any longer.
Hoenig: It's more leveraged itself number one, and number two, these others have become so large through the leveraging process, helped with the low interest rates, even in non-crisis times that you have a different set of circumstances. I would expect the Fed would continue to provide backup to money market mutual funds, asset backed commercial paper, should there be liquidity crisis in the future. I think it's very difficult to back away from, which leads me to your what you introduced with, and that is the repo market, and some of my objections to what went on last fall, but that was not a crisis period. That was a period in which you were trying to transition from this very extensive balance sheet that they had, this very extensive use of QE in the past to begin to normalize it. As soon as there was a hiccup in the market, the Fed backed away, and that's because you had to fund the federal government's debt without allowing interest rates to rise.
Hoenig: If you are going to peg interest rates at very low levels, and the government is going to continue to print money, and you're going to expect the primary dealers to purchase that government securities and redistribute it, you're going to have the Fed having to intervene, even in non-crisis periods. That's a very, in my view, a very unfortunate set of circumstances for the Central Bank to find itself in, but in the immediate period, the period of crisis, that's when the Central Bank does have a mandate and a responsibility to intervene to mitigate the effects of the crisis on the larger economy. That's what they've done and what they have to do, not just to banks, but to other institutions in the market that are bank like with their mismatch of assets and liabilities.
Beckworth: Yeah. I appreciate your pragmatism. You're very thoughtful on that, that, hey, we're in a crisis, let's respond to it because it is a crisis. In normal times, let's think through our options more carefully. I guess, my question is, in normal times, should we be rethinking how the system overall works in terms of money creation? The money market funds, the repo markets, they're effectively creating money assets. This maturity mismatch that you've talked about, it's effectively creating liabilities on certain financial, from balance sheets that act as money for big institutional investors, and they're not in the traditional banking system. These liabilities, they can be run on just like traditional bank liabilities can be run on, except traditional banks have FDIC. They're regulated, where the shadow banks aren't so much.
Beckworth: There has been some radical calls, and I'm not comfortable with them, but I'll just mention one now. Throw some out, for example, some want to regulate and dictate that any kind of money creation has to occur within a regulated bank. Somehow you would outlaw all shadow market money creation, or short-term liabilities. I'm not sure how that would work if it was even possible, but there are some smart people who've been advocating that. But I wonder if there's any other market friendly way to approach this, because the concern is that more and more of what we call money, money like assets are occurring on balance sheets of firms outside the banking system, as you note, and they can create a financial crisis in the future, because these are liabilities that can be run on. What can we do in a market friendly way to deal with that growth?
Hoenig: Well, that growth is enabled, in my opinion, only, by the fact that we have accepted and we encourage leverage in our economy. We are a much more leveraged economy today than we were even 50 years ago, and we are committed to that. Even when we entered this crisis, prior to entering this crisis, our debt, even private debt was higher in 2019 that it was in 2007. We've added to that even greater amounts of public debt because our debt, federal debt outstanding was in around 2010 or 2008, around $9 trillion, and by 2019, it was over $20 trillion. Today, it's over $24 trillion. You create that, you create the environment and the incentives to lever up. Now, these shadow banks are often funded by the commercial banks, whether they're a hedge fund, the exception is money market mutual funds, perhaps, but they are like banks, and we've allowed that to occur, and we've allowed that through this leveraging process. That's very important. The other element of it is we no longer have any external check. There's no rule, there's no standard for the creation of money.
We are a much more leveraged economy today than we were even 50 years ago, and we are committed to that. Even when we entered this crisis, prior to entering this crisis, our debt, even private debt was higher in 2019 that it was in 2007.
Hoenig: It's strictly whatever the Fed and the powers that be would like to see extended that will be extended. That in and of itself, I think creates the environment for even more leverage in the future. Remember, everyone who is not the central bank wants more money. It doesn't matter who it is. If you're a liberal in Congress, you want more money. If you're a business, you want more money. The incentives are to try and get the Central Bank to create more money, so you can have more money, you can leverage more until it becomes its own problem. I think a better solution than saying only money can be created within the regulated bank, which I think you would have a very difficult time policing. It would make you even more of a state police rather than a Central Bank is to address over time, in systematic fashion, the excessive leverage that we're carrying. That requires a very strong, independent central bank to avoid a future Volcker moment where we find ourselves in crisis from having too much money printed.
Beckworth: I'm very sympathetic with that, I agree. It's in my mind very difficult to police that, even if you could say in the first instance, police it. You know there'd be a new shadow banking system emerged somewhere else. It just seems to me, it'd be a very Herculean task to limit money creation to the commercial banking system. Think of the Euro dollars, for example, they're overseas. There's money creation outside the US. It's not clear how you could all contain that. I'm very sympathetic to what you're saying. I think you're right. It's all about funding with more capital, less leverage. So it's a long journey is what you're telling us. There's no quick fix.
Hoenig: That's correct. It's been a long journey to get here. It's not going to be a short trip if you want to avoid the economic chaos to get back, but it also requires a very systematic commitment to a slow, difficult deleveraging process over time. Just as a footnote, I think that's what September was all about. As you tried to move to the deleveraging, you got people very nervous and very unhappy, and therefore, you found yourself… that is the Fed had to backtrack and start growing its balance sheet again related to the repo market. Unfortunate, I think.
Beckworth: Yeah, for sure. Well, for those of us who like a corridor operating system, a thoughtful one, not one that ... I think you could argue the Fed accidentally tripped into a corridor system, all the developments last year, but to get to a corridor system, you have to make that balance sheet glean. I really wonder, will we ever see that at all again? I don't want to be pessimistic here, at some point in the future, we could, it'll be a long journey as you say, but the Fed's balance sheet is going to be really large after this crisis, so to pare it back down to something that would be consistent within a corridor operating system.
Hoenig: I don't envy the Fed, or anyone – what I worry about is that it's going to be highly, highly difficult, because everyone wants more money. The government will want more money. It's going to have a huge debt fund. The businesses want more money. If you don't do it, then interest rates go up and everyone starts to beat on the Fed. It's going to take a lot of effort. That's why I say, starting with the government itself has to commit to grow its debt less quickly than the GDP grows. That's number one. Then the Fed has to say, all right, we're going to let our balance sheet come down, and for you guys who speculated in the repo market, you're on your own. Then, you might be over time, without bringing the economy into a recession, you might be able to see some reasonable deleveraging. I don't mean to eliminate leverage. It's very important, but to make crises less traumatic by having less leverage, to try and cope with. Otherwise, our balance sheet, the Fed's balance sheet will next crisis go from, I don't know where to go this time. Let's say it goes to eight to 9 trillion. Next time, it'll be 15 trillion. I don't know where that ends except badly.
That's why I say, starting with the government itself has to commit to grow its debt less quickly than the GDP grows. That's number one. Then the Fed has to say, all right, we're going to let our balance sheet come down, and for you guys who speculated in the repo market, you're on your own.
Beckworth: No, I agree with you. We actually did a show with George Selgin on his book called “Fiscal QE.” It's a new book he has. Actually, it got outdated pretty quickly by what was happening with this crisis, so that's actually one of the shows we have sitting in the hopper. We never did a release because events passed it by pretty quickly, but the point of his book, which a really good one is that, the floor operating system, what the Fed currently has where you separate the size of the Fed's balance sheet from the stance of monetary policy, opens it up to this very thing you're talking about, that if the public, if Congress sees that, hey, the Fed can buy up, it can intervene in all these markets without any effect on the stance of policy without changing interest rates, well, let's try all kinds of new programs. You're right. If we can go up to $8, $9, $10 trillion balance sheet with no effect on inflation and still have lower rates, it's going to be a very attractive piggy bank for other folks to want to raid, which speaks to a point we're going to get to a little bit more later, and that's the politicization of the federal reserve and lack of independence.
Hoenig: It seems like it's such an easy thing to do, but if you go back and look at the period following the last crisis, and you look at it compared to the period following a recession in the early '90s, the growth rate, with all the stimulus that was put in there after 2010, the growth rate of the GDP was less than, almost lever up was almost half of what it was in the earlier period. Productivity was almost half of what it was in the early period. What you do is you have a sense of progress, but when you get down to it, it's not progress at all. At some point, it becomes counter-productive and then it becomes very, very troubling to the ability of your economy to continue to grow and provide an increase in wealth to the broadest base of your population rather than what you would hope for. I have to say that because of it has such strong implications for the future.
Beckworth: Absolutely. I think one of the big takeaways is, we're going to be disappointed what the Fed can actually do in terms of growth. I think we're going to be disappointed in terms of what the Fed can do with these new programs as I've discussed with several of our previous guests. Let's use that as a way to segue into the next bucket. We've covered Fed's traditional monetary policy, we've covered the Feds liquidity facilities. Those two first buckets, I think everyone is fairly comfortable with. You can argue on the margins and maybe, like me, you might want to level target added. Our previous guests was Scott Sumner, and he wanted to see the Fed do more with traditional monetary policy. But I think in general, most people would understand at least, what the Fed has done in this crisis with those first two buckets. It's this third bucket that's really controversial. Also, at the same time, understandable given that Congress isn't eager to do a whole lot and wants to pass the buck onto the Fed.
Beckworth: What I'm thinking of here are the credit facilities, and this is where the Fed is lending to the real economy, as opposed to doing traditional monetary policy or supporting liquidity in the financial systems. I think we all know what I'm talking about here, but just to be precise, the primary and secondary market corporate facilities, the municipal liquidity facility, main street facilities, three versions, the PPP one facilities. The Fed is intervening in corporate credit markets and state and local government financing and small and medium sized business financing as well. This is intervening into the real economy. We've had a lot of guests talk about some of the challenges they see in this, but I'm wondering, what challenges do you see in it? You're a former FOMC member. What concerns do you see, or maybe do you see a certain good too? Where do you stand on these facilities?
The Fed's Credit Facilities
Hoenig: Well, first of all, I would say, I understand, I think I understand what the FOMC is thinking about, and that is, you're trying to make this more democratic. You're trying to get it out to a broader base in terms of the real economy. Some of the bond market stuff, the primary and secondary, that would be controversial on its own since those are usually larger corporations. That's why this direct lending facility has been, I think introduced to make it more democratic so that you have the smaller businesses or intermediate businesses receiving some of this. I understand it. I do think that that is the role of the commercial banking industry, including the largest, rather than the federal.
Hoenig: It's disappointing to me that they're unable or unwilling to fill that role, and that the Fed is so willing to step into that role because you are setting again, a new precedent, mostly you. There's a very small amount of lending in the Great Depression I realize, but mostly new, and it does introduce another element of, oh, this is convenient. We're going to have you lend in the future, maybe not for an immediate crisis, but because we feel there's a need for it, and you will see that pressure, I think coming from Congress, depending on who is speaking, and from the general populace more in terms of their wish for access to broader base of credit. You are introducing, I think, some real risk into the Fed's independence in the future.
Beckworth: Yeah. I agree with you completely on that. I think the Fed has to be aware of that as well. I suspect the reason the Fed is doing this, is, like you said, because it wants to try to be fair, but also expediency. It's an institution that has technocrats. Everyone seems to trust it maybe more than other institutions, but it also, I think in part, because Congress is again, passing the buck. Congress is pushing, I think responsibilities it should be doing onto the Fed. It's an off balance sheet way of providing relief activity, so the price tag looks smaller, number one, but also it's a way to avoid some of the political gridlock Congress may face, and having to have to wrestle with it itself. But anytime you're dealing with the real economy and you're making decisions, and some groups may be better off, some might be harmed, it clearly becomes a question which Congress should be considering.
Beckworth: I think, like you said, it's going to politicize the Fed more and potentially harm its independence in the future. Some of my previous guests have pointed out, the Fed is also not well equipped to do this kind of lending. As you mentioned, the Fed is probably going to be better equipped to deal with the big corporations because they got securities, are rated. The Fed cannot do grants, and the Fed has to deal with firms that are solvent. Right there, it really makes it hard to reach into certain places. I do think we're going to be disappointed on many levels of what the Fed is doing with the smaller businesses, and it's going to create some political backlash.
Hoenig: Yeah. First of all, I do agree with you. I believe that this is a congressional Congress government responsibility. It is a fiscal policy action that is out there. It is unfortunate that you have such a divide in the Congress and in the government that you cannot get this done as close to right as possible for everyone's sake. Then it is unfortunate that the Fed feels this obligation. I can understand that completely. Because once you walk into this, getting out, it's a little more like quicksand than you might otherwise like. We'll have to see how they do. I think it means your balance sheet will grow more, which in the future will make it even more difficult to, shall we say, normalize policy or deleverage the economy. Only time will tell.
Beckworth: Yes. To his credit, Jay Powell, Chairman of Federal Reserve these past few weeks has been very adamant about Congress doing more. He's really been pushing on Congress to do more heavy lifting. I think maybe they recognize that there are limits to what they can do with the Fed. The Fed can't expand its balance sheet as big as it wants to, there are just real limits by law what the Fed can do. Now, Tom, I'm wondering if you've seen any, I don't know, perception out there in Kansas? Have you businesses that feel like they're not being treated fairly or that the programs aren't well designed for them? I know you have lots of contacts from your time there. Do you have any sense of what's going on on the ground level there in the Midwest, in terms of whether these programs are working and how they're being perceived by the public?
Hoenig: I think generally, they are perceived pretty well. Like so many things, the programs got off to a little bit of a bumpy start, but there's been a real effort, I've noticed by the legislative individuals that is the senators and some of the congressmen in getting this out and explained. There has been good, shall we say, help from some of the media, especially the business journals, in explaining how to do this, how to apply, how to get it, how to work with it that has made this go more smoothly here than what some people might've expected. Is it perfect? Hardly, but it's been, I think mostly received now as having been done pretty equitably across the board with a few exceptions. I'm pleased with that, to be honest.
Beckworth: Well, that's great to hear, which that would imply less political blow back from constituents and a better standing for the Fed going forward. Although, for the reasons we talked about before, there still might be some concerns about the Fed's independence in the future. Any parting thoughts here on concerns you have about the Fed's independence moving forward, the ability for it to do traditional monetary policy because of all these new areas it's getting into?
Fed Independence Moving Forward
Hoenig: On a couple of levels. Number one, during the crisis, there's no issue of independence because everyone wants the same thing or thinking the same way. As you move away from it, I think the Fed will be pretty successful on stopping the programs that are not growing them any further and seeing them unwind, but where they will, I think, be extremely challenged will be on unwinding the balance sheet effects of the program, the ability to say no to funding all new government debt that comes out to keep interest rates artificially low. That's when the independence of the Fed will be most important and that's when the independence of the Fed will be most challenged. I wish them all the best because they're going to need a lot of help to stay independent and to run policy in the best long-run interest of the country, not just the immediate part of the recovery.
I think the Fed will be pretty successful on stopping the programs that are not growing them any further and seeing them unwind, but where they will, I think, be extremely challenged will be on unwinding the balance sheet effects of the program.
Beckworth: Yup. I actually think Jay Powell is probably well suited for that role. He's very pragmatic. He's also, I think, very smart political operator. I remember there was an article that talked about him a few years ago, wearing out the carpet in Capitol Hill he's visited so many times.
Hoenig: I think he is very well equipped. I admire him. Number one, he is very articulate. He doesn't dance around with words as much as you would see some politicians perhaps, and he's very calm. I think people have confidence in him, which is extremely important, especially on the backside of this. I agree with you. I think he's a very good person to have in this role going forward.
Beckworth: Absolutely. We are fortunate to have a leader like him at the Fed during this time. Okay, so going forward, we've touched on these three buckets going forward, I'm thinking of some of the developments that might be on the horizon for the Fed. Let's put it aside the independence concerns, but let's talk about some of the tools that Fed might still employ. I hope you are right, that we will see a strong recovery third and fourth quarter. So we won't be needing all these additional tools, but let's think of maybe a worst case scenario, where this is a scenario where things don't get well quickly. Do you foresee the Fed, doing things like negative interest rates or yield curve control?
Negative Interest Rates, Yield Curve Control, and the Fed's Review of Its Policy Framework
Hoenig: Well, first of all, on yield curve control, that is a possibility. It's an effort that will affect asset prices, which is, I think something they could have on their mind if things don't go well, and so I could see that happening. I think they are wisely staying away from negative interest rates and should stay away from negative interest rates. I think there's a couple reasons. Number one, [negative interest rates are] very distortive, in terms of the allocation of resources, and number two, those who have tried it have been sorely disappointed, and find themselves in holes that they're unable to dig their way out of. That includes Japan and Europe. I do not envy either one of them for their economies or their management of the economy during and after the crisis. I don't see any need to follow their example relative to negative interest rates and the harm that it will do to our economy just as it has done to their economies.
Number one, [negative interest rates are] very distortive, in terms of the allocation of resources, and number two, those who have tried it have been sorely disappointed, and find themselves in holes that they're unable to dig their way out of.
Beckworth: Okay. One other that may be on the horizon is the Fed's big review of its policy. It started last year, the year before the strategic review of how it does monetary policy communication tools, the whole thing, but the big emphasis has been on what the Fed targets or how it targets. Effectively, there has been this discussion about moving from an inflation target, which you could call more precisely a growth rate target, to something closer to a level target where you make up for past misses. Both ways to be clear, so if you're below target, you've got to grow faster the next few years to get back up to your trend and target or path. If you were above it, you got to come down. That was, at least, talked about before this crisis emerged, and it was being manifested in this idea of an average inflation target. Of course, I would like to see a nominal GDP level target for many reasons.
Beckworth: I do think that a level target would make a big difference and the flexibility the Fed has in dealing with this crisis in supporting a recovery. My concern is, if they don't have a level target, they're going to dial back policy prematurely, but let's just take it as given. You may not agree with that, but I'm a big fan of level targeting. My question is, if you're on the FOMC. You were on the FOMC, but if you're in the FOMC right now and you have all these other things going on, Jay Powell's plate is so full right now. He probably can't see past it along with the other members, Rich Clarida, and other members of the FOMC, do you think they have time or they're thinking about the review, and do you think it's something that they're going to want to pass this year, or to finalize this year, given everything else that's going on?
Hoenig: Well, I do think that taking a review and look at it is a wise choice that they made. I agree with you. I'm not a fan of inflation targeting, never was, because there are so many other factors that you have to take into account in an FOMC meeting. I think it's, by itself, a bad target, whether nominal GDP or others, I think deserve a review. Now, in terms of, I think, as a result of this crisis, I doubt that there are ... I doubt, I don't know, but I doubt that this is on anyone's immediate agenda, and I don't think we'll have much of substance this year. If we do, I'm not sure I would want that because it would be rushed in my opinion. They need to, once they gets through this, look at where they are, and it's going to be even more difficult because they are going to have a balance sheet that's probably twice as large as it was when it started. They will also have even more pressure for what they target relative to current interest rate levels, and not just inflation targets. They need to, probably almost have to start over. I'm not sure that's a bad thing given the crisis and what we're coming through and what the future holds and what they're going to face.
Beckworth: Yeah. That's my suspicion as well. They've just got so many things going on. I'll go again, I think if they had a level target coming into this crisis, it would have been a big help for them, whether it's a price level target or a nominal GDP level target. I just think level targeting makes a big difference, but I suspect you're probably right, but maybe we'll be surprised. The original deadline was June of this year, which is coming up on us pretty quickly. Anyone over there in the Eccles Building is listening, please let us know. Can we expect a surprise birthday gift this summer or not? I know there's many fans out there of the show who are also big supporters of level targeting and we're waiting the big draft.
Hoenig: To be honest, David, I think, right now we're in a crisis, so people are worried about deflation. Another time they might, say nine months from now, depending on what happens to supply versus demand, they could have an inflationary concern. I think they need to let things settle through and judge what is the best way to map a course forward. I don't think they can do that by June because I don't think they're going to have enough experience with this immediate crisis, and they won't know where we are in the recovery, for sure. Why rush? Let's manage the crisis and get ourselves back, and I don't mean back to 4% unemployment. I mean back to where employment is declining systematically again, and then think carefully about the path forward.
Beckworth: Yeah. An image comes to mind right now, Tom, of a cartoon picture of Jay Powell juggling. He has a bunch of balls in the air already. He's got monetary policy, he's got liquidity facility ball in the air, he's got a credit facility, he's got a real time payment ball in the air, he's got bank regulations in the air, he's got repo market concerns in the air. Here's David Beckworth on the side trying to throw in another ball. A ball called nominal GDP, level targeting. I can appreciate the added stress that would create in terms of the juggling act he's already doing, the Fed's already doing, but yeah. Okay. Well, we'll have to leave it on that note, and maybe it we'll be pleasantly surprised, but I think you're probably right. We'll have to wait for a later time. Well, our guest today has been Tom Hoenig. Tom, thanks so much for coming on the show.
Hoenig: Sure. Glad to be with you. It's been my privilege.
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