Does the Fed's Framework Still Work? w/ Dennis Lockhart

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1:24And now to the top analysis of today's markets.

1:35Does the Fed's framework still work? Hi, everyone. Welcome to this extended Real Vision Daily Briefing. With me today is Dennis Lockhart, former president of the Reserve Bank of Atlanta. Hi, Dennis. Welcome. Hi, Maggie. How are you? I'm doing well. I'm excited to have you because I feel like, you know, Fed policy is front and center. It's what the markets are focused on. And And especially this week, we've really, it's been dominated by inflation readings, including today's University of Michigan Sentiment Index, which showed that some of those inflation expectations are climbing when you look at over five years.

2:11So I'm just sort of curious, what is your sense of the dynamics around prices right now? Well, we've had inflation for now two years. That is a surge in inflation for two years. And it's not a surprise to me that the public is beginning to expect inflation. And so inflation expectations, as you pointed out, are rising. And this is a concern. The Fed takes expectations very seriously. And because expectations are a sign of inflationary pressures becoming embedded in the process of the economy, which, of course, we want to avoid almost at all costs, avoid that self-fulfilling aspect of inflation.

3:02So the expectations numbers will certainly get some attention, it seems to me. Yeah. And they had been behaving well, right? That was the one thing that we could kind of rest on, even though those headline numbers were so sort of shocking at one point. How much of the Fed rate hikes do you think have hit the economy already? Have we seen the effects of those hikes, or are we still operating with a lag? I don't think there's a simple answer to that. But the orthodoxy within the economic profession is the expression long and variable lags. Monetary policy has its effect with long and variable lags.

3:46In my own view, there are certain sectors that respond almost immediately to higher interest rates, for example, auto loans or mortgage loans. And then there are others that take a long time. And to some degree, there is a kind of cumulative effect of the higher rates that weighs more in the later months than in the earlier months. I think we're looking at a combination of short, medium and long term, which is in a way of evading your question. But it's not as simple as just saying the lags are still at work and the effect of higher interest rate has not clicked in. I think clearly the effect of higher interest rates has kicked or clicked in.

4:41So how does the Fed wrap their head around that? If it's complicated and it's not clear, how are they adjusting policy? How do they know if they're going too far? Well, there are a whole lot of sort of guidelines or models that give some input into policy or are used in the policymaking process. An example would be Taylor rule type of models that give you a sense of what the interest rate level should be, the policy rate level should be. So it's not any one answer to your question. The committee looks at a whole range of things. And I would say in the final analysis, each individual on the committee is making a judgment as to the appropriateness of policy.

5:42Yeah. Just to remind you to our listeners, by the way, if you have questions, put them in the chat and we'll get to as many as we can. Also hit the QR code and sign up if you would like to stay with us past the half hour. So, Dennis, what do you think the conversation is right now around the Fed table, around the FOMC table? What are the governors and presidents most focused on? I mean, very few people get the opportunity to sit there. You know what it's like. It seems incredibly difficult right now. Every time we have this conversation, we kind of think we come back to the Fed really being between a rock and a hard place.

6:15Just so difficult navigating this. What do you think the conversation is like right now? Well, there are several conversations that go on. There's a conversations among the governors in Washington who are co-located and mostly in the office, I would say. So they have a chance to compare notes on their assessment of the circumstances. And then the presidents of the reserve banks who are out in their individual reserve banks may or may not be having many conversations among that group, but are talking to their economic staff almost every day to evaluate the situation. What I think is the focus at the moment would be first, sort of what is the core inflationary picture?

7:08What is the economy? How is the economy trending? And then second, what are the risk factors associated with the debt ceiling and the sort of on again, off again, small and regional bank crisis or crisis may be too strong a word. small and medium bank liquidity issues that seems to be feeding a credit contraction or at least a backing off of credit availability. Those are the things that seem to me to be on the table at the moment. It just occurs to me, I'm not sure that everyone really understands the way it works. And the Fed presidents play a really important role in that dialogue, don't they?

7:58It's my understanding that you're really, I don't want to say boots on the ground, but have that view into the real economy in the region that you're operating in to get a sense of what's happening. Because the US is, it's an enormous economy. It has a lot of different, some areas are experiencing certain dynamics and others are not. I would assume that information coming from the Fed presidents is extremely important in the decision making. Yes, I'd like to believe it's very valuable. And I think the governors and I'm quite certain Chair Powell values the input that they all get from the various Fed districts.

8:38The process between meetings is a very important process. And the staff and the presidents of the reserve banks are engaging with business people and community leaders throughout their regions and asking the question, how are you experiencing the economy? What are you worried about? And how does it feel to you? You're going to get different answers depending upon the sector represented by the person being interviewed. But all of that is accumulated and synthesized into something called the Beige Book, which is really a book or a report of anecdotal inputs. And those anecdotal inputs are often repeated at the table at the Federal Open Market Committee meeting and I think are a valuable input, even though it's anecdote, it's not data, it's not hard numbers.

9:44It is still used as part of the inputs to the decision. Yeah, absolutely. I mean, what you're hearing from people, I think sometimes gives you, especially when you're starting to hear it from different regions, it gives you a fantastic insight, I would think, into what's going on and maybe a little bit more in the moment than some of the data, which we know just by nature, the way it was collected, or at least it used to be, lags. So right now, you mentioned the problem, the concern that's probably going to be expressed after seeing that expectation number, because expectations matter so much.

10:22Prior to that, Fed Governor Michelle Bauman already came out warning that more rate hikes might be needed. Do you think that now, having seen that expectation data, do you think that the Fed's going to have to raise rates again in June? What are the options that they're likely weighing here? I think it's a complicated picture because I think you first start with the evolution of the inflation problem and the economy absent the banking situation, banking system situation and absent the debt ceiling. So if you were just to isolate that and look at the probability of a pause versus the probability of another rate increase, it will depend largely on the inflation data.

11:13The data we received this week struck me as confirming a view of gradual disinflation, but not rapid disinflation. So, you know, the Fed is not getting the climb down the ladder that it's looking for. And that would argue that they would at least consider another rate increase at the upcoming June meeting. Having said that, in the real world, they have these other two factors, and we don't know today how they're going to play out. The trend of credit availability is to some degree evaluatable or assessable. And this week, we had the Senior Loan Officer Survey, which seemed to say that banks, for a variety of reasons, were raising their credit standards.

12:09And at the same time, credit demand was declining. So it's a shrinking credit picture for more than one reason. The debt ceiling is a real wild card, it strikes me. And we will know, I hope, in the next few days how that's going to be resolved. And I hope it is resolved with the debt ceiling being raised. But if it goes to just the 11th hour or more, it's risky. And in a default situation, I'm sure the committee would have to factor that into their decision. So, as I said, there's more than one factor at work here. Some of them are very contingent. Some of them are more predictable. But, you know, at the end of the day, there were only probably two major decisions either to pause or to continue with a rate increase.

13:15My own handicapping of it is that the committee is now in a position to pause if there are compelling reasons to do that. Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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14:39Yeah, and I've got to think the two you mentioned are huge concerns. When it comes to the strain in the regional banks, I mean, won't another rate hike just exacerbate the situation? Well, I mean, we have people talking about this. about bank walks. They're not talking about bank runs, but they are talking about bank walks. And there's a concern that that's just going to continue. Yeah, I don't think you can deny that raising interest rates has, to some degree, caused this problem. And therefore, continuing to raise interest rates certainly doesn't make it better, even if banks are hedged, even if banks are are relatively liquid.

15:31Raising interest rates doesn't make it better. So far, the committee has tried to separate the two issues, financial stability on one side and inflation and monetary policy on the other. That was their position coming out of the most recent FOMC meeting, that these are separable issues. And I think the committee will try to continue to do that. But the severity of the conditions that we're facing could very well force a greater weight on the regional bank and small bank liquidity issues, even in making a decision on monetary policy. Yeah. I mean, they would like them to be separate, but that doesn't seem very tethered in reality, you know, to say they're separate.

16:29Well, how do they continue to hold on to that line? If you roll the film back a bit, and you remember we had three bank failures, actually Silicon Valley Bank, Signature Bank, and then with a bit of a lag, Republic National Bank. And I think J-PAL was probably working from the best information he had, but in so many words in the press conference, he said the problem has been ring-fenced and the deposit outflow of other banks has essentially ceased. ceased. That is what I heard him say in the press conference. And that could have been their assessment at that time, that this was a matter related to three banks and that the problem was largely contained.

17:23In that state of the world, separating monetary policy from financial stability policy would make sense. You don't have to allow one to pollute the other. But we have seen this week, mostly in stock prices, we've seen a continuing pressure on some of these banks and to some degree that the declines in stock prices reflects a continuing questioning of their survivability or their solvency. And it's just a matter of how severe this problem continues to be and whether it cascades. Do you have any concerns about it being systemic? The individual banks themselves are not systemic in the way we thought about systemic risk back in 2008 and 2009.

18:19And what I mean by that is the failure of any individual bank is not going to bring down the system. But what we seem to be experiencing here is collectively this size of bank, call it a medium-sized bank, a regional bank. Collectively, if you had a succession of runs on these banks, that's a systemic event. It's going to really rattle the economy and could lead to something far worse that internationalizes or moves upstream to some of the larger too-big-to-fail banks. So, you know, I do think you can argue that what we have seen and what we may be seeing cannot be dismissed as not systemic. That's a double negative there, but I'm trying to be a little bit more subtle in the choice of words than just say it's a systemic event.

19:25Yeah, yeah. No, I understand what you're saying. I mean, given the interconnectedness of the global economy, it's really hard for me to get my head around how anything's ring-fenced. But this brings up a really good question that Colin has. How does the Fed check for accuracy of information? And I'm thinking of it in terms of the speed in which things happen. So we know when we've seen some of these issues, especially with Silicon Valley Bank, it was sort of a virtual bank run, right? I mean, it happened in a way that we've never really seen before, given the fact that people now have bank ops on their phone.

20:00Is the Fed equipped to deal with that information in that kind of speed? Or is this something they're likely talking about? Well, I'm sure they're talking about it. Let me piggyback on something you said, and you referred to the nature of the bank run that we saw with Silicon Valley Bank. I think you could make the argument that we are in a new era of bank runs. It's not your grandfather's bank run. You know, it's a wonderful life with people standing in line outside a bank. It's chief financial officers with unguaranteed deposits who are on their cell phones, moving literally billions of dollars around to find a safe haven.

20:48And it can happen extremely rapidly. So I think everyone learned in the Silicon Valley bank episode that there is simply a new modern bank run, and it's different than maybe the way it had been conceptualized as a risk, even with recent years. And no one realized how rapidly this can develop. The impact of social media, for example, was not on anyone's radar screen that I'm aware of. Or if it was, it was a very, you know, academic, you know, in the background kind of recognition that maybe runs could develop with the help of social media. Well, we've experienced one now, and I think everyone is upgrading their real-time information gathering for accuracy and for speed.

21:44Speed, in some respects, maybe is as important as 100 % accuracy. You can be 80 % right and still make a decision that can forestall a problem. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

22:07Yeah, absolutely. When we're talking about it, I just want to go back to the strains in the banking system and the credit crunch that's sort of happening as a result of that. But we had a guest on earlier this week who was saying they're kind of estimating that it could be the equivalent of maybe three rate hikes. Some people have said as many as six. I mean, clearly, this is going to be a drag on the economy. How are you thinking about this? How much of an impact do you think it will have in terms of slowing the U.S. economy? I think it's very hard to quantify in terms of 25 basis point rate hikes, one, two, or three.

22:48I think that's a useful way of trying to make your assessment as scientific as it can be. But I think it's difficult. But what appears to be developing is the banks are pulling in their – how should I put it? The banks are raising their standards and becoming much more selective in terms of credit. And at the same time, the demand for credit is declining, probably driven by a gradually slowing economy, which is the result of the rate hikes we've had before. So in those circumstances, I think there is a trade-off between the banks doing the job for the Fed and the Fed doing it itself by raising interest rates.

23:49In other words, I think the Fed can make a judgment, and I'm sure there will be different estimates of the impact of the credit picture voiced at the table in June, but make a judgment of the substitutability of bank credit contraction versus another rate hike. and I think they're probably now in a situation of being comfortable making that kind of judgment and therefore putting a pause on the table. Yeah, yeah, that'll be on that side of the ledger. I wanna get to, we have a bunch of questions. I wanna get to a couple of them before we flip over. And this is an interesting one. And Achilles, everyone keeps complaining that the Fed's not looking at the right data.

24:48But isn't the Fed aware of this? Because I'm pretty sure there are smart people in the Fed versus what people generally give them credit for. Well, yeah. My experience is there are a lot of smart people in the Fed. And I would not have survived from the job if I weren't surrounded by people who were a lot smarter than me and better educated, particularly in economics, than I was. So yes, on the matter of data, the Fed does not have at least much of a stream of proprietary data, other than maybe the surveys and the anecdotes that are collected between meetings, as I referenced earlier. So the Fed is looking at the same data that Wall Street is looking at and that money management firms are looking at and that academic economists are looking at.

25:43It's the same data and no privileged information in the Fed. So the question really is how much confidence do you have? How much do you rely on the public data that come out mostly out of the government, but out of some private firms and other organizations that issue a data series of one kind or another? And the difference between the Fed and most other consumers of the data is the Fed has literally hundreds of economists who are following the data. So it's sort of more people working on it as opposed to something that's proprietary. And, you know, I think those people are extremely well qualified.

26:33They understand the underlying methodologies, which is important to know where the numbers come from and how the numbers are actually calculated and periodically are in touch with the statisticians who are the source of those data series. So that's the way I would characterize the, you know, do they have enough smart people question. Yeah. And it's people who are doing it in depth all the time. So they really, I think that really gives you sort of some sense of ownership. Just to give you a little bit more color. When I was at the Atlanta Fed and important data were issued, we would have a meeting any week of the six, seven weeks between meetings.

27:26So it's a continuous process. We would have a meeting, talk about the data that had come out and what its implication would be.

27:39Benjamin asking, in terms of the banking situation, is it possible to solve these bank run risks simply by removing the reserve requirement for loans? No, I don't think that alone. That may help in the sense of just easing up a little bit in terms of available funds and so forth for the banks. But I'll answer that by saying, you know, in a bank run, no amount of relief from reserve requirements is going to save you from the kind of deposit outflow that, for example, Silicon Valley Bank saw. And this is me speaking here I don't want to attribute this to anybody else as a view A bank is a fairly fragile edifice in the first place Leverage of 10 to 1 basically So a small capital base relative to total assets also a tendency to borrow short and lend long which is obviously is an insolvency problem waiting to happen if everything happened at the same time running a bank is reliant on the law of large numbers that you have deposits coming in and deposits going out every single minute of every single day but it all adds up to stability, providing there is confidence out there among depositors and the general public.

29:25So it is terribly reliant on trust and confidence. And when that confidence is shaken, I would call it the intrinsic fragility of the structure of a bank gets under pressure. I mean, And it just begins to express itself. And that's, in some respects, what we're seeing. That's a fantastic description. Does that concern you massively when we, again, look at the ability for someone to tweet something and cause everyone to pick up their phone? How do you address the issue of confidence and trust? Well, I do think we may have seen a major change in the dynamics of that confidence and trust question.

30:12or we've experienced it with the recent bank failures. Because as you point out, it's just an influential tweet can start a bunch of market actions that conceivably bring down an institution that otherwise should be stable, that is more or less fundamentally in pretty decent shape. and managing its problems. But social media can create just a panic that is all psychological, but it's real. It has its effect. So I do think we're in a somewhat different world, and I'm sure the regulators are evaluating how do they operate within that kind of context. Yeah, I would think so. I was going to say, I smell a white paper coming.

31:10I certainly hope someone's very quickly, very quickly looking into this. We have a bunch more really good questions. We have hit the bottom of the half hour. So if you'd like to continue with us, make sure you scan that QR code. For those of you who have to jump, have a fantastic weekend. Hope you get out and enjoy the beautiful weather.

31:34What's up, revolutionaries? Thanks for tuning in to the Real Vision Daily Briefing. For more content like this, head over to realvision.com and get unfiltered access to the very best, brightest, and biggest names in finance.