26th Annual Financial Markets Conference Transcript: Policy Session #4: Monetary Policy and Financial Stability Challenges During Balance Sheet Normalization - May 10, 2022

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Policy Session #3: Cyber Risk in the Financial Sector

Transcript

Vincent Reinhart: Good afternoon, everyone. We're about to start, so if you would find your seats, also find your laptop or phone, because you are invited to submit questions through Pigeonhole. We'll be checking it during the course of our remarks. At the outset, I'd like to thank the organizers for the invitation to be here and extend the same thanks to my colleagues sitting up here. I want to compliment them for scheduling this conference after a week of meaningful macroeconomic data and monetary policy events, notwithstanding the decision to make Mother's Day a travel event. For those of you who are planning in advance, next year's conference will definitely miss the employment report, probably miss the FOMC meeting, but most assuredly will impair Mother's Day.

We know from last week, from the employment report, that aggregate demand retains sufficient momentum to justify adding nearly a half million workers on net to payrolls. Those supply constraints still linger, in that there's a hesitancy to rejoin the labor market that keeps the participation rate well below pre-pandemic levels. As a result, the unemployment rate is back in the neighborhood of 3.5 percent. Supply disruptions and labor market pressures add to costs, and pressures on costs are adding to inflation, putting it at a 40-year high. I've plotted here the Fed's preferred price index, personal consumption expenditures, both headline and core, but it doesn't really matter. Pick any measure you want, it'll just change the left axis and it will still be appropriate to say, "and it's at a 40-year high."

Not surprisingly, a central bank with a dual objective of maximum employment and stable prices has set policy in motion. We learned last Wednesday that the FOMC not only raised the funds rate a half percentage point, it signaled that more of that magnitude is to follow. Market participants got the memo, in that Fed funds futures at the right are pricing in two half-point policy firmings at the next two meetings, and a funds rate that tracks into 3 percent next year.

As the FOMC statement also related, the balance sheet is in motion as well. Downward, beginning June 1. Working from a portfolio of $5.75 trillion worth of Treasuries, and $2.75 trillion of mortgage-backed securities, the Fed is going to get into motion to roll off ultimately $95 billion dollars of securities per month. In the meantime, the Fed's balance sheet will remain large, with its liability split between currency reserves and a large rolling book of reverse RPs.

This group will talk about both the setting and implementation of monetary policy, where the Fed should go, and how it should get there. Everyone in the group actively follows monetary policy from one side or the other of the public-private sector divide, and all spent time in the boardroom one time or another at FOMC meetings, with two actually raising the hand to vote on monetary policy, and one of them who still does.

Their bios are in the program, so I'm going to just introduce them in the order they're speaking and then have them speak for something on the neighborhood of five minutes. Then we'll turn it into a conversation. In that conversation, we want to include you. Please do put your questions into the app.

Speaking first will be President Loretta Mester of the Federal Reserve Bank of Cleveland, then Seth Carpenter of Morgan Stanley, Brian Sack, down at the end, of D. E. Shaw, and then Professor Jeremy Stein of Harvard. I'm going to ask Loretta to take it from here.

Loretta Mester: Okay, thanks very much, and thanks President Bostic, who is sitting over there, for inviting me. I've had the opportunity to speak and participate in a number of these conferences over the years, and I always am really pleased about how interesting the conferences are because they blend research and policy issues, and they never disappoint me. They're always excellent, and this year's conference is no exception.

What I thought I'd do in my remarks...I have the easy job, because I'm going to tell you what the Fed did. These guys are all going to tell us whether we did the wrong thing, the right thing, where we're going. I'm going to just describe how the FOMC intends to significantly reduce the security holdings on our balance sheet. Of course, these are my views and not those of the Federal Reserve System or the FOMC.

Throughout the pandemic, in addition to using our interest rate, our Fed funds rate, we've also used the balance sheet as a policy tool. We bought large volumes, as has been said, of Treasury securities and agency mortgage-backed securities. Our balance sheet now is about nearly $9 trillion in assets. It's about twice the size as it was before the pandemic. These asset purchases really were an important part of the policy response, first to the severe strains that were in the financial markets early in the pandemic, then throughout the pandemic they helped to support the economy.

Now we have markets that are functioning. We have a solid expansion underway. We have inflation far above our 2 percent long-run goals, so at the May meeting last week, the FOMC decided it's going to begin reducing the size of its balance sheet starting in June. Really to lay the groundwork for that, and to help prepare the financial markets, the FOMC after its January meeting had released a set of guiding principles for the reduction, then the committee gave more specifics about its plans in the minutes to the March FOMC meeting, and the plans announced last week are consistent with the earlier communications.

The balance sheet reduction is going to be done in a predictable manner, primarily by adjusting the reinvestment amounts of principal payments the Fed receives on its assets. Starting in June the Fed is going to allow up to $30 billion per month of Treasury securities, and up to $17.5 billion of agency securities, to run off the balance sheet. After three months, those caps are going to be $60 billion per month for Treasuries and $35 billion per month for agency securities.

To the extent that maturing Treasury coupon securities are less than the monthly cap, Treasury bills are going to make up the rest of the runoff, up to the cap. The plan was set by drawing on experience from the last time we reduced the balance sheet significantly. That was October 2017 through August 2019. Those assets, of course, had been purchased in the wake of the Great Recession. There's some important differences between what we did last time and this time. Last time the runoff caps were initially set at $6 billion per month for Treasuries and $4 billion per month for agency securities, and the phasing was very gradual. The caps increased by $6 billion and $4 billion respectively, every 3 months over the next 12 months, to $30 billion for Treasuries and $20 billion for agency securities.

This time, the phasing is only three months and the monthly runoff caps total $95 billion. That's almost twice the size as last time. Another difference is that last time balance sheet reduction started almost two years after liftoff of the funds rate from zero. This time it's starting about two-and-a-half months after liftoff. I think the thing to note is that, even though the gap between liftoff and the start of balance sheet reduction is much shorter this time, the level of the target range of the funds rate is only 25 basis points lower this time. That's because the funds rate rose very gradually last time.

Why the differences this time versus last time? It's because the economy is in a very different place than it was then. When the Fed began reductions in October 2017, balance sheet assets had grown to about $4.5 trillion, or about 22 percent of GDP. Reserves were about $2.2 trillion, or 11 percent of GDP. The unemployment rate was about 4.25 percent. Real output growth was near 2.7 percent, and inflation was running still slightly below 2 percent. In contrast, now the balance sheet is about $9 trillion, or 37 percent of GDP. Reserves have been averaging around $3.8 trillion, or about 15 percent of GDP. Labor markets are very tight. The unemployment rate is at 3.6 percent. The economy grew 5.5 percent last year, and instead of being below our goal PCE inflation is currently 6.6 percent, as has been said, a 40-year high.

Let me finish by discussing two items that the plan announced last week didn't address. The first is asset sales, and the second is the size of the balance sheet when reductions will end. The plan didn't rule out asset sales, and I should point out the FOMC hasn't discussed sales, but the minutes of the March meeting indicated that FOMC participants generally agreed that after balance sheet reduction was well underway, it would be appropriate to consider sales of agency mortgage-backed securities.

Now, an important benefit of sales is that they're going to help to speed the return of our portfolio's composition to being primary Treasury securities. That's consistent with the FOMC's stated desire in our principles to minimize the effect of the Fed's balance sheet holdings on the allocation of credit across economic sectors. One potential way to implement sales would be to sell agency securities up to the cap in any month in which principal payments were less than the cap. That's similar to our treatment of Treasuries. Another way to implement sales would be to set a monthly floor on reductions, which would be met first by principal payments received and then by sales. A potential drawback of sales is that, depending on the interest rate path, they could result in realized mark-to-market losses, which would lower the Fed's remittances to Treasury. It's important to note that such losses would not entail any operational challenges for the Fed in setting monetary policy, but they would pose communication challenges that would need to be appropriately addressed so that the public would understand the benefits of returning the balance sheet to a more normal size and composition, despite the losses.

Second, the plan did not indicate the size the balance sheet will be when the FOMC ends the reductions, but it did give some guidance. We're implementing monetary policy with an ample reserves operating regime, in which reserve levels are ample enough that control over the federal funds rate and other short-term interest rates is executed primarily through setting the Fed's administered rates, and active management of the supply of reserves is not needed.

The FOMC intends to slow and then stop the decline in balance sheet assets when reserve balances are somewhat above the level it judges is consistent with ample reserves. Once runoff has stopped, reserve balances will likely continue to fall for a time, reflecting growth in other Fed liabilities, until the FOMC judges that they have reached that ample level. At that point, the FOMC will then manage its security holdings to maintain ample reserves over time. The ample reserve level is uncertain. It's going to depend on the banking sector's demand for reserves, as well as the distribution of that demand across institutions. That's going to evolve over time.

If you look back at the last reduction episode, the FOMC ended run off when reserve levels were about $1.5 trillion, or 7 percent of GDP. When stresses developed in the short-term money markets in mid-September 2019, the FOMC judged that the level of reserves had fallen below the level consistent with ample reserves. In October 2019, the FOMC began purchasing Treasury bills and conducting term and overnight repurchase agreements, operations to maintain reserve balances at or above the level that prevailed in early 2019. This time, as the process to reduce the balance sheet progresses, we're going to once again be monitoring developments in money markets to determine that appropriate level of reserves at which to end the balance sheet runoff. Of course, it's going to be consistent with maintaining that ample level of reserve balances over time.

That's just a brief summary of what the plan is for the balance sheet. I'm really looking forward to hearing the other comments of the panelists here, and the discussion. Thanks.

Reinhart: All of us. Seth, why don't you enlighten us?

Seth Carpenter: Well, I'll at least give you some of my thoughts. Whether they're enlightening or not remains to be seen. Thanks for that, Loretta. I think that was very helpful to lay out the official view. I would also like to thank Raphael for having invited me to come down to be part of this. This has been a great conference so far.

"Where are we? How did we get here? What's coming next?" That is some of what I was going to talk about vis-à-vis policy in general, but specifically balance sheet policy. I think one important starting point is that this version of QE ended up being a bit different than what we had seen before. They were buying $120 billion per month versus the peak of $85 billion per month in the previous one. When the most recently ended QE started, the committee was saying that they were doing it for two reasons. One, for supporting financial market functioning. Second, to provide macroeconomic support.

I think that's an interesting point. Between this conference and the conference at the Hoover Institute at the end of last week, there are a lot of discussions. Is the Fed behind the curve? Have they made a mistake? I personally don't think where we are now, given how dramatically they've shifted course that you want to argue that they're too far behind course right now. If you did want to make a bit of a criticism, I still remember back in June of 2020 wondering why the pace of purchases was still at $120 billion per month. It seemed like, by that point, financial market functioning had been stabilized. Sure, you could make an argument for more macroeconomic support, but presumably the way to do that is through duration extraction so they could have dramatically cut the dollar volume, the nominal volume, done longer-term securities much like in especially the last version of the asset purchase program, the QE program, and had a smaller nominal amount. That would have made it easier, I think, to taper more quickly, to pivot, to reverse course. I actually think it's important to think about how we got here. In particular, the FOMC was buying from 2s all the way out to 3s. I personally struggled, again, from like June of 2020 until the end of the QE program, to know what the benefit of all those purchases of 2s and 3s were, but we are now where we are.

The balance sheet from February 2020 till March of this year went from 4.25 trillion to 8.9 trillion. That's huge. Then, of course, we got the taper and we're starting with hikes, and the QT is going to start in June, as Loretta laid out. What does come next? I think it's important here to think about QT in the context of overall monetary policy. We're going to have both the continued increase in the funds rate and the runoff of the balance sheet. The Morgan Stanley house view is that the peak for the funds rate next year is going to be about 3.25. That's consistent with the chart that Vincent had up from the market pricing. Where does this go? We think it's going to take something like two and a half, maybe up to three years, getting the balance sheet down to something like 6.5 trillion, maybe a little bit less. I think Loretta's elaboration on the endpoint was helpful. The committee said they're going to slow things down and then stop before they think they have to stop, so as to avoid the mistake/issue/problem, whatever noun you want to use, of September 2019. That's why we have reserves in our projection being the limiting agent for the shrinkage, and getting down to something like $2.25 trillion, and then that gets eaten down over time.

I think there are huge amounts of uncertainty there, and Loretta mentioned all the other liabilities on the Fed's balance sheet that can end up draining reserves. The clear one is the growth rate of currency that is going on. I think it will be an interesting question over time, and maybe we'll discuss this on this panel, what happens with the reverse repo facility, both flavors of it, the market-based one and the official institution one. The Treasury Department is now running a much larger cash balance than they ever have historically. To the extent that the economy is trending up in nominal terms, and government spending is trending up in nominal terms, maybe think the TGA should also be trending up. I think there's a huge amount of uncertainty about where the endpoint is, and I think the FOMC is extraordinarily well advised to do what they're doing, which is to say, "We don't know yet. We're not going to lay out the definition now." There's so much learning to be done between now and then that I don't think they need to lay it out.

What's the point of QT? We have inflation. Inflation is too high. Some portion of the excess inflation is temporary, frictional, and some part of it is standard macro inflation. QT is tightening policy, tightening financial conditions. Slow the economy. Trying to get a soft landing means slowing things a lot, but not too much. Here, I'd just point out again, why I'm not in the camp that the Fed is so egregiously behind the curve that there should be pitchforks and torches. Housing affordability is now the worst it's been in decades. Part of that is the rally in house prices, but mortgage rates have gone up a lot. That's very much due to monetary policy. Credit spreads and MBS spreads have already gotten wider. Again, that's the market seeing where the Fed is going, and starting to price it in. Equity markets are down a lot, and the 10-year is up something like 160 basis points year-to-date. All of that is the tightening of financial conditions. That is utterly and completely intentional by the FOMC. Tightened financial conditions slow the economy.

I think the cautionary tale, though, is that we haven't really seen this exact movie before. This is the first time the Fed's been hiking to reduce inflation since the '70s. I think that distinction matters a lot. As Loretta pointed out, the last time the Fed was hiking to keep inflation from going up too far above the target, it was still below the target. This time is different in that regard. We're facing much stronger growth now, and that was also part of Loretta's point. How should we think about QE in this context? I thought the paper that Stefania presented earlier was fantastic, really helpful. I am going to refer to Morten's comments on Stefania's work, so I'm almost surely butchering these things, but that QT looks a lot like QE with a negative sign. I think that's only true specifically the way Stefania laid it out, already adjusting for duration. When we think about what happened with QE, the Fed went out in the market and they bought specific securities in the secondary market. That is differential liquidity events, and they got to choose the maturity profile. The increase in supply from QT is going to come from Treasury issuance, and every time Treasury has to pick up their issuance to provide more funding, they do a lot more with bills. If you looked at the last couple of refunding announcements from the Treasury, there's going to be a little bit of an overweight of issuance towards the front end of the curve so the maturity profile of what's returning to the market is going to look a bit different than what it took away.

My colleagues at Morgan Stanley who do asset price strategy think that most of it's in the price already, with some exception for the credit markets. That seems right, but I think the other part that's important is it's uncertain. Where is the Fed likely to end up? In my view, the FOMC is going to look at what's going on with financial conditions tightening, with the economy and the real side, whether it's slowing enough. If there are huge uncertainty bands, if it's not doing enough, then you raise the funds rate more. If it's tightening things too much, then you do less. We saw this before the end of 2018, the beginning of 2019. Balance sheet was running off, funds rate was going up, market started to crack, and the Fed reversed course. I think that episode is really useful whenever you hear Chair Powell talk about being nimble. That willingness to respond to things is pretty critical.

I'll throw out, without an answer, a question. Maybe Brian can address it. There is an interaction between higher rates and the market having to hold more paper. Presumably some of the extra paper that the market's going to have to hold is going to get held by people who do it with leverage, through repo. Can we really be confident that everything is in the price if repo rates are going to be that much higher, or the rate that firms are going to have to pay to finance their holdings of securities are going to be that much higher in the future? I'm not sure.

I want to end with one observation. I thought Loretta helpfully brought up the fact that the committee has said that they will, in the future, discuss mortgage-backed security sales. Not that they've committed to it. I think my reading of the minutes is that there's more openness to it this time than there was last time. Last time it seemed like a very remote possibility. This time, it seems there's more active discussion. In our baseline forecast we have to write down what we think is going to happen, and it's not based on where the committee is now. It's our best guess of where things are going to be in the future when they have this conversation. We came to the conclusion that it's probably not going to happen, but for a very specific reason. The point of all of this is to slow the economy down enough, but not too much. Housing is always a sector that's most cyclical and reacts to monetary policy. We think housing activity will have slowed a lot over this next 6-9 months. By the time the discussion comes around I think it will be the judgment that we've got enough slowing in that sector that it won't be necessary.

Morten stressed this in his presentation, and he quoted Chair Powell in saying, "We really don't know how big these effects will be." If you're getting all of the slowing that you want, or most of the slowing that you want, and you could introduce sales into it but you're not really sure how big a deal that's going to be, I suspect caution will win the day, and they just end up, if it's not quite enough, to do a few more interest rate hikes rather than sell MBS. Now, if that forecast is all wrong, and the economy is blisteringly hot, and the housing market is still red hot, then I think sales will probably be much more appealing to the committee. Let me stop there.

Reinhart: Brian, Seth built up expectations for your remarks.

Brian Sack: I like how he's able to give me questions. [laughter] First, I'd like to add my thanks to President Bostic and to the organizers. It's great to be part of this. I'll start just by saying, this is a big adjustment for financial markets. It's not that often we can anticipate a single market participant setting out to make a $2- to $3-trillion adjustment to its portfolio and do it in such a transparent way. This adjustment is pretty fast. It's going to run at more than two times the pace as the last QT, so I think it's important to carefully consider what the consequences could be for financial markets.

I'm going to basically focus on two issues. The first is whether the SOMA adjustment is going to cause an abrupt and disruptive increase in Treasury yields and mortgage rates. Here, the basic mechanism I have in mind is the portfolio balance channel. This is well-trodden material at this point. Essentially, as the Fed reduces its holdings it requires the private sector to hold more Treasuries and more mortgage securities than otherwise, and that puts upward pressure on those rates. The FOMC's strategy in this regard is to make it predictable. They could have chosen predictable and slow. They've chosen predictable and pretty fast. The key is that it's predictable. I think that's a good strategy. I think it's effective. What does that do exactly? I think what it does is it brings forward the effects to the point where the path of the SOMA becomes known to the markets. What it also does is reduce the chance of unexpected variation in market prices and rates as the portfolio actually declines. I think that was the intention.

Essentially, I think that's what's happening in markets. I would argue the majority of QT effects are already in the yield curve. It's hard to see that and to parse that out from everything else going on in the rates market at this moment. Obviously, we're having a very abrupt repricing of rates for a number of reasons, including conventional policy expectations. I think the QT effects have occurred, and if you zoom in on particular periods like around the December FOMC, or around the March minutes that Loretta mentioned, I think you can see that in how the market was reacting. If I try to calibrate the effects of QT, first of all, I'll say it's hard to do this. As we've heard before it is a big range of estimates. Great research papers trying to tease this out, as we saw earlier today. I tried to calibrate it, and I think the effect is fairly moderate. What I did is I went back to early December, I looked at the New York Fed survey that Stefania was using, actually. I looked at the path of SOMA that was expected. If you calculate the change since then in the expected path of SOMA, and you apply the literature's estimates of the effects of QE, and you do that in reverse, you get something like a 25 or 30 basis point increase in 10-year yields from the repricing of QT, just to give you an order of magnitude.

That's a pretty manageable effect. As I mentioned, it's coincided with this very abrupt repricing in the rates market. I want to be clear. I think the environment in the rates market is very volatile, but I think that's tied to the uncertainty about the economy, the uncertainty about inflation, and the repricing of conventional policy expectations. As mentioned, the 10-year has gone up 160 basis points, so essentially conventional policy repricing has been much more dominant and important than the QT effects that have come out. My bottom line is I'm not overly concerned that we're sitting on the edge of some large QT effect that's about to hit the markets. I do want to recognize, we do face uncertainty about how all these things work, but my baseline would be that most of the effect is already in the price.

The second broad financial market issue to consider here has to do with whether the balance sheet runoff will produce any pronounced strains in funding markets. The portfolio balance is about the asset side of the portfolio, funding markets are about the liability side. Of course, mechanically, as the Fed reduces its portfolio of assets, the amount of liquidity that's provided to markets is going to go down. By liquidity, I'm going to define "liquidity" as bank reserves plus overnight RRPs. Basically the amount of overnight liquidity that the balance sheet has created.

That will go down mechanically. What's interesting is when you think about the risk around portfolio balance effects, those are concentrated at the beginning of QT, but when you think about the funding market risks, they're really concentrating more towards the end of QT when the level of liquidity has fallen, and the episode in 2019 was already mentioned. In fact, as we saw in 2019, the market stress came at the end. We had significant disruptions in funding markets, in particular the repo market, in September 2019. I think it's a good goal this time to see what can be done to prevent another September 2019. Let me just make two observations that I think are relevant about that. The first is, in determining how far to go with the balance sheet, I think that price signals from the market are much more effective than guesses at quantity signals. We all try to guess how far the balance sheet's going to go. We get a lot of quantity-based information about the level of liquidity that's needed. We all took the senior financial officer survey last time and tried to scale it up to some aggregate measure of how much reserves the banking system needs.

That's all very valuable information, but they're not precise signals. They can't be used as precise guidelines on how far the balance sheet can go. I think what needs to be done is to carefully watch price signals, and by "price signals" I mean overnight interest rates in money markets and watch how they're behaving. Last time those money market rates firmed, and when they got up to right around IORB, formerly known as IOER, got slightly above that, you saw their behavior change. They started to get more volatile, and in hindsight that was kind of the leading edge of signal that you're getting to a point of scarcity and potential risk. I think it's important to focus on those signals.

The second broad lesson is that it's much better to pull up early than to pull up late. There's essentially very little, or possibly no, cost whatsoever of pulling up early. You leave a little bit more liquidity in the system, it's probably more resilient, and it really just has no cost. Where obviously pulling up late, you generate the risk of these strains emerging in money markets which have real consequences in cost. I think the second lesson is try to avoid the inclination to want to get the balance sheet down as much as possible. Be willing to pull up, even when the signs of scarcity are still slight. If done right, this adjustment, money markets can have a good chance of functioning fine throughout the process. Overall, the Fed's facing a difficult task. It has to manage these portfolio balance effects, it has to manage the funding markets, but I think with a good strategy those risks can really be mitigated. I guess my baseline would be that the Fed has, and will continue to follow, a good strategy.

Reinhart: Thank you, Brian. Okay, Jeremy?

Jeremy Stein: Thanks. Let me add my thanks also to President Bostic and the organizers for having me. It's been a pleasure to be here. I thought I would focus primarily on the liability side of the Fed's balance sheet, and in particular on its interaction with a specific set of financial stability issues. To start the story, let me give the story of the villain. The villain is the so-called leverage ratio, or the supplementary leverage ratio, that banks and their broker-dealers face. As you know, the basic leverage ratio is risk insensitive, meaning that it charges as much capital for holding Treasury securities or Treasury repo as it does for, say, a leveraged loan. If it's binding it can be a very strong deterrent to, for example, making markets and Treasuries, or offering repo. If you think back to March 2020, where there was all this action, or dysfunction if you will, in Treasury markets, it appears that at least those constraints played some significant role.

Now, why is the leverage ratio binding? I don't think that was the intent when it was put together, basically, when the new rules were put into place. The thought or the hope was that it was going to be a backstop, but it was going to be the conventional, risk-based capital requirements that were going to be the primary binding ratio. That's turned out to not be the case. Some of that may be, we just got it wrong back then. A big part of it is probably this very large expansion in reserves, which has been referred to. Since in equilibrium, the reserves all end up held by the banking system, it blows up the bank's balance sheets, and therefore, all else equal, makes the leverage ratio more likely to be the dominant binding constraint.

If this is your diagnosis and you say, "Nobody with any sense thinks that the leverage ratio, the un-risk-weighted leverage ratio, should be the way we run bank regulation," the obvious thing is we ought to defang it, in one way or another. One way to do it, and this was done in the wake of March 2020, they temporarily excluded both reserves and Treasuries from the denominator of the calculation. Even if you don't want to exclude Treasuries, there's a pretty respectable argument for maybe excluding just central bank reserves. That would be one way to sort of skin the cat. Alternatively, you could keep them in, but you could just lower the...the US has a gold-plated requirement, relative to the international standard. It's 5 percent instead of 3 percent. You could just drop down there. Either way, you'd make it less binding. I just want to be very clear. This doesn't mean you're soft on regulation. You can be as hawkish as you like. I'm just saying you want the hawkishness to be expressed primarily through a risk-based constraint. If it were me and I was going to defang the leverage ratio, I would try to neutralize any effect on aggregate dollars of capital in the banking system by making a commensurate upward adjustment in the risk-based ratio. Just by way back, I think that would be the right way to proceed with that particular thing.

Now, I don't know what the appetite at the Fed will be. Michael Barr has been now designated as the incoming vice chair for regulation. He'll obviously have a strong voice in this. It's just worth noting that in spite of, I think, the fact that most of us technocratic types don't really like the binding nature of the leverage ratio, it's extremely popular with a progressive wing of the Democratic party, and it's become a bit of a totem for toughness on banks. It's not clear to me whether there'll be progress on this front.

Let me propose a sort of weird, backdoor approach. It involves dragging the FOMC, to some extent, into helping out a little bit with what's really a regulatory problem and ideally, in a first/best world, would be resolved by regulations. To set the stage, let me just remind everybody again what the balance sheet roughly looks like: again, assets side is approximately $9 trillion on the liability side, about $2.3 trillion of currency, $3.3 trillion of reserves. I think Seth mentioned this, just under a trillion in the Treasury's account, and then interestingly $2.1 trillion of reverse repo. This is where either foreign official accounts, but predominantly money funds basically, are lending to the Fed on a collateralized basis, collateralized by Treasury securities.

Now, here's an interesting thing. The RRP is currently around, as I said, $2 trillion. About a year ago, it was at zero. It grew really, really fast. What happened, well one thing that happened, I think it was in June of last year, is there was a corridor where the interest on reserves was here, and the rate that the Fed was paying on the reverse repo was I think 15 basis points below. They made a decision basically holding fixed the IOR rate. They raised the RRP rate, i.e., made RRP more attractive. In the wake of that, the RRP grew very significantly.

Now, I wasn't there so I don't know. I suspect the motivation, the primary motivation, and Loretta, you can correct me, was monetary control, to kind of firm up the floor. Another possibility is, here you have these money funds and the money funds can't really earn too much in a zero-rate environment, and you don't want them going off and doing stupid money fund things that they tend to do. Maybe you give them a little bit more yield. Either way, we did these things. The RRP rate went up and there was a very significant quantitative response. As the Fed has just raised rates, we're now at 90 on the interest on reserves and 80 on the RRP rate.

Here's a question. As the Fed now continues to hike, do they leave this spread where it is, or now that they're away from the zero lower bound and they don't have to worry as much about either helping out the poor money funds or firming up the floor, do they go back and drop down the RRP rate, in a relative sense? I would encourage them to maintain it where it is, or if anything maybe even tighten it up a little bit. I think it would be constructive and wouldn't cost too much. At least, and we have to be mindful of Brian's caveat, but at least in the initial phase of balance sheet shrinkage, let it come out of reserves. In other words, if you price the RRP so that it's still relatively attractive at the margin, more of the shrink can come out of reserves. What does that do? In the first instance, it just helps to debloat the bank balance sheets, makes this leverage ratio less binding, so next time we have a little bit of tension in markets you hope the banks can be a bit more helpful in their role as intermediaries. Again, this is not the way you would want to do it. It's a very backdoor thing, but I think right now it's a relatively low-cost thing. Of course, I agree exactly with Brian that as we get closer to the scarcity amount, like him, I don't see any particular point in trying to go all the way. I think one wants to be careful there as well.

That's pretty much all I had to say. I just wanted to flag one other thing, which is a little bit distinct but nobody else mentioned. We're talking so much about the effect of QT on term premiums, basically, as this sort of quantity-driven notion of term premiums. One thing that wasn't mentioned, which is another potentially important determinant of the term premium...this is more of a classical asset pricing, no quantities thing...is just the correlation between stocks and bonds.

For much of the last, I don't know, 20 years, term premia have been suppressed in part simply because stocks and bonds are negatively correlated. When one went up, the other went down. Makes bonds an attractive hedge. If you're running some kind of a risk-controlled portfolio, bonds are pretty attractive. If you think back to the high inflation environment of the '70s and early '80s, the correlation was positive. It's what you would expect if the surprises are coming from the inflation side. Inflation news is bad for both. We've seen that in the last couple of months, as bond yields have gone up at the same time as the stock market has gone down. If we continue to be in that kind of environment, and the correlation sustains as positive, I would think that that's going to be another source of upward pressure on yields. I don't think it's necessarily QT per se, but the idea that there's quite a lot of uncertainty about how the long end will behave, I think probably is the case. Let me stop there.

Reinhart: Indeed, over the past 90 years, in episodes when the short rate is rising because inflation is high, Treasuries and equities are just terrible hedges for each other, exactly because of that correlation.

Stein: Some of this will be mechanical. I don't know what kind of look-back window the various kind of more quantitative people who do this said, but at some point the three-month correlation or the six-month correlation may turn positive. Then you may get certain players wanting to get out of some of their duration.

Reinhart: Okay. Before I start asking questions of the group, channeling what's already been put in by the audience, let me ask you to ask questions. Is there anything you've heard your colleagues say that you'd like to follow up or ask a question about? Anybody?

Mester: It was for monetary control, [laughter] not for supporting him.

Reinhart: Not that that would be a bad thing, necessarily.

Mester: Just saying.

Reinhart: Brian?

Sack: Well, I'll make I guess two comments. One is, I completely agree that keeping the RRP rate and the IORB rate relatively close is good. It's efficient. When Joe Gannon and I wrote a paper on the framework back in 2014, we argued to have these rates either equal or at least close together, because I think it's efficient for the markets to be able to move the liquidity where they want it. If the SLR is binding, as Jeremy said, then it can go into the money funds, or vice versa. If the banks need the liquidity, then they can compete harder for deposits. I fully agree with that.

I think on MBS, Seth took the stand that there won't be MBS sales. I know he said he wasn't sure about that, but I'm maybe even less sure. Just to be clear, I don't think the case for MBS sales is going to be that housing is hot or cold or what have you. I think it's going to be, even when this portfolio adjustment is done, let's call that in the first half of 2025, there's going to be $2 trillion of MBS on the books, and they're going to be running off at $15 billion a month. The Fed can sell the MBS. It can do that in a way that's not disruptive to markets, if they're reallocating it into duration in terms of Treasuries. I think they could choose to do that just for cleaning up the portfolio, in some sense. Now I should say, they sell a lot of securities. The Fed runs auctions for Treasuries. MBS is a bit of a different creature. The Fed owns 29,000 CUSIPs, so you need to aggregate those. You have to define specified pools with certain characteristics. It's a bit of a different creature. I think it will take some time to set up, but of course, the desks can figure that out, and do it pretty efficiently.

Carpenter: It's also a different creature because the Fed owns a lot of 2s, and 2.5s. The current production coupon is much higher, so they will have that extra mismatch to contend with. Not insurmountable, I agree.

Reinhart: The Federal Reserve will be trying to put back much more duration into the market than it took out in the act of sale, relative to purchase.

Stein: It's funny. Listening to you guys, I feel like you're making a pretty decent case for not selling it. [laughter] I'm not terribly moved by the idea that we just shouldn't have them in the portfolio because it's icky. I mean, we done did the thing already. [laughter] You bought them.

Carpenter: It's only been for the past 14 years.

Stein: I guess it's a reminder that you did it, but you did it. Exactly for the reason that you say, they're not the current coupon, there's a million CUSIPs. It just puts the Fed a little on the wrong side of the bid-ask spread in every one of those transactions. You're losing a little bit of just friction on behalf of taxpayers, for what I feel like is a largely cosmetic purpose.

Mester: The only real way to get consistent with our principle, which we've said, primary Treasuries, is going to be to sell some of that MBS portfolio. We can do it in ways that aren't disruptive.

Stein: In other words, I guess it's a question of whether you think the inconsistency with the principle was in the buying of them or in the holding of them once you've bought them. You did an active, housing-skewed policy, which I thought was completely appropriate. I think it's neutral, to now just stay where you are.

Mester: My view of the principle is that would not be consistent with the principle.

Reinhart: Luckily enough, this was the most voted-on question from the audience, [laughter] and it combines another most voted-on question from the audience, so let me just reframe it so everybody gets to weigh in on the issue, as Loretta mentioned. This is a more abrupt phase-in of asset runoffs than before, and it expressed it as a need to get into gear quicker given the macroeconomic circumstances. General question: Do all of you agree that markets are resilient enough to absorb $95 billion of asset purchases a month? In particular, are you worried about the mortgage-backed securities market? If you haven't said it, there's a chance to say it again.

Lastly, should it be a concern about selling MBS that you'd have to post a loss? Is that about just communicating the loss? Is that just a risk about the optics, or is there actually a real political economy risk associated with the Federal Reserve shrinking the fiscal space in its bi-weekly payments to the US Treasury? Those questions, anybody want to address them first? It's an opportunity for all of you to weigh in.

Sack: I can start on the Treasury side. First, I should say the Treasury market functioning has been somewhat worse. Some measures of liquidity are worse than normal. Actually, the Treasury Borrowing Advisory Committee just did a chart on this at the last meeting, which is published on the Treasury web page in case people want to actually see the measures.

I think that's largely driven by the volatility that's in the market. This is, as we talked about, a very abrupt repricing of fundamentals. When volatility goes up, it's harder to make market liquidity go down. I don't think QT itself creates an immediate market functioning problem. As Seth highlighted, QT basically leads to Treasury just issuing more debt, so it's almost like any other change in the deficit, in terms of market functioning. Auction sizes will go up. In some sense, I think, market functioning-wise, the end of QE is a bigger deal than the beginning of QT because the end of QE is you actually took a buyer out of the market, a buyer who tended to buy the less liquid securities. QT doesn't have that same effect.

One thing I should point out, though, is to the extent we have more structural concerns about market functioning and liquidity. There's been a lot of focus in recent years on the size of the Treasury market relative to intermediation capacity. Obviously, the Fed's portfolio going down, and putting more of those securities in the private sector, exacerbates the structural problems. It's more that, than an immediate market functioning problem from QT.

Reinhart: Let's go this direction, for anybody wanting to weigh in. Jeremy, your turn.

Stein: I was going to say very much the same thing, which is I think there are real concerns about Treasury market function. That's part of the reason I was going on about the supplementary leverage ratio. There are other things one can do. I think the Fed's standing repo facility is helpful. I would have preferred to see it made broader, in terms of access.

The raw quantity that comes in, exactly as Brian says, if it's a bigger market, it's all the more important to have some intermediation capacity, but that itself doesn't cause dislocation. I think the one subtlety here is we've seen things before where it looked like, in the taper tantrum and in 2019, it looked like changes in quantities were having a big effect. I don't think that's a direct, mechanical thing. It's when it gets tied up with signaling about other stuff.

The taper tantrum was presumably in part because it was a signal about broader changes in the stance of monetary policy, and so forth. Here's where things again could get dicey. If you have some of this effect that I was talking about before from the term premium, just because of the correlations, and it's happening at the same time as QT, will people in the market start saying, "QT is a bit of a problem." I suppose that could happen. I think if you really tried to isolate, this is what Brian said, if you try to isolate the pure, direct effect, that's a little less worrisome than some preexisting structural fragility.

Reinhart: To Ken Rogoff last night: If there's any untoward effect in markets of a Federal Reserve operation, the Federal Reserve will own it. We live in that sort of political environment. Okay, Seth?

Carpenter: I'll continue down the political economy side, but your point about sales and potentially realized losses, I personally think having been born and raised in Washington, it is extraordinarily difficult to figure out what's going to get any particular political actor into really, really hot water. It very well could happen. There's a slightly bigger issue that is almost independent of sales and realizing losses, and it's the following: The Fed has net income. They remit that to the Treasury Department, and that directly reduces the deficit. A side note, the Treasury could do this same thing by themselves, by adjusting the maturity of what they issue and blah, blah, blah. That's what happens, so there have been times when the Fed has remitted something like $100 billion dollars per year. You think about the way Washington usually talks about fiscal packages, they do it over a 10-year window; $100 billion times 10 is a trillion dollars. A trillion-dollar fiscal package is actually a pretty big deal. It's the sort of thing that makes 535 people in Washington, DC, particularly excited.

If you had a different version of the world where you just rule out sales entirely, but you had the current portfolio and you raised the federal funds rate up to something like 3.5 percent, roughly, the interest expense on the liabilities would totally wipe out the interest income from the asset side. The pesky thing about fixed income securities is that the income is fixed. I think that's where they get the name. You would very conceivably be in a situation where you get back to zero remittances, and you have the same sort of potential political economy cost.

It doesn't have to get to the point where it completely wipes it out. You could easily get to the point where it just reduces it to $10 billion dollars in a year. Nevertheless, directionally, you'd see much less in the way of remittances. That seems unavoidable at this point, so there's going to be some diminution of the remittances that the Fed gives to the Treasury, and as a result, helping out the deficit. They've got a challenge. They've got that political economy risk. They're going to have to communicate about it in some sense. Now, with sales you recognize the loss when you realize it, according to Fed accounting. You would take a bigger hit to earnings in the specific period. If you could convince people to average over several years, then it almost doesn't matter. They should be roughly equivalent because you would sell them, have the loss in one year, you'd have a smaller balance sheet and so the loss on net income is going to be smaller in subsequent years. They'd be roughly equivalent.

That can be a very difficult challenge, and I will just say for anyone who's interested in this sort of thing there are some archive memos on the Fed website where we spent a bunch of time thinking about lots of different versions for smoothing remittances over time in the event of losses. The committee ultimately decided it's not worth doing, because at the end of the day it's really a bit of a shell game. Nevertheless, this question has been asked a lot, and I think it is something that at the very least is a communication issue that the Fed is going to have to confront, and it could become particularly acute if we do get to the point where net income is wiped out.

Mester: Yes, I think the communication issue is one that would have to be addressed. There's also a political economy of holding the mortgage portfolio as large as it is on the balance sheet. There's going to be two things that go on. Are we going to be consistent with the principle that we stated that we want to get back to a primary Treasury security, and what does that mean versus explaining to people what sales entail, in terms of what the balance sheet will look like in remittances to Treasury over a certain period of time?

Carpenter: Rock, hard place.

Mester: Yes, I think that's the kind of evaluation that we need to do.

Reinhart: Actually, let me follow up with a foundational question for which there's some support from the audience. In full disclosure, I was the editor of a 302-page doorstop by the Federal Reserve System in 2000, 2001, on alternatives to holding Treasury securities in the System Open Market Account. The answer is there was no alternative to holding Treasuries in the System Open Market Account. The committee just recoiled in horror. "Why? Why is it Treasuries only? Is that the appropriate policy?" That's the question from the audience. Anybody want to address that?

Mester: The reason that we think that's the right principle is that we don't want to get into the credit allocation business. Now, one could argue that the ties between the Treasury market and the MBS market are so tight, and that's what happened when we went in early in the pandemic to buy them. It didn't make sense to just buy Treasury. We had to buy the whole market. Fundamentally, it's an idea that you really want the Fed to be engaging in, just holding the broad market. Treasury is the one to hold, and not to really get into trying to support the housing market by using our balance sheet as the support for it.

Carpenter: Vincent, I remember that tome-like report that you talked about. It was my first assignment as a junior staffer at the Fed, and I think you made me learn a lot about the banker's acceptances market. I've never forgiven you. [laughter]

Reinhart: Go back to the founding of the Fed. It's a great, great learning experience.

Carpenter: I take Loretta's point very seriously. There's the perception that if you only hold Treasuries then you're being more neutral, and as a result you're not picking winners and losers. I think the evidence, though, is that the housing market is, pre-any QE version of the world, always much more sensitive to monetary policy. Even with just using interest rates as policy, they were already making sectoral decisions that way.

I think the other interesting observation is, if you look around the world, different central banks do things differently. There's some central banks that are disallowed from owning their own sovereign debt, because that's seen as monetizing the debt and being irresponsible in the extreme because you're just financing the government. I think over the history, both through time and across countries, there's a range of views that have come up, and the Fed ended up where it did partly through a lot of path dependence.

Stein: I really have nothing to add, just that I completely agree with Seth on both points, that monetary policy is inevitably going to favor certain sectors because they're more interest rate sensitive, or if it works through a bank lending channel because they're more bank dependent, that's just the way it works. Again, I think, exactly as you said, purity is really in the eye of the beholder here, as the ECB example illustrates. I understand, but it feels to me like a more cosmetic, as opposed to a deep, principled issue.

Reinhart: Indeed, one would say that there's a liberal interpretation of section 14 of the Federal Reserve Act that lets the Federal Reserve actually roll over maturing Treasury securities, given the prohibition of direct purchases, for that reason. Brian?

Sack: I agree with all that. I think there's maybe one more point to make. The government creates the risk for yield curve, right? It's the Treasury that issues the securities. If we think of the QE as a temporary change in the maturity structure of that, it's still within that space of government. I know it's not entirely pure and clean, but I think the central bank operating on the risk for yield curve through short rates, through duration pricing, through QE, to me it's a cleaner separation than you have in some other central banks that weigh into other assets. Basically, set the risk for yield curve, let the market price risk spread around that. Mortgages are a little in the gray area, but as a general principle that seems relatively clean to me.

Reinhart: Let's follow up on that observation, because a couple of you mentioned at one point or another that the Treasury could do something to offset what the Federal Reserve did. Or, the fact that Treasury had run up the Treasury general account had consequences for reserve management. In principle, the Treasury could offset any effect of QE and QT in terms of the maturity and in the hands of the public. We have a couple questions about that. Were there missed opportunities by the US Treasury? With regard to its issuance, given what the Federal Reserve was doing, has the Treasury been helpful in building up the balance, and then running it down? Any views at all, perhaps, including...

Stein: Maybe this is not exactly your question, but an interesting thing to think about when the Fed does such big QE is to think about government debt maturity from a consolidated perspective. I'm not going to get this right, and one of you guys will correct me, I think roughly speaking, the average maturity of all the debt, not yet taking effect of the Fed's purchases, is something like four or five years. The QE was big enough that it lowered it, I think, by roughly a year. The mechanism is basically exactly what Seth was talking about through remittances. In other words, when rates go up, it's as if the Treasury had issued more short-term debt. Their interest expense goes up faster. Why? Because they're getting less remittance from the Fed. That's a consolidated effect.

We have a very short, relative to other countries, in the UK I think that debt maturity is like 13 years, something like that. In a rising rate environment, QE on the one hand was very helpful, in some sense, in absorbing the debt. Now we have a big debt burden, and in a rising rate environment it basically rolls pretty quickly on a consolidated basis. It's not just because of the Fed but we're going to see our interest expense going up relatively rapidly, and I think that may be a bit of a cause for concern.

Reinhart: You could also ask a question at the front end of the yield curve. You'd be comfortable with $2 trillion in reverse RPs, but couldn't the Treasury just issue more bills? It's in fact that the demand for those reverses is evidence of a desire for that short-term paper. The fact that bill rates have sometimes been negative over the last couple of weeks, I think Brian wants to...

Sack: They could issue bills and hold more TGA, and that would be an effective draining tool. Bills do have some advantages relative to reverse repos, because they can be held by a broader set of counterparties. I say they can do this, conceptually. I think there are limits on how they're supposed to use TGA, and it's not clear that's a viable policy option at this point for this purpose. Conceptually, yes.

Carpenter: I guess I would just add the way I look at it, fully understanding the consolidated balance sheet perspective, and what the exposed ends up happening in terms of the deficit situation, I think it's, I'm an old institutionalist at heart, and I think it's important to have...the Fed's got a set of objectives. Treasury debt management office has a set of objectives, and I think they should each go about doing what they're supposed to be doing. They, in principle, operate at a different frequency, although given how long some of these macro shocks have happened, the Fed's balance sheet has stayed bigger for longer, but the Fed can react much more quickly up and down. I think the Treasury is intentionally, and appropriately, regular, and predictable with their issuance.

I'm quite proud of the fact that you can, if you plot the weighted average maturity of Treasury debt, it's sort of inflected right around the time that I was running the financial markets office. Part of that was because I said, "There should be a structure to this. You should think about long run. Is there a place where, in general, the market's willing to pay a premium?" If the answer to that is "yes," that the margin lean into that, and if there's a place where the market demands a concession, that the margin lean away from that. This was leading up to money market mutual fund reform. Bills were super-rich, relative to a coupon curve that extrapolated down to zero, and you knew that demand was going to go up with money fund reform. I said, "Let's raise the total amount of bills outstanding by a couple hundred billion, because the market is willing to pay for it. That's good for the taxpayer."

Again, I guess I do like to see Treasury having Treasury's objectives, the Fed having the Fed's objective. We should not be unaware of the ultimate implications for the deficit, but that's institutionally how I think it should work.

Sack: Can I have one quick thought on that? I completely agree. Someone has to be the last mover, right? The last mover is the Fed. You don't want the Fed doing QE and then Treasury offsetting that with its issuance pattern. I think we've established the Fed is the last mover. That has a consequence going forward. As the Fed does QT, it's been pointed out that the effects are going to depend on the duration that's issued, and that's up to the Treasury.

There's been some talk in the short run about, maybe Treasury's going to issue more bills and more short-term stuff, so there actually won't be this duration effect that causes QT to really have an effect. I think that may be true in the short run, but I think over time it's most reasonable to expect Treasury to issue around its average maturity, which I think is about six years. That's what we should think about, at least over time, in terms of the duration that comes from QT.

Reinhart: Okay, I'm pretty sure we're deep enough in the weeds to test an audience resilience that has sunny alternatives. [laughter] Let's go to another question that had a lot of votes. We've heard a lot about the quantitative effects of quantitative easing and quantitative tightening. How big an effect did QE have on lowering Treasury yields? How big an effect do you think QT will have on increasing yields? Also, why is everything mapped into funds rate equivalents? It was also easing and tightening financial conditions, i.e., what's happened to equity prices, what has happened to the exchange value of the dollar, what has happened to the price of Andy Warhol paintings? [laughter] Anybody want to give their view on the net financial market consequences of the changes in the Fed balance sheet?

Mester: I think it's interesting that you put it in terms of financial market consequences and not macroeconomic consequences. I think that's ultimately why we do these things, except for the market functioning role, which we did in the very beginning. There, the estimates are, I would say relatively small from what we've done, and maybe relatively bigger for financial market effects. Nonetheless, wide error bands. I think the chair is basically trying to make that point in the press conference, that it's hard to do the one-on-one equivalent of these things because it'll matter. Stefania's paper notwithstanding, the environment in which you're doing the QT and the QE matters in terms of the sizes.

Reinhart: Yes, I wasn't even sure he was in the building when it was done, based on the press conference remarks. Anybody else have a view on what the Federal Reserve has done to financial market conditions? The front end of the monetary transmission mechanism to ultimately influence the economy.

Carpenter: Well, I'll take a stab at at least part of that question. I feel reasonably good, directionally. I know where it's going. Your question about why do we always try to map it into Fed funds equivalents is I think that tendency is entirely a reflection of just how much uncertainty there is in the profession for exactly how these things work. We want to be able to tie it down to something that feels familiar, even though I would say any empirical estimate of the transmission of monetary policy through the funds rate has pretty wide error bands as well.

I personally think it also gets back to the tendency, at least in markets, for people wanting to have some sort of a financial conditions index, because it feels better/easier/simpler to be able to distill things into a single, unit-dimensional measure. I get that. I participate in that game, because it's my job, but I think it's quite flawed. One should always be humble about how much we know because the only way to distill things into a single, unit-dimensional measure is with a model, or some sort of historical correlations. There's every reason, in my opinion, to think that these are different. The simplest version of that is, if you were to raise the funds rate 25 basis points there's some historical correlation of what happens to other asset prices. You know for a fact, doing that is going to reset variable rate loans. Whereas if you stayed at zero and you just sold up the balance sheet, pretty sure variable rate loans are not going to reprice in that circumstance, and you're just not going to be able to get a real equivalence. I think it's just a shortcut, because trying to do it very, very carefully makes your brain hurt.

Reinhart: Anybody else?

Stein: Just because you mentioned financial conditions more broadly, Seth, you may have mentioned this just in passing: of the various other things we've seen, equities, long rates, the one that surprised me a little bit so far is if you look at high yield credit spreads, they've moved up, but at least subjectively not as much as I would have thought given how much other things have moved.

I don't know what's going on there. I suspect there's sort of a nonlinear air pocket at some point, that when it starts to move it may move a lot. I've worried quite a bit about the fragilities associated with the open-end bond fund complex. We started to see some of those fragilities show themselves in March of 2020, and then the Fed very unhelpfully ruined the empirical experiment. [laughter] We would have had a really good exogenous shock. They messed it all up by saving the industry.

As a result, I think some of the urgency for reform of some of those structures may have been tempered. I do worry about that. We haven't seen it yet, but I still worry that somehow, if you ask me where's the stopping point for the Fed funds rate, it's going to depend tremendously on whether we hit some kind of an event along the way. The place where I would...you know, the kind of event, stock market down 20 percent, I don't think has as much impact, getting to Loretta's thing, on the macro economy...Real disturbance and credit, I think empirical evidence would suggest has more causal kick on the economy. I think that's something to really be attentive to.

Reinhart: 2008, 2009 would be a very big observation.

Stein: By the way, here's a somewhat scarier notion. This is a wonderful paper by Simon Gilchrist, and Egon Zakrajšek, and others. Here's a thing we really don't want to have happen, which is in the GFC, unemployment rate went to 10 percent. Core PCE inflation fell by maybe 50 basis points. That's not the kind of Phillips curve you want to be dealing with if you're trying to get inflation down by a few percentage points.

They made the argument that some of that is because when you have real financial credit tightening, firms that are financially constrained often raise their prices to bring in current profits, to basically scare up a little bit of liquidity. Arguably, spike and credit can further flatten the Phillips curve, which is all the more reason one hopes that that's not the primary mechanism of tightening in this cycle.

Reinhart: Brian, do you want to add...?

Sack: Well, I'll just say, as has been noted, financial conditions have tightened quite a bit. Maybe we're not through it all, maybe there's air pockets out there that will cause it to go further, but to date we've had a very significant and rapid tightening of financial conditions. I agree with all the caveats of, it's really hard to map that to the economy. I always feel unsatisfied, though, when a panel, all the panelists just say "it's uncertain" and don't give a guess, so I would make a guess that, not just a pure guess, there's some analysis behind it: If you look at the tightening of financial conditions since December, it's probably worth 2 percent of GDP, or more. This is a big effect.

Now, it was necessary. There's no way we could keep financial conditions where they were in December. That would have been a tremendous mistake, so it's absolutely appropriate. It's a big adjustment, and this ties back to a point Seth made earlier about, is the Fed behind the curve? It's easy to look at spot Fed funds and say, "They've only gone up 75 basis points. That can't be right." I think that just misses the big picture. We've had a huge shift in policy message. It has allowed and facilitated a sizable shift in yields, in OIS 1-year, 1-year OIS has gone up 200 basis points in short order. That's generated a meaningful tightening of financial conditions. I think it's not so obvious anymore to sit there and say the Fed's behind the curve and needs to do more if you focus that discussion on something like 1-year, 1-year rates rather than spot Fed funds.

Mester: That's true, but the reason that's working is because we have credibility that we're going to follow through with the funds rate plan that's in the market. In that sense, "doing more" I guess could be interpreted as we don't have to raise the funds rate consistent with what's the expectation out there. I don't think you meant that. [laughter]

Reinhart: Which was Chair Powell's answer at the press conference, by pointing to the 2-year note, that the Fed isn't behind the curve. There's a firm expectation of subsequent policy tightening, and a credible commitment to that policy means that the tightening in financial conditions is up front. Forward-looking markets bring it quicker to you.

A couple of votes on something Jeremy opened up, which is about regulation. We're talking about the Fed moving the levers of its control, and the fact it's called the "supplementary leverage ratio" might be a clue that it wasn't intended to be the primary tool for regulatory policy. Any other regulatory changes that would be appropriate, either to help the Fed in its execution of policy or to make the financial system more resilient? Open sheet of paper here. At least a few people would like to hear your views on that.

Carpenter: I feel a strong need to email my regulatory compliance people [laughter] at Morgan Stanley and see what I can talk about.

Reinhart: Can you express your book right here? [laughter]

Sack: I agree with Jeremy. The SLR seems like it's been the main focal point. It's a big part of the constraints on institutions to intermediate in these markets, in repo markets and Treasury markets. I think it's open to debate how binding it is today. It's certainly binding for a few large institutions. In some sense, as he pointed out, as QT progresses, that provides relief in that direction. Reserves on the Bank balance sheet, it's hard to think of a scenario that makes that a riskier institution. This is immediate liquidity to an institution, so if creating all these reserves has made the SLR more binding, it's somewhat perverse.

Mester: One thing that we learned during the last episode is that you really need to actually engage with the banks to find out what their demand for reserves are, and how they're thinking about it. We might have a theory about what they should be demanding in terms of their reserves, but there are buffers that they might have that we're not thinking about. A lot of that engagement has happened, is happening, and will continue to happen as we go down this path, because we don't want to get into a situation where we've reduced the balance sheet so quickly that the reserves come down beyond the level that we think are ample. I think it's going to take some of that continuing engagement with the financial institutions to be able to gauge what's the demand for those. This is where the repo facility, standing repo facilities, are going to have an impact which we didn't have before as well.

Reinhart: You have two canaries in the coal mine. As Brian pointed out, you have financial prices. Where are overnight rates trading? What is the configuration of RP rates and the funds rate? You also have the demand at the reverse RRP facility that you didn't have in the past, lots of fans for that. I would just ask Jeremy. To me, that sounds like a great asset to run to at a time of stress. Do you worry about that as an instrument, an available mechanism, that could make stressful events more stressful, in the same way you might worry about making the benchmark rate the SOFR? Or perhaps CBDCs?

Stein: You're talking about the reverse repo, right? Just to pull back a little bit. Think about what happens normally in a flight to safety. People run. They want to buy, say, Treasury bills, but the Treasury bills reprice, so the yield goes down. Basically, we know we're going to have to create a spread between the safe and the risky asset, but with Treasury bills able to reprice down, that spread happens in part by T-bill rates going down rather than, say, commercial paper rates having to spike up.

The concern with the RRP, I think that you're expressing...I'm just trying to get a read...is that if you fix the rate, basically, and there's a perfectly elastic supply with a fixed rate, then that rate can't go down. All that can happen, basically, is people run to that and the riskier rate has to spike up. I think the right design, and Brian and others, we've all thought about this, is the RRP, you should have basically some kind of system...it's already built into, I think, the way the auction is set up...as some kind of a capping system. Not that it's unconditionally capped at 1 trillion or 2 trillion or whatever, but you don't want to allow the quantity to spike up very fast in a time of stress, for example.

It's a little bit more like the T-bills that are in fixed supply, rather than something that's in completely elastic supply. You could imagine some kind of a rule where you say, the quantity at auction today will never be more than 120 percent of the last three months' rolling average. That if it gets above that, then basically the price adjusts rather than the quantity being completely filled. Because I think otherwise, if you don't deal with that, I think that's a totally legitimate concern.

Carpenter: If I can jump in and take one of the Rs off, which is, just say the RP facility, the standing repo facility. I guess when I read some of the minutes from the Fed meeting and I have conversations with clients, I guess I worry about an overly comfortable view that that facility is going to prevent the sorts of issues that we saw in September 2019. I think of money markets as being pretty deep in liquid, but they're a lot like the Suez Canal, where huge volumes can go through as long as there's no disruption, but if there is one then everything sort of gets broken for a while.

To get to the point where someone would want to use a standing repo facility on a regular basis, I suspect it would happen after something is already broken. Maybe it's better to have it there ex-post so that things don't get worse than they would have otherwise. I don't see it as a way of giving me great solace that we're going to keep money markets smooth.

Stein: Let me push back on that a little bit. I was part of a G30 group that, among other things, recommended not only a standing repo facility, the ex-ante standing, but the broad access. One of the ideas we had in mind, if you think back to March 2020, all the people that sort of dashed for cash, right? If you have a bunch of Treasury securities, and you don't know that you'll be able to get repo financing for them, say, because the dealers are choked by the leverage ratio, do you think that I'm going to have to sell them? Things are getting hairy, so I better preemptively sell them now rather than wait.

If you had assurance that you would be able to monetize those Treasuries at the Fed, you might never sell them in the first place. Often people will say, "If we extend the repo facility to non-banks, there's kind of a moral hazard there of some sort." I think you've got to think about the relative moral hazard, which is: if you don't, then the Fed has to come in and buy. Taking a duration risk out of the market on a sort of after the fact, when things get bad basis is much more of a moral hazard than standing by ready to finance. I think creating the certainty that you will be there, and the hope of preempting these sales, is none of this is a panacea, but I think that that would be a valuable and relatively low-cost solution.

Mester: Same argument for the FIML, right?

Stein: Exactly. Exactly.

Reinhart: We are getting into the home stretch, so let's pull the focus up a little bit and give you all an opportunity. Chair Powell has a Tesla in the driveway. Suppose it was a DeLorean [laughter] and you could go back in time and change one thing over the last three or four years. It could be about the structure of implementation, it could be about the setting of monetary policy, it could, hint, hint, be the framework review. What would you change? Why don't we work backwards from Brian to this way? That way Loretta can decide whether she answers the question. [laughter] Or maybe we could run out the clock for her? [laughter]

Sack: What would I change? Well, a specific answer is I think the asset purchases probably continued too long. I don't think that was incredibly terrible for the economy, but I think if you calibrate a policy reaction function for asset purchases, and it's hard to do since we don't have much experience with them, but if you try to do that, it's very hard to understand why the purchases continued as long as they did. I think they should have stopped in early 2021.

I think that's kind of the specific policy issue. Maybe a second one would be the framework. As productive as it is in some ways, it did leave a lot of flexibility, and it was general and a little ambiguous in some ways. That lent itself to setting liftoff conditions for the funds rate that maybe were somewhat too late.

Reinhart: Jeremy?

Stein: I don't know that the framework is...maybe it played a role earlier on. I don't feel like it's too binding right now, but I'll say some bad things about it just because it offends my aesthetic sensibilities. I thought the framework, one, bought too much into the idea that we're never going to have to deal with inflation again, and we're in a divine coincidence world. So, you know, there's that. It was too much in love with kind of modern macro, in the sense that, "Well, we're going to say this stuff, we're going to commit ourselves to this framework." It's great to make these commitments because financial markets will listen, not even...wage and price setters will...that's a very important distinction, by the way, because financial markets actually are listening, but wage and price setters have lives that they're going about. The idea was that they would listen and that would help get inflation back to where we wanted it, just because we say so, but it's one of those things. If you make a commitment, if you're the only one who's listening, you haven't really accomplished much other than to compromise your own flexibility. The world is, I think, just much more complicated and multi-dimensional than in a lot of the models. I'm just not a fan of things of that genre, of making commitments and then finding yourself a little bit hamstrung by them.

Reinhart: Seth, anything? It could be general, or very specific.

Carpenter: I do want to echo the comments about the framework. I personally don't think the framework caused the high inflation that we're seeing, but I also don't think there was any need for the framework review, because this version of the world beforehand, I don't see anything that would have constrained the committee from saying, "Inflation is below target. We don't have to start hiking rates yet because we haven't got to target yet. We've been missing our target by a quarter percentage point or something to the downside. If we missed by roughly the same amount to the upside, we should have the same degree of urgency." I feel like, for all the reasons that Jeremy articulated, the framework was more of an intellectual exercise that probably didn't need to get done, but I don't think it came at a huge cost, other than time and taking bandwidth away.

Brian brought back up the point that I was making, though, about the QE program staying at $120 billion per month. I believed that before, and I think Brian captured it well. I do think it came at two versions of a cost. One, it makes the unwind of the balance sheet that much more difficult, because you've got such a big number. Second, I do think it's slowed down the pivot and reversal in policy.

Mester: Look, I think it's great to look back and learn from things that you could have done differently. I guess my focus now is, we're at this node in the game tree. What are we going to do to get inflation down to try to maintain good, healthy labor markets? Take the pain, what we're going to all feel, we're already feeling in the financial markets, the volatility, but we have to be focused on the dual mandate goals when we're at the Fed. Inflation is way too high. We've got to do what we have to do with our tools to get it down. It's going to take some time to get it down, because it's not just a demand-side issue. It's a supply-constraint issue, too. We just have to be focused on that.

I don't want to say that we shouldn't be looking back and learning from this episode, just like we did from the prior episode. Just as you know, the framework review is going to be reviewed every five years. There's a chance for maybe we'll get it right and consistent with your views going forward.

Reinhart: That sounds to me like the last word. I am getting the reminder that the group reforms at 6 o'clock to hear the keynote by President Bostic and questions by Julia Coronado, and dinner starts at 7 o'clock. Thank you, everyone. That concludes the panel.