The Fed's Biggest Challenge Isn't Inflation | Robert Hetzel

Is the Federal Reserve making the right decision? And when it doesn't, are there any serious checks and balances and accountability? Today we sit down with Robert Hetzel, who's a former Federal Reserve economist and author of multiple books. He's here to tell us the mistakes that Fed has made in the past and the lessons that we could learn from it going forward. I was at the Fed in 99, 2000, and the newspapers were full of the talk of a new era, a new paradigm. Inflation's dead. If monetary policy is to be stabilizing, you can't choose between rules and discretion. There's got to be an underlying rule, even if the Fed isn't willing to articulate it. You know, okay, he's a reformer, but he's not going to reform in this way, because the chair wants to dominate monetary policy. This new world really isn't such a new world after all. I'm Siamak. Welcome to Market Insider. Robert, it's great to have you on. Welcome. Good to be here. You have been an economist for a few decades inside different organizations in the Federal Reserve. A lot of people are wondering what's going to happen with the new Fed chair, and there's a lot of discussions, conversations where the interest rates are headed. But we want to talk to you more about how the Fed works. The Fed actually communicates on two tracks. One track is implicit, and that's the financial markets. Because the Fed can't predict, financial markets can't predict. Look at the SEP and how off it's been on inflation in the last few years. So the Fed needs a rule that's grounded in its best understanding of the economy. But the rule has to be such that when new information comes in, markets understand how the Fed is going to respond. And that way, the yield curve responds in a stabilizing way as new information comes in. I'll give you an example. This is obvious, but it's important. Let's say you go into a recession, and we need a lower funds rate. Households need to spend more and save less. They need to be more optimistic about the future. But you don't want the change in the yield curve to incorporate an increase in expected inflation. And that was the case after the Fed lost its price stability anchor in 1979, when Volcker took over. So you want markets to believe that the Fed will lower the funds rate in response to a recession. But when the time comes, it will raise the funds rate to prevent the emergence of inflation. So that's one thing. And then I put that together with actual FOMC behavior. And you really need to go back to William McChesney Martin and the Treasury-Fed Accord in 1951. And the Fed really had to create a modern central bank, the old real bills views. You got to allocate credit to productive uses. You're going to control inflation. It just didn't work. It was obvious after the World War II, we didn't have another Great Depression. So Martin came up with what he described as lean against the wind. Now, Martin was a bond trader. He was not an intellectual. He was not an economist. But what he meant was that the Fed had to behave in such a way that if the economy was growing unsustainably fast and rates of resource utilization were declining in a sustained way, well, the funds rate was too low. And vice versa. If the economy was going subpar, rates of utilization were decreasing, the unemployment rate was rising. Well, you needed to respond to that. Otherwise, you'd have this inflation. Okay. So that was called lean against the wind. And that's the sort of bedrock of every policy that the Fed has followed since then. But here's the thing. There are two versions of it. There's the version that the Fed moved to in the 1970 under Burns and Miller, where you thought a policy is balancing off inflation against excess capacity in the economy. But you didn't know there was excess capacity in the economy until you actually had lowered the funds rate enough to see inflation. So then you got into this Phillips curve trade-off world as long as if you let inflation in the door of how you were going to trade off inflation and excess capacity, high unemployment. Well, that didn't work. So the other version is to take away the punch bowl before the party starts. That was the version that Martin started with. And that can best be described as lean against the wind with preemptive increases in the funds rate. So you never see inflation because you keep excess capacity at a rate so that the economy is growing at potential, not too fast, not too slow. And you're not trading off between excess capacity and inflation. You're stabilizing the economy's rate of resource utilization. And then markets determine the unemployment rate and real GDP growth and so on. So those are those two frameworks, one that Martin started with, but then he got pushed off course by the Johnson populist pressures. And then you got Burns and Miller. That's a whole other story. That's lean against the wind with trade-offs. The other version is lean against the wind, take away the punch bowl, lean against the wind with preemptive changes and preemptive increases in the funds rate. So you never see inflation. And so the underlying policy in Volcker and Greenspan, and unfortunately they departed from this at various times, and we can talk about that. But the underlying policy was this policy of lean against the wind. That is, Greenspan would have described it or Martin would have described it as reacting to the imbalances of the economy as they develop. They weren't a model-based economist, okay. But you do so in a way that the markets understand what you're doing. There will be preemptive increases. And so the markets don't expect inflation. So the bond rate reflects the real behavior of the economy. It doesn't, like in our example, it doesn't move around depending upon what the inflation rates are going to be. That's the underlying policy. Now, you ask the question, well, what's Walsh going to do? Well, okay, we'll get into that, I'm sure. But fundamentally, he's got to make a choice of the kind of consistency he's going to impose on policy. And he's not doing that so far. Yeah, he's a reformer, but he's not getting at this fundamental issue of how you condition expectations in a way that stabilizes the behavior of the yield curve as new information arises. Where do you think we have been in the last couple of decades? So we had the 2008 crisis, you know, and some people say that the Fed didn't really foresee what was happening. And then we had the pandemic era. After the pandemic, we had a tremendous amount of inflation. How do you see these events? So if you don't have a framework, you know, maybe except the rudimentary framework I've outlined, everything just is rationalized, exposed. With the 2008 Great Recession, it was the housing bubble that crashed. And with the 2021-2023 inflation, it was the supply constraints due to the interruption of supply chains because of COVID. There's always some ad hoc explanation. And you can be sure, I mean, I love the Fed because I worked there for so many years, but the Fed rhetoric is such that by avoiding what's systematic in its policy, it never has to ask whether that was stabilizing or destabilizing. You want to go back to 2008? Yeah, let's go back to 2008, yeah. So first off, the thing to notice is that you had a combination of disinflation, a reduction in inflation, both headline and core, combined with an increase in unemployment. That can only come from contractionary monetary policy, okay? Now, understand that there are financial frictions, and that's what Bernanke emphasized. But if the Fed was really focused on getting credit flowing from reluctant savers to the users of credit, it wouldn't have missed on both sides. It should have missed, if you have this third objective, it should have missed on the inflation side, but we didn't have inflation. We had disinflation. So it helps to do a little bit of chronology here, okay? There was a worldwide commodity price shock that was set off by the integration of the BRICS, Brazil, Russia, India, China, and to the world economy that increased the demand for commodities. So that appeared in headline inflation. So headline inflation in the summer of 2008 was 4%. Underlying core PCE inflation was just a little over 2%. The Fed was very concerned that the high headline inflation would cause a rise in expected inflation, and then it would be stuck with that in a box where it might have to cause a recession, okay? So the peak of the business cycle was actually in December of 2007, and the economy had been weakening since spring, okay? Now, for a while, it looked like as the Bush rebates kicked in, it looked like the economy might be recovering. But when they wore off, it didn't. So in the summer of 2008, all the OECD economies went into a recession, okay? But that wasn't obvious from the data because of the data lags. So then you get Lehman in September, whatever, 17th, and then you get this disruption in financial markets. So with that disruption in financial markets, that's the time that the evidence that the world had gone into a serious recession in the summer became apparent. But newspapers just put those two together. You get a financial crisis, and you get the economy entering a serious recession, and therefore, it had to have been some credit shock that housing was the obvious thing. Now, that doesn't mean housing wasn't important and the financial disruption wasn't important because there was a huge loss in wealth because of the decline in housing prices, okay? And the financial disruption caused the real what would be later called demand for cash. So those lowered what economists call the natural rate of interest, the rate of interest that balances off, reallocates demand across time. So you get sufficient demand to keep output at potential, okay? Well, this was unprecedented, and I give the Fed credit for that. But it became obvious later that the natural rate of interest had become negative. Now, that became obvious later because to pull the economy out of the recession, the Fed had to go into quantitative easing and forward guidance, and we can talk about that. That was expansionary despite a zero funds rate. But the Fed didn't get to the zero funds rate until December, I think December 7, 2008. The Fed did lower the funds rate to 2% in April of 2008, but after that, it just let it alone. So the Fed wasn't lowering the funds rate to keep it in line with the natural rate of interest. Bernanke was a student in the Great Depression. He thought that the big issue in the Great Depression was not that you had a recession, but that it was so long, it just didn't go away. Bernanke attributed that to imperfections of frictions in financial markets. So that's what he focused on. What he should have done, he should have announced an inflation target to tie down expectations and then push the funds rate down aggressively and gotten into QE and forward guidance much sooner. So that's my take on 2008. When you were in the middle of all of this, because you were involved, how was it for you? It was very frustrating because I just remember so it were yesterday, the July retail sales number that came out was weak, very weak. So it was clear that the Bush tax rebates were not going to revive the economy. And we had a current account deficit, but that wasn't going to be stimulative. You can see the economy weakening, and that's reflected in the staff summaries of the economy and what was called the Green Book then. It's now called the Teal Book. But since the funds rate was at 2%, underlying inflation was slightly over 2%, the FOMC was like, oh, look, the real rate of interest is zero. And in the 1970s, when it was zero, we had inflation. So the problem can't be monetary policy. It's got to be this credit policy, credit frictions. And it was that analysis that made the Fed slow to lower the funds rate to zero. And then starting early in 2009 and the spring of 2008, going aggressively to quantitative easing. And were you guys surprised that we didn't have a lot of inflation after 2008? Because it seems like we did the same things in 2021, and we ended up with inflation. Beautiful question. OK, so you have to understand the interaction between the behavior of the funds rate and quantitative easing and forward guidance. So the way quantitative easing works is that the Fed is taking long-term assets, long-term government securities and long-term GSE debt and bonds, off the books of the public and replacing them with bank short-term deposits so that the asset portfolio of the public becomes more liquid. OK, and then the public will try to rebalance that to bring it back to normal. And when it does that, it goes out of short-term assets into long-term assets, whether it's consumer durables, equities, houses. And that's stimulative. OK, that's how quantitative easing works. But if the funds rate is negative, European central banks, the Fed wasn't willing to do it. The Fed wasn't willing to lower the funds rate and make it negative. So you had to bring up the natural rate of interest so that it would align with the actual funds rate. And eventually that happened. And then preliminarily in December of 2015, and then more aggressively in December of 2017, the Yellen FOMC began raising the funds rate because as the economy really got into a real recovery, then the natural rate of interest grows. OK, so that's half the story. OK, so people look and say, well, look, quantitative easing didn't cause inflation in the recovery from the Great Recession. Why? It couldn't have been the cause of inflation that emerged with the Fed's pandemic monetary policy, which involved a huge monetization of the pandemic payments that were made by Congress to households. OK, well, but it's very different. The Fed promised to keep the funds rate at zero until inflation actually rose significantly, about 2%. And the unemployment rate at least came to 3.5%, where it was in the pre-pandemic period. And so the quantitative easing in this period was stimulative, but the Fed didn't, as it did in 2016 and 2017, it didn't follow that up with funds rate increases. It had promised to keep the funds rate at zero. OK, so that's a very different. Now, monetary stimulus is inflationary. All that monetization of government debt was like Venezuela or Zaire or Argentina. It was just like that. Of course, Chair Powell would never admit that because it was like the 70s when the Fed thought that the unemployment rate should be 4%, and when it was 6%, which turned out to be the sustainable value, he thought, oh, there's a lot of slack in the economy. And so it was willing to pursue expansionary monetary policies under this illusion that there was slack in the economy and inflation. And so it was the same thing. Powell thought, well, going into the pandemic, unemployment rate was 3.5%, and we didn't have any inflation, it was below target. And so when Powell and Team Transitory saw inflation emerge starting in, well, 2021, 2022, they said, oh, it's got to be due to transitory factors, these supply disruptions. And so it'll go away on its own. We don't have to do anything. Well, by March of 2022, it was obvious that was not correct. And so the Fed began raising the funds rate to basically align it with a natural rate of interest. And then the experience of the pandemic inflation is a classic example of the Milton Friedman helicopter drop. You had a big increase in money, and that burned itself out through inflation. But fortunately, the Fed had maintained credibility. We can get into that. And so financial markets wasn't like the 70s, where they didn't just ratchet it up their expectation of inflation. The expectation of inflation stayed low. And that's what made the helicopter drop one and done. Once the excess money balances have been burned off through an increase in inflation, then you just got back to the normal situation of lean against the wind with preemptive increases in the funds rate. What are you seeing now? Is that stage gone? Are we in a new era? Are we in a more normalized phase? OK, so see, I've been around for a long time. And so I was at the Fed in 99, 2000, and the newspapers were full of the talk of a new era, a new paradigm. Inflation's dead. Productivity growth is going to raise output growth, but at the same time restrain labor costs so we can have real GDP growth well above the historical trend of 2%. And at the same time, we don't have to worry about inflation. So we're getting that same kind of talk now. So what's important to remember is how you're going to impose this consistency of policy going forward so we don't remake the same kind of mistake. The Fed did begin raising the funds rate in June of 1999, but it was very slow to do so because Greenspan thought that productivity growth would be restraining inflation. But what happened was that monetary policy was expansionary. But given the credibility that had been established for basically price stability, that expansionary policy impacted the stock market. Same thing happened in Japan in the late 1990s when monetary policy turned expansionary and it appeared in real estate prices in the stock market first. But then that collapsed, the so-called bubble. But that happened in the United States. So the stock market was pushed up to unsustainable values. It came back down to earth. That restrained spending. So we had a mini recession. Consumption stayed pretty stable over this period. But the question now is, and this is where the rubber meets the road, we may go into this period, but it doesn't look like there's any excess building in terms of imbalances or deficiencies. It looks like the economy is on a pretty steady course with stable inflation at the given funds rate. So it's not clear what's going to happen to the funds rate over the coming year. We really can't forecast. But that doesn't mean the rule isn't important. And the rubber is going to meet the road when, if policy is at least somewhat expansionary, output increases, but inflation stays down because labor costs haven't risen, which is typical in a recovery. And Walsh says, oh, yeah, yeah, yeah, I told you so. Well, but then the question is, well, is he then just going to wait until he sees inflation come back before he changes course? Or is he going to be willing to follow this underlying Volcker-Greenspan policy of preemption, that what he should be looking at is not the rate of growth of output and inflation. He should be looking at the expectations of inflation and whether the economy's rate of resource utilization is stable or whether it's rising unsustainably or declining unsustainably. That's the lean against the wind. And if it turns out that the labor market starts to strengthen, the unemployment rate falls below 4.2 percent. And other indicators of the economy, like inventories, indicate that the economy is growing above its sustainable rate. Will he be willing to raise the funds rate before he actually sees inflation, which would mean that, you know, maybe we're really back into the 1999 where this new paradigm, this new world really isn't such a new world after all. So not simple. Not simple. This is a time where it's not as clearly, we cannot tell what clearly. That gets into this issue of forward guidance. And unfortunately, the financial press mixes up forward guidance and a reaction function. OK, so we know Warsh isn't one of the dots anymore. It used to be that you'd have this summary of economic projections, the SEP, you'd have these dots from the participants sitting around the table in Washington at FOMC meetings, and they would be projections for what was going to happen with the funds rate, the inflation. And although they were constrained, they were told they had the forecast to return, you know, long run price stability. OK, well, Warsh's dot is not there. And so what the markets used to do, they used to take the median dot and say, oh, the job of the chairman is to achieve consensus. And so the median dot reflects that consensus. So the median value of the funds rate is the chairman's. OK, well, Warsh isn't there. So markets are saying, oh, you know, we're flying blind. We don't have this forward guidance. But we've got to be really clear, forward guidance is the Fed's best estimate of what the economy is going to do and what the funds rate will have to do based on its current projection of the economy, of what the economy is doing right now. That's different than a reaction function, which explains how the Fed will react in response to new information that comes in. And that gets back to what kind of lean against the wind policy we're going to have. So the Fed's not being as transparent as it should be. And it's not just that the Warsh dot is not there. So the Fed, as we've talked about, needs to be very aware of expectations and the belief that the markets are setting the yield curve in a way that maintains long run price stability. But every once in a while, not now, but every once in a while, you get into the situation where the FOMC's forecast of the economy, which is typically pretty well described in the field book now, used to be called the green book, the board staff forecast. And where the market thinks that the economy is. So the path that the FOMC thinks will stabilize the economy and the path that the markets think will stabilize the economy by giving you the right yield curve, those are different. And the FOMC has to sort out whether it's because they're making a different forecast of the economy from markets or whether the markets have a different reaction function. And so it's got to sort those two things out. And if it thinks that its reaction function is credible, then it'll give speeches and sort of go back and forth with the economy and maybe adjust its own forecast and get the market to adjust their forecast. So the Fed, frankly, is not being as transparent as it should be. And if it's not transparent, it can't be accountable the way it should be. So how can the Fed be more transparent? Is it to tell that this is to come out and say that this is the projection, but they're going to they might change the course based on new data? Well, let's let's talk about a reaction function. OK, any economist who writes down a model of the economy, and that's that's having the FOMC does, unfortunately, is going to is going to have a reaction function in it, which is a formula that shows how the Fed will respond in its policy setting, funds rate, whatever, in response to new information on the economy. OK, like we talked about what happens if there's a recession, but what do markets expect the Fed to do longer run to bring us out of the recession? How do we bring us out of this recession without inflation? So the Fed needs a reaction function, and the Fed's going to say, oh, we can't do that. That's a rule, mechanical, like somehow or other, it doesn't involve judgment. They still don't have to go through all this work to decipher what's going on in the economy. That's just that's that's just misleading. That's not that's not right. If you look at the models that economists build, there are two reaction functions. There's the original, quote, Taylor rule, 1993, where the Fed has explicit objectives for the unemployment rate and inflation. And then it assumes there's this long run natural rate of interest, and it moves the funds rate relative to the natural rate of interest, depending upon whether it's more concerned about inflation or inflation missing or unemployment missing. OK, that's that's a that looks at inflation and especially the real output, real GDP in level form. But there's also a difference form which is associated with the name of Athanasios Orphanides, especially where the Fed stabilizes expected inflation. As long as expected inflation is a price stability, then it doesn't have to, you know, it's not going to change, doesn't have to worry about communicating to the markets by changing the funds rate. OK, but then it forecasts what's happening to the rate of growth of the economy relative to potential. It's forecasting what's happening to the change in the rate of resource utilization. And that's the form of lean against the wind with preemption. OK, so there is, you know, economists will say, look, yeah, come on, you can give us a reaction function, but just choose policy. What kind of policy you're going to follow? Is it then is it going to be lean against the wind with inflation tradeoffs or lean against the wind with with preemption? And if so, then you're going to have to choose between a original Taylor level form reaction function and, you know, the first the difference reaction function with the first year you're moving slack around in the economy with the second, you're simply stabilizing the economy's rate of resource utilization. If the Fed got serious and tried to use the language of economics, which it really has to do if it's going to make forecasts that can be subsequently assessed, whether they were there was a problem with Fed policy or whether it was just somehow external forces or overwhelmed the Fed. It really needs to structure its decision making within this framework. So the period by period, there's some baseline and then the Fed can decide whether to depart from front or not. You know, OK, he's a reformer, but he's not going to reform in this way because the chair wants the chair wants to dominate monetary policy and he doesn't want to rule looking over his shoulder. He wants to be the guy. And so that's why he organizes FOMC debate in terms of what are we going to do with the funds rate this period rather than start organizing discussion by how do we impose long run consistency on meeting by meeting changes in the funds rate? And given that benchmark, then is there some reason to depart from it? Of course, that still involves a lot of judgment because you got to you got to assess what's happening with the economy. And that's, you know, that's that's always that's always a challenge. But that that's the you know, that's the thing about making policy in real time. But it would be more systematic, right? The way based on what you're describing, it will become more systematic across the board. Well, so OK, here's the thing. If monetary policy is to be stabilizing, it has to be there has to be an implicit systematic to it so that the the yield curve responds in a stabilizing way, a response to new information. So the issue is whether the not so much whether there's going to be this consistently consistency. The issue is whether the Fed is actually going to articulate it and explain, communicate to policy in terms of this baseline policy and then how it's choosing the individual policy action. But it's not right to say you if you want stabilizing policy, you can't choose between rules and discretion. There's got to be an underlying rule, even if the Fed isn't willing to articulate it. Robert Hetzel, it was great to have you on Market Insider. Tell us what you think about this conversation with Robert. Make sure to let us know in the comments. I'm Siamak. This is Market Insider. We'll see you next time.