Tim Duy on the Yield Curve, Inflation Targeting, and the Federal Reserve under Jay Powell

There are many different economic events that may indicate a recession is looming, and Treasury yield curve inversions may be one type of signal.

Tim Duy is a professor of economics at the University of Oregon, a columnist for Bloomberg, and a former economist at the U.S. Department of Treasury. Tim joins the Macro Musings podcast to talk about yield curves, Federal Reserve policy, and the future of the Jay Powell Fed.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]

David Beckworth: Tim, welcome back to the show.

Tim Duy: Thanks for having me here David.

Beckworth: Well, it's a real treat to have you back on. I was wanting to get someone to talk about yield curves, and Fed policy, and you're the first person that came to mind. It's great to get you back on the show. For our listeners if they want to go back to the earlier episode with Tim, and learn about the art of Fed watching. I highly recommend it. Tim is a master of this special art, and he lays it all out for you to try your own hand at Fed watching. Today we want to talk about treasury yield curves and Fed policy. It's become a hot topic. There is concern that maybe the Fed is making a mistake. To kind of delve into it, I want to begin Tim by asking you, what exactly is the treasury yield curve?

Duy: Well, here we're thinking about ... It's probably easiest to think about it as a chart. You have on the X axis treasury bonds in different horizons. So, maturity. You have a three month treasury bond, a six month treasury bond, a one year treasury bond. All the way up to a 30 year treasury bond. On the Y axis you have interest rates associated with each of those bonds. Typically, the yield curve slopes upward in that short term interest rates are lower than longer term interest rates. A yield curve is just simply the chart of all those various interest rates at the various horizons of treasury maturities.

Beckworth: Okay. This shows a relationship between long term treasuries, short term treasuries, and everything in between. What typically happens to it during the business cycle? During the boom and leading up to the recession?

Duy: During a boom, particularly after the Federal Reserve starts a tiny amount of monetary policy, what you tend to see happening is short term interest rates rise more quickly than longer term interest rates, which means that the shape of the yield curve is becoming less steep or flatter over time. This is pretty much what we've seen in every cycle, and we're currently seeing in this current cycle as well.

Beckworth: People start to get worried when that flattening happens, and even more worried when it becomes an outright inversion. One of the short term rates actually get higher than the long term rates, is that right?

Duy: That is right. I don't get worried per se about flattening. The flattening I think is very much consistent with what you'll see at the best part of the business cycle, at the meat of the business cycle is, it's typical to see the Fed has raised interest rates enough to really flatten out that curve. It's really the inversion that is the recession signal. Of course, it has to flatten before you get to inverted, but it can remain flat for a very, very long time.

Beckworth: All right. So it can be flat without any bad developments occurring. Just to go back to flesh out why this could be consequential, there is the expectation theory for the treasury yield curve. This gets sort of in the weeds with the idea, and correct me if I'm wrong, is that a long term interest rate is equal to the expected path of short term ratio, the average of a bunch of short term rates over that same horizon. If I'm looking at a 10 year treasury, the expectation theory says, well, it should be equal to a bunch of short term treasure bill rates, plus some term premiums, and some added compensation for holding that longer term treasury. Is that the correct way to think about-

Duy: Yeah, that's a common way of thinking about it. We would think that when the yield curve becomes inverted or those longer term interest rates drop. That's maybe telling us something that financial markets expect the path of short term interest rates to stay falling. That would be consistent with what we'd see during a recession, because during a recession the Federal Reserve needs to ease monetary policy.

Beckworth: So, if it completely inverts, if short term rates go above long term rates, two things could be happening. One, it could be that the Fed has just upped rates so much that they're higher than long term rates, or a combination of both, long term rates have fallen, and the expectation of short term rates is going to go down, because they expect some kind of weakening or recession ahead. Two things could happen. The Fed could raise rates, which you might think of it causing a recession if they raise it too much. But the flip side of that is if the long term rates go down, the market might be expecting a slow down. Where are currently now? What does it look like right now as we talk?

Duy: Typically, a very common section of the yield curve to follow is the difference between a tenure treasury rate, and a two year treasury rate, the 10-2 spread, has often been a very good predictor of recessions. That interest rate is ... That spread is sitting in about 30 basis points, so 0.3 percentage points. It's fairly narrow, but certainly not inverted where we think there would be a negative spread.

Beckworth: Some people look at the 10-2, and I've used ... It seems to be the most alarming, if you want to call that yield curves right now. There is also the 10 year minus three months spread. Sometimes it might even go 10 year minus three months spread. There's also the 10 year minus some even shorter rate like federal funds rate. Which one should we go for? Which one should we follow?

Duy: I tend to use the 10-2 spread, because the two year bond incorporates expectations about where the Federal Reserve is going to head, or about the path of the Federal Reserve policy. My position is that the expectation of where the Fed is moving is as important as where the Fed is right now. So, if I just look at the 10 years minus the federal funds rate, that's just giving me some indication about where the monetary policy is now. I really want to know also where markets expect monetary policy to be heading, because that expectation is already working its way through financial market.

Beckworth: All right. So we've picked the 10 year minus two year treasury yield curve. It's at 30 basis points. So it's getting pretty close to zero. Once it gets to zero that's when we get this inversion. That's when typically recessions have occurred. To be clear, it's a prediction tool more than a coincident indicator, correct?

Duy: Yeah, it's certainly not a coincident indicator. It's much more of a long leading indicator. It could be six months, it could be a year, it could be two years out before that recession actually emerges. This is why I think a lot of people tend to dismiss the signal from an inverted yield curve, because it happens so far ahead of the recession, which means it happens so far ahead of when the rest of the data is turning.

Beckworth: Yeah. You can look at the treasury yield curve, and this inversion as a signal about the future path of interest rates. Again, if it's inverting, the short story is that it implies that future rates are going to go down because of a recession or a leak in the economy. There's another story I've also heard is that when the yield curve begins to invert, the spread between short term and long term rates goes negative, it also means it's less profitable for banks and financial firms to do lending, which in and of itself, it goes from being a predictive instrument to being actually a spread that shows banks are becoming less profitable, and that too could have added to the slow down. Any thoughts on that interpretation?

Duy: Right. That is the alternative interpretation, but there is actually a causal relationship between the inverted yield curve, and the recession. The story is that banks, the financial sector overall is profitable, because it can borrow money on the shorter end of the yield curve at a low interest rate, and lend it at the longer end of the curve at a higher interest rate. As a consequence when the yield curve is inverted, that financial intermediation story doesn't work anymore. They actually become less profitable. Credits slowly contracts. As credits slowly contracts, eventually you'll find the economy slowing down, and entering into recession.

Duy: I'm in some sense agnostic. I think that banks can often find financing maybe less than you see at the two year rate. Maybe this is where the federal funds rate becomes much more important. I've tended to be somewhat agnostic, I'm not sure we really have a good idea what is the right story here. I think that once the yield curve inverts we just have to be much more cautious about saying, "Is credit contracting? Is there evidence that the economy is starting to slow down?"

Beckworth: So that's the theory, the ins and outs of the treasury yield curve. As you said, it's getting pretty low, it's flattening, it hasn't quite inverted, but this is really generating some conversation, sone concern among market watchers, Fed watchers, people who worry about the economy, and this includes some Fed officials. The question is, is the Fed leading to this inversion? Is the Fed getting ahead of itself? To put this in context, we go back to 2006, I love to bring this example up, and Timmy probably knew I was going to bring it up, because you know I like to do it on Twitter a lot.

Duy: That's right.

Beckworth: You can also say for example, Ben Bernanke has been appointed the chair, he hasn't been in office too long. He gives a speech that is titled, reflections on the yield curve, and monetary policy. The same thing that was happening then that's happening now. There is this flattening of the yield curve. He goes through what we just talked about, the different reasons why the yield curve might flatten. He really stresses that in addition to maybe short term rates expected to go down in the future, could be the term premium that added compensation that we're going to give hold some long term securities, that could also change.

Beckworth: He makes this case maybe infamous to the 2006 speech, that it was mostly the term premium, because of accounting rules changes, because of foreign Central Banks holding it. That was the reason that the old curve was flattening, don't worry about it. Of course, we know a few years later, December 2007 the Great Recession kicks off, and the rest is history. Any lessons from that experience for the Fed today?

Duy: Well, actually, what's remarkable is the story told by a Fed governor such as governor Lael Brainard is fairly similar to that, that we shouldn't really be terribly worried about the yield curve being flat, or inverted, because long term interest rates are being held down by essentially the Central Bank balance sheet, the Fed's balance sheet. It's also being held down arguably by aggregate easing on the part of Central Banks across the globe.

Duy: Those factors, those pressure factors are weighing down on the term premium, and thus the yield curve inverts at a lower level of interest rates than has happened in the past. That's certainly the same story now people are using this time as they did in 2006. That seems to me fairly clearly a cautionary story. Until proven different, I still tend to think that the yield curve, long term interest rates are being pinned down.

Duy: They're being pinned down close to 3% right now, as far as the 30 year interest rate. That's telling you something about the underlying natural equilibrium rate of the economy that is probably close to 3%. If you start to see the yield curve invert, if you start to see those two year weights climb to 3%, and it looks like the Federal Reserve is moving in that direction, then you really do have the same concerns you've had in the past, even though you're at a lower interest rate. I think you have to default to that option given the successful history of the yield curve in predicting recessions.

Beckworth: It definitely suggests some caution, some humility, when thinking about these issues. I've gone back and looked at the data. The New York Fed has this measure of treasury interest rates, or yield. Breaks them up by expected path of short rates over the long horizon versus the term premium. If you look at the 2006 episode, and I looked at it, they have data from 10 years, all the way down to one year treasury interest rates. I use that spread. What you see at the time Bernanke is giving that talk is, it's true that the term premium was declining, but in addition to that, the expected path of short rates was also declining at the time. There may be some truth that the term premium has been, is different this time. There is something else affecting it, that's pulling it down. It could also be the case that short rates are also being pulled down, because of this calculated slow down. It definitely gives precaution.

Duy: Yeah. That's the way I view it. I completely appreciate that it's very hard for policy makers to take either a strong signal from an inverted yield curve. The reason is, it just simply happens possibly so far early, relative to a recession, that in the scope of the entire ... Basically the entire universe of data they're going to see, there's going to be this one outlier. It's just going to be very difficult for policy makers to put too much weight on that one outlier, no matter how good of a predictor it has been in the past.

Beckworth: Yes, and you mentioned governor Lael Brainard. She's taking the Bernanke view of sorts. There's been a number of very interesting articles written on this. You've written on them too, but I'm going to read one from Bloomberg. The title is Kashkari Isn't Buying 'This Time Is Different' for Yield Curve. He's been one of these regional presidents who has been pushing back against the, it's different this time. I want to read a few quotes, because they quote him as well as some of the other regional bank presidents.

Beckworth: It seems that they're the ones who are the most concerned, or the board, which it's not many people, it's just a few three people. So that's not big group. It seems like the board is a little more sanguine versus some of these presidents who are more conscious. I wanted just to get a few quotes article. She's quoting, the author is quoting from a medium post that he wrote himself, but the article says, Neel Kashkari does not want to invert the yield curve.

Beckworth: He writes, there is little reason to raise rates much further, invert the yield curve, put the brakes on the economy and risk that it does in fact trigger a recession." He said. This time is different. I consider those the four most dangerous words in economics." Kashkari wrote, then she goes ... The author goes on to discuss some other presidents. The Atlanta Fed president, Raphael Bostic said last week that inversion could be a self-fulfilling prophecy if investors believe it will bring recession. St. Louis Fed chief James Bullard said inversions have historically signaled downturns and he doesn't buy that this time is different, and the Dallas Fed's Robert Kaplan is also “loath to say” those are his words, loath to say, that an inversion now would break from past."

Beckworth: These are some individuals that are a little more cautious. They don't want to move the pit too fast. Then she moves to Philadelphia Fed President Patrick Harker doesn't “See why we would move in a way that would invert the yield curve just to do it.” John Williams, head of the powerful New York Fed and a permanent voter on monetary policy, has walked a middle line, so he's kind of wavered on that. Then finally, Loretta Mester, who is also a regional president, she's not worried at all about it.

Beckworth: You have at least a good number of regional presidents who are more sympathetic to this concern that for whatever reasons that yield curves [inaudible 00:17:53] let's be cautious. Then you have the board, like Jerome Powell doesn't seem as concerned. You mentioned Lael Brainard, a couple of other articles that had a quote from that. In the June FOMC meeting this question was asked to him. He goes on, he gives a great explanation of what causes the yield curve, but he never really answers what role the Fed is playing on this. How do you see this break down? Is it truly a board versus regional president tension, or is there something more going on?

Duy: I think it's mostly the board versus the regional president, or as you said, a subset of regional presidents that are very much concerned about this. Those regional presidents tend to be on the government side of the policy spectrum to begin with. For example, Kashkari and Ballurd are clearly much more cautious about raising interest rates in this environment to begin with.

Duy: Simply because, sort of stepping away from the yield curve they look at the inflation outlook, and would say, "There is nothing here to be terribly concerned about. Why are we raising interest rates in the first place? Then secondly, we've got this indicator of the yield curve that's flattening, and really we should be very cautious about pushing rates up so high that we invert it. That though seems to me is still a minority view within the FOMC. I know you're talking about the quarter to a third of FOMC participants that seem to be very concerned about this particular issue.

Beckworth: It's interesting that you're seeing this dissension from the regional bank presidents. I imagine, if you want back in time to 2006. I'm sure, we could find this if I dug into the transcripts, but I suspect ... Maybe I'm wrong, but there would be a number of regional bank presidents who would be much more, not concerned. They were much more hocus back then.

Duy: Exactly. If you step back to 2006, and just think about where the economy was, you're really just coming off the housing boom, really before the financial crisis. Co-inflation was probably running close to 2 1/2% and had been a little bit harder. The decision in the board was to focus again on that data, and not so much the yield curve, because again, the yield curve is longer with the indicator. Think about the lags in monetary policy.

Duy: If the Fed has over overtightened that doesn't necessarily have an impact right now. That has an impact 12, 18, 24 months later. I think that disconnect between the lags in monetary policy, and also the lags in the inflation setting process. Inflation is going to be something that emerges late in the business cycle. You've got this inflation, now you're concerned that it's most prominent, but above the time where the inverted curve is going to invert. It's just hard for the Federal Reserve to all those things in such a way, that here is a way to the yield curve argument.

Beckworth: That's a great point. There is many moving parts of this story, the inflation is going up. You mentioned co-inflation, but another big part of the story was the commodity price shock at that time was beginning to emerge, which is in theory they should see through, because that's just a temporary effect on inflation, but they didn't. At the same time they got the yield curve going on, and there is a housing boom. There appears to be excesses in the economy. What's the responsible thing for a banker to do?

Duy: For what it's worth I'd also back it out a little bit and say, I become somewhat concerned when the yield curve inverts. I'd become more concerned if the Federal Reserve kept raising interest rates after the yield curve, because you could have an inversion, a small inversion, because there is a collapse in long term rates, because the world just got riskier. Some financial crisis has occurred, and people plow into treasuries.

Duy: In 1998, the Federal Reserve reacted to a similar type of inversion by cutting interest rates, and that was during the Haitian financial crisis. Of course, the inversion turned out to be fairly short-lived, and recession did not follow immediately. It wasn't until the yield curve inverted later in the decade, and the Fed kept raising interest rates in 2000, that you really saw the recessionary conditions emerge.

Beckworth: That's a great point. It's how does the Fed respond once they're in the dangerous territory of inversion, and how do they react to it?

Duy: Right.

Beckworth: The hope is again, the 2006 experience, which seems to be the most recent, and the freshest in our minds, would lead to some pause, some humility in acting too fast.

Duy: Another reason I think that the Fed might be cautious moving ahead here, is that, the FOMC, and I think Powell really feels this way too, is not too interested in pushing past what they perceive to be a neutral interest rate, without some pressing reason to push faster, without some pressing reason to actually be slower in the economy.

Duy: As we move closer to neutral, which I think we're going to get to the Fed's definition or somewhere within the range within the next two meetings or two quarters by the end of this year, I know that two interest rates hikes. I think the Fed is going to be moving much more cautiously going forward, and so might stop raising interest rates on the basis of that caution, not necessarily the yield curve.

Beckworth: All right Tim. This leads us to another interesting discussion, and that is, what is the shape of the Jay Powell Fed going to be like? I've seen him as a very down to earth, almost kind of foxy kind of guy. His press conferences seem very user friendly. He tries to explain things in an accessible manner. He seems like just one of the guys, so an average person. I'm wondering if that is going to change the culture of the Fed, or is it just Jay Powell we see? What are your thoughts on that?

Duy: I think that's mostly Jay Powell, and he's changing certainly the culture of the communications. That if you compare his press conferences to Janet Yellen. Janet would, she sometimes maybe linger on a question a little bit longer than was necessary. Much like you would expect from an academic, and would become fairly accustomed to having fairly academic type discussions.

Duy: I don't actually think that Powell is going to change that end of it that much. I think that he is very conscious of the fact that he's not a macroeconomist by trade. And that he really wants and desires that discussion around him to help inform his decisions. So, I don't think that he's going to want to really take a dramatically different path for the board itself than where it's been evolving under Bernanke.

Duy: It's not like we're going to have some reversion I think to the days of Alan Greenspan which is more less academic, and more autocratic arguably. I do think that he's not going to mince words at a press conference. He's going to tell you like he thinks it is, and he's not going to drag out the story. He's going to get in and get out, which is a very different approach.

Beckworth: Yes, and he's going to have some additions to his team soon. He already has Randy Quarles on and Lael Brainard, we mentioned them already. Richard Clarida has been nominated, so has Michelle Bowman. It seems like they're going to make their way in at some point. There is a curious case of Marvin Goodfriend. I'm not sure where he stands. I know he didn't have a very successful hearing for his admission by the senate.

Duy: Yes.

Beckworth: Do you see these people changing anything at the Fed, or is it kind of that it actually goes?

Duy: I think that they're mostly as far as monetary policy is concerned status quo candidates. The whole pack of them together, including Jay Powell, are somewhat less regulatory friendly than maybe the previous fed. That doesn't mean they want to dismantle the regulatory structures that have been put in place since the crisis, but it does mean that they would like to maybe ease some of those constraints, regulatory constraints, that the financial sector has faced in the last 20 years.

Duy: One big issue has been our community banking. Michelle Bowman will take that issue up and as far as what should be the capital requirements for small banks, versus large banks, versus very large banks? Those types of issues, I think you'll find them much more friendly regulatory environment from the industry's perspective. From a monetary policy perspective, I don't see them being as dramatically different than we've seen in the previous, the Bernanke, and the Alan types of Federal Reserves. What's going to be more interesting is, in order to test the Federal Reserve, we need to have a crisis of some sort. We need to have a recession. Right now we're making these judgements, but monetary policy for the last couple of years has been a fairly steady course.

Duy: We really want to know what happens when the Federal Reserve is not able to maintain a steady course, and whether it'd be they need to shift it in a more hocus direction or a downwards direction, and how nimbly will be able to make those shifts? I am hoping that Powell will be maybe perhaps a bit more nimble than Bernanke was during this last recession, and that he'll be able to shift gears a little bit more quickly than we saw in 2006 and 2007. He won't be as ... In some sense you can be somewhat tied down by being an academic, as much as you can be freed by being an academic, if you know what I mean. I'm hopeful that Powell doesn't ... Not being an academic means he might not have a strong ideological conviction to a certain expectation of the way the economy works.

Beckworth: Yeah. It will be interesting to see. Maybe to some degree his job will be easier, because Bernanke and Alan didn't break ground, and things that seemed radical at the time QE.

Duy: Right.

Beckworth: I mean, one thing that would be radical I guess if Jay Powell tried would be negative interest rates, but I've never went down that path.

Duy: I would be surprised. Honestly, I would be surprised if you got significantly negative interest rates. I think that's something that would probably drive in particular the conservative elements in congress, almost entire crazy. I have a hard time seeing that as really a politically acceptable option for the fed.

Beckworth: What about all this discussion about new monetary regime? There are some folks at the Fed who seem open to it. John Williams has talked about price level targeting. I know James Bullard has talked about nominal GDP level targeting. In general there are some broader conversations going on, there are some conferences that looked at some new regimes. Do you see the Jay Powell Fed is being open to reframing monetary policy, or is this going to be a long drawn out process?

Duy: I do think that they will be open. It's fairly clear. They'll be particularly open by the way, if they can't really raise interest rates beyond 3% without creating a recession, right?

Beckworth: Yeah.

Duy: Because the reason this is even a conversation is really because we had the zero bound problem. If we fall into a recession, we have very limited interest rate tools. We have to either use other tools like quantitative easing, or aggressive forward guidance for example, or we have to find a way to make our interest rate tool extend further. One way you can do that is by negative interest rates, which we mentioned in another way would be raising the inflation target, which has also been an issue that has risen. I'm fairly skeptical that you're going to get the inflation target dramatically higher, if higher at all.

Duy: Again, I think there'll be a lot of political pushback against a 4% inflation rate. Right now the nice thing about inflation being at 2%, is that it doesn't factor into a lot of decision making processes as far as they can tell us. It's far enough that people are terribly worried about it. If it was a 4%, you might in fact have a situation where people actually were more aware of what inflation actually was, and were changing their behavior as a result of this high inflation rate. It could also increase the amount of variation, of inflation across different goods and services. And that would create different winners and losers that could be distortionary. It could be something that we perceived as giving way to actually de-anchoring those inflation expectations that have been fairly well anchored at 2%. I don't want to drag this out too long.

Beckworth: No, this is interesting.

Duy: I suspect that internally and externally there's going to be a lot of resistance to raising the inflation target beyond 2%. You can argue that the fact that we got to 2% was something of a miracle. It's terrible right there.

Beckworth: Right.

Duy: Ahead of the financial crisis if this conversation is happening, they'd probably be thinking of a range of 1.5 to 2%. Now, things that could happen, maybe you have more of a band around that 2%. In order to make the symmetry more obvious, you say we have 1.75 to 2.25 inflation target range. We allow it to move within this range, and we're not terribly concerned around it, with the expectation that over time it's 2%. That could be something that could emerge as a compromise position to reinforce inflation expectations at 2% by allowing that overshoot that we talked about earlier.

Duy: Another issue that Ben Bernanke said, temporary price level targeting. That if we hit this zero bound, then we're allowed to run into inflation higher, to make sure we don't fall off our price level target essentially. Bernanke has explained how that can be done within the context of the existing framework, communications framework that the Federal Reserve has. I'm intrigued by that as a possibility. I could see, and perhaps price level targeting too all could be possibilities. I suspect it will all be in the context of still a 2% inflation target over time. Whether that's via price level targeting, or temporary price level targeting, or a range. I think that key element will probably be retained.

Beckworth: One other thing about the Jay Powell Fed that is different ... Sam Bell pushed back about this claim I'm about to make. He's been very warm about monetary policy rules, at least helping them inform his decision making. He's not saying I'm going to stick religiously to one or the other. He has said at both of his testimonies, the Humphrey–Hawkins testimony, he ended his statements by saying, "I like to look at monetary policy rules to help inform my decision making. I hope FOMC looks at them."

Beckworth: Then in the monetary policy reports, they had actually like a menu of rules, they've also added a list of rules on the board of governors website. I know, the first time this list came out was under Yellen, but it seems at least qualitatively that Jay Powell has stepped it up a bit. I mean, there is more rules being published in the website, but every time he's had testimony, he's a little passage in there, I like rules. Is that just part of maybe the increased communication transparency of the Fed, or is that something uniquely Jay Powell?

Duy: It might be more uniquely Jay Powell to focus a little bit more on those rules. He also by the way might just be more pragmatic that the congress has, or certain elements of congress have been pushing for more rule based decision making on the part of the Federal Reserve. For example, the audit of the Fed type of bills have been moving forward. It would be pragmatic of the Federal Reserve to emphasize the nature of those rules, and what those rules show, and why they're deviating from those rules without having to have the congressional mandate of doing that same job, right?

Beckworth: Right.

Duy: This could be one way the Fed is in fact trying to preserve more of its independence and have less interference with congress, then being fairly upfront with what I think was a reality is these monetary policy rules ... We shouldn't use the word rules. I don't know if we should use the word in dotted lines. Something else-

Beckworth: A benchmark of some kind.

Duy: A benchmark is a better word, exactly. We should have reference to these benchmarks to see how tight or lose we are relative to pass policy. I do think it's important to maintain these in the background. I think it's important that we make sure that these are not considered just background benchmarks, but maybe be much more forward about these are the benchmarks, and these are what we think is wrong with this benchmark at this point in time.

Beckworth: It's great to have a conversation maybe in retrospect. I know that Scott Sumner, my colleague at Mercatus has suggested they do annual review at the end of the year, maybe for the previous year, so you're not criticizing them in realtime, but maybe look back over the past year, or two years and say, "Okay, this is our goal. We deviated for this reason. Why did we do that?" Sometimes it's easier just to have a backward looking review than to in realtime, why aren't you sticking to this rule very tightly?

Duy: I think one place you could do some improvement too is make sure that you have emphasis on forward looking rules too.

Beckworth: Okay.

Duy: If you remember, Bernanke in one of his defenses of the Fed during the housing bubble, has said, "Look, if you look at the forecast that we had, monetary policy wasn't to this."

Beckworth: Right.

Duy: These tailor type rules are all backwards looking. Well, let's see what we're projecting right now, and how that would fall, or be consistent or inconsistent with the monetary policy type rule.

Beckworth: Right.

Duy: I do think, within the context of this too, the Fed has to be very open on some of the underlying parameters of those rules, like the real interest rate, which we don't think is appropriately set at 2% anymore, or the long run on employment rate, which we don't think is, whatever it might have been in the past, 5.4% or whatever. So, I think Powell is probably trying to say, "I like rules. I think that they're interesting. It's something we should be checking policy relative to." I think that he's doing it in part to outlay congress' fear that they need to be putting more structure on the fed.

Beckworth: Yeah. This will be an ongoing conversation I'm sure for some time, how to make the Fed more accountable, even if it's just evaluating their decisions after the fact? Let's move on, in the time we have left to one other very interesting discussion that happened last week. By the time this show comes out it will be several weeks ago. That was Donald Trump our president criticizing the Federal Reserves raising of interest rates, which is unprecedented, at least in recent history. Now, if you go back far enough you find other presidents have done the same thing. What are we to make of this? Is this earth shattering? I mean, on one level I can say it's not surprising given the president has said similar things about many parts of government. Is this something to worry about, or is the Fed insulated enough? I mean, what's the takeaway from it?

Duy: I'd be more worried if Trump had already appointed ... This is going to sound bad, but plain vanilla Central Bankers. What I meany by that is that they're not ... I don't think anybody there is somebody you would not see nominated out of any typical republican presidency. Arguably, Jay Powell or somebody could be nominated by a democrat or a republican. I don't think there's been any unusual tendency to ... There is no unusual candidates so far who have been nominated or appointed to the fed. That suggests that if Trump was really concerned about this, or really intended the Fed to follow him, he should have made different choices than he has. He could still make different choices, maybe as the Federal Reserve did, to move out of ... If in fact the economy was on more unsteady ground, he could try to force someone out, et cetera, or something like that.

Duy: What I think more likely is happening is that Trump is trying to basically shift the blame for any sort of negative consequences of his own policies, is that we do know ... Basically, I'm on a debate about how big a fiscal stimulus, or fiscal debt that the US economy can run. We just don't know. I can't tell you that at 3% interest rate this is something that I can be very terribly concerned about. It could be that in fact you do push the economy a little bit over, and edge into an inflationary territory, the Federal Reserve feels they have to respond to. Is that the Fed's fault, or is that the administration and congress' fault?

Duy: I know where Trump would like the fall to be laid. He wants it to be laid at the feet of Jay Powell. I think that's what he's setting up for. We can say the same thing about the trade battles that are going on right now is that, the sort of crises that have been created by Trump himself, and if they go bad, or if they do have negative consequences to the economy he'd like to be able to shift that blame onto Powell. I think that's really the best explanation for what's happening right now. If you want something else you're going to have to make different appointments than trump has made.

Beckworth: Yeah. He's making the case now as he's making a sales pitch to America, that if something goes wrong it's not his fault, it's the Fed's fault. On one level, it makes a lot of sense, in another level it also sounds like he's playing a game of 3D chess. He's a step ahead of doing this. The one thing that does concern me though is, he's appointed ... If everyone that's nominated gets into the Fed, there's still one open seat, right? Maybe Marvin Goodfriend doesn't make it, maybe his initial hearings as I mentioned earlier, didn't go so well. One to two more potential seats could be filled by Trump. You'd feel bad for that person if they were dovish, if he appointed them, right?

Duy: That's right. They would have interference of being his lackey, right?

Beckworth: Right. Even if they had a long track record of saying they believe, so they had a reason for it. If there were a certain way ... It would just look awkward. Again, I hope the interpretation will be the one that you put forth and not ... It's easy to get cynical in this day and age. It'd be easy to see someone appointed to the fed.

Duy: Right.

Beckworth: Like some commentators have said, I mean, Trump if anything may have pushed himself into a corner, because now the Fed itself, not just who he reappoints, but the Fed itself may feel pressure to show that they're independent, and on the margin, nudging towards a rate hike versus not another rate hike.

Duy: I can see that. Honestly, I'm going to say that Powell is a better person than that. That Powell is going to look at that situation and say, "I'm not going to trash the US economy, or risk trashing the US economy, just out of spite." Now, there is another 25 basis points, trashing the US economy, probably not. I think that Powell is not going to succumb to that kind of pressure. I'm a little bit more optimistic about that. I think you're also right. You could put two more doves, you could start daily tweets harassing Powell, you could start having congressional hearings, and changing the Federal Reserve act. There is other types of pressure that you could put on, and that we know the Fed will respond to.

Duy: As we talked about earlier, maybe Powell's more frequent reference to rules is the result of bringing some of that pressure to bear. You can see ways where this could go sideways, but if I had to really say what the Fed's problem is more likely to be over the next few years, if we hold onto the strong growth. If we take some of these trade issues off the table, like apparently we did, at least temporarily with Europe yesterday. That the economy could be on a fairly strong run here for the next year, when you're at something that looks like it might be in fact close to full employment, and there might be some inflation pressures as I said that might emerge, and that's going to be I think a bigger challenge for the Federal Reserve to navigate than Trump.

Beckworth: Adam Ozimek had a great article after this Trump statement. He said, something that'd be interesting to watch is if Trump making these calls about the Fed raising rates, if one of Trump's accomplishments, even if unintended, is to get republicans to tolerate a little bit more inflation. If they fall in line like, yeah, wait a minute. It's not out of the recovery just yet.

Duy: Yeah. I know there is the vein of conservatives that are really concerned about runaway inflation. I also think that a lot of the pressure leveled against the Federal Reserve over the past several years was less about some real strong convictions about inflation or understanding about inflation, and much more about, well, the economy is doing well, and so maybe president Obama is going to get reelected. Let's see if we can trash the economy, and so let's put pressure on the Federal Reserve. I think that accounts for a lot of the pressure at the Fed. Even Donald Trump in the campaign complained about Janet Yellen holding interest rates low to create a stock bubble to benefit then President Obama.

Beckworth: Janet has a very cynical attitude.

Duy: What can I say?

Beckworth: I agree. Trump was very clear about that. In fact, I was invited on a show to talk about that very comment. I think there are though legitimately people in the republican party, and I view myself right at the center too, but there have been people who truly believe in returning to the gold standard, very hard money, very strong views that zero inflation in all cases, in all situations is what we should aim for. Don't you get that since there are true believers out there as well?

Duy: There are certainly true believers out there. There is no doubt that there are Jerome Powells out there that are true believers. Also, it's easy to be a true believer when you're in the minority, right?

Beckworth: That's fair.

Duy: It's easy to basically play to your base when you know there is no chance of that policy really moving through. It would be much more interesting to see if half of the congress only had those views. Would they really want to move forward with a gold standard, or maybe a bitcoin standard, right?

Beckworth: Right.

Duy: Something equally irrational. You're right, there is a true ... The true believer problem by the way is getting back to Goodfriend. One of the things that's probably slipping up Goodfriend is that Goodfriend about the expiration dates on money, right?

Beckworth: It's a way of getting negative interest rates.

Duy: Exactly. That's what ran Powell off the deep end. It's kind of funny how Goodfriend got tied up between both those true believers, and on the other side of that coin, the democrats.

Beckworth: All right, Tim, in closing, there was an interesting piece done by Peter Conti-Brown on John Williams, it was a Brookings piece. Peter Conti-Brown was a little critical of John Williams becoming the New York Fed president. He's not the first one to make this observation, but kind of along the lines that, we need someone up there who maybe knows markets better. John is more of an academic, a Central Banker. Steven Williamson has surprisingly good arguing that John is more than qualified. I think a critique that I think was missing in this discussions is more the lack of diversity, and where we pick our Fed presidents from. Aaron Klein from the Brookings Institute as well has written a lot about this. He's written how a lot of the regional presidents have sat on boards before, or are somehow connected.

Beckworth: John Williams serves as a good example of this, he was at the board of governors, he was a staffer, he was at the San Francisco fed. There is this critique that they're tapping the same type of people from the same type of institutions, and so there is a lack of diversity in views, and there is therefore group thinking. I have implicitly made the same argument, say in 2008 when they were all ... Well, not everyone, but a lot of them were worried about inflation, while the economy was in free fall. What do you think of this critique of group thinking at the fed. Do we need to reach out and get different voices in there?

Duy: Well, you can argue by the way that this is not necessarily a problem just within the Fed, but within the economics profession more broadly, right?

Beckworth: Yes.

Duy: It's really a reflection of the profession not being particularly diverse to start with. And having fairly ... I don't want to say consistent ideological positions, better intellectual positions, but being similarly trained, right?

Beckworth: Right.

Duy: I think that's ... It's kind of reflecting what's going on in the profession, and adding to that is that if you're going to hire for a position with somebody with experience, you're going to look to people that have already been part of the system for a long time. That will aggravate again this ... Can I use the word inbreeding? I don't know if that's quite right. So, yeah, I do think that that's an issue. I think you have to balance the needs for this diversity, a diversity of opinions, with the reality, we also need that expertise.

Duy: For that particular position in the New York Fed position, we did really need someone that was really well steeped in monetary policy, and arguably also steeped in the academic end of it, given that the board between Powell, and Quarles, and Michelle Bowman, are not going to be as steeped in some of the academic traditions, right?

Beckworth: That's fair, right.

Duy: It's a position where we really did need to find somebody that was well qualified, and there is probably desire to keep John Williams within the Federal Reserve system, and give him a spot that he could live up from from the San Francisco Fed to hold that expertise in the system. I'm not as critical as maybe a Peter Conti-Brown about that decision. I think that the economic profession needs to work harder to diversify the pool of candidates, and part of that's certainly at my end, the university end to ensure that we have a more diverse array of PhD candidates coming up.

Duy: Then on the professional end, there is candidates then giving similar opportunities to what John Williams and others had over time. By that we'll create the pool. Part of that is going to be having people nominated as I think there is pressure to do. We saw pressure to nominate more diverse Fed presidents for example. That has been in part successful. That's certainly I think an ongoing trend, and a trend we're going to work with over time. It is imperative upon all of us in the profession to try to support that effort.

Beckworth: Yeah. As you said Jay Powell himself might be a step in that direction, pointing him to the Fed does bring in a little bit different perspective.

Duy: Certainly you're not getting ... This Fed does not have quite the number of PhD macroeconomists as in the past.

Beckworth: Right.

Duy: Again, I am not ... I think that you have to have a substantial group of PhD macroeconomists essentially that have deep experience and understanding with the economy. I do agree also that that can lead to group think. You have to make sure that you have some other voices in there that are willing to push on those voices to prevent that group think from evolving.

Duy: If we're going to have those other voices there we need to make sure that we also have that expertise in there as well. I do think that there is good cause to have John Williams at the Fed, and we should hope that the choice for his successor at San Francisco Fed is a more diverse choice.

Beckworth: All right. Well, on that note our time is up. Our guest today has been Tim Duy. Tim, thanks for coming back on the show.

Duy: My pleasure, it's always great to be on the show David.

About Macro Musings

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