Macroblog

July 5, 2022

Workshop on Monetary and Financial History: Day One

On May 23 and 24, the Federal Reserve Bank of Atlanta hosted a workshop on monetary and financial history. The workshop was organized by Atlanta Fed economist William Roberds, in cooperation with Michael Bordo (Rutgers University) and Warren Weber (Federal Reserve Bank of Minneapolis, retired). The workshop featured seven paper presentations, along with three panel discussions and a keynote lecture.

Exploring fiscal-monetary interaction
The first session of day one of the workshop featured three papers that examine interactions between monetary and fiscal policy.

The first paper  of the session was presented by Michael Bordo and Oliver Bush (Bank of England) and coauthored with Ryland Thomas (Bank of England). Their paper examines causes of the 1970s inflation in the United Kingdom, which was higher than in other advanced economies at the time. Bordo and Bush presented structural decompositions of the 1970s UK inflation. These decompositions suggest that a combination of fiscal responses to external shocks and passive monetary policy was the principal causal factor. The same decompositions suggest that fiscal reforms enacted during the 1980s and early 1990s enabled the Bank of England to reduce inflation to more acceptable levels.

In the discussion , Joshua Hausman (University of Michigan) proposed that the authors emphasize narrative aspects of this historical episode. What economic models were most conducive to policies that led to double-digit inflation? Given that other countries were using the same models, why did reliance on these models result in worse inflation outcomes in the UK than elsewhere? Hausman also noted that the lower inflation rates achieved from the 1980s onward did not lead to uniformly better economic outcomes, in the form of higher trend economic growth, lower unemployment, and higher growth of real wages.

The fiscal-monetary theme continued with the second paper  of the session, which was presented by George Hall (Brandeis University) and co-authored with Thomas Sargent (New York University). Their paper compares the financing of US government expenditures associated with the COVID-19 pandemic to the financing of World Wars I and II, which gave rise to expenditures of comparable magnitude. Hall presented an accounting framework that decomposes wartime financing into three main components: taxes, debt, and money creation. This decomposition indicates that in contrast to expenditures during the two world wars, COVID-19 expenditures have been funded very little by taxes and largely by debt. Also different from the world wars is the fact that much of the COVID-19 debt has taken the form of monetary assets, interest-bearing Fed reserves, and reverse repos. Hall suggested that the experience of the world wars indicates that inflation will eventually amortize much of the debt induced by COVID-19.

The Hall and Sargent paper was discussed  by Chris Meissner (University of California, Davis). Meissner argued that the COVID-19 shock was different from the world wars insofar as it was largely unanticipated, simultaneously global, and associated with widespread financial market disruptions. For this reason, reliance on debt funding might have been a more appropriate policy than for either of the war episodes. However, Meissner also suggested that reliance on debt financing might have significantly reduced the United States' ability to respond to future external shocks.

The final paper  of the first session was presented by Eric Leeper (University of Virginia) and coauthored with Margaret Jacobson (Board of Governors) and Bruce Preston (University of Melbourne). Their paper focuses on the performance of the US economy during the Great Depression and argues that the economy's initial recovery in the early years of the Roosevelt administration can be attributed to fiscal expansion combined with the repeal of the gold standard. Leeper argued that latter policy enabled the Fed to finance much of Roosevelt's fiscal expansion via unbacked bonds, but that the recovery was then paused by more restrictive fiscal policies adopted after 1937.

Kris Mitchener (Santa Clara University) discussed  this paper in the context of the large literature on the Great Depression, which has generally emphasized monetary rather than fiscal policy as a driving force in the initial Roosevelt recovery. Mitchener noted that for this reason, the paper's fiscal-monetary focus represents a new explanation of the post-1933 recovery. However, Mitchener also noted that during the Depression, most individual Treasury bond holdings were limited to higher-income households and that this heterogeneity would matter for the paper's arguments. In addition, banks held many bonds, and it would be desirable to model the effects of fiscal expansion on banks' balance sheets. Additionally, Mitchener recommended that the authors consider the effects of US policies on its international trade.

Putting inflation into historical perspective
The second session of the conference featured a panel discussion of the current inflationary outlook in the context of earlier inflationary episodes. The panelists were Robert Hetzel (Federal Reserve Bank of Richmond, retired), Jeremy Rudd (Board of Governors), and Mickey Levy (Berenberg Capital Markets).

Hetzel proposed that there are enough commonalities of the current situation with historical episodes—particularly the inflationary acceleration experienced in the 1960s and 1970s—for the Federal Open Market Committee to consider formally integrating monetary history into the policymaking process. He argued  that this integration would lead to a more transparent statement of the FOMC's monetary standard.

Drawing on his experience at the Richmond Fed during the 1970s, Hetzel recalled the Federal Reserve's intense resistance at that time to explicitly articulating policy objectives. He argued that although there have since been improvements, the Federal Open Market Committee (FOMC) could better articulate a monetary standard through integration of historical perspectives into policymaking. More specifically, this proposal would include (1) establishment of a committee of monetary historians that would report directly to the FOMC, (2) a restructuring of the Teal Book (the briefing document prepared by the Board of Governors staff for FOMC meetings) to include a historical breakdown of how the economy got to its current state, and (3) replacement of the FOMC's current Summary of Economic Projections, which reports a collection of individual forecasts, with a consensus FOMC forecast that would be informed by consultations with the historian committee in part (1) of the proposal and the historical breakdown in part (2).

Rudd's presentation  focused on potential changes in underlying inflation dynamics observed since the start of the COVID-19 pandemic. Rudd observed that prepandemic, Fed policymakers had been able to rely on stable long-term trend inflation in the US economy, as well as a flat Phillips curve (a negative correlation between unemployment and inflation), although the factors giving rise to these favorable conditions were not well understood. This lack of understanding has hindered Fed policymaking post-COVID, when inflation has increased in part due to large relative price shocks, creating uncertainty as to whether trend inflation has now moved higher. To overcome this uncertainty, Rudd argued that it might be useful to examine historical episodes and, particularly, the increase in trend inflation observed during the late 1960s.

Rudd proposed that the underlying dynamics in the 1960s were different from those of the current economy, because of less anchored long-term inflation trends and a steeper Phillips curve. Hence, we should reject a repeat of 1960s-style overheating as an explanation for the recent pickup in inflation. A commonality with the 1960s, however, is that policies adopted then seemed reasonable at the time, and policymakers didn't foresee them as fostering persistent inflation. A major question for policymakers, then as now, is whether the recent acceleration in inflation reflects a fundamental shift in the structure of the economy. Rudd concluded by noting that by the time this question is answered, reversing any increase in trend inflation could be difficult.

Levy's discussion  focused on a recent research paper coauthored Michael Bordo. The paper surveys cyclical patterns of Fed policymaking over its entire history, from 1914 until present. Bordo and Levy argue that in these cycles, the Fed has had a general tendency to wait too long to remove monetary accommodation. They cite four factors behind this tendency: shifting doctrines about how monetary policy should be conducted, ambiguity surrounding the Fed's dual mandate, misreads of data on the state of the economy, and political pressures.

Levy proposed that these same factors have been present in the most recent policy cycle, leading to delayed removal of accommodation. Movement to a neutral level of policy interest rates will now be difficult, he argued, and—given current negative real interest rates—a hard landing has a high probability. Levy concluded with three recommendations for Fed policy going forward. First, the Fed should place more emphasis on rules-based policy (for example, a type of Taylor rule) as a benchmark. Second, the Fed should adopt a less ambiguous interpretation of its dual mandate. Third, the Fed should pay more attention to the lessons of history and incorporate these lessons into its policy doctrine.

The conference's keynote lecture  was delivered by Barry Eichengreen (University of California, Berkeley). Eichengreen's presentation surveyed the evolution of payments instruments over the past millennium, from medieval-era banknotes in China to today's digital forms of payment. A theme of the presentation was increasing technological efficiency: transactions in paper money were more efficient than the physical transfer of coins, and modern types of electronic transactions are more efficient still. The shift towards digital forms of payment has recently accelerated, Eichengreen observed, because of the COVID-19 epidemic, which led consumers to prefer online forms of payment. This shift has occurred in virtually every nation with a sufficiently advanced cellphone network, but especially in Sweden, which coincidentally was also an early adopter of printed banknotes.

Eichengreen noted that a factor that has worked against more widespread adoption of advanced digital forms of payment is that in most countries (with exceptions such as Sweden) these are not ubiquitous. Network externalities may soon lead to the emergence of dominant private forms of digital payment, however, but such dominance could result in monopoly pricing and the need for regulation. Blockchain technology alone will not by itself resolve issues with digital payments. Stablecoins have the potential to supplant paper currency for many purposes, but monetary history teaches that fractionally backed stablecoins might be susceptible to runs, again suggesting a role for regulation.

The lecture concluded with the observation that retail-level central bank digital currencies (CBDCs) might offer advantages in terms of ubiquity and stability, but CBDCs would simultaneously pose operational challenges for central banks and could encourage disintermediation of commercial banks. For these reasons, Eichengreen suggested that CBDCs are more likely to be issued at the wholesale level—for example, to commercial banks—and these banks would in turn manage CBDC transactions that their customers initiate.

In his closing remarks, Eichengreen argued that although paper currency has been a ubiquitous form of money only within a relatively short period of human history, its advantages mean that it will likely persist even as digital forms of payment become more widespread. As the latter become more prevalent, strong network externalities will necessitate government involvement, both through the provision of CBDCs and the regulation of private forms of money.

In tomorrow's post, I'll cover the presentations and discussions in the workshop's second day.

By Will Roberds, a research economist and senior adviser in the Atlanta Fed's Research Department

• July 5, 2022 in
  • Financial System
  • Fiscal Policy
  • Inflation
  • Monetary Policy
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June 23, 2022

Financial Markets Conference 2022: Exploring the Financial Sector

Note: This is the second of two posts discussing the Atlanta Fed's 2022 Financial Markets Conference. You can read the first part of the conference summary here.

The Atlanta Fed's 2022 Financial Markets Conference, A New Era of Financial Innovation and Disruption: Challenges and Opportunities, featured policy panels, academic paper presentations, and keynote speakers exploring various developments having a significant impact on the financial system. This Policy Hub: Macroblog post covers some of the key takeaways from the discussion of three challenges facing the financial sector: central bank digital currency (CBDC); environmental, social and corporate governance investing; and cybersecurity. All three discussions highlighted how the answers to some seemingly straightforward questions involve a host of complex considerations. (My companion Policy Hub: Macroblog post focused on discussions of the current monetary policy environment, with a focus on shrinking the Fed's balance sheet.) More information on all of the sessions is available at the conference agenda page, which has links to the various sessions' videos, papers, and other presentations.

Which CBDC, If Any, Is Right for the United States?
The issue of whether the central bank should issue a digital currency, and what form such a CBDC should take, is a topic that central banks around the world have been studying with varying degrees of interest, sparked in part by the development of cryptocurrencies. The intensity of that interest increased dramatically with the announcement by Facebook, now renamed Meta, that it was developing a stablecoin called Libra, later changed to Diem. (A stablecoin is a currency that maintains a fixed value relative to some other asset, especially a sovereign currency such as the U.S. dollar.) Meta has since stopped development of Diem and sold its assets. However, the questions surrounding a CBDC remain. The FMC's CBDC panel  pointed out that this seemingly simple question involves a variety of deep, complex issues for policymakers to consider.

The panel was led off by Nellie Liang, undersecretary for domestic finance at the US Department of the Treasury, who provided broad context for the discussion. Her remarks  and slides  discussed President Biden's executive order for government departments to study the issues associated with digital assets.

Afterward, Charles Kahn, professor emeritus at the University of Illinois, presented  his paper  on CBDC. The paper makes the important point that a wide variety of choices need be made in the design of a CBDC and that these decisions should be based the intended benefits from adopting a CBDC. Kahn noted that although a CBDC may have many benefits over the existing system, in many cases it is not clear whether a CBDC is the right tool for obtaining the benefits. He then discussed CBDC developments in four of the CBDC leaders: Sweden, Canada, the Bahamas, and the People's Republic of China. These four countries have different priorities and have taken different paths. The two closest to the United States in terms of economic conditions, Sweden and Canada, have both done extensive work but neither has yet implemented a CBDC.

Following Kahn, David Mills from the Federal Reserve Board presented  the Federal Reserve's current thinking about CBDC. He noted that the Federal Reserve had recently published a discussion paper, "Money and Payments: The U.S. Dollar in the Age of Digital Transformation ," as a first step in fostering a broad and transparent public dialogue about CBDCs as well as a call for comments on a variety of CBDC-related issues. Mills indicated that the discussion paper raised a wide variety of issues that would need to be considered before adoption of a CBDC. Mills cited support for the US dollar's international role and promotion of financial inclusion as some potential benefits. On the other hand, he noted the potential risks it raises, including consumer privacy and financial system stability.

Paul Kupiec, from the American Enterprise Institute, provided a discussion and an article addressing several issues raised by a CBDC. He concluded that the United States should not adopt a CBDC. Kupiec argued that the issuance of such a currency would likely result in political pressures affecting the type of CBDC issued and, arguably more importantly, could create political pressure on the Fed to manage the rates paid on a CBDC for the benefit of holders rather than for monetary policy purposes. He also noted the risk that a CBDC could lead to a run on banks, with depositors shifting their funds to a CBDC. He offered as an alternative the development of private stablecoins and tokenized bank deposits that could be used for payments.

ESG and Money Management
There can be little doubt that interest in the topic of investing based on environmental, social, and corporate governance—commonly known as ESG—has exploded during the last decade. Participants at FMC considered some issues that ESG investing raises for money managers. The discussions highlighted that this seemingly simple concept in fact raises a variety of complex issues whose answers may legitimately vary among different money managers.

Dissecting Green Returns
Do ESG investors pay a financial penalty when accounting for nonfinancial considerations, or are they being rewarded through "doing well by doing good"? In a session moderated by Paula Tkac of the Atlanta Fed, a paper titled "Dissecting Green Returns" and presented  by University of Chicago professor Lubos Pastor addressed these questions. Specifically, Pastor and his coauthors Rob Stambaugh and Luke Taylor looked at the returns associated with environmentally sustainable investments. They note a conflict between theorists and practitioners. Investors, money managers, and some studies suggest that green stocks tend to produce higher returns. However, theory suggests that ex ante expected green returns should be lower than investments that are not environmentally sustainable. Thus, Lubos and his coauthors study the performance of green investments. They find that the past performance was superior, but that this performance reflects the unanticipated increases in the climate concerns of investors and consumers. The superior returns disappear after controlling for changes in investors' level of environmental interest. Their findings imply that the strong historical performance of green assets does not suggest that we should expect higher returns for green assets in the future.

Anna Pavlova, of the London Business School, began her discussion  by highlighting the theoretical reason that ESG investing should bring lower returns. She notes that one of the goals of ESG investing is to reduce the cost of capital to green firms, which requires that equilibrium returns on green stocks be below that of the returns on brown stocks (that is, stocks of companies with a large carbon footprint). That said, she also observed that there are a variety of ratings of overall ESG performance and for the environmental component. However, the correlations of these ratings are rather low and sometimes negative for a variety of reasons. Pavlova pointed to a paper she coauthored that offers a possible solution for the variation in ratings.

The panel discussion  on ESG investing, moderated by S.P. Kothari from the Massachusetts Institute of Technology, delved more deeply into the issues associated with this type of investing. Laura Starks from the University of Texas presented  a paper  that raised a number of points on ESG investing. For example, she noted that the number of institutional investors, and the amount of institutionally managed funds devoted to ESG, have grown substantially.

However, Starks devoted a large portion of her presentation to the difference between ESG values (or values-based) investing versus ESG value investing. Some ESG investors avoid supporting (or investing in) companies that engage in activities that violate the ESG principles. Alternatively, some ESG values investors focus on affecting firms' ESG performance, which can mean limiting their supply of capital to firms that are not strong on ESG or through engagement with the management of firms that are not strong on ESG.

In contrast, Starks said that an ESG value investor approaches ESG from the perspective of the value of the firm as an investment. Thus, an ESG value investor is concerned that firms' poor ESG records are likely to have lower earnings or higher risk in the future, or even both. However, similar to ESG values investors, a value investor can implement the ESG value by avoiding firms with poor records, or by engaging with firms' managers in an attempt to improve the firm's ESG performance.

Lukasz Pomorski, head of ESG research at AQR Capital Management, built on Starks's discussion of ESG value versus values investing. He notes that up to a point, ESG can be valuable for risk management, but at a certain point it becomes a constraint that can have an adverse impact on a portfolio's financial performance. In response to a question from Kothari, Pomorski explained that binding restrictions not only affect portfolio diversification but also the ability of active money managers to exploit their skill. A money manager may have above-average ability to evaluate firms in some disfavored industries, but an excluded industry precludes that money manager from using that skill to benefit investors.

Pomorski also addressed a point that Starks's presentation touched on. Firms can be influenced in two ways: the cost of capital and voting stock ownership. Pomorski emphasized that these mechanisms sit in opposition to each other. The only way to raise the cost of capital is to sell the stock, but only shareholders own votes.

The final panelist, Mikhaelle Schiappacasse from Dechert LLP, reviewed the evolving ESG rules in Europe, especially those related to green finance. She observed that the European Commission has set a goal of net zero carbon emissions by 2050 and is intent on using regulations on investment to support that goal. Thus, the European rules are pushing firms and investors to divest activities with big carbon footprints and invest in those with smaller carbon footprints. However, Schiappacasse also discussed some complications in implementing these goals. One major issue is often called "greenwashing"—firms and investment managers creating only the appearance, but not the reality, of being green. Another complication she discussed is that ESG money managers can get a good rating only by investing in green assets, so they can't work with brown firms in an attempt to shrink their carbon footprint.

Cyber Risk in the Financial Sector
Finance and cyber risk management often have a hard time understanding each other, according to Patricia Mosser of Columbia University, the moderator of the FMC's cyber risk panel . In part, the lack of understanding arises from having different goals. Cyber risk is about avoiding adverse shocks, but adverse shocks are unavoidable in finance, so finance's goal is resiliency to those shocks. Another important difference is the nature of the shocks. Cyber risks, and their resulting theft or disruption, are the intention of whoever created them. Moreover, cyber shocks are not random but happen at moments of increased vulnerability. The occurrence and timing of financial shocks, on the other hand, are not intentional.

The presentation  , by Jason Healey from Columbia University, noted that the nature of the cybersecurity problem has increased considerably from the early years. Then, it was simply a matter of controlling access to the computer room, but more recently anyone connected to the internet is conceivably a threat. In some respects, however, the problem has not changed much since the mid-1990s, and many of the risks remain the same. What has changed is our capacity to respond. For example, in response to an audience question, Healey noted the development of cloud computing, which allows individual firms to reduce their individual exposure to cyber risk but at the expense of increased systemic risk by concentrating risk in relatively few vendors. Healy also listed the ways that cyber risks could become a financial issue, and then he listed some ways a cyber-driven financial issue could become a financial stability issue.

Stacey Schreft, of the US Department of Treasury's Office of Financial Research and currently on assignment at the Federal Reserve Board, discussed some issues and responses to cyber risk. Schreft's presentation  included figures showing some of the parties in the financial sector who are vulnerable to cyber risk and linking these to concerns about traditional financial sector risk. Among the responses she mentioned is the mitigation of vulnerabilities through the supervision of financial firms from the grassroots level. Another response has been increased collaboration across the financial sector, both within the United States and globally. These responses are attempts to strengthen vulnerabilities in the financial system's stability and improve the way we measure cyber risk.

By Larry Wall, research center executive director of the Atlanta Fed's Center for Financial Innovation and Stability

• June 23, 2022 in
  • Financial System
  • Monetary Policy
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June 3, 2022

Financial Markets Conference 2022: Normalizing the Fed's Balance Sheet

The Atlanta Fed's 2022 Financial Markets Conference (FMC), A New Era of Financial Innovation and Disruption: Challenges and Opportunities, featured policy panels, academic paper presentations, and keynote speakers who explored various developments having a significant impact on the financial system. This Policy Hub: Macroblog post offers some highlights from the conference keynote speakers as well as an academic paper and policy panel on normalizing the Fed's balance sheet. More information on all of the sessions is available on the conference agenda page, which has links to the various sessions' videos, papers, and presentation materials.

Keynotes
The four conference keynotes touched on a variety of issues. However, because of concern about inflation running well above the Fed's 2 percent target and about how the Fed will respond, a large part of the keynotes addressed monetary policy–related issues. The conference kicked off with a fireside chat  featuring Roger W. Ferguson Jr. from the Council on Foreign Relations and Atlanta Fed president Raphael Bostic. President Bostic asked questions touching on all four of the policy themes, taking advantage of Ferguson's diverse background as a former Federal Reserve vice chair and chief executive officer of the Teachers Insurance and Annuity Association–College Retirement Equities Fund. In talking about current Fed policy, Ferguson referred to a survey he led of corporate CEOs that included a question effectively asking if the CEOs think the Fed will successfully bring inflation down. The answer that many CEOs gave is that so many factors and forces are at work they cannot be 100 percent certain the Fed can do this.

Harvard economics professor Kenneth Rogoff gave the Monday night keynote speech  on the importance of the political economy. Most of Rogoff's speech recounted the economic and political conditions that led to the current relatively high inflation rates. He concluded by noting that if secular stagnation returns, the Fed could find inflation and market interest rates once again near zero. Should this happen, Rogoff argued, the Fed should be given the tools to drive nominal interest rates well below zero, if necessary, to counteract an economic downturn.

The Tuesday morning keynote  , "Inflation and the Policy Response to Supply Shocks," was given by Charles Goodhart of the London School of Economics and Manoj Pradhan, founder of Talking Heads Macroeconomics. In their presentation , they contended that the low inflation rate observed in recent decades was largely the result of a large increase in the labor supply, mainly due to China's integration into global markets. They noted, however, that this growing labor supply is in the process of reversing almost everywhere except in African countries. They contend that this reversal is likely to lead to slower growth, and potentially stagflation, in the medium run.

The final keynote was a fireside chat  featuring Bostic taking questions from Julia Coronado of MacroPolicy Perspectives. Their chat devoted considerable attention to the current state of the economy, including both the recent negative shocks to supply and the potential for positive shocks to supply. One potential positive shock that Bostic discussed is the adoption of new productivity-enhancing technologies. Coronado pointed to a 2019 conference jointly held by the Federal Reserve Banks of Atlanta, Dallas, and Richmond titled Technology-Enabled Disruption: Implications for Business, Labor Markets, and Monetary Policy. Bostic indicated that at the time of this 2019 conference, monetary policymakers were concerned that technology was disrupting markets in a way that would be adverse to workers' human capital but the current problem is a shortage of workers.

Discussing the Federal Reserve's balance sheet
During and after the financial crisis, the Federal Reserve increased the size of its balance sheet from under $1 trillion to more than $4 trillion. These purchases, part of a process often called quantitative easing (QE), were initially intended to support financial market functioning and later intended to provide additional monetary policy accommodation because the Federal Reserve decided to keep its federal funds target rate above zero. As the economy strengthened in the late 2010s, the Fed reduced its balance sheet to just under $3 trillion in what was often referred to as quantitative tightening (QT). However, with the onset of the pandemic, the Federal Reserve once again expanded its balance sheet to more than $8 trillion in assets. As with the first rounds of QE in the wake of the financial crisis, the initial goal was to support financial market functioning but later focused more on providing monetary policy accommodation.

With a relatively low unemployment rate and inflation rates far above the Fed's 2 percent target, the current focus on policy has shifted to reducing monetary accommodation, which includes shrinking the Fed's balance sheet. Along with several keynote speeches touching on this issue, one of the academic papers presented at the 2022 FMC addressed one aspect of the reduction—the effect of QT on financial conditions—and one of the policy panels examined a variety of issues associated with shrinking the Fed's balance sheet.

Addressing the Unexpected Supply Effects of QE and QT
One challenge with analyzing the effect of monetary policy on the financial system is that market participants often partially anticipate policy moves, and market prices might at least partially incorporate the moves before a policy move is even announced. Stefania D'Amico of the Chicago Fed and her coauthor Tim Seida sought to get around this problem in the cases of QE and QT by looking at unexpected changes in the supply of Treasury securities at specific maturities in their paper "Unexpected Supply Effects of Quantitative Easing and Tightening ." D'Amico explained that their methodology sought to identify the effect of QE and of QT by looking for kinks in the yield curve arising from the unexpected changes in supply. They found that Treasury yields are more sensitive to QT surprises than to QE surprises. These effects do not diminish during periods of market calm amid economic expansion but are increased by interest rate uncertainty.

The discussion  by Morten Bech from the Bank for International Settlements highlighted the implications of the paper for both US domestic markets and the markets of other developed countries. In domestic terms, D'Amico's paper estimates the average supply effect of about 21 basis points (bp) per $1 trillion in balance sheet reduction, which increases to more than 70 bp when uncertainty about the 10-year Treasury rate is especially elevated. He noted that these estimates are consistent with Fed chair Jerome Powell's estimate of 25 bp per $1 trillion (which Powell says has "very wide error bands") and one market participant's range of 7 bp to 42 bp per $1 trillion. On the international front, Bech noted that the Bank of Japan and the European Central Bank have balance sheets that are significantly larger, as a proportion of their economies, than the Fed's. Thus, QE and potentially QT are not only a US issue but one relevant to other major central banks.

Examining Challenges during Balance Sheet Normalization
The panel discussion  of monetary policy and normalizing—or shrinking—the Fed's balance sheet started with the panel's moderator, Vincent Reinhart from Dreyfus-Mellon, presenting  a review of the current situation. Reinhart noted that the unemployment rate had dropped to near prepandemic lows and that inflation rates were at 40-year highs, prompting the Federal Open Market Committee (FOMC) to announce plans to raise its federal funds target rate and reduce its securities holdings.

Cleveland Fed president Loretta Mester provided additional perspective on balance sheet normalization. She observed that the FOMC's planned reduction will reduce securities holdings faster than what occurred after the financial crisis, but that this faster reduction reflects the current strength of the economy and the high levels of inflation. She also observed that the FOMC's statement didn't address two items. First, the announced plan talks only about reduced reinvestment of maturing securities and does not address the issue of balance sheet sales. In the panel's question-and-answer period, Mester observed that such sales of agency securities may be necessary if the FOMC is to meet its goal of having its portfolio consist predominantly of Treasury securities. Second, the FOMC had not set a target for the size of its balance sheet, only that it intends to operate in an environment of ample reserves.

The next panelist, Seth Carpenter from Morgan Stanley, forecast that the peak of the fed funds rate would be about 3.25 percent and that it would take the Fed about two-and-a-half to three years to reach its balance sheet target. He added his belief that financial market prices (except for some credit markets) already reflect most of the effects of the announced changes. Carpenter also suggested that it was unlikely the Fed would engage in the sale of mortgage-backed securities, observing that housing is among the most cyclical of sectors and that tighter monetary policy would likely slow it down enough.

Brian Sack from D.E. Shaw noted that it is not often that a market participant announces a planned reduction in the size of its balance sheet by $2 billion to $3 billion, as the Fed has done. He said he anticipates that QT will likely have a moderate effect on market rates, perhaps raising the 10-year Treasury yield by somewhere in the range of 25 bp to 30 bp. However, Sack observed, the reduction in reserves could lead to a strain in funding markets, like that experienced in September 2019. Sack suggested that although pricing is a clearer signal than balance sheet size per se, the Fed should watch behavior in money markets closely to judge when reductions could lead to strain in the markets.

The last panelist was former Federal Reserve Board governor and current Harvard professor Jeremy Stein, who focused on QT's potential to cause strains in money markets and threaten financial stability. In his view, the villain is the minimum leverage ratio requirement (the minimum ratio of capital to total assets a given bank must hold) imposed on banks by their regulators and especially its effects on the largest banks, which are also critical participants in money markets. Stein noted that the problem with the leverage ratio is that it does not account for the risks different types of assets pose. In Stein's telling, the ratio effectively penalizes banks' holdings of low-risk assets, especially the holding of reserves. Ideally, he said, the risk-based capital ratio that does not impose a similar penalty on low-risk assets would be binding, but he thinks that regulatory policy is unlikely to be changed in such a way that the risk-based ratio would become binding. Thus, Stein suggested that the Fed narrow the gap between the interest paid on bank reserves and the rate with which the Fed engages in reverse repurchase agreements with some money funds and other money managers, which would result in banks holding lower reserves and thereby relaxing the constraint imposed by the leverage ratio.

Please check Policy Hub: Macroblog soon to read my post summarizing the rest of the 2022 FMC. I will highlight three other important issues discussed there: central bank digital currency; environmental, social, and corporate governance (commonly known as ESG) investing; and cybersecurity.

By Larry Wall, research center executive director of the Atlanta Fed's Center for Financial Innovation and Stability

• June 3, 2022 in
  • Financial System
  • Monetary Policy
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December 2, 2021

Atlanta Fed Conference Investigates Inequalities in the Financial System

A commitment to an inclusive society also means a commitment to an inclusive economy. Such an economy would represent a rebuke of systemic racism and other exclusionary structures. It would represent a true embrace of the principles that all are created equal and should enjoy unburdened life, liberty, and the pursuit of happiness.

— Raphael Bostic, president and CEO of the Federal Reserve Bank of Atlanta, from the essay A Moral Imperative and Economic Imperative to End Racism

Despite the nation's progress toward a more inclusive economy over the last half century, vestiges of structural discrimination are still entrenched in US institutions, and often manifest themselves in the form of disparities in economic outcomes. To promote the topic of racial equality, the Atlanta Fed has partnered with other organizations, cohosting, hosting, or participating in several recent events, including the Atlanta Fed-Princeton University conference on Racial Justice and Finance in September 2020 and the Racism and the Economy webinar series, which began in 2020 and will conclude in early 2022.

On October 14–15, 2021, the Atlanta Fed kicked off the inaugural conference on Racial Inequality and Disparities in Financial Markets to further promote research on inequalities in the financial system. The conference, which was virtual, included presentations and discussions of six papers on racial or gender disparities in various financial markets, including credit markets for mortgages and automobiles, labor markets, and the academic finance profession.

Paula Tkac, associate director of the Atlanta Fed's Research Department, gave the opening remarks. She began by describing how researchers face a dearth of high-quality data in this area, but shared she is hopeful the increased interest in research on racial inequality will spur the effort needed to bring together better data sets. Tkac then called for "a deeper understanding of the 'whys', and insight into potential paths forward toward full economic inclusion" as research progresses. She stressed that this research is crucial in the context of the Fed's monetary policy mission, as a fuller understanding of the barriers stopping individuals from participating to their full potential in labor and financial markets is necessary for good policymaking. Tkac concluded her opening remarks with a quote from Atlanta Fed president Raphael Bostic from last year's Racial Justice and Finance conference:

The influence of race is multidimensional and persists over time. We must look "under the hood" at our institutions to see and truly understand their design and its implications...In your research, think about how you ask questions, particularly how you incorporate historical and institutional realities into your research designs. Examine the role played by institutions and structures and explore how the burdens they impart have contributed to inequities that are still with us...With such an understanding, we can then find more creative and accurate ways to incorporate race into our models, estimation approaches, and narratives. This, I hope, will yield better insights and result in a set of policy prescriptions that can truly create meaningful and lasting change.

Three papers in the conference examined racial disparities in mortgage lending. In "Racial Disparities in Mortgage Lending: New Evidence Based on Processing Time," authors Bin Wei (Atlanta Fed) and Feng Zhao (University of Texas–Dallas) looked at racial disparities in mortgage processing time, which is the time needed for a loan to be processed. Looking at the period prior to the 2008 global financial crisis, they found that Black borrowers experienced significantly longer processing times (about five days more) than did White borrowers for mortgages securitized by the government-sponsored enterprises. In contrast, processing times for the privately securitized mortgages were much shorter for Black borrowers, driven by the fact that Black borrowers were more likely to use nonstandard mortgage financing channels where fast-processing lenders and loan products proliferate.

In the second paper focusing on the mortgage market, "Mortgage Prepayment, Race and Monetary Policy," Kris Gerardi (Atlanta Fed), Paul Willen (Boston Fed), and David Zhang (Harvard) found that Black and Hispanic borrowers pay significantly higher mortgage interest rates than do White and Asian borrowers, and that the primary reason for the large gap in rates is due to differences in refinancing behavior. Minority borrowers are significantly less likely to have refinanced their loans in response to declines in mortgage interest rates, and as a result, they benefited less from lower interest rates.

In the third mortgage paper, "Mortgage Policies and Their Effects on Racial Segregation and Upward Mobility," Nirupama Kulkarni (Centre for Advanced Financial Research and Learning) and Ulrike Malmendier (University of California–Berkeley) noted that housing policies aimed at reducing racial disparities in home ownership can have unintended adverse consequences. Exploiting variation in the ease of mortgage financing created by the 1992 GSE Act, which explicitly targeted underserved neighborhoods, they showed that, while Black home ownership increased in targeted neighborhoods, white families moved out. As a result, segregation increased and the upward mobility of Black children deteriorated. They pointed to declining house prices, reduced education spending, and lower school quality in targeted areas as plausible channels for the decline in upward mobility.

The paper "Testing Models of Economic Discrimination Using the Discretionary Markup of Indirect Auto Loan" by Jonathan Lanning (Philadelphia Fed) examined racial discrimination in auto lending. Lanning presented some compelling empirical evidence for taste-based discrimination in the auto loan market. Auto loans are typically the largest consumer loans after mortgages. More than 80 percent of these loans are indirect, meaning they are arranged by a dealer on the borrower's behalf. The dealer has the discretion to mark up an indirect auto loan by as much as 250 basis points over the rate at which the lender is willing to extend credit. In exchange for the rate increase, the dealer receives additional compensation from the lender. Lanning found that the average markup for Black borrowers is about 14 basis points higher than for White borrowers. More importantly, the racial disparity in the markup is shown to be consistent with the taste-based discrimination theory developed by Becker (1957).

The final two papers in the conference examined the gender gap in the academic finance profession and in the labor market. In the paper "Diversity, Inclusion, and the Dissemination of Ideas: Evidence from the Academic Finance Profession," authors Renee Adams (University of Oxford) and Michelle Lowry (Drexel University) examined how diversity relates to variation in career outcomes within the academic finance profession. They conducted their research based on a survey they administered to current and recent past members of the American Finance Association (AFA) on the professional climate in the field of finance. The survey had 1,628 respondents, about 30 percent of them female. Survey results suggest that female finance faculty members in general have a lower satisfaction level than do their male counterparts. The authors found that gender discrimination is one of the most important causes for this discrepancy.

In the final paper, "Hidden Performance: Salary History Bans and Gender Pay Gap," Jesse Davis (University of North Carolina), Paige Ouimet (University of North Carolina) and Xinxin Wang (University of California–Los Angeles) looked at how salary history bans affected the wage gap between male and female workers. These bans prevent employers from requesting and using a job candidate's prior salary information. Many states have adopted these bans with the explicit intent of reducing the gender pay gap. The idea is that historical pay discrimination against women is propagated if employers are allowed to use past salary information to set pay for new female hires. Presumably, imposing bans should prevent the perpetuation of past discrimination. However, the bans have the additional, negative consequence of preventing potential employers from observing a signal of worker productivity. So the overall effect of salary history bans on the gender gap is unclear. Using a large-panel data set of disaggregated wages covering all public sector employees in 36 states, the authors do not find evidence that salary history bans significantly decrease the gender pay gap.

All in all, the conference proved to be a memorable event. Papers incorporated high-quality micro data and state-of-the-art empirical methods that uncovered evidence of racial and gender inequalities across a variety of financial markets. The paper presentations and thoughtful discussant presentations spurred a lot of dialogue and debate around the nature of the disparities and their implications for future policy. We hope to hold similar conferences in the future, perhaps on an annual or biennial frequency, to continue to promote and raise awareness of this topic.

Bin Wei, a financial economist and adviser,

Kristopher S. Gerardi, associate policy adviser and economist in the Research Department at the Atlanta Fed, and

Feng Zhao, an associate professor of finance at the University of Texas at Dallas

• December 2, 2021 in
  • Financial System
  • Inequality
  • Monetary Policy
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