The GIC College of Central Banking blog series allows our CCB Fellows to publish their thoughts and findings on issues relating specifically to the Central Banking community. This installment of the series consists of a Q&A with CCB Fellow William Poole, Former President & CEO of the Federal Reserve Bank of St. Louis, as a follow up to our recent College of Central Bankers Executive Briefing, Will Inflation Force the Slowing or Reversal of Central Banks’ “Easy” Monetary Policy and Increase Risks of Economic Downturns?, held on July 21, 2021. We encourage you to explore the questions submitted by GIC’s Members and Dr. Poole’s responses below and share your thoughts in the comments.

1. Don’t markets need less explicit forward guidance and to pay more for capital? – J. Paul Horne

For reasons I detailed long ago (in this paper from 2005 and this paper from 2007) I am not a fan of forward guidance. Toward the end of the 2005 paper I say, “What has happened in recent years is that core inflation—inflation excluding effects of food and energy—simply has not generated significant surprises. The Fed has emphasized that it focuses on core inflation so that monetary policy does not react to energy and food prices, which tend to be highly volatile. I have no doubt that both the FOMC and the market would respond to surprises in core inflation that seemed likely to be persistent and to indicate a developing inflation problem.” The first paper provides evidence that the market after 1994 came to have a better understanding of Fed policy. Unfortunately, I now do have some doubt about what the Fed is going to do.

In my 2007 paper, first understand my discussion of Figures 2 and 3. Then, I say: “Typically, the FOMC cannot be predictable because new information driving policy adjustments is not predictable. All of us would like to be able to predict the future. We in the Fed do the best we can, but the markets should not complain that the FOMC lacks clairvoyance!” I believe that the FOMC’s forward guidance since 2008 has been unproductive. Indeed, counterproductive because the Committee is seeming to predict things it cannot predict.

2. Don’t hear much about Money Demand. Does Money Demand matter? M2 Velocity appears to be in 20+year downtrend, any change ahead?
– Joseph Healy

The stock of money has been demand-determined at the interest rate the Fed sets for decades, except for the early Volcker years October 1997 – August 1982. Given the short-term interest rate set by the Fed, money and credit growth depend on demand. Think of a diagram with the supply of money infinitely elastic at the target fed funds rate. Where the demand for money intersects that horizontal line is the money stock we observe. The ratio of GDP to M2 has been declining, I believe, because the market has little incentive to economize on money balances.

3. Do you see any near-term (5-10 Years) threats to the US $ as world’s reserve currency? – Wallace Bruce

No. There is no currency with the combination of world-wide acceptability and political/economic strength of the United States on the horizon.

4. How long can the Fed keep soaking up all the excess reserves by paying interest on them? – John Palmer

The Fed is not soaking up excess reserves but immobilizing them. The interest rate the Fed pays is attractive relative to other options banks have. If the Fed keeps the rate on reserves where it is and there is a rapid growth in credit demand at, say, the bank prime rate, then bank lending will surge.

5. Do you factor demographics into your inflation forecasting? [Aging population/reduced demand having an influence, as in Japan]
– Elise Drake

Demographics are extremely important, but not all-important. Japan’s investment demand to build new school buildings, for example, is lower than it used to be. However, a proposition offered by Martin Bailey, from whom I took my macro course at Chicago in 1960, remains true.  Bailey argued this way. Consider an investment opportunity that would yield a positive return after operating expenses forever. An example would be the return from new land created by filling in an area of the East River south of Bellevue Hospital.  The water there is not very deep, and it would not be very difficult from an engineering perspective to put in a bulkhead to push the land area out into the East River. The land would be valuable and would earn a positive rent return forever. The present value of the return would become indefinitely large as the interest rate approached zero, thus exceeding at some point ANY finite cost of creating the new land. Many such potential investments are available, but blocked by political insecurity of the annual returns and/or environmental constraints on construction. For an example of current land creation, study what is going on as Shanghai fills in its harbor adjacent to the old city. We could easily finance rebuilding of Interstate highways and bridges if we would eliminate the ban on tolls on interstate highways and bridges. These are long-lived assets. Congress could rebuild by passing a bill with a few words. “The ban on tolls on federally financed highways and bridges is hereby ended.”

6. If you believe the Fed will fall behind the curve and the markets will force the Fed’s policy, do you see the “new” framework remaining as currently articulated or is it likely to be amended? – Regina Schleiger

Nothing I have read recently persuades me that the Fed is not falling behind the curve and digging itself into a market-expectations problem with its current pronouncements.

7. All of the recent increase in M2 happened during the “dash for cash” and the disruption of the Treasury Bond mkt in March and April of 2020. It has not yet been reversed, though. Would the panel expect to see this increase reversed, given that the “dash for cash” is well behind us now.
– Patrick Honohan

So long as the Fed keeps its policy rates pegged at zero, the potential for a money and credit explosion exists. The events of the spring of 2020 are long-ago history.

8. If the Fed has the “guts” to tighten sooner rather than later, is there not the risk of a financial asset collapse that slows the economy down as it did during the GFC? Then what does the Fed do? – J. Paul Horne

I assume GFC refers to great financial crisis. If inflation does rise as I anticipate, a better example would be 1997-1982. Although the failure of financial firms was very important in 2008, of even greater importance was the insolvency of millions of households when they could not service the mortgages that the GSEs had so foolishly encouraged. Bailing out the financial firms was a piece of cake compared with bailing out millions of insolvent households.

9. What will a “normalized” Fed balance sheet look like in the year 2025? Will it be larger or smaller on a normal $ basis? What assets and tools will be used to achieve that objective? – Bill Kennedy

Clarity in addressing this question is served by consolidating the Fed and the Treasury. In the consolidation, Fed holdings of Treasuries and GSE obligations disappear—assets of Fed and liabilities of Treasury net out. From the perspective of the private sector as a whole, Fed purchases of Treasury obligations have shortened the maturity of the assets held by the private sector. The private sector has traded longer-term assets for Treasury/Fed demand debt—the bank reserves that banks can convert to cash at 100 cents on the dollar and as quickly as desired. When interest rates eventually rise, the interest component of federal expenditures will rise quickly—more quickly than would have been the case if the market held the longer-term debt. Once the Fed increases the policy rates above the yield on its long-term assets, it will suffer capital losses and the earnings it can remit to the Treasury will decline. This point is obvious from consolidating the Fed and Treasury balance sheets. We have a huge federal budget deficit which is being financed, taking account of Fed and Treasury together, with a substantial amount of demand debt. We will look back 10 years from now and regret that the government did not sell more long-term bonds when it could have locked in today’s low long-term rates.

The danger is that Congress, not understanding, or wanting to understand, the simple accounting of consolidating Fed and Treasury for policy purposes, will object to Fed increasing rates because the effect on the federal budget deficit will be dramatic. That is an invitation to much higher inflation.

10. I wonder if you can discuss the appearance of “mission creep” of the Fed – from the dual mandate of unemployment and inflation to other areas, e.g., Climate Change, Wealth Disparity, Racial Inequality, etc. This seems to be a growing theme across all central banks. – Eric Hale

I agree completely with the thrust of this question. I once heard George Shultz, a very wise man, discuss the advantages of single-mission agencies. The locus of responsibility is then clear.  

11. What about inflation expectations? It seems financial markets are well anchored. It seems business pricing power is still modest. However, there is definitely asset price inflation. Would it be a mistake for the Fed to tighten to cool financial markets (asset prices) before real-side markets (price inflation) evidences a spiral? – Catherine Mann

These two papers, one from 2005 and one from 2007, have several fundamental themes. One is the importance of markets and Fed drawing the same conclusions from the same evidence/events. Another is the importance of dealing with inevitable and unavoidable uncertainty. We can add covid to our list of examples. The Fed must anchor inflation and inflation expectations. If we add the level of asset prices—all or a select few—to the list of Fed responsibilities, then we know from the extensive literature on optimal control that the Fed does not have enough policy instruments to deal with a large number of objectives. The Fed is already fuzzing up its inflation goal. In time, it will regret the step. It will not be easy to undo the damage right away.

The connection between my 2005 and 2007 papers is this: First, the outlook is based on my 1999 “Synching” speech, which may already be posted on the GIC website. That speech reflected, perhaps simply restated, mainstream macroeconomics after Lucas. The 2005 paper provided evidence that the market had an accurate grasp of Federal Reserve policy the day before each FOMC meeting. The 2007 paper provided evidence that the market’s predictions of Fed adjustments in the fed funds rate were not very accurate 6 months in advance.  

Given that FOMC policy adjustments clearly depended on arrival of new information—the LTCM dust-up in 1998, the 9/11 tragedy in 2001 and quite routinely developments in the labor market that neither the market or the Fed had predicted—forward guidance was not a good idea because the Fed could not predict the events that would drive policy adjustments. Policy that would be unresponsive to events would obviously be a poor idea. Thus, providing forward guidance could only mislead the markets and perhaps the FOMC itself.

The danger to the FOMC is that it might feel compelled to abide by its forward guidance in the face of events that called for a policy change. This concern is not trivial. All agencies, and private-sector leaders as well, have good reasons to abide by their promises, or apparent promises. It is a terrible mistake to make a promise you cannot support when the time comes. Of course, using the language of the common law, it may be possible to distinguish a case from an apparent precedent/promise. However, it is all too easy to make an argument that is transparently face-saving. Doing so makes things worse, in terms of market confidence that the Fed knows what it is doing.

Times become dangerous when the market no longer has confidence in what the Fed says. If you do not believe this statement, study market commentary 1978-81.

Is it a good idea today for the Fed to be financing the federal budget deficit? Whatever the language of quantitative easing might be, the fact is that the Fed is financing the federal budget deficit at a time when banks have a super-abundance of reserves.