An Open Letter to Randal K. Quarles, Federal Reserve Vice Chair for Supervision

Dear Vice Chair Quarles,

Nearly three years ago, we wrote an open letter congratulating you on your nomination as the first Vice Chair for Supervision on the Board of Governors of the Federal Reserve System. In that letter, we highlight the central mission of ensuring the resilience and promoting the dynamism of the U.S. financial system.

Today we write to express our profound disappointment regarding the plans (expressed in your June 19 speech on “The Adaptability of Stress Testing“) to limit the disclosure of this year’s large-bank stress tests. In our view, failure to publish the individual bank results from the special COVID-19 related “sensitivity analysis” weakens the credibility and effectiveness of the Fed’s stress testing regime.

Consequently, we urge you to reverse course and to announce this week the individual bank sensitivity results, along with the aggregates. To put it bluntly, the point of a supervisory stress test is disclosure. Anything short of full transparency leaves potentially destabilizing questions unanswered.

The Fed's Crystal Ball: Looking Beyond the COVID-19 Recession

Over the past 75 years, no one has seen anything like the COVID-19 shock to the global economy. Nor have we seen anything like the swift, broad and massive fiscal and monetary expansion that followed.

In the United States, the economic rebound has started. As states and municipalities relax the lockdown, businesses closed by the virus are gradually reopening and employment is rising. But, there remains tremendous uncertainty about the speed and extent of the recovery.

This was the backdrop for the Federal Open Market Committee’s (FOMC) release last week of its June Summary of Economic Projections (SEP)—the first SEP since December. Unsurprisingly, attention usually focuses on the FOMC’s interest rate projections: with the exception of two participants, the Committee does not anticipate an interest rate increase over the forecast horizon to the end of 2022.

In this post, we concentrate on the Committee’s projections for the real economy. Our conclusion is that these contain two elements of optimism. First, while the recession is clearly the worst since the 1930s, FOMC participants believe that the recovery will be roughly twice as fast as the one from the GFC. Second, their projections are that longer-run economic growth will match the pre-COVID pace. That is, in contrast to the GFC experience, COVID-19 will not usher in a slowdown in trend growth. Compared to the FOMC, we believe there is room for disappointment, especially with regard to the longer run.

Fiscal Space Has Limits, Too

In the battle against the economic impact of COVID-19, governments around the world are pulling out all the stops. In advanced economies, leading central banks have pushed interest rates to zero or below. And, a recent IMF estimate puts the combination of discretionary spending and automatic fiscal stabilizers (including unemployment insurance and progressive income taxation) at $9 trillion―more than 10 percent of global GDP.

With bond yields low or negative, the limits to monetary policy are clear (see our pre-COVID post). How large is the scope for additional countercyclical fiscal policy? With sovereign yields so low, the cost of additional financial expansion looks to be minimal, at least for now (see, for example, Blanchard).

Nevertheless, each time public debt-to-GDP ratios ratchet higher—as they did in the 2007-09 crisis and are now doing again—the question of “fiscal space” reemerges. When the next economic shock hits, will governments again be able to provide relief and stimulus on the scale required to meet society’s needs?

In this post, we highlight recent fiscal developments in advanced economies, and review the factors affecting the sustainability of their high and rising levels of debt. To foreshadow our conclusion, the fact that many countries’ fiscal positions were precarious even before the COVID crisis does not weaken the current case for stimulus. But, doubts about fiscal space are growing. So, it is important that governments find a way to make a credible commitment to future fiscal consolidation when their economies have returned to full employment. Failure to do so could threaten confidence both in government finances and in economic performance….

The Price is Not Right: Measuring Inflation in a Pandemic

Are prices really plummeting? If you watch the official government gauge of prices in the economy, you would think so. Between March and April, the Consumer Price Index (CPI) dropped by 0.8 percent―that’s a decline of 9.1 percent at an annual rate! Even if we exclude food and energy, prices still fell at half that rate. And, both price measures already had begun to fall the previous month. Is this the new trend? Are we in the midst of a deflation? The short answer is no.

The pandemic is an enormous shock to both supply and demand (see our earlier post). The productive capacity of the economy is lower both now (with the lockdown) and in the medium term (with the need to make economic activity biologically safer). Similarly, demand is lower both temporarily while people stay at home and in the longer term as the propensity to save rises to enable people to pay off elevated debts and build precautionary buffers. Determining which of these shifts prevails is essential for policymakers. If the demand contraction dominates, then trend inflation will fall and policymakers will need to implement further expansionary policies. Conversely, if trend inflation rises (implying that the supply constraints prevail), then policymakers will eventually need to introduce restraint.

In this post, we discuss the difficulties of measuring inflation during a pandemic—when demand and supply both shift dramatically. Our conclusion is that some indices provide better high-frequency signals of the trend. Unsurprisingly, headline measures of inflation are especially poor. Yet, traditional measures of “core inflation” that exclude food and energy may be equally bad. Instead, we suggest focusing on the “trimmed mean,” a statistical construct that disregards all goods and services whose prices change by the largest amounts (either up or down). In recent months, the trimmed mean CPI shows suggest that inflation has edged lower, but remains between 1½ and 2 percent per year….

The Euro Area in the Age of COVID-19

The founders of the euro had little doubt about the common currency’s role as a foundation for European peace and prosperity. Yet, they were not Pollyannas. For years before the start of monetary union in 1999, economists had warned that the member states of the European Union do not constitute an “optimum currency area” (see, for example, Milton Friedman). This means that a single policy interest rate might exacerbate, rather than mitigate, economic differences, creating severe strains among euro area countries.

Since the euro’s beginning, European leaders hoped and expected that as tensions arose, member states would come closer together—integrating their economies and financial systems, sharing burdens and risks. To a considerable extent, experience has borne out these hopes. Despite enormous challenges, no country has abandoned the euro and reintroduced a national currency. Today, an entire generation of people has come of age knowing only the euro. Moreover, as of November 2019, popular support for the single currency among euro area residents was at a record 76%, with sizable majorities in each member state (see Eurobarometer 92, pages 32-33).

And yet, over the past two decades, there has been only grudging progress toward a truly resilient monetary union. Politically and financially, the euro area remains divided. The COVID-19 crisis brings renewed tensions. With it comes a harsh reminder that standing still is simply not an option.

In this post, we review the progress toward completion of the European monetary union, and note key gaps that remain….

Helicopters to the Rescue?

Is helicopter money here? Do we need it now? Is it coming? The short answer to these questions is that it is not here and we currently do not need it, but should the economic disaster brought on by COVID-19 continue for much longer, that might change.

To be clear, the relief checks that governments are sending out to households and businesses are not helicopter money. Despite their enormous scale, the financing of these transfers is no different in character from that of traditional government benefits: governments are collecting taxes and issuing debt to the public.

Helicopter money is when the central bank finances government expenditure directly. In these circumstances, the fiscal authority, through its debt management policies, controls the size of the central bank’s balance sheet. This is monetary finance arising from fiscal dominance: to increase seignorage, the fiscal authority usurps the role of the independent central bank in determining the size of base money (currency plus reserves held by banks at the central bank).

Should monetary policymakers consider surrendering their independence in this way? In our view, a far better alternative is to peg the long-term interest rate at zero. Currently in use by the Bank of Japan, this policy of yield curve control allows central banks to retain a small, but significant degree of monetary control. It also captures the features of U.S. monetary policy from 1937 to 1951, when the Fed capped the long-term bond yield to support U.S. wartime finance (see here)….

Central Bank to the World: Supplying Dollars in the COVID Crisis

In his comments at Jackson Hole last year, then-Bank of England Governor Mark Carney highlighted the continuing dominance of the U.S. dollar: it accounts for one-half of global trade invoicing; two thirds of emerging market external debt, official foreign exchange reserves, and global securities issuance; and nearly 90 percent of (one leg of) foreign exchange transactions.

It also is the basis for the Global Dollar system (see our earlier post). The BIS reports that short-term U.S. dollar liabilities of non-U.S. banks total $15 trillion. Foreign exchange forward contracts and swaps—with a gross notional value of more than $75 trillion—add substantially further to U.S. dollar exposures (see here). And, the U.S. Treasury reports that foreigners hold more than $7 trillion of U.S. Treasury securities. To put these numbers into perspective, total assets of U.S. depository institutions are currently $20 trillion. In other words, the U.S. dollar financial system outside of the United States is larger than the American banking system.

Like it or not, the Federal Reserve is the dollar lender of last resort not just for the United States, but for the entire world. The Fed’s role is not altruistic. Instead, it reflects the near-certainty that, in a world of massive cross-border capital flows, dollar funding shortages anywhere in the world will spill back into the United States through fire sales of dollar assets, a surge in the value of the dollar, increased domestic funding costs, or all three.

The Fed’s extraordinary efforts to counter the COVID-19 crisis include aggressive actions to counter dollar shortages outside the United States. In this post, we explore those actions, including the supply of dollar liquidity swaps to 14 central banks (“friends of the Fed”) and—to limit sales that might disrupt the Treasury market—the introduction of a repo facility to provide dollars to the others. We also note the challenges facing countries outside the small inner circle that do not have immediate access to the Fed’s swap lines….

Inflation is not (and should not be) a key worry today

A very simple version of 1960s monetarism has two elements. First, controlling money growth is necessary and sufficient to control inflation. Second, leaving aside a financial crisis, the monetary base―the sum of currency in circulation and commercial bank deposits at the central bank―determines the quantity of money. Putting those together means that, in order to control inflation, all central bankers need to do is ensure that their liabilities grow at the appropriate rate. Conversely, when the central bank’s balance sheet grows quickly, inflation inevitably follows.

This simple monetarist reasoning was still on display in 2010, when Ben Bernanke received this letter from a group of 24 economists warning against further large-scale asset purchases by the Fed. At that stage, the central bank’s assets exceeded 250% of their level in September 2008. Over just over two years, the Fed had purchased roughly $400 billion in Treasury securities and $1 trillion in federally guaranteed mortgage-backed securities. But, as Bernanke explained at the time, the purpose of these asset purchases was to aid the economy in recovering from the crisis-induced recession. Moreover, in contrast to prior norms, since October 2008 the Fed had been paying interest on reserves, raising the opportunity cost for banks to lend.

Subsequent experience proved the letter writers very wrong. The Fed’s balance sheet continued to grow, peaking at $4.5 trillion in early 2015. And, over the decade just ended, inflation (measured by the Fed’s preferred consumption expenditures price index) averaged 1.6%―below the central bank’s long-run goal of 2%. If anything, in recent years, and despite massive central bank balance sheet expansions, inflation both in the United States and in other advanced economies has been too low, not too high.

With central bank balance sheets now surging again, we recount this history in the hopes of blunting any inflation concerns, which we see as profoundly misguided. Over the six weeks ending April 22, the Fed’s assets have grown by the same amount as they did from September 2008 to March 2013. While this does raise some serious concerns, inflation is not high among them….

COVID-19 Economic Downturn: What do cyclical norms suggest?

Business cycle downturns come in many forms. Some are big, others small. Some are long, others short. Some result from policy errors or euphoric booms, while others are the consequence of external events.

Nevertheless, downturns have some common features and regularities. Among those that have been reasonably stable over much of the past half century are the relationships among unemployment, activity and federal budget deficits. Using these, we explore the impact of the U.S. COVID-19 economic downturn that began last month.

To sum up, recent labor market developments already make clear that we are in the midst of the deepest recession since the 1930s. In fact, the coordinated shutdown of a large swath of the American economy has made this plunge more rapid than that of the Depression. Whether we are at the start of a second Depression depends greatly on how long we keep the economy in a state of suspended animation.

If the lockdown extends from weeks to months, the short-term pain will turn into long-term scarring. The longer it takes to reopen businesses safely, the more damage we will do to the many linkages and networks (including lender-borrower, supplier-user and employer-employee relationships) that make up the fabric of the economy. As the wave of bankruptcies grows, damage to the financial system will increase, as will the resulting harm to the economy’s productive capacity….

The Fed Goes to War: Part 3

For the second time this century, the Federal Reserve is a crisis manager. In this role, policymakers can lend to solvent but illiquid intermediaries (as the lender of last resort). They can backstop financial markets (as a market maker of last resort). And, when all else fails, they can take the place of dysfunctional private-sector intermediaries.

During the first financial crisis of the 21st century, the Fed’s response shifted from one role to the next as the crisis intensified. Yet, even compared to that massive crisis response, the Fed’s recent moves are breathtaking—in speed, scale and scope.

Indeed, with its most recent announcements on April 9, the Federal Reserve is committed to an unprecedented course of action to ensure the flow of credit to virtually every part of the economy. In carrying out its obligations under the newly enacted CARES Act, the Fed is effectively transforming itself into a state bank that allocates credit to the nonfinancial sectors of the economy.

Yet, picking winners and losers is not a sustainable assignment for independent technocrats. It is a role for fiscal authorities, not central bankers. Instead of using the Fed as an off-balance sheet vehicle for the federal government, we hope that Congress will shift these CARES Act obligations from the Federal Reserve to the Treasury, where they belong….

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Money, Banking, and Financial Markets