A 50-Year Retrospective On The Shadow Open Market Committee And Its Role In Monetary Policy

>> Michael Bordo: Hello everybody. Hi, I'm Michael Bordo and I would like to welcome all of you to our conference. A conference it's called a 50 year retrospective on the Shadow Open Market Committee and Monetary Policy. And I'm gonna talk a little bit about the Shadow and then introduce John.

So the Shadow of a Market Committee was founded in 1973 by Alan Meltzer, Carnegie-Mellon University. Carl Bruner, who was at Rochester, and Anna Schwartz of the NBR, and Anna, I worked with her for 40 years. So Anna was just a really special person, but the other two were two.

And so what they did was they wanted to provide a constructive forum for improving monetary policymaking. And they promoted the idea that the high inflation of the 70s was a monetary phenomenon and wasn't caused by the eclectic array of factors which at the time was the consensus view.

And the shadows minority vision, along with monetarism and Milton Friedman eventually won the debate. And as monetary policy issues have evolved over the past half century, the Shadow and research by its members have continued to influence central bank policy-making in the US and abroad. And the Shadow has always emphasized sound money and the importance of a nominal anchor in the conduct of monetary policy.

It has highlighted the benefits of a rules based monetary policy rather than a discretionary approach. It's highlighted the benefits of heightened central bank transparency on fiscal policy. The SOMC has urged fiscal restraint and the importance of the Fed to steer clear of fiscal policy, credit policy and its involvement through the balance sheet.

And these stances align closely with the beliefs and research of scholars here at the Hoover institutions. There's a complementarity between us and the range of the Shadow's expertise has broadened as the Fed and global central banks have expanded their roles. And adding to the shadows legacy of monetary policy scholarship.

Shadow members include experts on in banking, bank regulation, financial stability, the Fed's expanded balance sheet, its role in international finance, monetary history, that's me and government issues. And historically, several members of the Shadow have joined the Fed. And now the current Shadow includes several former FOMC Federal Reserve members.

The current issues facing monetary policymakers are critically important to healthy economic performance as they were in the past. The Shadow has played an important role as a watchdog on the Fed's policies in the past and promises to do so in the future. We thank the Hoover Institution and especially John Taylor and Marie Christine Slakey for hosting and arranging this special conference.

We also thank the Bradley Foundation and Smith Richardson Foundation for generous support to highlight the evolution of monetary policy in the Shadow. In the last 50 years, and to address the key issues facing today's policymakers. The conference includes participation by SOMC members, by leading scholars of the Hoover Institution, and current and former members of the Federal Reserve, and also foreign central bankers.

Now, John Taylor's famous rule, which is an essential chapter in every central banker's guidebook. And his pioneering research on monetary policy rules have been at the heart of the SOMC's core beliefs for the past three decades. And so now we have the privilege of having John Taylor tell us about rules versus discretion over the past 50 years.

So I'll turn the podium over to John and his slides, thank you.

>> John Taylor: I'd say it's impressive to see all of you, especially this table in front of me. Amazing experience for me. So I'm gonna talk about this title, rules versus discretion over the last 50 years. Where did he get 50 years?

Well, that's how long the Shadow has been operating, and it's 1973, is what I found out. It's prepared for this conference, which we have a title, a 50 year retrospective on the Shadow Open Market Committee, and it's role in monetary policy. And we're here in the tritel building.

So thank you, David and Joan at the Stanford University place. So let me first mention a few people who are behind the SOMC. Alan Meltzer, of course, an old colleague. Where's Marilyn? Marilyn, thank you for being here, thank you.

>> John Taylor: Alan and I are long-term colleagues. I grew up in Pittsburgh.

I admired Carnegie-Mellon for so long. It's a great place, thank you. And Carl Bruner was another member of the original group of three or four or five, however many you actually want to mention. And of course, Anna Schwartz is a very important part of the operation. I have to say, for me, maybe coming from Stanford, where Milton Friedman had his office a few doors down from mine.

I'm thinking of Milton, too, is part of the theory, part of the idea, part of what's going on in this whole thing. So the policy statement, which really goes back to Milton and emphasized a lot of monetary aggregates, that's for sure, more than I'm used to doing. So I'm going to do a little bit of that.

And let me say, if I might at the start, that I want to talk about policy rules. Maybe too much, maybe too much. I think it's very important that we don't forget about policy rules. We forget about them easily if we're not careful. So if you look at the second slide I have is table one from a paper I've recently written called the federal the monetary policy rules as reported in the Fed's report.

And you can see the Taylor Rule, 1993, that's 25 years or so ago. And it's got the interest rate, long term, short term, has the inflation rate pie and it has the unemployment rate LR, and of course, there's various versions of this, if you see. So the Fed has been reporting on this in various ways.

Some of you are responsible, perhaps not. But it's really for me a way to communicate, to have a discussion of what really is going on with Montezdae. Policy, and I can't say enough that I appreciate the opportunity to speak about this topic, given that the FOMC has talked so much about it.

Let me just, if you probably are bored by all the notation, which is part of the deal with Taylor rule, first is just the Taylor rule is the most important. But if you go to the second chart, I'll tell you more about it. This is going back 50 years.

This is a celebration, we're having 50 years. It's the federal funds rate, effective rate. And you can see the percent is on the vertical axis, years are on the horizontal axis, and it's called the effective federal funds rate. It goes back to the late 60s and 70s, 80s, 90s, 2000, 2010, and there it is at the end.

And so we've been seeing this for a long time. And this is the data, this is what the Fed reports. And you can see it got up to almost 20%, those are the bad old days. And what was going on when we were doing that, let's not go back to that, whatever we do.

But since then, and to some extent, it's because the Fed has followed a more rules-based system. I think that's part of the reason it's gotten lower. And you can see it's gotten a little high recently off to the right. It's a little bit of a dip down, but it's still very high.

And the ideal is 2% if you look in the measure I showed you a few minutes ago. So while it's been very high, it's something that we should try to avoid. I'd like to see it like 2%, 2 and a half percent, 4% in that range. And we don't know if it'll be in that range.

It's not just the Fed, it's other countries as well. So don't forget this chart, this goes back 50 years. And you can see we've had interest rates very high, very low, very, very low, very, very high. And we're sort of a medium stage at this point, trying to get them down a little bit, and we'll see if we're successful at doing that.

But that's really, in a sense, the goal. I think, of the goal is to get the interest rate down to this rate. Now, how do we do that? Well, we have a rule, we have a series of rules, and one of the rules is listed here. So I've got the rule circled in red, it's called figure two.

It's a so-called Taylor rule. A simple version of the Taylor rule is if inflation is 2, p=2, and the GDP gap is 0, y=0, then interest rate is 4. So maybe it's a little bit high now, but basically, it's where it should be. And that's coming, it doesn't really matter which version you use to say the same thing, but this is the so-called Taylor rule.

And you can dispute this, argue about it as much as you want, but this is the thing that's attracted a lot of attention. And I'll say it's been very gratifying to me. It's attracted attention, but it's not the only reason. Other central banks have followed similar kinds of things as well, and so maybe we can talk about that.

Mike said there might be some questions. I don't know if there are questions, but this is the first one. Just remember, the inflation rate is 2, p=2, and the gap is 0, y=0, the interest rate is 4. So where is it now? 4, now, let me just go to the next chart, which is more up to date.

And it's indicating the interest rate decisions that the Fed has made, as it says. Figure 3, the Fed held the interest rate lower than the so-called Taylor rule, and the inflation rates rose sharply as the Fed then tightened policy. I know it's hard to see, but the graph started to rise in 2016, and then it fell down in 2019, 2000, and then it started to increase again.

So what I say is the mistake, if you like, was going down all the way to nearly 0 and then reversing very quickly coming back up again. And so this is the kind of thing you wanna try to avoid. You wanna signal as much as possible what you're doing.

If the Fed really wanted to signal that in advance, it could have, but it didn't. We don't know exactly why it didn't. Maybe I'll look at some of the people who decided that. But that's the idea. And so the idea is as we have already talked about, start to come down again, and we get to this 4% level.

Now, the next chart is a little bit of history, goes back to January 2019. It's called figure 4. This chart shows that the policy was too low. You can see it's too low, and this was the reason the inflation rose. And so you can just study this a few minutes.

The policy rate is the dark blue line. The dashed line is the recommended policy based on the generous Taylor rule. And the recommended policy is a less generous policy rule is the one that you can hardly, it looks like a straight line. And you can see they're very low by any measure.

And so that is the notion that I've focused on a lot in my discussion. I said, be careful what you're doing if you're not exactly right on, and so that's the danger that you run into. We can debate this, the ideal would be to keep the rate as close as possible to the ideal rate at this point.

And this is an example of that. You can see how far they were off at the time. Now, finally, if you look at figure 5, and I'll try to wrap up as much as possible. This is figure 5. This is the actual implicit price deflator. So this is the best measure we have of the inflation rate.

And you can see how it got very high in the 50s, and 70s, and 80s and came down to quite low, except for this recent period where it jumped to nearly 10%. And that's the domestic price deflator. That's really what the Fed focuses on and looks on, at least one of the things they look at and talk about a lot.

And so now it's starting to come down, question's, will it stay down? Will it stay at this 2% target, which is the Fed has been very explicit about 2% about where they're trying to go? It's closer to 2 and a half, 2 and a half, 3. And so really that's the ideal.

And you could see, you wanna avoid these spikes. The spikes are not the ideal situation that you have. If you go to figure 6, this is the unemployment rate as well. Yes, the unemployment rate. So the unemployment rate rose well above the target range up to 15%. It's come down quite a bit, so we don't think about that so much anymore.

But you can see the rate really rose, this is from 2008 to the present. And you can see the unemployment rate rose quite a bit, and that's because of the Fed putting on the brakes and trying to do something about this high inflation rate, which they are trying to avoid.

So this is the Fed completely. Now, one thing that's very important to keep in mind, and I'll spend a few minutes on this, is the Fed is only part of the global monetary system. There are other countries involved as well. There's ECB. There's the Bank of Japan. There's China.

They're all over the place. And so the last chart I want you to focus on is the inflation rate in Latin America, our neighbor, it goes to January 22, and includes Brazil, Colombia, Chile, Mexico and Peru altogether. And then the LA five. And you can see it has increased really at the same time as the Fed.

And so this is, the Fed is not unique in this respect. The Fed has really led the way, perhaps its and a factor in all these countries. Now these countries will come down, we hope, to 4% or 2% or wherever they want to be. And the idea is to find a global monetary system, and that's the goal, which is similar to what the Fed.

So the idea here, and just conclude with this, the idea is, as we try to reform our international monetary system, let's try to find a way that we have other countries, Russia, China, Japan, be part of the same system, not exactly the same, but as part of the same system.

And they can do that by having a rule or a strategy which is similar, maybe not exactly the same, but similar to the Fed. That means there's more discussion internationally. I spent a lot of time when I was in government, working internationally, trying to figure out ways to have other countries be involved in this decision.

But I think ultimately what we want to have is a situation where not just the Fed, not just the Europe, not just China, not just Japan, but we have countries that are at the same method, same mechanism, and don't have this situation occurring again. So we're not there yet.

And let me just conclude that we're not there yet. We're close, if you like. We're closer than we were two or three years ago. We were very far away. We seem a little closer than we were. But we need to focus on this as a way to remedy the situation.

And I think ideally, we'd like to have. This is the Fed's, so called Fed's targets, 2% for inflation and the same 2% for globally, and have other countries be involved in that, too. So I'll stop there, thank you.

>> Michael Bordo: We can take a couple of questions and answers.

Questions and then answers. Okay, Bill Nelson.

>> Bill Nelson: Thank you, John. Bill Nelson from the bank policy Institute. So, to prepare for this event, I went back and read some of the original transcripts and research prepared for the very first. So I find it hard to say SOMC. SOMC meetings.

And I was really struck by the distinction that they expressed for caring about interest rates when thinking about monetary policy and the focus that they put on balance sheet items, including money. And so I was just curious. But of course, your rule is all about interest rates, interest rates that presumably are implemented through fine tuning operations very much sort of antithetical to some of the things that they held dear.

So I was hoping you could sort of pull those two things together and explain the intellectual connection between your work on rules based asset policy and their original views about what was important and what wasn't important.

>> John Taylor: So I've been interested in monetary policy rules all my life, starting before there was interest rate rules, where there were just money growth rules.

So I have some experience with that. And see, my experiences drew me away from that, not completely, but if we go back to that, it's fine, but it's so far driven me away from it. And I think in some sense, it's easier to think about what the interest rate should be.

Also, think about multi, this is a global situation. Think about Europe, think about China, think about Japan. If we have a way that 2%, 3%, 4% is the rate that's discussed as the second part of your question more globally, then we'll be in better shape. I think that's the way to think about it.

Is there a way that we can have the global system more attuned to a 2% target globally? Maybe 2% is too high, maybe it's too low, but it seems to be a rate which many people have agreed to have thought about. And so let's stick with 2% and try to find a way that other countries can be part of that.

>> Kevin Chen: Yeah Kevin Chen, that's horizon financial question. You mentioned about Japan, right? So Japan has been in zero interest rate for so long, they tried to increase the rate, caused such a big turmoil this year. Do you think, Taylor roll to apply to Japan? What's the pros and cons?

Let's say if we do increase to 3%, let's say.

>> John Taylor: Well, the Japanese, the Bank of Japan, I know most of them pretty well. Look at the tail of rule they talk about the tail of rule don't mean they follow it. They were too low that space. They were too low for a while, now they seem to be catching up.

And so that's a good sign. That's a good way it should be unfolding. It seems to me whether they'll go all the way or not, I don't know. It's not finished at this point. And they have big trading partners nearby, China in particular, and Russia nearby, which have to think about.

 

But I think the notion, bear with me, the notion that the Fed leads the way or is a leader in this method makes quite a bit of difference. So I think that's why I would argue that the Fed is a key player in this debate.

>> Speaker 6: Yes, in 2012, through the pandemic recession, m2 and nominal GDP were up 2 to 3%.

Then the federal reserve increased the money supply by 35% according to monetarist doctrine. A year later, inflation took off. Powell has said that he doesn't pay attention to money anymore. Is this a mistake on Powell's part? And do you think that money was the major cause of the inflation?

>> John Taylor: I don't think it was the major cause. I showed you charts which indicate that the rate was too low, the interest rate was too low. I'm not saying that money is not important. Money is very important. And I worked on money more than half of my life.

And so I think it's an important aspect, but it's not the only aspect. And I think to some extent, internationally, it's easier to think about other countries with having this same kind of interest rate as the US, maybe not exactly the same, different circumstances in other countries that will be better off.

And so that's the ideal I have is you have a system whereby not just the United States, but this is a global situation, other countries do the same kind of thing. So that's my short answer to your very difficult question.

>> Speaker 7: Thank you. I'm wondering, particularly in the last chart, there were actually several central banks that raised rates before the Fed, particularly in emerging markets like Brazil and Czechia.

And yet they seem to have had similar, if not worse, inflation outcomes in the United States. I'm just wondering if you could kind of walk through why you think that might have happened. Thank you.

>> John Taylor: So different central banks are different. There's different mechanisms, different ways, prices and wages are set.

So that's probably the reason why you're seeing not exactly the same, it looks like. Exactly. In fact, if you look around the world, some are in good shape, some are in bad shape. And so I think that's why monetary policy is so difficult. You have to have some sense of what's going on individually in each country.

And that's what I would argue for is looking at these Latin American countries as well. It's not just Latin America, it's just to give an example where the rate is increased substantially, the inflation rate has increased substantially during this period of time, and it gives you a sense of what to look for.

That's it. Okay.

>> Michael Bordo: Thank you.

>> Condoleezza Rice: I'm Condi Rice. I'm the Director of the Hoover Institution. And I have the pleasure of welcoming you here for a meeting that will recall the 50 year history of the Shadow Open Market Committee. Now, I must admit that as a specialist in international politics and having done some intelligence work, Shadow Open Market Committee sounded like a little bit of a contradiction in terms.

Nonetheless, I do know the importance of this institution. And in fact, we here at the Hoover Institution have a long connection with the SOMC. Milton Friedman, whose ideas spawned the SOMC, was a strong presence here at Hoover for more than 30 years. Alan Meltzer, a very good friend of John Taylor, and of course, one of the pioneers.

Michael Bordo, who was Friedman's student and has been here for well over a decade. And of course, members of the SOMC, Charles Plosser and Charles Calomiris and Andrew Levin and Mickey Levy, all of whom were Hoover-associated at one point. I know that this is a time when going back to look at the importance of this committee and all that it has done is of extreme importance.

John Taylor, who has spearheaded monetary policy here at Hoover for several decades and also across the country, holds from time to time these wonderful workshops, these wonderful conferences that allow us to look back on the great institutions that have really caused the tremendous prosperity and in fact, stability that we have enjoyed for so many years.

But I have to tell you that there can't be a more important time than to both recall that history and to try to build on it as we try to find some verities, some anchors in an international system, an international economy that is at best chaotic and in some ways dangerous these days.

We are facing so many extraordinary circumstances. Now, my good friend Steve Kotkin, the historian, always says that everything is unprecedented if you don't know history. So, I'm certain that there are precedents for what we're facing, but to the most part, they're not particularly good precedents. We are facing, I think, what I have called the return of the Four Horsemen of the Apocalypse, Populism, nativism, isolationism and protectionism.

And perhaps we have come to expect, we've come to take for granted the extraordinary international economy, one that was not supposed to be zero sum. An international system that has largely been peaceful and an international system that has largely been led by democracies. And we have come to take it for granted.

And that is definitely something that today we cannot take for granted. We have, of course, before us the China experiment, and I call it exactly that, because it was something of an experiment to try to integrate fully into the international economy a country who under Deng Xiaoping came out of its isolation.

But really only intended to come out of its isolation on the economic side and kept its principles of a state owned and Marxist economy at the center. For a while, we said of China, it's not possible to have economic liberalization and political control. And Xi Jinping came to power and said, thank you very much, I'll take political control.

We have seen the effects on the international economy of a China that is of a very different social and political system. I'm reminded that, when George Shultz and Ronald Reagan started the G7, the seven largest economies in the world were all democracies. That is not the case today and it is an unknown as to how this will play out for the international system.

We have another sad experiment which is that because of Russia's invasion of Ukraine, Russia has essentially been ripped out of the international economy with the valence of sanctions and restrictions. Russia is a more isolated economy now than it has been since well before Gorbachev. We forget that Russia once chose autarky, as they called it, not integration.

At no point in its history was the Soviet GDP was more than 1% of it accounted for in international trade. But in that 30 plus years after Russia was integrating and now Russia sits on the sidelines. I would ask you, as we think about this international economy and the backdrop for what you do and what the SOMC does, how long has it been since you've heard a politician in the United States say the words free trade?

It has become for both parties a kind of third rail. Replaced instead by discussions of tariffs by tariff man or those around him, by sanctions, by onshoring, friend shoring, national shoring and a pullback from the sense of an international economy that was supposed to operate first and foremost on efficiencies.

I don't have to tell you that the other words that no politician ever speaks are about deficits and what we do about the fact that we continue to borrow money that we do not have. When I was provost of Stanford, I used to say to the departments and the deans, I'm not the Federal government, I can't print money.

Well, the Federal government of course, takes that to an extreme and we see no slowing down there. The economic landscape is an extraordinarily more complex and more difficult landscape than 50 years or so ago when the SOMC was founded. It is also a landscape that is lacking in understanding of what it was intended to do and how well, it has functioned over those years.

Some work that we've done here at Hoover shows that some 35% of Americans do not trust markets. I'm not sure they even know what they mean by markets. I know that many of my students wouldn't be particularly clear on the concept. And so, there's an educational function, both of policymakers and of the next generation.

And there needs to be a renewal of a commitment to those principles, to those anchors that have led to so much prosperity over so many years. And so, in that context, I'm delighted that John has gathered you all here together to look back on this 50 year history, but also having looked back on that 50 year history, perhaps to look forward to what the SOMC will mean to an international economy that is definitely in need of principles and anchor.

Thank you very much, and enjoy the conference.

>> Gregory Hess: Good morning, everyone. My name is Gregory Hess, I'll be the moderator for this first session. It behooves us at the SOMC to have rules about our presentation, I'm gonna ask Mike and Mickey to go at each about 20 minutes, and then David will be about 10.

>> Gregory Hess: Total 20?

Total, 20, there you go. All right, please, Mike.

>> Michael Bordo: Welcome, everybody, this is our first session. Mickey and I are giving this overview paper that's gonna tell you what the shadow was, where it came from, and where it's going, and that's gonna be sort of the anchor for the rest of the conference, and then, each of the following panels will sort of fill in the details.

So, and I'll start off with the history, the old days. So this shadow was established in 1973 by the leading monetarist economists of the time, Carl Bruner, Alan Meltzer, and Anna Schwartz. And it was set up to promote Milton Friedman who was the pioneer monetarist, his modern quantity theory of money model, which was published in 1956, which emphasized the growth of the money supply as being necessary to lower inflation and the role of money to control the economy.

And the shadow, successfully in its period, raised the profile of the monetary aggregates during the great inflation period of the 1970s, and, we argue, likely influenced Volcker's disinflationary policies. And since then, the shadow has evolved. Let me go back, I think I'm first person always messes up the slides.

Okay, since then, the shadow has evolved significantly. It continues to promote rules over discretion. It argues that low inflation is the best foundation for achieving the Fed's dual mandate. And over the years, its research and recommendations have been wise and its predictions have been impression. We still remain actively involved in providing sound advice on monetary regulatory and financial policies.

So just to talk about the 70s for a couple of minutes, in a sense, we have said here, perfect timing, right Model. The 70s is a period of high inflation, not only is there high inflation, but wage price controls were imposed to try to stop it, which they didn't work.

And Chairman Arthur Burns of the Federal Reserve did not really believe that money was the major determinant for inflation. And what the shadow did is, it successfully promoted the critical role of monetary aggregate control, and it was pointedly argued that the Fed really was not following a good path.

And it also emphasized the importance of rising inflationary expectations. And what happened was the dollar crisis in 1978, in a sense, precipitated a great change. And the shadow was highly critical of what the Fed was doing in the 70s, and then, by the end of the 70s, okay, President Carter chose Paul Volcker to replace G.William Miller as the Fed chair.

Over this period, their story was, you have to reduce the money supply, you have to reduce it gradually. What happens is that, Volcker comes in and he agreed with the monetarists that money was important. But he was most concerned about the loss of credibility, which supported his belief that aggressive monetary policy tightening was required to break inflation.

In October 1979, Volcker announced the Fed's shift to targeting non-borrowed reserves, which would involve high volatility of interest rates. Interest rates shot up to 17% in the spring of 1980, money growth plummeted, then, in this period, President Carter imposed these credit controls, which generated a deep but temporary recession.

What happened was Volcker reversed course, and reduced interest rates, the economy recovered. Inflation shot up again, and inflation rose to up to 15%. Interest rates, he tightened again, interest rates went up to 21%. There was a very severe recession, it was followed by eventually, a decline in prices and price expectations.

So the interesting thing is, at the time, Karl Brunner, Alan Meltzer, they actually were critical of Volcker's aggressiveness, and they also were critical of how he did it. It's interesting that later in the 1980s, as Ed Nelson shows in his great work on Friedman, they actually changed, they came around.

But we think that the shadow and monetarism did influence Volcker. But regardless, the Fed reverted to interest rate targeting as soon as inflation receded in 1982. The question that still remains from this period is, whether Volcker used monetary aggregate targeting as a cover to raise rates, or as its true monetary policy instrument.

So I'm gonna turn the podium over to Mickey, and he's gonna talk about what happened since the 70s.

>> Mickey Levy: Okay, so, as Mike described the 1970s policies were in total disarray, wage and price controls, President Ford's win buttons, but there was no policies that really addressed inflation. And the shadow open market committee had the right model at the right time and pushed money, and Volcker came in and slammed on the brakes.

And we have to give a huge amount of credit to the leaders of the shadow Open Market Committee, particularly Alan Meltzer, who was just dogged in his pursuit of pushing the ideals of monetarism on the media. In Congress, there were members of the Shadow Open Market Committee, like Jerry Jordan, who's sitting over there, who promoted it, testified before Congress, so the committee was very active.

Then along came Volcker, he slams on the brakes, and this ushers in the great moderation. So the great moderation is, there's healthy economic growth and moderate inflation. And the shadow during this period continues to worry that inflation is. It's gonna shoot up again. We're gonna go back to the 1970s and it continues to provide targets for monetary base control.

And when we look back on The Shadow and the archives, it really overplayed its monetarist hand. It continued to recommend money growth targets despite itself acknowledging volatility and short-run money demand and velocity. And this was somewhat perplexing that Alan Meltzer and Carl Brunner continued to focus exclusively on the EMS despite the volatility.

Even though both, particularly Alan Meltzer, he was very close to the theoretical developments, including the transition to interest rates in the neoclassical model. And rules that guided not just deviations from inflation, but also countercyclical responses to real output shortfalls like the Taylor Rule. But beyond the EMS, The Shadow provided very wise economic advice and monetary policy advice.

It advocated a low inflation target well before there were official targets. And like the original shadow, it continued to promote rules-based policies, urge transparency and accountability of The Federal Reserve. And it opposed discretionary policy and fine tuning. And then in specific papers by various shadow members like Anna Schwartz, criticized or urged the Fed not to intervene in foreign exchange markets to manage the dollar.

It criticized the role of the IMF and the US Mexican Bailout. It did favor. Really going back to the 1970s, but particularly in the 1980s and nineties, favored responsible fiscal policy and actual rules that would limit government spending as a percent of GDP. In the Fall of 1993, The Shadow recommended monetary tightening that lowered inflationary expectations and led to the Fed's picture-perfect soft-landing in 1994.

But what happened during this period of the great moderation, while The Shadow, its policy statements continued to focus on the EMS, it fell out of favor. Journalists looked elsewhere. The following of The Shadow dissipated some, but it continued to do very strong research. Now, during this period, end of 1991, Jerry Jordan left the SOMC to become president of the Federal Reserve bank of Cleveland, which was a feather in the hat of The Shadow.

Lee Hoskins, who had been president of the Cleveland Fed, came on The Shadow as a member and pounded the table on price stability, and transparency, and accountability. Charlie Plosser joined The Shadow in 1991. In 1998, Bill Poole, who couldn't be here today, he left the Shadow Open Market Committee and became president of the Federal Reserve bank of St. Louis.

Which had always had a history of favoring monetarism. In 1999, Alan Meltzer retired as chair of the SOMC, and Charlie Plosser and Anna became co-chairs. And then the new joiners during the 1990s, Greg Hess, our moderator, and then Ben McCallum and Alan Stockman from University of Rochester. So this is just running through things.

One thing that Mike didn't mention is in our paper on the history of the Shadow Open Market committee, we have different appendices. One includes all of the history of the members of the Shadow Open Market Committee, all of the guest speakers we've had, and then an archive in the appendix of 50 years of papers for the Shadow.

And I encourage you to look at them, it's a good summary. Okay, so moving into the early 2000s, okay, so Meltzer has retired to write us three volumes on the history of the Fed. And the SOMC's research and recommendations were very strident, with a few changes, okay? It continued to support rigorously inflation targeting and rules over discretion.

But here we note that when we talk about rules, what rules mean have evolved over time. It's no longer a gold rule or it's no longer a money supply rule. It's evolved and by this time, the Taylor Rule had become quite prominent. And Ben McCallum on the SOMC was very rigorous in conducting analyses of the Taylor Rule and the MacCallum Rule to assess current monetary policy, not just in the US, but in Japan.

And I'll come to that in a moment. And also during this period, the Shadow evolved from providing recommendations on targets money to targeting interest rates. And this had really kinda bubbled under the surface during the 1990s. This early 2000s was really quite interesting, because once again, we were in the great moderation, and the Fed had its dual mandate that was put in place by The Full Employment Act in 1978.

But really from during the Volcker and Greenspan eras, they didn't really mention the dual mandate, but they were very symmetrical. They thought the best way to maximize employment and economic growth was stable, low inflation. That was their approach to achieving the dual mandate, and they were symmetrical. But then, beginning in the late 1990s, and particularly in 2002, the Fed, Became very, very fearful that a Japanese-style deflation would hit the US.

The Shadow completely rejected this notion. Charlie Plosser wrote a piece for the Shadow in 1998 about this. Alan Stockman wrote about it basically saying, look, the US economic structure is completely different than Japan. We just reject the notion that we're gonna have deflation here. And we urge the Fed to maintain its symmetrical assessment of inflation and a dual mandate.

Alan Greenspan didn't want any part of that. He shifted to an asymmetrical stance and said, we'll do anything possible to avoid deflation. At the same time, the SOMC, and hats off to Greg Hess, our moderator, who wrote a great piece warning about the excess risks taken by Fannie and Freddie, and commented in 2004, asking a question, can we avoid a financial crisis?

And so what happened is the Fed ignored the Shadow's advice, kept rates at 1% while the economy picked up and inflation went to 2, kept monetary policy way too easy, delayed raising rates. And this fueled the debt-financed housing bubble that led to the financial stresses. And this was really the end of the Great Moderation.

Okay, so back to the Shadow, 2006 comes around, and Charlie Plosser leaves the Shadow Open Market Committee to become president of the Federal Reserve Bank of Philadelphia. And we have to note that in 2012, he played a key role in the Fed's first ever strategic plan that established the 2% inflation target.

Lee Hoskins, who's not here today, retired from the Shadow, and Alan Stockman did, for health reasons. So the Shadow actually paused for a couple years to regroup. And then the modern Shadow Open Market Committee began in 2009, and we added some spectacular new members that contribute academic rigor, new dimensions of expertise.

Marvin Goodfriend, Mike Bordo, and Charlie Calomiris, who's going to participate later today virtually. He's sick and couldn't fly out here. And these new members, I mean, they just really highlight the dimension of the committee and its high scholarship and really intense interest in influencing monetary policy. And at the same time, the Shadow adjusted its routine.

It shifted the open half day meetings. It invited guest speakers for the first time. And the first guest speakers we had were Don Kohn and Athanasios Orphanides. Both were policymakers at the time, and it ceased preparing its policy statements. So then in the middle of the financial crisis, the Shadow focuses on the Fed's expanded balance sheet and expanded scope of policies, the factors that affected the monetary policy transmission mechanism and the economy, and then financial regulations and supervision.

And the Shadow was very concerned about the Fed's expansion of credit, and its massive asset purchases enlarged its balance sheet. And this crossed the boundaries from monetary into fiscal policy, particularly the Fed's purchases of MBS. And in 2009, Marvin Goodfriend's first paper for the Shadow called for an accord on credit policy that would establish boundaries of Fed intervention and its lender of last resort policies.

And so, in addition, during this time, the Shadow recommended higher bank capital requirements, reform of Fannie and Freddie, and improved government supervision. So on the Fed's balance sheet, the Shadow was very concerned. And Charlie, this is when you were still at the Fed, but the Shadow was very concerned that the Fed's large balance sheet and its expanded scope would ultimately threaten the Fed's independence.

And the Shadow urged the Fed to unwind its MBS holdings and move toward an all-treasuries portfolio. And on QEIII, which came later in 2012, the Shadow argued against QEIII. Basically, these large scale asset purchases, which had been an unconventional monetary policy that were used during the crisis in an emergency period, the Fed was using them under normal conditions to achieve the Fed's employment mandate.

And the Shadow argued against that. And then came the Fed's new strategic plan and 2% inflation target. The Shadow, of course, applauded this, but worried at the same time about the Fed's, the beginning of its asymmetric tilt toward its employment mandate. And this became more clear under Fed chair Yellen, who more explicitly prioritized employment.

And then as labor markets improved later in the decade, the Fed, its worries turned to low inflation, that it was too low. And around 2014 to 15, the Shadow was urging the Fed to lift off from its zero interest rate policy. So at this point, we had some new members join.

Peter Ireland, Athanasios Orphanides, and Charlie Plosser rejoined the Shadow after his stint at the Federal Reserve Bank of Philadelphia. Later, Debbie Lucas and Andy Levin joined. And then our most recent additions to the Shadow are Jeff Lacker, former president of the Federal Reserve Bank of Richmond, and Jim Bullard, former president of the Federal Reserve Bank of St. Louis.

So in 2015, with so many issues out there, from the Fed's balance sheet to its credit policies to its priorities, and then the regulatory environment, the Shadow said, okay, what are we all about? And we had a full one day off-site, and we Established core beliefs. It was a very interesting exercise, and our core beliefs that we actually wrote down, and it's on our website, have a lot of similarities to the original shadow, and they are a central bank that is independent from fiscal authorities and avoids credit allocation.

It pursues price stability through a rules-like manner with a policy rule that provides countercyclical support as long as price stability remains intact. It promotes financial stability with strong capital buffers, and establishes lender of last resort rules and boundaries that are agreed to in advance. So along comes 2000, 16, 17, 18, 19, and the Fed is becoming increasingly worried that inflation is too low, and it worried that inflationary expectations might collapse.

And along with the lower real interest rates, the Fed would be faced with the effect of lower bounden. The Shadow Open Market Committee argued against this. We pointed out that the CPI averaged exactly 2% during this period, and the PCE price index was a little below inflationary expectations were fairly well anchored to 2%.

And then we made the following point. If the Fed believes so strongly that it can manage inflationary expectations, why is it so worried that inflationary expectations might collapse? And we emphasize the importance of maintaining a symmetric assessment of the dual mandate and the Fed ignored these suggestions and instituted in August of 2020 its new strategic plan.

And the SOMC, led by myself and Charlis Plosser, criticize the Fed's new strategic plan, its new flexible average inflation targeting, its prioritization of employment, and discard for preemptive tightening. And a month after the Fed enacted their new strategic plan, we said, it's only a matter of time before things went wrong.

And based on unprecedented money growth and unprecedented deficits, Shadow members including myself, Michael Bordo and Peter Ireland, were among the earliest anywhere to predict the recent high inflation. And the committee correctly pointed out that the inflation was due to old fashioned excess demand, while the Fed's focus was, it's just transitory supply shocks, and and then in the shadow, there were many outspoken members, like Andy Levin, who said, you have to raise the policy rate above inflation.

And the Fed finally did that and helped lower inflation. Okay, so if we think about the last couple of years, some Shadow members have conducted some really key research. Athanasios Orphanides and Peter Ireland have proposed different rules and have shown empirically that each rule, if the Fed had followed it, would have outperformed the Fed's discretionary approach that facilitated its poor judgment.

Deborah Lucas and Charles Calomiris have emphasized that regulations and supervision should also be established and conducted in a rules-like manner. In the area of Fed governance, SOMC members, Andy Levin and Jeff Lacker have identified flaws in the Fed's governance that constrain the diversity of opinions, reduce dissents, and adversely affect policy deliberations.

And they recommend changes in the Fed's process of selecting Federal Reserve bank presidents, the voting rights of Federal Reserve bank presidents, and they have specific recommendations for improving communications and accountability and more. And then on the Fed's balance sheet, Charlie Plosser continues to analyze how the Fed's enlarged balance sheet ultimately threatens its independence, and he definitely favors a narrower scope of monetary policy.

Andy Levin has measured the cost to the taxpayers of the Fed's enlarged balance sheet, while Debbie Lucas has measured the cost of the Fed's bailouts of the government sponsored enterprises during the great financial crisis, and the costs of the government's overall credit extensions and forbearance. So let me just summarize.

The shadows come a long way, and it's been very active over the many years, and it continues to provide insights as an external and constructive critic of the Fed. And it's evolved from its monetarist origin and continues to promote sound monetary policy based on systematic rules that focus on price stability as the best foundation to achieve the Fed's dual mandate.

And really doesn't mind identifying flaws in the consensus themes and recommend alternatives. And finally, when we think about the last 50 years, there have really been three major mistakes the Fed made that led to really undesirable outcomes. The 1970s, the early 2000s, and then the recent rise, jump in inflation, and the Shadow accurately predicted and made recommendations on all of it.

And looking forward, the Shadow members, it's a great collegial committee, and they appreciate the committee's history and look forward to continuing to play its role as an outside critic of the Fed. Thank you.

>> David Wheelock: I'd like to thank the organizers for inviting me to participate in this extraordinary conference celebrating the 50th anniversary of the Shadow Open Market Policy Committee.

That's great. Thank you. And probably the most important thing I will say today is the disclaimer that as a current federal Reserve employee, the views expressed here today are my personal views and not any views necessarily of anybody else in the Federal Reserve system or any other. Entity in the Federal Reserve system.

You can ask Governor Waller at lunch if he shares my views or not. So, just to summarize, Mike and Mickey did a great job of summarizing their paper and highlighting the rich history of the institution of the Shadow Open Market Committee. It is the definitive history of the first half century of the Shadow Open Market Committee.

Its importance and includes the appendices which, listing the members and all of the position papers and so forth, have been written over the time. But really I think probably the most major strength of the paper is in linking the policy positions of the shadow to the major events of the era.

From the great inflation of the 1970s through the financial crisis of 2008 and 2009 up until the post pandemic inflation. It's mostly a friendly history, perhaps not surprising, but to be fair, the authors do note some shortcomings in the shadows analysis, particularly when the shadow overplayed its monetarist hand, to use the quote directly from the paper.

And that, of course, is the 1979 or post 1979 episode when the shadow continued to advocate for monetary aggregate targeting despite the velocity becoming quite unstable. So, a particularly important component of the paper and the discussion here today, I think, is to the extent to which the shadow has influenced monetary policy and other policies over its 50 year history.

And I'll be focusing most of my remarks on that. In doing so, I'll talk a little bit about the, similar and overlapping histories of the institution with which I'm employed The Federal Reserve Bank of St. Louis and the Shadow Market Committee, which have a shared history that at times become close.

And intertwined, but really has continued up to the present in terms of the evolution of thinking in terms of policy research and policy advocacy within the Federal Reserve Bank of St. Louis is in many respects parallel that of the shadow open Market Committee. And then, rather than resting on our roles, we should think about the next 50 years of the shadow and what it takes to keep the committee as vibrant and as dynamic in the next 50 years as it has been in the first 50 years.

So, as Mike brought up, the founding of the Shadow Open Market Committee in 1973 was in the midst of the great inflation era and all of that entailed. And the shadow was influential in many dimensions during that era. They had close connections with members of Congress and convinced the Congress to amend the Federal Reserve act to require the Fed to provide monetary growth targets, announced them semi annually.

And then there's the question on page one of the paper. Bordo and Levy write that the shadow likely influenced Paul Volcker to get serious about controlling inflation when he adopted new operating procedures in October of 1979. And so the Fed, for the first time in that era, finally accepted responsibility for inflation and took aggressive action to bring it down.

However, as the authors acknowledge, Volcker already was an inflation hawk, having dissented on monetary policy in favor of tighter policy when he was president of the New York Fed prior to becoming chairman of the board of governors. Moreover, the financial markets were clamoring for a change. The dollar was collapsing in international exchange markets and that there was financial instability that was really pressuring the Fed to do something to get inflation under control.

Moreover, Volker, Mike or Mickey said Volcker was not a monetarist. He would describe himself as a practical monetarist, but he did not adopt the gradualist prescription for slowly pulling down the growth rate of the money supply. Instead, he took what my former boss Bob Brash, called a cold turkey approach of slamming on the brakes and really cutting inflation, doing a hard stop.

Moreover, he wasn't a monetarist in the sense of controlling the growth of the money supply. As the next chart will illustrate, this is simply the monthly growth rate in M1 and M2 series. If anything, it became even more volatile after October of 1979 than before. Milton Friedman had a famous paper in the American Economic Review in 84 where he pointed this out, that this was not a monetarist experiment.

It's been called that, but it wasn't monetarism in the sense of controlling a stable growth rate of the money supply. So, that was one episode, one channel to thinking about the influence of the Shadow Open Market Committee in a very important period historically. Now let me switch gears and think a little bit about how the shadow was influential, at least inside one component of the Federal Reserve system, that is the Federal Reserve Bank of St Louis.

The St Louis Fed's story begins with Homer Jones, who became research director of the St. Louis Fed in 1958. Jones had been an instructor of Milton Friedman's at Rutgers when Milton was an undergraduate. And then kind of, ironically or coincidentally, he became a student of Milton's at the University of Chicago when Homer was finishing up his graduate studies.

So, he had very close connections with Friedman. At least one of Friedman's students, Jim Meigs became an economist at the St Louis Fed, one of the original founders of the little members of the shadow opener committees. So, there was a close connection there. There was also a close connection with Brunner and Meltzer through Brunner's students, Jerry Jordan and Ted Balbach, who came in as economist at the St. Louis Fed in the early seventies and then succeeded Homer Jones as research directors of the St. Louis Fed.

And Balbach remained research director up until the 1990s, and in fact, he hired Jim Bullard and myself in the early 90s. So, the St Louis Fed's presidents were advocating a monitor's policy agenda that became known as the mavericks of the system, because they were really pushing the Fed, both within the FOMC but also publicly, through speeches and writings, to take responsibility for controlling inflation, get money supply growth under control, and follow something like a rule based on the growth of monetary aggregates.

Not unlike the shadow, the St Louis guys found a lot of success in forecasting. They developed a small multi equation forecasting model based on the long run quantity theory propositions that turned out to forecast growth nominal spending extremely well throughout the 1970s, much better than the board's model was doing at the time.

And so they became, if you will, a bit overconfident, and ended up over playing the monetarist hand, much like the shadow did, by continuing to advocate a monetarist policy prescription well into the 1980s, pushing for controlling of the money supply growth and so forth. Despite the fact that velocity had become unstable, money demand was clearly making that untenable.

So, let's fast forward a few decades, not too many decades, but the St. Louis Fed's connections with the. The shadow continued and notably Under Bill Poole, who became president of the St. Louis Fed in 1998 after having been a member of the Shadow Open Market committee. After he left the Council of Economic Advisors under President Reagan, he became a member of the Shadow Open Market Committee.

And then in 98, he became president of the St Louis Fed. Bill continued to watch money supply growth, his favorite aggregate was MZM money with zero maturity. He was not overly dogmatic about it. He wasn't going back for an MZM rule or anything like that, but he definitely was monitoring the growth of the money supply and using that in his policy work.

But Bill had, of course, the shadow principles of the importance of price stability, importance of rules based monetary policies, the importance of clear communications. Like Greg Hess, he was an early Warner about Fannie and Freddie and the risks that they posed to the financial system. So Bill was very much in tune, I think, with the shadow and its positions.

Bill retired in 2008, Jim Buller became president of the bank. Jim advanced monetary policy positions were solidly grounded in economic theory, but also as an advocate of rules over discretion and clear communications. Central bank independence, very much again in line with positions that the modern shadow, if you will, was following as well.

So Jim used just as one illustration about the use of rules, in particular the Taylor rule. Very much in line with the positions that you quote in the paper, Mike and Mickey quoting Ben McCallum. And how he viewed the importance in and usefulness of rules, not that we're gonna be slaves to the rules.

But that they will be benchmarks or guideposts to help us understand where is policy relative to where it should be, and in particular as a rhetorical device. Jim very effectively used this picture we saw yesterday, thanks to John Taylor, of considering benchmarking current policy relative to where the Taylor rule suggests that it should be.

And Jim used what he referred to as a generous Taylor rule representation, think dovish Taylor rule. And so what this chart is plotting, of course, is the solid black line there, the actual target path of the federal funds rate set by the Federal Reserve Open Market Committee. And then the red dashed line is the most generous or dovish Taylor rule that one might wanna write down.

And then the shaded region above is a more traditional Taylor rule region. So just showing from mid 2021 up until mid 2022, when the Fed was holding the federal funds target close to zero. That the Taylor rule is predicting ever increasing interest rates that weren't happening. So illustrating that gap and then showing how rapidly the Fed was closing that gap starting in 2022, up through mid 2023.

My point is not to criticize or support what the Fed was doing, but to illustrate the use of the policy rule as a guidepost, as a metric, if you will, for gauging the stanch of policy. It was a very, I think, a very valuable and very helpful rhetorical device that Jim was using at the time.

So let me wrap up just a little bit with thinking about the next 50 years. Bordo and Levy demonstrate how the shadow had relevance, then lost it. Kind of went into a wilderness period, if you will, in the early eighties when it stuck with monetarism a little bit too long.

But then regained its relevance and invigoration over the decades since. Clearly the policy debates, the policy challenges of the world, are gonna continue indefinitely. And so the question for this conference, of course, and we'll hear more this afternoon about this, is the extent to which there's the shadow set up for its next 50 years.

And certainly the shadow is strong, it has a solid mix of academic economists and former Fed officials who bring a lot to the table. But then are we thinking about the early 1980s and where it sometimes got off track is maybe just not keeping up, if you will, with advances in modern macro and monetary economics.

So those were maybe lessons from the shadows early history, but there were also lessons from the St Louis Fed's history of the period as well. So I'll stop there, thank you.

>> George Tavlas: Good morning to everybody. Please. First, let me thank the organizers of this conference for the invitation to participate, and it's a pleasure to be a discussant of such a very rich paper by Mike and Mickey.

What I will do is focus on monetary policies during two of the episodes discussed in the paper. The high inflation period of the of the 1970s and the taming of inflation in the first half of the 1980s. In addition to the views of the shadow committee, I'll also discuss and compare the views of three economists.

Who helped shape monetary policies during those years, Milton Friedman and two Fed shers, Arthur Burns and Paul Volckers. I start with Friedman, Friedman's role in the formation of the shadow committee was pervasive, even if he wasn't a member. The conceptual framework that underpinned the shadow committee's policy advice in the 1970s and 1980s.

Was developed by Friedman in the 1950s and 1960s, sometimes in collaboration with Anna Schwartz, an original member of the shadow committee. That framework featured the following propositions, each based on Friedman's research findings. Inflation is a monetary phenomenon, the key to controlling inflation is to control money growth. The economic system is inherently stable and reverts to the natural rate of unemployment, there's no long run Phillips curve trade off.

The demand for money is a stable function of only a few variables, the supply of money is controllable by the central bank. Keynesian structural macroeconomic models are not reliable as guides for policy. Reduce fall models based on money, as in the classic 1963 study by Friedman and David Meiselman, provide a coherent picture of the influence of money on the economy.

Long and variable lags render discretionary policies unstable. To reduce both policy uncertainty and the influence of political forces on policy formation, policy should be rules based. Under Friedman's preferred role, the M2 measure of the money supply would grow by 3 to 5% annually. Should the quantity of money deviate significantly from its objective, it should be brought back to that objective.

Under the presumption the gradualistic policies reduce the social costs of disinflation. The main difference between Friedman's framework and the shadows framework is that Friedman favored targeting M2 as a shadow committee favored targeting the monetary base. Now, enter into this picture Arthur Burns, who was Fed Chair from 1970 to 78.

Burns had been Friedman's undergraduate teacher at Rutgers in the late 1920s. It was Burns who initiated the Friedman-Schwartz collaboration on their historical work on money. Beginning in 1948, Friedman thought that Burns shared his views about the importance of monetary policy. Soon after Burns became Fed Chair, Friedman wrote, my close friend and former teacher, Arthur Burns, is not just another chairman.

He is the right man in the right place at the right time. As it turned out, Friedman would be deeply disappointed. Under Burns, the Fed permitted the rapid monetary growth that contributed to the surge of inflation to double-digit levels in both the mid-1970s and the late-1970s. Why did Burns permit this to happen?

There were three main reasons. First, as Ed Nelson has documented in his superb work on Friedman, Burns arrived at the Fed holding a cost-push for you with inflation. He didn't believe in the effectiveness of monetary policy. Soon after he became Fed Chair, he championed wage-price controls to curb inflation.

Well, those policies failed, and that failure appears to have been the reason why the shadow committee was formed. Second, as Mike and Mickey have pointed out in their paper, Burns's decisions were often politically motivated, with the aim of ensuring Richard Nixon's reelection to the presidency. Precisely the kind of situation that a policy rule aims to avoid.

The third reason has to do with the technical advice that Burns received. The 1970s were the heyday of large-scale macro econometric models at the Fed and elsewhere. The Fed's model was called the FMP model. It was developed by a team of researchers at MIT, the University of Pennsylvania, and the Board of Governors.

The principal architects of the model were Franco Modigliani and Albert Ando. Who wanted to develop a tool to resolve their inconclusive debate in the 1960s with Friedman and mesmen on the relative effectiveness of fiscal and monetary policies. Here's how Ando and Modigliani described the Fed's model in 1975.

Fiscal policies have important impacts on characteristics of the long-run behavior of the economy. Monetary policy, on the other hand, will not have very substantial impacts. The advice that Burns received from at least some of his technical experts reinforced his prior beliefs about the ineffectiveness of monetary policy. And so Burns got inflation wrong.

Friedman and the shadow committee got it right. For much of the 1970s, money demand relationships were stable. Inflation forecasts, forecasts of reduced inflation for macro models were wide of the mark. The great inflation of the 1970s was mainly a failure to control money growth. And the way to bring down excessive money growth for both Friedman and the shadow committee was through gradual adjustment.

Now enter into this picture, Paul Volcker, who became Fed Chair in October 1979. CPI inflation was over 12%. Base money and M2 were both rising by 8%. In its semiannual statement at that time, the shadow committee continued to advocate gradualism in the reduction of base money growth. In his writings at that time, Friedman continued to advocate gradualism in the reduction of M2 growth.

Volcker had other ideas. Unlike Burns, Volcker appreciated the capacity of monetary policy to control inflation. But he also appreciated something else. As Bill Silber has documented in his excellent book on Volcker, Volcker appreciated the importance of endogenous expectations. To give an example, in 1975, when he had been president of the New York Fed.

He warned his FOMC colleagues not to be encouraged by forecasts of reduced inflation for macro econometric models because those models. In his words, do not take adequate account of the important factor of expectations. And so I come to an important difference between the policies prescribed by Friedman in the SOMC in the early 1980s and late 1970s and the policies implemented under Volcker.

That difference has to do with the acquisition of central bank credibility and its effect on the expectations. Credibility, once it's earned, it allows for gradual monetary tightening because the markets expect, they trust that once a central bank has begun to tighten, it will continue to tighten. This was plausibly the assumption underlying the gradualistic approach of Friedman and the shadow committee.

This is precisely what happened during the past several years. Volcker's actions, in contrast, were consistent with a central bank that lacks credibility and tries to acquire it. In the early 1980s, the Fed lacked credibility and in the absence of credibility, essential bank that embarks on a gradualistic tightening would be believed.

To bring down inflation expectations, Volcker believed that monetary policy had to be tightened abruptly and had to remain tight, even if it meant bringing the economy into a recession. In fact, in Volcker's case, it was two recessions. In the jargon of the literature, the Fed had to signal that it was hard-nosed.

This difference in optimal monetary response to an inflationary shock plays a central role in the New Keynesian model exposited by Gali and Woodford. Volcker's actions anticipated this literature. It also anticipated the game theory literature on the importance of central ban credibility developed in the 1980s and 1990s. This then appears to have been one reason for the difference in policy responses between Friedman and the SOMC on the one hand and Volcker on the other hand.

But as Mike and Mickey demonstrate, there was another reason. Both Friedman and the shadow committee were misled in the early 1980s by high rates of money growth. They thought that inflation would rise. They didn't account for money-demand instability. Volcker, in contrast, emphasized high interest rates as the indicator of policy tightness, not monetary growth.

Once credibility was earned, the Fed maintained it and it built on it by following, if implicitly, a Taylor-type rule from the mid-1980s to the early 2000s. So what are the conclusions? First, in the 1970s, the money supply rule would have prevented the steep rise of inflation and its entrenchment.

Friedman and the shadow committee got it right. What they also got right was the higher order issue that monetary policy matters, and policy rules also matter at a time when the profession downgraded monetary policy's importance. In the early 1980s, a monetary growth rule would not have worked. Money demand was unstable, the Fed not only had to bring down inflation, but it had to demonstrate to the markets that it was hard nosed, Volcker got it right.

After that was done, a policy consistent with the Taylor rule proved to be effective. The torch of policy rules was passed from Milton Friedman to John Taylor. Thank you for your attention.

>> Gregory Hess: Thank you very much, and apologies for my false start earlier. Mike and Mickey would like to just give a very 30 seconds for some responses and then we'll take some questions.

>> Michael Bordo: These were great comments and we really appreciate them. Dave, comments on St Louis, I completely agree with that, I spent a year at St. Louis in 1981, so I was there. But in a sense, if we think of what happened in the seventies with the great inflation, I think of this analogy of like, it's World War II, and it's D-day coming, okay?

And you've got this huge army develop massing US, Canada and Great Britain. Eisenhower's in charge, that's Milton, okay? Then you've got Patton, okay, very ambitious general, okay? That's the shadow or St Louis, and you've got Montgomery. So, you got these different generals, okay, and they're all under the command of Eisenhower/Milton, okay, reduce money growth, get inflation down.

And in a sense, if we look at the stories, they're all tied together. The shadow was very much intertwined, as we've been told with St Louis, okay? Homer Jones was at Rutgers, so I'm here from Rutgers and two of my colleagues. Burns was at Rutgers, so it was this campaign to do something and it was successful.

>> Gregory Hess: Becky, please.

>> Mickey Levy: Yeah, just very quickly, a lot of the discussion which was great focused on the 1970s. But I just wanna emphasize having gone through over 550 papers written by shadow members over the last 50 years, it's really a very rich committee that focuses on a diverse array of monetary issues today and is really quite relevant.

The other point, Greg, I'd like to make is this point that Volcker emphasized and followed through on in the late 1970s. And that is, he was extraordinarily worried, not just about the Feds, but the government's credibility. And so, he had to take very aggressive action. And there's a lesson in that for today was if you remember the Fed in their 2020 Act, their new strategic plan and leading up to it, they emphasize their ability to manage inflationary expectations through forward guidance.

And with that, they discarded the need for preemptive tightening. Volcker's lesson still resonates, that is, in order to manage expectations, yes, you can provide forward guidance, but you better back it up with action.

>> Gregory Hess: Let's go with a couple questions, if there are any, are there any questions at this point?

I'll go with Andy, please, I saw Andy Sander earlier, please, Andy Levin. We have a mic.

>> Andrew Levin: Well, first of all, thanks so much, really awesome presentation, and thanks to David and George for the discussion. I just wanna make three factual corrections. So, first of all, to George, within the Federal Reserve board, that model was called FSVM.

And I think it's an important fact, so it's Mit, Penn, and the s was for St. Louis Fed. So, they actually connects a little bit to David's remarks, too. It wasn't, at least at the board, and this is the era of Flint Brayton and Dave Reichstag, you could ask them, okay, it was the FSVM model.

Number two, in Mickey and Mike's talk, this idea of, well, maybe the SMC was a little bit too alarmist in the mid to late eighties. But I just checked, and you can check easily, the survey of professional forecasters, in 1991 long run inflation expectations were still at 4%, okay?

CPI inflation as of 1991. It wasn't until the mid to late nineties that inflation finally came down to where they've mostly been since then, which is around 2.5%, okay? It took a long time to really cement the credibility of the inflation, and maybe if the Fed had adopted a target much earlier, it would have helped, okay?

Fact number three, we've seen now twice Jim Bullard's really a remarkable graph. I just wanna point out the fact that in December 2021, the survey of, sorry, the summary of economic projections of the FOC had a median federal funds rate projection for the end of 2022 of 0.9%.

It was not 4% the way what we see in Jim Bullard's thing, it wasn't that they were saying at the end of 2020, okay? Now we realize we're way behind, they were still conveying to the markets and including Silicon Valley bank and other financial institutions that, we'll just pick up rates a little bit, kind of like we did ten years ago, it'll be a very long, slow process.

And it wasn't until really the middle of 2022 and really late 2022 that the Fed started clearly communicating that a lot more work was gonna need to be done.

>> Gregory Hess: Great points, Andy, wrap, Bob.

>> Bob King: Expectations through the lens of the two things, first of all, FOMC documents.

And second of all, a simple new Keynesian model stressing imperfect credibility. Now, at the time that we did that Marvin also was quite insistent that we should say that the Fed was not managing money, that managing money was just a screen, and then it was an excuse or a way of raising nominal interest rates extremely aggressively.

Now, not everybody agrees with that. Immediately after the conference, we had a high energy, perhaps I rate discussion with Robert Lucas about that. And I think it's still an open question in terms of that period, how much did the Fed really believe? The monetarist experiment dimensions and how much did they just raise rates?

>> Audience Member 3: Related to these comments, I want to suggest a proposition and get the panel to respond yes or no, especially Boker and expectations in that period. The proposition is, without the strong, unwavering support of the president throughout the early 1980s, Volcker could not have prevailed.

>> Gregory Hess: Jerry, you want a response to that?

>> Mickey Levy: Yes, absolutely. You're right, I mean, it was really quite striking that, so Volcker was nominated by Carter, and then President Reagan fully supported Volcker and his cold turkey policies, even though it created a recession. And if you remember back then, there were two back-to-back recessions, and Reagan supported Volcker and the Fed through the whole episode.

>> Gregory Hess: I would tend to agree that President Reagan did have a very strong commitment to get inflation out of the system. He, of course, moved on to a different Fed chairman after it was delivered.

>> Jack Krupanski: Hi, my name is Jack Krupanski. I've been following the shadow, or shadowing the shadow, for about 25 years now.

One question about two things, is the output gap effectively obsolete? And if you look at both the output gap and the dual mandate unemployment, do they really factor it all in? Should they, from the committee's perspective, factor in much at all in the conduct of monetary policy itself?

Or are they both more consequences rather than factors that you actually plug into what your rule should be?

>> Mickey Levy: Jack, you're bringing up a great question, because the gap between actual real GDP and potential is based on an estimate of potential, which shadow member Athanasios Orphanides has shown that is often adjusted after the fact to make the models look good.

And then the other angle on that, when you look at gaps. When we talk about the Fed's dual mandate of 2% inflation and maximum inclusive employment, nobody knows what maximum inclusive employment is, but it's generally agreed that it's beyond the scope of the Fed to achieve it. But it's part of its mandate.

>> Gregory Hess: And with that, I'm sure this topic will come up again. Thank you very much, everyone, for this great first session.

>> Deborah Lucas: Good evening, we've come to the last panel of the day on the influences of the SOMC and others outside of the Fed. I just wanted to start by saying that often what you hear at SOMC meetings is that monetary policy would be better informed, and a lot of missteps may be avoided if the Fed more seriously incorporated a more diverse range of viewpoints and frameworks into its deliberations and decision making processes.

So I applaud the organizers for assembling this extraordinary group, Donald Kohn, Roger Ferguson, Bob Heller, and Esther George. They collectively bring many decades of practical experience and wisdom to be able to shed light on how and when outsiders have had a meaningful influence on the Fed. So the question really is, does the Fed really listen?

And let me start to get some answers to that question by handing it over to Don Kohn.

>> Donald Kohn: So thanks for having me here. Someone earlier today referenced a variety of views in shadow open market committee meetings. And I think when you want a variety of views, you invite me.

On a few rare occasions when you're looking for a variety of views, I'm happy to be here. And I also note that this is kind of a reunion for monetary affairs. We must have about half a dozen former members of the division that I led for so long, and it's great to see everybody.

So this led me to reflect the topic, led me to reflect on how information gets into the Fed and then how it's processed once it gets in there, and how that's changed over the years. And then also to use monetary policy rules as an example of one of the topics that has changed over the years.

So there are lots of channels for outside information and views to get inside the Fed. And this was true even in the Stone Age, the benighted 1970s, that when I joined the Federal Reserve, policymakers and staff pay a lot of attention to other views that are expressed about monetary policy.

There are panels, even in the 1970s, there were panels of outside economic experts that came in and presented to the Fed. I remember going to them and seeing the people that I had been reading the articles in graduate school, Friedman and Samuelson and those guys. And the great thing about those panels was, as a staff member, you listen to them and you thought, they don't really know anything more than I know about this, even if they're smarter.

Outsiders become policymakers. And we've had several members of the shadow committee become policymakers, Bill Poole, Charlie Plosser, Jerry Jordan. But I do think it's important. And someone made this point earlier today to me, the Reserve banks are like the external members of the monetary policy committee that they have.

So they have their own staffs, they bring outside views, and it's really important to have strong, strong presidents representing a variety of views. The board tends to become a little homogeneous, in part because one president can appoint a whole bunch of people who tend to have similar perspectives.

So I think we rely on the Reserve banks to bring outside views into the meetings, and they certainly have done so over the years. And I think the other point in this, having all these monetary affairs people here brings this home, is former students. Students who come from universities, studied under people come into the fed, they bring those ideas, they bring that fresh thinking.

When I joined the Fed in the 1970s, there were several very important staff members who had been Friedman's students. Most importantly, including, I think, Steve Axelrod, who certainly had gone to Chicago, he didn't get his PhD, but he studied there. My friend and deputy for many years, David Lindsey, was a Friedman student.

Tom Simpson, who implemented monetary policy as a Friedman student. So there are lots of channels for outside influences getting in now. I think things have changed over time about how those channels, how that's been processed once it's get inside. And I think the receptivity and tolerance for alternative views on staff and policymaker levels has increased substantially.

So certainly under Arthur Burns and to some extent under Paul Volcker, and there wasn't a lot of tolerance for alternative perspectives. And staff publications were tightly controlled. What you could publish Reserve Bank publication. I remember being at the Kansas City Fed and having submit my articles to the board staff for review, for example, and that's loosened substantially over time.

And so all kinds of stuff, staff papers are published now that aren't necessarily in conformance with the official perspective. I think Ben Bernanke and Janet Yellen bringing the academic perspective really helped that process along. I think a second thing that's changed over time is, at least for a time, and Jim Bullard discussed this to some extent.

Academic fashion wasn't aligned with what the policymakers were looking for in terms of guidance. So you have the real business cycle stuff. So somehow what Paul Volcker did, raising rates to 20%, and that wasn't what caused that recession, it was a productivity shock. It was hard to convince us at the time that real business cycles this way.

And then you had the shadow committee pushing this monetary base targeting. And there was no way that the Federal Reserve was gonna target an aggregate. Most of which was held in currency outside the United States and subject to variations and those things, so it really didn't. But then I think John Taylor and his rule changed everything.

And Ben McCallum made this point in a talk to the shadow committee in 2015. That John, by putting interest rates at the center of the policy rule and at the center of policy, then aligned with what policymakers were interested in. And there could be much more dialogue between the policymakers and the academics when they were both talking about the same Instrument, even if they had different views about how it might be used.

And I think a final thing that's changed over time, that's helped the dialogue between outsiders and the Fed is greater fed transparency, transparency about what we're doing, why we're doing it. The publication of the transcripts, which I think had some pernicious effects on meetings, many more prepared statements, etc.

But certainly academics and outsiders, not just academics, but people on Wall street, are much better informed about what the Fed is doing and why. Maybe not enough. Everyone has a way of thinking about how that could be improved. But I think the difference today from 20, 30, 40 years ago is huge.

And that transparency helps the dialogue as well. So I wanted to reflect for a few minutes on policy rules and how the presentation, and Chris Waller talked about this, about his looking at this and how that's changed over time, and then what some of the limits are. So as early as the late 1970s, Fed researchers were fitting what we called reaction functions and evaluating, looking for and evaluating regularities in policy formulation.

Interestingly, the one study I can think of that was done, Arthur Burns, wouldn't let it be published because it said we weren't running policy very well. In June 1992, the Fed held a conference on operating procedures in the conduct of policy that had a lot of policy rule material, including McCallum's rule, being examined, and was summarized by Ben McCallum and John Taylor wrote the final essays in those.

In the 1990s, we in MA worked very hard on Taylor rules, especially after 1993 when I spent three months here enjoying John and Alyn Taylor's very nice hospitality, but also being subject to relentless proselytizing by John and we, Athanasius reminded me, we started sending a rules memo to the board after we came back.

We started including that stuff in blue books. We had the, that someone mentioned earlier in 1995 discussion of policy rules. In 2004, after I left monetary affairs, the blue book started to include a table and charts on rule results that's now fed on a regular basis to the board, to the FOMC chair.

Yellen highlighted this work in several speeches, including one here in 2017, in which she discussed three rules. The Taylor the balanced approach and changes rule. In 2017, the monetary policy report acquired a rules box comparing policy, the output of a variety of rules. Now, I think policymakers recognize the advantages of regular and predictable policy, but the role of rules and policy making has been limited.

At best, they could be characterized as guideposts, that's what Alan Greenspan called them, or broad guidelines that's what Janet Yellen called them, and they're often not referenced at all. And here I'm thinking about why the resistance to more emphasis. And I'm drawing particularly on two speeches given here at Stanford, Alan Greenspan in 1997 and Janet Yellen in 2017.

So Greenspan noted that policy rules assume the future will be like the past, that there are regularities that will persist. But he noted, and others have, there are shocks that hit the economy that aren't encompassed by the policy regularities in the period in which the rules were fitted and tested.

And Greenspan cited three things just in the ten years that he had been chair that caused the Federal Reserve to deviate at least temporarily, from what you might think it was a rule. The stock market crashed crash, the 90, 91, 92 credit crunch and the 96 and afterwards.

So he was speaking in 97, 96, 97 productivity increase. So he saw enough changes that meant that the rules were less useful than they otherwise might be. Janet Yellen cited fiscal policy, global growth, fed balance sheet, risk management factors as also reasons that they weren't encompassed by most of the rules.

Most rules, not all of them, use current or past values. Best practice, central banking, is to target a forecast and they are very sensitive, both Greenspan and yellow, using different words that noted they were very sensitive about assumptions about R Star, U star, and Y star. I thought the 1997 Greenspan speech was especially interesting since he ran the policy Taylor found as systematic and successful, but he rejected the rule that came out of that.

I think there were a lot of systematic aspects to policy between 1982 and 1987. One was a focus on restoring price stability, along with very close attention to what was happening to inflation expectations, with a lot of attention to what's happening, long term interest rates as an indicator of what's happening to expectations.

Second at the same time. So restoring price stability, but paying attention to the labor market, minimizing weakness or leaning against strength in the labor market. But it was clear that price stability was the goal after the experience of the 1970s. A second characteristic was it was forward looking.

It was critical to preempt possible increases in inflation, especially after the 1970s. But the focus, especially by Greenspan, was on the next few quarters. He was not a believer in long term economic forecasting. He'd had enough experience in which that wasn't very successful. But he was really good at looking out a couple quarters and kind of seeing what was coming.

I used to kidding me, took one questionable data point, divided it by another questionable data point, and somehow often got insight into what was happening next. So forward looking and inflexible in responding to unexpected developments. Rules in that context could be looked on as guideposts. Thinking about them if what you're doing deviates from a lot of rules, you ought to think about.

Why it deviates. Do you have a good rationale for changing, for not following the general policy, the rules? And I do think, arguably, Fed policy in 2021 and 2022 didn't adhere to these systematic things. It wasn't necessarily focused on restoring price stability. We've talked about that seemed to emphasize the employment side more.

The new framework explicitly didn't lean against strong labor markets. So it was less preemptive, less forward-looking, and it experienced some very unexpected developments on the inflation side, and it didn't really react flexibly. It kept with the same forward guidance. So I think there are lessons to be learned from the success of policy over the period.

John Taylor fit and others have fit their things, their rules. I think the systematic aspects from the nineties, from the 80s and 90s, may be as rule-like as we'll ever gonna get. But they do, the rules can play a valuable role in policy-making, so thank you.

>> Deborah Lucas: Thank you.

>> Roger Ferguson: Good, That was great, Don.

>> Deborah Lucas: Roger is next, but I'm just gonna put in a general appeal. We thought everyone would enjoy this panel more if you were Fed while we were speaking. So I'm now gonna say out loud to the general crowd, food hopefully will come while we're speaking.

But Roger, you're on.

>> Roger Ferguson: Great, thank you very much. It's always a great pleasure to be here. And when I was a Fed governor, to your point, I would always say, please going to need, because I'm used to people not paying attention to have to say anyway. So I'm really pleased to follow Don, because he did a really deep analysis into the rules issues.

I am gonna take it to a slightly different place. But first, I start with what struck me as a little bit of a sense of irony, because the title of this panel is influences of the SOMC and others outside the Fed. And we're supposedly celebrating Fed independence, independent central banks.

The definition of an independent central bank is you're not gonna be influenced by outside influences. And so I don't know what you want us to be. Either we follow your guidance, and we're not independent, or we ignore all sorts of outside influences, and we are independent. But let me take it much more seriously to pick up where Don left off.

But one of the things he didn't talk about, which I think is critically important to the influence of outsiders on the Fed. But more importantly, the influence of Fed on the outsiders, and something Don barely touched on, but I wanna drill in on, which is transparency. And so all of you know, the history of the Fed very, very well.

And I first became interested in this when Paul Volcker was the chair. Obviously, Paul had very little interest in any kind of transparency whatsoever. The entire policy approach was one in which they were focused on some version of the aggregates and let them move around or try to target them.

And then let interest rates go wherever they want it to go. My theory of why the Volcker Fed did that was, in part, it allowed them to say, we're not responsible for these interest rates. That's what market's doing. We are responsible for the aggregates. And that, I thought, was a little bit of, I think, without being dismissive, necessary in order to allow the Volcker Fed to do what had to be done.

And so one has to admire their ability, his ability, and their ability to think through this whole issue of so-called transparency. And, in fact, get to the outcome they wanted with a little bit of misdirection around how policy policy was gonna be unfolding. The other great thing that one admires about Volcker, of course, was the ability to create the aura that policy came from, this very non-transparent place of literally cigar smoke that surrounded everything, the building himself, et cetera.

But finally, one had to really focus in on something else about outside influences in the Fed, which was Volcker's ability to completely ignore terrifying kinds of outside influences in the Fed. So obviously, all of you recall the great demonstration from the farmers who bought their tractors and really effectively closed down the building.

Paul also led the Fed to think through how to respond to or ignore the threats that came in the form of these two-by-fours that were sawed off and sent into the building. So I start there because this whole notion of transparency, which academics have come to so value, I would say started at a place of, I would say, almost disrespect, you know, at the Fed for, I think, very, very good reasons.

Now let me then take it down from that to actually some other very serious things that were going on. At the same time that Volcker and his Fed were struggling with and dealing with this question of transparency. The Fed was under a great deal of almost legal attack vis a vis transparency as you may recall, there were a couple of lawsuits around all of this.

And the Fed ultimately, as a result of the FOIA Act of 1967, I think, was forced, is it 67? Let me look and see.

>> Donald Kohn: Keep going, keep talking.

>> Roger Ferguson: Was forced to start to release the minutes. And they first started, they decided they weren't gonna do it at all cuz they were doing it once a year not the minutes.

Yes, because they did once a year, they explained what the policy maneuvers had been during the course of the year. Then, because of the law, they ended up having you do it with a 90-day lag. And then they finally decided again, under the last period of Volcker, to start to do with a 45-day lag.

So if you're following the story around Fed transparency, it was not just the in transparency of what Volcker was doing, but more importantly, the real releasing of information was done once a year with the annual report. And then, frankly, because of legal developments, and I'll get the year right, they did it with a 90-day lag and then with a 45-day lag.

So I then fast-forward to Alan Greenspan's leadership. And Greenspan, as you know, and some other, I think, would criticize him a little bit for perhaps being not as transparent as you would have liked. And he himself was willing to get character himself with whole notion that he could sort of mumble with great incoherence.

He'd say things like, if you thought you understood what I said, you clearly were mistaken. But underneath all that, I think, was the Fed that, during his period, migrated actually in a way that was really helpful around transparency. And I think the Greenspan Fed doesn't get enough credit for all of that.

But under Greenspan's leadership, we started to do a couple of things that were very important. First, there had been the release of a statement after the meetings, if there had been a policy change. And then we decided that we release statements after every meeting if there hadn't been a policy change.

Big debate as to whether we disclosed the vote. We decided we would disclose the vote. We'd give those that had dissented a chance to explain briefly why they dissented. And these were all major moves. And I think people People, in some sense, don't give the Greenspan Fed enough credit for the progress that they made on transparency versus the goals and objectives of the academic world.

Very importantly, part of what Greenspan's Fed did was after each meeting, we also would release something that was a version of the tilt. Now, to be clear, we struggle with the language. We never got it quite right. But first real consistent effort at giving some form of Ford guidance emerged under the Greenspan Fed.

Now the place that he wouldn't go. And Don, I agree with him, I think, Don, you'll speak for yourself whether or not he agreed, was whether we should go to a formal inflation target. Many of the presidents, Jeff Flacker and your predecessor, A Broaddus, I think, were urging this kind of thing.

Others were as well, Chairman Greenspan, I think, was relatively reluctant to do this for a number of reasons. He will have to speak where Don can maybe speak for him. I thought it was not necessarily at that point a great idea, partially because of deep concern that I had about the ability to achieve the 2% target and to make an assertion that that was where you were gonna go if you weren't sure you can get there, I thought was pretty risky.

But once Greenspan left, Bernanke came in, spent a fair amount of time building a consensus, and then developed the formal 2% inflation target. And all of you seen now the history of how that's worked. The question of do we think about having a flexible average inflation target over time?

And now the expectation of a new review? And so, as we think about the big impact on the academic world, SOMC and others on the fed, taking a moment to think about how we've progressed in transparency, I think was very important. The other thing I want to identify, to pick up and compliment what Don had to say about rules, was implicit in all of this, was the number, the 2% question.

Again, going back to Volcker, as all of you recall, Volcker had a strong point of view that he expressed to me at least, was he didn't understand any of this, because the only acceptable inflation rate was zero. And so again, a place where the academic world and the Fed staff helped, was thinking about what is actually a reasonable inflation target.

And all of you understand that we ended up with academics first, with inflation target being some more acceptable inflation, not a target being somewhat above zero for lots of good academic reasons. The ability to move wages, real and nominal wages so you could reduce real wages without having to worry about nominal wages, and understanding concern about the so called zero bound these concepts came initially out of the academic world, I think, but quickly adopted by Fed staff and eventually by sort of Fed governors.

The other great outside influence was not just figuring out that inflation should be low and stable, but let's call it 2%. But then all the international developments starting the 1990s around the inflation targets, all of you know that inflation targeting started in New Zealand. Most of you recall that it almost started by accident.

So in 1988, as you may know, the then finance minister in New Zealand was on a tv show there, asked the question about inflation, and he came up and said, well, what do you think it should be? His answer was 1%. This Reserve Bank in New Zealand went back a little panicked and did some very quick academic work, not the kind that would have been in a peer review journal.

>> Roger Ferguson: And you know the story, right? Came up with 2% in 1990. The Reserve Bank of Canada followed pretty quickly than the bank of England. And now it took the Fed roughly 12 years or so to join the parade of the 2% inflation targeters. But this was another example of how outside influence is gradually spilled into the Fed, but in a very cautious way.

And I think that makes a lot of good sense. So we've talked about transparency and disclosure, we've talked about the inflation targets and how all that's evolved. Now, I wanna flip it around a little bit and talk about the third way in which markets or outside influences can influence the Fed.

And it has everything to do with something that Don talked about, which is inflation expectations, but more importantly, market dynamics and expectations of what the Fed is likely to do. And here I think this has become a bit of a double edged sword. We now have a very, very active Fed funds market.

At the beginning or before every meeting, the odds of 25 50 basis points move up and down. And I think we now have a very interesting dilemma in which the Fed is hearing what markets think about what the likely move is going to be. And there's a whole dynamic that's developed about do we reinforce market expectation or do we risk so called disappointing market expectations.

So a place where, I must say, I'm a little concerned about the interaction between the Fed and outside influences on the Fed is how we should think about whether or not we're getting good, clean market signals and the interaction between what we say, what the Fed says in terms of their transparency influencing market expectation, playing back to the decision making process itself.

I don't know what the answer is on how to deal with this cycle, but I think we should be quite clear that there are places where the inside and outside influences create not an easier way to deal with policy or an easy way to communicate with policy, but rather, I think, potentially a more challenging and difficult situation vis-a-vis policies.

And we've seen that unfold periodically during the periods where the Fed was raising rates and the period where the Fed started lowering rates. During much of the period when the Fed was raising rates, the markets, I think, was expecting it pivot more quickly. We saw at the beginning of this year or at the end of last year, an expectation the Fed would start to reduce, when in fact, the data didn't support that, and there was market dislocations.

And then most recently, we saw a little bit of experience where maybe the Fed was thinking one thing and the market was thinking maybe a more aggressive cutting. And so I raise all that to say, the topic here of influences on the Fed from the outside, I think have been net positive as Don pointed out.

Adoption of rules based approaches in a very careful, methodical way, adoption of theories of transparency, I think in a very careful, methodical way, obviously, moving gradually, but into a place of an explicit inflation target. All those things, as a former Fed official and friend of the Fed, strike me as being very good.

But some of the places where it's more controversial or difficult, maybe these issues of feedback loops to what the Fed says, what market expects, and then what the Fed does. So net I think the interactions have been very positive. You haven't undercut Fed independence, but I do think there's still some places where external influences and the Fed policymakers potentially need to continue to evolve and develop.

So those are my thoughts, thank you. Thank you very much.

>> Robert Heller: Well, good evening. Now it's only Esther and myself who stand between you and successful conclusion of the conference. I think just about everything that one could have mentioned has been mentioned here about Federal Reserve policy. So let me deal with some rather very personal observations.

Let me take you back 59 years from today. I was a young assistant professor at UCLA. I just joined the department. And Karl Brunner was one of the senior professors at UCLA. We both had an office on the eighth floor of Bunche Hall, tallest building on campus. Carl's was at the very end of the corridor.

I was about three or four doors down. And as was usual, a bunch of the faculty members would go out together for lunch to the faculty club. So I hope you're all enjoying your food right now. After we'd come back, most of the elderly members of the faculty were in the habit of having a little snooze, so they take their little nap.

I hope you don't follow them in that example. And not so Carl. As soon as he had settled down in his office, he would rip open the door, grab what he called a waldhorn, which was a little Swiss bugle, went out the door. And the next sentence then was and Jerry Jordan, who was sitting right here in the front row, would come running up with a stack of IBM printouts and serve up today's results.

New relationships with m two and the price level. And that was my introduction to monetarism, having gotten my PhD at Berkeley, where the word was never mentioned either. Quite frequently, Milton Friedman would also show up at the UCLA during the winter quarters because it was just too cold for him in Chicago.

So he would find an excuse or two to come out. And I learned what money was all about from these two gentlemen. Well, all the more I find it surprising that the current FOMC statements, and I looked at the last four years, the word money isn't mentioned one single time.

And in last week's economic report on the monetary policy report to Congress, Chairman Powell never single time uttered the word money. The question is still, how do you make monetary policy without ever mentioning money? And Milton Friedman would clearly turn in his grave. Have times really changed? Has the relationship between money and prices really broken down?

The answer is no. I had made a plot of the money supply, M2, and also the PCE inflation rate. The money growth is lagged by one year. And I don't think you'll find anywhere closer correlation between two variables than the money supply and the inflation rate shown here.

The relationship still persists even in today's modern economy, where so much has actually changed. As has been mentioned four or five times during the conference here, the Fed has three goals. Stable prices, maximum employment, and moderate long term interest rates. That's what the Federal Reserve calls its dual mandate.

In my mind, they don't even know how to count to three. Well, then they top it off to show off their math excellence to Congress, says price stability is what you need. Well, how do they define price stability? Price stability, according to the Fed, means 2% inflation per year.

And if you know the rule of 72, that means the price level will double exactly every 36 years. And then you wonder why young people worry, how am I going to buy a house when I get ready to buy a house 36 years from now? And it will be costing twice as much as it is costing right now.

So Federal Reserve has some basic problems with basic math, but let me switch to some other things. How did I get to the Federal Reserve? You may remember that there was a vice chairman by the name of Preston Martin, and Preston Martin traveled around the world. He gave a speech in Japan, and he said something about monetary policy.

And when he came back, Volcker talked to the press, and Volcker said that his remarks were incomprehensible. Those were his words. Well, Preston Martin was a bit chagrined. He resigned. As a result, the 12th district seat was open. I was lucky enough to be in San Francisco, and I got appointed to Preston Martin's old seat by President Reagan.

And I got the new job. Well, a couple of weeks passed, first or second FOMC meeting that I attended. And the decision was not to change policy, but as was custom in those days, there was always latitude for the chairman to slightly increase or decrease Reserve stringency a little bit.

So a week later, Paul Volcker testifies in Congress, and a Congressman asked him, he says, well, by the way, there was a whole coterie of Wall street observers who did nothing but watch the Fed. Those were the Fed watchers. Trying to discern the tea leaves, whether anything had changed.

Anyhow, Volcker is testifying in Congress and the congressman asked him, well, Mister chairman, was there a change in policy? Volcker's answer was, well, puff, puff on the cigar. We've been snugging up a bit.

>> Robert Heller: Having English as a second language, I'd never heard the word snugging up.

>> Robert Heller: I ran home to the Fed, looked it up in Webster's, and it said, tighten up the lines on the ship a little bit.

I was just about, as much as I knew before, but surreptitiously, Volcker had, and just a little bit of policy. So a couple of days later, some reporter asked me, what I thought about the change in policy, and I told him, well, there wasn't really a change and a little bit was changed anyhow, and stuff like that.

That was reported in the press. As soon as Paul Volcker read it, I got a call from Katherine Mallard, who was his iron fisted secretary, and chairman wants to see you. I marched in his office. If you got to his office, first of all, there was a big cloud of smoke from the cigars that he was smoking.

Second, every chair that you could possibly sit on, there was either a briefcase or stack of books on it. So you had to stand, like a little schoolboy in front of his desk. I'm standing there, and Paul Volcker says, he says, if you ever speak on monetary policy again, I will ruin your reputation.

I said, okay. I knew what happened to press Martin a couple of months earlier.

>> Robert Heller: So, I kept my mouth shut from that time on. So, the position was mum. Well, after that, believe it or not, Paul Volcker and I, we became the best of friends because our basic EU monetary policy was that there shouldn't be any inflation at all.

Like, Roger just mentioned a minute ago. And he called it the Germanic view of monetary policy, because he was proud of his German heritage, and Germany having gone through two terrible inflations. And as you heard yesterday, at Maesing. Was it yesterday, was today. Time passes. Digvijaya Singh, talk about, the German inflation, and every German does forget it.

Well, let me close with one short story on the Federal Reserve Flag. So I got to the Federal Reserve Board, and believe it or not, there's a guy, his name was Bob Fraser. Bob was the former tank commander in the US army, an imposing presence, and he was in charge of supplies.

So he showed me my new office, and believe me, it was the best office next to the White House of any place in Washington, DC. The corner office, Constitution Avenue and 20th or 21st, whatever it is, head on view of the Washington monument. So I was a very happy camper.

I walked into the office, but there wasn't any place to sit down. There was no desk, nothing. I was told by Bob Fraser, that the Fed was such a tight fisted organization. That the staff, would have to steal all the furniture from retiring governor's offices, so that they would have office furniture to sit on in their own offices.

I see, on laughing like crazy. Were you the guy that stole it up? No.

>> Donald Kohn: Did you take my desk, Bob? I always wondered who did that.

>> Robert Heller: Anyhow, Bob Fraser told me, he says, don't worry, we have $15,000 and we can go shopping. So, Bob and I, went shopping.

I bought a new desk that was equivalent to the resolute desk in the White House. Beautiful piece of furniture, a new couch, a new chair, bookshelves, the whole thing. After Frazier had furnished a new office, he comes by and he says, well, governor, is there anything else I can do for you?

I said, no, you've done a great job. I love my new office. He said, Marl, there must be something else I can do for you, governor. I said, no, no, really, I'm a perfectly happy man. He says, but, governor, there must be something else that you would want.

I thought, well, in order to go to the room, I got to have some wish. So I said to him, I said, well, your chairman Volcker, he has all these flags behind his desk. I said, why don't you get me some of those flags, too, for the office?

Thought they looked great. Poor Bob Fraser, looks at me in horror and he says, governor, I can't do that. He says, those are the chairman's personal flags. That's his personal flags. When he was deputy assistant secretary of the treasury. When he was assistant secretary of the treasury, when he was under secretary of the treasury, these are the chairman's personal flags.

I say, well, then, just give me an American flag and a Federal Reserve Flag. He looks at me again, with the big eyes and says, I can't do that either. The Federal Reserve doesn't have a flag. I said, well, okay, fine. I let him go. A few weeks afterwards, Emmett Rice was one of my colleagues, and he resigned.

And when Emmett left, Walker came and he said, okay, you're gonna be the new administrative governor. In those days, it was the youngest one, who got to be the administrative governor. Now, it's a position of honor, on the board. Anyhow, I was the administrative governor. So I said, now I have some real power.

I called Bob Fraser back again and said, hey, Bob, you make me a couple of copies of the Federal Reserve Seal. And he came with a bunch of xerox copies the next day. I took them home, and I gave them to my kids, and my son Chris. Christopher was at that time 9 years old, and he admired pirates a lot.

So he comes up with a flag design that was this piece here, reminded me an awful lot of a pirate's flag. Well, my daughter Kimberly was twelve years old at that time. She's with us tonight. She's now a professor of medicine here at Stanford. And here's her design.

So I take that design back to the board, and the graphics department makes the final design of the Federal Reserve flag. And here is the proud family standing there with their creation at the Federal Reserve board. But now, and I'm getting to the end of it, if I think about the contributions of Milton Friedman, Karl Brunner, Alan Meltzer, all the great people in the FOMC, I really should have come up with a different flag design.

This is the flag that I got with that. I thank you very much.

>> Esther George: This has been a terrific panel, and I might just stop now, I think, if we were going to. But I think my contribution will be to be very brief. But I want to say first of all, to the shadow open market committee group.

Thank you. I thought this was really very interesting. It's been a long day, but we've covered a lot of ground, I think, on some really important issues. And I personally have benefited from many of the views and the thinking that has come out of this group over the years.

One of the things I thought I would do tonight is to think about how many of the members of the shadow Open Market committee had contributed to our Jackson Hole symposium over the years. And you can go back just about to every volume, going back to Alan Meltzer, John Taylor, Ben McAllen.

I could go around this room and almost every one of you had made important contributions and certainly had influence in that way. I also thought in terms of influences, Don, something you said, which as a Fed president is so important, and that is the engagement we have with the general public in our regions, getting out in those regions and hearing from people across many sectors, and sometimes they serve on our boards.

You can have a manufacturer sitting across the table from a banker. You can have a community leader and somebody from the oil fields in Oklahoma, and the insight you gain from them, so important, but also an important opportunity to communicate with the general public, with that region about what it is the Fed is trying to do, how it's landing in terms of these communities.

So just in a short amount of time, because I heard this today, I've heard it since I left the Fed, which is a question about what's happened to all the dissenters and you know, they probably point that question at me on, but I think it's important aspect of our communication and one that has been raised by the shadow open Market committee, among others.

Jeff, I think you've written a paper that noticed the current chairman has had the fewest dissents of any chairman. Don, you and Gauti Egerson, I think, raised a question about this most recent period. Where were the dissents? And did that have something to do with maybe the very strong consensus culture in the Fed that may have missed or made it hard to challenge some of the assumptions there?

And I was also struck, just listening to Chairman Powell at the Jackson Hole symposium, talking about consensus in this way, which was that the good ship transitory was quite crowded, not just among the Fed, but more broadly. And so I just want to make a couple of comments about dissent as it relates to the culture of the Fed.

I mean, a lot of people have opined about why is it? And there could be many reasons, I think, about my time and what role, for example, forward guidance played. It sort of locks you in by saying, if I agreed to it on the front end, you play this out to a certain extent.

But there are two things that I think the Fed has to be conscious of and aware of, which is the very valuable consensus organization, the collegiality that comes there to make sure it stays what I'm going to say in bounds that you don't lose what can be a very important expression to the public of how we think about these issues, about the independent voices that come to these issues.

And one aspect of this is a quote that Alan Meltzer had in the New York Times. This was sometime around the financial crisis, but someone asked him about the Federal Open Market Committee and dissents. And he said, well, you know, it's a club, and clubs are very close to their members, and they don't want to offend the chair.

And so it's not popular to dissent. And so when I saw in the most recent meeting all the visibility around the fact that you had a governor dissent for the first time in some 20 years, it raises the prospect about how could that be and what is it?

And maybe it is because we are in a time and have been for a while of such political divisiveness, sometimes attacks on the fed itself, that maybe people feel like they have to close ranks, they have to be closer together there. But it does not go unnoticed by the public to say, what is that dynamic?

And the second dynamic around that culture that I think was something I observed as I left the Fed presidents, they've got twelve legal entities that each of them are running. But if you look at what's happened over the past three decades from a managerial standpoint, so, the FOMC aside, these twelve reserve banks have become increasingly connected through how they run their operations.

And the governance that's had to accompany that has made those twelve reserve banks have to think about how they collaborate, how they make decisions collectively. And I raise it because it extends to the culture. If you look at the most recent job description for a Fed president, you can go out, I think Pat Harker is the next Fed president that will be leaving.

The posted job description will have a very clear section about this system overlay and the importance of not only engagement there, but how you conduct, how you select staff that can work in that kind of construct. And so the cultural elements of that, I think we have to be mindful.

Of that they don't bleed over, that we don't become overly consensus focused when it comes to thinking about these very important issues that we've been talking about today. And that is, how do you bring to the table on some very difficult decisions a variety of views and then express those to the public, and I'll just close by saying this isn't a ding against consensus.

In fact, my own experience was one where I did not feel inhibited in terms of both expressing those views, registering a dissent when I felt that was important. But I think it's always important for every organization when it comes to their culture, to check themselves and to make sure that when you have a culture of consensus, it doesn't lead to blind spots.

That it doesn't lead to what I would call too much consensus that would handicap the public, because at the end of the day, we really rely on the public's trust in this institution and trust that we are looking at these issues from all angles, thank you.

>> Deborah Lucas: Great, thank you very much.

Good, we're going for it, this is a hardy group, okay. And I can't help but ask this, maybe I'm channeling a little John Cochran, but it's also my own interest, which is, I think, a theme that came out. And what many people said today in many different ways is that we believe in different ways that fiscal policy is one of the main determinants of prices.

And just imagine that there is kind of an outside consensus on that, do you see that as something that can somehow find its way more fundamentally into what the Fed does? Because I think a lot of us have said it for a long time, and somehow when I come and listen, I don't hear it reflected back at all, so I'm just kind of curious if anyone is willing to comment on.

I don't think it requires going full blown saying things that sound like they're for or against fiscal policy, but rather, is there a way of incorporating it into the framework in a way that's meaningful and not threatening to the Fed?

>> Roger Ferguson: Go on, Don.

>> Donald Kohn: So I think fiscal policy is hugely important for aggregate demand and sometimes for supply, depending on tax levels and things like that.

But I don't think, just reflecting on John's discussion, you're gonna find someone from the Fed saying, we don't control the price level, it's those guys in Congress and the president. So I think part of the culture of the Fed, and I hope this continues, is we are responsible for price stability, that is our responsibility, that's what the Federal Reserve act says and we are going to exercise that.

Now I do think that it was surprising in 2020, 2021 that there wasn't more discussion, I mean, I don't know what happened at the FOMC meetings. We haven't seen the transcripts yet, but there was practically no discussion in the minutes of the, particularly in 2021, the huge fiscal stimulus along with the opening of the economy as vaccines came in.

So there was a surge, a very V-shaped thing and I think the committee, interesting to hear Chris's comments on this. And Loretta's, the committee was counting on its forward guidance to tell it when to raise rates and it didn't need to comment on fiscal policy. And the forward guidance was in my view misguided in a number of directions, so they were relying on a poor thing.

But I also think there was a break from the Volcker Greenspan era and to some extent the Bernanke era, who all three of them talked about the implications of fiscal policy for interest rates. So you can do what you want with your budget, but I'm telling you what's gonna happen to interest rates you raised.

Greenspan famously said, you raise taxes, interest rates will be lower than otherwise be Volker worried about the dual deficits and all that, twin deficits and all that kind of stuff. So I think the Fed to some extent has pulled back too far from commenting on the implications for the macroeconomy of the fiscal policy.

And then my last point is we had a discussion, John included, about how important interest payments on the debt are going to become, and that is really going to put extra pressure on the Federal Reserve. So both the DS won't be able to get their spending increases, the RS won't be able to get their tax cuts, these, the huge things, so this is gonna intensify the political pressure on the Federal Reserve.

And I think it's so important that we maintain the independence of the Federal Reserve from short term political pressures, and I really worry about people's ideas about how that might be eroded.

>> Roger Ferguson: I sort of push a little bit back on your question which Don elaborate on this, but the entire setting of monetary policy has got to take into consideration the fiscal impulse.

And the models are completely built around this, so this notion that somehow another, it's not relevant, it's central to my experience, the way monetary policy is made. I agree with Don completely in that it is, I think, legitimate in a neutral way for the Fed to have a point of view that if the fiscal authority does one thing.

This might have implications in ways that will influence what the Fed is gonna do or how the economy is likely to unfold, I think that's a very legitimate comment to have or for them to have. I think the challenge, and we saw certainly with Greenspan, I don't know others, that you'd go to Congress, join Humphrey Hawkins, or semi annual testimony.

And you get these debates back and forth, trying to get the chairman to say something that seemed to lean one way or the other around a fiscal debate, I think that's a very dangerous place for us to be. The other thing I point out is something that came up today that I think we do have to think through very clearly, which is this tendency now that people recognize.

That the Fed can use its balance sheet and have been asked to drive certain kinds of policies to put a real limitation on how far that goes, because that will open a massive door. And I was very pleased to hear many people today talk about that because I think it's really important for the academic community and others to be quite clear about how one should think of the limitations there, because in the world in which fiscal.

School limitations are gonna become paramount. The thought that the central bank is gonna be this massive sovereign wealth fund, I think, is going to just continue to rise in pressure. So that's the thing. I worry less about fiscal policy per se, and much more about something that might be described as fiscal dominance or the misuse of the feds balance sheet for this broader range of tools.

Both parties are going to be looking for that. And that I think, is that strikes me as the real worry that one should have going forward here.

>> Deborah Lucas: Right. Well, yeah, let me open it up a little bit, take a few questions. Go ahead.

>> Audience 1: So I think my career at the Fed spanned the period before there were any announcements at all, after the FOMC meeting, through a period where quite elaborate statements being made.

And my perception at least was the more elaborate the statement was, the further in advance of the committee that the decision of the committee meeting, that the decision effectively had to be made because the statements needed to be prepared, the ground needed to be laid for them. And so my question is, is there an inherent trade off between transparency and the openness to dissent and debate?

>> Roger Ferguson: Not sure there's a trade off there. I mean, people have to come and have a point of view. For sure, though, I think you do point to one of these problems. And when I was there with Don shop, I chaired two of these committees on transparency and trying to figure out how he did all of this thing and made it also real time.

And so you well know and Don certainly participated in quite a bit that, I'm not sure how it runs now, but it used to be that there'd be a little break and Penn would go and sort of try to rework the statement as much as possible. I'm not sure I described the statements as being elaborate.

I think, if anything, they've gotten a little shorter. And v I've observed under Chairman Powell, there's relatively small number of changes that are made. So in some sense, I think they've become, it's not a critical comment, become a little bit more formulaic than they were when we first started doing them when I was there.

And so I will see how they evolve. But I think you put your finger on a really difficult point, which is you want them to be a good record, one page record of the meeting, picking up as much of the nuance as you can. But at the same time, there's this process of having to get them done.

The only other thing I'd add on this transparency thing is then having to also be prepared for the press conference, which comes a half an hour after the meetings are over. And that creates a huge dynamic in terms of getting all the statements lined up and some clarity around what the Q and A is going to be.

I've been very impressed with how well frankly, the Fed has been able to do that because that puts an even more pressure on the chairman and the committee to get itself organized around what the message is gonna be.

>> Deborah Lucas: Governor Waller, did you like.

>> Roger Ferguson: We need to hear from Chris.

>> Christopher Waller: So I'm always very hesitant to make comments.

>> Roger Ferguson: We need to hear from you.

>> Christopher Waller: What I'm gonna say I've said publicly already, so it's not the new, but I'll just reiterate. So I'm just gonna comment on fiscal policy stuff. So both chair Powell and myself have made public comments about the fiscal deficit not being sustainable.

I mean, we can sit there and look at when deficits, and this came up today in the decession Pat Keyhoe or some others had said, when you're running deficits of six to 7% of GDP and primary deficits of 2.5% to 3%, this is not sustainable when, when you're doing it in peacetime.

Now, I'm not gonna tell Congress how to fix that problem. And that's what we avoid. Maybe some of our European colleagues are much more blunt, but they're a supernatural, supernatural, a national, I keep saying natural, super national organization and they can't get away with this. But it is just arithmetic.

You can't do this. And we've made it very clear. My remarks today were about when the supply of treasury starts outgrowing the demand for treasuries, this is going to push up long term rates. It's just math. It's not anything and I'm gonna have to deal with it. The second point is there's a lot of talk about central bank independence.

And I've always taken the view that the best way to maintain my independence is not criticize my masters. You deal with fiscal policy, I'll deal with monetary policy. When I start telling you what to do with fiscal policy, you have every right to start telling me what to do with monitoring closely.

The third point is, and this was my very first speech as a Fed governor, there was a narrative going around in spring of 21 when we were at the zero lower bound that the Fed would never get off of it because the debt had grown so big that the interest expense would be so large, the Fed would never raise rates.

And I said at that time guess what? When we have to raise rates, we'll do it. And we did. So I'm not too worried about that concern. I'm done preaching.

>> Deborah Lucas: Great. Okay, I've been told that it's time for people to enjoy their dinner and the conversation at their table.

Let's give everyone a big hand. Thank you and let me just end by thanking, Mickey wants to say something. I wanna thank the organizers for an amazing conference today. It was really good. So

>> Mickey Levy: on behalf of the Shadow Open Market Committee, I wanna thank John, Taylor, Marie-Christine, and the Hoover events team, and everything about Hoover's generosity in hosting this 50th anniversary of the Shadow.

We also want to thank all of the participants, all of the current and past fed members, and all the participants who contributed so much of their time and effort into making this what we find a very rewarding conference. And I'll just conclude, Marilyn Meltzer, you were with this at the beginning, and my strong hunch is Alan's doing high fives now.

He's very happy, and he's looking forward to the future of the shadow open market committee. Thank you very much.

>> Kevin Warsh: Hello, everybody, welcome back for the newest session, the Search for the Nominal Anchor. It's an honor here to be moderating this panel. I've been friends of and admirers of the work of Greg, Peter, and Bob. The Search for the Nominal Anchor is the good title, I don't know which of the Johns came up with it, but I think the language is important.

It's a search because it's as if we're on an expedition, as if the nominal anchor itself might be hiding in plain sight or missing altogether. We have a tendency when we get together, groups like this to think back to some bygone era when policy was somehow perfected. That era never existed.

So there is a myth of the good old days. If only we could go back to a time where we're counting money, right? And the conduct of monetary policy was easy, but that day didn't exist. So what we're going to try to do over the course of the next 45 minutes to an hour is do a bit of history, but with an eye towards what are the lessons learned, what can we take to make policy going forward?

And I will provide for you a line from Hayek that you all know quite well. He said, if old truths are to retain their hold on men's minds, they must be restated in the language and concepts of successive generations. That's our deliverable. That's where, at the end of a day like this, we want to at least sow the seeds for how we go forward.

What I'm gonna do is make four moderators, per prerogative, quick statements, then first turn over to Peter to start with some history, and then we'll go to Bob and to Greg. Condi said at the outset of the discussion a couple of hours ago about the environment in which we find the broad economic policymaking happening.

I'd state it less diplomatically than she did. We have two hot wars and one larger Cold war. The world in a geopolitical, national security sense is, as our former colleague and dearest friend George Schultz said, at a hinge point in history. So if there were ever a moment where economic policy, the conduct of monetary policy in particular, needed a stronger ballast, it would be now.

To the extent we continue to make errors in the conduct of economic policy, it makes those geopolitical questions harder, the world more dangerous, not just less prosperous. So with that set, I think the goal of this conference and this panel is to start to ask the right questions, start to understand whether we have a new theoretical and empirical model, a new framework for Inflation.

We won't come out of this with easy answers, but at least by asking the big questions, I think we can agree potentially that the answer to this question is not looking at the latest data from the US government and rounding to a hundredth point about whether we're on track or off track to a 2% inflation target.

Looking so far to the right of the decimal point strikes me as suggesting we are off track. We are not asking the right questions. A preoccupation with whether the next move is 0, 25 or 50, preoccupation of the incredible staff at the Fed on forecasts of what policy will look like in 18 months time strikes me as answering a question which is far less important than this group has been called together to do.

So in some sense, my first prerogative is we need to think anew about the fundamental questions. What is inflation? What causes it? Is the Central Bank responsible for it or just a bystander? And how should it be measured? It is, as I said a moment ago, not obvious that we have the right empirical or theoretical framework for answering these questions, but it's high time we start doing that, especially given the policy mistakes and the inflation risks of this more recent period.

In some broad sense, we have to ask the question, is America's inflation problem because Americans are earning too much and living too well, or is it because our government is living too well, spending and printing too much? And we can try to dodge that and turn to furbis and output gap models, but if we don't at least know that's the question, it strikes me we're not gonna make huge progress.

So that second point from the moderator is whether the profession and central bank policymakers are ready to think anew with the benefit of history, to a new framework. Third, I grew up around this institution from the time I was a research assistant, and I have this silly idea, a bit old fashioned, that monetary policy has something to do with money.

This ought not be a dirty word in the world of central banks, but if one were to do a search of FOMC transcripts, the paucity of references to money speaks volumes about what the great and the good in the profession have to think about it. Again, if Milton were here, I think Milton would be sounding a lot like that Haya quote I gave, not going back to what he might have said or thought 30 or 40 years ago, but thinking anew about the role of money.

And fourth, and finally, before I turn it over to my panelists, absent finding a nominal anchor, absent developing a rigorous new framework, I'm afraid we're left with some puzzling contradictions. Contradictions that might be glossed over as the financial markets are at new all time highs, but are contradictions that are likely to find their way to policymakers.

I'll just note a couple of them. Is it right for a central bank to take credit for a soft landing if it does not take responsibility the inflation surge that preceded it? Is it right for a central bank that had announced In August of 2020 a brand new framework for inflation, flexible average inflation targeting?

Is it right for that never to be renounced or replaced, but just to sort of be left there as if it wasn't actually that important of a policy? And is it right to say we'll revisit that framework in a year or 18 months time? Or should that be among the first courses of business for policymakers in the US and around the world?

And two more contradictions I'll raise one. We talk about data dependence. It's a piety that we all throw around policymaking is data dependent. I think there are only two problems with that, the data and the dependence. But even if one were somehow to think that the data we're getting from the Bureau of Labor Statistics is a great forward indicator as to where the economy would be, it's not obvious to me that we're following data dependence if I think about the context of data over the last several months.

And a fourth puzzling contradiction, a final one, which, absent finding a new framework or a new nominal anchor, continues to confound me, at least in the darkest days of the global financial crisis. We created quantitative easing, though by a different name at the time because we said this is just going to be monetary policy by other means.

We cut interest rates to zero. We had run out of other tools. We had already begun bailouts of all sorts of institutions. And we said we need monetary policy to be looser. So we started buying the bonds and mortgages of other parts of our government and other parts of financial markets.

But now, as we fast forward, we think of a $7 trillion balance sheet. We say, that has nothing to do with monetary policy, that has to do with excess reserves and a new regime. And again, I find it a puzzling contradiction. Either it is monetary policy or it's not.

And if it is monetary policy, one problem is that monetary policy is loosening with the policy rate, but seemingly tightening with this other rate. Do we have a theoretical or empirical model how those cancel out? Or is it only monetary policy when we want it to be? These are some of the questions, none of the answers.

And for that, I'm going to turn first to our panelists to give us a bit of a history and see if we can't move forward from that. So let me introduce Peter and welcome him to the podium.

>> Peter Ireland: Okay, thanks, Kevin, great comments. So, like Mike Bordeaux said at the beginning of today's session, the shadow Open Market committee was founded in the early 1970s by Carl Bruner and Alan Meltzer against the backdrop of high and rising inflation here in the United States.

Allen would later recollect that his principal objective in forming the group was to advocate forcefully for monetary restraint as the preferred solution to the problem of inflation. Preferred in particular to the wage and price controls that were much more popular at the time. The specific approach to disinflation recommended by the early SOMC involved gradually reducing the rate of money growth by one percentage point per year along a multi year pre-announced path that would end once price stability had been restored.

Thereafter, money growth would remain constant. So the monetary policy strategy advocated by the early shadow Open Market committee really had much more in common with Milton Friedman's constant money growth rule than it did with, let's say, the Taylor rule that we all know and love today. It was cast in terms of quantity variance.

It made no attempt at any kind of short run stabilization objective, let alone fine tuning. Instead, it was directed exclusively towards restoring and then preserving long run price stability. Friedman would famously advocate for his constant money growth rule with appeal to the long and variable lags. Bruner, Meltzer, and other early committee members would argue for their preferred approach in similar terms, often citing our lack of a reliable structural model of the American economy and the lack of the kind of timely and accurate information about the current state of the economy that would be needed to conduct a successful stabilization program.

Now, in the paper that I prepared for today's session, I traced through the full details of how it was that these views gradually softened, at least somewhat over time. Part of the problem had to do with recurrent episodes of instability in the velocities of the broad monetary aggregates, m1 and m2.

But for Alan Meltzer, it seems the proverbial last straw on the back of the constant money growth rate camel came in the early 1990s because of an increase in the demand for US currency overseas. Which likewise destabilized the velocity of the monetary base. So in 1993, Alan introduced a new monetary policy rule that allowed the targeted growth rate of the monetary base to adjust adaptively over time in response to shifting estimates of the long run trend in real GDP growth and in base velocity.

So the Meltzer rule continued to share something in common with the Friedman rule. It was cast in terms of quantity variables, and it made no attempt at stabilization. But it was different for the obvious reason that it no longer called for constant money growth. The next episode or installment in the story came in the early 2000s, when Ben McCallum joined the Shadow Open Market Committee.

Not surprisingly, shortly thereafter, SOMC documents begin referring to the prescriptions of the McCallum rule. McCallum's rule is like Alan's in certain respects. It sets a target growth rate for the monetary base that adjusts adaptively to shifting estimates of the long run component of base velocity. Unlike, however, the Meltzer rule and the Friedman rule before it, and much more like the Taylor rule, McCallum's rule also includes a feedback term for stabilizing nominal GDP over the cycle.

So the way I would put it would be to say that the McCallum rule and the Taylor rule are similar both in terms of their objectives and in their design. In that they attempt to achieve modest stabilization objectives over the business cycle. At the same time, they preserve longer run price stability.

So again, in the paper I go through more of the details about this arc, according to which the shadow gradually gravitated away from Milton Friedman's constant money growth rule, more or less, and towards something that started to look more and more like the Taylor rule. And today, we don't have a committee consensus statement exactly on this matter.

But just speaking for myself, I'd be totally happy to see the Federal Open Market Committee adopt and make consistent reference to some variant of the Taylor rule. And making its decisions and describing the rationale for those decisions to the public. I think that would go a long way towards improving monetary policy here in the United States.

And I would guess that most of my shadow open market colleagues would agree with me on that. Now, before I wrap up, though, I do want to go back one last time to the original quantity theoretic framework espoused by Bruner, Meltzer and other early committee members and just ask, can we find any value today, enduring value to such an approach to monetary policy analysis and evaluation?

Most economists these days, I would guess, would say no right off the bat, for the simple reason that the monetary base grew by a factor of four during and after the financial crisis and great recession of 2008 2009, without generating anything remotely like that in terms of an increase in the aggregate nominal price level.

My counterpoint will be though, that if you begin to take even an ever so slightly closer look at the data, you can see that maybe there's more to it than that. So in order to do this here on this next slide, I'm plotting the same underlying series, the growth rate of the monetary base, but in two different ways.

Over on the left, monthly percentage changes in order to highlight two very brief episodes of extraordinary growth in the monetary base. One in 2008, second in 2020. Over on the right hand side, year over year percentage changes to highlight better intermediate term trends. And the first thing I wanna call your attention to over on the left is that during the, 2008-2009 episode, by far and away, the biggest percentage point changes in the monetary base occurred in a very narrow window of time.

Early fall 2008, before zero interest rates and before QE1. Instead, these increases in the base were driven by emergency lending at the height of the financial crisis. Now, this is difficult to remember today in light of everything that's happened since. But if you go back to mid 2008, so spring, summer, even into the early fall, the biggest macroeconomic concern, as opposed to banking and financial market concern on the Federal Open Market Committee in those days, actually had to do with the threat of higher, not lower, rates of inflation.

Those were the days when every time you drove by the local gas station, the price of a gallon of gas had reached a new and more astonishing peak. And the concern was that increases in oil prices were going to pass through and work to increase broader base measures of inflation.

So, the Fed reserve had to conduct emergency lending, and that in turn necessitated large increases in base money. But FOMC members did not want those increases in the monetary base to translate into higher rates of inflation. That was the rationale behind paying interest on reserves in the first place.

Now, it is true that the monetary base continued to increase because of QEs 1- 3. But first of all, in terms of percentage point changes, as opposed to absolute dollar amounts, those changes were somewhat smaller, if only because the monetary base had already increased by so much. What's more, those changes occurred over a period of many years, and some of them were eventually reversed by quantitative tightening.

So if you just calculate the average annual growth rate of the monetary base over the decade long period beginning in January 2009, it works out to be only about 7% per year on the high side by historical standards, but certainly not hyperinflationary. Another way of seeing this is to take a look at the growth rate of M2, plotted in the same two ways on this next slide.

And observe that QE1-QE3 never generated a persistent acceleration in m two growth. On the other hand, the second big burst in the monetary base in 2020 was accompanied by a surge in m two growth and was followed by higher, unwanted inflation. But look, you don't have to take my word for it, go back to Friedman and Schwartz.

And remember, a key element of the Friedman Schwarz's story is that to see the deflationary impulses sent through the American economy by contractionary monetary policy during the Depression, you can't just look at the monetary base, you have to look at M2 as well. That's where the enormous monetary contraction is so readily visible.

I'd also call your attention to a very nice recent paper by Samuel Reynard from last year's volume of economics letters. In which Samuel takes a look at a number of his historical episodes in the United States and other countries, as well, of large scale central bank balance sheet expansion, and shows that those episodes were followed by higher inflation, but only in those cases where broad money growth accelerated as well.

So far from being obsolete or completely useless, it strikes me that a quantity theoretic framework like that espoused by Bruner, Meltzer and early Shadow Open Market Committee members, would have served very usefully as a crosscheck against everything that the FOMC has actually done over the past 15 to 20 years.

In particular, sluggish m two growth in the aftermath of 2008-2009 confirms that despite everything, years of zero interest rates, wave after wave of quantitative easing, monetary policy was never over expansionary during that episode. But again, on the other hand, the surge in M2 growth in 2021 gave early warning that the Fed was overdoing it.

That was a major monetary policy mistake that might have been avoided, at least in part, had somebody on the FOMC been thinking about Bruner, Meltzer and the other early SOMC members. Thanks.

>> Robert Hetzel: I'm gonna focus on the importance of rules versus discretion, and I'm also gonna try to make relevant the continued importance of monetary control for the preservation of price stability.

And the subtext in this is going to be that the FOMC's use of the language of discretion obscures the nature of the monetary standard and makes it fragile, okay. So when it's public communication, press conferences, speeches and so on, the FOMC emphasizes the importance of discretion, that is flexibility.

And it seems to make sense, well, you can't really forecast the economy. You don't know what the big problem is gonna be. So you watch the economy evolve, and if the major problem is with maximum employment, well, you lower the funds rate. But if the major problem is with price stability, you raise the funds rate.

Seems to make perfect sense, but it does raise some questions. First of all, as a student of Milton Friedman, I'm thinking, well, if you really are making these decisions period by period, by looking out the window with the economy, what about the long and variable legs critique? Was that never relevant?

And I'm gonna rephrase that question, and the way I'm gonna rephrase it is in order for monetary policy to be stabilizing, the FOMC has to solve the simultaneous, the identification problem, the problem of simultaneity. That is, FOMC behavior affects the economy and the behavior of the economy affects the FOMC.

And so, if monetary policy is gonna be stabilizing, the FOMC has to sort out the one way causation. And the economists who take that seriously have a lot of problem with it. They have to use a model with the reaction function and think about how it influences expectations.

We don't hear any of that from the FOMC. So how does the FOMC deal with these problems, in particular the identification problem, all right? So if you think about it, we don't have a command and control economy. If we're gonna hit our targets of maximum employment and price stability, somehow monetary policy has to transmit to the collective behavior of an innumerable number of households and firms, and it's gotta organize it.

Well, if you think about that, that's got to happen through the price system. And the way the consistency in policy influences expectations. So, how does the FOMC square this reality with this language of discretion? And I argue that the FOMC communicates on two tracks. One track is to the public and it sort of communicates the message that, yeah, we manage the economy, don't mess with our independence, or you'll limit our ability to stabilize the economy.

But the markets understand the consistency of policy. And what I'm gonna do in the rest of my talk is I'm gonna try to make that last comment concrete and real. Okay, so since the 1951 accord, there's been a baseline monetary policy, okay? And that baseline monetary policy was called leaning against the wind by William McChesney Martin.

And the essence of it is that the Fed watches the rate of growth of the economy and through observing the rate of resource utilization in the economy, makes a decision about whether the economy is growing unsustainably fast or unsustainably slow. And then it responds, in a common sense way, to stabilize the economy's rate of resource utilization, okay?

Now, that's the baseline policy, but it occurs in two variants, and if you're interested, you can read the details in my book. Okay, excuse the shameless self promotion, had to do that. All right, so one variant I call leaning against the wind with credibility. It could also be called leaning against the wind with preemptive moves in the funds rate to preserve price stability so inflation doesn't emerge.

The other variant I call lean against the wind with trade offs where the focus is not just on preserving price stability, but the focus is on trading off between two independent targets of low inflation and low unemployment. It's gotta use a Phillips curve. And with this variant, when the economy begins to grow strongly rather than preemptive changes in the funds rate, you don't see these significant changes until inflation actually emerges.

And then you see these significant increases in the funds rate, okay? I'm gonna concentrate on the first one, I call it law leaning against the wind with preemptive increases in the funds rate to preserve inflation. And so a point I wanna emphasize is that with this rule, the FOMC is stabilizing, the economy's rate of resource utilization is not attempting to control real output.

The behavior of real variables, output, and employment emerge as a consequence of the operation of the price system, okay? As opposed to the other variant, okay? And that's gonna be important. So let's take an example to try to make it concrete. Let's assume that as information comes in on the behavior of the economy, it becomes clear that the economy is growing too fast.

Okay, well, the FOMC is gonna raise the funds rate. Now if you think about it, well, okay, the funds rate, the real rate of interest is below the natural rate of interest. So, let's estimate what the natural rate of interest is and move the funds rate up. And maybe you move it up three quarters of a percentage point or one and a half percentage points.

Well, that's not the way it works, the FOMC typically starts with a quarter of a percentage point, or if it feels it's behind the curve, half a percentage point. Okay, but the transmission to monetary policy occurs through the yield curve. But the yield curve is not constrained in that way.

Just because the funds rate is moved up by a quarter of a percentage point, that doesn't mean the yield curve is gonna move up by a quarter of a percentage point. What shapes anchors, makes the behavior of the yield curve stabilizing? Well, participants in financial markets, and especially the individuals trying to arbitrage.

Forward rates, they understand that the bottom line, that the North Star is gonna be returning the economy to a level in which the rate of resource utilization is stable, okay? Immediately, the yield curve is gonna move in such a way that markets feel like they're making their best guess of what the future path of interest rates is gonna be to achieve that objective, okay?

And the point I wanna make here is that the yield curve adjusts continuously as new information comes in, not just once an FOMC meeting, so there's a continual adjustment of the yield curve. And the effect of that is that the yield curve stays fairly close to the natural rate of interest.

That is the natural rate of interest being the real rate of interest that distributes aggregate demand intertemporally to keep contemporaneous aggregate demand equal to potential output. And it's that tracking of the natural rate of interest by the yield curve through this continuous adjustment that avoids the Friedman long invariable lag critiques.

So you don't get this big discrepancy between the real rate of interest and the natural rate of interest, okay? So, I'm gonna talk about what I think this is important and relates it to the kinds of things that goes back to the founding of the FOMC and my comments that price stability requires monetary control.

So, we've gotten away from that. And let's first of all ask why we've gotten away from that. Well, let's talk about M1. So in the early 1980s, what happened is that computers reduced the cost of switching funds, money out of the money market and bank deposits. And when market interest rates change, banks lag in the rate at which they change the interest rates on their deposits.

So let's say the economy weakens, interest rates in the money markets decline, but, But the rates on bank deposits still look pretty good. So there's a transfer of funds out of money market instruments, which are relatively illiquid into bank deposits. And so the composition of M1 between instruments that are relatively illiquid and savings instruments, and instruments that are relatively liquid transactions deposits, that composition changes.

So even though M1 growth rises, liquidity doesn't. What you really care about is the liquidity in the public's asset portfolio doesn't change. And so the result was that the behavior of M1 became countercyclical instead of pro-cyclical and stopped offering useful information for monetary policy. Okay, that was M1, we can talk about Divisi and so on.

Okay, but still. So how do you talk about monetary control? Well, in terms of this rule implemented by leaning against the wind, with credibility, it comes in, there's two aspects to the rule. You need credibility to main the expectation of price stability. And then you need this leaning against the wind rule that causes the real rate of interest to track the natural rate of interest and maintain equilibrium in the goods and services market.

Okay, so when you think about monetary control, then you've got these two aspects. First of all, with that credibility, the public is going to demand an amount of money consistent with the assumption of price stability. And given that the stabilization in economy's rate of resource utilization allows market forces to cause the real output to grow along potential, then with real output growing along potential, money demand will increase in line.

So you discipline the demand for money in these two ways, through the credibility of a rule and through preventing excesses in the goods and services market and keeping output growth potential. And with an interest rate target, then the banks accommodate that increased demand, which is consistent with price stability.

And with its interest rate pegged, the Fed accommodates the associated increase in reserves. So these procedures provide for monetary control, even though the FOMC may not even follow money, or certainly doesn't have procedures for controlling money, so.

>> Gregory Hess: Thank you.

>> Kevin Warsh: Excellent turn it over to Greg, who's gonna clean it up for us before we turn to Q&A.

>> Gregory Hess: I recognize that I'm between you some questions and lunch. So I recognize the tender spot I'm in, the Federal Reserve is on most days it is. Since the session is on the nominal anchor, I just thought it would be useful to remind ourselves what we actually mean by the nominal anchor.

And whether or not there has been some drift in our understanding of what indeed establishes a nominal anchor and what a nominal anchor is. So I tried to delineate the entire conversation into five important questions. And I think it's useful when you walk away from a seminar, to know that you've learned something.

I know, and I believe you will learn at least one thing of those five today, hopefully all five. The first is who first established the nominal anchor concept and why. Second is, what is the nominal anchor's original meaning by that author? Does the Federal Reserve have a nominal anchor?

And is the Fed's use of the concept of the nominal anchor the same as the original? Finally, did the Fed's nominal anchor go wobbly in the post-pandemic era? Let's begin. Anybody know who came up with the term? I probably know we read the paper yet, that's okay. But it's actually surprising.

And I'll tell you, I had it double checked with Ed Nelson, who I separately asked him, can you tell me who you think came up with the first use of the term nominal anchor? We came up with the same name and the same paper, and it happens to be a paper by Robert Barro in their economic journal in 1979.

And it has to be understood in the context of the post gold standard great inflation time period, which is when he wrote about. And there are citations around the early 80s that suggest that indeed, Robert Barro had put the word nominal in front of anchors. Other people would use the word anchor, phenomenal anchor in terms of what appears in the literature, first appears in this EJ article, and I will go to it right now.

The important thing for him, and this actually talks a bit on some of what Kevin said. He imagined this idealized world where international finance, monetary policy all works perfectly. It is based on the gold standard, where the central bank supports the nominal price, a reserve commodity, and that, in fact determines the price level.

Because once you've got the relative price of gold to money, and you have the amount of gold, then you can figure out the amount of money. Once you figure out the price, how much money you got. In most models, you know the price level. But more importantly, there's actually, and the key word at the bottom there is the word system.

The system possesses a nominal anchor, because internal to the gold standard's nominal anchor is a system that actually determines the amount of money that pins down the price level. And this is just continuing that article. By way of contrast, the absolute price level is determined only up the determination of the quantity of the fiat currency.

And because there is no theory of who and what the behavior of this monetary fiat currency can do. His belief was there is no obvious nominal anchor that prescribes some likely limits to changes in the absolute price level. In fact, he thinks about issues of whether or not we should have a monetary constitution.

There's no monetary rule at the time. Whoever determines the amount of money gets to determine the price level. There's nothing internal systematically consistent with constraining the amount of money in a fiat money system. And because of that, the absolute price level does not have a nominal anchor. What he is looking for, much like in the gold standard, is automaticity, which you can think of as the word systematic and consequently absence of political control.

If we fast forward just two years to a paper that Robert Barro published in an NBR volume edited by Bob hall on inflation, a book on inflation. He actually says that basically it is clear that the nominal anchor for the monetary system, weak as it was earlier, is now entirely absent.

And if you go further down, he uses a word that he will use again in some key papers with David Gordon, that future monetary growth and long run inflation appear now to depend entirely on the year-to-year discretion of the monetary authority. That is the Federal Reserve. That is the origin of nominal anchor everyone.

Here are some takeaways. So you did learn one thing, all right, you owe me. All right, so barrel search for nominal anchor has to be understood within this period of the gold standard, which was a self-contained system that determined that only provided a nominal anchor, but also provided a constraint on money that did indeed tie down the long run price level.

This is a system, and it has to be completely understood. Otherwise, you know, a nominal anchor without an effective system, which you can think of as a policy chain, an anchor without a chain is just a hunk of metal lying on the ocean floor. That's it, everyone. The nominal anchor doesn't work if there's not an effective policy chain connecting it to the ultimate price level that we are trying to stabilize.

So the next question is, does the Federal Reserve have a nominal anchor? And it turns out that, and this, I have to thank Andrew Levin, who told me, it's actually on the Fed's website, and you can actually go and Google, what is the Fed's nominal anchor ready for?

Right, everybody? That's it, 2%, the long run goal. That is an explicit objective, and you can see that it has a lot of the same words that Professor Barrow was emphasizing in his understanding of how to think about a nominal anchor. There's lots of words like policy strategy and systematic, but it's used in somewhat different way.

You'll see one of the key underlying words at the bottom is that it's not a systematic policy that drives it. It's not automaticity that drives it, it's actually a flexible and a adaptive strategy, which sounds a little fuzzy, everyone, but it does plans to systematically return inflation to 2% over time.

So, these definitions are what I'll call cousins, reasonably close cousins, but they are not the same thing. That is the next question. Does the Fed's use of the concept differ from the original? The original, once again, a nominal variable that can deliver price stability with effective constraints to make policy systematic and eliminate discretion.

The feds, well, the fed's nominal anchor is the empirical understanding of price stability. Probably not the worst idea in the world. A decent idea. The policy strategy is flexible, probably I'll insert the kind of commonly used term data dependent, but systematically returns inflation to the nominal anchor. These are not quite the same thing.

That doesn't mean that the Fed system does not form an effective chain, but maybe history will inform us whether it has or it has not. That is the final part and the final question that we're gonna get to. My God, there are lines everywhere. I tried to squeeze it in on one page.

Let's see how this works. Let's at least look at the red line. That is the rate of inflation. It has a scale on the right hand side. That is the variable. And this is defined over the period 2014 through, I think it is 2012 to current time period.

This is the time period over which the Federal Reserve has had that 2% anchor. So I just focused the attention just on that time period. You can see that inflation, as measured on the right hand side, was under 2% off and before the pre-pandemic recession. But of course, starting about 2021, the rate of inflation rose dramatically.

So that's the big piece of it. And during this time period, of course, there was a lot of instability in inflation, a lot of great concern about whether or not the Fed's nominal anchor was strong or whether it got wobbly. And people can look at expectations and do a whole bunch of different things.

But there are two things that were pointed out already by Axel today, which give me reason to believe that the nominal anchor did go wobbly during this time period. First one is the forward guidance trap. This is also emphasized in some great work by my SOMC colleague and dear friend Hafanasios.

And that is that the Fed made additional constraints to the conduct of both its interest rate policy, in terms of using outcomes-based, rather than policy-based forecast determinations of policy. And also with regards to its portfolio, its balance sheet operations that were kind of pre-committed to not increase interest rates until the purchases of treasuries had gone to 0.

And if you think about what Robert Barrow emphasized, what Robert Barrow emphasized is that you had to have a nominal anchor that provided appropriate constraints on monetary policy. And in this case, in terms of the forward guidance issues, it actually, it added additional constraints that were perhaps not helpful in obtaining price stability.

So it's not that the Fed put on the wrong constraints, it just put on additional constraints that prohibited it from adopting and obtaining price stability. What happened is, because of these additional constraints, it delayed the ability to raise interest rates and tried to slow down the rate of inflation that had grown so dramatically in the period of 2021.

And that's what I call the great delay. These additional constraints slowed down the Federal Reserve's ability to combat the rise of inflation in a timely way. They got behind it was because of the great delay. One of my views is that every great macro episode has the same first name, which is great.

So the second word you just have to fill in for yourself. The first piece is the great delay. The second one, of course, the second kind of error that if you think about what Robert Barrow suggested in thinking about the nominal anchor, which is to try to make it systematic, to make your policy systematic and automatic.

And the second is that you eliminate discretion. But of course, the transitory inflation call is about as discretionary as it gets. We always think about the distinction between transitory and persistent, or transitory and permanent as a statistical inference. And very seldomly do you get evidence that a rise of inflation is 100% transitory and worth walking past or hoping goes away.

Figure 1, as I showed before, shows that there's an incredible increase in m2, which has been pointed out by about half the reader so far, half the speaker so far. And what we see is that indeed, the fed did. Get behind that the inflation surged. Nominal income was rising.

The Fed's inability to raise interest rates during that time period, both because of the delay but also its determination that inflation was not an immediate problem, is the second part I refer to as the great denial. Concluding thoughts, everyone, and that will hopefully get us back almost on time.

Concluding thoughts. The nominal anchor is appropriately thought of as the system must be capable of delivering long run price stability and constrained monetary policy to be systematic and discretion free. This is the definition we get from the original article. This is the original understanding we get from Robert Barrow's initial article.

The forward guidance trap reveals that the Fed placed too many inappropriate constraints on monetary policy to deliver its price stability mandate. The transitory inflation call reveals the Fed had not sufficiently constrained discretion from its decision making to deliver the price stability goal. Descendants of John Taylor's rules would have helped any rule.

As Jim demonstrated, the Dovish rule might have even suggested that things could been moved much earlier. The advice of Marvin, good friend, another former SOMC colleague from, wrote a paper in the early nineties that suggested that even inflation scares need to be addressed in real time. A sturdier or nominal anchor for the Fed should be a key topic for discussion as it reviews its longer run goals and monetary policy strategy, and applying appropriate constraints and systematic and discretion free policy should be established both for interest rate determination and balance sheet and sheet determination.

And advocates for these constraints need to be at the table when those discussions are had. Thank you very much.

>> Kevin Warsh: Great, thank you, Greg. We've got time for a few questions before Chris leads us at lunch at noon. Let me call on folks. I see Andy over here.

Can we pass a microphone in the front?

>> Andrew Levin: Great session. So I just wanna make sure we get the history precise. So I just want to think back to March 2022, okay? Because I think that part of it is what Alsace just described, and part of it is team transitory.

But that wasn't all there was. Okay, so March 2022, the fed hikes. How much? A quarter point. I just wanna read you the statement. Okay, voting for, there was a bunch of names. Voting against this action was Jim Bullard. Actually it says James Bullard, sorry, who preferred this mean to raise the target rate by half a percentage point.

Okay, so the very first move they made wasn't a, we're really behind the curve here, okay. The other thing that's important to remember is there was a whole long period of, we're just moving back to our neutral. And so at the March 22 meeting, this is connected exactly to what Bob Hetzel was talking about, at the March 2022 meeting, they released fresh projections.

Their projection was that at the end of the year, the federal funds rate would be 1.9% and that it was gonna peak at two and a half and then come back down a little bit. And you must remember all this, all of you, right? How many press conferences there were where the Fed chair was talking about, well, we just need to move back to neutral, and that'll take care of the problem.

So I just want to ask, Kevin, since you're the chair of this, what can be constructed to help the fed combat the problem of group think? Because it seems to me that's the deeper problem underneath all of these other problems, the problem of groupthink.

>> Kevin Warsh: So it's a good question.

I'll try to give a brief answer. One is there has to be a genuine openness intellectually to ideas that would otherwise be thought heretical. Money is an idea that had fallen so far out of favor that any discussion around the table about M2 growth, I suspect would have been met by people that would sort of look aside.

I think that's a period of another error. So if you are justifiably humble, not just rhetorically humble, but justifiably humble about your forecasting ability, about the quality of furbus to be able to plot the future. If you aren't sure about the causes and consequences of inflation, you have to encourage people that might have views that are quite out of favor to step up.

So I'd say that's one. Two, there has to be an understanding that the more we give in forward guidance, the more that we are subject to human nature, the more we tell everybody what we're gonna do for our dots in the next several meetings of next year, what we all tend to do is we don't wanna be proven wrong.

So we crowd out ideas that might be against the forecasts we gave. I think generally that the long tradition that started around the time that I departed the Fed, that we be hugely transparent as if that is an unvarnished good with our forecast for the future. Number of interest rates has proven to slow the reaction function by policymakers to changes that would otherwise prove their forecasts to be wrong.

I think the most important parts of forward guidance is to say what your reaction function will be to different events. But the moment that you give your forecast, we all tend to lock ourselves into those. We tend to be resistant to change. We tend to herd in our behavior.

And Andy, as you know, it's one negative, one terrible negative consequence of the last decade over these forecasts is they're all largely the same. The growth forecasts, inflation forecasts from the staff happen to mirror very similarly the forecast from the other 19 participants around the table. Who wants to break from the center?

Who wants to do that? In which case when you're wrong, you're horribly wrong. Don Cohn and I I'll say this as a final point. Don and I used to have a lot of family fights when we were at the fed back in the day, but we had family fights.

And in some sense the fight we had then, which I would say is relevant now is it the job of the FOMC to minimize deviations in output and employment from what we state? Or is it the job of the FOMC to minimize very significant deviations in output and employment?

Are we really effectively in the fine tuning business because we have such great knowledge of these real and nominal variables, or are we in the business of avoiding very big mistakes? And I guess I'd summarize this, Andy, by saying the forward guidance we give, the process of speaking everybody so frequently about their dots and forecasts tends to exacerbate the risks that when you make a mistake, it'll be a doozy.

>> Robert Hetzel: One problem is that people are human and the stakes are so high, you just can't say, I screwed up. I caused the great recession. Why did Ben Bernanke write a paper in the AER where he only talks about credit policy. He never talks about monetary policy. Well, so that makes it very hard to learn, because the Fed just rationalizes whatever it's done, right or wrong, and then it goes, yeah, the economy's evolving, we don't really have a good way of learning.

So if you had a rule, then that would force you to move away from rationalizing what you did, but actually defend what you did in terms of that rule, and that would be a lot harder.

>> Kevin Warsh: Great, let's turn to other questions. John, right behind you.

>> John Cochrane: This is great, thank you.

I do sort of feel like I went to a memorial service for a friend who died in 1982, and where the eulogy starts with, wait, someone's screaming in the casket, maybe he isn't dead after all. I have a narrow question for Peter and then the larger question for the rest of you.

So Peter, right, the moan from the casket is that M2 went up before the recent inflation, and Peter pointed to M2 growth as this return of monetarism. But the problem with M2 is that the Fed does not control M2. And for the quantity of money to control the price level, the Fed must control the supply of money.

There are no reserve requirements. The interest rate on money is either zero or equal to the interest rate on bonds. We're in a perpetual liquidity trap. So this seems pretty obvious that this is a case where the price level determines m two, not m two determines the price level because it's completely endogenous.

That leads to my larger question. We danced around, what is this nominal anchor anyway? I sense two definitions. One is what is in the Fed's procedures to make it kind of pay attention to inflation a little better. But the other, and the one that Barrow, thanks very much Barrow had in mind, it's a property of an economic model.

What is the key ingredient of an economic model that allows that model to determine the price level? And we got a problem, guys, the Fed is not controlling the money supply. So even if that did, in principle determine the price level, we're not doing it. We do not have a gold standard.

That, in principle, could work. We're not doing it. Even if the Fed determined the money supply, when velocity is interest elastic, there are multiple equilibria, that doesn't determine the price level. Interest rate targets lead multiple equilibrium, that doesn't determine the price level. Our Fed does not engage in off equilibrium threats to kill the economy to deliver multiple equilibria, that doesn't determine the price level.

As you know, I think there's only one answer remaining. But I'm curious what your view is of the subject of this question, at least the economic one. What determines the price level?

>> Peter Ireland: Peter, in the interest of time, maybe you answer the first two question, and the other sound like the next meeting of the SOMC.

Right, two quick answers to the question. I mean, one is, is there any information content? Monetarist analysis has almost always been reduced form. Okay, and this is reduced form evidence. And you ask, does that reduce form evidence provide any signal for whether monetary policy conducted not in an attempt to target m two, but holding interest rates at zero while you're conducting quantitative easing?

Okay, is it inappropriately overly accommodative? Okay now, you're right, velocity moves around, I mean, I admitted as much. If your narrow definition of monetarism is we follow a constant money growth rule, my point was that that's dead, and rightly so. I still think that there's a legitimate question of what you glean from information about M2 against the backdrop of tremendous uncertainty about whether the Fed was overdoing it or whether to pull back would risk falling back into a terrible recession.

The second answer to the question would be, okay, just because the Fed reserve has a monetary system where it cannot control M2, one could conceive of a monetary policy system where it could exercise more control over M2. And the question then would be, would that be better or worse than what we have right now?

It's important to remember that Milton Friedman never argued that the constant money growth rule would be like the optimal policy in any kind of DSG model. What he argued was a monetary policy dedicated to holding m two growth constant would have been better than what we experienced during the Great Depression and better than what we experienced during the 1970s.

It so happens I still agree with that. And then you ask, well, the cry out in the coffin. I mean, the thing is, are we happy with what happened in 2020? Do we want to, as Kevin said, just, well, that happened, but now we're back to 2% inflation, or sort of, let's just move on.

I think a lot of people, that's what they want, and it's not really what I want.

>> Kevin Warsh: Great, we have time for one final question. I saw a hand over here.

>> Bob King: So I wanted to praise Greg Hess's archaeological work.

>> Gregory Hess: Thank you.

>> Bob King: I remember Barrow giving a version of that paper and some related seminars at Rochester.

And I think it's very important to recognize that what he was talking about was determining the price level. The current system we have in the United States of an inflation target, taken narrowly, does not determine the price level. It determines a rate of change of the price level.

And Barrow was actually very interested in what the behavior of the price level would be under a constant money growth rule, because it was a period in which the US was looking forward optimistically to a deflation, excuse me, a disinflation. A disinflation would cut the nominal interest rate, increase the real demand for money, and potentially cause havoc with analysis based on constant money growth rule.

Now, the final observation I'd make, given that that's ancient history, is to look at the recent years. I think there's significant evidence that during the recent period, some measures of market expectations for long-term inflation have gone up not hugely, but a percent. And some other shorter term measures of expected inflation have gone up much more.

Now, that's understandable if the world's partly transitory and partly permanent. And what seems a success for the Powell fed so far is that they've gotten those longer term numbers to come down. And yet it also suggests that there was some significant uncertainty in the public mind about that inflation targeting system.

>> Kevin Warsh: Greg, would that praise you? You're allowed the final word and then we're gonna call it.

>> Gregory Hess: Thank you, let's have lunch.

>> Kevin Warsh: Guys, thank you.

>> Athanasios Orphanides: Let me start by thanking John Taylor in particular, and the Hoover institution more generally for organizing and hosting this wonderful event. It's a great pleasure for me to introduce as our lunch Speaker Chris Waller, Governor of the Federal Reserve. Now, we all know Chris, and I'm not gonna go through his CV, I will just mention two things.

Number one, he only started his team as governor in December of 2020, so he's not responsible in any way for the August 2020 policy strategy that the Fed is currently operating by. So this is one element I want to mention. Second element I want to mention is that this is something I really appreciate for people in the Fed system.

Chris has been one of the dedicated civil servants operating the Fed system for many years. And I think as a nation in the United States, we're very lucky that we have so many people like Chris actually trying to run the country's monetary policy and do a good job.

Chris, the floor is yours.

>> Christopher Waller: Well, it's good to see everybody, a lot of you haven't seen in many years. And thank you, Athanasios, thank you for the opportunity to be part of this very worthy celebration. In support of the theme of this conference, I do have some thoughts on the shadow Open Market Committee's contributions to the policy debate, in particular its advocacy for policy rules.

But before I get to that, I'm gonna exercise the keynote speaker's freedom to talk about whatever I want. To that end, I want to take a few minutes to offer my views on the economic outlook and its implications for monetary policy. So let me start there, and afterward I will discuss the role that monetary policy rules play in my decision making and in the deliberations of the Federal Open Market Committee.

So this is kind of a two for one speech. In the three weeks or so since the most recent FOMC meeting, data we have received has been uneven, as it sometimes has been over the past year. I continue to judge that the US economy is on a solid footing, with unemployment near the FOMC's maximum employment objective and inflation in the vicinity of our target.

Even though the latest inflation data was disappointing, real gross domestic product, or GDP, grew at a 2.2% annual rate in the first half of 2024, and I expect it to grow a bit faster in the third quarter. The blue chip consensus of private sector forecast predicts 2.3%, while the Atlanta Fed's GDP now model, based on up to the moment data, is predicting real growth of 3.2%.

Now, earlier there were concerns that GDP in the first half of this year was overstating the strength of the economy, since gross domestic income, or GDI, was estimated to have grown a mere 1.3% in the first half of this year, suggesting a big downward revision to GDP was coming.

But visions received after our most recent FOMC meeting showed just the opposite. GDI growth was revised up substantially to 3.2%. This change in turn, led to an upward revision in the personal saving rate of about two percentage points in the second quarter, leaving it at 5.2% in June.

Now, this revision suggests that household resources for future consumption are actually in good shape. Although data and anecdotal evidence suggest that lower income groups are struggling, these revisions suggest that the economy is much stronger than previously thought, with little indication of a major slowdown in economic activity. That outlook is supported by consumer spending that has been and continues to be strong.

Though the growth in personal consumption expenditures of PCE has moderated since the second half of 2023, it has continued at an average pace of close to 2.5% so far this year. Also, my business contacts believe there is considerable pent up demand for durable goods, home improvements, and other big ticket items, demand that built up due to high interest rates for credit cards and home equity loans.

Now that rates have started to come down, and are expected to come down, more consumers will be eager to make those purchases for business spending. Purchasing managers for manufacturers describe ongoing weakness in that sector, but those for the large majority of businesses outside of manufacturing continue to report a solid expansion of activity.

Now let me talk about the labor market. Only a couple of months ago, it appeared that the labor market was cooling too quickly. Low numbers for job creation and a jump in the unemployment rate from 4.1 to 4.3% in July raised risk that the labor market was actually beginning to deteriorate.

To remind you of how bad the markets viewed that July data, some Fed watchers were calling for an emergency FOMC meeting to discuss a rate cut. While the unemployment rate ticked down in August, job growth was once again well below expectations. Many were arguing that the labor market was on the verge of a serious deterioration and that the Fed was behind the curve, even though a 50 basis point cut occurred at the policy the September FOMC meeting and then we got the September employment report.

Job creation, September was unexpectedly strong at 254,000 jobs, and the unemployment rate fell back down to 4.1%, which is where it was in June. The report also showed upward revisions to payroll gains for the previous two months. So together, the message was loud and clear. While job creation has moderated and the unemployment has risen over the past year, the labor market remains quite healthy.

Along with other new data on the labor market, the evidence is that labor supply and demand have come into balance. The number of job vacancies, a sign of strength in the labor market, has fallen gradually since the beginning of the year, even though it popped up earlier this month.

The ratio of vacancies to unemployed is at 1.2, about the level it was at in 2019, which was a pretty strong job market, to put that number in perspective. Recent research has shown that the ratio of vacancies to the number of people looking for job has been above one only three times since 1960.

The quits rate, another sign of labor market strength, has fallen lower than it was in 2019, a decrease which partly, yeah, partly reflects the hiring rate, has fallen as labor supply and demand have come into better balance. So, in sum, based on payrolls, the unemployment rate and job revisions, there's been a very gradual moderation in labor demand relative to supply, but not a deterioration.

The stability of the labor market. As reflected in these two measures, as well as other metrics I mentioned, bolsters my confidence that we can achieve further progress towards the FOMC's inflation goal while supporting a healthy labor market that adds jobs, boosts wages, and living standards for workers. I will be looking for more evidence to support this outlook in the weeks and months to come.

But unfortunately, it won't be easy to interpret the October jobs report to be released just before the November FOMC meeting. This report will most likely show a significant but temporary loss of jobs from the two recent hurricanes and the strike at Boeing. I expect these factors may reduce employment growth by more than 100,000 jobs.

And there may be a small effect on the unemployment rate, but I'm not sure it will be that visible. Since the jobs report will come out during the usual blackout period, for policymakers commenting on the economy, you won't have any of us trying to put out what this low reading might mean, but I hope others do.

Looking ahead, I expect payroll gains to moderate from their current pace, but continue at a solid rate. The unemployment rate may drift a bit higher, but is likely to remain low in historical terms. While I believe the labor market is on a solid footing, I will continue to watch the full range of data for signs of weakness.

Meanwhile, inflation, after showing considerable progress for several months towards the FOMC's 2% target, it's likely moved up in September. The consumer price index, or CPI, grew 0.2% over the last month, 2.1% over the past three months, and 1.6% over six months, and 2.4% in the past year. Oil prices fell over most of the summer, but then has recently surged.

Excluding energy and food that likewise tend to be volatile, and just as it did in August, core CPI printed at 0.3% in September and 3.3% over the last year. Private sector forecasts are predicting that PC inflation, the FOMCs preferred measure, will move up in September. Core PCE prices are expected to have risen about 0.25% last month.

While not a welcome development, if the monthly core PC inflation number comes in around this level, over the last five months, it is still running very close to 2% on an annualized basis. So we have made a lot of progress on inflation over the course of the last year and a half, but that progress has clearly been uneven.

And trust me, at times it feels like you're on a roller coaster. Whether or not this month's inflation reading is just noise, or if it signals some ongoing increases, is yet to be seen. I'll be watching the data carefully to see how persistent this recent uptick is. The FOMC's inflation goal is an average of 2% over the longer run, and there are some good reasons to think that price increases will be modest going forward.

I'm hearing reports from firms across the country that their pricing power seems to have waned as consumers have become more sensitive to price changes. There's been a steady slowing in the growth of labor compensation. Now, it's true that average hourly earnings ticked up in September to 4% over the last year.

And although it might seem like wage increases of 4% a year would put upward pressure on inflation, that is near 2%, that might not be true if one considers productivity, which has grown at an average annual rate of 2.9% in the past five quarters. Now, some of this strength was making up for productivity that shrank during the pandemic.

But the longer it continues up 2.5% in the second quarter, the better productivity supports wage growth of 4% or even higher without driving up inflation.

>> Christopher Waller: With the labor market in rough balance, employment near its maximum level, and inflation generally running close to our target over the past several months, I wanna do what I can as a policymaker to keep the economy on this path.

For me, the central question is how much and how fast to reduce the target rate for the federal funds rate, which I believe is currently set at a restrictive level. Now, to help answer questions like this, I often look at various monetary policy rules to assess the appropriate setting of policy.

Policy rules have long been of serious interest to the Shadow Open Market Committee. So before I turn my views to the future path of policy, I thought I would talk about monetary policy rules versus discretion, and begin with some background about the use of rules at the FOMC.

For a brief overview of the history of the advent of rules at the board, I've been directed to the second chapter of the Taylor Rule and the Transformation of Monetary Policy, written by George Kahn. And I have also consulted the memories of longtime members of the board staff.

Now, rules came along in the 1990s as the Fed was moving away from monetary targeting, focusing more on interest rate policy, and taking its first major steps towards increased transparency. There was immediate interest in Taylor-type rules among Fed staff and even some contributions to research on policy rules.

There was a presentation to the FOMC on rules in 1995, and that was the same year that John Taylor's Bay area colleague Janet Yellen was apparently the first policymaker to mention the Taylor rule at an FOMC meeting. While FOMC decisions mimicked the Taylor rule much of the time under chairman Alan Greenspan, he was famously an advocate of constructive ambiguity in communication.

And he and other central bankers since have resisted the suggestion that decisions be handed over to strict rules. Now, today, of course, a number of rules-based analyses are included in the material submitted to policymakers ahead of every FOMC meeting. And we publish the policy prescriptions of different rules as part of the board's Semiannual Monetary Policy Report.

Rules have become part of the furniture in modern policymaking. As everyone here knows, but for the benefit of other listeners on this live stream, Taylor rules relate the level of the policy interest rate to a limited number of other economic variables. Most often including the deviation of inflation from a target and a measure of resource use in the economy relative to some long-term trend.

Now, there are various forms of the Taylor rule, but they generally fall, in my view, into two categories. The first of these is what's called an inertial rule, and it has the property that the policy rate changes only slowly over time. I tend to think of it as an approach that captures the reaction function of a policymaker in a stable economy, where the forces that would tend to change the economy and policy build up over time.

When change does occur, a gradual response may give policymakers time to assess the true state of the economy and the possible effects Of their decision. One example I can use is a steadfastness of policymakers in the latter part of 2023, when inflation fell more rapidly than was widely expected, and again, in early 2024, when it briefly escalated.

The FOMC did not change course either time and approach validated by inertial rules. Now, a non inertial rule, on the other hand, allows and in fact calls for relatively quick adjustments to policy. The guidance from these rules is more useful when there is a turning point in the economy, and policymakers need to stay ahead of events.

One saw these non-inertial rules prescribe a sharper rise in the policy rate above the effective lower bound starting in 2021, as inflation began climbing above the FOMCs 2% target. So non inertial rules are also more useful in the face of major shocks to the economy, such as the 2008 financial crisis and the start of the pandemic in 2020.

The great promise of rules is that they provide a simple and reliable guide to policy. But what should one do when different rules recommend different policy actions given the same economic conditions? Right now, inertial rules tell us to move slowly in reducing the policy rate toward a neutral stance that neither restricts nor stimulates the economy.

On the other hand, non inertial rules tell us to cut the policy rate more aggressively right now, subject to the caveat, of course. That is, one is certain of the values of all of the star variables u-star y-star r-star. I think the answer is that while rules are valuable in helping analyze policy options, they do have limitations.

Among these are the limits of the data considered, which is typically narrower than the range of data that policymakers use to make decisions, and also the fact that simple policy rules do not take into account risk management, which is often a critical consideration in policy decisions. So while policy rules serve as a good check on discretionary policy, I still believe there are times when some discretion is needed.

As a result, I often prefer to think of them as policy rules of thumb. Now, turning to my view for the path of policy, let me discuss three scenarios that I have in mind to manage the risk of upcoming decisions in the medium terminal. The first scenario is one where the overall strong economic developments that I have described today continue, with inflation nearing the FOMCs target and the unemployment rate moving up only slightly.

This scenario implies to me that we can proceed with moving policy toward a neutral stance at a deliberate pace. This path would be based on the judgment that the risks to both sides of our dual mandate are balanced. In this circumstance, our job is to keep inflation near 2% and not slow the economy unnecessarily.

Another scenario, which is probably less likely in light of recent data, is that inflation falls materially below 2% for some time and or the labor market significantly deteriorates. The message here would be that demand is falling, the FOMC may suddenly be behind the curve, and that message would argue for moving to neutral more quickly by front loading rate cuts to get the policy rate near neutral faster.

The third scenario applies if inflation unexpectedly escalates, either because of stronger than expected consumer demand or wage pressures, or because of some shock to supply that pushes up inflation. As we learned in the recovery from the pandemic recession, when demand was stronger and supply was weaker than initially expected, such surprises do occur.

In this circumstance as long as the labor market isn't deteriorating, we can pause rate cuts until progress resumes and uncertainty diminishes. So most recently we have seen upward revisions to GDI, an increase in job vacancies, high GDP growth forecast, a strong jobs report, and a hotter than expected core CPI report.

This data is signaling that the economy may not be slowing as much as desired. While we do not wanna overreact to this data or look through it, I view the totality of this data as saying monetary policy should proceed with more caution on the pace of rate cuts than was needed at the September meeting.

I'll be watching to see whether data due out before our next meeting on inflation, the labor market and economic activity confirms or undercuts my inclination to be more cautious about loosening monetary policy. Now whatever happens in the near term, my baseline still calls for reducing the policy rate gradually over the next year.

The median rate for FOMC participants at the end of 2025 is 3.4%, so most of my colleagues likewise expect to reduce policy over the next year. There's less certainty about the final destination. The median estimated longer run level of the federal funds rate in the committee's survey of economic projections is 2.9%, but with quite a wide dispersion ranging from 2.4% to 3.8%.

While much attention is given to the size of cuts over the next meeting or two, I think the larger message of the SEP is that there is a considerable extent of policy accommodation to remove in the coming year, and if the economy continues in its current sweet spot, this will happen gradually.

Thank you again for the opportunity to be part of today's conference and for allowing me to share some thoughts relevant to monetary policy rules and my day job back in Washington. The shadow committee has elevated the public debate about monetary policy. May you continue to, to play that role for many years to come.

And thank you.

>> Athanasios Orphanides: Thank you, Chris. So this was a wonderful talk before our main course is served. But thank you also for agreeing to take a few questions. And I'm gonna start with a couple and then.

>> Christopher Waller: With all the sharks in the room.

>> Athanasios Orphanides: Yep, well, I'm gonna ace things.

I do not consider myself a shark in this setting, but I do want to start with the issue that you mentioned that, the economy is stronger than you thought, and this raises some questions about the stars. So first, perhaps policy has not been as restrictive as the Fed previously thought over the past couple of years.

Second, and you gave some data on productivity, perhaps productivity trends have started to shift. Both of those considerations have major implications about what the neutral rate is and would shape what the outlook for AIDS is. Based on the three scenario you have, can you tell us a little bit about how you think about this?

How have recent data, the last years of data Influence your thinking of the uncertain stars.

>> Christopher Waller: Right, so let me just start with productivity. So we've seen a reasonable number of quarters with two plus percent productivity growth. But you gotta remember, we had three quarters of negative productivity growth.

So the level of productivity was here. It drops, it comes up. Okay, it's gonna look like it's growing really fast. If you look from the first quarter of 2021 to now and look at the annualized growth and productivity, it's 1.7%, pretty much what it was for the previous 20 years.

So I hope this continues. But right now, a lot of what I think we're seeing is just a rebound from a bunch of quarters of negative productivity growth. But for the good of the economy, that's what I would really like to see is this continue on. Now, in terms of R Star, I sometimes feel like this is we could sit here and argue about this all day long and get absolutely nowhere.

But at the end of the day, you kinda have to have some idea of what it might be to go forward. Now, I gave a speech in Iceland back in May where I talked about R Star and where I thought were the causes of the long run decline in R star, and then ask a simple question.

Given that these are the causes of this long run decline in the real return on safe, liquid government debt, what are the factors that would reverse that and drive up R Star? Now, for me, the biggest concern I have would just be the unsustainability of fiscal policy. If the supply of treasury starts growing faster than the supply of demand or the demand for these treasuries, there's only one thing that tends to happen.

Prices tend to fall and yields tend to rise. So for me, the biggest threat to R Star down the road is unsustainable fiscal policy.

>> Athanasios Orphanides: Yeah, thank you for that. I'm gonna pile on on the R Star issue, but with a new angle. In your remarks, you focused virtually exclusively on interest rate policy.

And the policy rules that you mentioned are all interest rate rules. But of course, since then, global financial crisis, and with the effective lower bound constraints to policy, the Fed has been relying on balance sheet policies as well. Both to provide tremendous additional accommodation after the global financial crisis and then with the pandemic, and also to restrict monetary policy by shrinking its balance sheet.

And one of the questions this brings is, how do you see the new normal on the balance sheet? I feel like the Fed has not been communicating as much about that as about interest rates. But of course, we need to have some information about what the new normal balance sheet size is in order to determine how it relates to the neutral rate.

Since the two are linked, two tools can provide accommodation. If you fix the normal rate at a different level on the balance sheet, you're gonna have consequentially the different estimate of the neutral rate at the same time. How do you think about this?

>> Christopher Waller: Right, so the first thing I'd make on the balance sheet is we wanna make a distinction between the size and the composition of your assets and liabilities.

If our balance sheet was the current size and it was all currency, you wouldn't be talking about R Star or anything like that. So the size is not the issue. It's like, what are you buying? What are you holding that somehow is affecting market rates? So I think that's the first question.

Not the size, but what are you holding that somehow does this? Now, I've said this, and if somebody can prove me wrong, let me know, cuz I've been saying this for years. There is no economic theory for how large the central bank balance sheet should be. And we have examples in the world of central bank balance sheets that are 100% of GDP and they're running very low inflation.

They don't seem to be causing any problems. Switzerland, where'd you go? So it's not obvious just from looking around the world that the size of a central bank's balance sheet drives the performance or outcome of a lot of these variables. Now, in terms of the balance sheet, a lot of what we did was when you're at the zero lower bound, you're trying to put downward pressure on longer term rates.

You go out, you buy, you try to push up the price, drive down the yields. How big of an effect that is? Various estimates have about a trillion dollars of purchases, might give you 25 basis points. So it has potentially some effect. It's not clear it has a really big effect.

So if you take a trillion dollars out, it can't have really a potentially big effect either. Now, a lot of times when I talked at the US monetary Policy forum back in February 1, of the arguments I made, and I personally think a lot of this is like putting out a fire.

You have a bad economic outcome, you pour water on the fire, and then when the fire's out, you drain the water away. And when the water drains away, the fire doesn't restart. And that's the asymmetry of policy actions at a time. They do certain things in one direction that they don't necessarily have the same effect going the other way.

So I think right now, a lot of what we're doing in shrinking the balance sheet, we're just draining all this liquidity that we put in the system. And if we tell the markets like we did in 2022, roughly how much you're gonna take out, at what pace you can price it in immediately.

If you go back to when we put this out, long term treasury went up about 37 basis points based on about $1.7 trillion expectation. Sounds about what the estimates were.

>> Athanasios Orphanides: Okay, and we do have a few more minutes for questions from the sharks in the audience.

>> Athanasios Orphanides: Who would like to identify themselves as a shark in the audience?

Yes, please.

>> David Beckworth: David Beckworth, so back when this inflation began or when the attempts to create it began, you had a paper that came out that said that you could do this without creating a lot of unemployment.

>> Christopher Waller: Yep.

>> David Beckworth: And some prominent names pushed back against you.

>> Christopher Waller: Yep.

>> David Beckworth: Colorful claims, yes. So how do you feel now?

>> Christopher Waller: Vindicated.

>> Christopher Waller: I mean, no, in May of 22, I gave this speech wherever by using beverage curve analysis, which, trust me, at the time, most media didn't even know what it was. Now, they all know.

It was this argument that we're on this very steep portion. The beverage curve is a very nonlinear function from a theoretical model. And I was just arguing we're on this vertical portion of this thing. And as long as the involuntary separation rate didn't go up, you could just slide right down this beverage curve by putting downward pressure on demand and labor demand, and it would show up through reduced vacancies.

In that May 22 speech, I said, if we get back to where we were in 2019 in terms of the vacancy rate and jobs ratio, unemployment would go to 4.4%. I was wrong. It went to 4.1. So, I mean, that was what I claim, that's good theory. Good data work leads to good policy-making.

So, in that sense, that is what happened. But now, you've come down the steep part. Now, you're looking at the flat part. So if you continue to have this reduction in demand and labor demand, you're gonna start moving, and you'll see I have to stick with my own model.

You're gonna start seeing more unemployment, and that's suddenly why we're worried. I'm sitting here saying, we're in the sweet spot right now, we got to keep it there, that's our job. Go ahead, you got the mic.

>> Lorenzo Giorgianni: Thank you. Lorenzo Giorgianni with Tudor. Just wanna put you on the spot a bit.

So in the speech, you highlighted a modal scenario, which envisages deliberate cuts. You used the word gradual many times in your speech. You're now endorsing quarterly cuts, meaning we're skipping November.

>> Christopher Waller: I didn't say anymore quarterly.

>> Lorenzo Giorgianni: Okay.

>> Christopher Waller: I don't think I said the word in my speech.

>> Lorenzo Giorgianni: No, that's why I'm asking whether you can clarify what gradually deliberate means.

>> Christopher Waller: Eh, it's in the eye of the beholder. That's for you guys to figure out.

>> Lorenzo Giorgianni: That's fine. Second point, if in fact that means quarterly, and so the idea is to skip November, there is a considerable risk, I would say 50% risk, that on the day of the meeting you will have seen on the screens in Bloomberg markets moving 25 30 basis points up in yields with a significant tightening of financial conditions depending on the election outcome.

So how do you, in the speech you highlight a number of economic considerations that guide the decisions of the Fed. How would you weigh in the financial conditions side of it, which might actually jump in your face on the day of the meeting?

>> Christopher Waller: Yeah, I mean, as far as I know, no policy rule in this audience would say you react to the election.

I just don't see what it is. It would have to show up at some point in the form of inflation, unemployment, GDP growth. That's what goes into a policy rule, not the election per se. What you were just describing would be to something to say, we're gonna use discretion and, okay, we're gonna move the policy rate because of this one event, the day before that to me would be problematic.

So I don't see myself, I can't speak for anybody else, but I don't see us doing anything in response to the election in and of itself.

>> Athanasios Orphanides: Thanks, Chris. So I'm gonna take two questions before you answer. So first yes, and then the second.

>> Audience 1: I love your reference to constructive ambiguity, but I remember Greenspan having a slightly different take on it, which was purposeful obfuscation, which I thought was a more accurate term, at least these days.

In the spirit of Athanasios' question, it does seem that almost to a person at the Federal Reserve or on the FOMC, there's a minimization of the importance of the balance sheet at this current point in time. And your answer of water that puts out a fire but then sort of drains away, or your metaphor seems to be very consistent with that.

I wonder in your risk management exercises and how you think about the balance sheet, you often step back and say, well, maybe we're all wrong on that. Maybe the balance sheet actually was the reason policy wasn't that restrictive over the last few years. That the balance sheet exerted additional pressure, positive pressure on the economy, even as we were raising rates, and that all of these new balance sheet tools actually have enormous impacts on financial markets and the economy.

And we're really underestimating how restrictive we were and are. And that as we take that away, we really have a lot of risks to consider, that we do that in a careful way and not too quickly, like we saw back in 2017 and 2018, when we did it a little quickly and things got messy.

I just wonder how, how does that risk management of not understanding, and I'm a big believer in not understanding exactly how balance sheets work and how money and monetary policy works and how we bring money back into the debate on policy because we've left it aside. And it seems to have been a big part of everything that we've seen in the last 15 years has been balance sheet related.

So how do you think about that?

>> Christopher Waller: Well, I say-

>> Athanasios Orphanides: Thanks, but would you like to respond directly and then go, I don't care, you're running the thing? Well, so I thought this is such a long and deep question that you may want to have another 30 seconds to reflect on it.

So let's take the second question as well.

>> Jack Krapanski: Hi, my name is Jack Krapanski. What do you say to people who look at the persistently elevated prices so that even if the rate of inflation is low, some people may look at the high price level and say, that's not really price stability?

Is that the Fed's job to do something, or is that somebody else's job to do something about those elevated prices?

>> Christopher Waller: Yeah, when I gave a talk at Brookings last January I think, the idea that you have a permanently elevated price level because of temporary supply shocks just sounds wrong.

I mean, if they're temporary, they go away. Prices should readjust back down to the previous price level. So to me, that's always been a signal. There had to been a lot of demand involved in this inflation that drove up instead of it's just all supply now. It is true.

I mean, our job is not to be price level targeters. That is not our objective. We look like we did. We saw some graphs earlier in the conference today that looked like for long periods of time, the Fed was on a pretty good price level targeting path, and then it veered off by various points in time.

Now, in terms of the high prices that's again, one of the distinctions, price level effects versus inflation affects longer term. I get it. I go to the grocery store too, right? And there's stuff that I buy that I look at and go, I'm not paying that. I can afford to, it's not that I can, I just refuse to.

So I am, I understand where people who have a harder time being able to afford it have to be really angry about this. But the price level is what it is. It's going to be very hard to try to say, I want to go back to 2019 prices without doing some pretty dramatic, drastic monetary tightening.

And I don't know if people would really want to see, say, interest rates of 12 or 14% to get it back to 2019 levels. So that's kind of the problem you have with it right now. On the balance sheet, let me turn back to that. I mean, right now, the thing we worry about mainly is is there sufficient liquidity in the financial markets to function properly?

And we've slowed down the pace because we didn't wanna drain it too fast and then suddenly get some financial market dislocations like we saw back in 2019. So we're kind of slowed down the pace. We're watching price signals as well as quantity, and we're gonna slowly keep trying to drain it as far in, but we're gonna end up with an ample reserves.

We're gonna have a floor system for reserves that automatically means you're gonna have a much bigger balance sheet than you would if you were in a scarce reserves regime at some point.

>> John Cochrane: John Cochrane, Hoover, so we have noticed that we learned something here, that the inflation, the price level rise seems to have hit the least fortunate harder.

They certainly respond that way in political surveys these days. And that would lead, traditionally, the Fed has had hawks who worry about inflation and doves who worry about unemployment. I wonder if the Fed is watching this fact and if some of your doves are becoming hawks.

>> Athanasios Orphanides: And the last question.

>> Christopher Waller: I can't answer my other colleagues.

>> Athanasios Orphanides: Give me a second, Chris. Let's have the last question as well and then you respond.

>> Colby Smith: Colby Smith with the Financial Times. I just wanted to ask about the third scenario that you sketched out in your speech about inflation potentially re-accelerating or perhaps taking a bit longer to come back to target, and that potentially preempting the conversation about a pause, let's say, how much weight do you put on that potential outcome?

>> Christopher Waller: That's what you have to, that's kind of what you have to sort out. Earlier this spring, we saw this happen. We saw this rebound, and we had six months of very low inflation readings, and then unexpectedly in January, this thing just blows up. First thought, it's January, it's a seasonal, there's something, it's not going to continue.

And then we got it again in February, and then we got it again in March, and then by May, it's back down again. So this has been kind of a weird time for any policymaker because the data is been this kind of volatile. But I want to just point out that since March of 23, at the March SEP 2023, we projected three cuts of for this year.

And that thing hardly moved from March, June, September, December, January, March. Meanwhile, we went through a banking crisis when people said, stop cutting rates or stop raising rates. Sorry, stop raising rates. Then we saw six months of super low inflation and people were calling for cutting rates. We didn't.

And then it rebounded and there were even calls to start raising rates again, and we didn't. So we did not overreact to these kind of wild swings in terms of how we set policy. We never changed the policy rate during that whole period. And the SEP, if you go back and look, was three cuts for 2024 all the way through.

So I don't think of us as being overreactive in the data, because if you did, you'd see it in the SEP or you'd see it in our actual policy actions.

>> Athanasios Orphanides: So please join me in thanking Chris.

>> Steven Davis: My name is Steven Davis. I'm a senior fellow at the Hoover Institution. And I have the delightful and easy task, of moderating these three distinguished gentlemen with deep careers in central banking. And all of whom have made important analytical contributions to monetary policy, and central banking as well.

We're going to kick off with Jim Bullard, Dean, Purdue University Business School, and former president of the Federal Reserve Bank of St. Louis. After Jim, we'll turn to Andy Levin of Dartmouth College. Although, Andy has asked that if Jim hits it out of the park, he'd like to go last, but I think we're gonna make him go second.

And then Athanasios Orphanides, currently at MIT, will round it up. Jim, it's all yours.

>> James Bullard: Great, thanks very much. This is called Jim's view of the world I think, or intellectual leadership and its influence on Fed policy in the post war era. So I'm gonna try this out on you, see what you think.

In his book, the Age of Turbulence, Alan Greenspan relates an anecdote concerning his days as a graduate student in economics at Columbia University in New York, in 1950 and 1951. Greenspan was pursuing an economics PhD, which he says was a go to degree, for a person with ambition in economics.

Even at that time, his graduate advisor was future Federal Reserve chair Arthur Burns. Burns was a full professor, and an important figure in macroeconomics. Having published his book, co-authored with Wesley Mitchell, on business cycles and their measurement just a few years earlier. Greenspan describes Burns as an avuncular, pipe smoking professor.

He also says Burns liked to challenge his graduate students in class. One day, Burns asked the class, what causes inflation? There was no answer. Burns puffed on his pipe. Finally, he declared, excessive government spending causes inflation. Turbulence and Greenspan's personal life caused him to drop out of Columbia.

But this pre-monetarism anecdote has stuck in my head as an indicator of the immediate postwar mindset, regarding monetary policy, namely, that inflation was entirely a fiscal phenomenon. A few years later, in 1958, the St. Louis fed hired Homer Jones, to be the director of research. This was an attempt, ultimately very successful by the bank to enter the world of academic style research, in order to apply that research to problems in monetary policy.

Eventually, this paid off with the publication of the so called St. Louis model, Lionel Anderson and Jerry Jordan. For many years, this was the most widely cited paper in all of macroeconomics. The results there indicated that monetary variables were statistically more important than fiscal variables. With this and other innovations, intellectual leadership of monetary policy shifted toward monetarist ideas.

By 1979 with inflation in the US around the world running out of control, this intellectual leadership entered the practical policy realm. As the FOMC embarked on, a quote monetarist experiment, end quote, under then chair Paul Volcker. The experiment would put more emphasis on monetary variables, and was ultimately successful in vanquishing inflation.

The Volcker disinflation was a searing intellectual experience, the central macroeconomic event of the post war era in the US. It leaves a large imprint on today's macroeconomic thinking. The central theoretical lesson was the importance of credibility in achieving satisfactory monetary policy outcomes. That insight came most directly from Finn Kydland and Ed Prescott in their 1977, Time and Consistency paper in the JPE.

The paper stressed that, failure to deliver on promised policy would be understood by an intelligent and forward looking private sector, ultimately defeating the policymaker desires. This insight led to an entire literature on monetary policy games, and was cited as part of the Nobel Prize awarded to Kydland and Prescott in 2004.

When we say that the Volcker disinflation was successful, it is in the sense that the chaos of the 1970s was put behind us, and a new era dawned. It was not just that Volcker ended the high and variable inflation of the 1970s. The period from late 1960s, to the early 1980s was characterized by significant volatility on the real side of the economy as well.

Later, the empirical literature would reveal that the pre-Volcker US economy, was more volatile in a statistically significant sense. When compared to the post-Volcker economy, for both real and nominal variables. While there were four recessions in the 13 years, from 1970 to 1982, it would take about 40 years for the next four recessions to occur.

The Volcker disinflation was also painful, the 1982 recession, ultimately drove the unemployment rate to 10.8%. And it created the clear impression among generation of academic economists, as well as most global financial market participants. That a large recession was necessary, if the committee wished to reduce inflation from a high level.

The clear implication was that, one must not let inflation get out of hand, or even begin to get out of hand. This led to an age of preemptive actual monetary policy. For instance, ECB Bank president, Jeanne Claude Trichet, often used a phrasing that insisted that the central bank must remain especially, vigilante, quote.

Concerning inflation developments as another example, the campaign led by then chair Janet Yellen, called for increasing the policy rate in 2016 and 2017 when actual inflation remained below target. In one of the most important papers of post war macroeconomics, Thomas J Sargent, argued in 1982. That expectations alone, could be shifted by an agile policymaker, and that such a shift could be an extremely powerful policy tool.

This method had the potential to end high inflation without recession. Sargent produced historical examples from post World War II hyperinflations, in each of these in Germany, Austria, Czechoslovakia, and Poland. In each of these cases, the hyperinflation ended abruptly on the day, or even on the hour, once a credible monitoring fiscal regime was put in place in each country.

These disinflations did not have anything to do with Phillips curve effects. Sargent's recommendation from the ends of four big inflations paper did not work for Volcker. The Volcker FOMC was not able to end the double digit US inflation on the day, in the manner of the European economies.

This is because, good friend and King argued in 2005 JPEG paper, the Volcker disinflation was, quote, incredible. Volcker had to earn back the Fed credibility that had been squandered during the 1970s. Nevertheless, Sargent's insight would prove useful in the monetary policy response to the post pandemic inflation of, 2021 to 2023 in the US.

A point in time where the Fed had considerably more credibility. Good things came from the intellectual journey that led to the Volcker disinflation. The searing experience had taught macroeconomists that commitment and credibility were important. Perhaps the most important aspects driving satisfactory monetary policy outcomes was also important, as monashrists had emphasized, to assign responsibility for inflation outcomes to the central bank.

It was, after all, Paul Volcker, the Fed chair, and not the treasury secretary or the Senate Finance Committee, that ended the inflation. As these ideas began to be widely understood, some simple extensions began to be considered. If credibility and commitment were important, should the central bank simply state an inflation target and take consistent action to achieve it so that observers of monetary policy could plan accordingly?

By the early 1990s, the answer to this question was a resounding yes, and inflation targeting swept the global monetary policy. This process was aided and abetted by the European decision in the aftermath of the fall of the Soviet Union to create by treaty a unified monetary policy union.

Inflation targeting has been arousing success. Inflation targeting countries have had lower inflation and inflation closer to target than in the pre-inflation targeting era. Countries that bucked the trend, including, at times, Turkey, Argentina, and Venezuela, ended up with considerable inflation. Imitation is the sincerest form of flattery. Success in St. Louis with academic style research caused other banks and the board of governors to get into the research game.

Beginning in the 1970s, perhaps most notably, the Minneapolis fed began to partner with the University of Minnesota, and asked some of the professors there to work with the research team at the bank. This partnership led to a proliferation of new, innovative ideas that are still shaping the contours of macroeconomics today.

By the time of the publication of Chris Sims Macro and Reality paper in Econometrica in 1980, and Tom Sargent and Neil Wallace's Some Unpleasant Monetarist Arithmetic paper in the Minneapolis Fed's quarterly review in 1982, intellectual leadership had shifted again. This time the shift was toward deeper and more unknown territory.

These papers were methodological in nature, the macro and reality paper argued that the identification assumptions underlying most macro empirical work were, here's that word again, incredible. The pleasant monetarist arithmetic paper made monetarist assumptions, but found that because of monetary fiscal interactions, policy conclusions could be distinctly non-monetarist. Their paper brought up other issues about multiple steady states and long run rest points of the economy.

The important point was forcefully made, and intellectual leadership was seized. To truly get policy right, we were going to have to get more serious about the model building aspect of macroeconomics. Around this time, Bob Lucas remarked that, quote, when it comes to giving policy advice, we are in way over our heads.

And indeed, more serious models were produced, notably, when Caitlin and Prescott produced their real business cycle paper, published a real business cycle paper in Econometrica in 1982. Here was a coherent, micro-founded DSGE model that the authors argued fit the macroeconomic data relatively well. And shockingly, there was no effort to include monetary policy in the model at all.

Perhaps even more shockingly, the equilibrium study was Pareto optimal, meaning that despite the business cycles embodied in the model, there was no role for policymakers to play. When Cooley and Hansen published their version of the RBC model with money in the AR in 1989, they found that the monetary aspect did not affect the cyclical variables of the model.

This recalls Ronald Reagan's off-eased lament, sometimes I think we should just all go home. The lesson was clear, generally speaking, markets are going to do a very good job of allocating resources in the economy. This is true considering dynamic stochastic settings. To study a role for policy, there has to be something wrong, some aspect of the environment that's preventing the invisible hand from allocating resources efficiently.

This something wrong came to be known as a friction, and the most popular friction for monetary economics, for better or worse, came to be the sticky price friction. Michael Woodford described a model economy in his book Interest in Prices, published in 2003. He wanted to analyze a fully specified dynamic stochastic economy, like Kinlin Prescott, but one which also had an important friction in the form of sticky prices.

He stressed in his introduction that he maintained a type of virtual RBC economy, underneath his economy with sticky prices. This virtual RBC economy, with its Pareto optimal allocation of resources, would be attainable if either the sticky prices somehow became perfectly flexible. Or if the monetary authority followed an optimal policy regime that established the so called Wickslian natural real rate of interest for the economy.

The lesson was once again clear. If one wanted to impute an important role for monetary policy, one had to carefully specify what problem monetary policy is supposed to solve. For Woodford, it's the sticky price problem. This is what gives Woodford theoretical coherence. But in the realm of practical policy-making, it's far from clear that this is the type of role that is being ascribed to the FOMC.

Instead, the FOMC cites the mandates written into US law, which include stable prices. Woodford's argument was that by pursuing a solution to the sticky price problem, the central bank would end up stabilizing prices. The new Keynesian model came to dominate discussions of monetary policy, provide intellectual leadership in the field, and provide insight for actual monetary policy discussions.

The Taylor rule, developed in John Taylor's 1993 paper, could be incorporated into the new Keynesian framework to give practical recommendations on real time monetary policy decisions. Monetary aggregates did not play a direct role, but in some circles the model was considered new monetarist. Because the way it adhered to many monetarist principles, not the least of which was that the monetary authority had the main responsibility for inflation outcomes and had to maintain credibility with respect to those outcomes.

Many critical views of Federal Reserve policy characterized the FOMC as careening from one policy blunder to another. Little or nothing seems to go right in each decision by the committee is a fraught affair that could sink the economy or lead to unstoppable inflation. The critical view is summed up in Rudy Doernbush's famous quip, expansions don't die of old age, they're murdered by the Fed.

Yet in the last 20 years there have been just two recessions, both of which have clear causes. The global financial crisis stemmed from weaknesses in the us non-bank financial sector, not something under the direct control of the FOMC, and the pandemic was a natural disaster. Did the new Keynesian consensus get enough of the pieces together to inform a reasonably stable monetary policy for the US and other countries?

Has the Holy Grail been attained, to the extent that it can be? Perhaps, but the most recent candidate for a policy mistake is not the murdering of an expansion, but the fueling of an inflationary outburst in 2021 to 2023, of a type not seen in the US since the Volcker era.

How did it happen? I've argued elsewhere that the pandemic should be viewed as a war, and that the combination of wartime finance and low interest rates to support the war effort, is known to produce inflation across many different times and places. To end the inflation, fiscal rectitude had to be restored to its pre-war level, and in addition, monetary policy had to return to orthodoxy.

Both of these conditions occurred as divided government returned to the US after the 2022 midterm elections, and the Fed began raising rates aggressively during 2022. Inflation began to fall simultaneously with these developments and without a recession. As sergeant had suggested, the aggressive moves by the FOMC during this period shifted expectations back to pre-pandemic norms, to an extent large enough to bring inflation under control.

I'm gonna stop there. Thank you.

>> Steven Davis: Thank you, Jim.

>> Andrew Levin: Well, first of all, I just wanna say thanks to John Taylor and to Marie Christine, a really remarkable conference. I feel really fortunate to be able to participate. And actually thanks to Steve for herding cats on our panel today.

So my remarks are gonna be drawn from work that I've been doing over the last year and a half with Christina Skinner, who is a legal scholar at Wharton. I'm really proud that actually our article is gonna be published in the Vanderbilt Law Review next month. So I'm patting myself on the back.

I get to have a law journal article on my resume. It's more than 50 pages, but I think a couple hundred footnotes. So I'm not sure I wanna urge you to go read it. But actually, a synopsis, executive summary of it's been recently posted that Mercatus, thanks to David Beckworth and his colleagues.

So you could look at that one. Anyway, I'm gonna talk about this briefly, and anything I say that's intelligent and wise, you can attribute to Christina. And anything else imprudent or unwise, I'll take responsibility for. Okay, so the bottom line message is pretty simple as far as I'm concerned, which is the Federal Reserve needs an external review.

Let me just repeat it again. The Federal Reserve needs an external review. So there's been a lot of attention recently to the feds getting started with doing another internal framework review. So in these remarks now, I just wanna kind of make the case here why I think an external review is needed.

And I saw Roger Ferguson last night. I guess he might be here somewhere. He was one who came to the Federal Reserve and brought us management 101 principles. And the idea of external review, as far as I'm concerned, is management 101. Like whenever you have an organization, a good organization, hospital company, it doesn't matter what it is.

Occasionally you bring in outside consultants that take a look, and ideally the CEO of the board say, look, take a look at everything, and tell us what we can do better. Simple, and so the ideal here really would be for the Federal Reserve to welcome an external review.

Chair Powell, this fall, sometime could, at a press conference or a speech, just say, we welcome an external reviewer, and here's how we think it could be done. Another possibility is that the Fed has a boss. Congress is the Federal Reserve's boss. The Fed is not an independent branch of government.

And I think all of you know that from elementary school, there's only three, executive, legislative, judicial. Under the Constitution, the MACHE policy's actually given to the Congress as a constitutional duty. Congress has delegated that duty to the Federal Reserve. Congress is the Fed's boss. And as the Fed's boss, Congress should be requiring the Federal Reserve not just to do a one off, but to do regular, comprehensive external reviews.

Okay, so why? One of the things I heard all the time when I was at 20 years in Fed staff, if it ain't broke, don't fix it. Okay, I think when we look back at these last five years, we can see several major things that deserve an external review.

One of them is risk management. I actually thought that Governor Waller's talk today at lunch was fantastic, because I've been advocating for more than ten years, the Fed should be doing scenario analysis and contingency planning publicly. In fact, I think we heard about that at the Hoover conference back in May from President Goolsbee.

I would be thrilled if chair Powell would announce this fall that part of the internal framework review that the Fed will be doing is to look carefully at how they're gonna incorporate risk management into the public communications. Now, Mickey and Mike Bordeaux and I wrote a paper in June of 2020.

We actually gave it a shadow of me, I think maybe more than one. It's an MDR working paper and a Hoover working paper on scenario analysis. I'll give all the credit to Mickey and Mike, because actually, at the time, I was worried that we were heading into another Great Depression.

I was pessimistic about vaccines coming. They were actually optimistic and turned out to be right in January 2021. Actually, between December 27th of 2020 and March 15th, if I remember right, of 2021, the Congress put in place $3 trillion in fiscal stimulus in a course of three months.

Completely unprecedented. The Federal Reserve should have been already in the late fall, but certainly by winter and early spring, asking hard questions about how this might change the outlook. I just heard a talk at Dartmouth the other day, Karen Dinan and Doug Elmendorf talking about the fiscal stimulus and how extraordinary historic it was.

It just pleaded for the Fed to be doing a big rethink already at that time, and they didn't. Okay, so risk management of scenario analysis continuously playing, has to be done. By the way, you all know the Bank of England just had an external review. Wow, who did it?

I'm used to teaching, I'm sorry, someone raised their hand. Like who did it? Like in my class, I was going, no, I'm gonna call on you. I asked someone. Okay, so we all know our good friend, colleague, Nobel Prize winner, Chair Bernanke, did the external for review for the Bank of England.

What did he recommend? Scenarios announced contingency planning, improvements in forecasting. Why can't the Federal Reserve just ask him to come in and look at the Fed? Or ideally I think it would be better because of course he's not completely an outsider. To get three academics, maybe John Taylor, we could pick randomly, probably from this room, three or four or five people, just volunteer and send them in to be a team.

Chair Powell could announce that tomorrow or next week. Maybe he has to take a little time to get it together. Okay, but it could be done. Okay, number two, cost benefit analysis. The federal reserve's policies are gonna cost the US taxpayers over a trillion dollars. And when Bill Nelson and I first started working on this, it was kind of controversial, like, how could that be?

But now it's clear on the Fed's balance sheet. They've already had to borrow a couple hundred billion dollars. What I teach, and we all know this from econ one, is opportunity costs. So you can't just count the direct magic asset of the Fed, you got to look at how much would the Federal Reserve be paying in remedies right now if they hadn't done QE?

And so the cost of $1 trillion is real money, it's not just kind of paper losses here, we're talking about real cost to taxpayers. Did the Fed do cost benefit analysis before they put the program in place? Have they done it since? Now we're three years past the conclusion of the program, we still haven't seen it.

Fed Chair Powell could announce tomorrow or next week that the Fed is part of its framework review doing a cost benefit analysis ex post of that program, but then with implications for the next time around.

>> Andrew Levin: Three, there's the policy deliberation process. I'm very troubled still by the fact that there were no dissents during 2021, I'm really troubled by it.

It was a very complex period. There were people outside Larry Summers on one end, and I'll say, Mickey and Mike, maybe in the middle somewhere, or a little bit on the other end, okay? But reasonable, smart, intelligent people raising questions. Why was there not a single dissent within the Fed?

And I think the answer is because the way that the policy making process works is not the way Congress intended. Congress intended it to be an independent commission. The members of the Federal Reserve Board have 14 year terms, the Congress imagining that they would be like federal judges, everyone individually accountable.

The whole idea of consensus and unified kind of we're gonna have all our decisions behind closed doors, and then we're gonna present a unified front to the public. No, that is not what Congress intended. And it wasn't just 2021. It's amazing to me, it's troubling to me that we have 12 Federal Reserve bank presidents today, and they're all smart people, wonderful, amazing people, but not a single one of them has dissented from any FOMC decision.

I mean, in this room, I guess we have, let's see, Charlie Placer, I think, is here, how many times he dissented? Tom Hanek, how many times he dissented? I know Loretta dissented a few times. Jim Poehler, we all know he's dissented. And Charlie Evans, and we could go down the list.

How come not a single one of the 12 who are there now are dissenting? The Fed needs an external review. It has to encompass the selection process for the selection of the Federal Reserve. It should encompass the budgeting. I'm really disappointed that Ed Nelson is not here today.

Does anyone know why? He was invited, he was on the program, it's public knowledge cuz it was the email, okay? He said that he was unable to come because the Federal Reserve board changed their travel expense policies. And in effect, the Federal Reserve Board said they couldn't afford to send him here today, that's what it really boils down to.

And this is, of course, part of a broader effort to tighten the Fed's belt. I guess the phrase they would use, tighten our belts, which has also affected the recruitment of research economists to the 12 regional feds. I'm troubled but I don't think this is the right way.

If the Fed needs to tighten its belt to save, what, $500 or $1,000 for Ed not to be able to come here to this conference, not the right way to do it, especially if they've lost $1 trillion, it's just peanuts. Okay, they need an external review. Now, let me just say briefly, why can't the Federal Reserve do this itself?

And I think the answer we know, by the way, I think this was Tom Honeck at lunch today, he said, if he had it to do over again, he got a PhD in economics and math. Sorry, where's Tom? Am I remembering right? Okay, and he said he kind of wished, in retrospect, that he got a PhD in psychology.

And I totally hear, by the way, some of my best students at Dartmouth are joint majors in econ and psychology. Is because we know from human nature, it's very difficult to be critical of yourself and your past decisions, it's just difficult to do it. And some people are willing to do it, but it's not that easy to take an honest objective.

It's a lot easier to ask a friend or a colleague or someone you trust to do it. The Federal Reserve should initiate an external review. They don't have to wait for their boss, which is Congress, to do it. The Federal Reserve should initiate it. And there are plenty of people on the Earth, maybe some of the central bankers that we heard from earlier from other countries, some are in the audience here from Switzerland or Norway or Canada or whatever.

Pick it, a random out of a hat and a few academics, okay, and open the doors, then give them complete access to everything. And ask them to write a public report that would go to Congress, which is the Fed's boss. And the Fed could respond to it, and the Fed might not agree with it all, but this is management 101 again.

Because when you hire management consultants and they come in, if it's a well done process, you can set it up where you say, I'm gonna tell you what we really want you to write and make sure this is the, no, that's not good, right? What you actually do is you ask the management consultants to take a complete look at everything and come with their honest view.

And you don't have to agree with their conclusions, but it's helpful to provoke discussion and serious consideration. Okay, so last point here. The Fed should have regular external reviews, and they should be done by the Government Accountability Office, which reviews every other US federal government agency, including independent ones like SEC and FDIC.

They're all subject to comprehensive reviews by GAO. Why shouldn't the Federal Reserve be subject to comprehensive, regular reviews by GAO? You could put some protections in place to make sure there's no political interference, but take advantage of them. GAO reviews NASA, GAO is reviewing right now the use of AI in the federal government's law enforcement, cuz AI is now being used for fingerprint detection and facial recognition.

I would say, look, if JL can do rocket science and they can do AI, then they should be competent. And maybe they need to hire a few consultants to help them, but they could do regular, comprehensive reviews of the Fed. The others are fully independent IG. I'll stop there, but again, I hope this is a very simple, clear takeaway, the Fed needs an external review.

Thanks.

>> Steven Davis: Thanks, Andy.

>> Athanasios Orphanides: Thanks, Steve. So, it's a great pleasure to be here. I'm gonna start by saying that I agree with virtually everything both Jim and Andy have said. But instead, I'm gonna use slides, and I will try to focus on the topic of the session, which I understood to be the Fed's evolving interpretation and implementation of its mandate.

So, I'm gonna start with the picture, which is the picture I usually start from. I'm just taking it back to the beginning and ask you to simply have a look at the Federal Reserve's record in maintaining price stability since the founding of the Federal Reserve. Of course, we know that this record is checkered, and I want you to see there.

I don't think I can point here. But I want you to see, we have the recent episode, the post pandemic inflation is one spike. We have the great inflation episode is another one. And I want you to see two before. We have one in the early days of the Federal Reserve and another one in the 1940s.

So what I want to do is mention that, first of all, you can see there has been an improvement in the Fed's record in delivering price stability since the founding of the shadow 50 years ago. I mean, if it were not for the post pandemic policy error, I think we would have been giving the Fed a pretty good grade for managing this.

So this is the first thing I want to do. But then the second thing I want to do is link these performance and the occasional policy errors, including the latest one, to the evolution of the interpretation of the Fed's mandate. And to do that, I will put out the actual three key pieces of legislation that give the statutory mandate of the Federal Reserve.

1913, 1946, the Employment Act, 1977, with Humphrey Hawkins, the adjustment to that. But then focus on the fact that really, if you have a look at this, you're going to realize that over its history, the Fed has operated with a statutory mandate that has not explicitly recognized price stability as the primary goal of monetary policy.

If you check the current law from 1977, price stability is one of three objectives that are there in parallel. So starting from this element, this is different. This depends on the central bank, how it's done. This is the case for the Fed. Starting from that, we need to realize that the Fed's success in delivering price stability and fostering the good economic performance that is associated with it has rested over the past 110 years on the interpretation of its policy strategy.

Critical issue is at what times in its history the Fed has focused on systematic policy, focused on preserving price stability with modest countercyclical stabilization. And on what periods it has not acted in this fashion. And what I want to argue, and I will give you a few examples, is that at times the Fed avoided the temptation to overreach and focused on defending price stability as a means of fostering growth and prosperity.

I'm gonna identify briefly, before the founding of the Shadow, in 1950s, to have been a period like that. And then since the founding of the Shadow Open Market committee, I would identify the Greenspan-Volcker era like that. And this is the period that corresponds in some respect to what Bob Hetzel in the previous session was describing as the leaning against the wind kind of approach.

And we see episodes like that. But then at other times, the Fed has interpreted its mandate in an over ambitious fashion, raising expectations about what it can do that were beyond what is feasible to do with monetary policy. And I'm gonna identify the 1970s as a period like that.

In the recent years, when I look at the 2020 strategy review under Chair Powell, I see, yep, this is yet another example of overreach reaching to this point. Let me actually start by going back. One of the sources that I found very useful for understanding the Fed's thinking and communication of its strategy is to look at successive editions of the Federal Reserve System, Its Purposes and Functions.

So this is a quote from the first edition in 1939. Now recall 1939, the mandate of the Fed was accommodate business, no mention of price stability anywhere. And the Fed was struggling to find out a way to interpret its mandate to do reasonable policy. And you can see how they interpreted it.

They interpreted the mandate in a way by saying, well, really what you need to do is understand what the role of all government policies. And for the Federal Reserve really is to maintain monetary conditions favorable for an active and sound use of the country's productive facilities, full employment mentioned explicitly.

And a rate of consumption reflecting widely diffused well being. This is wonderful, wonderful language. Of course, the 1930s is exactly the period when the Fed committed its worst series of policy errors. This actually shows you a little bit of a disconnect of the nice language about what the intent may have been, but also the fact that they totally missed it.

And this is an illustration that good intentions do not imply good policy. In this case, you're gonna see that there is no mention of price stability anywhere. And from today's perspective, and based on what the shadow market committee has been pushing the last 50 years, that's where you start if you want to have good outcomes.

And that was totally, totally missing. Now, I already showed you before, 1946 was a major change. After the disaster of the Great Depression, after the war, the enactment of the Employment Act made it a legal responsibility for all government agencies to pursue maximum employment. This is what the law was.

But then you have to ask, what was the interpretation? Well, the Fed was actually careful. Even though the law said maximum employment, the Fed did not ever, as far as I can tell, describe what it was doing as trying to achieve maximum employment. So in 1947, in the second edition of the purposes and functions, you see the concept of high level of employment, which is far more reasonable than maximum employment.

This is a way in which the Fed was, of course, trying to respect the letter of the law, but interpreting that in a way that was more reasonable. I'm going to show you one more thing, 1947. I really admire how refreshingly transparent the Fed was with this quote from the second edition regarding inflation.

And recall the first two episodes of inflation that I have shown you. What were those? Well, the first one was the first decade of the feds operations, when the Fed really had to finance World War I. And the second one was the fed financing World War II. Its very clear, and I wish the Fed was far more transparent more recently.

If it is true, as Jim has suggested, that some of the effects of what we saw in the pandemic were like wartime monetary finance. That you can see here, 1947, the Fed is saying, look, we know what our legal mandate is. Prevention of inflation had to become secondary to providing the sinews of war, very, very clear cut.

But then again, despite the wording of the law being from 1946 on maximum employment, in the 1950s era, under Chair Martin, the Fed was trying very hard to interpret its mandate in a more reasonable fashion and get better outcomes. So you can see the third edition in 1954, for example, describing what is the basic function of the Federal Reserve system.

What is it, is to make possible a flow of credit and money that will foster orderly economic growth. That's it, no maximum employment there, of course, recognizing that this contributes to a rising standard of living, and so forth. So what happened later on? How is it that starting from this and with no changes in the statutory mandate of the Federal Reserve, we ended up with great inflation later on?

What happened? And, well, a number of things happened. There were misperceptions, a slowdown in productivity, missing the and so forth. But really, those are technical mistakes, that, if you have a price stability focused central bank, do not lead to a very high level of inflation. They do lead to a very high level of inflation if you also have a difference in the interpretation of the mandate of the Fed.

And indeed, Arthur Burns gave us the answer to that in his anguish speech in September of 1979. So I have here just one quote from that speech, the first paragraph saying, of course the Fed had the power to prevent inflation. Burns was not disputing that. But number two, highlighting the Employment Act prescribes that it is the continuing policy and responsibility of federal government to utilize all its plans, functions and resources to promote maximum employment.

The Federal Reserve is subject to this provision of law, and that has limited its practical scope for restrictive actions. So this was Burn's answer to, hey, I take the law more seriously than everybody else. Too bad if it actually results in high inflation. Of course, we know the law can be interpreted in different ways.

When Arthur Burns delivered this address in Belgrade in September of 1979, people at the board were already working on Paul Voltier's revolution. That happened, I think, two weeks after this speech was delivered. The law didn't change between September and October of 1979. The interpretation of the law changed, and this is how we came back to have a better way of operating.

Of course, we know what the results are during the disinflation, during the chairmanships of Volcker and Greenspan. I don't remember the Fed mentioning maximum employment in any of the speeches, either by Paul Volcker or Alan Greenspan, as how the Fed was operating. Instead, both cases, they were acting as if price stability was the primary mandate of the Fed.

And explaining, as in the quote, I have in the third bullet here, that the reason for going after price stability is because of the maximum sustainable economic growth that we associate with it. And as you would imagine, this was indeed reflected in the subsequent editions of the Purposes and Functions.

If you actually read the version from 1984, what is the Fed's goal? Well, it's to ensure that growth in money and credit over the long run is sufficient to encourage growth in the economy, in line with its potential and with reasonable price stability. This is actually exactly what Bob Hetzel was talking about when he was describing reasonable periods of policy at the Fed.

But of course, things did not change, did not stay like that. Things did change after the global financial crisis. Within global financial crisis and the very high unemployment that resulted, the way the Fed started communicating its objectives shifted quite a bit. In 2012, we have maximum employment showing up.

And in 2020, we have the prominence of maximum employment really being elevated further in various way. Unsurprisingly, you end up with high inflation once you do that. So I'm gonna conclude, I think just looking at this, we can all agree that price stability is essential. The question is how to interpret the Fed's statutory mandate in order to deliver good outcomes over time.

With a current mandate, my view, the Fed can be more successful if it simply avoids the temptation to overreach. It has done this successfully in the past. It can benefit from clear definition of price stability, 2%. But some of the other so called improvements, especially in the 2020 framework, the Fed can probably do better without, thanks.

>> Steven Davis: While the speakers are coming back to the stage, those are three engaging talks. I'm gonna ask the first question, and it relates directly to Jim's emphasis on credibility, or its absence in the conduct, successful or unsuccessful conduct of monetary policy. This idea of credibility, the way Jim told the story, it's kind of a nice storytelling after the fact, for when inflation fighting was successful and when it was not, and it sounds persuasive.

That's really the way you think about monetary policy. Then why doesn't the Fed and central banks around the world devote enormous energy to assessing in real time the credibility monetary policy stand? Now, it's not enough just to look at expectations for a couple of reasons. Expectations central banks do a lot of, that tells you about central moments.

Expectations derived from financial markets tell you about the marginal participants. Credibility is more encompassing than just expectations. Make this point with a concrete example. You're standing in the middle of 2020 or late 2020 before the vaccine was announced, there was tremendous uncertainty as to. Even in 2021, there was still a lot of uncertainty how well the vaccine would work.

So what you needed was not just an expectation, because people actually now have widely varying expectations, heard a little bit of that about how the pandemic would unfold. And so what you need to ask people is directly questions that get to the credibility of the central bank if you're going to take a survey approach.

If the pandemic lasts such long and requires this much government spending, and here I'm playing off the war time analogy, will the Fed switch its monetary policy as appropriate when the pandemic's largely in the past? It's very hard to get at that by just looking at expectations. So I guess I have a question.

If credibility is really central, why not try to measure it in a really serious rigorous, ongoing way, pretty much as a matter of course for central banks?

>> James Bullard: Well, sure, metrics are great, and I would be all in favor of, if we could get better measures of Fed credibility, then I'd be in favor of getting those.

I do think that if you look at a model and you say, what would the inflation expectation of inflation be five to ten years in the future? It should always be exactly 2%. And you don't see that in the data, you see it diverging from that every so often.

And what we saw, I think, in the first half, second half of 2021 and the first half of 2022 was that those seem to be diverging a little bit and quite a bit over shorter horizons. And I take that as a kind of measure of the credibility of the central bank.

I mean, in the model, that would never happen, cuz you just have a perfectly credible policy time. But in the real world, traders, financial markets, they start to wonder, maybe we're coming into a new era and the Fed won't do its job and somehow rationalize high inflation and just leave it high.

So, I think that was happening in mid 2022, and I've seen some graphs. Actually, Athanasios has some good charts on this. But once the Fed started raising rates, especially the 475 basis point increases in a row, that expectation got quashed right back down to 2%. The Fed was serious, and they were gonna achieve the 2% target.

>> Steven Davis: Thanks, let's open it up and see. John Cochrane was first with his hand up, as usual. Then we'll come over here.

>> John Cochrane: I know how to get a word in edgewise, I've been here before. This was great and I'll limit myself to two short questions for Andy, which were a wonderful discussion.

So the first on dissents, you make an important case, but some institutions are good with dissents, some aren't. The Supreme Court uses dissents. I remember many faculty meetings where we fought and fought and fought, but we did not say this was 35 to 22. And then for the next rest of the poor candidate's life, we're going to, well, I voted against you.

We all agree to vote 100% and carve it out of the value function. In the Fed's case, it is trying to convince people. It's trying to manage expectations, it's trying to set at least an idea that it's following a rule-based policy. And I would think that a constant cacophony of dissents, you'll remember Larry Summers came and said, no, you should have no dissents.

A constant cacophony of dissents would lead to much more what's the politics? What's up and down, much less ability to tie itself to at least the perception of a rule. The second one, you said external reviews would be wonderful, mentioned the GAO is a wonderful idea. I like the idea of external reviews.

But as we look across administrative agencies, the ones who get GAO reviews, they are not all models of a political technocratic competence. You mentioned NASA, who can't put up a rocket for under ten times what it costs SpaceX to do the same thing. The FTC, the SEC, they're all on various whole of government crusades of one thing or another.

The Fed is probably the best managed government agency this side of the National Weather Service, and certainly better than all the others. So, I am a little bit worried that this GAO external view hasn't produced wonderful results everywhere else.

>> Andrew Levin: I'm really glad that you asked the first question, because I think that it's amazing that Governor Mickey Bowman dissented from the last decision.

You have to remember that this is the first time in about 20 years that a Federal Reserve board member has dissented from any FOMC decision. And her courage, and it's just amazing, extraordinary. Now, I personally think that it was good for the Fed. And I think, as Governor Waller said at lunch today, the data has come in, in the last few weeks in a direction that there's now scenarios, certainly, that we're not visible on the day of the FOMC.

I mean there are scenarios now where the Fed actually needs to plateau the rates. And I think the extent to which, by dissenting, Governor Bowman conveyed a sense of this is a complex, difficult judgment call, was helpful to the Fed and helpful to the public, and should be helpful to the markets.

And you could ask Jeff Lacker, Charlie Plasser, as I said, Esther George, Tom Honig, there's five or six people, Jim Bullard, who, sorry, Jim, here we go, Jim, who have dissented. And I think that in each of those cases, it was a thoughtful, careful dissent, respectful difference in judgment that I think is absolutely appropriate to a public institution.

And not only that, but that's how Congress set it up. Congress set it up to have individually accountable, independent people making decisions. They didn't want it to be made behind closed doors and then come out and pretend, faculty meetings different. We're talking about a public institution whose decisions are affecting millions of people.

Okay, second question. GAO has saved a trillion dollars to the taxpayers, and they actually have external reviews by the auditors of other countries that come and review the GAO. They're very open. Okay, there's room for improvement at the GAO, too, but you can't blame the management consultant if they come in and do review.

So with the extent to which NASA may have some problems with or any of the other agencies you mentioned, GAO will come in and review the Fed. And the Fed may not take all of that advice, but do it. Just get the advice.

>> Steven Davis: Okay, in the middle here, and yes, you are still next.

And then we'll come over to you.

>> David Bapell: David Bapell. This question is for Andy Levin. It strikes me that if you want to have an external review, the Fed, the first step would be to have somebody ask chair Powell publicly. Why aren't you doing an external view? Now, I know you can't ask him that question, and I can't ask him that question, but there are a whole bunch of people, reporters, who ask questions at every single press conference and can ask him that question.

So my question for you, and in fact, a number of whom attend the Hoover Monetary Policy conference on a regular basis, and would be very familiar with this, and maybe someone who's attending this conference here right now, I don't know the answer to that. But, so my question is, why don't you ask them?

Why don't you contact the reporters who will ask tough questions at the press conferences and suggest they ask that question?

>> Steven Davis: So I think that is a suggestion more than a question. Do you want to respond or Jim may want to respond?

>> Andrew Levin: First of all, I applaud the reporters who are here.

I know some of them well. Okay, and what I would say is that the Fed has established ground rules for press conferences that if you make the Chair uncomfortable, you may not be invited to come back again. And I think that's very different than press conferences at other agencies.

I think those ground rules are not helpful to the public. Again, this is part of where Congress should initiate an external review to ask partly about, to what extent is the Fed being challenged in the media? Jim?

>> James Bullard: Yeah, I would just say on this that I certainly got asked about audit the Fed many times, and there is a standard answer inside the Fed, which is that there are three groups that are already auditing the Fed.

So you've got an external auditor that does not audit every single year. Then you've also got internal audit, which I found to be actually very effective and very useful inside the Fed. Those are at the various banks, and then you've got the inspector general, and that's been beefed up in recent years, and they're doing even more work than they did before.

So if you actually add up the audit hours, which we did at one point inside the Fed, it's phenomenally high. So it's not this kind of audit the Fed idea, which was no one's looking at any of this, I think, is not the right view of this. There's a ton of auditing already going on in the Fed, so.

>> Steven Davis: Thank you.

>> James Bullard: And also, the GAO is the arm of Congress. The reason that they have the inspector general set up is cuz the board is an independent agency. So that's just how it's done all around Washington. If you're an independent agency, then you have the inspector general.

The thought has been that you call it an independent agency, then you don't use GAO, use the inspector general. That's the way it's done inside Washington, they could change those.

>> Andrew Levin: I'm sorry, just as a matter of fact, this is in the paper with Christina, okay. And by the way, it's a Hoover working paper.

So if you wanna see the earlier draft of it, it's a matter of fact, the GAO does comprehensive reviews of every other independent federal agency, including FDIC, SEC, OCC. The Federal Reserve got an exemption in the 1970s that exempts the Fed and in particular the monetary policy function of the Fed.

But that's the only exemption, even CIA and the other. The GAO has to be careful how it does those national security kinds of things, but the Fed is really the exception right now. I think the boss should think about that exception.

>> James Bullard: So your paper is probably gonna be very useful on this dimension.

But actually, now that I think of it, the Fed, there was an audit of the boards of directors, I believe, of the Federal Reserve banks. My fellow colleagues might remember that. So there was some work on that at one point.

>> Andrew Levin: Actually, after the financial crisis, Ben Bernanke, in his testimony to Congress, he said, we would welcome a GAO review of all of our emergency facilities.

And the GAO did win and I think it was helpful. It wasn't perfect, nothing ever is in this world, okay? And actually, Dodd Frank also asked the GAO specifically to do an audit at the time of the selection of the Federal Reserve bank presidents. It's right, but the changes that we were talking about in the selection procedure actually happened five years later.

Maybe with Congress today.

>> Steven Davis: Let's move on cuz there's more people wanna ask questions. There's clearly been some auditing done and Andy wants more. Okay, so right here, yes.

>> Robert King: So, Robert King, Boston University. I wanted to comment on Andy's presentation, but Steve said something that also required me to make an observation.

For the last four or five years, I've been working conceptually on modeling credibility and reputation in an internally consistent manner, and making explicit comparisons to US inflation data. My conclusion off that is, it's the biggest single thing in terms of understanding the ups and downs of inflation in the United States.

But as part of that process, in ways that are related to what you asked, I did a literature survey, Google survey, etc., and I looked for the phrase estimated reputation and estimated credibility. And I found almost no studies that had that combination of phrases. One, interestingly, happened to be Axel Weber's thesis.

Okay, now, turning, turning to Andy, I think what you say is, is definitely something that the US government should do. But I wanna consider the role of the SOMC and its influence on monetary policy, because in a way, it's an auditor, it's a reviewer of practices. And the way in which Federal Reserve information is now provided is that analysts can go back five years later, maybe.

And they can look at what were the arguments that were made by the Federal Reserve officials for particular positions and critically appraise them. So if I wanna argue, was Jim Bullard a good inflation forecaster or not? And do I like his arguments, yes or no? Everything's there in print.

Now in the way I think about things, I sharply divide the Fed between a monetary authority and a banking/credit authority. And the degree of information we have about the credit dimensions of Fed decision making is so much smaller. Typically an FOMC meeting, or at least some of them, begin in the following way.

Well, let's close the meeting of the board and open the meeting of the FOMC. That is, let's stop talking by ourselves about huge decisions, and let's go to the open committee. So we can't really tell anything about the rationales for interventions that to my mind, in the last several decades have been far more consequential than the monetary policy decisions.

So even if we can't get Andy's external authority to come in and look at things in detail, if there were standards set for the reporting of the board in its decision process, I think that would be huge. I think otherwise, we're going to be stuck with a view of the Fed that's well captured by Janice Mialik's book, which is Limitless.

>> Steven Davis: All right, I need guidance from the organizers here. We're now at 60 minutes. Do you wanna go longer or should we cut it off? We're gonna stop, okay. I wanna thank the panelists. That was a great discussion. Obviously, there's an appetite for more.

 

>> Robert King: I'm Robert King, and I'm filling in for Charles Calomiris, who is regrettably ill and stuck in New York, but is gonna appear to us virtually later to do a presentation. I'm delighted to introduce the panelists, which are a remarkable combination of individuals that I've met in many different intellectual contexts.

Remember reading papers by Loretta Master on banking and then later I was delighted that when she became the president of the Federal Reserve bank of Cleveland. She had the wisdom to appoint one of my former students, Ellis Tolman, as her research director. Bill Nelson knows more about banking and the Fed than anyone I know, the knowledge is remarkable, it's based on many years of experience inside of the Federal Reserve system.

And now at the bank Policy Institute, he's sharing things more broadly. And then, of course, we have Daryl Duffy, who's got a span financial markets in ways that are preposterous. On the one hand, you have the originator of much of modern financial theory, particularly as applied to derivatives pricing, term structure, and so on and so forth.

You have the author of Dark Markets, and then you have a man who's willing to get his hands dirty with the plumbing of the financial system. So with that introduction, I like to ask Loretta to talk to us.

>> Loretta Mester: Thank you very much, and I really thank the organizers for inviting me to be here today, it's been a great conference so far.

Charlie Plasser was the one who introduced me to SOMC, and Mickey Levy as well and I think we talked a lot today about all the ideas that were generated by the SOMC and how important those ideas have been in driving better policy. But I think the other important thing about the SOMC, particularly for a body like the FOMC, is that it really does foster this thirst for different ways of thinking about things.

And I think that's probably as important as the ideas themselves, is this real, instructive way example of how you bring together people who may be thinking about things differently and coming up with sort of a view of the world and a way of sort of bringing those ideas together.

And it's been instructive, I think, as much as we've talked about some of the weaknesses of the FOMC process, I think SOMC, by showing that there's other ways of thinking about things, help the FOMC avoid group think and I think that's very, very important. The SOMC, I think also, really, it not only tolerates opposing ideas, it actually champions people who have opposing ideas and different ways of thinking about things.

And I think that's been a real important example to policymaking bodies like the Fed so I do feel honored to be here. So what I'm gonna do in my panel remarks is I'm gonna just make one simple point and that point is that the current ample reserves framework is not that simple.

Okay, so just to fix ideas, this is a session about the operating framework and just so that everyone's clear, when we talk about the monetary policy operating framework, it's about how the central bank implements its policy rather than what the policy actually is. So once they choose their target, this is how do you go about and make sure that your interest rate target is met and so really, if you think about the principle attribute you want of this framework is that it allow for effective control of a policy rate that's sufficiently tied to other market rates to allow for that transmission of monetary policy throughout the economy.

It has some other things that you'd like it to have, it'd be good if the framework worked in different economic circumstances and market circumstances, so that you don't have to keep changing the framework every time the economy changes. And in particular, you don't want the framework to make financial stability problems worse and even better than that, you want it adaptable to any kind of actions that are taken to address financial instability or market dysfunction.

So the current framework that the Fed's using involves a very high level of reserves as we talked about earlier today, and in January 2019. The FOMC went on the record and announced that it intends to continue to implement its monetary policy in what they call an ample reserves regime, also known as a floor system.

Now, the Fed still continues to communicate its policy by setting a target for the Fed funds rate, but it implements its policies through administered interest rates, interest on reserve balances, or the IORB rate, and the interest rate on overnight reverse repurchase agreements ON RRP. Now, before the global financial crisis, of course, the Fed operated in what is called a scarce reserves operating regime, also known as a corridor system, in which the FOMC, actively manages supply reserves in order to achieve its Fed funds rate target.

Now, I submit that both the scarce reserves regime and the Apple Reserve's operating framework have proven to be effective during the periods in which they've been used in terms of being able to control the interest rate. But the switch in frameworks was really necessitated because of the policy choices that were made during the global financial crisis and the pandemic.

So I thought it would be useful just to show you a couple of charts that illustrate just how much the Fed's balance sheet has changed in terms of both its size and composition. So in January 2007, the Fed was holding less than $900 billion on its asset side of its balance sheet and on the liability side, banks are holding about 20 billion in reserve accounts at the Fed.

During the global financial crisis and great recession, of course, the Fed engaged in three rounds of quantitative easing. So assets rose to over 4.5 trillion in January 2015, and that was the peak during that period, it was a five fold increase than before the financial crisis, and we thought it was very, very large.

Of course, on this chart, it doesn't look so high, given what happened later on, reserves peaked at 2.8 trillion in November 2014. Now, at such high levels of reserves, the Fed really couldn't use its corridor system to control its policy rate. But then, in October 2008, Congress gave the Fed the authority to begin paying interest on reserve balances at the Fed, and that allowed the Fed to use the floor system.

So that went along for a while, we got out of the financial crisis, and then in October 2017, the Fed began gradually reducing the size of its balance sheet by allowing assets to begin to roll off. And as a result of that, reserves had moved down to about 1.4 trillion by the middle of September of 2019.

And of course, that's when the repo rates and other short term money market rates began to spike. So at that point, the Fed concluded that it probably had let reserves fall too much, that it had neared the point of scarcity, and it began purchasing assets again. And of course, as everybody knows, the pandemic struck in March 2020.

So the Fed bought assets. Now, the first group of that asset purchases was really to address dysfunction in the treasury market, cuz the thinking was it would be a very bad idea to have a financial crisis on top of a pandemic crisis. And then it segued into once the funds rate was brought down to zero, adding monetary policy accommodation.

Of course, the Fed wasn't the only central bank doing this. Other Central banks also purchased assets during the pandemic. I think the chart on the left is one that Axel showed us earlier this morning. Other central banks also bought, this is a percentage GDP. And so we were one of many that were doing the same thing.

Then, when the economy recovered, the Fed began a second normalization process, or a second QT quantitative tightening of the balance sheet in June 2022. And that's still underway. So when that started, that normalization started, the Fed's balance sheet assets had risen to nearly $9 trillion. So about double the peak during the first global financial crisis period, where we grew the balance sheet, and that's about 35% of GDP.

Reserves were over 3 trillion, or about 12% of GDP, and ONRRP were about 2.5 trillion, or about 10% of GDP. And then since then, assets are down about 1.8 trillion, ONRRPs are down about 1.7 trillion. But reserves have actually risen a little bit of a tiny bit. So they're still at about $3 trillion.

They've fallen as a share to GDP, but in terms of nominal levels, they haven't really fallen. Now, one of the reported benefits of ample reserves, of the framework is that it's simple. And I would say it is simple, at least on paper, it's simple. So in the scarce reserves regime, the Fed estimates the daily demand for reserves supplies the amount of reserves needed to hit the funds rate target.

In ample reserves the FOMC doesn't have to do that actively management of the supply reserves based on estimates of reserve demand. It just supplies enough reserves so that banks are satiated. And so they're willing to invest their surplus reserves and other high quality assets if the market rate is higher than what they can get by holding those reserves at the Fed.

The IORB rate, and they're willing to lend them if they can earn a rate that's very near the IORB rate. So basically, the Fed can control the funds rate by setting that IRRB rate, which is an administrated rate, and typical, the kind of typical reserve fluctuations that you would see don't result in changes in short term market rates.

So that's simplicity and efficiency of not having to estimate that reserve demand on a daily basis in an ample reserves regime is appealing. And I seem to recall, and my colleagues can say whether I'm just making this up, but I do seem to recall, that there was even talk that the Fed would save on resources because they wouldn't have to hire as many people to actually do those kinds of estimates and have the knowledge to be able to estimate reserve demand each day.

It's a good story, even if it's not true. But I seem to think it's true. Okay, but this is all, sometimes, right? The theory is very compelling. It seems like it's a simple operating procedure, but the real world doesn't always cooperate. And in the US, we have very complex and segmented money markets.

And that means that that IORB rate, the interest rate on reserve balances, doesn't really provide what I would call a strong floor. So in particular, if you think about the Fed funds market, the federal home loan banks do 90% of the lending in the Fed funds market, and they do not earn interest on reserve balances at the Fed.

So they're willing to lend in the Fed funds market at any rate above zero. So that puts downward pressure on the funds rate. Similarly, money market mutual funds don't earn interest on reserves, but their lending in the money markets can influence the trading in the Fed funds rate market.

So the Fed had had to establish an ONRRP facility, and they did that in December 2015 when they were moving rates off that zero lower bound, because they were a little concerned that we weren't be able to move the rates up. So that facility is open to a broader set of money market entities, including the money market mutual funds.

So by controlling that rate, the rate ONRRPs and IORB rate, the Fed can effectively put a firmer floor on overnight interest rates. The other complication is that the discount, the primary credit rate, is supposed to be a ceiling, but because of stigma at the discount window, that didn't really fulfill its role that it does in the simple framework.

So the Fed established the standing repo facility to alleviate upward pressure in repo markets, which can then put upward pressure on the funds rate. And I think Daryl's gonna maybe talk a little bit about that in his remarks today about how well that worked. Okay, so not having to estimate reserve demand each day, again, is a benefit, but that doesn't get you out of the bind of having to know when reserves are actually approaching scarcity.

So you may not have to estimate reserve demand every day, but you have to know something about the demand curve for reserves, or else you have this danger that you may be allowing reserves to get too small. And then that undermines sort of the simplicity of the framework.

So that's not that easy to do. We found out over time, because bank size, business model, how banks manage their liquidity, the regulatory burden each bank faces for maintaining high reserves, all that can affect their desired reserve level. So the distribution of reserves across banks matters. It's not just the aggregate level of reserves.

And then, moreover, that demand curve for reserves can move around with market conditions. So there's a lot of monitoring that the Fed has to do, and the market test is doing that. And there's a number of, I give you a number of things that was public domain of what we're monitoring, what the Fed's monitoring, to ensure that it doesn't hit that, it stays bigger than the satiation point.

We're right at the satiation point, so I don't think that's that simple. It also isn't clear that one of the touted benefits. Of the regime is that it's better for financial stability. But there's some really interesting work by Vero Acharya and his co authors. Basically, what they're showing is that an increase in reserves may not increase liquidity, even though people think that higher reserves means better liquidity, because banks typically, when reserves increase via QE, they actually raise how much direct claims are on those reserves.

In other words, they'll increase demand deposits, they'll increase credit lines. And then when QT happens, when reserves go down, they don't lower those claims. And so what ends up happening is you have this ratchet effect that as QE happens and then QT, you end up kind of getting higher levels.

And the implication of that is then, because there's more demand on those reserves, right, when there is a financial instability, banks are not trading those reserves where they're scarce to where they're ample, and you don't have that going around. And so the Fed then has to come in, or a central bank has to come in and actually add liquidity in those places, even if the level of reserve seems like it's high.

So that leaves the banking system really vulnerable to liquidity shocks and more dependent on the Fed than in the prior regimes. And what Vero and his co authors argue is that that asymmetric behavior of the banks during periods of QE and then in periods of QT, which they call liquidity dependence, other people call it a ratchet effect.

They think it was likely the cause of what happened in September 2019 and March 2020, when there was a lot of market stress. So that's just a cautionary tale that just because there's a lot of reserves in the system doesn't mean they're gonna get to where they need to get to to alleviate stress.

And then there are a lot of other issues with ample reserves. Claudio Borio points out about the fact that, when the central bank ends up having to play a more significant role in the interbank funding market, that means they also then have to do more injections of liquidity when there's stress on the market.

Other central banks, like the Norges Bank and the Swiss National Bank, have actually switched from being a pure floor system to being a system that has tiering, so that they're trying to incent banks, give them the incentive to go back into the overnight bank funding market. And the ECB recently changed their supply driven floor system to one that's more demand driven.

So there are banks that are concerned about the fact that there's less trading in the overnight banking market, and they're trying to give incentives with their operating procedure to actually get that to be a more vibrant market for the Fed. I think the shrinkage in that overnight banking market has implications for what interest rate the Fed wants to actually target and communicate its policy.

And there was discussion in the November 2018 FOMC meeting about whether the Fed should switch away from the Fed funds rate because of the lack of trading in that market, which means it's a more volatile interest rate to another broader open market overnight bank funding rate. In the end, the FOMC stuck with the Fed funds rate on the argument what was a communication policy that everyone in the markets had grown used to.

Charlie Plasser, who's here, has done a lot of important work pointing out a number of the political economy costs if the central bank's balance sheet can grow to any size without any limit put on it by the operating procedure. Cuz remember, in the scarce reserves, there is that limit being put on the balance sheet, including the potential that Congress or the administration could use the central bank's balance sheet to fund fiscal policy initiatives.

I have to say, when I was putting the slides together, I ran across an article in the FT last week. It was an Op Ed column by Nathan Tankus, who was recommending that the Fed set up a disaster relief 13 three facility, I don't know whether anyone else saw this, for municipalities hard hit by hurricanes or other natural disasters.

And he basically was arguing that the Fed should use the balance sheet in that way. And in particular, what was striking in the article was part of the argument was that it would alleviate the problem caused by the fact that FEMA is subject to the appropriations process. So, again, we can talk about that later.

But I found that striking, that people think that these are idle issues, but they're not idle issues, they're still there. There's a bunch of other appearance issues here. We're paying large interest payments to foreign banks and to large banks, we give the appearance that we're not able to unwind QE, which could undermine use of QE in the future.

I know some people in the audience would say good riddance, but you wanna keep your tools for use later. So that's a problem. And we haven't been remitting anything to the treasury since September 2022. And, of course, that may generate criticism. So I just wanted to put up some things that I took from the transcript of the December 2018 meeting.

And, you know, these are quotes from Jay Powell. And I think these quotes really underscore the fact that the Fed does understand that these political economy issues and appearance issues are serious. And you can argue about whether they should go faster in trying to reduce the balance sheet, but I think they do understand that there could be implications if they don't bring the balance sheet back down.

So in conclusion, I would say the ample-reserve system is meeting the prime directive. It has allowed the Fed to control interest rates. I don't wanna necessarily want you to conclude that Nestor now thinks that we should go back to scarce reserves, cuz frankly, I think it would be very difficult.

I think the cost of going back would be probably high, and one would have to do a cost benefit analysis of the transition costs. But I do think it's important to be realistic about the system. It's not as simple as it's purported to be. It takes a lot of care and feeding, it reflects a choice about the Fed's footprint, right, in the markets.

You're making a choice by going with this system, and the larger Fed footprint may distort private sector liquidity risk management in a way that even though there's high reserves in the system, it may not be a more stable financial system. So I think there probably would be work that could be done to evaluate some of the things that the other central banks have done to see how they would work in a US context, which would maybe help limit the size of the balance sheet and put some limit on the floor system in the US, thanks.

>> Willam Nelson: Thank you, Loretta. All right, well, let me first thank Mickey and Michael for the invitation. I'm really excited to be among this group of folks, and I'm very happy to be celebrating the 50 years of public service of the shadow open Market committee. And Bob, thank you for those extraordinarily kind introductory remarks, and I.

I can honestly say I can't imagine a panel I'd be more happy to participate in than with my friends Loretta and Darrell. So I'm gonna talk, I'm gonna focus, there's gonna be a lot of overlap, actually, with my remarks with Loretta. I'm gonna focus on why the choice of monetary policy implementation framework matters.

I think that some people still look at this and they say, honestly, it just doesn't matter that much, as long as the interest rate target is hit. This is extracted from a longer paper I recently published on telling the whole story of how the Fed got so big and talking about how we can go ahead and get smaller again.

So my ambitious plan is to talk about the ratchet and the demand for reserves that Loretta mentioned. I can maybe go lightly over that, then point out how the Fed replaces the interbank market, something I see as a cost. And then dive into the costs of what I see as the Fed becoming somewhat more complacent about the size of its balance sheet and the risk that it's undertaking.

But perhaps more consequentially, costs from others outside of the Fed now seeing its balance sheet as an attractive way to fund things. And the resulting risks to Fed independence. And then we'll discuss why the Friedman Rule, or what Ed Nelson tells me really shouldn't be called the Friedman Rule, that some see as a benefit of the floor system isn't really a net benefit.

And then end with some reasons to be hopeful about the future. So all discussions of monetary policy implementation frameworks begin with a Poole model. Bill Poole was a member of the SOMC for 14 years. Loretta already used the model. It's a model of the determination of the funds rate, given the quantity of reserves provided by the Fed.

Where the orange horizontal lines are the quantity of reserves provided, and the purple line is something like a demand curve. I'll talk to you later, it's not really, but nevertheless, it traces out sort of what Fed funds rate will prevail, given that quantity of reserves, based on the quantity of reserves that banks want to hold.

And of course, under the corridor system, the Fed provided reserves set a target in the middle between the discount rate and the interest rate on reserve balances. It was actually 0 for much of that, that's why it's called a corridor system. And in the floor system, they provide an abundant quantity of reserves, pushing the interest rate down to the interest rate on reserve balances onto the floor.

Now, what the proponents of the floor system, they misused this model. If you go back and read the paper, the model is about the determination of the Fed funds rate within the day. It's about decisions that banks make at the beginning of the day, unsure about what's going to hit their account at the end of the day.

And Poole in the original paper says, the model presented here concentrates on these very short-term adjustments. However, it is obvious that the bank must make further adjustments if it experiences persistent reserve drains or accretions. And it's those further adjustments that have really tripped up the floor system, as Loretta has already discussed to some extent.

So what was the story behind the floor system? The idea was that the Fed would provide such a high quantity of reserve balances that the demand and supply could move around some without the interest, without the Fed funds rate really moving in a meaningful way. So the Fed wouldn't need to have to make short term interventions.

And Loretta's done a great job saying, well, that story of simplicity really didn't get borne out. And partly, that's because as the Fed provides reserves, banks adjust their balance sheets. They make use of those reserves. They don't just sit there idly in the account of the Fed, the banks adjust.

Moreover, examiners adjust their expectations about the quantity of reserve balances that banks will hold as a result. If you still want to think about things in terms of the pool model, you can think of the whole demand curve shifting out. And so you're always kind of near that steep part.

So you always can end up being tripped up by changes in the supply and demand. Now, you can see the consequence of this ratchet in this. The table shows the Fed staff's estimate of the quantity of reserve balances that would be necessary to implement a floor system. Now, the first estimate was done in April 2008, soon after the Fed Congress granted the Fed the authority to pay interest on reserves.

And the Fed did a big study to say, how should we use this authority? And they looked at a lot of different options. One of the options that they looked at was a floor system, and they rejected it out of hand as being much too radical. But as part of looking at it, they estimated, well, what quantity of reserves would we need?

And they concluded $35 billion. Now, the most recent estimate, it's actually April 2024, from the Fed staff and staff in the New York Fed, was that it would take $3 trillion. And you can see it just marched up in between. That's nearly 100 times higher. Now, you can also see it in the relationship between the spread of the funds rate over the quantity of reserves.

But I'm gonna skip that. This is my illustration of how simple it was to conduct monetary policy before, but I'm not going to talk about that. And then, so what are one of the costs, or at least what I perceive as a cost? The first thing is that the interbank market withers under the corridor system.

At the end of the day, the banks with extra reserves lend them to the banks short of reserves in the Fed funds market. Now, banks are overstuffed with reserves, so there is no such trading. And as Loretta noted, the trading is really just this strange arbitrage play between the FHLBs and US branches and agencies of foreign banks.

Now, some might say, well, so what? The whole question is, who cares if there's a lot of reserves? And there's a lot of people who would say, I don't miss the Fed funds market at all. But other central banks see this as a serious problem. So the Norges Bank, for example, in 2010, switching from something like a floor to something like a corridor, said they were doing it because they perceived that when they provided a lot of reserves, banks start not managing their liquidity as well.

And I'm going to read the quote from Andrew Bailey, because that was just a few months ago, the governor of the bank of England, describing the reasons why the bank of England is basically getting up off the floor. And he said, generally speaking, as reserves levels grow, the incentive for the banking sector to manage its own liquidity risk falls.

And to the extent that reserve supply crowds out healthy market intermediation in normal market conditions, a large part of the financial system's ability to manage its liquidity will be effective. Now, and I think back to Condie Rice's introduction at the beginning of this event. I value markets quite a bit, and I think that they're important things to preserve, and I think that's reflected here as well.

So another cost is that discount window stigma gets worse. Under the corridor system, borrowing from the discount window was relatively frequent. And most of that borrowing was for monetary policy purposes. Now, borrowing is rare, and it's almost entirely or entirely because the individual borrowing bank is in some kind of stress.

So it used to be my job back in 2003 and four and five to go out to banks and convince them to use the window. And I could claim legitimately, it's no reason to associate the borrowing, really with troubles at your bank. Now, it's a lot harder to do that.

And we know this is costly, we know that stigma is costly. Now, it happens for lots of reasons, but this contributes, first of all, it adds to that ratchet. Banks demand such high level reserves, in part to reduce the risk of having to borrow to zero. If you never want to run an overdraft, you need to have a lot of extra cash in your account.

But even more consequentially, the lack of preparedness to borrow was a significant factor in the banking turmoil in 2023. And I would argue it really contributed to making it systemic and the need for government intervention. Because the Fed looked around, they said banks don't have enough liquidity at the discount window.

If there's a run, there's gonna be trouble. Now, another consequence is that bank examiners expect higher stockpiles of reserve balances. If you go back before the global financial crisis, nobody expected a bank to hold reserve balances to meet liquidity needs. They didn't even pay interest. I'm reading the examination manuals.

Examiners judged a bank to be liquid if it had well diversified, reliable funding and access to the discount window. And abundant and cheap reserves have led to a sea change and in particular, the internal liquidity stress tests that banks are required to perform. And just examiner preferences favor reserve balances.

In David's excellent podcast, Macro Musings vice chair Randy Quarles stated that those examiner preferences were what led to the abrupt end of the last round of QT in September 2019. And in a recent speech just about a week and a half ago, Vice chair Barr stated that. Promoting the substitutability between reserves and reverse repos increases financial stability and monetary policy efficiency.

Now let me turn to costs that maybe haven't been discussed yet, but ones that I think are kind of significant, which at least viewed partly as an insider and then as an outsider. It seems that the as the Fed's balance sheet becomes unbounded and large, the Fed just becomes more complacent about having such a large balance sheet.

So, for example, in the December 2018 FOMC meeting, when the staff pitching the floor system told the committee that about $1 trillion in reserves should be necessary. Powell said, well, if that necessary amount needs to be higher, like maybe $1.5 trillion, he'd experience buyer's regret. Well, the most recently public, the available staff estimate, as I said, is for that they need $3 trillion.

And there have been no expressions of regret. Now, perhaps. And then some of the problems are that the Fed seems to be more able and ends up monetizing the debt. Now, I don't really exactly know what monetizing the debt really means. But luckily I don't have to know because Ben Bernanke defined it for me, in testimony before the House budget committee in 2011, when he was asked, well, are QE1 and QE2 monetizing the debt?

And he said, no, they're not monetizing the debt, because if they were monetizing the debt, we would be holding onto these securities. We're gonna get rid of these securities. We're gonna shrink our balance sheet back to the small way it was before then. So by that standard, the Fed's left monetizing the debt in the rear view mirror, but also, perhaps more dangerously at times, monetizing.

The Fed ends up having to monetize the debt. So Randall quarles here at this institute in 2020, explaining the Fed's actions, he said that the Fed may have to remain engaged in asset buying for some time. Simply because financial markets are dealing with too many treasuries to handle on their own.

Now, I won't talk about interest rate risk at length. My impression is that, so if you go back to 2002, the staff did a big study on the balance sheet, and they developed principles for the balance sheet. And those principles said interest rate risk is just the same as credit risk.

And if we're gonna incur a lot of it, we would take that very seriously, and we would want to talk to treasury and Congress first. Well, if you look, as an outsider at QE4, it sure felt like it was sort of casually backed into. Now, certainly, I mean, I'm of the view that the initial massive purchases were worthwhile, but then they just continued, and the explanation changed from one thing to another.

And they were locked in with very rigid forward guidance and a long promise taper adding to that interest rate risk. But also, I think, delaying, as was remarked earlier, the necessary liftoff in interest rates. Now, if I had time, I would also talk about decisions to have the treasury and money market funds and GSEs.

And foreign official institutions shift massive amounts of funds to the Fed's balance sheet. Decisions were made, I think, on the view that it didn't really cost that much to have this happen. Perhaps I think the most dangerous cost is that the Fed's balance sheet becomes an irresistible way for others to pay for things.

And this was a cost that was, for example, called out by Charlie Plasser, proud SOMC member, in the June 2011 FOMC meeting. In which he said, without some constraint imposed on the size of our balance sheet via an implementation framework. We might find it difficult to find ideas preferred by others as to how we might use that balance sheet.

And Randy Quarles in November 2018 said that that giant balance sheet and that unbounded balance sheet is what lawyers call an attractive nuisance. An attractive nuisance is something that is irresistibly appealing to passersby of impulsive and immature judgment, such as children and congressmen. Now, and I'll say in the same meeting, Loretta raised the same concerns, but not quite so pithily.

Now, this is not an abstract concern. The financing plank of the Green New Deal is basically the Fed will print money and pay for it. The CARES Act of 2020 encouraged the Fed to create a lending program for middle market firms. A 2021 nominee to head the OCC proposed that the Fed give everyone accounts.

And put money in the accounts of the underprivileged and worthy businesses, expenditures the Fed would finance by driving its equity negative. The ECASH Act of 2023 would have directed the treasury to create a digital currency, paying for the expenses by overdrafting an account at the New York Fed.

And the BITCOIN Act of 2024 would have directed treasury to acquire a stockpile of 1 million bitcoin funded with Fed capital and profits. Now, relatedly, the unbalanced Fed, I think, puts Fed independence at risk. Nothing in the law guarantees Fed independence. The president could nominate and the Senate could approve board members, including the chairman, who would take direction, who would agree to take direction from the administration.

And I think the prospect of using the Fed's balance sheet like a giant sovereign wealth fund adds to that enticement. Now, one of the advocates of the floor system say that its main advantage is that it satisfies something incorrectly called the Friedman rule. It's sort of called. So basically, the Fed can produce reserves for free, so it should produce them until money markets rates equal the IRB rate and their opportunity cost is zero.

But that's wrong for two reasons. First of all, the costs are massive of having an unbounded Fed. They're high, not low. The Fed and more consequentially, equally consequentially, the Fed already satisfied the Friedman rule. A line of credit and a deposit at a bank are economically nearly identical.

Both are promises by the bank to provide the Fed on demand. The Fed had been providing free, no questions asked lines of credit at the discount window since 2003 and free collateralized intraday credit since 2008. And they were doing that for basically the same reasons, and they were slowly working.

Okay, well, so I think there's reason to think the Fed's becoming an outlier. The Bank of Canada, the Bank of England, the ECB, and the RBA are all doing similar things, and there's reasons to be optimistic. Now, for those of us, especially for those of us who think the Fed should have a light touch with the financial system, now, for those who think that the Fed should have their finger in every piece, that's maybe not such good news.

So the Fed recently stated that banks could look to the discount window and standing repo facility instead of reserve balances as the means to meet a deposit run. The Fed now talks about reducing reserve balances until money market rates are a bit above the IRB rate. And that combination of letting banks hold fewer reserves and giving them a financial incentive to hold fewer reserves could gradually reduce banks demand for reserves, allowing the Fed to get much smaller.

Thank you.

>> Darrell Duffie: Thanks very much. So, as Loretta said, we spent the earlier part of the day talking about where the FOMC targets rates, but it doesn't work unless the market actually uses interest rates that are close to the target. And that's what this panel is about. It's about how does the Fed implement in the market the rates that it's targeting.

I wanna talk about a different problem than the ampleness of reserves. I talked about that in a conference here in May. And I think the panel totally agrees on the implications of whether or not there are sufficient amount of reserves in the system. By the way, I wouldn't agree that we just say we're just going to lower the amount of reserves in the system and make the banks hurt so that they can deal with less.

That's a very problematic approach. I was actually in China in August 2015 when the PBOC swore to its banks that it was going to starve them of reserves because they were too hungry for reserves. And when the markets blew up, the PBOC didn't have any other option than to supply reserves.

Fed is always gonna do that when it comes to a crunch. So we can't simply wish down the size of the balance sheet. And I'm gonna come back later with some policy ideas for how to mitigate some of these concerns. But I wanna talk about a different aspect of the corridor system, not related to pools curve, but rather to the capacity of the largest financial institutions to actually lend more reserves, even if they had tons of reserves.

And that's related to their ability to expand their balance sheets. So just two weeks ago, we had the end of another quarter. A quarter on which not us banks but foreign banks have to show their regulators they have enough capital. And of course, what they do is they expand their assets in the middle of the quarter, and then at the end of the quarter, they shrink their assets so that it looks like they have enough capital.

US banks don't have that problem, their capital requirements are based on daily averaging. But that doesn't mean that it doesn't matter in the United States, because when those foreign banks pull out of us money markets on the end of a quarter, all hell breaks loose on some quarters.

This last quarter end, it wasn't a total disaster, it wasn't like September 2019. But it should have sent shivers through anyone that's monitoring the effectiveness of the corridor system or the floor system for implementing US policy rates. And it also should give concerns to those who are worried about whether financial institutions that actually need money are going to be able to readily get money on future quarter ends.

So what happened on this quarter end is that when mainly large european banks pulled out of the market, all of that lending that they would have done had to be done by us banks. There were also some additional demands for lending on the end of a quarter because it's a Treasury issuance day and other things are happening.

You can see what happens in the repo market, which is the market that really matters. As I'll emphasize later when targeting us interest rates, it's the repo rate that matters. This is one sample of the repo rate called the GCF repo rate. I picked it because it's the most regular.

It's centrally cleared as a uniform set of collateral, it's general collateral. It's one where you can actually see the shadow price of funding in the repo market. And you can see it was regular as all get out until the last day of the quarter, sitting one basis point below that floor, below the interest rate, on reserve balances.

So very, very effective implementation of monetary policy. But then on the quarter end, because capital requirements started to bind, not the ampleness of reserves, but capital requirements started to bind, that rate shot up to 5.22%. On the next day, there were still problems in the market. It was 5.16%, and then it went right back down to normal within a couple of days.

Why does that matter? It matters because there's not only a floor on this system, which is the interest rate on reserve balances. And as Loretta explained, there's a backstop, which is the reverse repurchase facility rate. There's also implicitly going to be a ceiling that prevents these kinds of problems showing up in money markets.

And those ceilings are the discount window for banks and the standing repo facility for repo dealers. And the largest players in both markets are bank affiliated. They're subjected to the same capital requirements. So these large bank dealers can't really step into the market aggressively on quarter end, because their balance sheets are constrained.

And that's why they don't go to the standing repo facility to get additional funding. So, for example, the bank of Mike Bordo, who's sitting here, he could have said, well, I don't really need to pay 5.22%. I could go to the Fed and I could get funding at the standing repo rate, which is 5%.

That's 22 basis points lower, that's a lot. And it's a multi trillion dollar market. But he doesn't do that. Why not? Why wouldn't he take the opportunity? On October 1, there was $600 billion of repos conducted by large banks at rates above 5.14%, $600 billion. But the standing repo facility took in $100 million on that day.

So why weren't those $600 billions obtained at the Fed if they had to be obtained? Why weren't they obtained at the Fed at a much cheaper rate? It's because, and Bill is an expert on this, the discount window and the standing repo facility, it's not a good look for those largest banks to use those.

There could also be some teething problems, because this is the first time that they've actually been used. But the extent to which these safety ceilings on market interest rates are actually used is a concern. And this is the opposite problem, not the opposite, but it's a complementary problem to the ampleness of reserves.

The problem is basically That the bond market is getting too big relative to bank balance sheets. And that's not the fault of the Fed, it's the fault of the fiscal authority. It's borrowing so much money that the quantity of bonds that need to get financing in the repo market is growing by leaps and bounds relative to the sizes of the banks that intermediate those markets.

So the vertical axis on this chart is the ratio of total treasuries outstanding to the total size of all primary dealer balance sheets. And pre crisis, it was looking kind of good in terms of capacity of the market. The quantity of treasuries per unit of balance sheet was going down.

And that was based on light regulation. The banks would basically have no problem expanding their balance sheets whenever they wanted to, to get a few basis points of arbitrage. Because they weren't heavily, they weren't lightly even regulated for capital. Then after the financial crisis, many of you got religion and said, we need financial stability, we have to regulate these banks for capital.

And that meant that these banks balance sheets were not gonna grow fast. Meanwhile, the US government was borrowing money, Handover Fist. And now we have roughly four times as many treasury securities per unit of balance sheet space as was available on the eve of the financial crisis. So the bond market is just basically too big.

And that's why we saw this blip at the end of last quarter. There's just so much demand for financing relative to the available capital at the dealers. What about the Fed funds market? I added to the same chart the effective federal funds rate on those days. Wow, the Fed nailed it, 4.83%, day after day didn't budge on that really bad day on the end of the month.

Why not? Well, Loretta and Bill already discussed this. The federal funds market is kind of an artifactual market sitting way on the side of money markets. I'll show you, and this is my last chart, I'll show you to scale the size of the repo market compared with the federal funds market.

So the big blue blob and that big rectangle, that's a recent estimate of the repo market. Actually, it's a big underestimate because a lot of repos are now being found out in the bilateral unmonitored market, and they're starting to get measured. Recently, the fixed income clearing corporation cleared 9 trillion of repos in one day, a record.

Now let's look at the federal funds market. That's the little red rectangle down in the bottom right of the screen. And that's about 98 billion last measured so it's very small relative to the repo market. And of the federal funds market, most of it is this artifactual trade between federal agencies that don't get any interest and European banks that have these lighter regulations.

So the European banks are basically entering into a negotiation of split the pie, which is an artifactual way to set a rate. The tiny, tiny little green rectangle at the bottom right, if you can see it, that's the actual amount of borrowing by US banks in the federal funds market.

It's about 5 billion a day compared to the 4000 billion in the repo market. So the repo market is the engine room of money markets. That's where the Fed is hoping that when it targets a rate, the rate actually takes a grip on markets. And nailing it in the Fed funds market, well, it's nice for communication purposes, but it's not really what the Fed is trying to do.

The Fed is trying to actually get the larger money markets to follow the rates that it's setting. So what can the Fed do and what can policymakers more generally do to help this problem without, as Bill said, without blowing up the Fed's balance sheet a whole lot more?

Well, one of the things the Fed can do is to innovate its payment system. Other central banks have found a way to get a lot more of the uses, the intraday uses of payments done with a far smaller amount using what are called liquidity savings mechanisms. So things like incentives and rules that move the money through the system faster in the middle of the day, so that banks don't have to start the day with so much balances.

Another thing that the Fed could do is to take this standing repo facility, which is the ceiling in this picture, and expand it to a wider set of counterparties. Loretta alluded to this and a G 30 report that was shared by Tim Geithner, to which Jeremy Stein, Pat Parkinson and I contributed.

Suggested that this standing repo facility be made available to a wider set of market participants. So that we wouldn't be depending on the capital constrained banks to intermediate the 100% of this market. A lot of the funding when you're going to blow through that ceiling could be obtained from the Fed.

Now that's antithetical to this footprint problem. However, there's a mitigant to that, which is the Fed doesn't have to face every one of those non bank counterparties, non dealer counterparties. It could face that time. Okay, so it could instead centrally clear that wider set of repos so that it's only facing the central counterparty, doesn't have to vet so many market participants.

Well, the last one I mentioned, since I'm running out of time, is that not all, as today, not the vast majority of repos need to be intermediated onto bank balance sheets. We could have a money market in which borrowers and lenders can face each other directly, even if they're not banks, and that's called direct repo.

It's a pretty active market in Europe, and it's hard for the Fed to mandate that, but the Fed could encourage or foster the growth of direct all to all trading in the repo market. And then we wouldn't depend on this balance sheet problem. Thank you very much.

>> Harold Ulick: Maybe a question to Loretta Mester or Darrell Duffie.

Actually, all three. So, Harold Ulick, University, Chicago visiting fellow at Hoover in the good old times, the federal funds rate was, of course, the key market interest rate. Cash balances and reserves had an interest rate of zero. And the Fed was trying to move that rate up and down.

Everybody was staring at that and that was, in Daryl's language, the elephant in the room. Now, the federal funds rate is, I'm sure it's important for some players in the market, don't get me wrong, and they probably millions, billions of dollars moved there. But in the overall scheme of things, it's something that we can pretty much neglect.

And I'm even not sure that the repo rates that Daryl showed are all that important. I think I agree that once you open the discount window to a larger set of institutions, once you make the discount window equal to the interest on reserves. And once you put more, I don't know, hand holding into the financial market, so that financial market players really use that rather than having teething problems and having problems borrowing from the Fed rather than from private market participants.

Many of these frictions seem to go away as far as a bigger macroeconomic picture are concerned. Now the interest rate on reserve is really the key interest rate, and that's the one that's moving lending conditions up and down. And the federal funds rate and maybe even the repo rates are sideshow to all of this.

So why are we still talking about the federal funds rate is my question, other than having the small frictions go away.

>> Robert King: So I'm gonna trust to Jeff Lacker to make his question really short. Then we're gonna got John Cochran, and then we're gonna have the panel respond quickly and we're gonna go to break.

>> Jeff Lacker: I agree that a large fed balance sheet opens it up as a target for special pleading for people who want to have the Fed participate in credit allocation. This has been a problem under the corridor as well. Ever since the 1951 accord discount window, lending has been divorced from monetary policy cuz the Fed could always sterilize any lending.

And this is why the FDIC and the OCC came to the Fed for lending for too big to fail banks. And it's why Proxmire Press the Fed forced it to start buying agency debt, including the debt of the Washington Metro.

>> Robert King: Excellent question. John.

>> John Cochrane: Thanks, this was wonderful.

You guys have focused on the question of how does the new regime affect interest rates properly. And the answer I hear is you want to nail a price, you need a flat supply curve for all comers. And if you wanna fool around with something other than that, you're gonna have trouble nailing a price.

But you left out, you didn't address the other big question, I think, of the interest on reservist regime, and here the ghost of monetarism is creaking in that coffin in front of us. We now back in the old days, there was a rationing of quantities and there was an opportunity cost of liquidity.

And now, even though I love it, we live the Friedman rule, we live a permanent liquidity trap. We're hoping that interest rates transmit to the rest of the economy entirely through prices with no change in quantities, no opportunity cost of liquidity, no rationing, the means of transaction, so forth.

I kinda like that, but I'm a little nervous about it. Among other things, interpreting history, was 1982 really just about the cost of freely provided interest rate lending, or was there something involving the machinery of the financial system? Maybe it's better now, maybe it's not. Maybe the Fed is gonna have less trouble.

Anyway, answer that ghost.

>> Robert King: Okay, super quick answers.

>> Loretta Mester: Right, on the Fed funds rate as the target. Carl yes, you're right, partly if you go back and look at the transcript of that December 2018 meeting, you'll see there was a big discussion about whether we should change the target.

The end of the day, it was decided not to. One, I think because people were comfortable with the Fed funds market, it was all communication. It's how do you communicate? You're exactly right. The control is the administered rates. This is about communicating policy. But the other thing that's undercurrent there, and Charlie Plasser has talked about this also, is there's governance issues.

If you were to switch from the Fed funds, right, then you have to say it's an administered rate. That's not an FOMC decision, and I think that also played a role in sort of like punting. Okay, let's keep it, we seem to be able to control it. We can link these short-term money market rates together and we're controlling them and let's punt on that.

>> Robert King: Yeah.

>> Loretta Mester: But I think it's open.

>> Robert King: Darrell.

>> Darrell Duffie: Further discussion. I'll try John's and I'll leave the Proxmire one to Bill.

>> Darrell Duffie: Well, John, to some extent, it's not really costs and benefits when you're up against the wall. It's not feasible in the current regulatory framework to steer rates by scarcity of reserves because banks are required in the current regulatory regime to prove that they have enough liquidity on their own without relying on the Fed.

So they have enormous demands for reserves to meet their liquidity needs. And we can't really go back to a world in which you could squeeze them down to the point where they just barely have enough reserves to lend to others. The needs that they have for meeting the regulatory requirements and payment needs in the course of a day are orders of magnitude bigger than the adjustment you would need to make on a daily basis to target the rate.

So it's just not feasible, Don Cohn, taught me.

>> Robert King: Yeah.

>> Darrell Duffie: That in my first encounter with him.

>> Robert King: I gotta turn to Bill next.

>> Willam Nelson: Okay, so I'll take a shot at Jeff's question. And I completely agree these pressures existed before, but as I think was Charlie's point, and certainly I agree, back in under a corridor system, the Fed could be no bigger than, a little bit bigger than the demand for currency and they couldn't and they couldn't control the demand for currency.

And now under this system, they can be as big as they'd like.

>> Robert King: Okay, thank you very much, panel, for an excellent session.

>> Michael Boskin: Okay, we're getting started a bit late and people will start wandering in, but we have a very full panel. We have four excellent speakers who have made important contributions to our subject, which is fiscal and monetary issues, their interaction, etc. John Cochrane, Debbie Lucas, Charlie Plosser, and Pat Kehoe.

I'm gonna be much more ruthless than previous moderators by limiting everybody to ten minutes, because we're supposed to be done by 5 o'clock and it's 5 to 4, so we'd like to leave some time for questions and the inevitable one or two minute overage when I say time's up.

Okay, so we'll do the best we can, and if we go a little over, I'll apologize. I'm Michael Boskin, Stanford economics department at Hoover Institution. And having listened to some of the panels, I apologize I missed some of the morning because I was having my eyes dilated. And if I call on somebody later and you're a good friend and I don't recognize you, that's because my eyes aren't fully recovered.

I do wanna mention if this occurs against this discussion, and discussion this morning occurs against the backdrop of a much richer intellectual history than we're able to discuss so far, including around what the national debt does and deficits do. We'll hear more about that in a moment. That includes three Nobel Prize winners who thought that the major thing about the debt was it had real effects because it decreased the apparent price to taxpayers about what the cost was of funding, spending.

We've had Ricardian equivalence reborn. We've had Jim Tobin saying it's very different types of characteristics of federal debt, facility, features of the debt, maybe, especially now that we have tips. We've had a long history of experiments with different evaluations of them and the like, and all the way up to Olivier Blanchards presidential debt, addressed the AEA, basically saying, don't worry about the debt, we can roll it over forever.

It's not that big a deal. I kinda deconstructed that in the papers and proceedings the next year. But if you're interested, I'll send it to you. It doesn't really hold up. The assumptions are all pretty bad, and we've run the experiments, and interest rates eventually got above, above the growth rate.

So any event. Also, much of what's about to occur, I think we deserve to mention a few things that have happened. The most important thing is the immense explosion of the national debt in virtually every major economy in society, and secondly, the tremendous change in what governments are spending on.

When I was an undergraduate, it was still the case that the majority of federal government spending was on purchases of goods and services. Now, unfortunately, we need to increase defense spending in a dangerous world. But that's a sideshow. The government really is a redistributor of resources. You might say it's a fiscal cross hauler between people in their peak earning years in their retirement, or from a little bit to the poor, but mostly big transfers, especially via social insurance and unfunded entitlements to the middle class.

And I think it's probably worth just saying, if you pardon me from exercising my own opinion about this, since we're primarily borrowing these days for subsidies, transfer payments, tax credits and things of that sort, it's worth remembering the original purpose of the federal debt, according to Alexander Hamilton.

Who argued for the federal assumption of Revolutionary War debt from the states because it was, quote, the price of liberty. So governments have changed. There are many other things, if I have a chance, I'll mention that would affect this discussion, but I think it's worth having that in mind as we hear this important discussion of the role of fiscal policy and fiscal policy and inflation, fiscal policy and monetary policy.

So I'm old enough to remember when and perhaps to get away with saying ladies first. So, Debbie, I'm gonna call on you first.

>> Deborah Lucas: Debbie. Ok, well, thank you. I'll just jump right in. I think that many of you here today are going to agree that the Fed and other central banks as well, should avoid crossing the line from monetary to fiscal policy.

That is, for a variety of reasons. As Paul Tucker has eloquently argued, it seeds democratic control over fiscal policy to unelected officials. And in the US, there's no constitutional authorities to do so. It also risks central bank independence should things go awry with those policies. However, there's no general agreement over how to or where to draw the dividing line.

In my view, questions about which central bank policies cross the line into fiscal policy and what should be done about it are some of the most important and most under discussed issues in central banking. I've circled back to these issues several times in presentations I've made at the Shadow Open Market Committee. 

Changed my mind a few times, but I want to return to them again briefly today. So what I'm going to do is revisit alternative definitions of when a Federal Reserve action is actually fiscal and suggest what a preferred definition I'd like to work with. And the reasons for that.

I'm going to provide a few examples of Federal Reserve policies that I think have clearly stepped over the line into fiscal, and also highlight a few policies where I think some people have described them as fiscal, but by my definition they really aren't. Finally, I'm gonna highlight the large, albeit indirect but misleading, fiscal effects from how the Fed remittances are accounted for in the fiscal budget.

And then I'll suggest at the end that really at least the first step in the remedy of all of these things is towards greater transparency and better measurement of fiscal policy effects of what the Fed does. Okay, so let me just start with two definitions I'm going to state and dismiss.

So if you look at Wikipedia, or even the Fed's own definition of what a monetary policy is, they'll basically say monetary is what central banks do. The Federal Reserve actually says monetary policy is the Federal Reserve's actions as a central bank to achieve three policy goals specified by Congress.

So in other words, if the Fed does it, it's monetary. And kinda similarly, if you look at definitions of fiscal policy, it usually refers to tax and spending policies, and the emphasis is again on the agent taking the action and the tighten of actions undertaken. So this kind of definition, based on actors and specific types of actions, are clearly not helpful for drawing an economically meaningful line between the two types of policy.

Well, in the past I was very sympathetic to the idea that a central bank policy action is fiscal if its real and distributional effects can be replicated with tax and spending policies. However, if you think about that definition for a few minutes, you'll probably convince yourself that it causes all monetary policy to be fiscal.

And I think perhaps there's an element of truth in that description, and that in fact, monetary policy is simply a carve out of certain fiscal policies. But nevertheless, that definition also isn't helpful in identifying the monetary policies that make the largest and most troubling incursions into the fiscal realm.

My preferred definition is then that a central bank policy action is fiscal if it causes a direct transfer of value to or from the federal government. This definition purposefully creates a parallel between how traditional fiscal policy actions, taxes and spending, are quantified in the federal budget and how the fiscal actions the Fed also could be.

And importantly, I'm emphasizing direct transfers here because I wanna emphasize that I'm excluding pecuniary externalities from the definition of what makes a central bank action fiscal. So for example, an open market purchase that lowers interest rates has a pecuniary externality that affects the government because it lowers the cost of new treasury borrowing.

That benefits the government at a cost to savers. However, I wanna exclude that kind of an effect for several reasons. The first is that, as the example I just mentioned showed, of lowering interest rates, pecuniary externalities are exactly how conventional monetary policy operates. So I don't want to redefine all monetary policy again as fiscal policy.

But second, the size and duration of pecuniary externalities are very hard to assess. Evidence of this is the continuing debate over the efficacy and size of the effects of quantitative easing. The third reason is kind of pragmatic. I want to create a level playing field between fiscal policy as it's conducted by different parts of the government.

So I want to use a similar definition for monetary fiscal actions as for other agencies doing fiscal actions. Okay, so to be a little more, so let me be a little bit more concrete about what I think is implied by this definition. I wanna give an example of two Fed policies that I think have had fiscal significant, fiscal costs, and that haven't really been recognized as significantly stepping over a line.

So let me start out first with the cost to taxpayers of above-market interest rates that's paid on reserves. And it's interesting to me, as I was listening to the last panel, that kind of touches on similar issues, but in a slightly different way. So we know that the government now pays out, or not now, but it has in the past paid out an above market interest rate to private entities.

When it pays an above market interest rate on reserves, it's a type of government spending, to be specific. In the wake of the GFC and the Great Recession, the huge growth of Fed's balance sheet was financed by reserves. Those reserves were easily attracted, why? Because the Fed had the newly granted power to administratively set the interest rate that it paid on excess reserves.

So the question of how much subsidy is really the question of how much above market rates was that interest that was paid? It's hard to answer that question precisely because it's not clear what the right reference interest rate is. But here I'm taking the reference interest rate for illustration to be the three month t bill rate.

And so what's on this plot is the difference between the interest that was paid at the time it was interest on excess reserves relative to the three month t bill rate. And if you add it up over the ten years I'm looking at here, which is 2008 to 2019, the total comes to about 30.6 billion of additional interest over the market rate relative to the three month rate.

Relative to the overnight, it was somewhat more, about 40 billion. Another way you can look at it is, again, this kind of came up before, but something else that happened over that period is that banks were getting this above market interest rate on reserves, and then those institutions that couldn't go directly to the Fed were lending money to the banks in order to get part of the benefit of that above market reserve rate.

And so you could ask the question, well, what's an estimate of how much money was transferred effectively from the government to those banks? And doing a calculation then relative to the Fed funds rate, you get an estimate of about 21 billion. Another issue then is that the Fed has increasingly participated in credit policy, and these policies at times expose the Fed to significant fiscal risk and costs.

I think that practice started for the first time on a large scale during the GFC, and then it accelerated during COVID. So the policies I have listed here were authorized under the CARES Act, which directed the Fed to create several new facilities that authorized it to directly lend to businesses and municipalities.

And they really had a lot of lending capacity under those facilities, about 1.8 trillion of authority to purchase securities in total. Of course, they purchased much, much, much less than that. Things got better, but there was large risk exposure. And if you, there have been estimates that have been done by me and others that looked at things like the Main Street Lending facility and assessed the multi-billion dollar cost.

So the assistance was given despite the fact that the Treasury was in a first loss position because the Treasury wasn't granted enough resources to cover all contingencies. Maybe more provocatively, I want to suggest that my definition leaves some Fed activities on the monetary side of the line, that some of my colleagues on the SOMC would instead argue are crossing the line.

And I want to briefly mention an important category of those policies, although there isn't going to be time to do justice to the other side of the debate. So I'm gonna assert that when central banks buy private sector securities at market prices, say MBSs or corporate bonds in the secondary market, those actions are not fiscal.

That's because those are essentially zero NPV transactions if you ignore pecuniary externalities. The government receives securities that have an equal value to what it pays out. So of course these transactions could be a bad idea for a lot of reasons, and I think often they are. But still, they do not create direct fiscal costs or benefits.

Another thing that I'll mention is that a lot of the lending facilities that the Fed creates I would also not consider. Consider fiscal simply because there's enough backing, either by the treasury or by collateral requirements and so forth. So there isn't significant cost left to the Fed. And perhaps surprisingly, just to name one thing on this list, the ones in bold are from the pandemic.

The ones above it are carries over from the GFC. But in any case, you know, the Paycheck protection program cost about $700 billion and it was administered by the Fed. Yet it wasn't a Fed fiscal action because the treasury bore that cost and it was recorded properly in the budget.

So it's a fiscal action that I would argue the Fed shouldn't have done for appearance purposes, because a lot of people still come away with the perception that it was fiscal and the Fed is to some extent blamed for it, but it wasn't fiscal under that definition. So the last thing I want to mention is having important fiscal effects, albeit indirect ones, is the way that fed remittances are accounted for.

And so I would say that this is not the fault of the Fed directly, but rather a flaw in the rules governing federal budgetary accounting. But nevertheless, it creates very large fiscal distortions. And it's not a problem that the Fed has tried to correct, at least they haven't done it publicly.

So the issue is that the Fed's remittances are booked as revenues in the federal budget and thereby create fiscal space that reduces the budget deficit and accommodates higher spending. And these apparent profits have grown as the size of the balance sheet has grown. So why is this a problem?

Well, it's because that additional fiscal space is illusory. The Fed earns a higher rate of return on average on its assets than it pays on its liabilities, but that difference is not an economic profit. The profits are easily understood to be illusory because the action of buying, say, 100 million of treasury securities with 100 million of reserves is clearly, again, a zero NPV transaction.

It neither creates nor destroys value. What's happening is that the risk premiums and the term premiums are being booked as profit, when in economic terms, they're not. It's well understood, in fact, in budgetary circles, that this type of accounting creates a paper money machine for the government that, in principle, could be used to essentially wipe out all deficits.

So I'm just, I'll do this really quickly, okay. So how big are the effects, are the distortionary effects on the budget of this remittance accounting? Well, from the period of 2013 to 2023, it was about $790 billion, over longer periods, more than a trillion dollars. And as was discussed earlier, now the remittances have gone negative, which itself has its risks, perhaps to the Fed's independence.

So I'm sure I'm out of time. So let me just say that in terms of what should be done, it seems just clear that greater transparency and clearer thinking about fiscal and distributional consequences of the Fed's policy is essential for several reasons. The Fed needs to be held accountable to the public and its elected representatives for its fiscal actions.

If it had to acknowledge them, to quantify them, it would force it to adopt a more explicit cost benefit mindset in deciding on its policy actions. It could protect the Fed from being pressured to take actions that fiscal authorities didn't want to do themselves. And in the end, it might help protect the Fed's independence.

So hopefully, the Fed will move in the direction, devoting more resources and staff to addressing these sorts of questions. And more broadly, it would be great if the government would harmonize and improve the fiscal and monetary accounting practices to make them more transparent and move them closer to the economic reality of the situation.

Thank you.

>> Patrick Kehoe: Okay, I'm gonna talk about some lessons from optimal monetary and fiscal policy. And this is joint with Chari, Juan Pablo Nicolini and Eleanor Pastrino, who's with Hoover here, Cheri Nicolini in Minneapolis. Sensible policies are formulated as rules, as John Taylor taught us, it's not sensible to ask what should we do today.

It is sensible to ask what rules should we adopt and stick to. He successfully applied this reasoning to determine a practical monetary rule, which is justly famous. We should follow John lead and find a practical fiscal policy rule. Current fiscal policies violate basic principles for optimal rules, as Mike Boskin alluded to in his opening remarks.

So I'm going to discuss how we should finance government spending with taxes, debt and inflation from theory, they wanna contrast what these desirable fiscal policies are compared to how we have actually financed it. And my punchline is going to be we need major changes to how we're currently conducting fiscal policy to avoid future inflation and at worst, even potential default on debt, directly or indirectly.

So what are the prescriptions for optimal fiscal policy from theory? The premise is that present value revenue should equal the present value of expenditures. And like Mike started with, I'm not a big fan of if the interest rate is less than the growth rate, we should go on a fiscal bonanza that Olivier Blanchard argued.

I think that's absolutely crazy, we maybe come back to that in the comments. So I'm sympathetic with what Mike said. I'm gonna presume that throughout. So, from Lucas Stokey, which is the theory paper, and some of my work with my friends, which was an applied paper, I'll put them together and I'll argue that it's desirable to keep labor taxes, tax rates and tax revenues roughly constant, to smooth tax distortions over time.

But the same exact reason you want smooth consumption over time. It's costly to have things go up and down for consumption. It's costly if tax rates go up and down because of concavity and you want to keep them pretty smooth. So if you follow that rule, what are the implications for debt?

Throughout, I'm gonna talk mostly about wars, because if things are going right, war should be the main thing you're spending money on in surprise ways and that's what you should be using debt for. I'm gonna start with perfectly foreseen wars to make it real simple. So you have a cyclical, deterministic war peace cycle.

You have war for a while, then you have peace, have war for a while, then you have peace to make it simple. What's the plan for labor tax, taxes and debt? Well, the same constant tax rates in peace and in war, so you have a current stream of revenues.

You don't want them to go up and down, you don't wanna raise taxes like crazy in the war, that's the last thing you wanna do. So in peacetime, you run down the debt to prepare for the war, in wartime, you issue new debt to pay for the war.

On argued historically, Britain followed something close to the Lucas Dokey plan for debt management for over 200 years. Here's a picture, this is the ratio of real public debt. To trend GDP in Britain from 1700 to 1918, it's a picture from barrow's article. Now they weren't perfectly foreseen, but they knew there were some wars coming.

And if you look at the first 120 years, they ran dead up during the wars, then the next hundred plus years, they ran it right back down during peacetime. At the end of the piece now look at the numbers, at the beginning ithe 17 hundreds, it was 20%, the ratio of debt to GDP was about 20%, it got up to 140%.

And they ran it right back down to 20%, just in time for World War I, and they did it all over again. That's what Lucas Stoki says, and they kinda did it. How about stochastic wars? We know we're gonna have wars, we know they're gonna recur, we don't know exactly when they're gonna occur, so think of them as probabilistically, but you know they're coming.

Now, the MOT theory has a little bit more implications for inflation. It's still desirable to do the same thing on the tax revenue side. You still don't want taxes to go up and down, you want pretty flat, you do not want to raise taxes during the war, you wanna smooth out tax distortions.

But now you want a way to make the debt, you wanna use the debt to vary with the state, so you wanna transform nominal debt into some kinda real debt. You basically wanna sell the people IOUs, and you want to get the money when you need it, and pay out the money in peace when you have it to pay them back, loosely speaking.

So you wanna move resources from peacetime states, we have a lot of revenues, not much spending to wartime states, we have a lot of spending and flat revenues. And also you don't wanna distort people savings ahead of time, by having x anti distortions, and this is the subtle part.

You need to balance the inflation in the states when you need it, with deflation in the other states, so that someone lending you money ex antenna, you're not distorting the returns they get. Or they might not even give you the money to start with, cuz you're gonna try to burn them at the end and inflate it away.

So the average returns on nominal debt shouldn't be distorted, and this is in theory. You might ask, so that's the same plan, I'll just summarize the same plan for revenues, run down the debt, pay for the war issue, new debt. Now the plan for inflation is, when war breaks out, it should be well understood that you can inflate away some of the debt to get some revenues.

And when peace is restored, and this is the hard part, you should actually deflate, you shouldn't try to inflate it away. You should actually deflate to fulfill your promises, to give the debt holders a reasonable rate of return on their money, that's not always what happened in practice.

You're not gonna raise revenue from this overall cuz you're gonna give the outside people a fair rate of return, and you just wanna transfer resources from peace to war. That might sound a little bit extravagant. Is it even feasible? Well, there's some nice historical evidence on optimal inflation policy under the gold standard.

Let me talk about that. So Mike Bordo who's my go to macro historian, when I wanna get some feeling for what actually happened, along with Finn Kidland, a long term co author, have some nice paper on implementing this policy, under the gold standard. Now simplistic view of the gold standard is, it stops inflation.

You have a constant price of gold to fiat currency, if you do it right, inflation stopped. The gold bugs say, go back to this because they have some fuzzy ideas of what happened, they think inflation was constant, it wasn't, so they should read a little bit. So in practice, the gold standard was suspended during the war to decrease the value to local currency, and induce inflation.

So you weren't paying out much money when you didn't have it, but the whole promise was, you know I'm gonna do that, you, me being the government, but I'm gonna commit to return to the pre war parity during peace. And Winston Churchill who I admire very much, tried to get out of this, and he wasn't allowed to in England, he wanted to inflate away all the debt.

So, Mike and Finn argued that Britain, France and US implemented a policy just like this, in World War II is one example. And some, they go earlier to World War I and earlier, so they suspended the gold standard, but then returned to the pre war parity. And the returning pre war parity is the hard part, cuz it means deflating and paying the debt holders what they quote deserve.

The key message this is a quote from them to commitment to return to the gold parity after the war enabled the authorities to issue debt and collect seigniorage at much more favorable terms. Okay, so that's like they did actually try to do that. Now, why might fiscal policy matter overall?

And this is, I'm sympathetic to what Mike started with, and I should learn this quote, that government debt is the price of liberty. So Sargent and Veldi have a nice paper about France and England. They fought many wars, even though you would have thought the French were to win maybe they have a population four times as big.

They're a bit poor, but you should think they should all else equal, should win most of the time. But England won every time, except for the American Revolution, where they were helping the Americans, and we won that one. North and Weingast is here in history, he argued that fiscal policy institutions matter.

The English Glorious Revolution eliminated the king's ability to do lots of things. They give a lot more power to the people, in particular eliminated their ability to unilaterally default on debt. In France, there were no such institutions, so French kings would coerce the nobles and to give them money and then systematically default after the war.

French nobles get tired of that, and stop coughing up the money. So Britain, because of these institutional differences, raised more funds to France to fight wars. And what I wanna emphasize is perhaps the English fiscal policy helped win the wars with France by enabling them to get the money when they needed it.

Well, now how about us? Us being the US, have we been as responsible as the people we talked about Britain, US during world War, some of these other countries? Well, let's take a simple look. Federal debt is a shared GDP, here's the historic path. After World War II, we were up to about almost 120% GDP per capita, and we did what Lucas Stoki argued, run down to debt during peacetime.

We ran it down from over 100% down to about 20%. We call that period the same sober and responsible period. Now, to be honest, there was a little bit of repression, a little bit. Bit exposed inflation jamming the stuff in. But I'm gonna look back with a bit rose colored glasses to our greatest generation and say they did the right thing.

Then after that we got into a Cold War with the Soviet Union. So that was another mini-war. We ran back up to debt. That's fine, that's part of the plan. But then we were responsible again during this peacetime. We ran actually primary surpluses and ran it back down.

Now we're down to 30ish, which seems like a reasonable number. But here's this problem, the problem that we call the age of irresponsibility. The debt went from 20 some percent, now it's like 80 and that's gonna keep going up. Now if you look at some of the CBO and the OMB projections, we call this projected bipartisan responsibility.

Both parties, one party wants us cut taxes but keep G. The other party wants to raise G like crazy and keep taxes. Both of both are irresponsible. That's projected to reach unprecedented levels. And if you keep going, it's going to 200% of GDP if you believe some of these forecasts.

And these are conservative, actually, how do we build up that debt? Well, it's kind of obvious. We consistently spent more than we raised through taxes during peacetime. Not running it down. You should be the other way. So, there's two lines. Look at this line. The blue line is how much we're spending.

The green line is how much we're taking in, during peacetime they're supposed to be the other way. And in peacetime it's still getting big. Okay, what's the root of the problem? Well, John Cogan has a nice book entitled the High Cost of Good Intentions. And the key idea is even though there is a noble purpose of assisting people who through no further known or destitute, neither tax revenues nor revenues generated by growth.

The G part have been able to keep pace with this amount we're spending bringing national debt to a record. And I emphasize during peacetime you should not be running record debt to GDP during peacetime. He has a nice story about even if civil war veterans are still getting money through their descendants plans now 100, whatever it is, six years later.

He argued, since World War II, the federal spending to GDP went up 6%. All of it is accounted for by entitlement spending. Everything else went down, including in defense as a share of GDP. Citi's current high spending, low tax regime is just not feasible. We must choose between a modest welfare state, low spending, low taxes, or a high welfare state, more like Europeans with high spending, high taxes.

I personally favor the first, but that's a matter for society to decide. What's the key lesson? Keep your powder dry. History tells us we will have wars. Having fiscal capacity to raise our spending and fight them is help deters our adversaries. And if we don't deter them, we have to go through with it.

What's the future? Well, we have lots of things in our future and we always will. Will China invade Taiwan? Will Russia invade Poland? Maybe, I don't know. We should be prepared for that. This precautionary theory, so to speak, of maintaining fiscal capacity so you can have the money when you need it.

That's what I mean by keep your powder dry. And if so, will we rule our current responsibility? Remember France versus Britain. We wanna be like Britain, we don't wanna be like France. So why does monetary policy matter? Let's talk about some lessons first and let me bring it back.

So there's a lot of studies of historical inflations. Nearly every single one had two forces, irresponsible fiscal policy and monetary authority to bow to the pressure to monetize the debt. Who documented that? Tons of people. Some of my favorites are Tom Sargent, famous paper on Four Big Inflations.

And George Hall and Sargent have about six papers that go painstakingly through it. Tim Kehoe and Nicolini have this nice book in Latin America and it goes through the Latin Americans experiences. And it's always the same too. Irresponsible fiscal monetary authority gives in. So, what should the monetary authority do in the face of irresponsible fiscal authority?

The key thing is resist pressure to monetize. Stick to something like a Taylor roll and don't give in and just monetize. So we shouldn't be enablers of reckless fiscal policy. Let the debt go up until you get political pressure to reduce it. Brazil did that during the rail plan.

They just hardcore stopped inflation, let the debt go up and fiscal reforms eventually brought it down and they got out of a hyperinflation. Concluding, fiscal monetary policy are obviously intimately connected. But the root of almost all the problems historically is the imprudent fiscal policy. Once it's fixed, monetary policy is easy.

Keep us more or less stable price level, little bit of stuff over the cycle. But that's peanuts. Adopt balanced budget rules. Maybe, this is an idea as though a fiscally responsible state separate. One way they do it is separate the operating budget, the current spending from the capital budget.

Long term investments, impose a balanced budget on operating budget, do not allow have some limited escape clauses. This is not my area of expertise, but I was reading about Utah. They seem to be doing a decent job. In the meantime, resist the pressure to monetize the debt, let the deficit build up if you're a monetary authority.

And hopefully you get pressure. That dynamic has played out numerous times. Hopefully it will again. Thank you very much.

>> Charlie Plosser: All right, it's a pleasure to be here, but my husband is on the site schedule route. I'll not try to be more welcoming than that at this point.

This has been a fascinating day, and the panel and the last two panels and all of them have been great. And I'm gonna try to cut short some of my remarks because I can just say, see Pat Kehoe, see Loretta Mester, see Bill Nelson. The debate over the appropriate relationship between monetary and fiscal policy, is it really an old one?

 

However, it's really taking on a lot of renewed interest since the crisis of 2007 and 2008. As both the Fed and the treasury have initiated policies that breached the accepted norms that have largely been in place since the Treasury-Fed Accord in 1951. My view is that these new policies have undermined the institutional arrangements intended to support the independence of our central bank.

And frayed the boundaries between monetary and fiscal policies. In two papers by Tom Sargent in 2010 and 11, he wrote about the history and the struggles of economists and economic theorists. To provide guidance as to where to draw the lines of between the markets for money and the markets for credit.

And that's a- As a quote. He characterized these challenges as trying to balance, and again I quote, stability versus efficiency. Ambiguities, uncertainties, and the path forward arise partly because the choices are difficult and involve conflicts of interest that thrust us beyond macroeconomics and into politics, end quote. I don't pretend to answer these deep conceptual problems that sergeant describes.

But I do take seriously the view that choices involve conflicts of interest, particularly among government agents and political economy, issues that have important implications for how we think about drawing these lines. Economic historian Douglass North was recognized for his work for the Nobel Prize on the role that institutions play in economic growth.

He argued that institutions arise as a way for heterogeneous actors to constrain interactions among parties, both public and private, to ameliorate fictions and other hard to resolve conflicts of interest. These institutional arrangements take the form of laws, contracts, business and corporate arrangements, and even institutions that establish the constitutions that establish the institutions of our government.

The evolution of central banks should be viewed in the same light. Central banks have been around a long time, and the institutions have evolved. The drove standard, for example, served as a commitment device that tied the hands of central banks and the fiscal authorities in ways that helped define the boundaries between monetary and fiscal policy.

By limiting the scope and potential conflicts in a particular manner, the collapse of the gold standard provided governments with the freedom to use the printing press, that is, fiat money, as a means to finance government spending. It also heightened the stability versus efficiency, conflicts of interest and tensions.

That conflict would propose the tension between short term political demands to finance government budgets and the longer term demands for a stable currency. Now, while technology and other innovations have changed over time, this fundamental conflict remains at the heart of the institutional design of a central bank and the desire to establish boundaries between monetary and fiscal policies.

Thus, the independent central bank has arisen as an institutional response to the conflicts of interest and political problems alluded to by Sargent. Now, the desirable degree of independence is achieved by limiting the goals and powers of the central bank, and of the physical authorities, for that matter. To do that in ways that seek to address these thorny conflicts of interest.

Of course, governments always maintain the upper hand since it can change the law. But the idea is to make the institutional arrangements, the commitment enough to make that changing of the laws and expensive power to exercise by the government. Put differently, the institutional arrangements seek to tie the hands of both monetary and the fiscal authorities in ways that make those commitments credible.

The new threats to the Fed independence have largely arisen due to the important changes in the use of the Fed's balance sheet initiated by the Fed itself and by the physical authorities. Some actions were intended to influence the allocation of credit and are a form of fiscal policy that turns private liabilities into public or taxpayer liabilities.

Other actions by the fiscal authorities explicitly tapped the Fed's balance sheet to fund off budget spending. The Fed and Treasury also exploited emergency provisions in the Federal Reserve Act to lend to and to bail out private institutions and investors in a manner never before exercised. Applications of this practice lacked systematic guidelines, little in the way of restrictions that contributed to more hazard and incentivizing more risk taking rather than stability.

These actions and others contributed to the breaking down, in my view, of the boundaries between monetary and fiscal policy. So I wanna touch briefly on three interrelated and similar aspects of the institutional framework that helps draw the lines between monetary and physical policy. And how those events and policy choices adopted during the subsequent to the 2007 and eight recession, are affecting this delicate balancing act of the conflicts of interest that exists.

So I wanna talk briefly about governance, briefly about mandates and scope of responsibilities. And a little bit about the limitations or constraints on the authorities granted the bank. First, governance, political failures in the early attempts to establish the central bank in the US were very distasteful and took nearly three, four of a century after the closing of the second bank of the United States before Congress tried again.

The result, of course, was the Federal Reserve system. It was designed as a decentralized institution with geographical dispersions of semi-private reserve banks and a board of governors in Washington. Part of their motivation for this setup was to decentralize and make decision making more diverse, less focused on the financial centers at that time of, let's say, New York and the short run politics of Washington.

After the collapse of the gold standard, changes were made in the Fed's governance. The Banking Act of 1935 removed the treasury secretary and the control of the currency from the Fed's board. It granted 14-year terms to the Fed governors. Established a new entity, the Federal Reserve Open Market Committee, to govern the conduct of open market operations.

 

These changes reduced the role of the physical authorities in the direction of participation in the conduct of monetary policy. But it did grant greater control to the politically appointed board of governors and open market operations. Here we can see the tension and struggles between monetary and physical policy and how to draw the boundaries.

In some response To the criticism recently of actions taken during the great financial crisis, you can hear suggestions that the Fed needs to be held more accountable. To some, that translates into the Fed needs to be more political. For example, some have argued that Reserve bank presidents should become political appointees or they not be allowed to vote on monetary policy matters.

This weakens independence. My view is a better way to promote accountability and maintain independence is to be found in limiting or narrowing the scope of responsibilities and authorities of the central bank, rather than inviting greater political interference in day to day decision making. What about mandates? Well, authentic shape is discussion of mandates earlier today.

Other reserve banks central banks are giving are given a great deal of latitude in the instruments they have, mostly in buying and selling securities. But narrow mandates focus the central bank on well articulated objectives that make it easier to evaluate the institution's success for failure and thus to hold it accountable.

Narrow mandates also serve to discourage or limit central bank's discretion to use its powers or authorities to justify actions that are not related to the mandate. Narrow mandates can also help provide central banks with grounds to resist or to say no when physical authorities ask them to do things that stretch too far beyond the mandates.

Unfortunately, the trend in the US and other countries in many cases is to expand the scope of the mandates and it pushes them further and further away or into the political arena and the fiscal policy, again weakening the institutional framework that is designed to support independence. When establishing the long term roles and objectives for any organization, it's important that those objectives be achievable.

Assigning other unachievable objectives, even within organizations, is a recipe for failure. In the case of the central bank, which could result in the loss of public trust and confidence, for example, in the active pursuit of the maximum employment dimension of the Fed's social dual mandate has been a problem for the Fed and continues to be, the Fed notes in its statement.

I'm gonna revert back to the 2012 statement. We could talk about the 2014 20 statement, but I don't wanna do that. But essentially it says the maximum level of employment is largely determined by non monetary factors that affect the structure and dynamics of the labor market. The statement goes on to say this explains why the Fed does not specify a specific numerical target for the maximum employment.

This acknowledges, by the way, appropriately in my view, the weakness of the case, that maximum employment constitutes an achievable objective for monetary policy, or that there's a mechanism for true accountability. Lastly, I wanna mention operating authorities and restrictions, and this was covered in great detail and very well by both Loretta Mester and Bill Nelson in the earlier session.

And there is a case that interest on reserves is a major issue because interest on reserves, in Sargent's words, subverts independence of both the fiscal and the monetary authorities and puts at risk that independence. And so Mike tells me I'm out of time, so I'm gonna skip the details.

But that discussion was, was excellent. And the point that many of us have raised dating back to the early days of growing interest on reserves and adopting fluor system, which in our view, in my view, is very dangerous, and funding a new disaster relief program out of the Fed's balance sheet is a perfect example of what we may be in for if we don't address constraints on that.

The only other point I would like to make is that between 1951 and 2007, when the Federal Reserve act said that the Fed could not buy private sector securities, could not invest in state and local securities, during 51 to 2007, the Fed pretty much operated a treasury's only policy.

And in August 2007, 90% of the fed's balance sheet was US government securities. In 2015, only 55% of the fed's balance sheet was US government securities. So it shows you that the composition of the balance sheet of has dramatic effects. And one thing to say, again is that putting restrictions on what the Fed can do protects its independence.

And expanding those authorities, expanding the markets or activities of the private sector and markets, is a sure way to undermine fed independence. And that would be a very big mistake out in there. Thank you very much.

>> John Cochrane: I wanna thank my previous panelists, because they said three quarters of what I was going to say, and hopefully that'll spare me from saying it again.

Let's get to it. We just had an inflation. Let's route the question history. There's what you saw, inflation in just about January 2021, out of nowhere. The Fed didn't do anything unusual, at least as far as interest rate policy. Interest rates went to zero in the recession, like they always do.

So where did inflation come from? Question one. Question two. Notice inflation plateaued and then eased just about as the fed started raising interest rates. Why did inflation plateau and ease? Standard theory tells us that if the interest rate is below the inflation rate, inflation rate should continue to spiral upward until the interest rate exceeds the inflation rate.

That didn't happen. It started all on its own. And, of course, what happens next? Well, I have a theory of this, as you can imagine. Notice what else happened. I plotted here on the right hand axis, the federal debt during and after the pandemic, especially, the US government handed out $5 trillion of checks to people, 3 trillion of which was monetized.

That isn't necessarily bad. There's a big crisis. It's been analogized to a war, but that's what we did, and it had the obvious results. That seems like a simple one. Now, I interpret this through the fiscal theory, the price level. You knew this was coming. But I wanna make a plea for it.

Of course this is like exercise 101 from fiscal theory. I also will claim I'm trying to sell a book. There's the pretty cover. And in selling the book in 630 pages, I believe, and I make the claim, it is the only known coherent economic theory of the price level that we have, consistent with current institutions.

Fiat money, an interest rate target, no money supply control, and our fed does not make blow up the world equilibrium selection threats. It's the only one we got, so you might as well pay attention to it. How does it digest this episode in a little more detail? It's just prices, present value of dividends.

The price level adjusts so that the real value of nominal debt is the present value of surpluses. I think that's been said about three times. Pat said it for sure on his first slide. Inflation is always too much money chasing too few goods. Just how much is too much relative to the government's ability to soak up money by charging current taxes, or by charging future taxes by soaking it up with debt?

Now that insight, this is quite different from keynesian stimulus, because what matters is debt, not debt. Deficits relative to GDP GAAP, but debt relative to expectations of future repayment. The long run ability to repay is what makes it inflationary, not the debt itself. The top little chart there shows you responsible fiscal policy, in Pat's words.

You borrow for the war, you pay back with surpluses afterwards. You can have lots of debt and deficits with no inflation if you're going to repay the debt, that is good responsible fiscal policy. Government debt is a wonderful thing. It allows you to win wars if you issue it, and with promises of repayment, and it doesn't cause inflation.

Inflation comes when the same debt and deficit is not matched by future surpluses, deliberately or not deliberately, that's how you run a state contingent default via inflation. That's what I think happened in 2021. And that's the important distinction with Keynesian stories. And of course, with long run, inflation can come out of nowhere, just as stock prices can come out of nowhere when information comes out.

That's the basic theoretical view here. With that in mind, it's not so easy as just saying big deficit. You have to think about why do we have debt and deficits? Why didn't people think that it was going to get repaid? Well, when you just look a little bit at the history of this time versus 2008, it's actually plausible.

I don't know for proof, but plausible. Congress suspended its pay for spending rules. The zeitgeist of the era was go big. Interest rates are low, as Janet Yellen said, r less than g. Modern monetary theory, secular stagnation, stimulus, and so forth. I think Jim Bullard's analysis is very appreciated.

The ARA and the IRA in early 2001 really said we're not going back to normal fiscal policy. This is not going to get repaid the way we normally do. And then the easing came, as Jim said, exactly when Congress shift and we went back to normal levels of irresponsibility.

Also in 2008 we got lucky with negative interest costs for a decade. That is certainly not going to happen again. Now I've told the story. We actually tell models. This is fiscal theory exercise number one. What happens if we dump a lot of debt and we don't have plans to repay?

To make that clear, here are the equations. This is just a standard new keynesian model completed with fiscal theory. What happens if we dump some debt? If we have a big deficit and no plans to repay and the Fed does nothing? Interest rates stay constant. This is just a quantitative version.

We tell quantitative parables. This is my quantitative parable. What happens is inflation surges. The interest rate stays low so that the real returns on government debt are low. That's how we slowly inflate away the debt. The price level rises. It's as if the reduction surplus makes a price level jump, but then smoothed out through sticky price declines.

So here's the lesson. This can happen. Inflation can come from fiscal shocks, even with the central bank doing absolutely nothing. When this event happens, this unfunded deficit happens. There must be inflation to eat away the debt. The fed can smooth list, you'll see that in a minute. But it cannot avoid inflation like that.

Second notice this inflation goes away. A one time fiscal shock. I dumped 5 trillion on you. Once the price level has gone up, it goes away on its own. Even if the fed does nothing, there is no spiral away. There is an easing even all on its own.

That too is consistent with the episode and answers the puzzles of the standard analysis of the period. What about money? That ghost of monetarism has been rustling around in the casket this whole afternoon. How do we differ from, and Peter pointed out the m two expansion. Now, money and fiscal theory agree.

A helicopter drop a money finance deficit causes inflation. Money is just a form of government debt. The key distinction does an exchange of money for bonds have exactly the same effect? We both agree give you 5 trillion, you're going to inflate. But if I give you 5 trillion and take back $5 trillion of treasury debt, does that have exactly the same effect?

If you're a monetarist, yes. Only the quantity of money matters. If you're a fiscal theorist, we look at the wealth effect, not the portfolio effect. The latter has almost no effect. That's the crucial difference. In fact, Friedman's examples, as I think Pat just said, were almost all cases of money financing deficits.

Examples, histories where fiscal and monetary agree. But that's the crucial conceptual difference. Well, the ghost of Adam Smith just came down and gave us the most perfect natural experiment. To answer this again, the experiment, I give you $5 trillion of debt. Does that causes inflation? We agree. I give you $5 trillion, take back $5 trillion of treasuries.

Does that cause inflation? Monetarists, yes. Fiscal theory, no, we just did it. And that's what the graph on the bottom right shows. In the COVID era, 5 trillion, we get inflation. In the QE era, 5 trillion, take 5 trillion back, absolutely nothing. How about other stories for where inflation came from?

Monopoly, greed, price gouging, roundup, the usual suspects, or supply shocks, which were alluded to earlier? Remember, supply shocks are relative prices. They're a relative price shock. The price comes up, it comes back down, and one price relative to something else, they're not the price level unless they induce a monetary or fiscal policy response.

And that is true in every model. You see estimates supply shocks or demand shocks. Every one of those models, it cannot raise the overall price level unless it induces a fiscal or monetary policy shock to raise demand. It's always demand that causes inflation, everything going up. So I think, yes, the supply shock induced the government to do war finance and more inflation, but it could have done this and it could have done that.

That was the choice. It's always demand. The supply shock is the carrot that leads the fiscal or monetary horse that leads inflation. Do you really want to call this a carrot shock and not a horse shock? So what I wanna say more generally about monetary fiscal intervention, that was history.

Makes sense. Recent history, longer history. Has there ever been a substantial inflation that did not come from printing money to cover deficits in a country with good growth, steady primary surpluses, reasonable debt. But the central bank made some sort of technical mistake. I'm overstating these, but pretty much no.

Every successful disinflation has combined not just monetary, but monetary fiscal and microeconomic policy reforms. And the history of Latin America, as Pat said, is full of monetary. Reforms that didn't work because they didn't do all the other ones. That's the essence of monetary fiscal interaction. Second point I want to make, this is still the introductory slide.

Tighter monetary policy that reduces inflation. This is the challenge going ahead. When we get inflation again, when, not if, it will happen, the Fed will want to raise interest rates. Tighter monetary policy, by raising interest rates to reduce inflation, imposes fiscal costs. It raises the interest costs on the debt.

And that's not a minor issue. At 100% debt to GDP, 1% interest rate is 1% surplus to GDP that you gotta raise to pay the interest costs. Second, if you disinflate, there's a windfall to bondholders, they get paid back in more valuable money. Someone's gotta pay that. Third, if you think monetary policy works the way the Fed thinks it works, a softer economy, the Phillips curve and so forth, it induces less tax revenue, automatic stabilizers, stimulus bailout, it induces fiscal deficits.

So monetary policy causes those fiscal expenses. In theory, and I'll survey every theory we know higher interest rates that do not induce tighter fiscal policy to pay those expenses do not lower inflation. And that's true in every single model we have. What we have is always joint monetary and fiscal, you can't be bothering me already.

Okay, so let me show you, this is Sergent, ends of inflation. We solve the fiscal problem, inflation goes away instantly, it's always monetary and fiscal policy. The 1980s, the supposedly the great side of monetary policy was in fact a joint monetary, fiscal, and microeconomic reform. Look at those high real interest rates.

Who paid for those high real interest rates? Answer, we did, there's the primary surplus deficit. And with Social Security reform, with tax reform, with deregulation, with microeconomic reform, the economy grew like crazy. And there were huge fiscal surpluses which paid those fiscal costs. 1980s was a monetary, fiscal, and microeconomic reform which together disinflated, that's always the case.

This is a New keynesian model. Yes, I can do a totally New keynesian model. On the left, the standard three equation. New Keynesian model, a monetary policy shock. The Fed lowers inflation. There's inflation on the bottom, see, that's how it's supposed to work. But wait a minute. The interest rate is higher than inflation.

There's interest costs on the debt. Who paid those interest costs on the debt? Footnote four, passive fiscal policy levies lump sum taxes to pay the interest costs on the debt. What if the Fed cannot count on the treasury to raise lump sum taxes to pay the interest costs on the debt.

The top right one is the same New keynesian model. It is the same path of interest rates. It's a different path of monetary policy shocks. Different monetary policy shocks can give rise to the same interest rates, jiggered so that there is no fiscal policy response in a standard New Keynesian model solved in standard New Keynesian ways.

If you raise interest rates, but you cannot have a contemporaneous fiscal tightening to pay the interest costs on the debt, inflation goes up. Inflation only goes down if monetary and fiscal policy tighten together, even in the totally standard new Keynesian model. Here is the old Keynesian model, adaptive expectations, the standard Fed story for inflation.

So what happens is the monetary policy tightens, the interest rate rises, we go down, we follow the Taylor rule, and interest rates go down. Chase inflation down, and we get rid of inflation. Standard story for the 1980s. The interest rate is higher than the inflation. The interest costs on the debt rise.

Fiscal policy had to tighten in order to pay those interest costs on the debt. If it did not, even the old Keynesian ISLM model, higher interest rates do not lower inflation. This is fiscal theory, again, a higher interest rate with no change in fiscal policy, it can lower inflation now, but only by raising inflation later.

I think this is what happened. The Fed raised interest rates. The Fed matters, even holding fiscal stuff constant. But all you can do is lower inflation now by raising it laters unpleasant interest rate arithmetic. You can move inflation through time. So the Fed lowered inflation immediately, as you saw it does, but you can see at the cost of higher inflation in the long run, you get kind of stuck.

Gee, sort of exactly where we are. So let me close, Mike, I see you getting nervous by talking a little bit about the future. Here are the CBO projections and monetary fiscal policy in the future. CBO projections, as Pat said, they are optimistic. One reason they're optimistic is they assume nothing bad will ever happen.

And you can see where we got our debt. We got our debt from now responding to the two last once in a century crises, there will be more once in a century crisis. So in this fiscal environment, I just said, if the Fed wants to raise interest rates to fight inflation, fiscal policy has to tighten substantially to pay all those fiscal costs.

And if it does not, the Fed cannot lower inflation. The Fed loses its power to lower inflation in every theory we have. Well, that may well be the problem we face in the middle of the next inflation. The bigger problem, I think even bigger problem. People look at this and say, some sort of vague debt crisis is coming, I agree with Pat.

The problem is the loss of borrowing capacity. Pat said, what happens if China invades Taiwan or maybe win? Well, let's draw that out, what's gonna happen? Pacific trade comes to an end, massive economic shock, massive financial shock. What's Uncle Sam going to want to do? Bail out all the banks, stimulus like crazy and then, we got to rebuild the military stat.

Uncle Sam is gonna come to the financial markets with 10 trillion of borrowed money, printed money, and with the recent experience in mind, our bondholders really gonna fork over 10 trillion of new savings and say, yeah, this is great. You're gonna pay this back someday with Social Security and Medicare completely unreformed or are they gonna say, heck no and the inflation breaks out much faster this time.

The loss of fiscal capacity is a fiscal disaster. Who cares about the inflation? Our inability to meet the next crisis is one big reason. Now this does not have to happen. This is a self-imposed wound and I have to close on. Yes, I am gonna close this time on something optimistic, which is there is a way out.

If this leads to, you heartless conservative, you're gonna throw grandma from the bus versus no, you're gonna raise taxes and destroy the economy. What's the way out? The way out is growth. This graph reminds you that the surplus versus deficit of the us government is primarily driven by the level of the economy, not by tax rates, not by spending policies.

We need more tax times GDP. Well, rather than rate tax rates, let's raise the GDP. Growth is the magic elixir that allows us to get out of this problem. Yes, you can also tax more effectively and spend a little more effectively, but the easy way out is growth and growth is the problem.

Last slide, I promise, the bottom is potential GDP growth rate. It was 4% before 2000. It's 2% now, it's zero in Europe. That's like the screaming long run economic problem, and we're wasting our time with this inflation stuff. But in the meantime, getting back to strong growth would solve the fiscal problem, would solve the inflation problem.

Thank you.

>> Michael Boskin: We started 15 minutes late, so I'm gonna reclaim half that. Ask the panelists to come back up real quickly. We'll take a couple of questions. I wanna get a couple of quick comments. These are the notes I've taken on, questions I'd like to ask. The left side's intellectual history.

The right side is what's happened in the economy, and I've only been able to ask a small percentage of them, and I'm sure all of you do. So, every one of these sessions could have gone twice as long fruitfully, with a marginal return that was quite substantial. It's not surprising that I have two current colleagues and one former colleague from earlier in my career on the panel.

I agree with almost everything that's been said, almost, not all, but I want to just quickly mention a few and then add a couple of things to take up questions. First, I think Debbie is really onto something important about improving transparency in our budgeting and our information systems about what's fiscal, what's monetary.

We can't really get at what Charlie was arguing for, much greater seriousness about achieving objectives or losing credibility if we aren't able to measure it. By the way, let me put in a plug for more accurate measures of inflation. Were moving in that direction, but now we have a new frontier about what to do about putatively free goods.

Those of you who don't waste your time on the microeconomics of all this, it's quite fascinating, and we'll see where that winds up. One thing that was mentioned by John at the end, emphasizing cost of growth, something that I've been involved in. And I think one of the three big changes in post-war evolution and macroeconomics, which was time horizons expectations and incentives, is incentives.

And we talked a little bit about incentives in institutions like the Fed, public choice kinds of things. We didn't talk much about marginal tax rates. And I still remember advising candidate Reagan and helping him design his tax policies. I'm kinda where 401Ks and IRAs came from. But in any event, before we had inflation indexing of tax brackets, there was immense pressure to bring inflation down, and there were many reasons to do that.

But in any event, that I think was part of the reason why Reagan stuck with Volcker. I think that's important to appreciate, and supported the disinflation plus other things that went on, and John could worry about that. Pat, we have tried fiscal rules. I was involved in one, we've had when we lost the nominal anchor of a balanced budget or then balanced budget over the cycle.

People proposed, for example, I developed capital accounts for the federal government. We almost got president, when I was outside advisor, brought in by Dave Stockman and Marty Feldstein. We almost got President Reagan to order the OMB to start producing them. But then Cap Weinberger, then secretary of defense, went ballistic that we'd be giving the Russian secrets by measuring our depreciation.

So accounting can get you in trouble in various ways. In any event, we had Graham Rudman, which was basically just projecting you get to a balanced budget. It didn't work, we extended it. Same thing happened with Maastricht rules. We put in 1990, we put in a marginal balanced budget rule called a paygrow rule, which I think probably made sense.

However, because Bush agreed to a tax hike in that same deal, it got badly discredited. So I think it's important to focus on that as well. I'd also say that I'm glad John is challenging the central bank canon, perhaps as a sufficient but not necessarily a necessary condition, that you gotta get the funds rate above the inflation rate.

So I think that's something we really do need to grapple with. He has his proposed answer, and we'll see how that penetrates and broadens in the profession over time. Pat, I really like your idea of separating a capital budget from an operating budget, but wars are important, and let's hope we don't wind up in a really major one anytime soon.

It's looking risky right now, but we've really underfunded the military for some time. And both in the Clinton administration, the Obama administration, now in the Biden administration, whatever you think of everything else they did, as a factual matter, they were trying to decrease real military spending. Some of that may have been desirable.

We certainly need to get a bigger bang from the buck in the military. But when you add that to the fiscal pressures coming from the impending insufficiency of Medicare and Social Security, there's gonna be a serious reckoning that we're gonna have to deal with this. I'd add one final thing, which is that there's a lot of statistical, there are many studies by economists.

Alberto Alicina, I think, was the main one early on, but many since then, that you're talking about successful disinflations. But there's also successful budget consolidations, and the evidence seems to be that they've been overwhelmingly on the spending side of the budget, not on the tax side, as a broad empirical generalization.

So I'll end, let's take two or three questions, then we'll have to get on to the next panel. Okay, we've got people in the middle, and, I apologize, people on the edges. Maybe we can start in the back row, and take those two and see if we have time for one more.

We'll take all the questions at once, so we'll ask the panelists. That was a good suggestion.

>> Audience 1: I've got a question. I'm wondering why the fiscal response to the financial crisis did not lead to inflation. Was there an implicit assumption that in fact there would be primary surpluses generated then in a way that there was not, with response to COVID?

And then, relatedly, given the implication of interest rate policy for deficits and primary surpluses, should interest rates in fact have been kept at zero to minimize the inflation post Covid? Thank you.

>> Audience 2: This is a question for John. So FTPL does seem to do a good job explaining the inflation surge and the disinflation.

Now, we're close to 2%, and we still see CBO forecast getting worse and worse. Should we not see inflation going up as a result of that? How do we explain where we are today now that we're seemingly past the inflation surge in disinflation via the FTPL theory?

>> Jack Krapanski: I'm Jack Krapanski.

Back in 2008, the TARP plan, the revised TARP plan, where they did forced loans to banks at a high interest rate. Could that have been done by the Fed, or was that inherently fiscal policy?

>> Audience 3: Japanese debt to GDP ratio is 250%. The BOJ's balance sheet is 140% of GDP.

They've monetized probably 60% to 70% of all GGBs. How does that fit into the fiscal theory of the price level, given that inflation is still low and seemingly running out of steam? Thanks.

>> Michael Boskin: Okay, so John, several of those were directed at the fiscal theory of the price level.

So let's have your concise answer.

>> John Cochrane: Yeah, concise is hard. I will advertise that these questions come up often enough that you can find written answers on my website, an essay about Japan, and a longer essay called Fiscal Histories about what's different between 2008. This time. The short version is there's lots of reasons why Japan is different from the US.

And low interest rates is one of the big ones, and we'll see how long that lasts, they are also fragile. And also, it's not a distinguishing problem for fiscal theory. Every theory says if it's unsustainable for fiscal theory, it's unsustainable for passive fiscal policy as well. So it doesn't really distinguish theories.

But there's a story for Japan. There's also a story for 2008 fish now, history is always a story, but in 2008 at least we made fun of them. But at least the administration had the decency to say stimulus now, debt reduction later. And nobody even had the decency to say this time.

Together with they got really low interest rates. Together with it was much smaller. Together with it was also direct government spending, not checks to people. And also with it was a period of very deficient demand. This one was arguably less so. And somebody's at the other fiscal theory we got the fiscal theory questions.

Why don't we have Zimbabwean hyperinflation? Now, the CBO is a projection, it's not a forecast. And they say right there, this is unsustainable. This will not happen. We don't know how it won't happen, but it will not happen that debt to GDP goes up like that. Why are bond markets still buying the us debt?

I think bond markets think this is a great country. It's a self inflicted wound. America will surely do the right thing after we've tried everything else the way we usually do. And when they lose that faith is when things blow up.

>> Deborah Lucas: Very quickly on tarp. It was a completely fiscal action.

I think it was about $500 billion of legislative authority. When they decided how they were going to use the money, they decided the only way they could make it really big was to put it at the equity part of the capital structure. So basically, the government was providing very subsidized purchases of things like preferred stock and options from the banks.

And I think there's no way the Fed could have had that large credit related expenditure without it would, well, they wouldn't have even contemplated, is what I would have said. But there was a lot of fiscal authority that went into that bailout.

>> Michael Boskin: I would just add one quick thing about the fiscal side and the future paying down the debt.

I had a star undergraduate some years ago who won the university wide prize for the best undergraduate thesis. Who concluded through a variety of consistent vector auto regression studies that the most stimulative short run fiscal policy is one that precisely is consistent with what you're saying in the real economy, not just in dealing with price level and inflation.

Unfortunately, went off to Goldman Sachs, made a lot of money and never published it. But any event. Let's hear a big round of applause for all these great speakers.

>> Thomas Hoenig: Okay, we're gonna end this part before we take a break and reception talking about the lender of last resort, too big to fail and financial systems savior. My favorite topics, and we have some really great people speaking today. Jeff Lacker, who is a former colleague and now current colleague, Maya Mercadis is gonna be the presenter and I've read his material and I tell you he's gonna take us further down the trail of good intentions and moral hazard that consequence of.

So that'll be good, and then Amit will be next, and then Charlie Columeris will be video. So take it away.

>> Jeffrey Lacker: Great, thank you. Thank you, Tom. So to explain the scope of this paper, which I admit is a fairly lengthy one, I need to start with two definitions.

Monetary policy actions change the quantity of central bank liabilities via buying or selling government securities. Credit policy involves acquiring private sector obligations, holding fix the monetary liabilities of the central bank, that is, sterilizing the transaction via offsetting sales of government securities. Some transactions, some things the central bank do, or a combination quantitative easing, purchases of mortgage backed securities for example, or central bank credit programs that expand the balance sheet are combinations of monetary and credit policy.

So my agenda today is first to survey the history of ideas, theories of the case, doctrines, for the want of a better word about how the Fed should conduct credit policy. And along the way, I'll summarize the shadow open market committee commentary on credit policy. In the interest of time, I have to be selective.

Refer you to the paper for anything else you're interested in. So the Fed was founded to solve a monetary problem. When the public shifts from deposits to notes in a fractional reserve banking system, the money multiplier falls and the money stock shrinks. Unless there's an offsetting increase in high powered money by the central bank.

The Fed was founded to increase high powered money in a panic or in response to seasonal shifts in the demand for currency. At the beginning of the Fed lending was how the Fed was going to do this. So, combination of monetary and credit policy the Fed founders were very aware of the british experience.

The bank of England had an effective monopoly on node issue, and the bank managed its monetary liabilities through its lending policy, as the Fed was expected to do at the beginning. The bank, I'm sorry, purchasing government debt outright was politically sensitive for reasons that have to do with the constitution of Britain, which contributed to Pat Keough's note that Britain was better at raising money than the French.

So when Walter Bagehot and Henry Thornton, more importantly before him in 1802 urged the bank of England to lend in a crisis. It was to solve exactly this type of fractional reserve monetary problem, and to do it by increasing the supply of high powered money. But it was not to address any credit market problem.

It was to address a monetary problem. What they recommended became known in the 20th century as the lender of last resort. Role of the central bank. A better name though, would be monetary instruments supplier of last resort. The crucial point is that the lending is unsterilized. Sterilized lending would be pointless in a monetary crisis.

Thus, fed lending doctrine, number one present at the founding is that the Fed should lend in the pursuit of monetary stability. If purchases of government securities are for some reason problematic, as they were for the authors of the Federal Reserve act, in the interest of time, all I'll say about the real bills doctrine is that it was a fallacy.

It was known in the 1920s to senior the smarter members of the leadership of the Federal Reserve to be a fallacy. But nonetheless, Fed leaders in the early 1930s misread signals because of the doctrine, with disastrous consequences. The third founding lending doctrine of the Federal Reserve was Paul Warburg's mercantilist idea to try and move the business of financing US foreign trade transactions from Europe to the United States.

Doing so, he said, required that the US have a central bank of its own to provide backstop support to the bills market to counteract foreign central bank support for their bills market. So this idea fizzled, and in the interest of time, I won't say anything more about it either.

So the great contraction is a big topic. Time constraints require that I skip this too. There's information in the paper about this debate about the role of bank failures and the Fed lending in that episode. But I have here this great quote from Friedman and Schwartz in which they say that if the bank failures had occurred to precisely the same extent, without the collapse in the money stock, they would have been notable, but not crucial.

If they had occurred, but a correspondingly sharp contraction in the money stock had occurred by some other means, it would have been a disaster. So that's Friedman in Schwartz position. So the role of Fed lending changed significantly after the middle of the 20th century. After the 1951 Treasury Fed accord, open market operations became the primary tool of monetary policy.

Fed lending became a vestigial appendage, entirely unnecessary for the conduct of policy. Over time, the Fed moved to tightly targeting the federal funds rate, and Fed lending was routinely sterilized. Beginning in the 1960s, the Fed started getting requests from the FDIC or the OCC to lend to failing banks to allow those agencies to delay the closure of the failing banks.

This facilitated the exit of short term uninsured creditors and it had the result of shifting losses to the FDIC or to other creditors. The Federal Reserve staff started calling these lender of last resort operations, but they really had nothing to do with Bagehot or Thornton or monetary stability because one, they were sterilized and two, in these instances depositors weren't fleeing the currency, they were fleeing to other banks with no implications for the money multiplier.

As larger and larger precedents were set, the Fed was deliberately ambiguous about its likely future actions seeking to preserve its discretion. Moral hazard grew in the form of an overall funding cost advantage for larger banks viewed as likely to be benefiting from this treatment, but perhaps as importantly an advantage for short term funding over longer term funding.

How big is the federal financial safety net? I asked two Richmond Fed economists to make that calculation for year end 1999. They estimated that 27% of financial sector debt total financial sector debt US 27% was explicitly guaranteed at the end of 99 and another 18% was implicitly guaranteed based conservatively on past actions for similar institutions or announced policy.

The total safety net went from 45% at the end of year end 1999 to over 60% the next time it was estimated, which was for year end 2009. So while these too big to fail precedents were expanding, the Shadow Open Market Committee naturally had some things to say in the tumultuous year of 1974 following the bailout of Franklin National Bank.

A key episode Allan Meltzer, one of the co founders, argued against preventing failures and for preventing the spread of distress through the monetary system, very much in line with what Thornton and Bagehot were talking about. Anna Schwartz, another co founder, wrote extensively in the 1980s and 1990s, both for the SOMC and elsewhere, criticizing forbearance and how the Fed handled crises.

She distinguished between what she called real financial crises, by which she meant the scramble for high powered money in response to shifts out of deposits and into currency or hoarding of reserves and other episodes which she called pseudo crises. And she asserted that no financial no real financial crises have occurred in the United States since 1933.

And she noted the moral hazard effects. I love the sentence the bugaboo of financial crisis has been created to divert attention from the true remedies that the present financial situation demands. Classic Anna, so Anna Schwartz gave the Homer Jones Lecture, we heard about Homer Jones earlier today at the St. Louis Fed in 1992, and she titled her lecture the misuse of the Fed's Discount Window.

In it she noted how Fed lending since the 1960s represented a major departure from its traditional approach, and she called for closing the discount window and restricting the Fed to open market operations in US treasury securities. Again, this is consistent with Bagehot and Thornton and her and Milton Friedman's diagnosis of the Great Contraction.

Marvin, good friend, my former colleague at the Richmond Fed, joined The Shadow in 2009, but even before then he wrote extensively on Fed credit policy. He pointed out that credit policy is extraneous to monetary policy and inherently distributional. He made this point in a paper with Bob King in 1988.

This point was also made by Milton Friedman in his book A Program for monetary stability 1960 I think it was. It amounts to selling treasury securities and lending the proceeds to the private sector. Because it channels credit at favorable terms generally, it will inevitably entangle the Fed in distributive politics which risks the critical independence of monetary policy.

Goodfriend advocated for what he called a credit accord analogous to the 1951 Treasury Fed accord on monetary policy policy. Under his proposed accord, the Fed would limit its balance sheet to holding treasury securities and would leave credit allocation to the treasury to be carried out with duly appropriated funding.

A little bit of information here about an announcement a so called credit court announced in 2009, it was sort of a fig leaf, so I won't spend more time on it. Fed lending in connection with too big to fail rescues represented a departure from the three founding Fed lending doctrines that I mentioned earlier.

So how are we to understand the late 20th century Fed credit policy? Marvin Goodfriend and I studied this question in a paper we prepared for a 1998 conference at the bank of Japan. Credit Central bank lending is analogous to private line of credit lending. We observed line of credit lending involves a commitment problem.

Private line of credit contracts presumably structure ex post incentives for a profit maximizing lender constrained by their contract to lend in the circumstances that are from an ex ante point of view, optimal and not lend accordingly when it's optimal. The central bank's ex post incentives are not necessarily those of a profit making maximizing lender, however.

So there's no guarantee that a central bank choices about lending are going to be optimal ex ante. There's a desire to avoid deadweight resolution or closure costs, even if that would be part of an ex ante optimal arrangement, which we know can be true. There's a fear of political blame if financial turbulence results from not lending.

On the other hand, there's a fear of criticism for overreach for lending too far afield. This is a situation that James Buchanan described as the Samaritan's Dilemma. What you want them to believe ex ante is not what you're going to end up doing ex post necessarily. Thus we get constructive ambiguity, a communication strategy that attempts to discourage expectations of rescue while preserving the option to rescue an event.

The general result is a cycle financial distress occurs at a failing institution. Short term creditors are rescued, setting a precedent that expands the implicit safety net. Regulators and or legislators crack down on the specific risk taking that was the proximate cause of the crisis, which heightens the incentive to bypass the regulated sector, pushing risk taking into the so called shadow banking world.

The fringe of the implied safety net is where the next crisis hits and the safety net continues to ratchet and expand outward. The system grows more fragile over time as interventions continue across an expanding domain. So from this perspective, I think we can extract an implied lending doctrine number 4, which I call the Reluctant Samaritan Fed.

Lending decisions are made case-by-case on its at its discretion to mitigate ex post resolution costs, help the FDIC or someone else to avoid closure failing banks. To avoid the political fallout from financial market turmoil that might arise if lending is withheld, but also to minimize the perceived expansion of the safety net and perceived departure from past precedent.

Communication tries to minimize expectations of future intervention but preserve maximum discretion. So there we were at the end of the 20th century, entering the 21st century as the great financial crisis played out, there was some continuity with 20th century lending doctrines. At the very onset of the crisis on August 9, 2007, monetary stability was in play.

A sudden sharp rise in perceived counterparty credit risk in the banking system led to an increase in the demand for reserve account balances, exactly the type of hoarding that Thornton and Bagehot described, and that had had the potential to reduce the money multiplier. To maintain the federal funds rate near its target, the New York Fed's trading desk needed to add a huge amount of excess reserves, which they did via open market lending operations, precisely the response that a classical lender of last resort doctrine prescribed.

But note that it was automatic under interest rate targeting regime and did not require any sort of intervention into credit markets per se. More broadly, though, monetary stability in the sense of Thornton and Bagehot were never a serious problem during the great financial crisis. There were no flights from deposits to currency to speak of, and no scramble for reserves or high powered money that the desk could not easily meet.

Then, at the zero lower bound, the demand for high powered money was satiated. So the reluctant Samaritan doctrine seemed operative as well in the great financial crisis. And I'll just touch on a couple of things. Interventions such as in the Bear Stearns case, restored calm to financial markets simply by raising expectations of future interventions in similar cases.

In other words, the Fed intervention prevented the contagious spread of the expectation that the Fed might not intervene to rescue investors and other similar firms. At the same time, the Fed's response in the great financial crisis went well beyond 20th century doctrine. Starting on August 16th, 2007, near the very beginning, the Fed undertook a prominent and aggressive campaign to encourage banks to borrow at the discount window.

The Fed cut the discount rate from 100 basis points over the federal funds rate to just 50. The next morning, the Clearinghouse, an organization of the largest banks in the country, convened a call for its members on which then-board Vice Chair Don Cohen and then-Federal Reserve Bank of New York President Tim Geithner urged banks to view the discount window as open, and available, and free from stigma.

Tim Geithner organized a coordinated and publicly announced demonstration the next week in which the top four US banks borrowed billions from the discount window. The effort to boost discount window borrowing ultimately failed, however. Discount window lending rose from about 200 million before August to a peak of 7 billion in September, then declined.

Borrowings at the federal home loan banks increased by $237 billion in the second half of 2007. This highly visible fed effort to promote borrowing must have had serious incentive effects. Capital markets were open for the large banks over the next 12 months, and they could have raised more equity than they did.

Notable example, Lehman Brothers. In April 2008, they go out with an equity offering. They received subscriptions for $30 billion. They took five. They could have raised more money, but weren't willing to incur the dilution costs to make themselves less vulnerable. In short, banks did not seem to be net worth constrained in 2008.

On the funding side, large borrowers could have easily reduced reliance on overnight repo borrowing. Though it may have been costly, this campaign to promote fed lending was far different than the Fed's 20th century approach, where the Fed seemed somewhat defensive about its intervention somewhat chagrined. And the discrete credit programs that came later were also far out of scale with what happened in the 20th century, lending doctrine for the 21st century.

So what we saw in the great financial crisis, the extent to which it represented a break from what happened in the 20th century, suggests that the Fed is now operating under some new lending doctrine. What might that be? The board's website provides some clues. I've reproduced here some verbiage that can be found under the tab Financial Stability.

They talk about a financial stability mandate to promote financial stability. How in a crisis financial markets may effectively cease to function, and the Fed is empowered to intervene in credit markets to restore the normal flow of credit. So this articulation that you find there in the supporting documentation and subpages leaves us with some unanswered questions.

Among them, the operational meaning of the undefined terms in bold. But also how credit markets ought to function when uncertainty about economic fundamentals becomes significantly elevated. What is normal when the real economy is in distress? That's the question. So digging down underneath the board's website language, you can discern, I think, the influence of economic ideas.

A large literature in economics emerged in the 1970s, or starting in the 1970s or so, exploring economic models with limited information, that is, adverse selection, moral hazard, and the like. The best of these were very clear about the economic fundamentals of preferences, endowments, and technologies. Information problems, just like technological constraints, limit attainable outcomes.

When applied to financial arrangements, such models are capable of displaying as endogenous outcomes recognizable financial contracts like debt, and recognizable multilateral arrangements like banks. These models have significantly advanced our understanding of financial arrangements. Some of these models provide examples, and I'll call them possibility propositions, in which, under certain circumstances, central bank lending can improve outcomes.

But the case for central bank lending in these models is typically quite as sensitive to key assumptions. In many settings in which the Fed intervened in the great financial crisis, the match between possibility propositions and reality was not at all obvious. I'll mention just a few. The celebrated Diamond-Dybvig example of a Pareto inferior run equilibrium is sensitive to depositors being isolated from each other and from the bank, and to the form that investor contracts are allowed to take.

And it's not clear that those restrictions are a good match for modern markets. Cash in the market pricing depends on market segmentation and banks' lack of access to funding. But in August 2007 and beyond, there were widespread reports of money on the sidelines waiting for more advantageous pricing.

Adverse selection models are notoriously delicate. And then there's the credit channel, which starts from the premise that limited information implies that contracting frictions, and that implies that credit extension is costly. All well and good. I totally buy onto that. Ben Bernanke and Mark Gertler, in the late 1980s, took this observation further and argued that in times of financial crisis, investment might collapse.

The laissez-faire, no-intervention allocations in their model are Pareto optimal, however. So their argument, essentially, is that transferring net worth to banks via subsidized central bank lending can be a worthwhile trade-off for society. Evidently, this is at least an empirical question. So here isn't the place to hash out the merits of these possibility propositions.

I just wanna point out that during the great financial crisis, there was no staff work that I'm aware of, and virtually no policymaker discussion of the applicability of these various propositions. No work comparing model frictions to observations No quantitative assessment of redistributive interventions, just no real interest in the economic foundations of the credit market interventions that were being considered.

Moreover, to the extent that financial markets might have seemed to the casual observer as excessively fragile, there was no effort made to assess whether that financial fragility was inherent in laissez faire financial markets were induced by 40 years of bailouts. Staff analysis seemed to start with a broad premise of inherent fragility, and proceed directly to program design, which is what occupied the vast bulk of their time and effort.

The influence of ideas, then, of this economics literature that's been so productive, was to license a general presumption in favor of interventionism. So I think this general presumption played a significant role in Fed credit policy and its break from 20th century practice. Second candidate for the first century shift in credit doctrine is politics.

So the distributional nature of Fed credit policy places the Federal Reserve at the very center of this fraught and fluid relationship between banks and the state, the history of which Charles Calamiris and Stephen Haber so vividly described in their 2015 book, Fragile by Design. Early 20th century credit policy owed much to politics such as that expressed in Warburg's mercantilism, as it did to theoretical ideas such as Thornton's monetary theory.

The evolution of Fed credit policy in the second half of the 20th century was also a byproduct of political environment and governance. Having an independent balance sheet with which the Fed, after the accord could intervene without monetary policy consequence left the Fed exposed in possession of a vestigial tool of keen interest to the banking industry but subject to a serious time consistency problem.

The reluctant Samaritan fed and was fed by the growth of large banks, but might have struggled by itself to meet the challenge of subprime losses in 2007, given the induced fragility of the system. The influence of politics and inherent fragility perspective seemed to have been complementary. The credit view emerged alongside of and rationalized the growing interventionism of central banks.

In 2007, the credit view's commitment to interventionism dovetailed with the self interest of Wall Street, whether intentionally or not, and exacerbated moral hazard. The resulting turbulence provoked a fierce populist backlash, but for now, inherent fragility seems to be the prevailing view. We have, therefore, what I describe as the sell side savior, sell side because intervention favors those selling IOUs of some sort.

The Federal Reserve intervenes in any credit market at its discretion to restore the normal flow of credit to borrowers when financial markets experience distress. Interventions are designed to be seen as fair. Interventions are chosen ex post and the domain is broad, any debt market is in scope. Political support for intervention is broad as well.

So the risk of blowback for overreach is small. The reluctance of the late 20th century has receded, the political constraint now simply is that interventions are seen as fair. So this is where I believe we find ourselves. My hope is that in the years ahead, the shadow open market committee can contribute to a constructive evolution of Fed lending doctrine.

Thank you.

>> Amit Seru: Thank you to the organizers for inviting me. It's a real honor to discuss this paper. The paper is very rich, as you all saw from the presentation, I learned a lot from it. It masterfully tells you about the progression of Fed's role in monetary and credit policy.

I have limited time, as you know, and I know that everybody's tired, and so I won't be able to do justice discussing everything in the paper, but I highly recommend everybody to read it. What I will do is I will focus my remarks on one aspect that connects a lot of the themes in the paper.

And that theme is going to be about governance and how it's intertwined with credibility for independence that Fed has. There's nothing to disagree really in the paper, from my perspective, I'm actually very happy that I'm going after Charlie. It's hard to outdo Charlie Kalamiras, for those who know, you'll see it what I mean.

Even though he's going to be online, it's going to be hard. So the way I want to sort of structure this discussion is to talk about the healthy tussle between public interest view and the private economic interest view of regulation. This tension is articulated by this famous quote by Stigler, not invoked Milton Friedman many times, obviously, but Stigler just is a good reminder that we have to be mindful of the fine line one has to draw when regulating the industry.

And this is particularly salient for banking and Fed, partly based on how the governance for the Fed is set up. What do I mean? So if you look at how the governance of Fed is set up, it has different classes of board of directors. Some come from the industry, some public at large, and some from the Fed.

Now, of course, a structure like this, it's pretty unique, it could have many benefits, but the structure is also particularly susceptible to interests of the industry. And this was articulated many times, including by GAO, for example, this is a quote from 2011. And concerns like these are amplified when you also look at the heavy movement of personnel between the Fed and the private sector.

So, here is a plot that some of the analysis that I have done, where, if you look at all the Feds and whats the flow of employees who work in the Fed to the private sector, financial, non-financial, and otherwise, and you see a pretty substantial number there. There's nothing wrong with that, per se, this allows for a vibrant talent pool that gets attracted in the Fed to begin with.

But the fact is that the structure that I showed you before, and these patterns tell you that, like, the governance needs to be extra careful about maintaining credibility with respect to independence from the industry. And this applies both for monetary policy and for financial stability. If you had taken any class on corporate governance, and I do teach corporate governance, the general governance principle in such a setting would tell you that you got to establish a pretty strong credibility for being.

Independent. And where will that come from? Well, they'll come from various themes that have been articulated for 50 years, probably by this forum. And also we've heard many, many speakers talk about. So it comes from, obviously, the commitment. So emphasizing rules rather than discretion. We saw that starting from John Taylor's talk yesterday.

It comes from establishing reputation. Reputation for what? Willingness to take tough decisions. And it comes from transparency. And we saw a bunch of these themes in the previous panel. Charlie and Debbie both talked about this. So this obviously connects with all of those things. So in my discussion, what I wanna do is to argue that this credibility on independence is dented, and it's dented in a pretty substantial way.

I think there is now a lack of commitment because there is simply too much discretion in the system right now. What that means is that there is an interaction with, potentially reputation. Why? Because discretion leads to automatically finding ways to not take tough decisions, which means you lose your reputation.

Now, Fed has been a fantastic institution. Reputation building takes time, but reputation can be destroyed very, very quickly by such decisions. So let me elaborate what I have in mind based on some of the research I've done with my collaborators. So why do I say that there's more discretion potentially in the system?

Now, we've had a bunch of failures, Jeff sort of talked about the whole history. And whenever there is failures, we think about rules. And what rules? Well, we are going to regulate the banks. We are gonna supervise them. And here is a list of the rules. We are great at addition, we are not great at subtraction.

We know that. But a lot of these rules, especially spiking after the financial crisis, are all about supervision. What can banks do? What can they not do? And we are going to figure them out. And are they safe or not? So you would think that with so many rules, there is not much room for discretion.

And let me give you an example on how much discretion there really is. And this is based on a pillar of financial stability. And one of the pillars of financial stability is trying to figure out the CAMELS rating. What does CAMELS do on a bunch of dimensions? Capital, asset quality, management quality, earnings quality, liquidity quality, sensitivity risk.

We are gonna rank banks from 1 to 5, 1 is good, 5 is bad. And with so many rules, we've kind of minimized the discretion, at least that's the hope. Now, you can see that some of these components will have more discretion than others. For example, management quality.

Now, what do we do with these ratings? We add them up. We construct a composite, and again, a composite score gives you a rating from one to five, one good, five bad. And all the policy decisions are then pegged to this, from deposit insurance to whether banks are allowed to expand and so on.

And so is there a lot of discretion? Well, we sort of looked at the data to tell us that. So we looked at CAMELS ratings and asked how much of the variation in the composite ratings of are getting driven by different components? Because you could argue that some components are more discretionary, others are not.

And what did we find? 50% of CAMELS rating is driven by management quality. That is a lot of discretion, I would argue. You could say that, well, there's a lot of discretion, but how do we know it matters? Turns out when there is fragmented responsibilities, overlapping jurisdictions, same rules can be interpreted very, very differently.

Here is one way to see this. A vast majority of banks in the US financial system, actually I'm keeping track of time just to make sure. Self governance, all right, turns out that when responsibilities are fragmented across many regulators, you could have a lot of discretion playing a role.

So a bunch of banks in the US are supervised in rotation between state regulators and federal regulators. So same bank looked at by state, then by Fed by state, and so on. The advantage is you can look at what are the camels rating given to the same bank by two regulators virtually at the same time.

And I'm gonna show you that figure. The white bars are going to be when states are looking at the bank. The dark bars are when the fed are looking at the same bank and giving it a camel's rating. Remember, higher camel score on the y axis, tougher rating.

So here is how it looks like when the states come in the white vertical lines, they lower the camel's rating. When the feds look at the same bank, the dark vertical bars, they raise the CAMELS rating. When the states come, they lower the rating, you get the idea.

Especially when the states and the local economy's not doing very well. You would argue that this is a lot of discretion in the system. Now that was just two regulators. Just to remind you, we have a system now of these many regulators. I know that John Cochran likes this figure because that makes his plea on the fiscal theory of price level very clear to at least one of the regulators.

When you have so many regulators in the system, it's hard to argue that there is not going to be discretion multiplied. That means many voices, uncertainty for banks, and certainly not a clear firm rule-based approach. Now, discretion has also meant that we have not taken tough decisions. In my view, we saw that in terms of monetary policy.

Lots of people talked about monetary policy was too loose for too long. Financial stability's similar, we saw it in the turmoil last year. Here is one way to see it. If you look at the fundamental issue in the financial sector, what is the issue? The issue is this.

On the-x axis is different size of banks. On the y axis is how much leverage, how much debt they have. You can see that. I don't know how to explain this, but all the leverage is the same, and it's 90%. It's pretty high. What that tells you is that small decline in asset values, whether they come from credit risk in 2007 or interest rate risk like last year, will threaten insolvency.

Now, one simple tough way to think about this is that, well, the way you sort of solve for shocks is you create more buffers, have more equity in the system, but then banks start complaining. What is the complaint? Equity is expensive, we can't run the business. And that has been the general complaint.

But we now can see that there are many other institutions out there who, non depository institutions, who are doing the same kind of activity. These are called shadow banks, non banks, whatever you might want to call them. Now, some people are calling them private credit. Here is an example of one such industry.

So this is the $12 trillion mortgage industry. And if you look at the leverage debt levels of non banks doing the same activity as banks, this is what the picture looks like. What is this picture? Telling you that they have a lower debt, which means more equity than banks, especially the gap is highest for middle and small banks.

What that tells you is that small and medium banks have a lot of leverage. They could do it at much lower leverage. That means they are eating subsidies and over levered. This issue has been all around, all the turmoil and the banking crisis. A tougher rule based approach would tell you we need to identify an insolvent bank, we need to restructure, we need to raise equity.

Why do I say that discretion has crept in? Because the discretionary approach is the easy approach, I feel. Why? Because now we can reinterpret solvency, which is hard to sort of pin down, but we can call it liquidity. And once we call it liquidity, we are in this Heisenbergs principle applied to physics, but this is in liquidity world, and I like to call it Heisenberg's paradox.

Why? Because we can neither define nor measure this. Liquidity is sometimes slow, sometimes fast, sometimes sudden. Could be multicolored. You get the point. But all that does, as Jeff has pointed out, is if we rely on liquidity, we can immediately go to lender of last resort and infest the whole system with subsidies, because we are clearly not looking at what costs it is potentially putting us through.

I will not repeat this chart because Debbie talked about it and then it was talked about in other panels as well. But you can look at the size of the interventions out there. When it's a liquidity problem, seems like there are only benefits, there are no costs. But we don't know if all of these events were actually liquidity events maybe they were, maybe they weren't.

And if you look at the size of the intervention, they kept going up. And this, I again argue, is probably because discretion is endogenously leading to a mission creep, which also we have spoken about, by the way, because fed is such an elite institution and something that everybody looks and aspires to, this has spread everywhere.

That's a separate cost that one has to think about. If you look at who is right now doing the discount window lending, there is this entity called FHLB that some of you might have heard about. They are doing a lot of discount window lending. They did it in Covid, they did it in the great financial crisis.

And why are they doing it? Well, they were supposed to stabilize house prices, but I do not know if that's what they are after anymore. All of this is to say that the credibility is a question, and I will sort of give you three examples and then wrap up to show you what I mean by the credibility being dented.

So let's first talk about the recent financial turmoil with failures of SVB First Republic da da da da. Republic first. Actually, Republic first is a bank that failed. What was the diagnosis of the Fed? Surprise, surprise. Liquidity. The Fed report mentions liquidity 300 times, and insolvency was mentioned once, which I always joke was a typo.

It has been quickly adopted by other regulators. And while this is all great, and liquidity was diagnosed and we injected the system with more liquidity, which should be short-term, mind you, over months, banks kept failing despite the liquidity infusion. And the reason was SVB and other banks were insolvent.

They took interest rate risks, they didn't hedge it. Their values fell. The values will be there. This is not a liquidity event. This is a capital issue. This is a reorg issue. But we don't want to take tough decisions, and that's fine, but this is not the worst part.

The worst part, which gets at the credibility, is simultaneously there was this Basel three endgame discussion going on, which Fed was also a part of. And part of the discussion there was, hey, banks should raise capital. Why? Because many things. But also look at the turmoil last year.

But remember, Fed's report itself always said it was liquidity. So how long do you think it took industry to latch onto it, to say, hey, the turmoil had nothing to do with capital? We don't think this is a capital issue at all. And lo and behold, the Fed then comes back and says, well, we can't push this through.

That raises the question, who is fed playing for? A lot of people have raised this issue. This is not my issue. Similarly, there is a big debate about innovation in the financial sector. Whether it's Fintech, whether it's payments, whether it's crypto, whether it's private credit right now, it suffices to say that US is behind the curve in a lot of this innovation.

And it's not because innovation is not happening in the US, It's not being brought into the financial sector. And why is it slow? Well, one narrative is that the banking sector argues that this is really bad for their profits. No surprise. Yes, that's what competition does. It also forces incumbents to innovate.

Here is banks complaining about CBDC. What's the complain? Deposits will go, we will lose our profits. And low and behold, Fed comes back and says, well, this is not even something that we are taking seriously, which is all fine, but then the question is, again about governance and credibility of independence.

The last example I will just mention very briefly is the one which many of you have already brought up, which is about the unwinding of what has been wound up in the Fed balance sheet. Here is another picture one last time. We have seen this picture. The fed balance sheet is huge.

We did this and the whole notion was around this time we are going to unwind. But I don't see much of unwinding at that time. Why did that happen? Because there was a lot of pushback from the industry, from other places that, well, this would be bad for us and so on.

So we just let go. And every time fed lets go, credibility is an issue. So let me conclude. I think this is a great paper. Everybody should read it. I learned a lot about it. My main theme here was to talk about governance. I argued that governance in the case of Fed faces a little bit more headwinds than otherwise just because of the unusual structure.

The unusual structure has clearly some benefits, but there are also costs. And to be effective you got to establish some reputation. Right now there is too much discretion that blunts the will to act tough. There is a propensity to reinterpret events that leads to infestation of lender of last resort.

I also should note that if you have too much discretion, there is no metric to evaluate the performance of the Fed either. Some of you have already brought that up. What do I have in mind there? That if it's heads, I win, I save the system from sudden shocks because shocks are all of a sudden and tails also I win because if there's turmoil, see heads, shocks are sudden and I save you.

If you think this is just something that I am making up, you should just read the press right now and see what investors are saying. Here is a quote from an investor in the press last week. Investors have comprehended that they will make money in good times and bad, this is investing in bank stocks.

That should tell you a lot about what the industry feels. Feel that governance tells you that if your credibility is dented, you need to reorg or reset. This is a great institution, and we should not lose it by not resetting or re-orging, and that would be my plea.

Thank you.

>> Thomas Hoenig: Thank you. Thank you very much. Now I think we're going to have Charlie join us.

>> Charles Calomiris: Thanks for your tolerance. As you can hear, I got a sudden cold or whatever it is, and so I couldn't be there. And I hope I don't lose my voice.

I don't think I will. First of all, let me compliment Jeff. This was a remarkably comprehensive review of the issues and the specific positions that SOMC members and the committee as a whole have taken on this controversial and difficult area. And I think he did the SOMC a great service by going back through all this material, and it's impossible to do justice to what he did as a discussant.

And he laid out the various points of view, I think, very well. And of course, I love all that Amit said. I very much share both of their concerns about excessive bailouts. And in my own research, this undisciplined and politicized bailout process that is not, I think, in many cases, not justifiable on the basis of economics.

And is certainly much worse because it has so much discretion built up in it. Seems to be, I think, a major concern, and I think Jeff shows it's been a major concern of the SOMC, and that's something that all of the SOMC members who've worked on this have in common.

I think it's important to say that when you ask about the solution to it, that's where you see a dividing line in some of the writings of the group. In fact, Jeff himself mentioned in his comments that Friedman Schwartz said, well, we don't care if the whole banking system disappears.

If all the lending of the banking system disappeared and all they did was produce deposits, that would be fine. So, in fact, I guess that means 100% reserve requirement on banks would be fine. And from a cyclical standpoint, the disappearance of all bank credit wouldn't be an issue from their point of view.

Of course, Jeff also noted that in the 1970s and 1980s, a different point of view about bank lending. They saw it as a major and important state variable in the economy, that not just the supply of money, but the supply of bank credit was very important because it didn't have good substitutes in the financial markets and even across the banks themselves.

So that in certain locations if bank credit dried up, the fact that some other state had a surplus of bank credit wouldn't be enough to create a normal, functioning economy in the place where the bank credit disappeared. So the thing that happened in that 1970s and 1980s was a view that bank credit supply in the local area of the economy was very important.

And that, in a sense, even if the money supply, which is an integrated aggregate, even if that's behaving fine, local credit supply matters still. The reason I'm emphasizing this, which Jeff also mentioned, is because, as I'll show, this is a very important thing to bear in mind, because it would be, of course, much easier for us if that weren't true.

And within the SOMC, Jeff mentioned Anna Schwartz's Homer Jones lecture and also a paper by Goodfriend and King back in the 80s. But what those papers did was they said, well, with a properly functioning fed funds market, banks can distribute, we can prevent the money multiplier from collapsing.

Banks can provide credit reserves to each other. And so we really don't need anything but open market operations to preserve financial stability and macroeconomic stability. I don't agree with that view. And I'll also, although I don't want to say too much about Alan Meltzer's points of view on this because he's not here to defend himself.

But, of course, Alan, I think, especially in the last paper that he wrote, which was, he was a co author of mine, took a different view. And that different view, I think, is that we do care about bank credit. And unfortunately, because we care about bank credit, we still need some of these mechanisms.

And that's where the difficulty is. And the way Alan always used to put it, whenever he would testify about the lender of last resort was the Federal Reserve has never articulated the rule that should guide the lender of last resort. And I would generalize that to and the government, in its implementation of TARC and the creation of those, has not articulated the general rule that should govern that either.

And in a paper I wrote with Luke Lavin and Mark Flandreau, we tried to come to some sort of beginning of articulating what a rule based approach would look like for that. So I want to emphasize, I think, that the interesting thing about the shadow committee is that it's always been very skeptical of the actual policies and seen them properly and correctly as politicized and often ineffective and wrong-headed and counterproductive.

And yet there are two groups within the writings of the Shadow committee members, one that says, let's just get rid of them, and another that says, well, we can't get rid of them because there's this little problem called bank credit matters. And so if local bank credit matters, we do have to take interventions that worry about bank credit more seriously.

And so I think that's the interesting kind of intellectual differentiation, despite all the commonalities. And I think that fits very well with Jeff's overview. Next slide, please. So I've already talked about most of this. I also just want to, in passing, also say that, Jeff, when you talk about Thornton and Bagehot, they use the word money a little differently from the way we do because they were talking about bills of exchange and domestic bills

Most of the market that they were looking at, which they called money, was actually a credit instrument that also served as a monetary instrument. So when they say money, and more generally when people used the word money in the 19th century, they didn't mean M2, they meant money market instrument.

And I think that, you know, it's a little hard to say that they backed the narrow view of, let's say. That Anna took in her Homer Jones lecture. I don't think they did. So what I want to do next slide, please, is talk a little bit about what I think the implications of these, and then just give you a little bit of a taste for why I think we're stuck with the more difficult view, which is we have to try to articulate, formulate a rule to guide our interventions.

We can't just dispense with them. So the first thing I'm gonna talk about empirical work that shows why three kinds of things are true. One, a negative shock to banks net worth can't be sort of immediately undone with a monetary expansion. And I'm gonna use the example of New York City in the 1930s in just a minute.

Second point is a sudden shock to borrowers pre-existing supply of credit that they were getting, let's say, through the commercial paper market, was properly and best dealt with by the Fed. This is, I think, a big success of the Fed, the Penn central crisis of 1970, using lender of last resort, rather than trying to solve the problem with expansionary open market operations.

Basically, lender of last resort was a well articulated smart bomb that dealt with a temporary credit problem fairly well. And a third implication of this is that because of asymmetric information, when shocks hit, and people can see that there's been a big shock, but they don't know the incidence of the shock, then they start seeing one bank in trouble, and they can think rationally, in fact, that other banks may be implicated.

And it's that kind of asymmetric information that sort of informs lender of last resort policy. And again, generally, the open market operations are not gonna be a solution to this kind of information problem. They don't stop, lets say, withdrawals from banks based on depositor fears, they can't really open market operations just can't solve that problem.

That's why you need, depending on how severe the problem is, you need either traditional central bank discount window lending or lifeboats or tarps or something else. And comparing those and trying to understand why they're differently useful in different periods was the subject of this paper that I wrote with Flander and Leven.

So those are the three points I'm trying to make that I think we have a lot of evidence that tells us we can't just dispense with the lender of last resort and rely on open market operations. It just doesn't work very well to solve a lot of real world problems that we understand are well grounded as problems in economic theory.

Next slide, just to give you a sense of New York City banks. Now, by the way, none of these banks failed. This is an average of the bank banking system in New York City, none of them failed during this period. But you can see that the ratio of loans to cashless treasuries went from January 1929 it was over three, and by January 1940, it was three.

And what's happening there is there's a huge contraction of the banking system because the bank suffered real losses. And as part of restoring the confidence, that column marked P is telling you what the implied default risk in basis points of deposits in New York City banks were. So you can see they restored that confidence over time.

But to do so, they had to basically become much less risky on their asset side, which is why they got rid of all their supply of lending practically. And the point is, in these situations, bank credit contracts, sometimes dramatically. In a paper that Joe Mason and I wrote, that's in the AER, in 2003, we developed the kind of instrumental variables approach to try to measure how big the local, that is, state specific contraction of credit was, and then how the exogenous contraction of bank credit locally affected state income.

Next slide. And so, just to give you the bottom line answer here, it looks like the elasticity of state income with respect to the local contraction of bank credit was about 0.4 to 0.5. In other words, putting aside the aggregate effects having to do with the money supply, which are common across the whole country, if your state had a 5% contraction of credit supply, that meant roughly a two and a half percent contraction of state income.

And that's putting aside the aggregate effects that you might attribute, let's say, to the money supply. Coming to Penn Central, the point here was we had an evolution of a new kind of market in the US in the 1960s, commercial paper market, which was nothing like the traditional commercial paper market.

Again, language can be very deceptive. This was a very different market. It was not a bankers bills market, it was a new kind of credit market, and the holders were corporations and other institutional investors. But it was nothing like that traditional market. This was a fairly new market.

It appealed to extremely credit worthy firms that had access to the bond market, and that all of the CP is basically rated at a very, very low tolerance for risk. As soon as you got any risk, you were rationed out of this market. This was only not just investment grade, but only double a rated short-term.

And Penn Central was a commercial paper issuer, they went into default. And this was a major shock to the market. In fact, it completely restructured the market for commercial paper as people realized that their ways of thinking about risk were wrong and suddenly this very large amount of commercial paper is not gonna be rolled over.

All these borrowers had migrated out of their banking relationships into the commercial paper market because they were so low in risk. And all of a sudden they needed money like crazy. So the Fed said there's a big gap between the Fed funds rate and the discount rate, which was interpreted, of course, as a non-pecuniary penalty on the margin for accessing the discount window.

So the Fed basically said, if what you're doing is accessing the discount window to pass it through to commercial paper that's rolling over, we won't penalize you at all. And this was a very effective way to create a pass through. And note, especially people didn't know how long it was gonna take for the commercial paper market to be restored.

And so it was really nice.

>> Thomas Hoenig: We gotta finish up.

>> Charles Calomiris: Okay.

>> Thomas Hoenig: You're out of time. Keep going, but just wrap up.

>> Charles Calomiris: How much, okay, we'll do. So the point is this worked very well. And if you had tried to do. Do it with open market operations.

I don't think it would have worked very well. Would have been, you could have done something, but it wouldn't have been this kind of smart bomb that it needed another thing. On bailouts, just in Canada, twice in 1906 and 1908, the bank of Montreal decided to orchestrate a lifeboat to let bank.

These failing banks, be acquired by the aggregate of all the surviving canadian banks. They generally didn't organize life waves, they let banks go. But in these cases, they acquired these banks as they were failing. So what it shows is that this is not just a government intervention or a political sort of move, but that sometimes private entities can decide to bail out banks to acquire them to prevent.

And I've discussed with Steve Haber, we discussed these examples more to prevent a kind of systemic risk that comes from the fact that there's asymmetric information in the credit market. Next slide. I'll skip right to the conclusions stay with this slide for a minute. This is the last substantive one, because what it's basically talking about is why you need part or rfc in the 1930s.

And the reason you need that is because sometimes lending to banks that are insolvent, or even near insolventhe. Or even just very risky, isn't good enough because it actually takes their collateral away from them. Because the Fed gets the collateral first claim on the collateral actually makes the banks more prone to runs.

And everyone understood this in the thirties, and that's why we created these kinds of assistance for banks. And in the next couple slides, just flip through them. One next. Okay, so this one, those two slides are showing you that banks that received for exogenous reasons, unrelated to their risk, received earlier preferred stock assistance by the government.

Not only had better survival histories, but also were able to maintain their loan growth better than other banks. Now onto the conclusion. So, really, I've just tried to show you that I think that we're stuck with the difficult problem of having to actually have a systematic policy for lender of last resort.

Which includes the Fed, but actually includes the treasury, too. And that I don't think that we're there at all. And I think this is the same message, really, Amit and Jeff would agree with, which is this really needs to be the thing that we focus on. And I'll stop there.

>> Thomas Hoenig: Thank you very much, Charlie.

>> Charles Calomiris: Thank you.

>> Thomas Hoenig: We have a couple minutes. Well, we'll make a couple of minutes, put it that way, for, say, three questions, and then we'll let.

>> Audience 1: Thank you. Amazing presentations. I don't want to derail the conversation away from the main topic.

But I think that, looking forward, one risk is that the next big crisis might be a debt crisis, a treasury type of run on Treasuries. If that investors smell that risk and we start having wobbles in the treasury markets, I guess the Fed will come in and intervene under the guise of some market functioning issue.

So how do you think about that part of the financial stability mandate of the Fed? What are the rules of the road? Seems to be a very fuzzy area where repeated interventions there might actually induce significant more hazard.

>> Jack Krapanski: Hi, I'm Jack Krapanski. Real simple question on Silicon Valley bank.

Before that happened, I thought bank runs were just a thing of the past, the 1930s or something. How frequently do you think actual bank runs will be in the future? And isn't there some way, Silicon Valley had assets, so the student. Couldn't the Fed have taken the assets but kept the depositors hold so that we don't have this banking integrity?

I don't want to protect the bank, but I want to protect banking integrity so people don't have to feel like they have to run.

>> Thomas Hoenig: Okay, we'll let Jeff reply, and then.

>> Jeffrey Lacker: Thank you to is this on? Thank you to Charlie Kalimiris and Amit Saroo. I really appreciated your comments, Charlie.

We have a lot to talk about offline sometime, but I appreciate your generous spirit. The Fed does intervene at times in the treasury market, saying they have concerns about market functioning. At a certain level. I know what they're talking about. At a certain level, I don't like at the level of a model with preferences, endowments, and technologies spelled out.

I'm not quite sure I get it. And again, it goes back to this question of how should markets behave when, how should financial markets behave when the real economy is really uncertain? So about runs, there's a good paper by Jonathan Rose, 2015, a working paper at the board of governors that documents the runs in the great financial crisis.

He shows they were all runs from one bank to another, the runs like we had in the Great Depression, where people took their money out and took currency home with them. Those are things of the past. But runs are a real thing, and they're less about people showing up in line than they are about large depositors that have access to a bunch of different banks that just move their money to another bank.

But thank you. Those questions.

>> Amit Seru: I'll just say one thing, which is people focus on Silicon Valley bank. But that's what I was trying to say in a roundabout way, that there are many banks with very similar features. All of them paced, run or threat off a run, because they have large uninsured deposits and their assets are depressed.

There is nothing about liquidity. When your assets are depressed for a year or a year and a half, it's a solvency issue. We can call it liquidity, but that's my point.

>> Thomas Hoenig: Agree.

>> Charles Calomiris: I wanted to just answer the question directly about what the FDIC could have done.

So we do have this capability of paying out a large percentage of uninsured deposits, even though the bank has failed. So in the case of Silicon Valley bank, for example, the FDIC knew that it could have paid out 90% of uninsured deposits with the bank failing. And so the notion that somehow it was needed, as secretary Yellen said,.

To bail out the bank so that they could pay out 100 cents on the dollar was just completely fallacious, and it really showed how political this bailout was. So the answer to your question is yes, it could have been solved a different way.

>> Thomas Hoenig: Thank you all very much.

Thanks the panel, for all their work. Thank you.

>> Deborah Lucas: Good evening, we've come to the last panel of the day on the influences of the SOMC and others outside of the Fed. I just wanted to start by saying that often what you hear at SOMC meetings is that monetary policy would be better informed, and a lot of missteps may be avoided if the Fed more seriously incorporated a more diverse range of viewpoints and frameworks into its deliberations and decision making processes.

So I applaud the organizers for assembling this extraordinary group, Donald Kohn, Roger Ferguson, Bob Heller, and Esther George. They collectively bring many decades of practical experience and wisdom to be able to shed light on how and when outsiders have had a meaningful influence on the Fed. So the question really is, does the Fed really listen?

And let me start to get some answers to that question by handing it over to Don Kohn.

>> Donald Kohn: So thanks for having me here. Someone earlier today referenced a variety of views in shadow open market committee meetings. And I think when you want a variety of views, you invite me.

On a few rare occasions when you're looking for a variety of views, I'm happy to be here. And I also note that this is kind of a reunion for monetary affairs. We must have about half a dozen former members of the division that I led for so long, and it's great to see everybody.

So this led me to reflect the topic, led me to reflect on how information gets into the Fed and then how it's processed once it gets in there, and how that's changed over the years. And then also to use monetary policy rules as an example of one of the topics that has changed over the years.

So there are lots of channels for outside information and views to get inside the Fed. And this was true even in the Stone Age, the benighted 1970s, that when I joined the Federal Reserve, policymakers and staff pay a lot of attention to other views that are expressed about monetary policy.

There are panels, even in the 1970s, there were panels of outside economic experts that came in and presented to the Fed. I remember going to them and seeing the people that I had been reading the articles in graduate school, Friedman and Samuelson and those guys. And the great thing about those panels was, as a staff member, you listen to them and you thought, they don't really know anything more than I know about this, even if they're smarter.

Outsiders become policymakers. And we've had several members of the shadow committee become policymakers, Bill Poole, Charlie Plosser, Jerry Jordan. But I do think it's important. And someone made this point earlier today to me, the Reserve banks are like the external members of the monetary policy committee that they have.

So they have their own staffs, they bring outside views, and it's really important to have strong, strong presidents representing a variety of views. The board tends to become a little homogeneous, in part because one president can appoint a whole bunch of people who tend to have similar perspectives.

So I think we rely on the Reserve banks to bring outside views into the meetings, and they certainly have done so over the years. And I think the other point in this, having all these monetary affairs people here brings this home, is former students. Students who come from universities, studied under people come into the fed, they bring those ideas, they bring that fresh thinking.

When I joined the Fed in the 1970s, there were several very important staff members who had been Friedman's students. Most importantly, including, I think, Steve Axelrod, who certainly had gone to Chicago, he didn't get his PhD, but he studied there. My friend and deputy for many years, David Lindsey, was a Friedman student.

Tom Simpson, who implemented monetary policy as a Friedman student. So there are lots of channels for outside influences getting in now. I think things have changed over time about how those channels, how that's been processed once it's get inside. And I think the receptivity and tolerance for alternative views on staff and policymaker levels has increased substantially.

So certainly under Arthur Burns and to some extent under Paul Volcker, and there wasn't a lot of tolerance for alternative perspectives. And staff publications were tightly controlled. What you could publish Reserve Bank publication. I remember being at the Kansas City Fed and having submit my articles to the board staff for review, for example, and that's loosened substantially over time.

And so all kinds of stuff, staff papers are published now that aren't necessarily in conformance with the official perspective. I think Ben Bernanke and Janet Yellen bringing the academic perspective really helped that process along. I think a second thing that's changed over time is, at least for a time, and Jim Bullard discussed this to some extent.

Academic fashion wasn't aligned with what the policymakers were looking for in terms of guidance. So you have the real business cycle stuff. So somehow what Paul Volcker did, raising rates to 20%, and that wasn't what caused that recession, it was a productivity shock. It was hard to convince us at the time that real business cycles this way.

And then you had the shadow committee pushing this monetary base targeting. And there was no way that the Federal Reserve was gonna target an aggregate. Most of which was held in currency outside the United States and subject to variations and those things, so it really didn't. But then I think John Taylor and his rule changed everything.

And Ben McCallum made this point in a talk to the shadow committee in 2015. That John, by putting interest rates at the center of the policy rule and at the center of policy, then aligned with what policymakers were interested in. And there could be much more dialogue between the policymakers and the academics when they were both talking about the same Instrument, even if they had different views about how it might be used.

And I think a final thing that's changed over time, that's helped the dialogue between outsiders and the Fed is greater fed transparency, transparency about what we're doing, why we're doing it. The publication of the transcripts, which I think had some pernicious effects on meetings, many more prepared statements, etc.

But certainly academics and outsiders, not just academics, but people on Wall street, are much better informed about what the Fed is doing and why. Maybe not enough. Everyone has a way of thinking about how that could be improved. But I think the difference today from 20, 30, 40 years ago is huge.

And that transparency helps the dialogue as well. So I wanted to reflect for a few minutes on policy rules and how the presentation, and Chris Waller talked about this, about his looking at this and how that's changed over time, and then what some of the limits are. So as early as the late 1970s, Fed researchers were fitting what we called reaction functions and evaluating, looking for and evaluating regularities in policy formulation.

Interestingly, the one study I can think of that was done, Arthur Burns, wouldn't let it be published because it said we weren't running policy very well. In June 1992, the Fed held a conference on operating procedures in the conduct of policy that had a lot of policy rule material, including McCallum's rule, being examined, and was summarized by Ben McCallum and John Taylor wrote the final essays in those.

In the 1990s, we in MA worked very hard on Taylor rules, especially after 1993 when I spent three months here enjoying John and Alyn Taylor's very nice hospitality, but also being subject to relentless proselytizing by John and we, Athanasius reminded me, we started sending a rules memo to the board after we came back.

We started including that stuff in blue books. We had the, that someone mentioned earlier in 1995 discussion of policy rules. In 2004, after I left monetary affairs, the blue book started to include a table and charts on rule results that's now fed on a regular basis to the board, to the FOMC chair.

Yellen highlighted this work in several speeches, including one here in 2017, in which she discussed three rules. The Taylor the balanced approach and changes rule. In 2017, the monetary policy report acquired a rules box comparing policy, the output of a variety of rules. Now, I think policymakers recognize the advantages of regular and predictable policy, but the role of rules and policy making has been limited.

At best, they could be characterized as guideposts, that's what Alan Greenspan called them, or broad guidelines that's what Janet Yellen called them, and they're often not referenced at all. And here I'm thinking about why the resistance to more emphasis. And I'm drawing particularly on two speeches given here at Stanford, Alan Greenspan in 1997 and Janet Yellen in 2017.

So Greenspan noted that policy rules assume the future will be like the past, that there are regularities that will persist. But he noted, and others have, there are shocks that hit the economy that aren't encompassed by the policy regularities in the period in which the rules were fitted and tested.

And Greenspan cited three things just in the ten years that he had been chair that caused the Federal Reserve to deviate at least temporarily, from what you might think it was a rule. The stock market crashed crash, the 90, 91, 92 credit crunch and the 96 and afterwards.

So he was speaking in 97, 96, 97 productivity increase. So he saw enough changes that meant that the rules were less useful than they otherwise might be. Janet Yellen cited fiscal policy, global growth, fed balance sheet, risk management factors as also reasons that they weren't encompassed by most of the rules.

Most rules, not all of them, use current or past values. Best practice, central banking, is to target a forecast and they are very sensitive, both Greenspan and yellow, using different words that noted they were very sensitive about assumptions about R Star, U star, and Y star. I thought the 1997 Greenspan speech was especially interesting since he ran the policy Taylor found as systematic and successful, but he rejected the rule that came out of that.

I think there were a lot of systematic aspects to policy between 1982 and 1987. One was a focus on restoring price stability, along with very close attention to what was happening to inflation expectations, with a lot of attention to what's happening, long term interest rates as an indicator of what's happening to expectations.

Second at the same time. So restoring price stability, but paying attention to the labor market, minimizing weakness or leaning against strength in the labor market. But it was clear that price stability was the goal after the experience of the 1970s. A second characteristic was it was forward looking.

It was critical to preempt possible increases in inflation, especially after the 1970s. But the focus, especially by Greenspan, was on the next few quarters. He was not a believer in long term economic forecasting. He'd had enough experience in which that wasn't very successful. But he was really good at looking out a couple quarters and kind of seeing what was coming.

I used to kidding me, took one questionable data point, divided it by another questionable data point, and somehow often got insight into what was happening next. So forward looking and inflexible in responding to unexpected developments. Rules in that context could be looked on as guideposts. Thinking about them if what you're doing deviates from a lot of rules, you ought to think about.

Why it deviates. Do you have a good rationale for changing, for not following the general policy, the rules? And I do think, arguably, Fed policy in 2021 and 2022 didn't adhere to these systematic things. It wasn't necessarily focused on restoring price stability. We've talked about that seemed to emphasize the employment side more.

The new framework explicitly didn't lean against strong labor markets. So it was less preemptive, less forward-looking, and it experienced some very unexpected developments on the inflation side, and it didn't really react flexibly. It kept with the same forward guidance. So I think there are lessons to be learned from the success of policy over the period.

John Taylor fit and others have fit their things, their rules. I think the systematic aspects from the nineties, from the 80s and 90s, may be as rule-like as we'll ever gonna get. But they do, the rules can play a valuable role in policy-making, so thank you.

>> Deborah Lucas: Thank you.

>> Roger Ferguson: Good, That was great, Don.

>> Deborah Lucas: Roger is next, but I'm just gonna put in a general appeal. We thought everyone would enjoy this panel more if you were Fed while we were speaking. So I'm now gonna say out loud to the general crowd, food hopefully will come while we're speaking.

But Roger, you're on.

>> Roger Ferguson: Great, thank you very much. It's always a great pleasure to be here. And when I was a Fed governor, to your point, I would always say, please going to need, because I'm used to people not paying attention to have to say anyway. So I'm really pleased to follow Don, because he did a really deep analysis into the rules issues.

I am gonna take it to a slightly different place. But first, I start with what struck me as a little bit of a sense of irony, because the title of this panel is influences of the SOMC and others outside the Fed. And we're supposedly celebrating Fed independence, independent central banks.

The definition of an independent central bank is you're not gonna be influenced by outside influences. And so I don't know what you want us to be. Either we follow your guidance, and we're not independent, or we ignore all sorts of outside influences, and we are independent. But let me take it much more seriously to pick up where Don left off.

But one of the things he didn't talk about, which I think is critically important to the influence of outsiders on the Fed. But more importantly, the influence of Fed on the outsiders, and something Don barely touched on, but I wanna drill in on, which is transparency. And so all of you know, the history of the Fed very, very well.

And I first became interested in this when Paul Volcker was the chair. Obviously, Paul had very little interest in any kind of transparency whatsoever. The entire policy approach was one in which they were focused on some version of the aggregates and let them move around or try to target them.

And then let interest rates go wherever they want it to go. My theory of why the Volcker Fed did that was, in part, it allowed them to say, we're not responsible for these interest rates. That's what market's doing. We are responsible for the aggregates. And that, I thought, was a little bit of, I think, without being dismissive, necessary in order to allow the Volcker Fed to do what had to be done.

And so one has to admire their ability, his ability, and their ability to think through this whole issue of so-called transparency. And, in fact, get to the outcome they wanted with a little bit of misdirection around how policy policy was gonna be unfolding. The other great thing that one admires about Volcker, of course, was the ability to create the aura that policy came from, this very non-transparent place of literally cigar smoke that surrounded everything, the building himself, et cetera.

But finally, one had to really focus in on something else about outside influences in the Fed, which was Volcker's ability to completely ignore terrifying kinds of outside influences in the Fed. So obviously, all of you recall the great demonstration from the farmers who bought their tractors and really effectively closed down the building.

Paul also led the Fed to think through how to respond to or ignore the threats that came in the form of these two-by-fours that were sawed off and sent into the building. So I start there because this whole notion of transparency, which academics have come to so value, I would say started at a place of, I would say, almost disrespect, you know, at the Fed for, I think, very, very good reasons.

Now let me then take it down from that to actually some other very serious things that were going on. At the same time that Volcker and his Fed were struggling with and dealing with this question of transparency. The Fed was under a great deal of almost legal attack vis a vis transparency as you may recall, there were a couple of lawsuits around all of this.

And the Fed ultimately, as a result of the FOIA Act of 1967, I think, was forced, is it 67? Let me look and see.

>> Donald Kohn: Keep going, keep talking.

>> Roger Ferguson: Was forced to start to release the minutes. And they first started, they decided they weren't gonna do it at all cuz they were doing it once a year not the minutes.

Yes, because they did once a year, they explained what the policy maneuvers had been during the course of the year. Then, because of the law, they ended up having you do it with a 90-day lag. And then they finally decided again, under the last period of Volcker, to start to do with a 45-day lag.

So if you're following the story around Fed transparency, it was not just the in transparency of what Volcker was doing, but more importantly, the real releasing of information was done once a year with the annual report. And then, frankly, because of legal developments, and I'll get the year right, they did it with a 90-day lag and then with a 45-day lag.

So I then fast-forward to Alan Greenspan's leadership. And Greenspan, as you know, and some other, I think, would criticize him a little bit for perhaps being not as transparent as you would have liked. And he himself was willing to get character himself with whole notion that he could sort of mumble with great incoherence.

He'd say things like, if you thought you understood what I said, you clearly were mistaken. But underneath all that, I think, was the Fed that, during his period, migrated actually in a way that was really helpful around transparency. And I think the Greenspan Fed doesn't get enough credit for all of that.

But under Greenspan's leadership, we started to do a couple of things that were very important. First, there had been the release of a statement after the meetings, if there had been a policy change. And then we decided that we release statements after every meeting if there hadn't been a policy change.

Big debate as to whether we disclosed the vote. We decided we would disclose the vote. We'd give those that had dissented a chance to explain briefly why they dissented. And these were all major moves. And I think people People, in some sense, don't give the Greenspan Fed enough credit for the progress that they made on transparency versus the goals and objectives of the academic world.

Very importantly, part of what Greenspan's Fed did was after each meeting, we also would release something that was a version of the tilt. Now, to be clear, we struggle with the language. We never got it quite right. But first real consistent effort at giving some form of Ford guidance emerged under the Greenspan Fed.

Now the place that he wouldn't go. And Don, I agree with him, I think, Don, you'll speak for yourself whether or not he agreed, was whether we should go to a formal inflation target. Many of the presidents, Jeff Flacker and your predecessor, A Broaddus, I think, were urging this kind of thing.

Others were as well, Chairman Greenspan, I think, was relatively reluctant to do this for a number of reasons. He will have to speak where Don can maybe speak for him. I thought it was not necessarily at that point a great idea, partially because of deep concern that I had about the ability to achieve the 2% target and to make an assertion that that was where you were gonna go if you weren't sure you can get there, I thought was pretty risky.

But once Greenspan left, Bernanke came in, spent a fair amount of time building a consensus, and then developed the formal 2% inflation target. And all of you seen now the history of how that's worked. The question of do we think about having a flexible average inflation target over time?

And now the expectation of a new review? And so, as we think about the big impact on the academic world, SOMC and others on the fed, taking a moment to think about how we've progressed in transparency, I think was very important. The other thing I want to identify, to pick up and compliment what Don had to say about rules, was implicit in all of this, was the number, the 2% question.

Again, going back to Volcker, as all of you recall, Volcker had a strong point of view that he expressed to me at least, was he didn't understand any of this, because the only acceptable inflation rate was zero. And so again, a place where the academic world and the Fed staff helped, was thinking about what is actually a reasonable inflation target.

And all of you understand that we ended up with academics first, with inflation target being some more acceptable inflation, not a target being somewhat above zero for lots of good academic reasons. The ability to move wages, real and nominal wages so you could reduce real wages without having to worry about nominal wages, and understanding concern about the so called zero bound these concepts came initially out of the academic world, I think, but quickly adopted by Fed staff and eventually by sort of Fed governors.

The other great outside influence was not just figuring out that inflation should be low and stable, but let's call it 2%. But then all the international developments starting the 1990s around the inflation targets, all of you know that inflation targeting started in New Zealand. Most of you recall that it almost started by accident.

So in 1988, as you may know, the then finance minister in New Zealand was on a tv show there, asked the question about inflation, and he came up and said, well, what do you think it should be? His answer was 1%. This Reserve Bank in New Zealand went back a little panicked and did some very quick academic work, not the kind that would have been in a peer review journal.

>> Roger Ferguson: And you know the story, right? Came up with 2% in 1990. The Reserve Bank of Canada followed pretty quickly than the bank of England. And now it took the Fed roughly 12 years or so to join the parade of the 2% inflation targeters. But this was another example of how outside influence is gradually spilled into the Fed, but in a very cautious way.

And I think that makes a lot of good sense. So we've talked about transparency and disclosure, we've talked about the inflation targets and how all that's evolved. Now, I wanna flip it around a little bit and talk about the third way in which markets or outside influences can influence the Fed.

And it has everything to do with something that Don talked about, which is inflation expectations, but more importantly, market dynamics and expectations of what the Fed is likely to do. And here I think this has become a bit of a double edged sword. We now have a very, very active Fed funds market.

At the beginning or before every meeting, the odds of 25 50 basis points move up and down. And I think we now have a very interesting dilemma in which the Fed is hearing what markets think about what the likely move is going to be. And there's a whole dynamic that's developed about do we reinforce market expectation or do we risk so called disappointing market expectations.

So a place where, I must say, I'm a little concerned about the interaction between the Fed and outside influences on the Fed is how we should think about whether or not we're getting good, clean market signals and the interaction between what we say, what the Fed says in terms of their transparency influencing market expectation, playing back to the decision making process itself.

I don't know what the answer is on how to deal with this cycle, but I think we should be quite clear that there are places where the inside and outside influences create not an easier way to deal with policy or an easy way to communicate with policy, but rather, I think, potentially a more challenging and difficult situation vis-a-vis policies.

And we've seen that unfold periodically during the periods where the Fed was raising rates and the period where the Fed started lowering rates. During much of the period when the Fed was raising rates, the markets, I think, was expecting it pivot more quickly. We saw at the beginning of this year or at the end of last year, an expectation the Fed would start to reduce, when in fact, the data didn't support that, and there was market dislocations.

And then most recently, we saw a little bit of experience where maybe the Fed was thinking one thing and the market was thinking maybe a more aggressive cutting. And so I raise all that to say, the topic here of influences on the Fed from the outside, I think have been net positive as Don pointed out.

Adoption of rules based approaches in a very careful, methodical way, adoption of theories of transparency, I think in a very careful, methodical way, obviously, moving gradually, but into a place of an explicit inflation target. All those things, as a former Fed official and friend of the Fed, strike me as being very good.

But some of the places where it's more controversial or difficult, maybe these issues of feedback loops to what the Fed says, what market expects, and then what the Fed does. So net I think the interactions have been very positive. You haven't undercut Fed independence, but I do think there's still some places where external influences and the Fed policymakers potentially need to continue to evolve and develop.

So those are my thoughts, thank you. Thank you very much.

>> Robert Heller: Well, good evening. Now it's only Esther and myself who stand between you and successful conclusion of the conference. I think just about everything that one could have mentioned has been mentioned here about Federal Reserve policy. So let me deal with some rather very personal observations.

Let me take you back 59 years from today. I was a young assistant professor at UCLA. I just joined the department. And Karl Brunner was one of the senior professors at UCLA. We both had an office on the eighth floor of Bunche Hall, tallest building on campus. Carl's was at the very end of the corridor.

I was about three or four doors down. And as was usual, a bunch of the faculty members would go out together for lunch to the faculty club. So I hope you're all enjoying your food right now. After we'd come back, most of the elderly members of the faculty were in the habit of having a little snooze, so they take their little nap.

I hope you don't follow them in that example. And not so Carl. As soon as he had settled down in his office, he would rip open the door, grab what he called a waldhorn, which was a little Swiss bugle, went out the door. And the next sentence then was and Jerry Jordan, who was sitting right here in the front row, would come running up with a stack of IBM printouts and serve up today's results.

New relationships with m two and the price level. And that was my introduction to monetarism, having gotten my PhD at Berkeley, where the word was never mentioned either. Quite frequently, Milton Friedman would also show up at the UCLA during the winter quarters because it was just too cold for him in Chicago.

So he would find an excuse or two to come out. And I learned what money was all about from these two gentlemen. Well, all the more I find it surprising that the current FOMC statements, and I looked at the last four years, the word money isn't mentioned one single time.

And in last week's economic report on the monetary policy report to Congress, Chairman Powell never single time uttered the word money. The question is still, how do you make monetary policy without ever mentioning money? And Milton Friedman would clearly turn in his grave. Have times really changed? Has the relationship between money and prices really broken down?

The answer is no. I had made a plot of the money supply, M2, and also the PCE inflation rate. The money growth is lagged by one year. And I don't think you'll find anywhere closer correlation between two variables than the money supply and the inflation rate shown here.

The relationship still persists even in today's modern economy, where so much has actually changed. As has been mentioned four or five times during the conference here, the Fed has three goals. Stable prices, maximum employment, and moderate long term interest rates. That's what the Federal Reserve calls its dual mandate.

In my mind, they don't even know how to count to three. Well, then they top it off to show off their math excellence to Congress, says price stability is what you need. Well, how do they define price stability? Price stability, according to the Fed, means 2% inflation per year.

And if you know the rule of 72, that means the price level will double exactly every 36 years. And then you wonder why young people worry, how am I going to buy a house when I get ready to buy a house 36 years from now? And it will be costing twice as much as it is costing right now.

So Federal Reserve has some basic problems with basic math, but let me switch to some other things. How did I get to the Federal Reserve? You may remember that there was a vice chairman by the name of Preston Martin, and Preston Martin traveled around the world. He gave a speech in Japan, and he said something about monetary policy.

And when he came back, Volcker talked to the press, and Volcker said that his remarks were incomprehensible. Those were his words. Well, Preston Martin was a bit chagrined. He resigned. As a result, the 12th district seat was open. I was lucky enough to be in San Francisco, and I got appointed to Preston Martin's old seat by President Reagan.

And I got the new job. Well, a couple of weeks passed, first or second FOMC meeting that I attended. And the decision was not to change policy, but as was custom in those days, there was always latitude for the chairman to slightly increase or decrease Reserve stringency a little bit.

So a week later, Paul Volcker testifies in Congress, and a Congressman asked him, he says, well, by the way, there was a whole coterie of Wall street observers who did nothing but watch the Fed. Those were the Fed watchers. Trying to discern the tea leaves, whether anything had changed.

Anyhow, Volcker is testifying in Congress and the congressman asked him, well, Mister chairman, was there a change in policy? Volcker's answer was, well, puff, puff on the cigar. We've been snugging up a bit.

>> Robert Heller: Having English as a second language, I'd never heard the word snugging up.

>> Robert Heller: I ran home to the Fed, looked it up in Webster's, and it said, tighten up the lines on the ship a little bit.

I was just about, as much as I knew before, but surreptitiously, Volcker had, and just a little bit of policy. So a couple of days later, some reporter asked me, what I thought about the change in policy, and I told him, well, there wasn't really a change and a little bit was changed anyhow, and stuff like that.

That was reported in the press. As soon as Paul Volcker read it, I got a call from Katherine Mallard, who was his iron fisted secretary, and chairman wants to see you. I marched in his office. If you got to his office, first of all, there was a big cloud of smoke from the cigars that he was smoking.

Second, every chair that you could possibly sit on, there was either a briefcase or stack of books on it. So you had to stand, like a little schoolboy in front of his desk. I'm standing there, and Paul Volcker says, he says, if you ever speak on monetary policy again, I will ruin your reputation.

I said, okay. I knew what happened to press Martin a couple of months earlier.

>> Robert Heller: So, I kept my mouth shut from that time on. So, the position was mum. Well, after that, believe it or not, Paul Volcker and I, we became the best of friends because our basic EU monetary policy was that there shouldn't be any inflation at all.

Like, Roger just mentioned a minute ago. And he called it the Germanic view of monetary policy, because he was proud of his German heritage, and Germany having gone through two terrible inflations. And as you heard yesterday, at Maesing. Was it yesterday, was today. Time passes. Digvijaya Singh, talk about, the German inflation, and every German does forget it.

Well, let me close with one short story on the Federal Reserve Flag. So I got to the Federal Reserve Board, and believe it or not, there's a guy, his name was Bob Fraser. Bob was the former tank commander in the US army, an imposing presence, and he was in charge of supplies.

So he showed me my new office, and believe me, it was the best office next to the White House of any place in Washington, DC. The corner office, Constitution Avenue and 20th or 21st, whatever it is, head on view of the Washington monument. So I was a very happy camper.

I walked into the office, but there wasn't any place to sit down. There was no desk, nothing. I was told by Bob Fraser, that the Fed was such a tight fisted organization. That the staff, would have to steal all the furniture from retiring governor's offices, so that they would have office furniture to sit on in their own offices.

I see, on laughing like crazy. Were you the guy that stole it up? No.

>> Donald Kohn: Did you take my desk, Bob? I always wondered who did that.

>> Robert Heller: Anyhow, Bob Fraser told me, he says, don't worry, we have $15,000 and we can go shopping. So, Bob and I, went shopping.

I bought a new desk that was equivalent to the resolute desk in the White House. Beautiful piece of furniture, a new couch, a new chair, bookshelves, the whole thing. After Frazier had furnished a new office, he comes by and he says, well, governor, is there anything else I can do for you?

I said, no, you've done a great job. I love my new office. He said, Marl, there must be something else I can do for you, governor. I said, no, no, really, I'm a perfectly happy man. He says, but, governor, there must be something else that you would want.

I thought, well, in order to go to the room, I got to have some wish. So I said to him, I said, well, your chairman Volcker, he has all these flags behind his desk. I said, why don't you get me some of those flags, too, for the office?

Thought they looked great. Poor Bob Fraser, looks at me in horror and he says, governor, I can't do that. He says, those are the chairman's personal flags. That's his personal flags. When he was deputy assistant secretary of the treasury. When he was assistant secretary of the treasury, when he was under secretary of the treasury, these are the chairman's personal flags.

I say, well, then, just give me an American flag and a Federal Reserve Flag. He looks at me again, with the big eyes and says, I can't do that either. The Federal Reserve doesn't have a flag. I said, well, okay, fine. I let him go. A few weeks afterwards, Emmett Rice was one of my colleagues, and he resigned.

And when Emmett left, Walker came and he said, okay, you're gonna be the new administrative governor. In those days, it was the youngest one, who got to be the administrative governor. Now, it's a position of honor, on the board. Anyhow, I was the administrative governor. So I said, now I have some real power.

I called Bob Fraser back again and said, hey, Bob, you make me a couple of copies of the Federal Reserve Seal. And he came with a bunch of xerox copies the next day. I took them home, and I gave them to my kids, and my son Chris. Christopher was at that time 9 years old, and he admired pirates a lot.

So he comes up with a flag design that was this piece here, reminded me an awful lot of a pirate's flag. Well, my daughter Kimberly was twelve years old at that time. She's with us tonight. She's now a professor of medicine here at Stanford. And here's her design.

So I take that design back to the board, and the graphics department makes the final design of the Federal Reserve flag. And here is the proud family standing there with their creation at the Federal Reserve board. But now, and I'm getting to the end of it, if I think about the contributions of Milton Friedman, Karl Brunner, Alan Meltzer, all the great people in the FOMC, I really should have come up with a different flag design.

This is the flag that I got with that. I thank you very much.

>> Esther George: This has been a terrific panel, and I might just stop now, I think, if we were going to. But I think my contribution will be to be very brief. But I want to say first of all, to the shadow open market committee group.

Thank you. I thought this was really very interesting. It's been a long day, but we've covered a lot of ground, I think, on some really important issues. And I personally have benefited from many of the views and the thinking that has come out of this group over the years.

One of the things I thought I would do tonight is to think about how many of the members of the shadow Open Market committee had contributed to our Jackson Hole symposium over the years. And you can go back just about to every volume, going back to Alan Meltzer, John Taylor, Ben McAllen.

I could go around this room and almost every one of you had made important contributions and certainly had influence in that way. I also thought in terms of influences, Don, something you said, which as a Fed president is so important, and that is the engagement we have with the general public in our regions, getting out in those regions and hearing from people across many sectors, and sometimes they serve on our boards.

You can have a manufacturer sitting across the table from a banker. You can have a community leader and somebody from the oil fields in Oklahoma, and the insight you gain from them, so important, but also an important opportunity to communicate with the general public, with that region about what it is the Fed is trying to do, how it's landing in terms of these communities.

So just in a short amount of time, because I heard this today, I've heard it since I left the Fed, which is a question about what's happened to all the dissenters and you know, they probably point that question at me on, but I think it's important aspect of our communication and one that has been raised by the shadow open Market committee, among others.

Jeff, I think you've written a paper that noticed the current chairman has had the fewest dissents of any chairman. Don, you and Gauti Egerson, I think, raised a question about this most recent period. Where were the dissents? And did that have something to do with maybe the very strong consensus culture in the Fed that may have missed or made it hard to challenge some of the assumptions there?

And I was also struck, just listening to Chairman Powell at the Jackson Hole symposium, talking about consensus in this way, which was that the good ship transitory was quite crowded, not just among the Fed, but more broadly. And so I just want to make a couple of comments about dissent as it relates to the culture of the Fed.

I mean, a lot of people have opined about why is it? And there could be many reasons, I think, about my time and what role, for example, forward guidance played. It sort of locks you in by saying, if I agreed to it on the front end, you play this out to a certain extent.

But there are two things that I think the Fed has to be conscious of and aware of, which is the very valuable consensus organization, the collegiality that comes there to make sure it stays what I'm going to say in bounds that you don't lose what can be a very important expression to the public of how we think about these issues, about the independent voices that come to these issues.

And one aspect of this is a quote that Alan Meltzer had in the New York Times. This was sometime around the financial crisis, but someone asked him about the Federal Open Market Committee and dissents. And he said, well, you know, it's a club, and clubs are very close to their members, and they don't want to offend the chair.

And so it's not popular to dissent. And so when I saw in the most recent meeting all the visibility around the fact that you had a governor dissent for the first time in some 20 years, it raises the prospect about how could that be and what is it?

And maybe it is because we are in a time and have been for a while of such political divisiveness, sometimes attacks on the fed itself, that maybe people feel like they have to close ranks, they have to be closer together there. But it does not go unnoticed by the public to say, what is that dynamic?

And the second dynamic around that culture that I think was something I observed as I left the Fed presidents, they've got twelve legal entities that each of them are running. But if you look at what's happened over the past three decades from a managerial standpoint, so, the FOMC aside, these twelve reserve banks have become increasingly connected through how they run their operations.

And the governance that's had to accompany that has made those twelve reserve banks have to think about how they collaborate, how they make decisions collectively. And I raise it because it extends to the culture. If you look at the most recent job description for a Fed president, you can go out, I think Pat Harker is the next Fed president that will be leaving.

The posted job description will have a very clear section about this system overlay and the importance of not only engagement there, but how you conduct, how you select staff that can work in that kind of construct. And so the cultural elements of that, I think we have to be mindful.

Of that they don't bleed over, that we don't become overly consensus focused when it comes to thinking about these very important issues that we've been talking about today. And that is, how do you bring to the table on some very difficult decisions a variety of views and then express those to the public, and I'll just close by saying this isn't a ding against consensus.

In fact, my own experience was one where I did not feel inhibited in terms of both expressing those views, registering a dissent when I felt that was important. But I think it's always important for every organization when it comes to their culture, to check themselves and to make sure that when you have a culture of consensus, it doesn't lead to blind spots.

That it doesn't lead to what I would call too much consensus that would handicap the public, because at the end of the day, we really rely on the public's trust in this institution and trust that we are looking at these issues from all angles, thank you.

>> Deborah Lucas: Great, thank you very much.

Good, we're going for it, this is a hardy group, okay. And I can't help but ask this, maybe I'm channeling a little John Cochran, but it's also my own interest, which is, I think, a theme that came out. And what many people said today in many different ways is that we believe in different ways that fiscal policy is one of the main determinants of prices.

And just imagine that there is kind of an outside consensus on that, do you see that as something that can somehow find its way more fundamentally into what the Fed does? Because I think a lot of us have said it for a long time, and somehow when I come and listen, I don't hear it reflected back at all, so I'm just kind of curious if anyone is willing to comment on.

I don't think it requires going full blown saying things that sound like they're for or against fiscal policy, but rather, is there a way of incorporating it into the framework in a way that's meaningful and not threatening to the Fed?

>> Roger Ferguson: Go on, Don.

>> Donald Kohn: So I think fiscal policy is hugely important for aggregate demand and sometimes for supply, depending on tax levels and things like that.

But I don't think, just reflecting on John's discussion, you're gonna find someone from the Fed saying, we don't control the price level, it's those guys in Congress and the president. So I think part of the culture of the Fed, and I hope this continues, is we are responsible for price stability, that is our responsibility, that's what the Federal Reserve act says and we are going to exercise that.

Now I do think that it was surprising in 2020, 2021 that there wasn't more discussion, I mean, I don't know what happened at the FOMC meetings. We haven't seen the transcripts yet, but there was practically no discussion in the minutes of the, particularly in 2021, the huge fiscal stimulus along with the opening of the economy as vaccines came in.

So there was a surge, a very V-shaped thing and I think the committee, interesting to hear Chris's comments on this. And Loretta's, the committee was counting on its forward guidance to tell it when to raise rates and it didn't need to comment on fiscal policy. And the forward guidance was in my view misguided in a number of directions, so they were relying on a poor thing.

But I also think there was a break from the Volcker Greenspan era and to some extent the Bernanke era, who all three of them talked about the implications of fiscal policy for interest rates. So you can do what you want with your budget, but I'm telling you what's gonna happen to interest rates you raised.

Greenspan famously said, you raise taxes, interest rates will be lower than otherwise be Volker worried about the dual deficits and all that, twin deficits and all that kind of stuff. So I think the Fed to some extent has pulled back too far from commenting on the implications for the macroeconomy of the fiscal policy.

And then my last point is we had a discussion, John included, about how important interest payments on the debt are going to become, and that is really going to put extra pressure on the Federal Reserve. So both the DS won't be able to get their spending increases, the RS won't be able to get their tax cuts, these, the huge things, so this is gonna intensify the political pressure on the Federal Reserve.

And I think it's so important that we maintain the independence of the Federal Reserve from short term political pressures, and I really worry about people's ideas about how that might be eroded.

>> Roger Ferguson: I sort of push a little bit back on your question which Don elaborate on this, but the entire setting of monetary policy has got to take into consideration the fiscal impulse.

And the models are completely built around this, so this notion that somehow another, it's not relevant, it's central to my experience, the way monetary policy is made. I agree with Don completely in that it is, I think, legitimate in a neutral way for the Fed to have a point of view that if the fiscal authority does one thing.

This might have implications in ways that will influence what the Fed is gonna do or how the economy is likely to unfold, I think that's a very legitimate comment to have or for them to have. I think the challenge, and we saw certainly with Greenspan, I don't know others, that you'd go to Congress, join Humphrey Hawkins, or semi annual testimony.

And you get these debates back and forth, trying to get the chairman to say something that seemed to lean one way or the other around a fiscal debate, I think that's a very dangerous place for us to be. The other thing I point out is something that came up today that I think we do have to think through very clearly, which is this tendency now that people recognize.

That the Fed can use its balance sheet and have been asked to drive certain kinds of policies to put a real limitation on how far that goes, because that will open a massive door. And I was very pleased to hear many people today talk about that because I think it's really important for the academic community and others to be quite clear about how one should think of the limitations there, because in the world in which fiscal.

School limitations are gonna become paramount. The thought that the central bank is gonna be this massive sovereign wealth fund, I think, is going to just continue to rise in pressure. So that's the thing. I worry less about fiscal policy per se, and much more about something that might be described as fiscal dominance or the misuse of the feds balance sheet for this broader range of tools.

Both parties are going to be looking for that. And that I think, is that strikes me as the real worry that one should have going forward here.

>> Deborah Lucas: Right. Well, yeah, let me open it up a little bit, take a few questions. Go ahead.

>> Audience 1: So I think my career at the Fed spanned the period before there were any announcements at all, after the FOMC meeting, through a period where quite elaborate statements being made.

And my perception at least was the more elaborate the statement was, the further in advance of the committee that the decision of the committee meeting, that the decision effectively had to be made because the statements needed to be prepared, the ground needed to be laid for them. And so my question is, is there an inherent trade off between transparency and the openness to dissent and debate?

>> Roger Ferguson: Not sure there's a trade off there. I mean, people have to come and have a point of view. For sure, though, I think you do point to one of these problems. And when I was there with Don shop, I chaired two of these committees on transparency and trying to figure out how he did all of this thing and made it also real time.

And so you well know and Don certainly participated in quite a bit that, I'm not sure how it runs now, but it used to be that there'd be a little break and Penn would go and sort of try to rework the statement as much as possible. I'm not sure I described the statements as being elaborate.

I think, if anything, they've gotten a little shorter. And v I've observed under Chairman Powell, there's relatively small number of changes that are made. So in some sense, I think they've become, it's not a critical comment, become a little bit more formulaic than they were when we first started doing them when I was there.

And so I will see how they evolve. But I think you put your finger on a really difficult point, which is you want them to be a good record, one page record of the meeting, picking up as much of the nuance as you can. But at the same time, there's this process of having to get them done.

The only other thing I'd add on this transparency thing is then having to also be prepared for the press conference, which comes a half an hour after the meetings are over. And that creates a huge dynamic in terms of getting all the statements lined up and some clarity around what the Q and A is going to be.

I've been very impressed with how well frankly, the Fed has been able to do that because that puts an even more pressure on the chairman and the committee to get itself organized around what the message is gonna be.

>> Deborah Lucas: Governor Waller, did you like.

>> Roger Ferguson: We need to hear from Chris.

>> Christopher Waller: So I'm always very hesitant to make comments.

>> Roger Ferguson: We need to hear from you.

>> Christopher Waller: What I'm gonna say I've said publicly already, so it's not the new, but I'll just reiterate. So I'm just gonna comment on fiscal policy stuff. So both chair Powell and myself have made public comments about the fiscal deficit not being sustainable.

I mean, we can sit there and look at when deficits, and this came up today in the decession Pat Keyhoe or some others had said, when you're running deficits of six to 7% of GDP and primary deficits of 2.5% to 3%, this is not sustainable when, when you're doing it in peacetime.

Now, I'm not gonna tell Congress how to fix that problem. And that's what we avoid. Maybe some of our European colleagues are much more blunt, but they're a supernatural, supernatural, a national, I keep saying natural, super national organization and they can't get away with this. But it is just arithmetic.

You can't do this. And we've made it very clear. My remarks today were about when the supply of treasury starts outgrowing the demand for treasuries, this is going to push up long term rates. It's just math. It's not anything and I'm gonna have to deal with it. The second point is there's a lot of talk about central bank independence.

And I've always taken the view that the best way to maintain my independence is not criticize my masters. You deal with fiscal policy, I'll deal with monetary policy. When I start telling you what to do with fiscal policy, you have every right to start telling me what to do with monitoring closely.

The third point is, and this was my very first speech as a Fed governor, there was a narrative going around in spring of 21 when we were at the zero lower bound that the Fed would never get off of it because the debt had grown so big that the interest expense would be so large, the Fed would never raise rates.

And I said at that time guess what? When we have to raise rates, we'll do it. And we did. So I'm not too worried about that concern. I'm done preaching.

>> Deborah Lucas: Great. Okay, I've been told that it's time for people to enjoy their dinner and the conversation at their table.

Let's give everyone a big hand. Thank you and let me just end by thanking, Mickey wants to say something. I wanna thank the organizers for an amazing conference today. It was really good. So

>> Mickey Levy: on behalf of the Shadow Open Market Committee, I wanna thank John, Taylor, Marie-Christine, and the Hoover events team, and everything about Hoover's generosity in hosting this 50th anniversary of the Shadow.

We also want to thank all of the participants, all of the current and past fed members, and all the participants who contributed so much of their time and effort into making this what we find a very rewarding conference. And I'll just conclude, Marilyn Meltzer, you were with this at the beginning, and my strong hunch is Alan's doing high fives now.

He's very happy, and he's looking forward to the future of the shadow open market committee. Thank you very much.