How a Former Fed Vice-Chair Is thinking About the Next Fed Chair

27:47You know, first of all, I want to say, you know, I remember the concern that the Fed had in 2009 about does the market see the Fed as a hair trigger on inflation? I don't think a lot of people remember this, but in early 2009, the market was pricing in rate hikes by the end of 2009, which seems almost unbelievable in retrospect when you remind us that the Fed went seven years without a hike. So there really was a very intense challenge on the Fed's hands to convince the market that it was going to stay on hold for a very long time. And I think Ford guidance clearly played a sort of specific tech role there.

28:24Let's talk now about balance sheet. Bill Dudley wrote a column for Bloomberg Opinion after the Walsh nomination, and he was sort of critical. He said he didn't think that Walsh was going to be able to shrink the balance sheet much further unless there were some other changes perhaps relating to banks' capital requirements, et cetera. Walsh's own criticisms of the balance sheet seem a little bit of a moving target at some point. And how well do you, I mean, maybe I would ask how well does any economist have a handle on the effects of balance sheet policy? But what's your read on sort of the reality of Warsh's coming intersection perhaps with the balance sheet?

29:01Yeah, so I think there are two related but distinct elements to this. The first is that Kevin has been publicly and consistently critical of every expansion in the Fed's balance sheet since the first QE1 program. So he very famously said he was opposed to the QE2 program in 2010, although I think he did vote for it, but then he left soon after. And so there's the issue of backward looking. Oh, the Fed should not have been buying treasuries and mortgages as it did. And I think there's no reason to think he's changed his mind. Indeed, Secretary Besant wrote a piece with a very provocative title, the Fed's gain of function monetary policy.

29:45And he was also critical in retrospect of the expansion in the Fed's balance sheet. The important question, of course, for OddLots listeners and for markets is, OK, that's the past looking ahead. And one of the many interesting things that Kevin Warsh said during his, I guess, campaign to become Fed chair was to call for a new accord between the Treasury and the Fed with regards to the balance sheet. Now, he hasn't provided a lot of details. What we do know is what the first accord between the Fed and the Treasury looked like, which was back in 1951. And what was interesting about that, it was essentially the Fed's declaration of independence to raise rates without getting approval from the Treasury, which is why Fed historians think of it as really a signal event in Fed history.

30:32So I don't think that's really an issue now. Presumably what Kevin means when he talks about an accord is a mutual understanding between the Fed and the Treasury about the size and composition of its balance sheet. And so, for example, you could agree that the Fed needs to have the current size balance sheet, but it should not own mortgage-backed securities or 30-year Treasury. It should own T-bills. So that's a conversation you can have. You can also have a conversation about the Fed having a smaller balance sheet. I admire Bill, and I read that column and agreed with almost all of it. The point being is to get from here to there is not straightforward.

31:14In particular, it involves the banking system in terms of the level of reserves in the banking system. The Fed has been very reticent, although it's been tempted and it's discussed selling mortgage-backed securities. You can find it in the transcripts going back a dozen years, two years. And so right now, there is no appetite in the existing Fed to think about shrinking the balance sheet through any sort of a sale. And then finally, and I do want to get this on the table because I think it's a very important point that is often imperfectly appreciated, is the following. In 2008, coincident with the global financial crisis, the Fed also achieved from Congress the statutory authority to pay interest on bank reserves.

32:00Until that point, the Fed created reserves by buying securities, but they earned zero interest rates. And not just the Fed, but most other central banks now pay a market rate of interest on bank reserves. And the reason why that's important is the following. What it means is that when the Fed does do a QE program, when it buys a mortgage security or a treasury, it's not really printing money in the sort of money and banking sense that you're buying a coupon and paying for it with a$100 bill and thus extinguishing the coupon payment. But what the Fed really does now with modern QE and interest on reserves is it's not extinguishing government debt.

32:41It's just changing the maturity composition of government debt from fixed to floating. Because at the end of the day, the Fed's balance sheet and the Treasury's balance sheet are consolidated. When the Fed's profitable, the Treasury gets that interest income. In recent years, the Fed has not been profitable and it's been withholding those remittances. And so once you think of it that way, then you start to think about a scenario where a Treasury Secretary could, if he chose to, say, you know what, I want to be the big sheriff in town when it comes to maturity composition. So if I think there are too many 30-year Treasuries, I'll buy them and sell T-bills and the Fed can buy the T-bills.

33:20And so there are scenarios over time where we could rethink what QE is in addition to what the size of the balance sheet is. But this is not a 30-minute or a one-week exercise. This will be a pretty complicated, intricate process. But I don't want to rule out out of hand that it's something that is beyond considering or discussing.

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35:34So other than his distaste for the size and potentially composition of the Fed balance sheet, there's something else that Warsh doesn't seem to like, and that's, I guess, traditional economic models. So he's been critical of the Phillips curve, For instance, he's been critical of data dependency at the Fed, which kind of leaves the question, if you're not going to focus on data and you're not going to focus on models, what are you actually using to formulate monetary policy? Do you have any read on what that could be? I think, you know, and I've known Kevin, I think, for a dozen years. I didn't, our terms as Fed officials did not coincide, but I've gotten to know him since.

36:18And we've met many times and had many conversations and the like. And I read most, if not all, that he writes. You know, my sense is really that his critique is that a lot of economic models in macro tend to put a lot of emphasis on the demand side of the economy. Now, I can point you to my first speech as Fed vice chair in October 2018, where I also put on the table that policy needs to think about the supply side of the economy. And the Fed doesn't want to be in the business of raising rates because too many people have a job if that's not inflationary. And the way you sort of score that circle is your outlook on productivity.

37:00productivity. And so it is correct that if you get more growth because you've got a more productive economy, either through innovation or deregulation, then the Fed should not get in the way of that. And indeed, during my time, the Powell Fed didn't. The models, both in the Fed and outside in 2019, were saying, and indeed, if you look at Fed communication in 2017, it was saying if the unemployment rate falls below 5%, we'll have to hike rates because that's going to be inflationary. And by the time I got there, the unemployment rate was in the fours and we didn't have inflation and it got down to the low threes.

37:36And so it is correct that there is a supply as well as a demand side to the economy. And if the supply side can grow faster with higher employment without inflation, the Fed should not get in the way with that. So I 100 % agree with that. Now, the challenge is the economy, as Jay Powell said, the economy is constantly changing. And maybe just a little bit of a wonkish comment for the wonks in your audience. And let me set the record straight. You know, the old saying, facts are stubborn things. And we all live, you know, three of us were around in the 1990s. And Greenspan is justly complimented, as he should be.

38:17Indeed, what I teach this material, I always emphasize this period for recognizing that because of the Internet and connectivity and personal computing, that there potentially was an imminent increase in pickup and productivity. And the staff and other governors were saying we should hike rates in Greenspan. And I said, no, let's see. We may get this may be a productivity led boom. And that's indeed the story between 1995 and 1999. But if you look at the Greenspan Fed in 1999, it was hiking rates, even though we had very strong productivity growth and we had strong economic growth in the face of a very buoyant stock market.

38:59And what people forget is that by 2000, the federal funds rate was at six and a half percent. So it is true that Greenspan did hold off for several years. But by the end of that tech internet boom, and dare I say irrational exuberance, his famous phraseology, Greenspan was hiking rates very aggressively in the face of very strong productivity growth. So when people refer to that period approvingly as a reason for the Fed to hold off from hiking or certainly continue to cut rates because of productivity, you have to look at the entire decade. You just can't cherry pick three or four years. This is interesting.

39:41You know, just while we're here talking about Greenspan, I mean, why did he raise rates so aggressively? And did Greenspan's own rate hikes in the late 90s not really gel with his own comments about the capacity for the economy to grow during a time of expanding productivity? The explanation, I would argue, was really twofold. I do think by that time, although I haven't memorized the memoir, but I think by that time, the irrational exuberance piece was a factor. There is a wealth effect. So if stocks are going up, people are wealthy, they spend more. And so central banks don't like to be in the business of pricking bubbles.

40:23But there is a connectivity between a very, very fully valued stock market and your macro outlook. You know, we all remember, some of us remember pets.com, you know, the sock puppet Super Bowl commercials. And also, I just think by that point, although inflation had not moved above, I should also mention the other fascinating thing about that period is it's clear now from the transcripts that the Greenspan fed by the mid to late 90s. was in essence running what we would now call an inflation targeting regime and that the target was two. But Greenspan was always resistant to the idea the Fed should ever publicly say that they were targeting 2 percent inflation.

41:01But by the late 90s, you have inflation moving up close to 2 percent. And you could really I view this as a period where Greenspan is basically saying, I don't want to go back to the bad old days of 8, 7, 5 percent inflation. And so it was probably preemptive as well, not resisting the productivity, but merely trying to keep the economy in balance. And then the final thing I'll say, sorry to be wonky, is that as a matter of economic modeling, other things being equal, if you've got faster productivity growth, you'd expect that to move up what economists call the neutral rate of interest anyway.

41:38And I think actually Bill Dudley made that point in his column as well. Never apologize for being wonky on this show. I want to go back to the question of central bank independence. So if we assume that Warsh truly wants to do his own thing outside of presidential influence, and again, there are some people who doubt that is the case. But if we take that premise, how does he actually display or demonstrate the central bank's independence when you have a president who likes to talk about interest rates and likes to joke, as we were saying earlier, about, you know, I'm going to sue Warsh if he doesn't lower rates.

42:23You also use the word campaign in Kevin Warsh's campaign, which I thought was an interesting choice of words to describe the last several months. That's OK. He's a good choice. And there were three other candidates and it worked. I think I think there'll be a couple of things, Tracy, that we'll see pretty soon. In fact, I'll let you and your listeners decide if it's a joke. But one thing I find humorous I'll share with you is that, you know, if Jay Powell really wanted to complicate the situation for his successor, you know, he cut rates at the March and the April meeting to get the funds rate down to the level where at least the committee seems to think is the destination so that there's nothing for the next person to do.

43:09I don't think Powell's going to do that because I don't think it's - Monetary policy by trolling. I don't know if that's a, that doesn't sound like a Powell thing, but that would be funny. But, you know, but there is a kernel of truth to it, which is, as we said earlier in the podcast, the power of the chair is the power of persuasion. Warts will only have one vote. You've got some very, very high profile and confident people. There's a voting rotation, as your listeners know. So right now you've got folks like Beth Hammock and you've got Lori Logan. Neil Kashkari in Minnesota are voting now and Anna Paulson in Philadelphia, I believe.

43:47And, you know, and Lori Logan and Hammock and Kashkari will not will not be shy publicly or I'm sure in the meetings if they disagree with what they would perceive. And I'm not saying Warsh would do this as, you know, we're going to keep cutting rates below a level where the committee seems to have a broad sense that the neutral rate, the destination rate is going to be somewhere in the low threes, you know, three and a quarter, three, whatever. And so I do think that we'll, under the sort of baseline scenario for the economy, we may get to that level of rates sometime this year. And then at that point, the issue would be depending on if there's political pressure on how the worst Fed would navigate that.

44:33And my sense is notwithstanding all the discussion of the supply side benefits of AI and deregulation, you know, if the hint or the discussion of a future rate cut would trigger nervousness in the financial markets, break even inflations go up, expected inflation measures go up. You know, I think Walsh and the Fed would take that seriously. My read is that he will navigate the data as it comes. He'll want to focus on the supply side. But at the end of the day, look, no Fed chair wants to go down in the history books as the Fed chair that squandered 40 years of price of stability. And so at the end of the day, and this is, I think, perhaps what the president was referring to on more than one occasion when he was thinking about who he was going to choose.

45:24I'm paraphrasing, but he said something like, you know, people will say one thing and then they get in the job and they disappoint you. And so I think that that's an element of the of the institution and of the committee structure that will continue to be relevant. It's so interesting. I mean, something that's interesting is when you mentioned the 40 years of general price stability. It's interesting that like Arthur Burns, that is a name that has a lot of it's been tarnished, right, because of inflation. And yet Bernanke, who, you know, went through the great financial crisis, the worst downturn ever, by and large is remembered as having been a very good central bank chief.

46:01And so it's striking that, yeah, you have a few years of inflation, everything's out here a disaster. But if you have a great recession underneath your term, by and large, you could still have a pretty good reputation. I want to ask, though, the thing is right now we still have above target inflation and maybe AI will drive a productivity boom and allow the economy to grow very fast with low rates, et cetera. In the here and now, though, we haven't even gotten back to 2 % yet. And a lot of these benefits of AI are still very theoretical. Yeah. Well, I'll be even more blunt. I think you can make a case that although longer term AI will be disinflationary as the productivity benefits arrive, I think you can make a very plausible case that between now and then, the CapEx build out to train the models is going to be increasing demand in a fully employed economy before the productivity benefits arise.

47:04And so if I were still teaching intermediate macro, this would actually be a pretty interesting case study to go on on the chalkboard that in five years you've got more GDP per worker. That's great. That's disinflationary. But between now and year five, you're going to be double doubling your tech capital spending investment, which is adding demand before the productivity benefits show up. So it's not a slam dunk to me at all about what about what AI means for for monetary policy near term, even though maybe in five years the productivity benefits are so large, it will it will have a different, you know, tend to be disinflationary.

47:41So I think it's AI is complicated along every dimension you can think. It's a complicated technology. It has complicated economics and social potential ramifications. And I think it's it's not a slam dunk easy situation for the for the central bank either. I have one last question about central bank independence. Setting aside Warsh's comment, something we haven't talked about at all is the subpoena to Jerome Powell over the offices, over the renovation. Powell was very specific in that he thought the subpoena was motivated by punishing him or trying to get back at him for doing great policy that the president didn't like.

48:22Two things related to that. A, does the subpoena, in your view, sort of add to your worry, either medium or long term, about how long the central bank truly will be an independent institution in the United States? And a corollary to that, you mentioned Powell controlled the wars by doing all the rate cuts now. What do you see as the odds that he stays on the board until his term as governor ends, even if he's no longer chair? First of all, there is precedent, and the Fed's a very, very precedent-focused institution. Legendary Fed chair, indeed, he had a building name after him, Mariner Eccles, was an FDR appointee.

48:59And then when Harry Truman became president, Harry Truman named another Fed chair, and Eccles stayed on and actually became a real thorn in Truman's side. I would be surprised if Jay Powell stays on for the remainder of his term as governor, which runs through January of 2028. Would I be shocked if he stayed for a meeting or two? No. Only Powell knows. He's been asked that question two dozen times, and he always gives the same answer. But I sense he's probably not going to be staying on. You know, in terms of this case, you know, Powell's comments can can, you know, stand for themselves. I won't weigh in.

49:41What I will say, though, is we have not only this, the current thing that you just mentioned about investigation on the on the building. You know, we also have the Lisa Cook case. That's right. It's going to weigh in on on that. And this is all sort of tied up into this idea of can Congress establish a central bank with a degree of independence to raise or lower rates? And an important element of this is this idea of for cause removal. You know, beyond that, it's just going to play out. And I don't have any particular expertise about where it will land. And what I will say is at the end of the day, I do expect that the Fed is an institution and it will have sufficient independence to raise or lower rates because of its institutional structure.

50:26And I think ultimately the courts are going to back that up. All right, Richard Clarida, truly the perfect guest. Thank you so much for coming back on All Thoughts. Thank you. Thanks, Rich. That was great.

50:49So that was a really fun conversation. I like the idea, or I'm not sure I like, I am intrigued by the idea of monetary policy by trolling. That would be so funny if there was like no room left to cut by the time Kevin got there, and then he couldn't fulfill any inclination to cut. But I think it actually raises an important point, and I'm thinking back to the conversation we did with Emi Nakamura, where she talks about central banks building up a sort of store of credibility and then having to spend it at various points. If you have a president who is so opinionated when it comes to interest rates and certainly not shy about tweeting or talking about them, I feel like it inherently starts to spend down some of that credibility because it just becomes very, very difficult, I think, to demonstrate your own independence.

51:43Yeah, I think it's going to be really tricky. You know, it's obviously something we talked about with Skanda last week, which is that there's multiple potential nominees who would have come in with a willingness to cut rates further at this point. Christopher Waller being an obvious one. He's been voting for rate cuts, but he also has a lot of credibility because he was voting for rate hikes in 2022, 2023 and so forth. I think it's going to be, you know, it'll be tricky for Walsh. But on the other hand, look, I would say also, you know, it's easy to say, oh, he's got to come in. He's got to build credibility.

52:14A lot of people really like him. A lot of people who have worked with him at various times who have known him think he's a serious thinker, that he knows what he's talking about, that even if he doesn't always agree with them, particularly on things related to the balance sheet communication, that he's an honest broker. So maybe, you know, maybe we are overstating the risks or maybe it's easy to overstate the risk that he comes in and has a real fight on his hands to get the policy agenda that he wants. Oh, to be a fly on the wall of the first meeting with Warsh, right? Yeah, it'll be it'll be super interesting.

52:47I also really like I wonder if he's going to get rid of the press conference. That's my prediction. I would not be surprised. And you know what? I'll say like these are new things. It's not like he'd be overturning 80 years of precedent here. This is a very modern thing. And a lot of the communications innovations were, as Rich said, a very specific purpose when the Fed was at ZERP to convince the market that it would stay low because – and they needed to make that case. So if there's a sort of honest look at all of these post-GFC monetary policy changes, I don't – I certainly think that's totally fine.

53:24I think Jackson Hole might be in danger. too. You think so? Yeah, maybe. Just out of pure self-interest. I hope not. I hope not too. Because I enjoy going to one of the most beautiful places on Earth every year, but we'll see. Yeah. I hope it doesn't go away. Alright, shall we leave it there? Let's leave it there. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our producers, Carmen Rodriguez at CarmenArmand Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks.

53:55And for more Odd Lots content, go to Bloomberg.com slash OddLots for the daily newsletter and all of our episodes. And you can chat about all of these topics 24-7 in our Discord, discord.gg slash OddLots. And if you enjoy OddLots, if you like it when we talk about new Fed chairs with former vice chairs, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

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