Bill Dudley: inflation wasn’t caused by too much money

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Bill Dudley talks to Unhedged

The interest rate cycle is not over and inflation is not back to 2 per cent. And yet it feels appropriate to start taking stock. Inflation fell from 9 per cent to 3 per cent in one year. Quantitative easing flipped to quantitative tightening without triggering a systemic crisis (yet). The economy’s resilience has defied all expectations. What lessons should investors and policymakers take from it all?

Unhedged recently spoke with Bill Dudley, former president of the New York Federal Reserve and chief US economist at Goldman Sachs, about inflation, monetary policy and the US fiscal crisis he sees coming. We start by discussing how monetary policy works in a financial system stuffed with cash (an “ample reserves” or “excess reserves regime”, in the parlance). Rather than carefully managing the supply of money, the Fed uses other tools to put a floor under interest rates. Dudley says that makes the likes of M2 growth, a money supply measure that some argue is linked to inflation, a red herring.

The conversation below has been edited for clarity and concision.

Unhedged: What’s something you’d say isn’t widely appreciated about monetary policy today?

Bill Dudley: A lot of people still don’t understand the importance of the shift in the Fed’s operating regime to an excess reserves regime, where they set the rate on reserves [often known as the interest rate on excess reserves, or IOER] as the primary tool of policy.

We still have people talking about money supply growth as a big driver of economic activity, when money supply is mostly driven by QE and QT. When the Fed’s doing QE, money supply grows fast; when the Fed’s doing QT, money supply shrinks. And those things may be correlated with economic activity. When you’re doing QE, you’re trying to stimulate the economy; when you’re doing QT, you’re trying to restrain the economy. But it’s not like money growth is directly responsible.

I hear people all the time talking about how QT is restraining monetary policy. Now, that’s true in the sense that it’s removing accommodation. But it’s not true in the sense that the balance sheet is still very large relative to where the Fed started QE back in 2020. It could take another year or two to get the balance sheet back to where they want it. Until you get it all the way back there, it’s still accommodative. And I have so much trouble explaining to people that the rate of change is different than the level.

Unhedged: Let me offer you the pushback that folks will give you here. That is: the Fed got inflation wrong. Everyone got it wrong. Most of Wall Street got it wrong. But you know what got it right? Year-over-year M2 growth, that got it right.

Dudley: Well, that would be a much more compelling observation if the same thing had happened after the great financial crisis, which it didn’t. M2 is going to be correlated with the shift from QE to QT. But if you go look at M2 growth after the GFC, you saw a lot of QE, you saw rapid growth of M2. And there was no inflation, no consequence for growth. M2 just doesn’t have much relationship to economic activity.

People just don’t understand how the Fed’s operating model has changed. Quantities of money don’t really matter very much. What really matters is the interest rate that the Fed sets on reserves.

Unhedged: Why does it matter that we’re in an excess reserves regime?

Dudley: I think the excess reserves regime is much better than the prior model, because it allows you to do things that you couldn’t do easily before. Under the old model, you’re trying to balance the amount of reserves precisely to generate the federal funds rate. Remember, the Fed didn’t have the authority to pay interest on reserves until the Tarp legislation passed [Troubled Asset Relief Program, passed in late 2008]. So the Fed could only set interest rates by having just the precise amount of reserves in the banking system to generate the interest rate that they wanted. 

All of a sudden, you get the ability to pay interest on reserves. That allows you to cut that link: you can now have a big balance sheet but still control the economy. It allows you to offer open-ended liquidity facilities, without worrying about how much they’re drawn down. In the lead-up to the GFC, the Fed had to be very careful about the facilities not getting too large, because if they got large, we’d have to turn around and drain all the reserves that were added through the liquidity facilities. The facilities had to be set up so that the added reserves wouldn’t be unmanageable. 

Now that we’ve switched to an excess reserves regime, the balance sheet can be as big as you want, and you can still set interest rates where you want. There’s no tension between the two things.

Unhedged: So if the excess reserves regime gives you both the granularity on rate-setting and the ability to run liquidity facilities, why is the Fed so committed to doing balance sheet normalisation?

Dudley: I think basically to rebuild capacity so you have the ability to do QE again, without taking massive interest rate risks.

Unhedged: Now that you’ve seen QE conducted a few times in different climates, what is the stimulative effect of another marginal $100bn of QE, when you’re already in an excess reserves regime? It seems to me like the main effect is moving to the excess reserves regime in the first place.

Dudley: Not very powerful. In the last episode, once the Fed stabilised markets, it switched to QE for monetary policy reasons — trying to find another way of adding accommodation with interest rates at zero. QE is designed to flatten the yield curve, drive down the bond term premium and, therefore, stimulate the economy through financial conditions.

It made sense at that point. But they just stuck to it for too long. Once you had all the pandemic fiscal transfers and the vaccines were introduced, there was no need to continue doing QE. They kept it going for probably nine months longer than they needed to, in part because they were worried about another taper tantrum.

Continuing with QE did two things. Number one, it added more deposits to the banking system and probably created more temptations for banks like Silicon Valley Bank to take on excessive interest rate risk in their portfolio. I’m not saying that the Fed made SVB make their mistakes, but it created the conditions. If SVB didn’t have as many deposits, they probably wouldn’t have been as tempted to buy lots of long-dated bonds. The second consequence is the more QE you do, the more interest rate risk the Fed takes on their own balance sheet. This year, the Fed is going to lose close to $100bn, because the cost of its liabilities, the interest it pays in excess reserves, is way above the rate it’s earning on its Treasuries and agency mortgage-backed securities.

That’s not to say QE is a bad tool. But like any tool, there’s a cost.

Unhedged: How much credit should you give the Fed for the falling inflation we’ve seen so far?

Dudley: I’d answer in two parts. First part: when did they get started? D minus; really late. Beginning to raise rates in March 2022 when the economy was growing fast and inflation was really high — they get a bad grade for that. Now, they’ve definitely caught up and are either at or pretty close to where they need to be; A minus.

The consequences of being late turned out to be pretty mild because inflation expectations stayed well anchored. And it turned out that a good chunk of the inflation was pandemic-related as opposed to related to the economy. What we’ve seen over the past six months or so is that the labour market isn’t as tight as we thought it was going to be. Wages are coming down, even though the unemployment rate is still very low. So you’re starting to see evidence that maybe the Nairu [“non-accelerating inflation rate of unemployment”, the lowest unemployment rate consistent with stable inflation] is lower than we thought.

Unhedged: Could we get a soft landing? 

Dudley: It’s certainly possible. My view for two years was that we were going to have a recession at some point, because the Fed had let the unemployment rate get well below Nairu. And this is coming back to the story you have in the FT on Claudia Sahm and the Sahm rule [which states that a 0.5 percentage point rise in three-month average unemployment signals a recession].

I’ve always thought that once the unemployment rate goes up by more than a certain amount, the chances of recession go up dramatically. Now what we’re finding is maybe that’s not the case. That’s the key question right now: does the unemployment rate have to rise to 4.25-4.5 per cent for the Fed to achieve their “final mile” on getting inflation back down to 2 per cent? If you think it does, then a hard landing is highly likely.

Unhedged: I want to ask you about the fiscal deficit. People talk about the term premium or Treasury market functioning. In Washington, it’s all about a debt crisis. How would you frame the risks from big deficits?

Dudley: You have to split it into two things. One is the Treasury market functioning issue, which is more about the amount of Treasuries that have to be financed versus the capacity of the dealer community to digest Treasuries if there’s a shock to the market.

The second set of problems is around fiscal sustainability, very large chronic budget deficits, what happens to the debt-to-GDP ratio and the willingness of investors to view this as a sustainable path. There have been times in US history where people have balked at the path of federal debt. And the most recent time was the mid-1990s when [Bill Clinton’s political strategist] James Carville famously said, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

That’s the market saying, “no, we’re going to price in a bigger term premium because we’re worried that eventually this is going to be resolved by the central bank being forced to monetise the debt”. At the end of the day, that’s really the threat.

I don’t think in the US we’re anywhere close to that. But you can imagine a trajectory for the fiscal deficit where the Fed tightens monetary policy a lot and drives interest expense up. Then, people in Congress start getting upset that the Fed is making their job more difficult. This situation would also presumably be exacerbated by bond investors being less willing to take on debt because they are nervous about the pressure that the Fed is under. In principle, the government can take away the independence of the central bank. Hopefully that never happens, but there’s always that risk.

A really good example that doesn’t get a lot of attention is Canada in the early 1990s. Canada at the time had very large provincial government debt and large federal debt. Investors started to balk. Interest expenses started to become very burdensome. And that’s why the Canadians actually got religion on fiscal deficits. They got so close to the precipice, it cured them for the next 25 years. 

I think there’s going to be a US fiscal crisis at some point. But I couldn’t tell you if it’s next month or five years from now.

One good read

Much as it pains us to praise Robin Wigglesworth, he has written a good review of the new book on Ray Dalio.

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