Fed Answers

And now, here are my answers to the “Fed Questions.” There aren’t really right answers on most of these, but a Fed chair should understand the questions and the pro/con arguments.

Question: Should the Fed modify its 2% inflation interpretation of its “price stability” mandate? Should the Fed aim for zero inflation, or a steady price level?

After an inflation surge, should the Fed try only to bring subsequent inflation back to target, while accepting higher prices, as it does now? Or should the Fed slowly bring back the level of prices, to achieve its inflation target as a long-term average?

My Answer: I favor zero inflation, and a price level target. Like Alan Greenspan, I think the Fed should get there slowly and opportunistically rather than all at once, because I distrust my own understanding of dynamics and adjustment to new regimes. Unless, of course, Congress mandates a price level target, but that might reset expectations quickly.

A price level target implies that if there is a spurt of inflation or deflation, the Fed should aim to slowly and gradually bring the level of prices back to the original level. We don’t shorten the yard by 2% every year, why should we undo the standard of value by 2% every year?

I think that this is what Congress had in mind when it mandated “price stability.” We had closer to price level stability under the gold standard, and that experience was certainly in Congressional minds. But my argument does not rest on legalisms, and indeed one can take Congress’ acquiescence at the Fed’s target as an implicit endorsement.

Sensible answers can vary, and they reflect your view of the economy. Isabel Schnabel, asked this question at the recent Hoover Monetary Policy conference, dismissed the idea, saying she didn’t think any sane central banker would, after stabilizing inflation at 2%, want to induce a horrible recession just to bring the level of prices back. I don’t think such a recession would be needed. If it were, I would hold a different view.

The zero bound is another argument for the 2% inflation target. In a recession the Fed can only lower rates to 0%. If people expect a return to 2% inflation, then the real rate is -2%. If people expect a return to 0% inflation, then the real rate is only 0%. It’s like wearing shoes that are too small because it feels so good when you take them off.

I don’t think additional negative real rates do much. When whatever financial problem started the recession is ongoing, the level of the overnight rate is not very relevant. Once that financial clog is cleared, I don’t think additional “stimulus” from overnight rates is that important.

Moreover, a price level target has the advantage that any deflation in the recession will be reversed too. So you will still get expected inflation and a negative real rate in a recession, along with the opposite automatic stabilization after any inflation in a boom. The current flexible average inflation targeting includes this idea, promising to make up past shortfalls. It is, however asymmetric, not promising to atone for past overshoots. I think the latter would have the same salutary effects in constraining inflation. Those who advocate a target for the level (not growth of) nominal GDP as a target advocate the same mechanism. (I’m not nominal GDP target fan either, but let’s keep going.)

The second part of the question asks a candidate to show an understanding of forward-looking targets that forget past mistakes vs. a target of overall average performance. I prefer the latter, because it is more accountable and transparent. The Fed can say it has acted perfectly consistently with its target in the last 5 years because after a mysterious surge of inflation, the Fed did what it could to bring inflation back to target.

Question: What strategy or rule should the Fed adopt in place of its ill-fated Flexible Average Inflation Targeting? Or should it abandon strategies and just raise and lower interest rates as it sees fit?

My answer: You might expect me to endorse the Taylor Rule, and I admire it a lot. But I am torn between that and Larry Summers’ view, expressed at the 2024 monetary policy conference, that each shock is different, that nobody really knows how the economy works, and a firm “I’ll do whatever it takes” commitment to the target without specifying the exact action is better. Say “we’re going to Wally World,” not “we’re going to turn left on main, then right on I-55” and so forth.

In part, I don’t fully trust either in the standard practitioner model that higher nominal rates reliably lower inflation, or the standard academic model that the Taylor rule works by selecting from multiple equilibria. The FAIT was a mess though, pretending to be a complicated rule but with so much hedging and verbal escape clauses that it wasn’t really a rule. Yes, if inflation surged, I would start raising rates aggressively and we’ll see what happens next.

In sum, my answer is a well-educated waffle. I need to think harder about this one.

Question: Should the Fed address employment by simply focusing on price stability, avoiding the inflation and disinflation that upsets labor markets? Or should the Fed sacrifice some price stability to try to pursue employment goals?

My Answer: Price stability. The record of trading inflation for better employment is poor. Just keep the price level stable and employment will take care of itself. Avoid surges of inflation and panicked rate rises that cause recessions to control inflation. Don’t repeat 1979, and you won’t repeat 1980.

Again, answers can vary and depend on how you see the economy. If you squint at the cloud of data and see a firm exploitable Phillips curve that just happens to shift and squirm, but you think you can tell in real time where it’s shifting and squirming, you will come to a different view. I think the Phillips curve, especially positing that labor market slack or tightness is the single crucial causal determinant of inflation, is such mush that I don’t put it at the center of my thinking.

Question: Should the Fed aim for “inclusive employment,” worry about left-behind areas, or include other distributional goals? Should the Fed view its mandate as direction not to worry about anything else, or a starting point from which missions may creep?

My Answer: I favor a narrow mandate, interpreted also as a list of things the Fed should not pay attention to. I also favor Fed independence. Mission creep into contentious political areas will undercut independence.

Question: Should the Fed be formally accountable for its inflation performance, fulfillment of its mandate, or actions that exceed its mandate?

My Answer: One could say that via regular reports to Congress, and periodic reappointments of its members, that the Fed is already accountable. Congress is certainly free to grill Powell now on “how did you interpret ‘price stability’ to mean 2% inflation?” and so forth. But I think a bit more formal accountability would all in all be a good thing.

Question: Which economic theory do you think best describes monetary policy? There are many today including Keynesian, New-Keynesian, Monetarist, Modern Monetary, and Fiscal theories, and they disagree fundamentally. Should the Fed manage the “credit cycle” with regulatory as well as interest rate tools?

Answer: This is in part a trick question to see if a candidate is familiar with various schools of thought, evidence for and against them, where their bodies are buried. Just echoing “I think high rates lower spending which lowers output and via the Phillips curve lowers inflation” gets you a C-, and shows you don’t know what’s actually going on in the Fed’s own models.

The best academic theory I know of is the Fiscal Theory of the Price Level, combined with long-term debt. But I know there is a lot I don’t know.

However, as an economist, my loss function gives a high reward for a new theory that turns out to be right, and only a mild penalty of comfortable obscurity if I am wrong. As a policy maker, my loss function would weight much more making sure I am not wrong and do not make disastrous mistakes. I would have to put a lot more weight on other theories, including the standard policy view even though there is no well thought out economic theory behind it. That view assigns the Fed much more power than FTPL and suggests that interest rates lower inflation more robustly than FTPL does. But I would also understand each theory has its limits, each captures a small slice of historical events, and each has well-known failures. Recessions sometimes cause disinflation, but sometimes disinflation is painless or actually happens in a boom. I would also understand that there are lots of poorly-modeled frictions. While many economists jump on those fractions as policy levers, I regard them more as dangers to overly aggressive policy making. I would put a lot of weight on historical experience.

No, the Fed should not try to manage the “credit cycle,” along with many other expansions of its mandate into macroeconomic dirigisme.

Question: Did Quantitative Easing significantly affect long term rates, output, and inflation? Should QE continue as a routine part of the Fed’s tools? If QE works, should the Fed more directly target long-term rates rather than buy some bonds and see what happens?

My Answer: I don’t think QE did much. If I give you two $5 and a $10 for each $20 do you spend more? The treasury sold more long term debt than the Fed bought. QE did move markets on announcement, but I don’t think price pressure effects last forever. At most it had information effects, shock and awe that the Fed was so desperate, and a signal rates would be low for a long time. On the other hand, that also means QE didn’t do much damage either. A Fed Chair should have a well articulated view.

Question: Should the Fed continue to pay interest on ample reserves? Or should it stop paying interest, return to a tiny quantity of reserves, and manage interest rates by changing that small quantity? Should the Fed continue to pay banks more on reserves than it pays other institutions? Should the Fed follow other central banks and elastically lend new reserves to banks as they demand, rather than strictly control the size of its balance sheet?

My Answer: I favor ample reserves that pay a market interest rate. I favor a flat supply curve rather than trying to control the balance sheet (QE) as a separate policy lever. I favor a narrow corridor, and equal treatment for all comers.

Ample interest paying reserves have been a great innovation of monetary policy since 2008, with many benefits. The fear they would necessarily lead to inflation was proved wrong in a great worldwide experiment. Three cheers for the Fed, and for Ben Bernanke who inaugurated this policy.

Question: Should the Fed maintain its prohibition of banks that hold only reserves, such as TNB, which the Fed in 2024 denied a master account on fanciful grounds? Or should the Fed encourage such narrow banks, as impossible-to-fail institutions that can provide low-cost transactions services and large safe uninsured deposits? Should the Fed allow access to reserves and its payments system to a larger range of financial institutions—such as money market funds —that aren’t banks? Should the Fed allow stablecoins to hold reserves? Should the Fed institute a digital or crypto dollar? Should the Fed instead encourage Treasury to offer fixed-value, floating-rate electronically transferable debt—essentially, reserves—to people and non-bank financial institutions?

My Answer: The Fed’s denial of a master account to TNB was a disgrace. The reasoning was beyond fanciful, showing that the Fed has really no idea what “financial stability” means. (The Fed worried that people would run to narrow banks in a crisis. Never in history has the Fed’s response to a crisis been “you have to sit and hold illiquid assets.” And people can run to bank deposits and short term treasurys directly now.)

Narrow deposit taking and equity financed banking is where financial regulation should go. I think a wide range of financial institutions should have access to something that looks like reserves. Honest stablecoins are just an implementation of a narrow bank or money market fund, so why not. But they should be able to pay interest. The last treasury proposal gets the Fed out of much of this business, which would be a good thing. I would work with Treasury to make it happen.

Question: Was it a mistake for the Fed to buy trillions of dollars of new Treasury debt, thereby financing the huge 2020-2022 deficits with new money? Was it a mistake for the Fed to keep interest rates at zero for a year after inflation surged in 2021? If so, how will you avoid repeating these mistakes?

My Answer: These were mistakes. I would avoid a repeat by introducing the concept of supply — not all shocks are the same, and not always insufficient demand. The Fed should respond differently to supply vs. demand shocks. (The Fed is in danger right now of responding to a tariff supply shock as if it were low demand, with stimulus. Plus ça change…) I would introduce the concept of fiscal inflation, which obviously was what was happening. And yes, pay some attention to the Taylor Rule, and when inflation has surged to 10% maybe you should think about raising rates.

More deeply, the episode needs a thorough review of what happened, and how did the Fed get it so wrong. “Supply shocks” hit that aren’t our fault is not good enough.

There is an interesting view in academia that inflation was indeed an as-if optimal response, a once in a generation debt default to pay for a “war.” If so the Fed should say “we inflated away debt to pay for Covid spending without current or future taxes. We’ll do it again in the next war.” They do not say this, and that suggests it was a mistake. I’m not above once in a hundred years state contingent default to finance really necessary spending however. Though maybe like the Fed I might dissemble about it so that they don’t think every hundred years means every four.

Question: How will you improve the Fed’s decision-making processes? How will you restructure the Fed’s operations, including staff size and scope, diversity programs, and research?

My Answer: I don’t want to give a full reorganization plan here, in part because I don’t have one. The question really asks, do you think such a reorganization and review is necessary, and my answer is yes.

Question: Higher interest rates raise interest costs on the debt. Inflation wipes out federal debt. Should the Fed think about these budgetary implications? Should it work with Treasury to coordinate policy?

My Answer: The Fed studiously avoids fiscal policy. Well, except some ill tempered remarks several years ago asking for more fiscal stimulus. But we can’t avoid the fact that the inflation of 2021-2023 had fiscal roots. Without $5 trillion unfunded deficits there would have been no inflation. With those deficits, the Fed had limited ability to control inflation, though some. Monetary and fiscal policy are intertwined. And we can’t avoid the fact that if the Fed can affect real rates of interest, it affects interest costs on the debt, at least until inflation erupts. And if higher interest rates soften the economy, they result in deficits. Separation of monetary and fiscal policy only works with low debts or with governments that adapt tax receipts and spending to monetary policy. Some “coordination” is necessary. At least the Fed can talk about this. “Transitory” and “supply shocks” won’t paper over the next fiscal inflation. Every country with budget problems has a public debate between central bank and fiscal authorities. We really can’t avoid it. I would prefer of course tighter fiscal rules to control inflation, rather than a subjugation of monetary policy to finance deficits.

Question: The Treasury issues long-term debt, which pays a fixed rate. The Fed buys that debt and turns it into floating-rate debt. That makes interest costs flow on to the budget faster. How should the Fed and Treasury agree on the proper maturity of the debt? Should the Fed only buy short-term debt?

Answer: To start, the Fed chair must admit that large QE which buys long-term treasurys does lower the maturity structure of the debt. Then admit that the current Fed losses are a cost to taxpayers, from undoing what little interest rate protection the treasury had bought with its long-term debt issues.

The Fed pretends to ignore the Treasury. The Treasury pretends to ignore that the Fed undoes whatever it does. We need a new accord about who is responsible for and accountable for the maturity structure of the debt and the exposure of taxpayers to interest rate risks. I think it should be the Treasury, and the Fed should hold only short-term securities, or swap out the interest rate risk with the Treasury.

Question: Should the Fed continue to buy mortgage-backed securities? In 2020 the Fed announced a corporate bond-buying program, to prop up their prices. Is it proper for the Fed to prop up asset prices? Should the Fed worry about stock prices and exchange rates?

My Answer: No, no, and no. The wider the mandate, the less the Fed can be independent.

There is a case for central banks to be forbidden Treasury securities and restricted to hold private or foreign securities. Doing so helps to isolate the central bank from pressure to monetize the debt. My judgement is that at present isolating the Fed from pressure to prop up particular interest group’s favorite assets is a more present danger. But that may not last and I get to change my mind.

There is a separate intriguing argument that the Fed should only hold indexed debt. But that’s for another day.

Question: Will you end bailouts and how? Will the Fed again bail out money market funds and their investors as it did in 2008 and 2020? Will the Fed bail out stablecoins if they prove not so stable? Will the Fed allow losses among uninsured depositors? What financial institutions will the Fed allow to fail, or to suffer credit losses in the next crisis? How will you deal with failures and contraction in private credit? Can you define “financial stability” and “systemically important” in ways that don’t mean “nobody loses money?”

My Answer: If I were Fed chair, there would soon be a speech announcing the end of bailouts, and a narrow and precise definition of “systemic,” as a systemic run only. Get your ducks in order, and get your liquidity ready for fire sales buying opportunities. The Fed won’t front-run those next time. Bank stocks would tank, and I would need the legal job protections!

Question: The Fed failed to notice simple interest rate risk in the Silicon Valley Bank collapse in 2023, yet continues to implement massively complex regulations, which also reduce competition and raise costs. How will you reform financial regulation? How much of the money that banks invest in risky assets should come from equity? Are “climate risks to the financial system” worthy of separate study, regulation, and disclosure?

My Answer: The empty presence of technocratic competence is nowhere more evident than in financial regulation. See “toward a run-free financial system” for my program. No, climate risk the financial system is a political agenda to force de-banking fossil fuels and subsidize politically connected so-called green energy hiding in a fantasy.

Question: Treasury markets, dominated by dealer banks, have experienced turmoil. Do you think reforms to liquidity and capital regulation will solve the problem? Will you allow or require exchange trading of Treasurys, and allow other investors access? How would you react to a global sovereign debt crisis, with governments unable to roll over debt and interest rates spiking?

My Answer: Channeling Darrell Duffie here. The dealer banks got a monopoly, in exchange for providing liquidity. They didn’t provide liquidity, time to end the monopoly. I don’t think we need a phone call market with insiders to provide liquidity in treasury markets.

But all that won’t mean much when the great global sovereign debt crisis hits. Plumbing issues will not then be the problem.

I should have put the question, “if you have to choose between monetization and forcing the US to explicit default, which will you choose?” I would grudgingly admit monetization. Shh.

Question: Should financial regulation be integrated with or separated from monetary policy? Should financial regulation be less independent of Congress and the administration, as other regulators are?

My Answer: I’m torn on this one. The essential arguments for independence, time consistency, doesn’t really apply to financial regulation. Monetary policy and bank regulation are somewhat intertwined, which argues that whatever independent institution does one should do the other. But perhaps they are less intertwined than we think, and the Fed maintains a lot of separation between the two functions which denies the intertwined argument.

Yet the more accountable regulators (FDIC, OCC, SEC) don’t seem to do a tremendously better job than the Fed. We must admit that for all its faults the Fed has been a lot better than most government agencies.

I’m for much better financial regulation, and would listen to arguments both ways. What structure will allow and force a thoroughgoing reform of Dodd Frank? Maybe a less independent one, if some administration someday decides to make it a priority. I suspect internal regulators at the independent Fed would never want to upset that apple cart, as they haven’t implemented simple liquidity reforms for years. I thus lean a bit toward accountability. But be careful what you wish for as a different administration might have already infected financial regulation with scope 3 climate disclosures, aggressive debanking, “equity” in finance, DEI from top to bottom, and worse.

Question: These questions are the tip of the iceberg. The financial and monetary system have evolved past the current Fed, and a wise Fed chair will need answers.

Addition: The proper amount of independence, and the legal structure of the Fed is back up for grabs. The Chair ought to have some knowledge at least of the pros and cons.

Obviously, anyone giving these answers wouldn’t make it past the first round of interviews to be Fed chair. I doubt anyone giving any clear answers to these questions would do so.