How a Former Fed Vice-Chair Is thinking About the Next Fed Chair | Odd Lots

Thank you. Looking forward to our discussion.

I think it's a very sensible choice. It makes sense along important dimensions. In particular, it's important because I think based upon background and what he's been writing recently that Warsh will work very well with Scott Bessent at the Treasury. There is Fed independence that we'll get into, but it's important as a practical matter that the Fed work well with the Treasury, and so it makes sense along a lot of dimensions.

Yeah, thank you for letting me add some color to that because there are dimensions and domains where it would actually be a very bad idea for the Fed to be dominated by the Treasury. But along several dimensions, a collaborative working relationship is important, and I'll name several. First is the Fed, going back to its founding, is the fiscal agent of the government. It has a responsibility to make sure that the Treasury market has adequate liquidity, that it functions properly. And so that's an important element of the job and always has been. It's also important because the Fed has an important role in bank regulation, but not a monopoly role. The controller of the currency, which is within Treasury, also has a regulation responsibility, as does the FDIC. So as a matter of necessity on bank regulation, there needs to be a degree of coordination, and so I would really highlight those two areas.

There is a tradition, it's not in statute, there is a tradition that the Treasury Secretary and the Fed chair meet on a regular basis, oftentimes over breakfast. And so during my time, that was the primary point of contact was bilateral between, when I was there, Jay Powell and Steven Mnuchin, and then when Janet Yellen became Treasury Secretary. So that's informal. There are typically not staff in the room for that. There's also the Financial Stability Oversight Council, which was a creation in Dodd-Frank, which by statute is chaired by the Treasury Secretary, and then the Fed, among other agencies, also participates in that process. And then thirdly, as I mentioned, anything involving bank regulation is typically going to involve, at the senior or even the vice chair for supervision level, interaction on bank regulation.

Well, I think you have to look at the entire picture, and Kevin was also very involved with Ben and Tim Geithner and Dudley in the crisis response to the global financial crisis, which really played out over a period of 12 to 18 months. And I think by most accounts, in my judgment, he actually added a lot of value in the fog of war. Inflation, as I myself learned, especially in periods of crisis and unusual large shocks, inflation forecasting can be challenging. So I don't think I would hold that particular episode against him. I think it does fairly characterize the way that most of us think about Kevin throughout that period and really the last 15 years, is he has been a pretty consistent critic of the Fed under the second half of Bernanke and then Yellen and Powell, and typically the criticism has come from the hawkish direction. And certainly in that episode, his criticism of the Fed was that, in some certain quotes, would indicate that hawkish inclination as well.

Maybe just I can follow up because in your earlier comment, you also mentioned his recent advocacy for lower rates. Now, it's important this is in the context of a committee that under Powell's leadership beginning in September of 2024 already began to cut rates. In fact, when I did your show earlier and we were talking about that right after I think the initial rate cuts under Powell, I made reference to what I've been calling for some time now, the Fed is running what I call the quote 2-point-something inflation target, which was they don't like it to start with a three, four, five, six or seven. But if inflation gets down to 2-point-something, they can start to talk and think about rate cuts as they did under Powell and importantly at the December Fed meeting. So just about six weeks ago, the Fed indicated through those very imperfect dot plots that a majority of the committee, of that existing committee which Kevin will inherit, felt that at least one more rate cut this year given the circumstances would be appropriate. So yes, Kevin has come out in favor of rate cuts in his public comments. I don't know what he said privately to the president, but I doubt that they differed from what he said publicly. But that's in the context of a committee that at least a majority of whom think that in this year it'll be appropriate to cut at least once.

Tracy, it's a great question because a point that I like to make, at least in my professional time, which goes back to Paul Volcker, we tend to talk about the Fed as the Volcker Fed, the Greenspan Fed, Powell, Yellen, Bernanke Fed. And that's appropriate because in this era, Fed chairs have been persuasive and they've usually got their way. But importantly, the Fed as an institution was specifically designed by the Congress in the 1930s in such a way that any material monetary policy decision, do they raise or lower interest rates or do they buy or sell Treasuries, requires an affirmative vote of a committee comprised of 12 members. And so as I've liked to say and I'll say it again, really the power of the Fed chair is the power of persuasion because at the end of the day he or she only has one vote. Now it's often argued that, well Rich, that's silly because rarely do Fed chairs get outvoted, and that's true. It happened once or twice under Volcker. It happened way back in the 1940s. And so yes, empirically it may appear as though chairs always get their way, but remember Fed chairs know where the committee is leaning and oftentimes or in certain circumstances they may themselves decide not to be on the losing end of a particular vote but to try to persuade the committee over time to move in their direction. Now one thing I can't really speak to the Greenspan Fed, but beginning under Bernanke and continuing under Yellen and certainly with Jay Powell, there is a lot of pre-FOMC meeting communication. And indeed Powell during my time there would have individual bilateral discussions with the other 18 people, not just the voters, but if you know there are 12 voters and another seven Reserve Bank presidents who don't vote in a particular year, so Powell would have 18 individual phone calls or face-to-face meetings before every meeting. I don't think that was the practice under Greenspan, for example. And so part of really what a Fed chair does is to get a sense of where individuals on the committee are, but really an important power that the chair does have is the chair sets the agenda for the meeting and the staff briefings for the most part are prepared by the board staff, sometimes with input from the Reserve Bank presidents, and the board staff reports to the chair. And so the agenda for the meeting and oftentimes details about the sort of analysis that would be useful for the discussion will be something that the chair will have a view on. Now, you asked for anecdotes. During my time, because of my background in monetary economics, Chair Powell, Jay Powell, did ask me to take a pretty hands-on role in interfacing between himself and the staff, in particular the forecasting and the monetary affairs groups, but ultimately my role was really in service to what he wanted to do to produce a successful meeting. The final thing I'll say, you got me sort of wound up.

The final thing I'll say is, and I think this has been publicly reported, but at a typical Fed meeting, there is a policy announcement that comes out at 2 p.m. That's a decision, and the committee, of course, is discussing that decision, but it's discussing other options. And at a typical meeting, in addition to the Fed's statement and the policy action that was the outcome of the meeting, the committee is also discussing alternatives, actually tangible alternatives, alternative A, alternative B, alternative C. And there can be quite extensive back and forth in the meetings about those alternatives. And so even at the end of the day, what the public sees is the Fed decided to keep rates on hold and there were two dissents which were governors and Waller, a lot more was being discussed at the meeting as potential alternatives to that statement and that decision, and a lot of discussion in meetings can be about what the committee thinks might be appropriate for the next meeting or the meeting down the road. Indeed, one of the many things I learned, I made a promise to myself when I was in the job to try to learn something new every day, and I usually did. And one of the things I didn't appreciate before I got into the Fed is especially the chair and the policy team, you really need to have a sense of the arc of both the year in terms of the data flow you're likely to get and the arc of where decisions need to be made and how they're made. And so there's a lot sort of like an imperfect but not completely a bad analogy is we've heard of legendary football coaches who like script the first 50 plays of the game. Now sometimes they move away, but they want to have a plan about how they'll react if the defense does a certain thing or the other. And it's not dissimilar to the way at least when I was at the Powell Fed that we would be thinking not only about the January meeting and then start thinking about March, but really the arc of the year, you know, based upon your view of the data and a number of other considerations. So those are some tangible examples of the way chairs I think put their imprint on the process.

Yeah. So I think let's focus now on communication since that was your specific question, but perhaps later also talk about Kevin's other critiques, which are broadly the balance sheet sort of mission creep in the size and the composition of the balance sheet, and then the third critique is grounding Fed policy, both actions and communication, more towards a policy rules framework and less moving away from what he calls meeting-by-meeting discretion. Let's talk about communication. And having observed and taught this and actually done it for four years, I want to begin with a historically factual statement that's important to provide some context. It is perfectly possible to conduct a very successful monetary policy without any forward guidance. Paul Volcker did it for eight years and Alan Greenspan did it for 17. You know, there would be little hints and winks and nods, but forward guidance as we know it today is really something that was not really in the toolkit of Paul Volcker or for the first 17 years, Alan Greenspan. Now, Greenspan's endlessly fascinating. And one of the fascinating things about Greenspan is that in his last two years, and I would say not coincidentally at the time that Ben Bernanke was a Fed governor, right at the very end in 2004 to 2006, Greenspan began to dip his toe into forward guidance. But for the most part, that was not really part of the toolkit. So why did forward guidance, first of all, then what is forward guidance and why did it become part of the toolkit? Well, at its most basic level, forward guidance is providing information to observers and importantly to financial markets about the committee's expectation of the path for interest rates. Now, there's a huge academic literature. I've contributed to it myself. And one of the interesting things that you might find that might be surprising about that literature is it spent a lot of time 20 years ago arguing that forward guidance was irrelevant because the Fed's looking at inflation data. The market's looking at inflation data. If inflation's too damn high, the Fed will raise rates. If it's low, they'll cut rates. So you don't really get any incremental benefit by telling people what you're going to do if they know you're going to do it anyway. And so the case for forward guidance then has to rest on something other than it's okay to talk about what you're going to do. And where forward guidance really became a focus of the Fed was out of desperation at the zero bound. So rates got cut to zero after Lehman Brothers. The economy was in free fall. The financial system was on the verge of collapse, and the Bernanke Fed could not use conventional policy to lower rates because they had hit, you know, a zero bound. And so they began to provide guidance to the markets to essentially reassure markets that they were not on a hair trigger to hike rates because they kept noticing that even though the economy was weak, inflation was low, unemployment was high, the bond market kept pricing in rate hikes that they had no intention of delivering. And so forward guidance really took on an important role when the Fed was trapped at the zero bound. Now an interesting corollary then is what do you do when you raise rates above zero? And of course the Powell Fed did that beginning, well Yellen and then Powell did that, and I was actually there for the rate hikes in that cycle. And the Fed by the time I had arrived, importantly because of the dots, the Fed had continued to use forward guidance even after rates got above zero, and oftentimes the dot plot was an input into that since it provides imperfect but potentially useful information about the committee's intention to adjust rates. Let me say, however, that I think it's entirely appropriate that Kevin Warsh or anyone who becomes a Fed chair now think about the cost and benefits of forward guidance. Indeed, I've said for at least a decade, including before when I joined the Fed, that forward guidance and quantitative easing are not exempt from the laws of economics. They have benefits but also costs. There are probably diminishing returns. And so I don't think it's at all inappropriate for the Fed under the leadership of the chair to think about benefits and costs of forward guidance in circumstances when it may be useful and circumstances when it may not be. Let me just add a little caveat here. Another dimension of Fed communication that's changed has really been the result of a change in technology and access. So, you know, if you go back to the 1980s, yes, when Volcker gave a speech, people would read it and the Times and Wall Street Journal would report on it, but other than that, Fed communication was pretty limited. And of course now, of course, we all have access to the internet and financial news, and each Fed president and Fed governor give speeches, and so there's a lot more individual discussion of what individuals on the committee think would be appropriate policy as well as formal guidance as well. So I think that's sort of where we are on forward guidance as of today.

I think you hit the nail on the head. I think the most robust prediction I would make is it would increase to some extent market volatility, in particular interest rate volatility. And importantly, and I'll just be very direct and blunt, in the decade, remember rates were at zero for seven years after the global financial crisis. Janet Yellen did not hike rates until December of 2015. And they've been on hold for seven years. And so not only was realized rate volatility low at the front end of the curve, but the Fed was using a lot of forward guidance and a lot of quantitative easing. And that was suppressing interest rate volatility for a very long period of time. And then even once the Fed began to lift off, because it was deploying forward guidance, that also served at the margin to suppress rate volatility. And you see this, for example, the MOVE index, which is basically a bond market index. So volatility got down to very low levels. So part of what has been happening really in the last several years under the Powell Fed is bond market implied volatility has gone up relative to the suppressed levels of the decade before the pandemic, but not really up to levels that were at all unusual back in the 1990s. And so I think my first-order assessment is we may be going back to what I would call more normal or pre-GFC levels of rate volatility. Now the Fed is not the only game in town when it comes to rate volatility. There's reasons for rate volatility to be elevated because of uncertainty about fiscal policy, for example, as well.

Seven years without a hike. So there really was a very intense challenge on the Fed's hands to convince the market that it was going to stay on hold for a very long time. And I think forward guidance clearly played a sort of specific tech role there. Let's talk now about balance sheet.

Yeah, so I think there are two related but distinct elements to this. First is that Kevin has been publicly and consistently critical of every expansion in the Fed's balance sheet since the first QE1 program. So he very famously said he was opposed to the QE2 program in 2010. Although I think he did vote for it, but then he left soon after. And so there's the issue of backward-looking, oh, the Fed should not have been buying Treasuries and mortgages as it did. And I think there's no reason to think he's changed his mind. Indeed, Secretary Bessant wrote a piece with a very provocative title, the Fed's, you know, gain-of-function monetary policy, and he was also critical in retrospect of the expansion in the Fed's balance sheet. The important question, of course, for Odd Lots listeners and for markets is, okay, that's the past. Looking ahead, and one of the many interesting things that Kevin Worsh said during his, I guess, campaign to become Fed chair was to call for a new accord between the Treasury and the Fed with regards to the balance sheet. Now he hasn't provided a lot of details. What we do know is what the first accord between the Fed and the Treasury looked like, which was back in 1951. And what was interesting about that, it was essentially the Fed's declaration of independence to raise rates without getting approval from the Treasury, which is why Fed historians think of it as really a signal event in Fed history. So I don't think that's really an issue. Now, presumably what Kevin means when he talks about an accord is a mutual understanding between the Fed and the Treasury about the size and composition of its balance sheet. And so, for example, you could agree that the Fed needs to have the current size balance sheet, but it should not own mortgage-backed securities or 30-year Treasuries. It should own T-bills. So that's a conversation you can have. You can also have a conversation about the Fed having a smaller balance sheet. I admire Bill, and I read that column and agreed with almost all of it. The point being is to get from here to there is not straightforward, and in particular it involves the banking system in terms of the level of reserves in the banking system. The Fed has been very reticent, although it's been tempted and it's discussed selling mortgage-backed securities. You can find it in the transcripts going back a dozen years and two years. And so right now there is no appetite in the existing Fed to think about shrinking the balance sheet through any sort of a sale. And then finally, and I do want to get this on the table because I think it's a very important point that is often imperfectly appreciated, is the following. In 2008, coincident with the global financial crisis, the Fed also achieved from Congress the statutory authority to pay interest on bank reserves. Until that point, the Fed created reserves by buying securities, but they earned a zero interest rate. And that not just the Fed, but most other central banks now pay a market rate of interest on bank reserves. And the reason why that's important is the following. What it means is that when the Fed does do a QE program, when it buys a mortgage security or a Treasury, it's not really printing money in the sort of money and banking sense that you're buying a coupon and paying for it with a $100 bill and thus extinguishing the coupon payment. What the Fed really does now with modern QE and interest on reserves is it's not extinguishing government debt. It's just changing the maturity composition of government debt from fixed to floating. Because at the end of the day, the Fed's balance sheet and the Treasury's balance sheet are consolidated. When the Fed's profitable, the Treasury gets that interest income. In recent years, the Fed has not been profitable and it's been withholding those remittances. And so once you think of it that way, then you start to think about a scenario where a Treasury Secretary could, if he chose to say, you know what, I want to be the big sheriff in town when it comes to maturity composition. So if I think there are too many 30-year Treasuries, I'll buy them and sell T-bills, and the Fed can buy the T-bills. And so there are scenarios over time where we could rethink what QE is, in addition to what the size of the balance sheet is. But this is not, you know, a 30-minute or, you know, a one-week exercise. This will be a pretty complicated, intricate process. But I don't want to rule out of hand that it's something that is, you know, beyond considering or discussing.