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Monetary Policy and Central Bank Targets with David Beckworth (Mercatus Senior Research Fellow) · The Capitalism and Freedom in the Twenty-First Century Podcast

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[MUSIC]
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>> Jon Hartley: This is the Capitalism and Freedom the 21st Century podcast,
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an official podcast of the Hoover Institution Economic Policy Working Group
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where we talk about economics, markets, and public policy.
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I'm Jon Hartley, your host today.
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My guest is David Beckwourth, who is a senior research fellow at
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the Mercatus center and the host of the Macro Museums podcast.
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Welcome, David.
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>> David Beckworth: Well, thank you for having me on your program.
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>> Jon Hartley: So, David, it's really fun to have you on here.
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I recently was on your podcast.
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You're a really big figure in my mind in the sort of macro policy space.
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I'm curious, how did you first get interested in economics?
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And how did you get interested in economics podcasting?
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How did that all happen?
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>> David Beckworth: Well, I took some econ courses in undergrad.
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It never dawned on me to become an economist.
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This didn't strike me as something I would do as a career.
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But later on, working on an mba, I took some more coursework in economics and
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it really began to click like, I love this.
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And so at that point, I went back, took some more coursework, some more math,
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got into a PhD program, went from there.
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Now, how I got into podcasting.
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Long story short, I started blogging back in the glory days of
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blogging the right after the great financial crisis and
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great time to be alive as a macroeconomist blogging.
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Terrible time for
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humanity suffering through the slow recovery from that period.
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But the blogging opened up doors, op eds.
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I actually got some books out of it.
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And eventually that opened up more doors to where I got offered a job at
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the Mercatus center to be a scholar there in their policy group.
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And then when I got there, I just thought, there's a missing market for podcasts
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that touch on macro and regulatory issues in the financial policy space.
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And so I pitched the idea.
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It was a little reluctant at first.
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Folks didn't think there'd be a market or appetite for such things.
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But it's gone well.
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We've been running it since 2016.
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You've been a guest, a number of guests.
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We're getting close to their fifth hundredth episode, so so far, so good.
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>> Jon Hartley: It's amazing.
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I enjoy listening to it and I know many, many others do, and
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I think it's fantastic, too.
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You spent a good amount of time working at treasury previously.
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I guess you've always been interested in macro issues.
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I know you did your PhD at University of Georgia,
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and I think George Seljen was on the faculty then.
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I feel like this is maybe what you were called to do, and
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it's so wonderful to see all these wonderful shows being produced.
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I want to talk about, I think some of the themes that I think
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are consistent in your w some of the things you've advocated for
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throughout the podcast and in your academic writing as well.
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I think one of the big things that you're very early to was NGDP targeting.
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And I'm just curious, could you explain what NGDP or
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nominal GDP targeting is to our audience as you see it?
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>> David Beckworth: Yeah, let me provide a little history how I got into nominal
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GDP targeting, because I think that's useful.
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So as you mentioned, I went to the University of Georgia and George Selen was
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there and he's the one who actually first introduced me to nominal GDP targeting.
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And at the time he was actually selling it as a way to deal with
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big positive productivity shocks.
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So if we have massive productivity surge like we had in the early 2000s, late late
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1990s, early 2000s, what's the best way for Monte policy to deal with that?
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And he argued he had a specific form called a productivity norm, but
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basically it was a form of nominal GDP targeting.
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So it was a totally different set of problems, but that's where I first saw it.
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And then it became popular again after the 2008, 2009 period.
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But here's what it is.
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Nominal GDP targeting is an approach where the central bank
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would target total dollar spending or
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equivalently total dollar income instead of targeting the inflation rate.
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Now over the medium to long run,
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you would get a inflation rate with a fallout of that.
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Because by targeting total dollar spending or nominal GDP,
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you're implicitly targeting real GDP and the price level as well.
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And if you're targeting some kind of growth rate,
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you're targeting the growth rate of real GDP and an inflation rate.
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So what's different about a nominal GDP target versus an inflation target is over
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the short term, that's the big difference.
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Over the med long run, you're probably going to be very similar in the outcomes.
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In fact, if you look at US GDP nominal GDP measures between crisis,
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they look pretty straight.
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It looks like the Fed is implicitly targeting something like a nominal GDP
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target, but where they differs in the short run, the short run,
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the Fed is much more sensitive to movements in inflation.
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In the short run if they were targeting nominal GDP,
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they would keep their eyes focused on the growth path of total dollar spending.
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And I've mentioned nominal GDP.
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Some would measure with final sales domestic purchasers.
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There's even a proposal to target just PCE a component of nominal GDP.
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But effectively you're aiming to stabilize aggregate demand
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directly as opposed to a symptom of it.
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The Feds, when it targets inflation,
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it's ideally trying to target inflation being driven by demand and
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demand shocks and it tries to see through supply shocks that cause inflation.
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So what we're saying is cut to the chase,
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target directly aggregate demand and do so by looking at nominal GDP.
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>> Jon Hartley: So for the viewers that aren't as familiar, so
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you've got nominal GDP, you've got real GDP.
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Real GDP is basically nominal GDP minus inflation.
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So in other words, nominal GDP is real GDP plus inflation.
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And if you look at the post World War II US economic era,
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you'll see that real GDP I think is growing at 4% for
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a long time, 3% and 2% more recent years or more recent decades.
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And then NGDP or nominal GDP is roughly depending on,
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you know, the inflationary period.
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You can add say 2% to that perhaps obviously much higher
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during periods of higher inflation.
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So I'm just curious like what is the exact.
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So we talk about it as like this is a target the Central Bank since
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the early 1990s have been targeting inflation and
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prior to that for a brief period of time in the 80s.
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They were targeting monetary aggregates like M1 and
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m2 o how much money is there in the economy.
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But for the past say 30 years or so,
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central bank's been targeting inflation targets.
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And I think some people, including myself, would argue that it's been a very
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successful program in terms of anchoring long term inflation expectations.
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And also inflation has been relatively speaking much lower in
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the past few decades, minus the past few years or so.
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And we could talk a little bit about that as well.
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But I'm just curious like in your mind, what is the exact policy tool that
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allows the central bank to achieve an NGDP target?
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I mean we had like interest rates at 0% for a long time in the 2010s and
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we did lots of QE as say Japan is getting like.
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I think getting NGP to a certain rate or
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level target, say a 4% or 5% trend path.
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I feel like couldn't, couldn't have been possible in the 2000 and tens.
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Even if you tried harder.
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How could you have gotten NGDP to a higher level?
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Say when you're at the lower bound.
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I'm curious, how do you think an NGP target is really achievable in your mind?
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>> David Beckworth: If you look at nominal GDP from the end of the Great Recession up
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until 2020, the beginning of the pandemic, it looks like a stable 4% growth path.
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If you didn't know those two periods, the before and after,
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you would think the Fed was effectively.
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So the Fed did do something like this.
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Now, you could argue it should have been faster 5%, that's far fine.
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But I would say that concern is a concern that happens no matter what.
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You're at the zero lower bound, whether you're targeting inflation, a price level
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target, a nominal GDP level target, the same issues are going to be there.
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And I actually did write something in response to this concern and
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it would apply to an inflation target as well.
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This was at a, I presented this at a Cato monetary policy conference in 2019, and
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I recommended kind of a dual approach.
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When you're at the zero lower boundary, you follow something like a McCollum Rule.
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A McCollum Rule would actually you would,
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instead of thinking about interest rates, you would adjust the monetary base.
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And a McCollum Rule, by the way, was a very popular rule up,
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really up until the Taylor rule comes and displaces it and
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the adoption of inflation targeting and interest rates.
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But the McCollum rule, which was well known in the 1980s early 90s,
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says that the central bank should target nominal GDP but
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use the monetary base as an instrument.
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And a lot of people came to that same conclusion once we hit the zero
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lower bound, yeah, maybe we should rely more on qe, the balance sheet.
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Now we can raise questions about Wallace neutrality policy and
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effectiveness proposition, things like that.
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But in my paper, I argued what you'd want to do is you want to do something more
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like a McCollum rule where you think about adjusting the base monetary base.
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When you're above zero, you're outside the zero lower bound,
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you go to a more standard Taylor rule, but
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a Taylor rule that has nominal GDP in it instead of the regular arguments.
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I also argued in that piece, when you fall into a McCollum rule world where you're at
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the zero lower bound, you want to have a fiscal facility to give it the umps,
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the very thing that you're concerned about.
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So I argued, you got to have fiscal policy hand in hand with monetary policy at
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the zero lower bound.
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That's what the Fed needs now there are all kinds of problems that come with
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that because once you give the central banks extra fiscal ability,
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then you get into questions of delegation of authority.
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Is this democratically accountable?
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But I will leave it at that.
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That the same issues apply to the inflation target,
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would apply to a nominal GDP target when it comes to zero lower bound.
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>> Jon Hartley: Well, I do think one difference though is that you're talking
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about a level target versus say an inflation rate target, right?
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And so I think something that the Feds,
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I guess maybe thought a little bit about in the past.
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But the thing about a level growth target is you can
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get these issues, things like hysteresis.
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For example, after the Great Recession we had a massive
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decline in output or in real GDP and nominal GDP and
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it never got back to its pre trend like that,
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pre, say 4% or 5% NGDP trend.
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Now after having the big collapse, there was a pretty straight 4 or 5% target.
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How do you think about that?
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Do you reset the, like what is the target exactly?
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Or what's the reset the target after a big drop like that or
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do you try to get back to the original trend?
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How do you think about issues like hysteresis and things like that?
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>> David Beckworth: That's a great question and really two responses and
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it's driven by this question.
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Was that collapse something that could have been fixed by policy,
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monetary, macroeconomic policy?
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If your answer is yes, then I would have argued more aggressive monetary and
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fiscal policy could have brought us back up some kind of helicopter drop.
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Something like we saw in 2021 where we saw a complete collapse of the dollar size,
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the economy.
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But we saw a quick bounce back and
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I think that partly had to do with the fact that it was supply shock.
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So there's going to be some quick recovery, but then also the incredible
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excessive amount of fiscal support as well kind of closed that gap and
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then went above where it should have gone.
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So if you believe that the collapse after the Great Recession was something that
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could have been fixed with policy, then yeah, you use aggressive policy.
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If you think it was a permanent structural change that wouldn't have mattered,
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then this is where I would go.
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And this would be also how would you deal with a nominal GDP level target?
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Let's say there's no crisis but potential real GDP changes.
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And this is often a question I get, well, how do you know?
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Okay, sure you embed 2% inflation in that, but what if potential real GDP changes?
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What if it grows from 2% right now?
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To 2.5 to 3%.
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Or in the case you just suggested, what if it goes from 3% down to 1%,
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some big shock in that case, you have to update your target.
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Now, generally, changes in potential rules GDP are slow moving.
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Generally it's a very gradual adjustment of the target.
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So it's not gonna be something that's terribly hard to think about or
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to process or even to implement.
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And what I would recommend is you would follow some kind of consensus measure
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where potential rule GDP is going.
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Now, going back to 2008, my view is that that collapse could have been avoidable.
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I think we could have returned back to the same growth path or level.
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I think it would have taken more aggressive macroeconomic policy.
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It would have required the Fed being aggressive as it was,
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but also announcing a level target.
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I think level target goes a long ways.
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It's a signal.
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In fact, level targeting was something really big in the New Keynesian
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literature, as you know, Michael Woodford, Gut Ergensen, and, and for
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them it was forward guidance.
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Wait for the march, >> Jon Hartley: I guess, right?
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>> David Beckworth: Yeah, except just to get things up.
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In fact, all of that Princeton School,
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Scott Sumner has a paper called the Princeton School of Macro.
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All of them were thinking about Japan.
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Krugman, Sinson, Gotti, Ergensen, Michael Woodford.
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They were all there at that time thinking long and hard, how do we get out of Japan?
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And all of them were very keen about a permanent increase in the price level,
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getting the price level back up.
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And many of them would talk about, well,
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we need to have a permanent increase in the monetary base.
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Well, the thing is, what is a permanent increase in the monetary base?
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That's effectively.
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It's a non Ricardian fiscal regime where you promise not to raise taxes in
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the future.
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It's a policy move where you do not change what you're doing.
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What happened after 2008?
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There was a commitment to shrink the Fed's balance sheet.
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There wasn't the fiscal support.
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I think a policy difference could have been different and
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we could have returned it.
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But over time, as time goes on you come to realize, okay, that's not going to happen.
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We're at a new norm.
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You adjust your target.
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And that's one reason, Jon, I came up with this measure called the nominal GDP gap,
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or a neutral measure of nominal GDP.
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It's based on consensus forecast and it gradually does because if you simply draw
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trend lines, at some point they become outdated.
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Eventually expectations change, people update their views, contracts change.
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And so you want to have a flexible understanding.
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And I think that's true with a nominal GDP target.
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Eventually potential real GDP will change, and so you gradually,
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slowly update your your nominal GDP target.
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But again, there normally wouldn't be big swings.
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>> Jon Hartley: How would you deal with the fact that like,
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I guess a GDP is published like 2 months after the end of the quarter.
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Unlike say, unemployment or CPI,
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they're published pretty close to the reference month.
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How would you deal with that fact?
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I know some people talked about NGDP futures markets and things like that.
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Like that.
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How do you deal with the fact that I guess, you know,
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you wouldn't even get NGDP estimates in a real time kind of fashion.
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I mean maybe you want to get the BEA or [INAUDIBLE] start publishing it more
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quickly, but I don't know if how feasible that would be.
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>> David Beckworth: Yeah, great question.
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Probably the two biggest questions I get about nominal GDP targeting,
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it's that one, the data revisions are huge.
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One, they come out, like you said, delayed and secondary, sometimes huge.
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And the other one is the potential world GDP, that one.
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So I think I've addressed the potential world GDP.
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This one I think is probably more of a challenge.
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But there's I think several responses to it.
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You, you mentioned what I think would be the gold standard and
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nominal GDP futures market, but that's nowhere in the works.
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I don't want to bank on that.
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I want to bank on reality.
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What could we actually do?
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So what I, what I suggest is again going to a forecast,
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going to consensus forecast or where nominal GDP is going.
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And even if the measures are awful over time,
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a long consensus forecast is very helpful.
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You mentioned Lars Findsen, he says target the inflation forecast.
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So it's useful and we provide some workaround to that.
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Again, this nominal GDP gap measure I have created, which also implies
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a neutral level nominal gdp, I have a real time measure versus the ex post.
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After all the big revisions, even the five year revisions, and they aren't that big,
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there would have been some periods where there have been differences, but
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again the big differences wouldn't have made much significance in terms of vast
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changes in setting the interest rates, things like that,
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because I do tie it to a policy rule, a reaction function.
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So I would say target the forecast is probably the easiest thing to do,
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number one.
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Number two though,
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I think there's also the ability to rely on many multiple real time measures.
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There's, there's monthly real time measures.
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You could put that together with a forecast of inflation.
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This is just one example and I'm sure there's more out there.
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But Lars Christensen, who's also an advocate of nominal GDP targeting, he for
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example has tinkered around with this weekly economic indicator series.
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Used to be the New York Fed and I believe the Dallas Fed now publishes it.
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And he takes that, and takes an inflation breakeven forecast and
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combines those two together and kind of gets a real time sort
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of forecast look at where he thinks the economy is going.
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He does it every month.
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I mean the Data for the weekly series is weekly on the real side.
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So there's, I think there's many ways to do that.
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There's real time indicators you could use as proxies.
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PCE comes out monthly.
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That's why some have advocated that there's revisions to that as well.
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Of course there's the market based version of PCE you could rely on.
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But I would say, you know, use the real time data sources available.
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So number one forecast, number two, more real time.
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And the third point I would bring up you touched on and
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I would say that the data is somewhat endogenous to the target.
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If you were to adopt a nominal GDP target, I guarantee the Fed
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would find ways spend resources on getting data that would better
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inform it on what's happening to the, the current measure.
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Again, there's different ways to measure it.
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May I should be very clear about this.
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I said nominal GDP or total dollar spending.
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You could look at final sales, others have just looking at gross labor income.
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Some have looked at pce.
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So there's different ways to kind of slice this up but, and
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each one may have certain advantages in terms of data collection.
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But I do think the data challenge is surmountable and
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even with the data we have now we, I think there's ways to use it.
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We have a framework review coming up, as you know, and
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we've written a number of policy briefs.
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And my policy brief,
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I definitely would love to see the Fed go all in to a nominal GDP level target.
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I know they won't.
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So my recommendation has been, many others,
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is simply use something like forecast nominal GDP as kind of a cross check.
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Use your standard indicator, labor market indicators, things like that.
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But also look at forecast of nominal GDP.
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Plug them into a reaction function, see what they say.
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You were at the American Economic association meetings.
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Jason Furman was there.
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He recently talked about, he's finding his religion again for
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monetary policy rules, you could have a rule that has nominal GDP forecast in it.
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And again you don't have to go all in but you use it as a cross check.
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>> Jon Hartley: Interesting.
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Yeah, I mean it's interesting, I guess, that the proposal on rules is really using
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them more like a guideline or a benchmark or something like that.
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That's interesting thought.
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I mean, correct me if I'm wrong.
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I don't think we have any central banks around the world yet
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doing NGDP like targeting.
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I don't know how close we've come.
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I know Bernanke has said some positive things maybe once or twice in the past.
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But I'm just curious, assuming that we're not adopting NGP targets anytime soon for
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maybe some of the challenges that we've sort of outlined,
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I really want to talk about maybe just inflation targeting and
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its kind of different variants for a little bit.
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You've been doing a lot of really great work, along with other scholars that
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Mercatus getting prepared for the next Fed policy framework review.
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And I'm curious what your thoughts are on the flexible average inflation
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targeting regime that we've been in for nearly five years or so.
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That was sort of really the brainchild of former Fed Vice Chair Rich Clarida.
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This was a framework that they put out really right before the big
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inflationary spiral that occurred in the early 2000s.
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In part, I think the flexible average targeting was in part responding
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to this period where the Fed wasn't able to hit its 2% inflation target for
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many years in the 2010s and was coming in below.
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But you know, at some level, I think there's maybe, I don't know,
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I feel like a little bit of regret in the sense that, you know,
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I think that the fate or flexible average inflation target was a bit flawed in that,
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you know, it wasn't really clear, you know,
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if we were going to take some average over some period of time, it wasn't clear,
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you know, what period of time or years we were averaging over.
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You know, the Fed generally, historically has followed, you know,
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a year over year or one year look back window.
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Right.
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But how many years back would it be?
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How flexible would it be?
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So I think we're all sold, or at least I'm sold on inflation targeting in general.
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We could debate what exactly the right target should be.2% or.
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Paul Volcker, for example, was pushing for
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a 0% inflation target the rest of his life after leaving the Fed chair or
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leading the Fed board, as did other central bankers.
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In fact, in the early 90s, John Crow at the Bank of Canada argued for
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0% inflation target too.
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But in terms of, you know, the F and the a, you know, averaging,
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thinking about levels versus rates of change and where do you fall on all that?
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If we can't have an NGDP target, we have to stick to inflation at some level.
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How do you think about that?
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Do you think that the Fed's flexible average inflation targeting regime's
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been successful or do you think that going forward the Fed will abandon it and
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so will monetary policy scholars?
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>> David Beckworth: Well, based on what Jay Powell said to Catherine Rampel at
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The Washington Post back in November, he had a sitdown with her and
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she asked him about the review.
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And he said his base case scenario is a reaction function, ie,
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a Taylor rule that does not promise to make up for past misses or
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promise to overshoot Shoot the target if they've undershot, which I find
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a little troubling because that to me rules out makeup policy altogether.
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And I guess the one thing I would encourage FOMC members,
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if they're listening to this, is we wanna maintain, hold on to makeup policy.
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I do think fate was not the best way to do it, but fate did introduce it.
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I will say this,
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FAIT I think is an historic sea change in terms of monetary policy.
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It's the first time a central bank has talked about targeting something like
24:29
a price level.
24:30
Now, I should take that back.
24:31
I believe the Reichsbank in Sweden did price level targeting explicitly for
24:36
a while, 1930s, maybe 1940s.
24:39
It's a while back.
24:40
But modern central banking, the Federal Reserve and
24:44
FAIT is the first central bank to incorporate several decades of research
24:48
literature about zero lower bound about makeup policy board guidance in terms of
24:53
a framework that I think you could also call temporary price level targeting.
24:58
The Bernanke, a version of it, Rich Claire to call it a version of it.
25:02
So I think it's a step, it's progress.
25:05
I would do things a little bit differently.
25:06
And my worry is that they're gonna completely throw the baby out with
25:10
the bath water.
25:11
At least that's the signal they've sent.
25:13
And, and every place I've been, I've heard FOMC members say, yeah,
25:18
bait was designed for a different period, which is true.
25:21
There's been several conferences on this at Hoover, multiple events at Brookings.
25:27
They've talked about this, papers have been written.
25:30
In fact, the paper that I wrote up,
25:31
I kinda summarized what I thought was the consensus from all these different talks.
25:35
But there were a number of critiques of FAIT.
25:38
And maybe we should step back and
25:39
just remind our listeners what actually happened in fate.
25:42
So prior to FAIT, flexible average inflation targeting,
25:45
the Federal Reserve and FOMC had FAIT fit flexible inflation targeting,
25:50
which was officially introduced in 2012.
25:52
So there was a consensus statement.
25:55
In that consensus statement, it outlined 2% PCE inflation.
26:00
That statement, though, also had in it the other part of the dual mandate,
26:04
maximum employment.
26:06
And it talked about deviations, no numbers, but deviations.
26:08
So it had both sides of the dual mandate.
26:11
So you can call it a flexible inflation target because it's aiming for
26:14
2% inflation.
26:15
But it also has its eye on avoiding business cycles, full employment.
26:19
We go to 20.
26:20
>> Jon Hartley: It was the first time that the Fed had ever actually announced that
26:25
it was targeting inflation.
26:27
Yes, it was very late to the game many of the other big advanced economy
26:31
central banks had announced this by the 90s.
26:34
2012 was actually relatively pretty late compared to the other central banks.
26:37
>> David Beckworth: Yeah, and to be fair to the Fed though they were implicitly
26:41
doing something close to two by the early to mid-90s least some studies have
26:45
found that they were there, but not officially there.
26:48
Like it took Ben Bernanke coming on board and really talking them into it.
26:51
But there, there are discussions in the transcripts back in the 90s about should
26:55
we go to an official target.
26:56
But you're right, 2012, but
26:58
that consensus statement becomes kind of like a constitution for it.
27:01
And this is again another reason why I'm a little worried about them completely
27:05
throwing out the makeup part.
27:07
So 2020, they changed it quite radically to include there's gonna
27:12
be makeup policy on the inflation target if it's below, not if above.
27:17
So if you're below, you make up from below and then once you go above,
27:20
it's just regular flexible inflation targeting.
27:23
So that's very much in the spirit of Bernanke's temporary price level target.
27:27
You try to maintain the price level path, but you only do so if you're below.
27:32
If you're above, you let bygones be bygones.
27:34
The other big change was on the maximum employment part.
27:38
Instead of having deviations would be something the FOMC
27:40
would be concerned about.
27:41
They then said shortfalls.
27:44
So only if the economy was, was weak or cold relative to potential would
27:48
they respond if it was overheating off the table.
27:52
At least according to the language of FAIT.
27:54
Of course, the Federal Reserve abandoned those principles in 2022 [LAUGH] when
27:59
labor markets were clearly overheating and they started raising rates.
28:02
So the FAIT introduced those two asymmetries.
28:06
They would only do makeup policy from below 2% and
28:08
they would only respond to shortfalls from maximum plum.
28:11
That was a big sea change.
28:13
Now, the challenges in those one I think a fair critique.
28:18
A lot of people, Gotti Ergenson and Don Kohn have a paper,
28:21
a number of people have written along this.
28:23
The Roamers had a paper recently and in one sense fate was fighting the last war,
28:28
the last decade of zero lower bound.
28:30
You want a framework that can handle any situation, not just the low inflation.
28:34
That's, that's fair, totally fair.
28:37
Also there's, there's concerns about what does it mean to be makeup policy
28:42
doing makeup, how all, how high, how long above before we go back to two what
28:47
is a shortfall and how much do you respond.
28:50
So there's a lot of uncertainty and there wasn't much clarity on that.
28:54
There's also some concern that this was putting more weight on maximum employment.
28:58
Both the roamers and again Gotti Ergensen Don Kohn said FAIT effectively put more
29:03
weight on maximum employment than the priceability part of the dual mandate.
29:09
So it added an inflationary bias, which is fine if you're in a zero lower bound
29:12
world, but if you're outside of that, you don't want that.
29:15
So there's definitely room to recalibrate this, make it more effective.
29:20
But I do worry if you completely throw out again the baby with the bath water,
29:24
I'll make a policy that they'll have gone too far.
29:28
So what I recommend they do is use nominal GDP level targeting as a benchmark and
29:32
any incremental change you make, have it move in that direction again.
29:36
They're not going to go all the way there.
29:37
But so here's what I would recommend.
29:39
I would recommend getting rid of the shortfalls part,
29:41
go back to deviation so it's both above and below.
29:44
And there's been some other great work, Michael Kiel.
29:47
>> Jon Hartley: A symmetric target is one thing that you want.
29:48
>> David Beckworth: Yes, yes, a symmetric target, Michael at least on the,
29:52
on the maximum employment side, Michael Kiel did some work where
29:56
he showed using models that if you respond systematically to shortfalls,
30:00
ironically you make more shortfalls in the future because you're kind of not
30:04
responding to the overheating and you can actually exacerbate the business cycle.
30:09
If you respond symmetrically, then things can actually be better.
30:17
On the inflation side, I don't think it's great that they respond from below
30:22
only for communication purposes, but I do get why they would do that and
30:26
I would recommend at this point to keep, keep that part.
30:30
And let me go back to the original again, motivation idea behind this as I
30:34
understand, and that's Brandon Bernanke's temporary price level target.
30:39
>> Jon Hartley: Which is metric target to some degree.
30:42
>> David Beckworth: Yeah, well, it's very similar to FAIT.
30:43
It just doesn't have all the language about the maximum employment.
30:46
It also says if you're below 2% below your target, you run the economy hot.
30:51
You actually have inflation above your 2% until the price level gets back on its
30:56
original trend path, but you don't.
30:58
>> Jon Hartley: [INAUDIBLE] the paper for those that are listening,
31:00
this is a Brookings paper that Ben Bernanke wrote in the late 2010s.
31:03
It was very influential prior to the Fed.
31:05
>> David Beckworth: Yeah.
31:06
[INAUDIBLE] >> David Beckworth: And
31:07
the reason he gave for why you would only do it from below,
31:11
which is what fate is is because he said, look,
31:14
what if you have inflation above 2% and it's driven by negative supply shocks?
31:20
So the economy is contracting already, inflation is going up.
31:24
Why would you want to undershoot for several peers?
31:27
You'd add more,
31:28
more harm to the economy on top of the negative supply shock already.
31:32
And that I agree with that.
31:34
And that's exactly why you would want to do something like a nominal GDP target.
31:37
I didn't mention this earlier, but one of the big reasons for
31:40
nominal GDP targeting is it's a way to work around supply shocks.
31:43
We don't know in real time whether inflation is caused by demand or supply.
31:48
We maybe we can figure out, look at the news, but it's really hard,
31:51
it's not clear in the data.
31:53
And we know 21, 22, all this talk about is this transitory inflation or permanent?
31:59
That's another way of saying is this.
32:00
Driven by temporary idiosyncratic supply shocks or
32:03
just something more permanent and we simply don't know.
32:06
So instead of trying to play God and figure that out,
32:09
look at the total demand in the economy.
32:11
Keep total demand, total spending stable and those shocks will work themselves out.
32:16
And if, and if you're way above the trend path, whatever your target may be for
32:20
total spending, then maybe you have some issues.
32:23
So the supply shock was a very reason Bernanke had
32:26
a below asymmetric price price level target.
32:30
And I say look, that's great, why don't you go all the way?
32:33
If you go all the way, take the logic to its limit,
32:35
you end up with the nominal GDP level target you mentioned.
32:37
Bernanke endorsed it.
32:40
Christina Romer endorsed it in the 2011 New York Times.
32:44
She even had an op Ed said Ben Bernanke needs his Volcker moment.
32:49
And in the op Ed she said he needs to go all in and
32:52
adopt a nominal GP level target.
32:55
Michael Woodford A lot of people have endorsed this for
32:57
a zero lower bound world.
32:58
There's other arguments more recently that we could talk about if you want for, for
33:03
doing that as well.
33:04
But back to fate.
33:05
I, I just hope they don't completely throw out everything and go back to fit flexible
33:09
inflation target because I think there's some things we want to keep interesting.
33:13
>> Jon Hartley: Well, I know I, I feel like the Fed certainly, I think before any
33:18
kind of framework, any meaningful framework change I feel like has
33:23
to sort of get inflation back to 2% and sort of to kind of ensure its
33:28
credibility before really thinking too much about maybe further changes.
33:34
And I know there's some people out there who advocate for a 3% inflation target.
33:38
But I think getting inflation back to 2% in a sustainable
33:43
fashion is kind of first and foremost, my last sort of question or
33:49
sets of questions here is really about Fed plumbing.
33:54
And you've written and spoken a lot about this through your podcasts and
34:00
this gets back to the kind of abundant reserve system and
34:05
how much 2008 and the first rounds of quantitative
34:10
easing really changed how the plumbing around the Fed and
34:15
the short term money markets really work.
34:20
So one thing that's happened is we used to be in the system,
34:26
some might call reserve neutrality or a scarce reserve system.
34:33
And that was a system where you do open market operations that would move the Fed
34:37
funds market and that's all the Fed needed to do.
34:41
But since 2008, because the money supplies has been shifted so
34:46
far out to the right or we have what's called an abundant reserve system.
34:52
Now the Fed, in order to raise interest rates,
34:55
has to actually use price floors, so things like interest on excess reserves,
35:00
the reverse repo rates and so forth.
35:03
And that's how it's able to raise interest rates without unwinding
35:08
all the quantitative easing that it's done in the past.
35:12
And so the Fed's been in the system where it's now been able to both
35:17
adjust interest rates while also having a Fed balance sheet that
35:22
has trillions of dollars of long term assets on it, lots of quantitative easing.
35:29
Part of this also changes the system of from those
35:34
that are familiar corridors and floors, and
35:38
this kind of gets back to the whole reverse repo IOE up
35:43
versus IBeer rates being part of, say an abundant reserve system.
35:50
Can you explain us, what the difference between corridors and floors are and
35:55
can you explain sort of what's going on now and that with Fed or sort of with
35:59
various central banks winding down or trying to wind down their balance sheets
36:04
now that we're sort of in better times now and have been trying to escape inflation.
36:09
Can you explain what the shift that's kind of going on now where central banks
36:14
are really trying to get away from the abundant reserve supply driven system to
36:19
some degree, and maybe with the exception of the Fed trying to incrementally get
36:24
back to a demand driven system and maybe not fully a quarter system.
36:28
But can you explain what all this means and where things are at and
36:32
where things you think are going?
36:36
>> David Beckworth: Yeah.
36:36
So you've covered a lot of ground there.
36:39
Prior to 2008 in the US and in many places around the world for advanced economies,
36:44
most central banks were operating on some version of a corridor system.
36:48
So it's also called scarce reserve system.
36:51
Bill Nelson calls it a necessary reserve system.
36:53
But very few reserves were actually in this system, at least compared to today.
36:59
Very few reserves in the system also compared to the currency.
37:02
So in terms of central bank liabilities is mostly currency, a little bit of reserves.
37:07
And the interest rate that was set on those reserves was
37:11
determined in some interbank market.
37:14
Banks would lend their excess reserves to each other.
37:17
And in the case of the US it was the federal funds market and
37:20
all that the Fed would do, the Fed would adjust the size of its balance sheet,
37:25
inject or pull out reserves liabilities, and that would move the supply up and
37:29
down a downward sloping demand curve for reserves.
37:32
So if the Fed wanted to target 5% interest rates, it would adjust supply and
37:36
then you would be on that.
37:38
And it required very few reserves, it was scarce.
37:41
As you said, at the other extreme, where we are today,
37:45
you have a floor system where you increase the supply of reserves so
37:49
much you get to a part of the demand curve for reserves that's flat.
37:55
And when you get to that point, no matter how many reserves you increase,
37:59
even decrease some, it's gonna be at that level.
38:02
And typically that kicks in during a zero lower bound environment.
38:06
But when you add administrative rates, you mentioned interest on reserves,
38:10
you also mentioned overnight reverse repo.
38:13
That's kind of like the leaky floor system.
38:15
Sometimes market rates don't stay at that interest in reserve.
38:18
So the Fed had introduced another way to maybe clog that floor overnight reserves.
38:24
So the Fed can prevent risk from going down.
38:27
Now on the top, it also has interest rates from it going too high.
38:30
It has a discount window rates, it has the also the standard repo facility.
38:36
So the Fed has these facilities that try to keep rates within it.
38:41
And given that their administrative rates, it's in a very narrow window.
38:44
And if in a perfect world we didn't have market frictions,
38:47
it would be like a straight line.
38:49
But it's not quite that way.
38:50
There are arguments for both systems.
38:52
So the scarce reserve system, you have a very small balance sheet.
38:57
So the financial footprint of the Federal Reserve is much less.
39:00
You also have a close link between the size of the balance sheet and
39:05
monetary policy itself.
39:07
So if you wanted the Fed to again change policy, you would have to increase or
39:10
decrease reserve, change its balance sheet.
39:12
Today that's not the case, you noted this.
39:14
The Fed can simply change an administrative rate without changing
39:18
the size of its balance sheet.
39:19
Now for advocates of the floor system, that's a big deal because then the Fed can
39:24
inject liquidity into say, a strained banking system without
39:28
affecting the stance of monetary policy via interest rates.
39:32
For advocates of a corridor system, they'd say that might be a bad thing because if
39:36
you have a system like that, it becomes a temptation to politicians.
39:40
So you're telling me, Fed, that you can keep interest rates pegged and
39:43
increase your balance sheet, but
39:44
why don't you buy up a bunch of bonds to build a wall or to fund a green New Deal?
39:48
And so the balance sheet, if it looks like a free lunch, it's really not.
39:52
But as you know, is a good economist, but
39:54
to many politicians it becomes a free lunch.
39:56
So there's arguments for and against.
39:58
There's also questions of what's easy.
40:00
Advocates of the floor system said this will be super easy because we're using
40:04
administrative rates.
40:06
Hasn't turned out so easy as many expected.
40:09
Also, when you have a corridor scarce reserve system,
40:14
it relies much more on banks to fund each other.
40:18
And we have largely lost that in the US.
40:20
The federal funds market is a shell of itself.
40:22
And this is a nice transition to the second part of your question.
40:25
Other central banks around the world are actually gradually moving back.
40:29
They're a long ways from a corridor system, but they're gradually moving away
40:33
from supply driven kind of ample, abundant reserve system.
40:36
And their motivation has been twofold.
40:38
Number one, there's been a lot of losses on central bank balance sheets and so
40:42
the fiscal authorities, parliaments, they're worried about that.
40:46
But secondly, and particularly in the case of ECB,
40:49
because I talked to Isabel Schnabel on the podcast about this,
40:53
their motivation for going back was to resurrect the overnight unsecured
40:57
interbank market where banks would lend to each other unsecured.
41:01
Well, if you're going to lend unsecured,
41:03
you better know your counterparty really well.
41:05
So there's price discovery, there's, there's learning about new risk that are,
41:09
that currently is missing.
41:10
You don't find this in any other market and they, they want to resurrect that.
41:14
Now again, we're not probably going to go to balance sheets the size they were
41:17
before 2008 but in my mind that's a great step.
41:20
We're going back, we're getting the markets more involved.
41:22
Banks rely on each other less.
41:24
On the central bank for liquidity in the US it hasn't happened,
41:27
I think in part because of some of the financial regulations.
41:31
I think there's just some complacency.
41:35
I think you get the right people at the Fed though, things could change.
41:38
And I think ultimately you alluded to earlier,
41:41
we were slow to adopt inflation targeting.
41:44
The rest of the world was on that bandwagon.
41:46
I think eventually we'll, we'll have to come around as well just because the cost
41:50
of maintaining large balance sheets are just going to continue to grow over time.
41:55
And I think doing more moving in direction of something between a floor and
42:00
a scarce reserve system, a corridor system might be useful.
42:05
The central bank of Norway, the Norges Bank,
42:08
it has something called a tiered reserve system.
42:10
Loretta Mester has advocated something like this where some of the reserves
42:14
are remunerated.
42:15
They do get something at the bank, but many of them do not.
42:18
And so it's kind of a compromise.
42:20
I think that's where the world is going, and I suspect with enough time,
42:24
the Fed will be there, too.
42:25
>> Jon Hartley: Interesting.
42:26
I mean, it's fascinating.
42:27
We've been in this period for almost 20 years of era of big balance sheets,
42:33
big central bank balance sheets, lots of quantitative easing, abundant reserves.
42:40
It's interesting to see now central banks really sort of trying to
42:43
think about some sort of an exit strategy, the extent that it's possible.
42:48
And I still don't think we're necessarily getting back to where we were
42:53
prior to the global financial crisis anytime soon.
42:56
But it's very interesting to hear about these sort
42:59
of alternatives that other central banks around the world are doing.
43:03
A real honor to have you on, David, and hear about your career and ideas.
43:06
I know there's so much we could talk about and
43:08
I would love to have you on again at some point.
43:10
I really want to thank you for joining us and really for the great service that I
43:14
think you've done for the economics and macroeconomics and finance community with
43:19
all the wonderful podcasts and writing that you've been doing over the years.
43:24
>> David Beckworth: Well, thank you for having me on your program.
43:26
>> Jon Hartley: This is The Capitalism and Freedom in the 21st Century Podcast,
43:28
an official podcast for the Hoover Economic Policy Working Group,
43:31
where we talk about economics, markets, and public policy.
43:34
I'm Jon Hartley, your host.
43:35
Thanks so much for joining us.
43:36
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