Kathy Bostjancic is the chief US financial economist at Oxford Economics and joins Macro Musings to discuss the outlook for monetary and fiscal policy in 2021 as well as in financial markets. Specifically, David and Kathy discuss the prospects for Fed policy and personnel under the Biden Administration, immediate concerns facing the Fed as the COVID pandemic continues into 2021, what steps the Fed can take to make their new AIT framework credible, how large scale asset purchases have impacted asset prices and the real economy, and much more. Read the full episode transcript: Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected] David Beckworth: Kathy, welcome to the show. Kathy
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Kathy Bostjancic is the chief US financial economist at Oxford Economics and joins Macro Musings to discuss the outlook for monetary and fiscal policy in 2021 as well as in financial markets. Specifically, David and Kathy discuss the prospects for Fed policy and personnel under the Biden Administration, immediate concerns facing the Fed as the COVID pandemic continues into 2021, what steps the Fed can take to make their new AIT framework credible, how large scale asset purchases have impacted asset prices and the real economy, and much more.
Read the full episode transcript:
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Kathy, welcome to the show.
Kathy Bostjancic: Thank you, David. My pleasure to be on.
Beckworth: Great to have you on. You are one of those individuals that I have grown to know via Twitter. It's been great to chat with people like you. We would never probably have met had it not been for Twitter and my growing and expanding network of friends and fellow travelers along the path of economics and markets. It's been a real treat to get to know you, chat with you, to read your notes and your comments that you put on Twitter.
Beckworth: Today we're going to have a fun conversation about markets, about economic policy, fiscal policy, but before we do all that, Kathy, tell us a bit about yourself. How did you get into economics, into markets? What's your career journey?
Bostjancic: When I graduated from undergraduate I had an economics degree and concentration in math and really was interested in the intersection of economics and the financial market. I was lucky enough to land a job on Wall Street on the sell side of things and started out right out of undergraduate as a research assistant. Worked very hard and I was supporting the foreign exchange operations as a researcher helping to support a foreign exchange operations at Citibank. At the time, Citi was the largest foreign exchange dealer in the world, so it was quite dynamic. I learned a lot after being a bit intimidated by the traders and some of the sales people after a while kind of settled in and really enjoyed it and realized for me it was the right choice. You really were able to research and learn about the economies and how it affected the markets in this applied economics.
Bostjancic: Now, especially with the foreign exchange market, it doesn't always move in tandem with fundamentals. There's other factors at play. But it was a great opportunity. I started out focusing on the G7 economy. I was running quite broad and not able to... because of how much to cover... get too deep. But then I made a switch in my career, just switching to another investment bank on the sell side, and there moved up to an associate economist slash economist and really there I focused more on the US economy and got a lot more focused on the Federal Reserve and monetary policy and also treasury operations and fiscal policy, as well as analyzing and forecasting the high frequency data: things like retail sales... this morning personal income and consumption were released... and then how that would feed into GDP and our overall forecast for the US economy.
Bostjancic: There, spent a lot of time in that position as what they call a fixed income trading desk economist. I sat among the traders and salespeople, which was always lively, but at the same time we're also supporting. You would go to early morning meeting for the foreign exchange group, which was on a different floor, or our equity division. It was quite dynamic and really a lot of fun.
Bostjancic: Then I just continued that until... I guess I've been... I went to a place after Wall Street called The Conference Board, which was a big shift for me in the sense that there was no longer the buzz of a trading floor and was in supporting trading operations, but it was... I kind of give it the equivalent of a sort of a think tank. Kind of a funny story that in going there I kind of said... because this was in 2008 during the financial crisis when things were quite tough and opportunities on Wall Street were not so plentiful. I remember saying to the chief economist at the time at The Conference Board, Bart van Ark, who I admire quite a lot, "I don't know how long I'll stay. Maybe I'll start out as a consultant but my background... I've been on Wall Street. I don't know what to do besides being in the financial markets." He said, "That's okay. We haven't really hired many too many non-PhDs like yourself." I had a Master’s degree. "So let's just see how this experiment goes." I ended up staying quite a while. It was six years and loved it.
Bostjancic: The switch for me, David, was that I was now dealing with corporates and the real side of the economy. I could tell you just very quickly that there was an interesting episode come my first introduction dealing with corporation in the midst of the crisis. I was pulled into a conference call and they said, "You understand what's going on the financial markets. You just came from a financial firm. Explain to us what's going on. We've been caught a bit flat-footed," the company said, "and we're trying to decide how we're going to perhaps adjust production and it may entail some large layoffs." Even though I had sat next to traders who were easily trading in millions of dollars, billions, at any given time... lots of money flowing through the financial markets... I found a lump in my throat because it was the first time I really started to think about people and ramifications from a corporate strategy perspective.
Bostjancic: From there, it was nice because I was also... started using the Oxford economics model and then was contacted and there was an opening at Oxford. It was a nice segue. Now we both... as our customers, we have corporate clients and they're varied. We also have nonprofits and think tanks, central banks, but we have financial clients as well. It's a good mix for me to be at Oxford. That's a bit of a condensed history of my path in the economics field.
Beckworth: That's very interesting. So you've seen some front line action during currency crisis. Imagine like the Asian financial crisis '98. You were probably in the midst of that. Lots of, I imagine, sleepless nights when you had events like that. And then the story you just told about your input could have a bearing on the real lives of people in this corporate firm. That's super fascinating. Maybe it might be useful to share some advice because there are a lot of grad students, young people, who listen to the show. I've gotten lots of feedback from them. Since you've been on Wall Street and that is a career path they can take, is there any particular advice you would give them if they choose to go down that path?
Bostjancic: It's so highly individual and personal, our experiences, but for me I think the key was being adaptable. As I said, I worked in different environments. And even being adaptable within the financial markets. I started out in foreign exchange in the G7 and then I shifted to the US and was more involved with fixed income trading. Just being adaptable and being open minded and trying to learn as much as you can. I think the other thing that I tell young people is nowadays the quant skills are in such high demand. Certainly, learn as much as you can there but don't forget about the soft skills either. You have to know how to present and talk to clients.
Beckworth: Very useful advice. Well, Kathy, a very exciting career you've had for sure. Maybe tell us one more thing about it. What is the typical day in the life of a chief US financial economist? What do you do?
Bostjancic: It's not different over the years, to be honest. The first thing I do... and maybe it's out of habit... I check the financial markets to see what the price action has been over night and I see if there's been any big news that's come out that I should be aware of before I start my day. Then I'll proceed to read the financial press: the popular press, Wall Street Journal, Financial Times, Bloomberg, Washington Post, things like that. Then, I guess with the Trump Administration, also check your tweets and also, David, as you know we've interacted through Twitter. I also like to see what others and sort of associates around the globe are saying.
Biden Administration and the Fed
Beckworth: Okay. Let's move on then to monetary policy and fiscal policy and the outlook for it in 2021. You cover this and you've written some interesting research notes lately on it. One of your research notes is titled, *How Biden Can Reshape the Fed.* Maybe walk us through that. What should we be looking for from the Biden Administration with regards to the Fed?
Bostjancic: I think the first thing is he's inherited a very dovish Fed. I think any alterations he makes will just kind of marginally push the needle towards more dovish. Right now probably the most immediate thing [Biden] could do once his administration and he get past the fiscal and the health agenda, because that comes first, but there is a vacancy on the board of Federal Reserve, so the governors. There's an opening. One was just filled right at the Trump Administration, Christopher Waller, and he's quite dovish and comes from the St. Louis Fed. But Biden could fill that role. I would suspect he would go with someone who's very pro-employment, pro-growth, with those inclinations, so very dovish. That's the most important or immediate action.
Probably the most immediate thing [Biden] could do once his administration and he get past the fiscal and the health agenda, because that comes first, but there is a vacancy on the board of Federal Reserve...I would suspect he would go with someone who's very pro-employment, pro-growth, with those inclinations, so very dovish.
Bostjancic: Then what I think a lot of people are having fun speculating about is would Chairman Powell be reappointed to another four years as chairman. His chairmanship expires in February of 2022 but probably towards the end of this year there'll be some chatter and discussion about some of the leading candidates. My sense... and I know you had Sam Bell on previously, who I don't know personally but I also enjoy reading his Twitter comments and he's very knowledgeable on the personnel at the Fed, but I agree with him that most likely Chairman Powell would be reappointed. I think that is typically the norm with presidents. President Trump has, in many ways, stood out differently than his predecessors and did not reappoint Janet Yellen, but I think Powell probably wants steady hands. We're still amidst a crisis here. He's proven himself to be quite competent and maybe despite being a little too eager to lead interest rate increases in 2008 since then he's really pivoted along with, probably, the support of his vice chairman Richard Clarida and also New York Fed president Williams. They're sort of considered the troika. Maybe also Brainard in that you could see her breaking into that group as well. But they sort of, together, focus more on the employment and the slow employment, and the fact that we still have a deficit of more than nine million workers during this ongoing pandemic.
Bostjancic: But that will raise a lot of interesting chatter. If he gets some pushback from the more progressive members of the Democratic Party, maybe he would then look towards someone like Lael Brainard. She's not only kind of proven to be very sensitive to promoting growth and employment but she's also been pretty tough, I would say, on banks in terms of regulation and capital buffers. She has dissented many times from the steps to rollback Dodd-Frank bank legislation. That's really been under the watch of Fed governor Quarles, who also is the vice chair for supervision. His seat, by the way, expires in October of this year. My educated estimate or guess is that Brainard would be a candidate to actually become the vice chair for supervision. If she doesn't become chairman the supervision would be a great role for her. But obviously we'll see how that plays out. But those are, I think, the two or three critical ways to fill the vacancy for the Fed governor, appoint whoever the next chairman is going to be, and then filling that position for bank supervision.
My educated estimate or guess is that Brainard would be a candidate to actually become the vice chair for supervision. If she doesn't become chairman the supervision would be a great role for her.
Beckworth: And then, also, maybe no more tweets about the Fed.
Bostjancic: Right. Doesn't have to defend himself as much.
Beckworth: I remember people commenting, once Trump was taken off of Twitter, "Who do we go to Twitter for any more? What is the attraction of Twitter?" Well, the attraction at least for me is meeting people like you and having fun conversations but I understand the bigger point. This should be interesting year. To summarize what you're saying, a return to normalcy maybe, kind of institutional, let's get back to the way things were pre-Trump era.
Bostjancic: I think that's right. A return to normalcy maybe across the board but certainly with regard to the Fed and certainly a lot less acrimonious relationship. I think the criticism would be much more behind the scenes if there are any. And I think the other point, which others have talked about, is that with Janet Yellen as treasury secretary now. She of course was the former head of the Fed or the chairman. There'll be a nice relationship. And she has obviously worked with Powell in the past so they should have a good working relationship. But at the same time Yellen respecting the clear lines or delineation between the Treasury and the Fed.
Beckworth: So what has been Wall Street's response to Janet Yellen being appointed as treasury secretary? Are they happy with her?
Bostjancic: Oh yeah, I think very happy. And it was expected especially with... The Georgia race was a big turning point for many policy decisions and also the appointments just makes it a lot easier for President Biden to get his nominations confirmed by the Senate. I think once we saw the results of the Georgia races it was a very high likelihood we would get Janet Yellen and she's sure hands and competent. I think from that standpoint Wall Street's quite happy. I think... and we'll talk about this, I'm sure... the other question is just what's the trust of fiscal policy. What's next? What's coming?
Beckworth: Okay, let's talk about, then, Fed policy itself. The Fed has a new framework this year and, as you know because you've listened to past shows, I talk about that a lot on here. I'm a big advocate of a make-up policy in some form. Of course, my dream would be nominal GDP level targeting. That's a long ways from happening. But we do have this average inflation-targeting framework. The idea is to have some kind of make up when you're below target. How do you view it? Do you view it as successful so far? Room to grow? It needed credibility? Where do you think it stands?
The Fed’s New AIT framework
Bostjancic: It's a good question. I would say we're still in the infancy of the new framework but it's going to be tested. Maybe the first test was just over the past month or so leading up to the FOMC meeting, which concluded on January 27. There had been some chatter from some regional Fed presidents, particularly the Atlanta Fed president, Bostic, who is a voting member this year. He rotates on to be a voting member. He had suggested that maybe there would be some tapering of the QE asset bond purchases even before the end of this year.
Bostjancic: That, along with the prospect that we could get significant additional fiscal stimulus after just having 900 billion passed in December, started to fuel the so-called reflationary trade in the bond market. I would say part of that reflationary trade is also higher growth expectation. It lifted the 10 year treasury note yield pretty significantly higher. In a short period of time we went from 90 basis points nominal yield to an inter day high of about 1.18. Still very low but going beyond that 1% threshold and going a bit higher started to attract attention. I think Chairman Powell and also Vice Chairman Clarida came out with pretty strong Fed guidance. It was in between the meetings, but basically commented that it's just premature at this point to think about raising rates or tapering. That really helped to tamp down on long term rates. And along with the idea that while growth was recovering... Right now we're in pretty slow patch, even though we got 4% GDP growth yesterday which normally would be outstanding growth, but when you still are two and a half percent below pre-pandemic growth levels it's not so great and it comes off annualized over 30% growth rate in Q3.
Bostjancic: All of that put together, really the bottom line is that the leaders of the Fed, the so-called troika, are indicating, "Let's hold off. Let's not get too far ahead of ourselves." What they certainly don't want is long term rates rising quickly or abruptly. Then that, one, counteracts any fiscal or some of the fiscal stimulus that's in the pipeline or is coming, and then can hurt the economy: the interest rate-sensitive sectors of the economy. At this point we still have a long ways to go in terms of recovery.
The bottom line is that the leaders of the Fed, the so-called troika, are indicating, "Let's hold off. Let's not get too far ahead of ourselves." What they certainly don't want is long term rates rising quickly or abruptly...At this point we still have a long ways to go in terms of recovery.
Beckworth: I was very pleasantly surprised to hear Powell come out so forcefully in the press conference about that issue of asset purchases tapering sooner rather than later. He pushed hard against that. He also pushed very hard against tightening in response to inflation. They really are making a case that inflation is going to have to temporarily go up and stay up above 10% for some time. So I was pleasantly surprised to see him make the case. I think that's a great way of looking at it, Kathy, is that he passed the first test. January FOMC was their first test. He made my little heart happy. He made the markets happy, I guess. So kudos to Chair Powell and the rest of the FOMC.
Beckworth: So that's the good part. Let me bring up the part where I'm less convinced or maybe even worried. You can maybe calm my fears here. If I look at break evens... and I know break evens aren't a perfect measure of inflation expectations, but the five year break evens, last I checked, was 2.2 and it's maybe down a bit from there. If I look at that and then I also know that I need to subtract about 10 to 20 basis points to make it a PCE equivalent, the break evens are in CPI measurements. We want to have it in PCE form because that's what the Fed looks at. That's what it targets. We're just about 2% and maybe even... and maybe I should get your thought on this... then it might be overstating things because the Fed has bought up a lot of tips. I was just looking at this the other day. They normally hold about 10% of the outstanding tips and it jumped about 20, so they doubled the shared tips they hold. That might be distorting some of the liquidity premium, which affects the expected inflation.
Beckworth: In any event, best case scenario we're looking at 2% over the next five years. If I want AIT to be credible, I want some evidence that they're actually going to see through and allow some inflation to go above 2%. I would think you'd want to see that a bit higher. The other point I often bring up is if you look at the summary of economic projections at the Fed's own forecast of inflation two, three, years out it's at most 2%. Those summary of economic projections are conditioned on, quote, appropriate monetary policy. I guess I need a little more convincing that this is going to actually work. Again, they passed January test, but should I be worried? Am I maybe over anxious here? Or are there some big hurdles to clear still for this to really become credible?
Bostjancic: I think there's a lot of uncertainty. I can understand being a bit concerned of whether this will actually play out as the Fed hopes and whether they actually have the wherewithal to see it through, I think that's the other question. The next test is going to come soon. Inflation is going to rise because of weak base effects in comparison. Last March inflation rates declined quite sharply because of the pandemic. Since then it's still been quite muted but the year-end year rate will pop just because it's an easy comparison. The question will be how does the Fed handle that.
The next test is going to come soon... Last March inflation rates declined quite sharply because of the pandemic. Since then it's still been quite muted but the year-end year rate will pop just because it's an easy comparison. The question will be how does the Fed handle that.
Bostjancic: As we discussed, Chairman Powell really went out of his way to say, "We're going to look through that base effect and any transient increase inflation. On top of that we're probably going to get an increase in inflation because we're rebounding and reopening. If all goes well and the vaccines are dominate and we have herd immunity sometime around the summer but even during the spring if activity starts to rebound, that could lift inflation higher. The Fed has to stand pat there, which they've said they would but I think beyond that you're right. Then what happens to inflation? On one hand, will they sit back and allow it to go to 2% or even above without tightening? Prematurely kind of short circuiting that.
Bostjancic: I do like Vice Chairman Clarida's comments. He said that "We would not commence rate liftoff until we've been at 2% for at least a year." He's giving this a time period that we didn't have before and he's really suggesting it has to be very sustainable. But we shall see if we get to 2%. The other thing I would just add there is, as you know, if you look at... it's quite interesting... the dynamics we're seeing goods inflation now. We hadn't had that for a long time and that's related to the pandemic. But service prices are slowing so we're going to see some reversal of that and how that plays out is going to be very interesting.
Beckworth: So maybe I just have a little more faith that once 2021 really comes online and we have the heat pick up in the economy inflation will pop up and the service sector will fully recover. If anything, I'll be worried that there's too much inflation on the other side. Maybe I should be careful for what I wish for.
Beckworth: So you think the framework so far, then, is it's on track. There's still questions to be had. Is there anything different they could be doing to help it gain more credibility? Any concrete steps you would propose if you were chair of the Fed?
Bostjancic: I think that one of the things that was missing, and I think you were one of the commentators on Twitter making this point, is just having even more guidance. Like, yes, you gave us a framework. We know that you've adopted this flexible average inflation target. But inflation, how high will it go before you start to feel uncomfortable at the Fed and for how long? I feel Vice Chairman Clarida filled that gap a bit. We'll see if others agree and take that on. That will be quite interesting. But I think that's useful. I also applaud them for giving us some guidance on the QE, the quantitative easing. It's less concrete than the guidance on interest rates, the rate lift off, but I think that's okay and they have been sort of been filling that in, too. They said there's substantial progress towards the dual mandates. Everyone's asking what's substantial but again we're starting to get a bit of that forward guidance via the verbal guidance.
One of the things that was missing...is just having even more guidance. Inflation, how high will it go before you start to feel uncomfortable at the Fed and for how long? I feel Vice Chairman Clarida filled that gap a bit. We'll see if others agree and take that on.
Bostjancic: I think the other thing that we're wrestling with is how are they going to know they're at full employment. Now their full employment mandate is even wider because now it's supposed to be broader and more inclusive. Now you've got to look at other measures as well to make sure that you're getting inclusive gains. And what happens with the labor force participation rate? A lot of people have exited the labor force. That participation rate has declined. Was some of the baby boomers... was their retirement accelerated because of this and they're not coming back to the labor force? Some other younger families and younger parents of children that some of them have been sidelined because their children homeschooling, at least remotely, for part of the week. Will they return? And how quickly do they return? A lot of data that needs to be looked at very carefully.
Beckworth: But you're suggesting a little more clarity on the framework would be helpful here?
Bostjancic: I think so. I think yes. They continue to give some clarity, whether it's verbal... It doesn't have to necessarily be formal, but verbal, and I think they've done it on the inflation front. I now wonder if we need a bit more clarity and guidance on the employment mandate.
Beckworth: The employment change was pretty remarkable. They went from this equal deviations from both sides to short falls and that's it. That's a pretty asymmetric one sided understanding. What exactly does that mean? That would be nice to have. I will note that, as you know, Clarida did mention in his speech he had his definition of what that meant. And it's great that Clarida did mention that one year window there. That was pretty remarkable, too, in itself.
Beckworth: Another concern... or not concern. Maybe another observation about this framework is the Fed has talked about having another review in five years and whether it happens or not, I don't know, but I do recall Brainard in a Q&A saying she'll be eager in five years to look back and see how this framework has done. Well, the clock is ticking. We started this in August last year or some time near that point. The clock is ticking. We're still well under 2%, so these windows that you're talking about, how long before we actually hit the gas pedal and really try to catch up? How long do we make it last? I do think clarity's important. I think it's also important for them to realize the clock is ticking. I think that should be something that keeps them up at night to think about and consider as they go into their next few meetings.
Beckworth: You talked about asset purchases. Some people worry about the size of the Fed's balance sheet. I'm just wondering what your sense is from your clients, from Wall Street. The Fed's balance sheet is about 7.4 trillion. It was near three trillion before this all started. It's quite a big increase relative to previous QEs. What is your sense? Are banks, Wall Street, financiers worried about this at all? Or they just think it's business as usual?
Bostjancic: There is, I think, a lot of questions about the balance sheet's going to be handled going forward and is it going to be as easy to disengage from these asset purchases as the Fed hopes and televises? Because we know in the past that's not been so smooth for them. We've gotten taper tantrums and then of course we had the problem... The repo market just, months before the pandemic hit... because they reduced the level of reserves too much. They were shrinking the balance sheet out. My sense is there's not going to be any shrinkage of the balance sheet. They'll just let the balance sheet as a size of GDP on it's own sort of wind lower or at least stabilize. Probably more like a stabilization. But they're not going to look to reduce the balance sheet outright.
Bostjancic: This is related to the question you asked me before, too, that there's some concern that maybe the Fed... not just with the balance sheet, that's part of it... but the pledge to come in and revive emergency facilities if needed to back stop the financial markets and the fact that the interest rates are really low. There's a huge amount of liquidity on the monetary policy side along with fiscal side. Maybe it's fueling some froth and bubbles and we saw a price action obviously this week that was a bit frenzied. I'm not sure I would attribute it directly to monetary policy but perhaps there's something there. But maybe in general... and your comments about Brainard are just so interesting because when she looks back maybe one of the ways they evaluate things is also what impact did we have on financial stability and asset prices, right? What they've done so far, the money that's been injected, and even on the fiscal side some of this money is going through not to the real economy but to the financial assets. You're inflating assets more than prices. I think that will be something to consider, now they'll have two cycles to look at: this one and the financial crisis.
Beckworth: I'm curious to know since you were on fixed income desk and you still work with us pretty closely, what is your view on QE and large scale asset purchases? Do they really make that much difference? There's people who believe they make a big difference. There's some studies that show that and there's a lot of people who are skeptical that you're just doing an asset swap, particularly at the zero lower bound. You just mentioned it seems to be contributing, at least, to higher asset prices overall. On balance, where do you come down on QE? Is it, on net, a good thing? Maybe just a waste of time? What do you think?
QE and Large-Scale Asset Purchases
Bostjancic: I think it's a useful tool and I think the first round of QE, especially in the financial crisis, were the most impactful in terms of really supporting the economy. But then I think there are diminished returns and then perhaps the psychology starts to kick in that the markets... whether it's really helping the economy or even juicing the markets, if the markets believe it is, that in itself is an issue and that can fuel prices. Then if the Fed tries to at least even just slow purchases, they could have problems, which is not great. Whether we believe it has an impact or not it does, because if market players think it does I think that's the basic thing.
Bostjancic: I think the other thing that was introduced in both of the last recessions or crises... really both of them are crises... was the fact that the Fed would come in with these emergency liquidity facilities, which I think were quite helpful and they were needed. I think we can't have markets, especially like the treasury market, freezing up. Our system won't work. But it also introduces that put, the Fed put, which that in itself can be a bit dangerous for encouraging too much risk taking.
Beckworth: That's probably the one criticism that I think it's a good one, a useful one, is that the system we have in place is simply the Fed will step in when the dollar funding system breaks down. It's a global response and as you said it was necessarily. In the absence of that stepping in, we would've had a terrible, much worse financial crisis than we did in March of last year. But it does seem to be a very much ad hoc process as opposed to maybe fundamentally addressing the underlying issues in the money market. The Fed's balance sheet is going to continue to grow. Whenever there is a problem they're going to have to step in. They open these facilities.
Beckworth: There's people on the left who are worried what this does or incentivizes for global shadow banking. It encourages more dollar investments on the margin. People on the right, of course, it means a greater footprint for the Fed. But I don't know what the solution is either. I don't know if there's an easy way out of where we are right now given the dollars used so widely.
Beckworth: So Wall Street itself is not terribly concerned about the large size. Just something to kind of watch and observe for now and then maybe eventually need to address it?
Bostjancic: Yes. I think some are concerned that they are artificially supporting the market for too long. I think there is that concern. And then what's the exit strategy? I do think there is concern. But at the same time I think there's a relief that the Fed did step in, to be honest.
Beckworth: Yeah. Pick your poison.
Beckworth: So on the exit strategy is the concern another taper tantrum might occur? The Fed might lose control when it has to unwind?
Bostjancic: Yeah, because the Fed in the last cycle... and it was really, a lot of this, under Janet Yellen's helm... was trying to normalize both interest rates and the balance sheet and they didn't get very far in either one. In their attempt to normalize the balance sheet there were problems all along. First it happened under Chairman Bernanke even just suggesting that asset purchases might slow, settle a deeper tantrum. We know in 2013, '14, rates shot up very high, long term rate. They want to avoid that and Powell went through that experience. That's probably really scarred into his memory and his consciousness as he's going forward now. Then of course when they did even they though maybe there was a period where they could reduce the size of the balance sheet, saying, "Well, we're not really tightening. We're just normalizing the balance sheet and there's plenty of reserves. We've adopted this new reserve system." It's the scarcity of reserves that they had before. There's plenty of reserves.
The Fed in the last cycle...was trying to normalize both interest rates and the balance sheet and they didn't get very far in either one. We know in 2013, '14, rates shot up very high, long term rate. They want to avoid that and Powell went through that experience. That's probably really scarred into his memory and his consciousness as he's going forward now.
Bostjancic: That didn't go so well and it's still... I think there was a problem. I think they did lower the reserves too much and banks did have some trouble getting the reserves they needed. But there also was some psychology in that, too. We talked to many clients who were saying, "They're really tightening. They don't understand they're removing liquidity from the system and they're removing too much." There was a mix of both reality and, I think, some psychology at play.
Beckworth: Let me share with you my understanding of that event and tell me whether I'm right or wrong. As you mentioned, we're in this new framework: the ample reserve framework or floor operating system. Even though the absolute amount of reserves has grown dramatically up to this point when we had this crisis, the demand for reserves also grew because of all these new regulations coming out of Dodd-Frank. As a result, the Fed was trying to shrink its balance sheet as small as it could possibly without getting to where it would face a scarce amount of reserves relative to demand. They tripped over that, I think, accidentally. It was that perfect storm, as you recall: tax receipts were coming due. A number of things that were shrinking the amount of reserves... And even though the absolute amount of reserves were high, relative to demand it wasn't sufficient. So yes, monetary policy was effectively tight. Quantitative tightening, QT, did make a difference.
Beckworth: In my view, I think what's important is to get into the plumbing, the regulations, those things that incentivize banks to want to hold more reserves. I'm not sure there's an easy path forward at this point.
Bostjancic: Yeah. Your summary of what happened is quite accurate. They did stumble upon and they had even surveyed the primary banks and investment banks to ask if they had... well, really more the banks... adequate reserves what would be the level of the threshold. The threshold that the major commercial banks were giving the Fed were much lower than where reserves were. Everyone sort of miscalculated in a sense. It also is, as you said, that the banks... because of the regulations or at least their interpretation of the regulations felt they needed to hold bank reserves. They wouldn't hold things like treasuries because they felt maybe they weren't as liquid. I think after that experience the Federal Reserve bank regulators were trying to go in with soft guidance, or softer guidance, saying, "No, it is okay. High quality collateral or liquidity can be treasury securities. You don't necessarily have to hoard bank reserves." Maybe further work needs to be done there and maybe something more formal.
Bostjancic: I also think that under Janet Yellen's leadership at the Treasury, and even the Federal Reserve has looked at this: they need to do some type of reform or look into what happened in the treasury market. The idea of having any breakdown of trading and issues in the most important... is the bedrock of the global financial system. Something needs to be done or looked into and I think there will be. Whether it'll be an easy fix is another question.
Beckworth: Okay. Your title is chief US financial economist. In the time we have remaining I want to switch gears and look at financial markets and get your take on what's going on there. Kind of the context right now is we are recording this near the end of January is that GameStop has been soaring in price. There's an interesting story beyond that. One interpretation is it's a bubble. It's well above the fundamentals. This raises bigger questions about the financial markets in general, stock market in general. Is it overvalued? Are asset prices growing too rapidly? I want to maybe start with that simple question. Are we in a frothy environment for asset prices? Or maybe they're justified by the hope of a super strong recovery in the future. What do you think is happening?
Are Asset Prices Overvalued?
Bostjancic: It could be a combination of all of those factors but I think in terms of if you have an optimistic view what could be driving that, as you say, is that there's this great hope and expectation that we're going to have a real bounce in activity come this spring and summer, especially as service sector activity comes back online. We're expecting that consumer spending. We're going to have two quarters back to back. That's the strongest in 70 years. Those help to justify... and we're at the early part of this economic recovery or expansion and that's typically when riskier assets outperform and interest rates are very low. As we were talking about, there's a tremendous amount of liquidity both from monetary policy but also on the fiscal side, especially if they inject even more or send out checks to individuals and support to households. In the past year or so I think the aggregate savings has been twice as much as what it had been in the previous 12 months: something like 700 billion extra compared to the year before. Total aggregate savings about one and a half trillion. That's a lot of money and it's not getting funneled into the real economy. A lot of that's going into money supply and then into the stock market.
We're at the early part of this economic recovery or expansion and that's typically when riskier assets outperform and interest rates are very low...In the past year or so I think the aggregate savings has been twice as much as what it had been in the previous 12 months: something like 700 billion extra compared to the year before. That's a lot of money and it's not getting funneled into the real economy. A lot of that's going into money supply and then into the stock market.
Bostjancic: There's a bit of frothiness, no doubt, but I think there's also embedded in there some real fundamental reason it should be doing well. It could be... again, staying with maybe the more optimistic scenario... that we don't get expansion of PE any more. Priced earnings, they may actually start to narrow and contract a bit. But the next leg could be the E: earnings start to pick up. But maybe the overall equity market kind of trades sideways but we see that beneath the surface, a rotation towards more value stocks. We'll see how that plays out. At Oxford we're cautious. I'm not the strategist at the firm but our strategy team is cautious. They think that the equity market probably is overvalued. There is froth but not necessarily a real big retrenchment of prices but a bit of a moderate correction could be in store.
Beckworth: So nothing that would devastate the economy. Nothing big or significant. Just some small portion is frothy but maybe consistent with what we've been going through and where we're headed.
Beckworth: Let me ask this question, then, Kathy. If we ever were in a situation where asset price of the stock market was way overvalued, how should policy respond to this? I ask the question because I've been asked this question recently, again, given the context of what's going on. People are asking, "Are asset prices overvalued? Should the Fed do something about it? Should they step in?" I'm very reluctant to have the Fed do that because I remember 1929. The history from that's very clear. The Fed tightened, helped trigger the Great Depression. It wasn't the only cause. It helped trigger it. There's a number of other examples. Japan, late '80s. They kind of got ahead of themselves. And there's this old debate: do you prick the asset bubble or do you mop up afterwards? It just seems to me, at least, that central banks aren't very good at doing surgical strikes at asset prices without creating a whole lot of collateral damage. If we do find ourselves in a situation, what do you see as the best policy mix for bringing asset prices down to a more sustainable level?
Bostjancic: I would be in your camp, David. I think it is dangerous, one, for the Fed to try to determine whether we're in an asset bubble because even strategists and people who are trading these assets can't say for sure. We only know with hindsight. And then, two, what's the remedy? If you're really sure there's an asset bubble, what do you do? I thought Chairman Powell handled it well and it is in line with what you laid out, is that they'll be there in a sense afterwards to support things and support the economy. Of course, that does also engender the whole Fed put but that's another issue. But pricking the bubble, in doing so... Let's say he was asked, "Would you raise interest rates and tighten policy," and he said, "That would really adversely hurt the economy and then therefore would make asset prices even more likely to fall hard. That doesn't seem to be the right answer either." He pointed to, as others have spoken about, macro prudential or regulatory tools. Maybe that's the area the Fed is getting back to. Maybe they need a third mandate: financial stability. Maybe they need to do a lot more work on what exactly are macro prudential tools and how would we use those.
I think it is dangerous, one, for the Fed to try to determine whether we're in an asset bubble because even strategists and people who are trading these assets can't say for sure. We only know with hindsight. And then, two, what's the remedy? If you're really sure there's an asset bubble, what do you do?
Beckworth: I was, again, pleasantly surprised to hear a lot of what he said at the press conference. One thing he stressed is an economy at full employment, running hot, is one of the best things for financial stability: keeping the economy running fully employed. And I like that because I think it gets the causality in the right direction: keep people spending, have them able to make their payments on their debts, their mortgages. That's the best way to ensure financial stability in terms of plain old monetary policy, putting aside macro prudential considerations for the time being, as opposed to the narrative you've often heard, is it was financial instability that leads to the weak economy. So you've got to get to the financial system first. Maybe it's useful to take it from the other perspective like he suggested. Let's get the economy itself at full employment, keep it there, get incomes growing, pay off all our income debts, and we'll have a much easier time with financial stability.
Bostjancic: I think it's a good point and it's not one that... as you said, it's a bit counterintuitive to how people sort of look at it. It sort of reminds of when I played a lot of sports growing up and even in college. There's a saying that says the best defense is a good offense. Not exactly the exact metaphor or parallel, but there is something to that. Let's strengthen the economy and make sure it's strong enough to be resilient to any of these exogenous shocks. But at the same time I think we do need some macro prudential [policy] and regulation because why not have both to have the best of both worlds.
There's a saying that says the best defense is a good offense...Let's strengthen the economy and make sure it's strong enough to be resilient to any of these exogenous shocks. But at the same time I think we do need some macro prudential [policy] and regulation because why not have both to have the best of both worlds.
Beckworth: Absolutely. Not to get on my soap box here, but that's why I'm a big advocate of nominal GDP level targeting because implicitly there's an argument inside of that that what you're doing is you're maintaining the expected growth path of dollar incomes for households and businesses and that allows them to meet their financial obligations, which in turn minimizes, doesn't completely guarantee but at least minimizes the prospects for financial instability. I think the Fed's average inflation targeting framework is a step in that direction. If they're going to make up policy, again, the policy is often sold in terms of higher inflation temporarily but really it's higher income growth, higher spending, temporarily. That's a similar way of restoring or maintaining that full employment, the ability to meet financial obligation. I am very hopeful that it will work despite my concerns and will contribute to financial stability going forward.
Beckworth: We have a few more minutes left, Kathy, and I want to end on this question. One of the big puzzles that we have faced in advanced economies over the past decade prior to the pandemic has been low inflation. The US had its inflation below target, but the ECB, Bank of Japan, Switzerland even more so, all these advanced economies seem to be plagued by low inflation and, for that matter, low interest rates as well. But I wonder, what is your take on what is fundamentally causing that? Is it bad monetary policy or just something else more fundamental?
What’s Driving Low Inflation?
Bostjancic: Our view, and we've done a lot of work at this at Oxford, is it's really predominate disinflationary forces that are outside the purview of central banks. It's technological gains, it's globalization, that playing a critical role. But that said, I think the framework review in the US, and I know Canada is embarking upon one as well and even the ECB seems to be looking at the dynamics of monetary policy. You could make the case that when we had all this disinflationary forces before in place that the Fed maybe was slow to realize that and did tighten policy too much. You can make that case maybe in their last cycle and then also this one. Maybe it's just incumbent upon central bankers. And I think the review sort of highlighted that, is that we're not going back probably to, and the Phillip's curve is flatter, a high inflation environment any time soon and maybe the focus should really be trying to employ as many workers as possible and just really promote growth.
We're not going back probably to...a high inflation environment any time soon and maybe the focus should really be trying to employ as many workers as possible and just really promote growth.
Beckworth: Yeah. That's the view I hold, too, that there's secular trends, developments, out there that have forced us into this corner. Maybe central banks could've done a bit better. They could've avoided raising interest rates like the Fed did between 2015 and 2018, but those trends are with us. Demographics, technological: a lot of things happening. I think it's important that we recognize that and wrestle with that, and I agree with you. The framework is a good step in that direction.
Beckworth: Well, Kathy, our time has come to an end today. It's been a real treat and pleasure for me to chat with you. Thank you so much for coming on this show.
Bostjancic: My pleasure, David. Really enjoyed the conversation.
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