Jeremy Stein: The exclusive exit interview


Harvard economist and former Federal Reserve governor Jeremy Stein speaks at a seminar at the International Monetary Fund in Washington in spring 2013. IMF Staff Photograph/Stephen Jaffe/Flickr

Harvard economist Jeremy Stein made waves as a governor at the Federal Reserve when he suggested last year that the nation’s central bank should consider using monetary policy to pop financial bubbles and combat instability. He stepped down from the Fed in May, but the debate he helped start rages on among the world’s top economists.

In his first public interview since leaving the Fed, Stein talks to us about why there's no free lunch when central banks try to use broad new regulatory powers to stabilize the financial system. He argues that the Fed's new exit tools could be a trillion-dollar success and offers some guidelines for how they could work. And he reflects on his time at the Fed and the surprising potency of central bank communications.

Stein plans to put his experience to good use: In ths spring, he’ll be teaching a new undergraduate course at Harvard. The topic? The Fed as an integral player in financial markets.

This transcript has been edited for length and clarity.

Q: How far do you think you moved the ball in terms of the discussion within the Fed over the role financial stability should play in monetary policy decisions?
A: I think it’s getting a very full and open airing, which is terrific. I would point for example to (Minneapolis Fed President) Narayana Kocherlakota in particular, who has done a great job in terms of just advancing the conversation, and I think this is all going to pay dividends down the road.

Q: Norway and Sweden have kept their benchmark rates higher than they would have been otherwise because of financial stability concerns. Are there any learnings from their experience?
A:
You have to be a little careful in what you take from experiences in different countries. The appeal and potency of macroprudential tools can be somewhat country-specific.

I agree with the proposition for the most part that if you have a housing bubble and you have access to tools like restraints on loan to value ratios or restraints on debt to income ratios that’s probably a more surgical way to go.

But if you’re trying to rein in housing in particular, note that housing is a substantial part of how the monetary transmission mechanism works as well. In that sense, there’s no completely free lunch.

Q. In other words, there could be macroeconomic consequences of using macroprudential tools?
A.
The idea that there’s some purity -- there’s one thing that’s purely macro, which is monetary policy, and one thing that’s purely regulatory -- that’s a convenient benchmark. I don’t think that’s entirely realistic. You’re going to get some of the macro along with some of the prudential.

Q: Are there things that are still missing from the Fed’s tool kit?
A:
I think we don’t really know. Some of this macroprudential stuff is a nice idea, but we don’t know if it will really work. If we had another real serious housing boom, I think it would be harder to deploy some of the kinds of tools that you see in other countries, such as starting to impose loan-to-value requirements.

Q: How much of your time was spent thinking about the Fed’s new exit tools, such as the overnight reverse repos? What exactly was your role?
A:
 There was some evolution in the thinking during the time that I was there, at least in terms of relative emphasis on different tools. The overnight repo in its current form, where the Fed is setting the rate -- that was an interesting evolution.

Q: Why is that so important -- that the facility be rate-based versus quantity based?
A:
I think that makes the implementation a little bit easier. But I think what really matters in the end is just how much financing you do this way, with repo. The Fed had been financing the entire balance sheet basically with reserves. The key question is, how much do they increase the amount of RRP and decrease the quantity of reserves in the system? It’s the quantity of reserves in the system that to a first approximation tells you how much slippage there’s going to be between interest on reserves on one hand and the funds rate on the other.

Q: That gets to another question, which is the relationship between the reverse repo rate and the fed funds rate.
A.
If your only real concern is monetary policy implementation and controlling rates, I think then there’s lots of ways you can do it.

For example, suppose the RRP rate is 5 basis points and it’s creating a pretty tight floor at five. Meanwhile the interest on reserves is 25 basis points, so the federal funds rate is going to be between 5 and 25.

Now, suppose you wanted to raise rates a lot. One thing that would work perfectly well is to raise both of these things by 200 basis points. The fed funds rate would still be somewhere in the middle.

If you decide you want to talk about your goal just in terms of the fed funds rate, you might like to have a tighter band around it. You might want to have a range of only 10 bps as opposed to 20. To do that, you might have to raise the floor: You have to have the reverse repo rate be closer to the rate of interest on reserves. To me as a macro thing, either one—a tight band or a somewhat looser one—is fine. You may prefer one or the other on communications grounds. But macroeconomically, it doesn’t really matter.

However, with the tighter band, because you’ve set the reverse repo rate higher relative to the interest on reserves, you’re gonna do more business with that. The money funds are going to find it more attractive. Instead of having $300 billion of repo outstanding, you might have, say, a trillion.

Q: Is that problematic for the industry?
A.
I don’t think so. The way I’ve come to think about it is you really shouldn’t try to ask monetary policy to answer this question for you. I think there are independent merits to having a significant chunk of RRP outstanding that don’t have to do with traditional monetary policy but are more important for financial stability.

Here’s one simple virtue: You’re saving the taxpayer a little bit of money. You might say one job you give to the Fed is to fund its balance sheet as cheaply as possible. So if you’re using less of the 25 basis points financing and more of the 5 or 10 basis points financing, you’ve saving taxpayers 15 or 20 bp on over $3 trillion. That’s not nothing.

Also, the reverse repo is very similar to the Fed producing a form of T-bills: It’s a safe investment that’s broadly accessible.

If you think of financial stability policy, and some of the problems that we had leading up to the crisis, it was the search for safe assets. There weren’t enough T-bills so money funds went around searching for things that look like T-bills. If the government won’t make safe assets, then the private sector will make things that resemble safe assets, such as broker dealer repo, hedge fund repo, asset-backed commercial paper.

But we think that when the private sector tries to make too many safe assets – they’re doing this by basically funding overnight – that creates a financial stability problem. We’ve tried very hard with regulation to lean against this, which is basically designed to tell the private sector not to do so much short term funding.

But if you think about why they do it, they do it because it’s cheap. It’s cheaper to borrow on a very, very short term basis. And part of the reason it’s cheap is because there’s a shortage of that kind of paper. If the Treasury doesn’t create enough of it, the private sector is going to fill in the gap. When the yield curve starts to steepen at the short end, there’s going to be the question of whether there’s enough short-term paper. I think then that if we provide more, it satiates the money market funds and then there’s not going to be quite as much incentive for private actors to fund short term.

It’s my general theme in life. Don’t ask regulation to do everything. Incentives matter – a lot

Q: What you’re describing, though is what some people say is the potential problem with unlimited reverse repos. There’s a possibility that everyone will move out of these private sector assets and into the Fed’s facility.
A:
I would say that there’s an ex-ante issue and an ex-post issue, and you’ve got the latter exactly right.

On the one hand, you may want to make some of this stuff available on average, so that basically, in normal times, there’s not too much of a scarcity of safe assets. At the same time, you may not want to make the supply infinitely expandable when things start to go haywire. Because then that might encourage people to bail out of everything else and come running to the Fed.

But I think you can have the best of both by saying something like this: Suppose your policy is we’re going to do a trillion of repo in normal times, but we’re never going to let the facility grow by more than 10 percent in a short period of time.

You want to be there as a supplier of safe assets in normal times, but you don’t want to expand the program quickly if things start going badly. But there’s no reason that the two are not both attainable.

Q: Do you have any thoughts on the steps toward exit? There’s been a lot of discussion around reinvestments and when they should end.
A:
One thing we learned from the whole taper business is that often the impacts of these things can be exaggerated if they take on some kind of signaling dimension. Even going from $85 billion to $84 billion in bond purchases at some point would’ve been a big deal. Now, they go down $10 billion at every meeting, and nobody notices at all. It’s all sort of, what’s the default?

Q: You also mentioned in a speech the challenges of Fed communication, including this line: “There is always a temptation for the central bank to speak in a whisper … But the softer it talks, the more the market leans in to hear better and, thus, the more the whisper gets amplified.” Have things gotten better? Where do we stand?
A:
I have continued to be puzzled by how low various measures of volatility are, which concerns me a little bit. Based on the fundamentals, if you think about all the uncertainty about what’s the right long run rate, when is the Fed going to lift off, it just doesn’t feel like this is a very low volatility environment.

I worry a little bit about if there’s a danger of people misinterpreting the dots. The dot for 2016 is just a forecast; it’s not a promise. But earlier on, the forward guidance did have an element of commitment. The 6.5 percent threshold was pretty much a commitment. Some market participants might be forgiven if they’ve blurred that distinction in their minds.

Q: Were there surprises that you learned, ways that you think about the institution of the Fed differently than you did before coming in?
A.
The communications aspect, I have to say, was pretty eye-opening. I probably spent more time prior to coming to the Fed thinking about what is the right thing to do – questions like should you be doing QE3 or not—and less time poring over the wording of Fed statements. Just realizing how important and how delicate the communications piece is, and how much this is a two-way interaction, I found that very interesting.

 

Ylan Q. Mui is a financial reporter at The Washington Post covering the Federal Reserve and the economy.
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