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SOMC: Assessing the Fed’s Responses to the Pandemic Crisis

Thu, May 28, 2020 EVENTCAST

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SOMC: Assessing the Fed’s Responses to the Pandemic Crisis

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SOMC: Assessing the Fed’s Responses to the Pandemic Crisis

EVENTCAST 11:00am—12:45pm
Thursday May 28
Thursday May 28 2020
PAST EVENT Thursday May 28 2020

On May 28, the Shadow Open Market Committee convened to discuss the Federal Reserve’s responses to the coronvirus pandemic and the economic lockdown.

AGENDA:


11:00 AM - INTRODUCTION
Mickey Levy, Berenberg Capital Markets

11:03 AM - PANEL I: THE FED'S STRATEGY AND OBJECTIVES IN HISTORIC PERSPECTIVE
Moderator: Allison Schrager, Manhattan Institute
Michael Bordo, Rutgers University, ”Lessons from the History of Wars, the Great Depression and the Financial Crisis”
Mickey Levy, Berenberg Capital Markets, “Assessing the Risks of Deflation and Inflation”
Peter Ireland, Boston College, “Issues in Monetary Policy Strategy”
Athanasios Orphanides, MIT, “Observations on Central Banks:  Comparing the Fed and the ECB”


12:00 PM - PANEL II: THE FED'S CREDIT LENDING
Moderator: Charles Plosser, formerly president, Federal Reserve Bank of Philadelphia
Deborah Lucas, MIT, “The Fed’s Expanded Lending Facilities”
Gregory Hess, Wabash College, “Has the Fed Overplayed Its Hand as Lender of Last Resort?”
Andrew Levin, Dartmouth College, “Conducting Monetary Policy Under Extreme Uncertainty”

 


The Shadow Open Market Committee, under the auspices of the Manhattan Institute, is an independent group of economists that provides external perspectives on policy choices by the Federal Reserve and other leading central banks. The SOMC addresses a wide range of macroeconomic issues, including monetary policy, banking and financial regulations, and fiscal-policy matters that bear on monetary-policy decisions.
 

Event Transcript

Mickey Levy:

Welcome to this virtual meeting of the Shadow Open Market Committee sponsored by the Manhattan Institute. And MI has just done an excellent job organizing this meeting and providing invaluable IT expertise.

Mickey Levy:

So a lot has happened since our last meeting on March 6 that was held in New York just before the widespread government shutdowns were imposed and the COVID-19 pandemic blossomed. At that meeting, six Fed members participated and several emphasized that the Fed would respond aggressively to the economic and financial fallout that might occur in response to COVID-19. And of course, the Fed has responded, and very aggressively. And, in addition, there have been all of these government shutdowns, so we've seen an unprecedented period, both for the economy and for monetary policy, and the Fed's lender of last resort facilities. And that will be the focus of today's meeting, discussing the various aspects of what the Fed has done.

Mickey Levy:

We have two separate panels today. Following opening remarks by each panelist, there will be more than enough time for Q&A.

Mickey Levy:

So I'd like to start with the first panel and introduce Allison Schrager, who is senior scholar at the Manhattan Institute. So, Allison, carry on.

Allison Schrager:

Thank you, and thanks so much everyone for joining us, despite what I'm sure is sort of deep Zoom fatigue at this stage. So we have a great panel. I'm going to get right to it. I'll just introduce our panelists briefly.

Allison Schrager:

We've got Michael Bordo from Rutgers University, who is going to be talking to us about the history and giving us some perspective on where we are with monetary policy.

Allison Schrager:

Mickey Levy, who you just saw from Barenberg Capital Markets on assessing the risks of inflation and deflation. It's actually both we have to worry about.

Allison Schrager:

We have Peter Ireland from Boston College, who will be talking about the strategy the Fed is going with, and I'd say certainly deviations from the norm.

Allison Schrager:

And you'll have to excuse me if I don't say this correctly, Athanasios Orphanides from MIT, who will be giving us some perspective in comparing how what we're doing compares with what the ECB is.

Allison Schrager:

So then let's get right to it. So I just want to sort of explain that first, each of the panelists will be talking for about six minutes, then they're going to have a little discussion amongst themselves, and then we're going to open it up to questions. So there should be a screen for you to pose them, and then hopefully we'll have time for plenty of those too.

Allison Schrager:

So Mike, how can we relate the Fed's monetary policy action to the response to COVID-19, and how do you relate that to different historical experiences? I mean, obviously we've never really experienced anything quite like this, certainly in the modern era, certainly in the modern Fed era, history never exactly repeats itself, but it does often rhyme. So what are the key lessons from history here?

Michael Bordo:

Okay. So the Feds acted most aggressively to shield the U.S. economy from the COVID-19 pandemic, and a reexamination of historical precedence is important to evaluate the Fed's actions.

Michael Bordo:

So there are four salient episodes that intersect. They intersect in this kind of Venn diagram like this, and they have immediate relevance to the current crisis. So the events were the Spanish flu pandemic of 1918 to 1919, the Great Depression, the Great Contraction from 1929 to 1933, World War II, and the global financial crisis of 10 years ago, 2007 to 2008.

Michael Bordo:

So the first pandemic of 1918, that was really pretty terrible. It killed upwards of 50 million people worldwide and 675,000 in this country. There were two waves. In the spring of 1918, that began in army camps in the Midwest and spread to some other parts of the country. And then things died down. And then there was a second wave in the fall when the troops came back from World War I, and that was really bad.

Michael Bordo:

There were no cures or vaccines available. The highest mortality rate was amongst working age people between age 20 to 40, versus today, which is people over 60.

Michael Bordo:

The pandemic led to a mild recession. There was a sharp drop in industrial production in the fall, and then there was a speedy bounce back. There was no significant increase in unemployment.

Michael Bordo:

There were these non-pharmaceutical interventions that we have today. They had something like that. People were encouraged to wear masks. Schools and churches were closing, big assemblies we're discouraged, but there was no government-mandated lockdown and most of the interventions that occurred were done at the city level. There was no monetary policy response.

Michael Bordo:

So the question is, why was the recession milder? Well, I think it reflected... First of all, the economic structure was very different of the economy back then. It was less urbanized, more people were living in the country and farms. There was more primary and secondary production farms and agriculture and mining and fishing and all that, and less manufacturing, less services like we have today.

Michael Bordo:

Second was World War I. The war was raging, and the negative shocks to the labor force in consumption that occurred were offset by the war demands of the U.S. government. So there were people that pulled back from work, people that got sick, et cetera, but they hired more people.

Michael Bordo:

Third point was people had different attitudes to mortality back then than now. Medical technology was much less advanced and there were lots and lots of diseases that people died from, and, we had the experience right then of the mass deaths of World War I. So I think this really affected people's attitudes.

Michael Bordo:

So the key lesson for today is that, without the mandatory lockdown, we might've had a milder recession, driven only by the exogenous fear response on spending an hours work. But that's an empirical question. In the case of Sweden is one way of testing that.

Michael Bordo:

The second episode is the Great Contraction from 1929 to '33, and that was the worst recession of all time. We had a 35% decline in output and prices. Unemployment peaked at 25%. It reflected a failure of Federal Reserve policy in not preventing for serious banking panics.

Michael Bordo:

So the key lessons from that event is the need for aggressive monetary policy to stabilize the economy and for an effective lender of last resort.

Michael Bordo:

The third event is World War II. And that war, like World War I, was a huge existential shock, in some ways, similar to today. It required a massive government intervention to marshall resources for the war effort. The Fed became subservient to the Treasury, financing its fiscal deficits. It payed both short term and longterm treasuries. The inflation that followed was somewhat suppressed by wage price controls.

Michael Bordo:

After the war, the Treasury pressured the Fed to continue its accommodative monetary policy and to continue the bond price tags. They did this because they thought there might be a reoccurrence of the kind of recession that occurred after World War I.

Michael Bordo:

So what happened was, that once the controls were removed in 1945, pent up demand fueled a rapid inflation of 15% per year from 1945 to 1948. The Fed push to regain its independence to fight inflation, and they finally achieved that in the Federal Reserve-Treasury Accord of early 1951.

Michael Bordo:

So the lesson for the Fed is that once the pandemic emergency comes to an end, it must reduce its expansionary policies to avoid a run up in inflation. And to allay inflationary or expectations, it should clearly spell out its exit strategy.

Michael Bordo:

Okay, the fourth event was the recent global financial crisis. And a chairman of the Fed, Ben Bernanke, was a student of the Great Depression. He was an expert. And he followed aggressive lender of last resorts based on what was Article 13.3 of the Fed, based on what he saw happen, to prevent what happened in the Great Depression, and to prevent the breakdown of the financial system.

Michael Bordo:

And so the Fed also followed expansive monetary policies until it hit the zero lower bound when it adopted quantitative easing and forward guidance. These policies did temper the global financial crisis and the recession, but it took a long time for the Fed to realize that the crisis was primarily a solvency event and not a liquidity event. And the key action that ended the crisis was the stress test of the major commercial banks.

Michael Bordo:

The Fed's lender of last resort policies had serious spillover effects. Many of its policies were a form of credit policy, which is really fiscal policy, and it involved picking winners and losers. This policy threatened the Fed's independence, and the second was moral hazard. The Fed's QE policies and forward guidance only had a limited effect in speeding up the recovery from the great financial crisis. Okay? There was a very slow recovery. QE was hindered by paying interest on excess reserves and a poor communication strategy.

Michael Bordo:

So the lesson for debt today is the Fed's using the same playbook as it did in the GFC, but it's added in some new institutions and markets. The corporate bonds and [inaudible 00:13:55] are two example to shield from bias lender of last resort policies.

Michael Bordo:

So this suggests that the road of credit policy has gotten even wider, and the threats to the Fed's independence, even greater. Moral hazards also increased. Moreover, it's basing its monetary policies on QE and forward guidance again will continue to be of limited consequences. The Fed has rejected the use of negative rates from its toolkit, a tool which might actually be more potent. And my colleague, Andy Levin, and I have written on that, and Andy might mention this later.

Michael Bordo:

So in sum, the lessons from history never exactly repeat themselves, but they often rhyme, and not heeding them is perilous. Thank you.

Allison Schrager:

Thank you. So for Mickey, the Fed has shifted into high gear. It's pumping money supply everywhere it feels like, but inflation has actually receded in recent months with the economy being in a deep contraction. How should we weigh the risks of inflation versus deflation going forward and what signals should we be looking for?

Mickey Levy:

Okay, Allison. So basically, I'm going to talk about two things. Right now, in response to the deep economic contraction, there is moderate deflation, but it is really not a worry. But at the same time, The Fed, through its actions and very aggressive increase in its balance sheet, has planted the seeds for a potential rise in inflation that we have to be concerned about.

Mickey Levy:

The second point I'd like to emphasize is the mechanics of the sharp rise in money supply in March. And I would explain that it's not part of the inflation risks, rather, it resulted from cash hoarding by businesses, and it was closely linked to the severe stock market correction.

Mickey Levy:

So with regard to deflation and inflation, the combination of the pandemic and related health fears, and the government shut down, have created a situation of insufficient aggregate demand for all goods and services relative to productive capacity. Yes, production has been curtailed, but the environment's really dominated by insufficient demand. Nominal GDP has fallen over 12% in the first half of 2020. So that while prices of some essential goods like food at home and healthcare have gone up, the CPI fell rather sharply in March and April. And even as oil prices bounce back, we should expect some mild deflation.

Mickey Levy:

But what I'd like to emphasize here is that troublesome expectations of deflation that would lead people to save rather than spend have not appeared. And so that's a critical point. And as the economy recovers, there will continue to be insufficient demand, so we should have continued very soft price pressures as businesses cut prices to try to stimulate product demand and consumers look for bargains.

Mickey Levy:

Following the 2008, '09 financial crisis, as with other early stage recoveries, inflation continued to recede. So we can expect soft prices, low inflation, and maybe even mild deflation in the initial stages of the recovery. But this temporary deflation is actually a natural adjustment to the deep contraction and is a positive for the economy, as long as expectations of deflation do not become embedded in behavior.

Mickey Levy:

Now, the Fed's dramatic asset purchases and growth in its balance sheet is now over $7 trillion, and is growing rapidly as it continues its asset purchases and ramps up its lending to businesses. This is a necessary condition for inflation, but it's not a sufficient one. As long as the base money, that is, reserves plus currency, slosh around in financial markets and not put to work in the economy, it will not generate higher inflation.

Mickey Levy:

So excess demand for all goods and services relative to productive capacity is a necessary condition, and that is not going to occur right away. We have to fill that gap of the sharp decline in aggregate demand, but the Fed really needs to keep an eye on this.

Mickey Levy:

And I would just add one other point about this. The Fed's QE2 and QE3 and zero interest rates following the financial crisis did not generate higher inflation because they failed to stimulate economic growth. We saw no acceleration in nominal GDP in the four years following the implementation of QE3. But the present situation, not only consider what The Fed is doing, but fiscal policy that's added 13% of deficit spending into the economy and [inaudible 00:19:24] stimulus, the Fed has to follow this very, very closely. And a key indicator I'd be looking at is nominal GDP, the extent to which it accelerates and grows on a sustained basis.

Mickey Levy:

Now, could you please turn to the second slide in my show? Not this one, the next one, and the next one. Okay. When we look at the dramatic spike in money supply, like M2, we've read that in has increased dramatically in March and April, it reflects the extreme cash hoarding by businesses and should not be considered or interpreted as a key indicator of the Fed's inflationary monetary policy.

Mickey Levy:

So if we consider what happened in March, particularly right after the last Shadow meeting, businesses faced the realities of the rapidly spreading pandemic and the realities of the forced government shutdowns that would abruptly halt their product demand and cash flows. And they threw down their unused lines of credit from banks and left the proceeds as bank deposits. And as shown in these two panels, this generated a spike in C&I loans, commercial and industrial loans. A dramatic slide, and much more dramatic than anything that occurred during the financial crisis, and then the associated spike in deposits.

Mickey Levy:

Now, go to the next slide, please. And this is verified in the Federal Reserve's HH statistical release that all the deposit increases were made by businesses. So this surge in cash hoarding and deposits that you see in March and April is mirrored in the spike in M2. So what I'd like to emphasize here is the spike in C&I loans raised banks' risk-weighted assets and lowered their capital to asset ratio. So banks responded by cutting back loans elsewhere, and some of the big banks cut leverage to money managers and hedge funds, and forced selling into illiquid markets.

Mickey Levy:

So what was interesting is, right after this, at the end of March, the Fed quickly responded to the surge in banks' cash by easing regulations on bank and cash ratios. But show the next slide, please. The spikes in M2, shown on the left, in a percentage basis, it's just huge. The spike in deposits and C&I loans and the severe stock market correction in March were all related to adverse behavior and business cash hoarding. And my expectation is, as the economy and business cash flows and uncertainties dissipate, businesses will begin paying down their lines of credit, the spike in M2 should largely reverse, and C&I loans should fall.

Mickey Levy:

So with that, I conclude my remarks. Thank you.

Allison Schrager:

Thank you. So Peter, in considering monetary policy during the pandemic and the government shut down, it seems pretty clear that The Fed has moved fully into discretion land and maybe not following a more systematic rules-based approach that has been advocated by scholars like Milton Friedman and John Taylor, and certainly were considered best practice when I was in grad school. So, I mean, do you think they'd be better off following more of a rules-based approach? And in terms of the policies [inaudible 00:23:30] supply channels, do you think we should be concerned about the recent spikes in the money supply and some of the Fed's policies, like paying interest rates on reserve?

Peter Ireland:

Allison, those are great questions. Thanks for asking. Let me address mainly the most basic and fundamental of the issues you raised. Mickey just did, I think, a very nice job of analyzing recent movements in M2. Mike talked a little bit about interest on reserves, so let me focus my comments instead on the issue of rules-based monetary policymaking. Another way of rephrasing your question would be to ask, is it desirable or even feasible at present for the Federal Open Market Committee to make monetary policy in a more systematic rule-like fashion under present circumstances, unprecedented, and against the backdrop of an enormous amount of uncertainty?

Peter Ireland:

To answer that question, I think it's worth acknowledging first that Federal Open Market Committee members have always rejected calls to make and describe their policy actions with consistent reference to a specific simple pre-announced rule. And the reason, the argument that they give against a rules-based approach to monetary policymaking, in the broadest of terms, typically starts with the observation that, well, the U.S. economy is highly complex, it's ever changing in its structure. And so, what would seem to follow from those observations immediately, that Fed Reserve policy must also be highly complex and ever changing in its structure.

Peter Ireland:

That conventional wisdom then implies that it would be an act of folly to constrain the Federal Open Market Committee to follow a specific monetary policy rule. Doing so would simply unnecessarily constrain the Committee as it attempts to successfully fine-tune the economy.

Peter Ireland:

Now when you first hear that argument, it seems perfectly sensible, so where do the problems creep in? When you think about it more carefully, you see the problems come in at the very end with the phrase "successfully fine-tune the economy" because experience has shown that even under the best of circumstances, it is extremely difficult for a central bank to operate under pure discretion, making decisions on a meeting by meeting monthly basis in an attempt to successfully fine-tune the economy.

Peter Ireland:

And to see that this counter argument, the argument against a rules-based approach, applies with specific force at present. Just ask yourself the following question, can you think of anything that the Federal Open Market Committee could do now specifically with the federal funds rate, with forward guidance, with quantitative easing, with any of its other tools, that would significantly increase the odds that, over the course of the next 12 months let's say, the inflation rate in the United States will come in at 2.0% instead of 2.2 or 1.8 or even 2.5 or 1.5?

Peter Ireland:

I think honestly, the answer to that question is no. And the reason is, as Mickey mentioned in his comments, there are just too many other things happening in the economy right now. It's totally unrealistic to expect that the Fed Reserve can exercise that kind of fine-tune control over the rate of inflation. And actually, the same argument would apply even more so to the rate of unemployment.

Peter Ireland:

Now before we get too broken up about the negative answer to that first question, ask yourself another. Do you really care? Do I really care? Do any of us really care about whether inflation over the next 12 months in the United States is equal to 2.2 or 1.8%, or even 2.5 versus 1.5? Honestly, speaking for myself, the answer is no. I would gladly take any outcome within that range or anywhere close to that range. Instead, what we're all concerned about are extreme outcomes, like Mike Bordo was talking about earlier, on either side of the inflation picture.

Peter Ireland:

So one scenario that we definitely want to avoid is the scenario where insufficiently accommodative monetary policy persists over a period of years, generating significant and sustained deflationary pressures to begin to push the aggregate nominal price [inaudible 00:28:39] further and further below the level that everybody expected it to be at going back before the crisis even began, not maybe something quite as bad as what we experienced during the Great Depression, but something similar in kind.

Peter Ireland:

And on the other side of the picture, what we want to avoid is a situation like the one that emerged in the late '60s and '70s where-

PART 1 OF 4 ENDS [00:29:04]

Peter Ireland:

Like the one that emerged in the late 60s and 70s, where a prolonged period of fiscal and monetary stimulus contributed to building inflationary pressures, which persists significantly for years and years. Again, maybe not as bad as what we experienced during the 1970s, but something similar in kind. Now the good news is, there is something that the Federal Open Market Committee can do right now to drastically minimize the chances that we will see either of those two extreme outcomes.

Peter Ireland:

And that would be to announce specific policy rules for managing the federal funds rate and for determining the length and magnitude of quantitative easing, bond buying programs, and to adhere to those policy rules going forward. Those policy rules would make clear, that monetary policy needs to remain accommodated so long as the short run deflationary pressures, that Mickey referred to just a minute ago, continue to hold sway.

Peter Ireland:

On the other hand, those same monetary policy rules would also indicate just as clearly that monetary policy accommodation would have to be removed and even replaced by monetary restraints, if significant inflationary pressures begin to build and persist. That is, the announcement of these monetary policy rules would comprise the kind of fully articulated exit strategy, that Mike Bordo called for, at the end of his remarks as well.

Peter Ireland:

So by announcing and adhering to specific monetary policy rules, the FOMC would make a great contribution by automatically removing uncertainty about their actions from the long list of risks that we face currently, the FOMC would also be acting to reassure all Americans, businesses, consumers, financial market participants, that the Fed remains committed to maintaining the healthy environment of long-run price stability, which is after all the best environment to provide for a long-run gains in income and jobs as well. So let me stop there. Thank you again.

Allison Schrager:

No, thank you. And I just want to say, before we go to our last speaker that, please field your questions. I know we have a really sort of large and interesting group, so we'd love to hear from you too. So Professor Orphanides, can you give us some perspective on how, what the fed is doing is comparing to how the ECB is managing their crisis?

Athanasios Orphanides:

Thank you, Allison. So a pleasure to be a part of this panel. And most of our discussion is about the Fed, but I think it's useful to put this in a global perspective. And the comparison with ECB is a natural one, given the similarities of the US and Euro area economy being the two largest, advanced economies in the world. And also, the commonalities of the crisis that we're facing right now globally. So the pandemic is a crisis that requires prompt and decisive action. And first of all, it's a health issue, it's not a monetary policy issue. But even though health is the primary driver for everything, fiscal and monetary policy respond do become important.

Athanasios Orphanides:

As Mike pointed out in his intervention early on, as a result of the lockdown and the need for social distancing, we do have a very significant drop in aggregate demand that's global, that has resulted in a recession that is anticipated to be the deepest on the record in the United States and in the Euro area. Is kind of a, it depends a little bit. In the United States, the Great Depression was somewhat worse than what we expect right now. In the Euro area actually, that's not the case.

Athanasios Orphanides:

So the issue is, what is the response that we can see? And what I'd like to do is share a couple of slides to show you what the ECB has been doing relative to the Federal Reserve. Let me see. You need to, no, I need to do the correct sharing, which would be this one. Okay. So the response to the pandemic by central banks, first we can talk about the response of interest rates, the Federal Reserve started the crisis in a better place than the ECB did. As you can see here, with the Federal funds rate, going back to 2004, the Federal Reserve had completed it's easing cycle and has started to tighten as they're recovering, the United States was fairly complete.

Athanasios Orphanides:

In contrast, in the Euro area, the recovery was not yet complete and the ECB did not really have the luxury of being able to cap rates below where they were already at, at the time. So with interest rates being constrained by the zero lower bound, in the case of the ECB, somewhat negative, the most important response becomes balance sheet policy. And unfortunately, if you compare the balance sheet response of the ECB and the Fed, you're going to see that even though I would have expected the response to have been similar, the response of the ECB has been far more timid than that of the Federal Reserve.

Athanasios Orphanides:

You can see here in the last couple of months, the Federal Reserve has already crossed $7 trillion in the balance sheet with the latest data, they increased its balance sheet by almost $3 trillion in the last two, three months. By contrast, the ECB has not even increased its balance sheet by not even €1 trillion a year. I have here the euro and dollars comparison. And of course, the exchange rate is not one to one. It varies somewhat. And this reflects some of the special challenges that the ECB is facing with its policy. As you know, the ECB has been facing legal challenges for its balance sheet policy. Indeed, it appears that this has been the case for a number of years making the ECB be far more timid when it came to activating its balance sheet policies. And of course this has got consequences. This is a part of the reason why the ECB has not been in a very good position at the beginning of this crisis.

Athanasios Orphanides:

The inability or reluctance rather, to expand its balance sheet appropriately, to complete the recovery from the global financial crisis in the Euro area, to bring inflation up close to 2% in accordance with its definition of price stability, has been quite costly. And you can actually see this by having a look at the survey expectations on inflation that the ECB compiles. So what I show in this chart is the longer term inflation expectation in the ECB's survey of professional forecasters. And you're going to see the very last observation which was completed just this quarter, shows the medium to be just about 1.6% significantly below than definition of price stability.

Athanasios Orphanides:

You will see that before even global financial crisis, the ECB had managed to have very well anchored inflation expectations between 1.9 and 2% consistently. The reluctance to use balance sheet policy in the last several years has actually led to a disanchoring and the risk is that this disanchoring may actually become far worse as we're in the pandemic, unless the ECB manages to find a way to reverse its previous inclination to maintain tight monetary conditions.

Athanasios Orphanides:

And of course, this leads us to the biggest risk for the Euro area, the biggest concern for the ECB. And in my perspective, perhaps the biggest potential policy mistake we can see from a central bank in the advanced world right now, which is the continuous difficulties with economic divergency in the Euro area. One very simple way to see this is to simply compare how the ECB monetary policy is being transmitted to interest rates. Just a straightforward comparison of the government bond yields between Germany and Italy shows that the ECB has had a terrible time actually ensuring that the monetary policy transformation works equally well in both countries.

Athanasios Orphanides:

If you focus in the last three months, you will see for example, that once again, while ECB monetary policy has been quite effective in maintaining extremely low interest rates for Germany, supporting fiscal policy and providing monetary, support in that country as well, the same policies have actually led to an increase in interest rates in Italy, which again creates problems for the Italian economy. And it's not going to be straightforward to manage to contain the health of the Euro area going forward at the moment, if once again, the ECB is implementing policies in a way that cannot hold the other Euro area together.

Athanasios Orphanides:

So I wanted to show these challenges to you, compare to the policy response of the Federal Reserve, the ECB is once again, quite a bit more timid. My concern is that going forward, the Euro area may once again be a risk for the United States and the global economy as well. And we're going to have to hope that the ECB will find the courage to, I would say, match more closely what the Fed has been doing in the last two months. Thanks.

Allison Schrager:

Thank you. So I have a bunch of questions coming in, but first I want to give the panel an opportunity to respond to each other. If anyone has any impressions or questions that what the other have raised. Anyone have anything they want to share?

Allison Schrager:

Okay, great. So if anything comes up, feel free, but we'll go to audience questions for now. So Doug Carr asks, "Going into the crisis, rates were 100 basis points below neutral due to futile efforts to reach the 2% target and the high excess reserves, which Bernanke states depressed straight." Sorry. "Her reserves were intended to provide liquidity and stimulus. Did these policies leave the Fed in a weak position to respond now?"

Peter Ireland:

Well, I can say a little bit about that. That's a great question, Doug. And I guess the answer is basically, yes. Just a little bit of history there. Remember that the Fed began paying interest on reserves at the height of the financial crisis. And the whole idea in the moment of crisis was, the Fed knew that it needed to do a lot of emergency lending, but it did not want the resulting increase in what were essentially discount window loans to flow through to the broader monetary aggregates, to nominal GDP and to fuel inflation. And at the time that concern was perfectly legitimate. It's hard to believe now that those were the days back then, but those were the days when every time you drove by the local gas station, the price of a gallon of gas had gone up. The big concern was with inflation, not deflation.

Peter Ireland:

So the system with interest on reserves, it did what it was designed to do at the time, which is to allow for emergency lending, allow for growth in the supply of base money without fueling inflation. But then, the policy of paying interest on reserves persisted and the problem instead became fighting deflation and having interest on reserves in place made it, the policy continued to work as it was designed to work. The Fed kept on creating base money and it didn't show up in broad money growth, it didn't show up in higher nominal GDP growth, and it didn't show up ultimately in bringing inflation back to 2%.

Peter Ireland:

But at this point, I think we have to take what's given is given, in retrospect, it would have been great to have gotten rid of interest on reserves, we're stuck with it now. Just to go back to a point that Nicki made in his comments. I'm not too worried about rapid, 25% growth in the M1 money stats since late February, because I agree. Most of that is simply accommodating the increase in demand. Nevertheless, the fact that we are seeing growth in the broader monetary aggregates now that we didn't see, but consistently with QE1-3, after 2008, at least it's reassuring to me that the Fed's policies now are appropriately accommodated and working to offset deflationary pressures.

Mickey Levy:

Doug, is the fed in a weak position now? I would say yes in part, because they never unwound their emergency measures in 2008, 9, and just let the balance sheet go up and up. And finally, even before this pandemic, the Fed started to admit that it's QE2 and QE3 and sustain zero rates didn't have the impact on aggregate demand that they earlier said it did. And so now they're in a weak position because the balance sheet's so large, rates are at zero and they want to continue to be of help ending the contraction, but the weak position is what policies should they use if they're earlier QE didn't work and they're reticent to go to negative rates? So I think the Fed is in a weak position based on what it did in the past and what it did in the past didn't work as well as they advertise that it did.

Athanasios Orphanides:

Mickey, let me take the other side of this, because it's... I would agree that with a very low equilibrium, real interest rates and in light of the zero lower bound, central banking is harder to do, monetary policy is harder to do, and we need to rely more on fiscal policy. So I agree with that, is making the Fed and other central banks because the low R-star is a global phenomenon in a relatively weak position. But I will say that the Fed is in a pretty darn good position compared to some other central banks, for example, the ECB as I mentioned before, precisely because it expanded its balance sheet far more decisively and added a few tenths of a percent inflation, essentially ensuring that inflation and inflation expectations would stay close to subject.

Athanasios Orphanides:

It's quite remarkable, if you check the most recent Philadelphia Fed SPF, inflation expectation numbers, for example, but despite everything that is happening, the survey respondents still continue to trust that the Fed will deliver PC inflation five to 10 years out, close to 2%. There was a 0.1 drop in the average inflation expectations to 1.9. That's not a big deal. Compare that with the ECBs problem of actually facing now responses with inflation expectations, being believed to come down to 1.6 as the median response. This is what makes it much harder for monetary policy to respond. So I would argue that the Fed, even though is not in an extremely good position, no central bank is. In a low R-star world, it's actually not in a bad position compared to other central banks.

Allison Schrager:

So I have another question from Cathy. I hope I said that right. "Our interview worried that the Fed is fueling asset price inflation. The rise in balance sheet and money supply fuels higher asset prices, but not in goods and services."

Michael Bordo:

I'll answer that. I mean, since the great inflation in the 1970s, we've never really had any big run ups in commodity price inflation, but we have had asset price booms. And it seems like the transmission mechanism of monetary policy has changed and this will probably happen again. I mean, we're talking about what happens after the deflationary phase that Nicki talked about, and if the Fed keeps following expansionary policy and its balance sheet still keeps rising and it keeps interest rates very low, yeah, that'll go into various kinds of asset prices. But it depends on that deflationary phase, how bad it is. I mean, if we end up with the worst case scenario, which is the Great Depression and we have deflation, that's not something to worry about, that's going to happen a lot later.

Mickey Levy:

So Cathy, my response is, yes, I'm worried that the Fed's aggressive policies have contributed to the appreciation in asset prices. And in fact, if I think about the rebound in the stock market and the sharp declines in bond yields, I would say, yes, the Fed's policies have contributed a lot to the asset price appreciation.

Mickey Levy:

I would take another angle on this and say, I'm also worried that markets rely so much on and expect so much out of the Fed to pump things up. And I think this is a very unhealthy relationship that the Fed knows it's in this trap but doesn't know how to take the steps to get out of it. And the other point I would make is, I remember former Chair Bernanke, when he rolled out QE3 in summer of 2012, he said, "Okay, we're going to go to open-ended QE, this is going to pump up asset prices, encourage risk taking and all of that is going to stimulate stronger economic growth." And it did just about everything except for accelerate aggregate demand and nominal GDP. It did pump up asset prices. So I think your question's a very good one, but it's not just my worry what the Fed's doing, but my worry about this complex and unhealthy relationship that markets expect the Fed to do that and rely on the Fed to do that.

Allison Schrager:

Right. So I have a question for Professor Orphanides, and this is from John Chu. "What government or central bank coordination steps would you advocate for in this crisis? Also, LCCs need help, what do you suggest?"

Athanasios Orphanides:

Well, it's not clear to me that the answer on central bank coordination would be any different with respect to pandemic, as with respect to other crisis we had, including the global financial crisis. Ultimately, you cannot be providing liquidity to other countries unless you are in alliance, strategic alliances are along country. So it's very difficult to provide real resources to other countries without conditions. Best response is for every central bank to focus on maintaining price stability and support aggregate demand, to be in line with price stability in their own country.

Athanasios Orphanides:

In terms of the cooperation we've seen in advanced countries, the swap lines have worked exceptionally well, again, as they did during the global financial crisis. And I will give a lot of credit to the Federal Reserve for taking the leadership position globally to provide these swap lines. But there is so much you can do with respect to emerging economies. The Federal Reserve cannot really extend similar swap lines to most emerging economies, because that becomes the foreign policy issue more than anything else. And you can't really rely on more than goodwill and provide real resources along this lines.

Allison Schrager:

Right. So a question from Steve and Mellon, "To what extent can we, or should we expect a process of balance sheet normalization, perhaps several years from now? What lessons can we learn from the previous balance sheet normalization process in terms of its pace, magnitude and targeted on point?" Did we ever get through that normalization even on the last one?

Athanasios Orphanides:

Well, if I could say a few words on this. So I remember a few years ago, I had argued that one way to see the normalization of the Fed's balance sheet, before they started reducing it, was that they could simply plan on keeping the level of the balance sheet the same and simply count on nominal GDP growth over the next couple of decades to reduce the size of the balance sheet relative to the GDP of the country.

Athanasios Orphanides:

And indeed, the only complete normalization of the Fed's balance sheet we have in history is the normalizations that occurred after the Great Depression and the Second World War, and that's what the Fed did. Over the following two decades, it relied not on positive nominal GDP and growth. And we say, size of the balance sheet there was effectively the same than the balance sheet, when GDP ratio came down to what it was, pretty much before even global financial crisis. And they could have done the same thing. And I think we can do the same thing.

Athanasios Orphanides:

Problem with the balance sheet is that we need to look at this in the context of the very low equilibrium, real interest rates we have. We need to rely on balance sheet policies because R-star is so low and as long as we are hampered by the zero lower bound. So we need to have the additional accommodation in the economy that is coming from the balance sheet. So the only way I would see the balance sheet normalization coming faster is if other factors, which could materialize, lead to an increase in the equilibrium real interest rate, which would then mean that the Federal Reserve no longer needs to rely on balance sheet policies to provide the accommodation, then I could see them shrinking the balance sheet.

Athanasios Orphanides:

But unless we have a situation where the equilibrium real interest rate rises by a couple 100 basis points, frankly, I don't see a need for the Federal Reserve to bring down the size of its balance sheet, even from the elevated level it has right now. I would much rather say that I would go to pick up something from Peter's talk that I find very important, what would be most important would be for the Fed to commit to a systematic rule that tie the size of its balance sheet to the ultimate objective, which ultimately would be price stability and nominal GDP growth in line with potential GDP growth, and 2% inflation.

Mickey Levy:

Steve, I would just toss out the point that, if you look at the change in the Fed's balance sheet since mid-March, almost all of it to date has been because of purchases of treasuries and MBS. But as we know, there is a very long list of lender of last resort facilities that the fed has committed to and is putting in motion. And right now, I think over the next, beginning last week, and over the next couple of months, you're going to see a tremendous increase in the balance sheet, through its purchases of corporate bonds and its direct lending to businesses. And right now the treasury is capitalized, the Fed to allow the fed to make over two trillion in direct loans to businesses.

Mickey Levy:

So to your point, I think one of the critical elements in a strategy for eventual normalization of the balance sheet, is to unwind the lender of last resort facilities once the economy gets going, that are no longer needed. And so rather than talk about a total size of the balance sheet, I think it needs to look product or facility by facility ask, what are each one's supposed to accomplish and are they still necessary? And that should be the strategy for eventually unwinding, the Fed getting out of some of these fiscal and credit policies.

Allison Schrager:

Right. So we're running out of time. So I'm going to combine two, we have a lot of good questions I didn't get to, so I'm going to combine two and we'll end with that. So a one is from Anne-Marie. "How can one evaluate reported price indices under such a major disruption to market basket? The price of goods and services purchased had shifted dramatically and many items unavailable at any price and measured price-"

PART 2 OF 4 ENDS [00:58:04]

Speaker 1:

how many items unavailable in any price and a measured prices for other things. And then there's a similar question from anonymous of, you know, what percent of price changes in the PDC PCE deflator is caused by factors the Fed can even control? Which specific product types does FLMC have the most control compared to all other factors, E.G. type or preferences, tech, and other government policies?

Mickey Levy:

Okay. Yeah. Ann Marie, I mean, you're right. The BLS is out conducting its survey, and has already mentioned it has a difficult time collecting these. But, if you... We don't have data yet, on the PC deflator, but we do on breakdowns of the CPI. And a sizeable portion of nearly 40% is shelter and housing. You could look at other sectors where they do have... Where they have compiled data, showing prices are declining, but I would expect revision to these prices and price adjustments. The BLS is doing as well as it can under a very distorting environment. And to the other question, what portion of the PC deflators caused by factors the Fed can control, the answer is none in the near term. I mean, the Fed through its policy, generates a certain amount of nominal activity and inflation, and the components of price changes of goods and services depends on aggregate demand relative to aggregate supply. So in the short run, the Fed has no control at all over the inflation numbers.

Athanasios Orphanides:

But in the medium and long term, it has full control because inflation is everywhere, and always a monetary phenomenon. And if I would add to a bit you were saying before, by bringing something that Peter brought up earlier again, I don't think it matters that much.

Athanasios Orphanides:

I would agree with Peter on this one, if actual measure of inflation, whichever way you measure it, is a half a percentage up or down in the next few months or quarters. What I consider most important for the medium and long term effectiveness of monetary policy is for the central bank to maintain credibility that it will deliver over the medium to longer term, price stability as it has defined it. This is why I actually pay a lot of attention on whether inflation expectations remain anchored. And we can get a lot of information from inflation expectations, far more information right now, I would say, rather than from actual measured prices, given the uncertainty in any imperfections for guiding monetary policy. And all we need is to have a monetary policy rule that will us link that and maintain the credibility of the central bank.

Michael Bordo:

Ann-Marie, that's what happened in world war II. I mean, there was rationing, there were goods that just weren't being produced, and... But people were still finding them. And so it was a big problem of measurement and the kind of measures that they did had to be revised greatly. And that was one of the problems that they didn't, in a sense, inflation looked a lot... It was a lot less than actually was there. There was a lot of suppressed inflation. And so the same thing will happen now. It's something that'll get fixed. They'll figure it out later, but it means that the measured price indexes will be distorted.

Allison Schrager:

So I want to thank everyone, but I was supposed to introduce Charlie Plosser, but he actually has a question. So I think he's going to do the next panel, but we're going to kick that off with his question to this panel.

Charles Plosser:

All right. Thank you, Allison. Great panel, guys. I just had a quick question for Athanasios, because he raised the question about credibility and commitment to the long run target of inflation. What, then, do you make of the fact that this year the Fed abandoned its long-term strategy of committing to a 2% inflation rate, and didn't recommit it's [inaudible 01:02:22] and view, and the effort to say, "Well, we're going to review everything coming forward."

Charles Plosser:

What do you think that does to their credibility, and how that might be affected during this effort, when credibility is going to be really important?

Athanasios Orphanides:

Hi, Charlie, it's a very good question. It actually reminded me of Marvin Goodfriend's insistence on how important it would be for the Fed to commit more credibly to its 2% inflation objective, and improve its policy statement. So I would say that right now, personally, I'm willing. We're in crisis. And I think they have properly accommodated. They have properly followed the accommodative policy. I would give them the benefit of the doubt until June. And in June, I hope that with the introduction of proper communication, that in my view was very unfortunately suspended in March with the publication of either something similar to the old fashioned summary of economic projections, or something far stronger than that. And we can have a discussion of what would be good to communicate. We can have a restoration of that commitment.

Athanasios Orphanides:

I expect, and I hope that the Federal Reserve already had a June meeting, will restore its 2% longer term projections on inflation, reaffirm that that is the longer term target. And, in my view, would be good if they give us some risk scenario, to tell us how they are going to be handling different eventualities, like the inflation and deflation situations we've seen, so that we can be assured that they will deliver 2% inflation in the long run. So, frankly, I think the suspension of the SUP and communications in March, and the fact that in January, as you pointed out, they did not really reaffirm the statement, are not good signs, but the suspension in January was part of their review process that is now going to take a while longer. And I think the Fed still has an opportunity to improve its communication and commitment to price stability.

Charles Plosser:

I hope you're right.

Allison Schrager:

All right... So, moving on to the next panel.

Charles Plosser:

Well then, good morning, I guess, or afternoon now almost. Welcome everybody. I want to thank you for joining us today. It's been a fascinating and interesting discussion so far, and there's clearly much more we can discuss and probably will discuss. In this session, we have three panelists who will continue the discussion, but we're going to focus more specifically by following up on some of the issues related to credit lending by the Fed and some of the policies they've chosen. You know, in the Great Recession, the Fed undertook a lot of in-lending activities, credit policies, if you will, and lending, but it was mostly directed at financial institutions. The argument being, and Ben Bernanke made this argument repeatedly, was it was important for the Fed to conduct lender of last resort operations. And I, here I refer to that is most people when they say lender of last resort from a central banking point of view, refer to lending to financial institutions, not necessarily non-financial institutions, because the goal is to keep the financial institutions functioning when in case they are solvent, but not liquid.

Charles Plosser:

Many of you may remember that in 2008 Congress, two senators wrote Ben Bernanke a letter and said, "We in Congress would like the Fed to consider lending directly to the automobile companies because they're failing, and we don't know what to do with them right at this point. So we need you to lend."

Charles Plosser:

Now you might react to that by saying, "Well, it's not surprising that Congress would want to ask that question when the Fed had already lent to creditors, or Bear Stearns, to AIG, Fannie and Freddie."

Charles Plosser:

And so it's not clear... That the Congress was, that was a surprising question. Ben's answer to that question was, "No, that's not our role."

Charles Plosser:

Well, roll forward here to 2020, and all bets are off. We've expanded credit lending, not just lender of last resort, but credit lending broadly to the economy to include corporations, both high risk and low risk investment grade, and junk bond companies, high risk companies. We've extended it to state and local governments. We've extended it to all sorts of parties that we didn't extend lending to in 2008. And so I think there are a lot of questions that we ought to be asking or trying to understand about "Is this appropriate? Is it not appropriate? And how will it all play out?"

Charles Plosser:

So, our panel to talk about things and some other issues is made up of Debbie Lucas from MIT. Debbie, welcome.

Deborah Lucas:

Thank you.

Charles Plosser:

Greg Hess from Wabash College, Greg. Good to see you.

Gregory Hess:

Hi Charlie.

Charles Plosser:

And Andy Levin from Dartmouth College. They will be our commentators today. And they'll have some interesting thoughts that, like I say, on the issues that I raised, as well as some others. So I want to start with Debbie and ask her... Compare a little bit, the lending activities of the Fed now versus the previous crisis. What do they look like? How are they different? And what are the costs and benefits of taking on these new responsibilities that the Fed has taken on in this crisis, that sort of expanded the view of lending, the role of lending from the previous crisis. How do you see all that playing out over the next few years and maybe even decades, Debbie?

Deborah Lucas:

Yeah. Well, Charlie, thanks for that tall order. I'm sorry, not to be able to see everyone in person who's on this call. So I wanted to use my time to address those questions and briefly comment on the massive new credit facilities that the Fed is running, but in particular, I'm going to frame it in terms of several issues. First, I want to ask whether the actions are significantly overstepping the line between monetary and fiscal policy, as I think some people believe, as Charlie mentioned, I want to compare these actions with what the Fed did during the financial crisis and the Great Recession. The third thing I want to ask is whether it was a good idea for Congress to assign the role of intermediating the new lending programs to the Federal Reserve rather than to some other Federal agency. And then relatedly, what does it all mean for public expectations about what the Fed's job really is and its future ability to maintain independence over monetary policy?

Deborah Lucas:

Okay, so, so the Fed's emergency facilities to respond to the pandemic, which the Fed always refers to as their Section 13(3) of the Federal Reserve Act Facilities. I mean, you can divide these into two broad categories and there's a lot of them, but in terms of the two categories, the first might be described as direct lending or bond buying, and that's for businesses of various sizes, and also to state and local governments. So that includes the new muni lending facility, the Main Street lending programs for small and medium businesses, and the primary market corporate credit facility. In total, the capacity of those facilities is just below $2 trillion.

Deborah Lucas:

The second set of facilities are what I'd call liquidity facilities. And as that name implies, these facilities require significant collateral, or they involve transactions at fair market prices. And those liquidity facilities include an alphabet soup. That includes MMLF TALF swap lines to foreign central banks, PDs, DPF bath, and the new PVPC. So in terms of the size, what's interesting and disturbing is it's potentially unlimited and [inaudible 01:11:32], okay. So on those [inaudible 01:11:35] facilities, many of the acronyms I just read off are familiar to Fed watchers from the 2008 crisis, because they've been essentially resurrected from that time. And then, as now, it was very tricky to evaluate the Fed's potential exposure to tail losses, because the potential size was effectively unlimited. They basically are described at maybe having some starting target amount, but those caps could be revisited, depending on what happens in the market. To compare to last time, even though they were effectively unlimited at the peak, the draw down on those facilities never exceeded $500 billion.

Deborah Lucas:

And I should say, that's excluding the swap line. So even though it was potentially trillions and trillions of dollars, luckily it never reached that. I might also add, as it came up earlier, as if you look at the plot of those past facilities, they were actually liquidated quite quickly after the crisis subsided. So unlike the Fed's main balance sheet, it's kind of more straightforward to wind that down.

Deborah Lucas:

Also, to put those programs in perspective, relative to the Fed's other activities, and as Mickey and others mentioned earlier, its balance sheet has expanded by almost $3 trillion since the start of the pandemic to an all time high of $7 trillion, but that was primarily through its more traditional activities of buying treasury securities and government back-mortgages. So I think of that broadly as also part of its liquidity job and less having to do with these emergency facilities.

Deborah Lucas:

Okay. So the Fed sees its role as providing emergency liquidity without taking on credit risk and thereby avoiding crossing the line to fiscal policy. I actually want to argue that these emergency facilities were structured to be consistent with that goal and that they should not be understood as the Fed becoming deeply involved in fiscal policy. So this always requires a definition of what's meant by "fiscal." I use that term to mean an action that's equivalent to a tax and spend policy that involves some kind of coerce transfer of real resources that's directed by the government. In the case of credit programs, I think of a credit program as fiscal, if the loan terms involve some kind of a subsidy. So the Fed, the reason I'm arguing it's not fiscal, is that the Fed is not assuming any significant, uncompensated credit risk from these new facilities, and in fact, the facilities were carefully constructed to avoid just that.

Deborah Lucas:

What happened is, Congress, and I guess with the guidance of the Fed, took a page from the 2008 playbook of the financial crisis and how TARP was used. So, the facilities are structured so treasury is generally in our first loss position that shields the Fed from essentially all default losses.

Deborah Lucas:

So for example, there's this new paycheck protection program liquidity facility that the Fed has instituted. Even though they're buying these extremely risky paycheck protection loans, there is no additional risk to the Fed because under the CARES act, there was an appropriation that covered those forgivable loans under the program. And for the other risky new programs, they've been structured as these special purpose vehicles where the treasury has been put into a first loss equity position. So in my view, this all maintains the Fed's legitimate role as a provider of emergency liquidity, but nonetheless, the perception that the Fed is engaged in risky lending and the fact that the Fed seems to be allowing that perception to prevail without pushing back on it very hard is quite concerning to me, perhaps German policies, the wide perception of being willing to do what it takes to be advantageous somehow to the Fed right now.

Deborah Lucas:

But it also entails the risk that the Fed is going to be the subject to unrealistic expectations about what it can be expected to be able to do or what its responsibilities truly are in the future. So could involving the Fed in this way have been avoided? I think the answer is yes. The alternative would have been for the CARES act to have put other agencies in charge of intermediating the new risky lending facility.

Deborah Lucas:

So for instance, the treasury in my view has at least as much capacity and expertise to run the bond buying programs as the Fed does, and the Fed could have been asked to provide indirect liquidity support as it does for the PPP. And all of that would have put a brighter line between fiscal and monetary policies.

Deborah Lucas:

Lastly, and perhaps most worrying to me, what seems like perhaps the biggest departure from the past is that the Fed is now more involved in picking winners and losers through these facilities. I think it's hired an external manager to try to avoid doing that, but again, the perception that they are picking winners and losers could be quite damaging to their independence in the long run. Thank you.

Deborah Lucas:

[00:18:59 silence]

Deborah Lucas:

Charlie. You're muted.

Gregory Hess:

Yeah you are, Charlie.

Charles Plosser:

Sorry about that. Sorry. Thank you, Debbie. That was very interesting. Greg Hess is now going to take over the podium, so to speak, and talk about lending facilities and... And again, lending to risky assets, corporate bonds, high yield bonds and municipal securities. Do you think the Fed's really overstepped its bounds?

Gregory Hess:

Well, you know, as an academic, I'm trained never to answer the question until the very end, but I'm trying to be a little bit better and I'll give you just kind of the headline at this point. I see that, and indeed, the Fed is trending that way, that it is overplaying its hand as lender of last resort. And my first piece of evidence is that, you know, starting with Alan Greenspan, going to Ben Bernanke, going to Janet Yellen, emerging to Jay Powell, every Fed Reserve chairman has taken on the second surname, which is the same and that's the word "put," and it does, you know... It does give you this suggestion that there is something going on out there that the Fed is intervening in ways that is actually distorting the way people, price risk, and how markets ultimately function. But I do want be fair overall. And I'm going to do that by sharing a screen with you right now. Just give me one second, everyone, share a screen... See if I can do with this one here... Okay... Hold on one second...

Gregory Hess:

Hopefully everyone... Can you get, can people see that screen? Can people see the second screen? The PowerPoint slide?

Gregory Hess:

Let me see here.

Gregory Hess:

[00:21:23 silence]

Gregory Hess:

Can everyone see the slideshow?

Gregory Hess:

[00:21:33 silence]

Gregory Hess:

And there it is. Shared. Sorry, everyone. I'm always a little slow on these things. And let's play it from the start.

Gregory Hess:

You know, the Fed has a certain kind of elements to its title. You know, the section 13(3) allows the Fed to engage in an extended credit and emergency lending to bank and non-bank financial institutions, primarily for the purposes of providing liquidity to the overall financial system. I do want to note that these are board of governor decisions, not FRMC decisions, and that's something that does come into play in creating insiders and outsiders in the Federal Reserve system. It is something that does require treasury approval, which has happened. And it is a far cry from kind of the more simpler view of lender of last resort functions that Walter Bagehot, you know, emphasized in his time, which was to lend freely and provide ample liquidity during times of panic against good collateral at penalty rates.

Gregory Hess:

But there is a view that, you know, a very simple view that says that maybe the Fed has not really overplayed its hand as lender of last resort. As has been pointed out earlier, the Fed has only tapped four of these new aid programs, and that they only account for about 3% of the 3, a little over $3 trillion increase in the Fed's balance sheet, which means that up to this point, the Fed has not got deeply involved in the credit game. And that means that the problems have been minimized because they've not taken such a large position, of course, as some of the earlier speakers noted, that the view is that those will be rising further in the future.

Gregory Hess:

Now, we do also know that in 2014, the Fed did also get involved in credit, aAnd the Fed did have a big, you know, footprint in terms of market activity. And it did seem to ease back on that. It took them a while, but it took them by, by about 2014, the Federal Reserve did manage to pull back on a lot of this additional activity. And that should give a good credibility, that it can not only create these programs, but it knows how to, not only take them up to high levels, but it also knows how to bring them down to much more modest levels.

Gregory Hess:

At this point, we know that the Fed has tried to move quickly. It's moving very transparently. It's putting timestamps on program. There are time periods when no more loans are going out. And that is actually well within a pretty good practice of being a good lender of last resort, but there are some... There is a view that I tend to place a little more weight on, which is the view that's in favor of the fact that the Fed maybe has overplayed its hand.

Gregory Hess:

The first one is kind of what I call legacy issue. We had a discussion earlier that whether history, you know, repeat itself or it rhymed, but history does bring its own baggage. And we know that after the financial crisis of 2008, that things changed in how the Fed operated and a lot of that was positive, but a lot of it did weigh it down and made all its future choices much more difficult. [00:25:34 Orange] back securities, for example, are now 25% of the Fed's $7 trillion balance sheet. Obviously that was a big part of the Fannie Mae Freddie Mac moved conservatorship, which is still an unresolved issue, and in our democracy and our market based democracy. It also, you know, brings to mind the whole reason why the Dodd Frank bill came about, which was this view that some institutions were deemed too big to fail and there were special treatment.

Gregory Hess:

And so we know that there are legacy issues every time the Fed gets involved. And our big question right now is what's the big legacy issue that the Fed is creating for itself. Part of it is creating winners and losers. We are worried about that. The Market Street Lending Facility is the one that probably worries me the most because it's getting into small and medium sized businesses and directly getting into the game of lending. And, you know, that's very hard to do at an arm's length basis when you're as big as the Federal Reserve system. In fact, that's kind of just my final point here. You know, at some point the Fed is becoming so big that it's, in many ways, becoming the only game in town. In some ways, they've adopted this new mantra, and you can see once in a while emerging in some of the language that comes through the Federal Reserve board, that they're interested, now, in smooth market functioning.

Gregory Hess:

In world of risk, we know that the outcome of risk oftentimes is occasional volatility. And so I do become worried that in emphasizing smooth market functioning, that the Fed is overemphasizing volatility. Usually they only emphasize volatility on the way down and that, you know, it's going to start to cloud how risk is being priced in our world these days. And who is the Fed crowding out in its attempt now to institute credit and enter the whole kind of credit market in terms of being a lender to small and medium sized firms. Thank you.

Charles Plosser:

All right, Andy.

Speaker 8:

Great. Well, it's been really great to be able to be part of this today. These are really critical issues for every American people, scared about their lives and their livelihoods, trying to balance those things. I think it's critical.

Speaker 8:

The Federal Reserve has a critical role in all of this. And I just want to emphasize, first of all, it's really critical for the Federal Reserve to have open public debate about its policies, its plans, its strategy. It needs to be careful. It needs to listen. And I appreciate that Fed officials are continuing with their Fed listens program, but there needs to be open debate. This should not be a time when the Federal Reserve has a unified front to pretend that these are simple, obvious issues with clear answers. They're not. So, the Federal reserve was designed precisely to have a diverse set of views coming from regional Federal Reserve banks, as well as within the board of governors itself. And this is a time when there needs to be clear, open debate about the approaches. Mickey Levy, and Mike Bordo, and I have been working hard on a new paper. We're hoping it will be ready to release-

PART 3 OF 4 ENDS [01:27:04]

Andrew Levin:

... hard on a new paper. We're hoping it'll be ready to release early next week. The paper is about the rationale for the Federal Reserve to start using scenario analysis and contingency planning, both in its internal deliberations and in its public communications, to help the public and the Congress and the financial markets understand where the key [inaudible 01:27:26] uncertainty, and what's the Federal Reserve strategy and contingency plans for mitigating the various types of risks. This is an approach that I've been talking about for many years, Mickey has been talking about for many years, Mike Bordo and I have written about some of this in our work, and so the three of us are now coming together.

Andrew Levin:

Let me try to just explain to you a little bit, some key messages from that paper. Again, those of you who are interested, I'm happy to provide it to you next week. One message is that the virus itself is dangerous, but it's dangerous in a complex way. It doesn't affect everyone the same. Half the people who get it have no symptoms at all. A lot of the ones who have symptoms, it's pretty manageable. Most people who are under 50 years old are completely safe. In fact, I just double checked, in Korea, there's been thousands of deaths, but there has not been a single death of a person under 30 years old.

Andrew Levin:

On the other hand, it's important to point out this is not just dangerous for old people. There's been a lot of deaths of people over 50 years old, a lot of people over 60 years old. The infection fatality rates look like they're one, 2% for people in their 50s and 60s, in Korea and Italy and Spain, in New York City. We have good data. So this means that the public policy response to this needs to carefully distinguish a disease that's really, really minimal risk for people under 50 years old and very high risk for people over 50, and particularly, for people getting older than that.

Andrew Levin:

Now, given those that picture of the disease, the questions what [inaudible 01:29:17] implications for the economy? In our paper, we describe a benchmark scenario and then we bracket it with two alternative scenarios. So let me just talk through those with you. One approach people have been talking about a lot recently, is what they call the Nike swoosh. And since all of you know what the Nike swoosh looks like, I'm not going to draw it for you. But as Mickey and Mike and I have talked through this, and Mickey's talked to lots of other people too, we don't think that's the right way to think about what's going to happen. We think a better description is what we call a check mark. And I want to show you that check mark, actually. I'm going to try to share my screen here. Hopefully this'll be easy.

Andrew Levin:

Okay. This is what it looks like. We call it an outward tilting check mark because we have this incredibly horrifying drop in economic activity, retail spending, employment, and not just unemployment claims, but people who are not at work, people who have dropped out of the workforce, they're not searching for a job right now, some of those people don't even want a job right now. It's been horrifying in terms of the speed of the damage to the economy in the last couple months. The check mark is that we're going to get some substantial, pretty rapid recovery in the next few months, as things start to reopen. There will be a sense of relief, a huge sigh of relief, if some things start to look more normal again, but that's not the end of the story. Probably next year, still at the end of next year, unemployment can still be worse than it was at the peak of the last recession. And the recovery from there over the next few years can be very long and slow and painful, just like it was last time.

Andrew Levin:

The Federal Reserve needs to think carefully about this kind of check mark scenario. What's the strategic plan? That means probably unwinding some of its emergency facilities as we get moving up the check mark, but probably needing to have effective monetary stimulus for years to come. And as Mike mentioned, as Mickey mentioned, our assessment is QE3 just didn't work as planned. It might've had some benefit for asset prices, but it did not stimulate GDP growth, it didn't stimulate payroll growth. It didn't help accelerate the recovery. So the Federal Reserve needs to take a hard look at that, self-critical look, that they have never taken of QE3, and try to figure out if this check mark scenario is going to happen, how can we help the US monetary policy to get a more satisfactory recovery?

Andrew Levin:

Okay, that's our benchmark scenario, and Mickey and Mike can weigh in on this too. But I used, I guess my Paint 3D to show you two other scenarios. Let me just sketch them in here quickly. One of them, is more like a V-shape. How could that happen? Well, we know that there's a lot of major pharmaceutical companies and brilliant scientists and researchers actively looking to try to develop a vaccine, an antiviral medicine. Now, public experts have been cautious that that probably will take a couple years, maybe longer. There's never been a vaccine against the coronavirus before, but we have new, cutting edge technologies that are being used for this.

Andrew Levin:

We should be taking seriously the possibility there could be a vaccine developed in the next six months. And if that happens, and it can be widely disseminated, we could actually be going back to normal next year. Maybe by the end of the next year, we're pretty close to where we were before the whole pandemic started. That would require the Federal Reserve to unwind much faster. And the concerns that Mickey raised earlier about being back in the late 60s or 70s, where inflation was going way above the target in ways the public was very unhappy with, would be a lot of questions. So the Federal Reserve needs to carefully consider what its contingency plans are if there was a miracle vaccine or antiviral medicine that becomes available in the next six, nine months or so. Different than the check mark scenario.

Andrew Levin:

The other one I've drawn, which is the gloomy one, we call it the severe adverse scenario, is that there just isn't much recovery. There might be a modest pickup over the next few months, but retail spending continues to be held down. Even as the economy opens legally, people are still worried and scared. This is what we've seen in China, that retail spending there is very gloomy still. And that holds back the economy, and we see more and more bankruptcies, more and more defaults on mortgages and student loans and auto loans and credit cards. We get an adverse feedback loop between the economy and the financial system like we had in the Great Depression, and like we started to have in 2008 and '09. Now, the question in that scenario, which we have to take as a plausible scenario, we hope it doesn't happen, but like I said at our last SOMC meeting, hope for the best, prepare for the worst.

Andrew Levin:

What's the contingency plan here? Let me sketch out three different possibilities the Federal Reserve should talk about openly, publicly, with Congress and with the public. One, is they could take their current purchase programs to the limit, buy lots and lots of shares and corporate equities and corporate securities. We could end up with a scenario where the Federal Reserve effectively has a huge footprint in the economy for many years to come. The irony of that is it would end up looking a lot like the Soviet Union. The government would essentially be owning a lot of corporations and maybe effectively owning a lot of small businesses. They would have to show up at shareholder meetings, weighing in on all kinds of issues about executive compensation and environmental issues. Is that the direction that we want to go? We need to think about this now, before we get there.

Andrew Levin:

Another possibility is the Federal Reserve just stays on the sidelines, say's "Sorry, but there's nothing more we can do to help. It's a horrible situation." That's what they effectively did in the early 30s. The third option, which Mike Bordo and I have been recommending for years, we were warning about this kind of severe adverse scenario, was let's go to negative rates, carefully, deliberately, in a way that insulates ordinary families and small businesses. Mike and I think it can be done. We've explained how that can be done. We're mystified. Why is the Federal Reserve Board so willing to do these other kinds of extraordinary actions and completely taking the negative rates off the table? That should be a matter of public debate and discussion with Congress, with financial markets, with ordinary people in the public.

Andrew Levin:

So I'll stop there. I look forward to having questions and further discussions today. Thank you.

Charles Plosser:

Great. Thank you very much, Andy, and thank all the panelists for their contributions. We're going to open up for questions. Make sure if you're in the audience, if you have a question, please submit it.

Charles Plosser:

I guess I'll start us off with one question, and this is actually related to one of the questions that came from the audience. In the previous crisis, 2007 and 2008 and 2009, the Fed embarked on these unconventional policies. As I said in the introduction, that when Congress asked him to rescue or lend money to the automobile companies, he said no, but now we seem to be doing, lending to lots of people.

Charles Plosser:

Several of you have mentioned, how does this end and what's the exit strategy, and an exit strategy to what? So one might ask, is whether this is the beginning of a more systematic pattern by Congress, not the Fed, to use the Fed for fiscal actions? They made it semi-legitimate by saying "We'll undertake," as Debbie said, "The first 10% of losses." But what if the losses are 50%? But as long as Congress feels like that they can take taxpayer risk with a small amount of equity investment, it's a lot easier to spend that way than it is spending other ways.

Charles Plosser:

So the question that came from the audience, is this not the beginning of a more systematic pattern of Congress to engage in monetary financing on a more regular, without unusual, extra circumstances events?

Deborah Lucas:

So I would like to go to that. So as you said, and as I very strongly believe, they really haven't done that yet. I think it's right. The 10% doesn't sound like that big a cushion, but actually, that 10% is on investment grade securities. And so actually 10% is quite a huge buffer on those. But more fundamentally, what I think is, what I hope is, that the Fed will be able to convince Congress that if the losses turn out to be in the tales, that Congress will appropriate more money to cover them.

Deborah Lucas:

So I think it's not clear yet that anyone has wanted to go over that line. I definitely think they shouldn't, but I think they have actually been very careful so far. So I'm still optimistic that there's a general understanding that the Fed is not supposed to be doing fiscal policy in that way.

Charles Plosser:

Andy, did you have a comment?

Andrew Levin:

Yeah, sure. I think first of all, it's not just investment grade bonds anymore. They're buying bonds that used to be investment grade that are now below investment grade. I think in the case of our check mark that I described a minute ago, this will probably all be fine. In fact, like what happened last time in 2008, '09, a lot of corporations might want to get their bonds quickly off the Fed's balance sheet and be eager to find ways to do that. Because they don't want the Federal government to have opportunities to be intrusive in their corporate decisions.

Andrew Levin:

I do think that there are scenarios, and it'd be great to hear what Debbie thinks about this, she knows a lot more about some of this than I do, but there are scenarios. Just like what happened with MBS. There were AAA-rated MBS that became junk. There must be scenarios here where there's a lot of corporate bankruptcies and where the losses go beyond the 10%. I think the question-

Deborah Lucas:

Right.

Andrew Levin:

One more sentence. The question the Fed is going to face in that case, is to what extent did this program help Main Street rather than Wall Street? And if the answer to that is that this mostly helped some big corporations, that a lot more money than Congress was anticipating was put into this with very little help for the actual labor market and for ordinary small businesses, and that most of this really went to big corporations to ease corporate bond holders, then there's going to be very serious backlash like we saw 10 years ago.

Andrew Levin:

Remember Occupy Wall Street and the Tea Party, both sides of the aisle were upset. That could happen in spades if we end up at 20, 25% unemployment for many months to come, and all of that first round of money has been used up with very little to show for it. I think that's the thing that the Federal Reserve should be very worried about and concerned, and trying to help people understand what's going on.

Deborah Lucas:

Right. So I think though that this flood gate was opened wide in the last crisis. You all know that my little side business is estimating the cost of all of these things. So TALF is an example that's been brought back, that hasn't come up in this conversation, that has very much that [inaudible 01:42:19] nature of if there's massive crashes in the value of asset-backed facilities, the amount of Treasury support to that facility is not actually large enough to cover those tail losses.

Deborah Lucas:

So I understand that what they did had to respect the fact that they were only going to appropriate so much money. They did what's reasonable, is they put in enough money to cover most circumstances. And so again, I think they couldn't put 100% reserves because then the CARES Act would have been $5 trillion instead of $2 trillion. So the question is what's reasonable and what's the expectation in going forward? So I'm still confident, I'm still fairly confident, that the expectation is that Congress will have to appropriate more money if things go really poorly.

Deborah Lucas:

And then again, on this issue of who they're lending to, as I said, I think they're very unfortunate that they ran this through the Fed and not through the Treasury. Because it was a political decision. It was not the Fed's decision to lend to these particular groups, it was in fact Congress's decision to do that and they should be on the hook for it. It would be much cleaner, perception-wise, if Treasury had done the lending and then the Fed had provided the liquidity. It would have amounted the same thing, it would just have been cleaner communication. But I'm still not sure that it really changes. I'm still not sure you want to blame the Fed or put it all on the Fed.

Gregory Hess:

Yeah. I'll just say quickly, that I don't get the sense that ... I've been thinking more about the Market Street Lending Program. I don't get a sense that this is what was the Fed's idea, the first idea they came up with for something that they really want to do. I'll just be honest. I haven't talked to anybody in the Fed system about it, and there there's a timestamp on it, which is September 2020.

Gregory Hess:

They're going to keep listening for awhile, and my guess is a little bit will get done near the end and they've built this facility, but I don't, it doesn't appear they're into it nor have they, or has anybody, come up with clean and cogent arguments why there isn't a private source of funds out there that couldn't have provided these types of loans. That's also, ultimately, the most worrying part to me.

Andrew Levin:

Okay. So in a good scenario, all the relevant things come back and everything, everyone's fine, and this is just a minor footnote. Okay?

Andrew Levin:

I think the real questions are in the scenarios, and again, we could debate them probabilities. Whether it's 40% or 20%, it's a substantial probability that we're not going to have a rapid bounce back, we're not going to have a complete bounce back, and that there could be a lot more corporate bankruptcies. We know there's small businesses closing already and disappearing. We know that. So I think what I'm disappointed about still, and I think there will be political consequences to this, is the Federal Reserve has the ability to move very rapidly and to markets and buy securities that are traded, and that's what they did. That's how most of the money that they've used so far, Mickey mentioned this, that's how mostly it's been used. They haven't been moved very quickly in taking actions that would help Main Street.

Andrew Levin:

So if we're lucky, it won't matter. But if in these less benign scenarios, Congress, the public, will be very unhappy, and the same criticisms that happened 10 years ago, that the Fed was really effective in rescuing Wall Street, but yet again, unemployment's high and terrible, and lots of small businesses and people getting kicked out of their homes, and all these sorts of things could happen. It's a political decision in the end. I totally agree with that. That's why I think the Federal Reserve needs to help Congress understand what the Fed can do, what it can't do, what it should do and what it shouldn't do. If the Federal Reserve says, "We've thought about this, and we don't think we can take that on, we don't think we should take that on," then they could push back. It should be a public debate.

Charles Plosser:

So I pushed back a little bit in 2008 and 2009, even within the Fed and it wasn't easy. But [inaudible 01:46:43] does it matter, Andy? If it's not effective, then what's happened to the Fed's credibility? That's another thought to keep in mind.

Charles Plosser:

Another question here. This is related to negative interest rates. There's evidence of the negative interest rates in some countries such as Japan didn't work and Sweden recently ditched its negative interest rate experiment. So what makes you believe that the negative interest rate policy for the Fed would produce the desired outcome for the US?

Andrew Levin:

Okay. I'm assuming I should take that first?

Charles Plosser:

Yes, I think so.

Andrew Levin:

And by the way, I do want to just emphasize here, debate is important. I think it's a really valuable function of our shadow committee, that we have a range of views, of Debbie ... Charlie, you know that I admire tremendously the role that you played 10 years ago in [inaudible 01:47:35] voice and dissenting. I didn't always agree with you. I don't always agree with you now, but having a debate is important, and that's what we're asking for the Federal Reserve to do.

Andrew Levin:

Okay. So on the negative rates, again, I don't want to go through it all because my board, I have it in writing. But we presented a serious proposal to introduce digital cash, to introduce a system of graduated fees so that people could make changes between paper cash and digital cash for free, up to some amount, 10,000, $50,000. You can pick whatever number you want. But beyond that point, it starts to become more and more costly for a big financial institution to conduct arbitrage.

Andrew Levin:

Athanasios said this in the first panel. Let me just repeat what he said. He said, "As long as we're hampered by the Zero Lower Bound, my view is that people will look back probably at what's happened now like they looked back in the early 30s and say, 'It's time to end the gold standard.' Now people are going to say, 'It's time to get rid of the Zero Lower Bound.'" We have to do that. That's the priority. If we really want the Federal Reserve and other central banks to have more flexibility, to be more systematic and transparent.

Andrew Levin:

Again, I won't go through this any further except to say, please read the paper that Mike Bordo and I put in the [inaudible 01:48:56] Journal or in the Hoover Working Paper series because I think those would help answer at least some of the questions.

Charles Plosser:

If you will, each of the panelists, if you've got comments on the other panelists' work or points that you might want to make related to their comments, feel free to do so now. Anybody?

Gregory Hess:

Please, Debbie.

Deborah Lucas:

No, go ahead.

Charles Plosser:

There's several more questions on negative rates. I'd like to say that I think this is an incredibly important time for thinking about the Fed as an institution and what its future is going to look like. The steps it takes today, or during this crisis, have repercussions for its institutional arrangements, how Congress and the public thinks about itself about it, how they want to arrange the central bank as an institution.

Charles Plosser:

I think one of the things that, and this is sort of related to what Andy is saying, we need to think longer and harder about the repercussions. The long run consequences of the actions that they take today may seem a long way off, but at the end of the day, those repercussions and consequences, whether it be loss of independence, whether it be a Congress that's more inclined to want to use the Fed for off budget policy, I mean, those are political questions that are looming large in this event and are looming larger now than they were in 2008. I thought they were large then, and now they've just grown, given what we've done. So I think those are things that we need to think long and hard about, and I would encourage the public and others and academics to ask those hard questions and see what's going to transpire.

Charles Plosser:

I guess Mickey has a question that we'll throw out. We've still got a couple of minutes left. This is for Debbie, apparently. Mickey asks, "How specifically should the Fed be coordinating with the treasury on specific lending facilities or terms or financially? What's the right model here?"

Charles Plosser:

I've found your idea appealing that, the Treasury could have done this as easily as the Fed could have, in some respect and been more true to the separation of policymaking, and by the way, accountability, which I think is the most important piece here. But how do you envision that working?

Deborah Lucas:

Well, I don't envision it working. I was doing Monday morning quarterbacking. I mean, my point was that ... I mean, what I feel is now the Fed was given the responsibilities in the CARES Act to do what they're doing, and they could have pushed back harder than they did. I know that Ben Bernanke, last time around, didn't do a bunch of things that the Fed was asked to do because he didn't think it was appropriate. And so this time, for whatever reasons, there was either not as much push back or it wasn't possible to push back, but they accepted these facilities. So there's nothing that could be done now.

Deborah Lucas:

I was just making the point that these were actions that Congress has enacted and the Fed is acting as an agent and not as really the primary decider. I think what they need to be doing is communicating that more clearly. I'm trying to communicate it for them. I think they need to communicate that more clearly themselves, because I think that clearer communication would help protect them from this idea that the Fed is helping Wall Street and not Main Street. Because it's really Congress that made the decision to do those things.

Deborah Lucas:

I just want to make one more broad point, which is there has been this huge perversion in all of this legislation, in what credit policy can do and can't do. So credit policy cannot deal with solvency problems. And actually, the poster child for that was the Paycheck Protection Program where they call something a loan, where in fact it was way for companies to pay [inaudible 01:53:56] or so they didn't have to go on unemployment benefits. Now, that is a complete misuse of credit. Luckily, the Fed wasn't put up in front of that one, maybe they were able to push back on that and it went to the SBA.

Deborah Lucas:

But I actually think that the programs where the Fed did take them on, I might not be, I might not think they were a great idea, but I don't think they're a terrible idea. Because I think the point of them is that for companies that actually, at least at this moment, are solvent, you don't want their inability to go to the capital markets to be the thing that forces them into insolvency. So if they're fundamentally solvent at this moment, let's make it easier for them to continue. I think that actually is a legitimate role of asking the Federal Reserve to somehow provide the liquidity to help with that.

Charles Plosser:

Thank you very much, Debbie. And once again, thanks to all the panelists for your thoughtful comments and the discussion. I want to thank the audience for their attendance and presence here in questions. This has been the first time the SOMC has ever done anything like this on live streaming, but we hope everyone's enjoyed it and enjoyed the comments. So with that, I think we can call this Spring SOMC meeting to a close. Thank you all for very much. Thank you, Mickey. Thank you, the rest of the members.

PART 4 OF 4 ENDS [01:55:36]

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