MacroScope

Interview: Richmond Fed’s Lacker on Libor, ‘soggy’ growth and the limits of monetary policy

July 16, 2012

There appears to have been a significant slowdown in the second quarter. In particular we saw the pace of job creation slowed to a pace of 75,000 per month in the second quarter down from 226,000 in the first quarter and there are also concerns about slowing growth globally, beyond Europe but also in the emerging world and China, which was highlighted in the minutes (to the June meeting) this week. So, where do you think we’re headed? Are we just going to remain in a soft kind of pace? Are there upside risks to growth? Are there downside risks to growth?

Growth has definitely softened. The data are unmistakably weaker in the second quarter than we had hoped they would be. I think everyone recognized the first quarter and the end of last year were a little bit stronger than we might be able to sustain in the middle of the year but it’s definitely come in softer than I’d expected.

At the beginning of the year, it seemed as if Europe wouldn’t maybe weaken as much as we thought but lately the weakening from Europe has been coming online. In the U.S., I think we’re in a situation where we’re going to fluctuate from between the level where we are now to a level that’s more like we saw six or eight months ago. We’re going to have soggy patches, we’re going to have stronger spurts. If you look back over the last three years that’s the record you see. I don’t see a reason for that to change markedly.

There are some risks to that outlook. I do see downside risks of a more substantial global growth slowing than we’ve seen so far. I also see upside risks over the last twelve months. I think there’s enough potential for us getting past major sources of uncertainty. There’s a risk that resolving that uncertainty unleashes a stronger more positive outlook on the part of businesses and consumers that leads to stronger growth than we’ve seen so far.

And that would be some sort of resolution in Europe?

And the U.S. fiscal situation. On the real side I think (the risks) are sort of balanced. But my central outlook is for kind of soggy growth for the remainder of the year with the likelihood of some gradual pick up after that.

Since March or April I’ve marked down my forecasts a few tenths. I think it’s at roughly 2 percent for this year, fourth quarter-fourth quarter and more than that next year. Somewhat more. But you know that’s like a month old already so we’re going into another cycle and I’ll take a look at it again in the next couple of weeks.

So what about the outlook for inflation? Where do you see us heading?

The broader context is over the past two years moving upward from the low of around 1 percent by way of trend to around 2 percent now. In recent months, we’ve had lower inflation numbers because energy prices have been falling. That seems to have played out. Energy prices seem to have bottomed out. And I think after a month or two, after we get past that — the beneficial effect of falling energy prices — I think we’re going to trend back to about 2 percent. That’s where I see core trending in the next six to 12 months and my outlook for overall is to be a bit there. There are risks on both sides. Core might soften a bit relative to 2 (percent) but on the other side the drought condition, food and energy prices could tick up again so I see risks on both sides on inflation. But I think it’s a balanced outlook, I think it’s a good outlook.

We get much less credit that we deserve, I think, for having kept inflation through the last five years at around 2 percent, remarkably close to 2 percent on average despite wild swings in energy prices. We’ve sort of fulfilled the implicit promise that’s now official as of January of the 2 percent inflation trend that we achieved from ’94 on coming into this recession.

Two percent may be a magic number for inflation but it’s not that great of one for growth and I guess that’s the side that people are more disappointed in. You’ve been opposed to further monetary stimulus at this point and you’ve talked about the natural rate of unemployment … being somewhere not too far from where we’re at (8.2 percent in June).

Yeah, we might be pretty close to it right now.

If that’s the case, do you fear that public sentiment about the Fed, which is seen as a steward of economic policy — that by falling short on the growth side the Fed will erode its (credibility)?

The thing I worry about is that expectations for what the Federal Reserve –  what any central bank can do for real growth and labor market outcomes has become overinflated. I worry that people expect more than we can actually achieve on that. The science of it, the empirics of it that we understand are that the effect of monetary impulses on the economy – there can be an effect on growth and employment but they tend to be transitory and the effects on inflation tend to be persistent and long-lived, show up a little bit later. There’s empirics on this that go back decades that keep being confirmed in more modern models.

There was one paragraph in the minutes – suggesting several participants indicated an interest in exploring the possibility of new tools for monetary accommodation. I’m wondering what new tools are there? Some of the things that came up that people discussed – there was one camp of people that read it as liquidity actions because it came after the context of a European contagion problem but because of the word monetary or financial accommodation and they read it as something to the effect of what the Bank of England is doing with kind of lending, credit incentives and cheap funding for firms that can be shown to be making loans.

There’s no shortage of ideas out there. I probably don’t have anything to add on that subject beyond what’s already in the public domain. You cited a couple of things. It’s not hard to think of things that if you wanted to do more you could do.

But it’s nothing that you would favor in particular?

At this time I don’t see the need. I mean, inflation is about where (the Fed wants it). The evidence seems pretty strong to me that the impediments to growth don’t stem from just a sheer lack of spending capacity. Consumers have the capacity to borrow more and spend,  save less and spend. Businesses have tremendous capacity to lay their hands on the resources to invest, if they wanted to. I see the impediments as more on the supply side than on the demand side. And I don’t think those are things that monetary policy is capable of really remedying or offsetting to a substantial extent right now, so that’s a strong influence on my policy outlook.

In your dissent against the last decision, you cited the fact that inflation is already running close to target so how can we push any deeper on the pedal. But in the context of how the inflation target was framed, isn’t it kind of asymmetric to say – aren’t you treating it as a ceiling rather than a long-term target if you don’t allow it to fluctuate above target for some time.

Well, we’ve let it fluctuate. Last year it was about 2-3/4 on a 12-month basis for two or three quarters last year. We let it go up, we do that all the time. It’s just do you deliberately engineer it to go up? When it when up last year we had the expectation because of what energy prices were doing that it was going to subside back to 2 percent. So I don’t see this as an asymmetric approach. When you’re where you want to be you don’t push yourself off of it deliberately.

But then you’re really left with a troubling outlook for unemployment because when you let things get bad for that long, you get into the early stages of the kinds of problems that Europe is having where you get these large populations of disaffected youth and a general lack of hope in the outlook of people. […] Lately, America seems to have a low self-esteem. How do you get over that if not through some kind of stimulus — if it’s not monetary then doesn’t it have to be fiscal? Don’t we have to have jobs programs or more concrete opportunities for people, more direct ways for them to get from A to B?

I’d hesitate to make broad characterizations of current mood states for the country. There’s a lot that’s going on that’s good — there is a lot of growth and innovation going on. It’s not highly visible but there are new products, new companies starting up, new things happening. At the same time, the labor market clearly is having a hard time with this overhang of folks who’ve lost their job in this recession and in the recovery and are having a hard time finding a good, new place to work, a good new source of employment. That’s bound to be frustrating for a lot of people. It’s bound to be a cause for concern for people who have their jobs and who see their friends and neighbors who are unemployed. That’s bound to affect people’s broad sense of the dynamism of our country.

I think that impediments to growth are a lot of little things that have changed in the last five or ten years that are gumming up that engine that we’ve had in the United States that’s served us so well for so long, the engine of creativity and innovation and growth. I think we need attention at a kind of a granular scale at those impediments to growth, to resolving uncertainty about regulatory changes we have in train, to resolve uncertainty about regulatory costs, tax burdens. I think we have some work to do to clear that up. And it’s not a matter of – this isn’t a partisan agenda I’m sketching out, it’s decide one way or another how these things are going to go. Whatever value judgment we make about it, let’s make it and get on with it rather than fighting about it. I think that’s the key to unleashing more of that energy you talk about.

What do you make of trends in income inequality in this country? Do you think it’s a problem? It was the focus of these Occupy protests that seemed to come and then go. But it’s an issue that’s been on people’s minds. Inequality seems to be at its highest level since the ‘20s or ‘30s. Is that bad for the social fabric and for how people get along when it’s that extreme? Do you think CEOs, for instance — financial sector CEOS — are paid too much?

I see income inequality as the result of a broad array of forces. But broadly speaking the change in the technology that people use in the workplace has dramatically altered over the past four or five decades. The change in the technology used in offices and the factory floor has changed the skills that people need, has changed the return to having certain skills. That to me seems compellingly to be the fundamental, first order thing that’s driving the opening up of this gap. My broad concern is at this mid-skills level. Obviously there are personal services, physical therapists, nursing, business services where proximity is important. They’re going to do ok even if the skill level is a little lower. But at this middle skill level, I think we’re not keeping up and we’re just not developing the opportunities and not doing the training that we need for the middle class. I see that as the core thing behind these long-term trends.

One thing that’s been a factor in the trend of stagnant wages in the U.S. and kind of the changing skill sets that are relevant to the jobs available is competition with the overseas labor pools and China in particular. How big a factor do you think that is? How much of the China-bashing that comes out of Congress is justified? How many jobs are we losing to an undervalued Chinese currency?

That’s hard to quantify. But you know what we’re hearing from businesses from our region that compete with China or source to China is that that wage differential, that wage advantage in China, is rapidly closing and in some cases has evaporated. And that fits with what you would expect. It’s only temporarily that one place can be so out of line in costs with another place. Eventually it’s going to equilibrate across countries.

And as far as China’s slowdown – is that a big fear for you? It was cited in the minutes as a concern. […] Brazil seems to be slowing down pretty rapidly, India –  does the emerging world simultaneously slowing down with Europe leave us without an engine of growth?

I mentioned earlier that one of the downside risks is that the growth slowdown we’ve seen so far deepens further and broadens and is larger than we expect.

I want to talk about too big to fail, one of your favorite topics. I was thinking this week, after the ECB cut the deposit rate to zero and Denmark cut it to negative 25 basis points. […] It got me thinking about interest on reserves and the fact that one of the main restrictions to cutting rates all the way to zero is the notion that it could lead to trouble in the money market fund world. And given that the money market funds are themselves a kind of too-big-to-fail entity, is that another example of the too-big-to-fail problem interfering with the efficacy of monetary policy?

I don’t think of it that way. I don’t think of the money funds as an impediment to what we do with monetary policy.

You’ve been one of a few Fed officials who have talked about breaking up institutions?

I actually haven’t advocated that per se. Richard Fisher and some others are associated with that.

But I feel like you’ve hinted that you might be sympathetic to that idea.

In the piece I did with Gary Stern, the Wall Street Journal piece on living wills, I pointed out that if you’re an advocate of breaking up banks, you’re probably wondering how to know how to break them up – how small to make them, how to divide them, when do you know that they’re too complex. I pointed out that the living will work is exactly how you would find that out. You go through the planning exercise of figuring out just what it would look like to fail an institution, resolve, unwind, whatever you want to call it […] to resolve a failing financial institution without government funding. And figure out what the impediments are.

What is your feeling about the results of the first round of living wills that came out recently?

We don’t have the results yet. They’ve made their submissions. There’s a public piece of their submissions. Our staff is in the process of going over it. We’re involved with that work here at the Richmond (Fed) because of the large bank in Charlotte that’s participating in that exercise. In my view, this is the most promising aspect of Dodd-Frank. If we’re going to end too big to fail, this is our best hope.

How soon would you test that authority and on whom?

Well, as soon as you’re ready. These are tremendously large and complex institutions. There’re a lot of details to work through, a lot of work to be done. It’ll take some time, it’ll take a lot of effort, both on their part and our part and the third party consultants that are running around helping people do this – it’ll take a lot of work on a lot of people’s part to get to a point where policymakers can have that relative confidence.

Do you think too big to fail banks clog the transmission mechanism of monetary policy in any way?

No I don’t. They respond to incentives. Their short-term funding costs are lower than they otherwise would be and I think that’s clear from the rating agencies that give them an uplift of a couple of notches because of the implied government support. Even implicit support — because this uplift applies to things that aren’t insured by the FDIC. So it lowers their funding costs.

There are some analysts who see truly, truly robust capital requirements as a way to circumvent a very detailed regulatory process. It’s just like you have that inherent safety net of having a lot of capital – but nobody seems to agree on a figure and nobody really even seems to agree on what capital is. So where are we on the capital regime globally with Basel III, and what do you think is the right number?

I’ve always been sympathetic to more capital. Broadly speaking, we let margins get too thin going into the crisis and I think the corrective action the world’s regulatory community has taken since then has been very beneficial. So I applaud it. The difficulty is you have a number of authorities across the globe moving more rapidly or more aggressively than others – this tilts the playing field and could lead to moral hazards arising from a shift in activity to other institutions where you haven’t been as aggressive. So the international cooperation and coordination of these things is essential. While at times that may limit the speed and magnitude of the increases, I still think we’ve accomplished a lot with the Basel accords and the increases we’ve put in place and are planning for.

So you still think U.S. banks are well insulated from European contagion?

Yeah, the information we have suggests that the U.S. banking system has an exposure to European problems that is manageable.

Let’s talk about Libor a little bit. How big of a systemic risk do you see the Libor problem as? There’s a lack of trust on the part of the public, there’s a lack of trust on the part of investors. There’s the sense that you have the same old banks, up to the same old tricks and they’re getting away with it and they’re going to continue to get away with it. It strikes me as a much larger version of the robo-signing problem where you have blatant fraud and you have very little prospect of aggressive criminal action against people committing the fraud?

We have a lot left to learn about all the details of what went on, what banks’ reporting was like and how faithful it was. If you look at the design of the survey and the design of the mechanism to produce the Libor rate – it’s not asking for actual transactions, it’s asking a what if, a hypothetical. If you just looked at it, without having read any of these stories, you’d suspect that it provides some measure of discretion within narrow margins to an individual institution as to what they report. So it shouldn’t have been a surprise to anyone who read closely the procedures and the instructions to the survey respondents.

The survey arose decades ago in what was a relatively small and minor market and only later were all the dependencies on that indicative rate added. I think we’re likely to see substantial effort devoted to finding or constructing alternative measures that are less vulnerable to the exercise of discretion?

Do you have any suggestions in that vein? Is this something (the Fed) is working on?

Some research needs to be done on this but a seemingly attractive alternative is – GCF repo rates that are based on actual transactions in a very deep and liquid market and very risk-free and seem ideally suited for this. But I understand some work needs to go on to really drill down into that. It’s even more obscure sounding than L-i-b-o-r, but we can overcome that I bet.

Let me say about Libor that the revelations broadly are another episode that is damaging to people’s confidence in the financial services industry and that’s a shame.

In the minutes, there was some concern mentioned about getting to a point where the Fed has such a presence in the Treasury market that it begins to somehow affect the functioning of the market. […] Is this something you’re concerned about? Have you talked to market participants who are concerned about a shortage of Treasuries?

It is plausible that the scale of our holdings of Treasuries might be affecting bid-ask spreads in the market or might down the road should we expand it more dramatically. I think of those effects as sort of subsidiary to our policy actions. If we wanted to expand our balance sheet that would be a minor byproduct that I think markets can adapt to.

But I presume that if it comes to MBS supply it’s not an issue of clogging up the market but you just don’t want to be there because of your view that it’s fiscal policy right?

I favor a policy of the Federal Reserve holding only U.S. Treasuries as assets. For us to hold anything else is the functional equivalent of us selling Treasuries to the public and using the funds to invest in some private security, and I think that’s an inappropriate role for a central bank. I think it amounts to choosing to channel credit to a sector and I think the flipside of that is, if it has any effect unofficially in that sector, it must be having some countervailing cost to some other sector. Someone else must be getting less credit as a result.

What if the argument is made – I think some within the Fed view the problem as one of the efficacy of regular monetary policy. That is, if one of the principal channels of transmission for policy in the past was housing, and one of the key leaders of recovery, and if that transmission mechanism is broken, then maybe that’s why policy ends up pushing on a string.

This automotive analogy never did much for me. I don’t think of transmission mechanisms as broken or functioning or working. Housing varied with much greater magnitude across the business cycle because it’s more interest-sensitive than other sectors. You go across sectors and you see some are more interest-sensitive than others, investment is more interest-sensitive than consumption, it’s just been a standard feature of business cycles.

Having said that within each of those sectors there is supply and demand. And if the demand for something is low, it may be the most interest-sensitive sector around but demand might be really low and so reducing interest rates might do little for it. And I think that’s the situation we’re in with housing. We have a huge overhang in vacant homes, and we’re experiencing a broad shift away from ownership of single-family detached homes towards rental and multi-family units and I think that just exacerbates this oversupply which is largely single-family attached homes. As a result I think it’s going to be several years before we occupy the inventory we have adequately and need net new construction for an expanding population. […]

I don’t think we should look to housing to power the recovery. I’m gratified at the contribution it’s made recently to growth but I don’t think we should expect housing to be the engine that powers this expansion. So I don’t see it as an obstacle to overcome.

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