Balancing Act: Austan Goolsbee on the Federal Reserve and the Economy

He's emerged.

You know, my claim to fame is I was right above the stairwell from Brent. You go down the stairwell, three offices in there, that's where he was. We almost wrote a paper together. Remember that? It just didn't work. We had the data, we crunched, and it just didn't.

Yeah, it was close. There's still time. So, you know, hopefully soon enough. So,

yeah,

Okay. So monetary policy is the control of one interest rate basically. But the Federal Reserve System and the Federal Open Market Committee meet every six weeks in Washington. They vote on the Federal Funds rate, but it's basically about short-run interest rates. And economists think of it as the divine coincidence that the law gives the Fed the job to do two things when setting that interest rate: maximize employment, stabilize prices, which we have interpreted to mean get inflation to 2%. The divine coincidence is that most of the time when you're trying to maximize employment, it's the times when unemployment is high, inflation is low. And usually in the times when inflation is high, unemployment is low and they're overheating. And it kind of works because the most cyclically sensitive parts of the economy are also the most interest rate sensitive parts. So if it looks like things are overheating, then you raise the interest rate, kind of cools it down and you get inflation down. If it looks like you're teetering on the edge of recession, you lower the interest rate, you get more investment, you get more construction, you get more consumer durables purchase. That's what the Fed does on monetary policy. And that's gets most of the public attention. But Brent was right to raise there are other functions of the Fed. One is it's the lender of last resort. When everything goes wrong, the financial institutions can come to the discount window if they have good collateral and get us through a crisis, the various crises. We run a major portion of the payment system, the plumbing that underlies the financial system in the United States, wire transfers, ACH, direct deposit, the majority of that is going over the Fed rails. And then we're kind of a, as part of that, we're a bank to banks. And all the cash in the entire economy is printed by the Bureau of Engraving and Printing, but is distributed through the Feds. And we've got many tens of billions of dollars of cash sitting in the vaults down underneath in the way basement. And there's armored trucks coming in every day. And we're running it through machines and pulling out the counterfeit and the whole bit. And then we're major parts of our communities. When they set up the Federal Reserve Act in 1913, they were suspicious as people are today about the federal government controlling the entire monetary system of the United States with no input from the rest of the country. So they built 12 reserve banks from out in the heartland. And I at that time we were the West. I don't know. And so we come there, we're supposed to represent our regions, the seventh district, widely acknowledged the greatest of all the districts, but we're most of Michigan, Indiana, Illinois, Wisconsin, Iowa, 90% of that economy, kind of heart of the Midwest. And we play a key role in just getting out, talking to people, and hearing from them.

Some of the most obvious. Now, the rules of the committee are everybody's only supposed to speak for themselves, not speak for the committee, not speak for anyone else. And they're very hush-hush and secretive, as you might imagine, of what happens in the meeting. There's a federal blackout period surrounding the meeting and they drop the shade so nobody can see in the windows and it's like the situation room. You got to leave all devices outside of there. So I'm not going to tell you what what he said, but I will say it's obvious from the statement. Every time there's a decision comes with a statement and the statement this time was dramatically shorter and did not involve what we call forward guidance. So in the statements before Chairman Warsh, there would be the committee feels that it cannot cut rates until X thing happens, that it would kind of make a sort of a semi-forecast of what's on people's mind. Chairman Warsh has never been a public fan of forward guidance and he scaled the statement way down and that sparse statement that is purged of forward guidance has a bunch of the financial analysts like, ah what what does this mean? We're used to having more information. I'm sympathetic and was sympathetic before. I have always been uneasy with the use of forward guidance on a routine basis in the statement. I kind of don't like it, I think. And why? A couple of reasons: one, there are moments when forward guidance no question is useful like when we're hitting the zero lower bound and the rate is already to zero and now what do you do? Your options in monetary policy are quite limited. So when that happened, that's when they started creating forward guidance that maybe we could get all the rates to go down if we start saying we don't think we're even going to contemplate raising the rates above zero until we see XYZ happen. I described the purging of the statement a little bit like a caffeine cleanse that even if you like forward guidance, it still makes the forward guidance more effective if you're not drinking three cups a day every day. And that we kind of got into an element like that. The other more technical thing that makes and made me uncomfortable with forward guidance is there is a sentiment that goes let's not surprise anybody. The point of forward guidance is let the world understand what the reaction function is so nobody's surprised. Now, the problem with that is then there's a sentiment, well, we can't do anything until if we have the forward guidance, we got to go at least another meeting and take the forward guidance out before we actually do it. And if you get on that, you can just make yourself slow-footed and move too late. All of that said, I do think there's an element of any time the Fed says something that is a prediction, that's a speculation that ends up not being true. And it might not be your fault. It might be something happened. There was a war you couldn't have expected. But I think anytime you hear the Fed officially making a prediction that doesn't turn true, the credibility takes a ding. And that might not be a big ding, but that's what I don't like.

I think that's from business uncertainty. Businesses are like, we just don't know what the rules are going to be. So we're not going to get rid of any of these people, but we're not going to bring on any new people. We're just going to sit and wait.

Yeah. Some on rules, some on tariffs — there's a lot of uncertainty across a lot of spaces.

Yeah. You don't decide to bring on new people. Now, in different sectors, of course, this isn't true. I have a son who's a coder. Look, there are layoffs in some sectors, but in the overall economy, I think it's been pretty stable and characterized like that.

Okay, so the productivity growth rate — economists love productivity growth. It's probably the most talked about and important thing to us. If the public asks what's one number nobody pays attention to that they should, this is the number. The prospect that some technology would raise the productivity growth rate is wonderful. That's what made us the richest major economy in the world. It will make us rich again. But remember, the Fed is about the business cycle, about the short run and stabilization. A lot of this productivity is long run in nature. We've seen in the last two and a half years productivity growth is a fair bit higher — 75 basis points, one full percentage point higher than the trend before COVID. I don't know if you can attribute it literally to AI because AI adoption hasn't been fast enough yet. But I gave a speech at Stanford saying it looks like it might be tech-driven as opposed to a one-time bump from COVID. If so, big general-purpose technologies take time to diffuse through the economy. Here's the part where I want to caution everybody. If you knew it was coming, it makes a huge difference. Is this productivity growth expected so everybody understands it, or is it landing on us unexpectedly? What's happened so far landed on us unexpectedly. But now this is the most expected increase in productivity growth of our lifetimes. The problem with expected productivity growth is that's an increase in your wealth today. If I tell you you're going to get a big pay increase in two years, you want to spread that spending out — you start spending now. If you have IPOs worth a trillion dollars and suddenly everybody at these companies is rich and starts buying stuff, or data centers have massive investments planning on high equity valuations, you can easily overheat the economy in the short run before the productivity has arrived. So I do think it matters a lot to the Fed — not just whether it increases productivity, but whether it's shifting activity into the present and overheating the economy.

There's a loose parallel — kind of like a cousin but not an identical twin — at the end of the '90s, where there was a big runup in valuations, a big increase in internet use, and an increase in productivity growth. A lot of people remember Alan Greenspan, the Fed chair at the time, arguing we don't have to raise interest rates because productivity growth will lower inflation and we can run the economy hotter. That's a parallel, but it goes even farther. That was circa 1996 and it hadn't shown up in the data yet. Greenspan deduced there must be an increase in productivity growth happening because corporate profits were going way up, unemployment was falling, and there was no inflation. He said it must be that productivity growth is increasing and we just don't know that yet. And he was right — that was the famous conundrum. But by 1999, the data proved him right, and the Fed started raising interest rates rapidly on the grounds that this was overheating the economy and there were dangers of inflation and valuations getting out of control. One of the lessons from general-purpose technologies — electricity, telephones, combustion engines, computers, the internet — is it takes much longer for them to spread throughout the entire economy than you'd think. Certainly longer than the biggest AI promoters are alleging. They're kind of like, within two years every job is going to be gone and AI will be running everything. But if you look at electricity, phones, engines, it took much longer.

He's being polite. He's like, 'You need to be more...'

I'm not going to argue with that.

Look, a lot of the Midwest has been dealing with relative population decline — sometimes absolute, but at least growing slower than other parts of the country. Our mutual friend Ed Glazer, one of the leading urban economists, has a paper asking why some places grow and some don't. He identifies three key factors: since the invention of air conditioning, what's the temperature in January? The Sun Belt has done better. Two, what's the skill base of the workforce? And three, how diversified is the industrial base? Those three things are very correlated in the Midwest. Where you've seen the biggest population declines have been in places with lower average education and skill base, and more one-company, one-industry towns. Agriculture and manufacturing have also had long-run declines in workforce share due to productivity growth. As the price of cars goes down in real terms, each person doesn't buy two cars — they just spend less on cars. Mostly the Midwest has behaved as the macro economy has, but we are dealing with this population decline.

Yeah. In the hopes, it is this productivity growth thing. We've seen it. If productivity growth is higher, it means our standard of living is going to go up. Our wages can rise faster without generating inflation, and that will be fabulous. We'll have to manage the dislocations, but overall that still makes me quite optimistic. And the continued entrepreneurial character of the United States as an economy is worth a ton. If you ever find yourself thinking 'woe is us,' go talk to people in other economies. Anybody would happily trade places with us. The worrisome stuff, in the Fed's sense, is that inflation proves substantially more persistent than we are currently forecasting. We just went through that. The Fed made a mistake thinking inflation was just going to go away from the supply chain. It didn't fix quickly; it took a lot longer than they thought. That is entirely possible again. The very fact that people already got burned once makes them much more prone to declaring defeat. If people go into wage negotiations thinking inflation will be 7% next year and demand 8% wage increases, and employers think they'll have to raise prices even more — that kind of spiral is self-fulfilling and really difficult to get out of.

I didn't say didactic. I said it was a master class. All right, all this to talk about a glass half empty. Well, it was like giving you a compliment. He's like, 'Oh, you're saying I'm boring.'

Professors, we can filibuster the whole time. No questions? We got some.

Okay, this is a very important point. I wouldn't characterize it that downturns come from shocks plus leverage. Financial crisis and much bigger shocks happen when you have leverage. If you look back at subprime mortgages, the losses were a certain size. But if you borrow against it, then when the value of that asset goes down, everybody's got to get in a fire sale — they're having margin calls. Hey, where's the money? And that thing can spiral into financial crisis. That's certainly what happened in the Great Depression. There was a big initial shock, but that leverage spiraled into a thing that did not fix itself. The normal self-correcting mechanisms kind of fall apart. That happened in the 2008 financial crisis. The good news, if you want to think of it that way, is if you're afraid of bubbles, this looks more like an equity bubble — much more equity and less leveraged overall than 1929 or 2008. It looks more like the 1990s bubble in the internet. If you think that's a bubble, which was mostly equity, if something like that goes down, it doesn't make life fun. A lot of people lose a lot of money, but it doesn't turn into a financial crisis. So I'm hopeful that that's true. At the same time, there are frothy elements and you're starting to see stories about private credit, stories about debt financing of data centers, and we're going to want to watch the amount of leverage on those grounds.

Okay. The Fed system is a financial regulator. The reserve banks don't set the policy — the regulatory policies are set in Washington by the Board of Governors. We employ most of the actual bank supervisors and the people who go down and check to make sure the banks are following the rules. We are the operational wing, but we aren't the determiners of the policy. There's been a rise of fintech and financial firms that are non-banks. That's been happening for many decades — the rise of money market funds, the rise of a whole bunch of non-bank financial institutions. The 2008 crisis was not exclusively but was heavily concentrated in non-bank financial institutions. So whenever you see rapidly rising non-bank financial institutions where you're not totally sure whether they're being regulated...

Yeah, they might be hedge funds and private credit. The farther away from literal banking it is, the less information we have about it. And so we don't know. But my rule — I always say the first rule of financial accounting is nobody hides good news. So if you say, 'Well, I wonder how much inherent problem there is in X business,' if they're not out telling you there's not a problem, look at the numbers — that's not a great sign, because if you have good news, you share it. That said, we learned in 2008 the hard way that one of the key lessons is what matters for financial crisis, as opposed to just speculative investors losing their money, is how connected you are to the rest of the financial system. Right now, a lot of these to my mind are not super integrated into the full financial system and the overall level of leverage isn't as high as it has been in some other times. So that's more comforting on the financial crisis front.

The rent is too damn high problem. Okay, the Fed doesn't control the mortgage rate. Let me just start with that. We're setting an overnight rate that's kind of like between banks. It does matter, our rate. Mortgages are 30 years long, so those are the long rates, not the short rates. What the Fed does in the short term does have an influence, but the market determines what those rates are. And you can have circumstances where the Fed cuts the short-term rate and the long rate goes up because people think there's going to be more inflation, or the opposite. That said, here's a really striking fact of the last several years. If you talk to any young person, new family starting out, they say, 'Geez, my grandpa had one income and it wasn't even that high by today's standards. And look at the house he bought. I can't even afford a condo. What has happened?' If you go plot housing inflation — and we want to be careful, we tend to think of it as rental prices — the cost of housing relative to goods inflation has been changing at 4-plus percent a year, every single year, for 40 years. Now it doesn't take two Booth professors to tell you that if you compound a thing 4% a year for 40 years, you're going to have a big number. Everybody's not wrong. The relative price of housing is massively more expensive than it ever was when your grandpa was buying a house. Then the question is why? I don't totally know. I do think the economist's first answer is not wrong: you want house prices to stop growing this fast, you've got to build more houses. And we went through a period where we did not build houses. Part of that was coming out of the housing bubble popping — there was a widespread perception we built too many houses. Takes a long time to build houses, so I think we're still a little bit in the shadow of that. Part of it was in COVID there was a weird change in demand for space. The price of office space went way down because people aren't coming to downtowns, and the price of residential housing went way up because it was just transferring where people were doing the work. Last four or five months you've seen some progress on the housing inflation front. It hasn't been growing as fast as it did pre-COVID or post-COVID, but it's a huge component of the affordability challenge. I think when people say affordability is killing us, I don't think they're just talking about core inflation being 3.4% instead of 2%. I think they're looking at big tentpole goods — housing, college education, health care — a series of things whose relative price has been rising even faster than overall inflation.

Yeah.

Because I can rail against the idiots and now I've been like, 'No, no, you know, it was...'

I learned a lot as I took the job. I kind of understood decently well the monetary policy part of the job, and I will still say going to the first FOMC meeting — everyone says this, if you're an economist that's just about the coolest room in the whole world and it's awesome. It's just as awesome as you want it to be. There's a giant table, the shades come down, all the phones around, and then they're going to go around the table and it's like, 'Jay Powell, what do you think about the economy?' Of course, day one is about the economy, day two is about the rates. And I said, no offense to the Senate, this is the world's greatest deliberative body. And I didn't realize just from a workforce point of view how mission-driven the organization is. From the top level, all the presidents and the governors — they take the job extremely seriously. You're in this room. You're out of the elections business. You're out of every business. You've joined the Night's Watch. You know, if you used to watch Game of Thrones, we're down there thinking about maximizing employment and stabilizing prices, and it's all about what it should be. We got 1,700 people at Chicago Fed. These people are believers. And that's been pretty amazing. It's changed a little bit my view of the Fed to see how much operationally it matters — running the plumbing of the financial system — but also these are public servants of the highest order. So now I feel bad for criticizing them as much as I did. They do an amazing job.