Jeffrey Lacker on Fed Governance and Learning from the Recent Inflation Surge

Jeffrey Lacker is a senior affiliated scholar at the Mercatus Center, but has also previously worked at the Federal Reserve Bank of Richmond from 1989 to 2017, serving as its president from 2004 to 2017. Jeff is also a returning guest to podcast, and he rejoins Macro Musings to talk about Fed governance issues and the lessons learned from the recent inflation surge. Specifically, David and Jeffrey also discuss the issue of maximum employment, how the Fed could reform its governance structure, what the central bank should address during the next framework review, and more.

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Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Jeff, welcome back to the program.

Jeffrey Lacker: My pleasure, David. Great to be here.

Beckworth: Great to have you on, and great, again, to have you on as an affiliated scholar at the Mercatus Center. We've got some big guns now. We've got you, Tom Hoenig, and a few others.

Lacker: That’s very flattering.

Beckworth: We are glad to have you on board. Now, last time we were on the program, we talked about your speech and then it became a policy brief on governance issues, and that was a great piece. You had three main points, if I recall correctly, the decline in diverse viewpoints at the Fed, the growing role of the Board of Governors in Fed president selection, and then growing fiscal pressures from Congress. So, an important discussion, still relevant, probably more relevant today as time has gone on, and so, I want to go back there for a little bit during this show, and then later, we'll get to discussions about the recent inflation surge and the lessons from that.

Beckworth: But I want to tap into you. You're a 28-year veteran of the Federal Reserve System, so you know the inside. You know, politically, what works, economically, what would work, and we talked about governance issues. So, we've had a number of guests who have come on who have thrown out suggestions for reform, like how can we make the Fed better, from the governance perspective? There's also the monetary policy reform perspective. We'll put that to the side.

Lacker: Right, how to do.

Beckworth: How to actually do it. In fact, maybe we'll talk about that in the second half of the program. Well, let's talk about governance issues. I'm going to list a number of guests and just throw out their proposals, and you tell me what you think. You can rank it, you can evaluate it however you want to. Let me begin, though, before I start listing them, with a quote from a recent paper from Andy Levin and Christina Parajon Skinner, and the paper's titled, *Central Bank Undersight: Assessing the Fed's Accountability to Congress.* And I think it's just a useful framing to set up this conversation, and they say this, "The Fed would not be the first agency in US history to outpace Congress.”

Beckworth: “By now, it is well documented and understood that after World War II, the imperatives of the Cold War motivated the formalization of various intelligence agencies that exercised expansive powers hidden from public view. It was not until the early 1990s that Congress established mechanisms for exercising meaningful oversight of the intelligence community. In similar fashion, Congress may now wish to revisit its mechanism for overseeing the Federal Reserve System, given how radically the Fed has changed.” So, that was the push of your last time on the show, and it's the push of these proposals that I'm now going to share with you.

Beckworth: Let me begin with a recent guest that we had on the program, actually two recent guests, Dan Katz and Stephen Miran, and they had a paper that was titled, *Reform the Federal Reserve's Governance to Deliver Better Monetary Outcomes.* They called their reform agenda “monetary federalism”. It's probably the most radical one I'm going to throw out today, so we'll start with [what is] really radical. Here's what they would have us do. Number one, they want to nationalize all of the reserve banks. Take the Richmond Fed, for example, completely get rid of the private side of it, make it completely public.

Beckworth: Part of that motivation is to make it open to FOIA requests, but everyone there would be a federal employee or a Federal Reserve employee, so nationalize it. Also, have every president serve at the FOMC, so no rotation. So, basically, you're empowering the regional Fed banks to be actively engaged [in the] FOMC all of the time, be able to vote, but also empower the president to fire, at will, anybody at the Fed. So, they want to increase what they see as democratic accountability, but also increase this regional representation, and, also, limit the Board of Governors membership terms to eight years. But, basically, a monetary federalism is their view. Empower the reserve banks, nationalize them, and also empower the president. Where do you land on that?

Jeffrey’s View on “Monetary Federalism”

Lacker: So, I listened to the show where you interviewed those guys, and I've read the paper. It's intriguing. There's some good points, but there's some really troubling points as well. First, nationalizing the reserve banks, as a financial matter, as a matter of where the money goes— they're effectively nationalized now. There's a dividend that the reserve banks pay to the member banks that own them, but it's fixed by statute. So, as a matter of the ownership structure's effect on governance and the incentives of the leaders of the institution, earning profits is not a factor in the Fed's decision-making.

Lacker: In contrast, for the Bank of England in the 1700s and 1800s, it was a factor, and that plays a role in all of the discussions about lender of last resort then. That's a different topic. I think that allowing all of the reserve bank presidents to vote, giving them all voting roles, is a good idea, as a general matter, in all of these governance proposals that I read. My ears prick up about the role of the Federal Reserve Bank presidents. I think it's very important. I think it's important to the robustness of the discussions around the table, and there's a reason for that. The reserve bank presidents have their own research staffs. These vary in size from, I don't know, 20 to 90 PhD economists.

Lacker: And they're able to come to their own independent assessment. Now, they don't do without the benefit of the work of the huge numbers, hundreds of PhD economists at the Board of Governors. But the dynamic is different, because they have somebody like kind of a red team, blue team thing. They have another team to go over what the board staff is presenting to the committee, critique it, offer different perspectives, and I think that those different perspectives, brought to the table repeatedly, eight times a year, are a really valuable element of the discussion, and really help make the whole exchange more robust.

Lacker: In contrast, the governors, other than the chair, see the board staff presentation about the current state of affairs and what policy should do without any independent help. They get one economist, maybe, to help them, but they don't really have the same access to the staff, and as a result, they're not as well equipped, let's say. They're not as well-armed coming into the discussion. They're all good people, smart, they do their best, but with your own staff there, 20 economists to go over, and to have them fight it out in front of you, and hash out what the issues are, I think that's really valuable.

Lacker: So, I like the idea of more presidents serving and their independence, but this idea of having— I like the idea of federalism in general, because the whole idea of reserve bank presidents and governors, that's this key federalism in the Federal Reserve System, [and it] was what Carter Glass insisted on in 1913 and in 1935. He wouldn't roll over for Marriner Eccles, and he insisted on reserve bank presidents being able to vote, having a voting role, although not a majority voting role. But this is a weird version of federalism, to have a federal entity created by Congress, and then these state governors get to appoint people. At a minimum, you'd have some state governors having a role in playing two different presidents, because some districts cross state lines or bisect a state. But it just seems odd if you don't, plus, if you don't, in addition, look at the district boundaries, and that's a whole other--

Beckworth: That's fair enough. I think I asked them about that, and they said, "Yes, we didn't have the time or space to get into all of the geographical challenges of the proposal." But let's say, for the sake of argument, that they're able to realign districts, draw them up based on population, so a better-drawn map of sorts. How would you select the presidents to get away from the growing influence of the Board of Governors? I mean, is it the state governors? Let's just say that you could do a fair, equal way, each governor had some equal vote, but how would you do it?

Lacker: It doesn't strike me as likely to be the case that governors feel robustly accountable for their appointments, their votes on appointments, to the Fed presidencies. It's a job for— The agency was created by Congress, these entities were created by Congress, they're accountable to Congress. I think that accountability should flow up through Congress. And I like the focus of— you mentioned Andy Levin and Christina Parajon Skinner. I like the focus of their proposal on making that oversight more robust. I think that's where the focus should be.

Beckworth: Okay, well, let's come to their paper in just a moment, but while we are on the regional banks, let me jump down to a proposal from Mike Belongia and Peter Ireland. This is a paper that they gave at the Shadow Open Market Committee, so, maybe you were there when they did this. But Peter's also come on the podcast, and I believe he shared it with me on the podcast as well in a previous show. But they would actually reduce the number of regional banks from 12 to 5. They would make them all permanent FOMC members, but they would reduce them from 12 to 5. And I believe it was New York, Atlanta, Chicago, Dallas and San Francisco. How do you feel about that?

Reducing the Number of Regional Fed Banks

Lacker: I'm less well-disposed to that. Peter Ireland's a good friend. He used to be a colleague. He used to have his office next to me in Richmond. But it seems to be premised on taking for granted that only five presidents vote, so, might as well strip out a lot of the other infrastructure. So, the Federal Reserve does a lot, the Reserve Bank presidents do a lot besides think about what they're going to say at the FOMC meeting or the next monetary policy speech that they give. The IT systems move $4-5 trillion a day. They've got cash operations. Now, they're developing a new payment system. There's this FedNow fast payment system that they're trying to stand up. So, they've got a lot, operationally, on their plate that they're accountable for, in the sense that a CEO is accountable for what goes on under them. That work takes time and effort, and I think that the Federal Reserve System made good use of the talents of the 12 CEO types they had. I think that delegating that all to first vice presidents would be a mistake. I'm open to something like that, [but] I'd rather see more districts than fewer.

Beckworth: How many?

Lacker: So, the glaring thing about the districts is that the San Francisco one is so huge. At the time, it was a twelfth of the banking system, in 1913. Now, it's 30% of the US economy. And there was a proposal in Congress about a decade ago to add two districts, one in Seattle and, I think, one in Arizona, not surprisingly, supported by Congressmen in that district. But that seems like an equally plausible direction to go in.

Beckworth: We recently had Mary Daly here at Mercatus. We did a podcast with her, and I asked her, "You've got a really large district." She goes, "I travel a lot."

Lacker: Yes, you have to. My district spans Maryland to South Carolina and most of West Virginia, and I had my hands full getting around the district. I just can't imagine what it would be like in San Francisco. Fly to Utah and Idaho and Arizona.

Beckworth: That's a lot of territory to cover.

Lacker: Yes, sure is.

Beckworth: Again, we're on the regional banks. I want to go to another proposal that touches on them. This is from Peter Conti-Brown. He did a working paper for us titled, *Restoring the Promise of Federal Reserve Governance.* One of the points or arguments that he makes is that the non-voting regional bank president should be quiet, sit to the side. I think he used the term, "They should have the observer status,” to keep the committee focused. His paper really pushed more for the governors to have more power. In fact, [the] other half of his proposal was to increase the pay of the governors, because, as you know, their terms are about two years now, on average, [that] they serve. They've fallen, even though they’re 14-year terms, they leave quickly. So, he noted how the regional bank president salaries— the average is around $400,000, whereas, if you're a governor, you're making maybe $200,000, at most. So, let's go back to that first point, though, that if you're not a voting member of the FOMC, you keep your mouth shut. You sit to the side unless you're called upon. What are your thoughts?

Addressing Peter Conti-Brown’s Proposals for Fed Governance Reform

Lacker: As you might expect, it just doesn't strike me as a useful thing to do, to take a bunch of people who've thought a lot about the issues and have them just sit on their hands, and then a really important discussion— I mean, you read the transcripts of those meetings. They go on for eight hours over two days, and there's a lot said and a lot thought about. And people respond to each other, and to just shut a bunch of people up just strikes me as unproductive.

Beckworth: Okay, that's a hard pass from you on that one.

Lacker: But on the salary side, I'm very sympathetic to that because, first of all, I think that the decline in average tenure of the governors is, I think, an important issue. I think that it has to do with more than just salary. I think how the chair treats them is also a factor. But I think that a chair who welcomes the input and discussions with the governors, as Bernanke did, to my knowledge, we should be able to attract good people if they're compensated enough, or you get academics that go back after two years. That's part of the dynamic as well. But the salary issue was a point of tension between some governors and the reserve bank presidents.

Beckworth: Yes. As the Reserve Bank presidents talk about their nice vacations that they're going on, the governor's like, "Well, we can't afford that."

Lacker: Well, it wasn't obvious that the reserve bank presidents didn't also bear a public sector discount of some measure. If you look to other organizations that are nonprofits with a similar span of control, similar number of employees, or similar scale operations in terms of expense budget, like universities, reserve bank presidents were arguably underpaid.

Beckworth: So, what you're saying, then, is that Peter Conti Brown's proposal for salary reform for the governors is actually good economics, because it's looking at opportunity costs. These people that we would want at the Fed, at the Board of Governors, or even regional banks, they could be working somewhere else, making a lot more. And so, we're not getting all of the talent that we need. So, let's make it easier for them, at least, to say yes to the offer if it comes up.

Lacker: Well, it's related to this, is this norm around public speaking. As I discussed in that Mercatus policy brief, there's been a transition over the last 20 or 30 years. Under Greenspan, reserve bank presidents and members of the Board of Governors didn't voice independent perspectives on monetary policy. Bernanke opened that up, to his credit. I thought that that was a good, constructive thing, and it greatly aided the public's understanding of what the Fed was trying to do and what different perspectives there were about that. But there was something of a backlash in the last 10 years or so, and there's been kind of a reining in.

Lacker: I think that a culture in which you're expected to speak your own view— the way Supreme Court justices get to write down their views and dissents, or the way that some central banks around the world have minutes in which individual participants' views are attributed to them by name. So, this person's views were the following, this person's views were the following. Those kinds of mechanisms and norms, in which all of the participants on the deliberative body have a voice and will have a public voice— I think that kind of norm and practice can attract people and have them stay, it can make it a more attractive position.

Beckworth: Sure. So, there's a number of reforms that would encourage people to stay longer at the governorship position, salary being one of them, but also the culture of the environment in which they work. So, we want to make it easy for them to stay the full term, if possible. Okay, the last set of reform proposals— we touched on these authors earlier, Andy Levin and Christina Parajon Skinner. Their paper, that I mentioned before, was *Central Bank Undersight.* That's a play on the word oversight, but undersight, *Assessing the Fed's Accountability to Congress.* And they have several things that they propose.

Beckworth: One of them is just enhanced congressional oversight, so, Freedom of Information Act [requests] on all of the regional banks. So, if we want to see what's going on, we can get it. Because right now, if you put a Freedom of Information Act [request] to a regional bank, they can say, "No, we're a private organization. You can't have access to it." Also, they want to have GAO reports on the Fed. Andy Levin has pushed really hard for going back and just evaluating the QE programs. And, again, not saying that this is the way you should do monetary policy, but kind of looking back. Also, [appointing] an independent IG, a truly independent IG, for the Fed. Not one that reports to the Chair, but one that reports to Congress, so, Congressional enhanced oversight. The other thing is that they would like to see more detailed reporting from the Fed to Congress, and they give a good example. The 2012 inflation target that you were a part of, they note that Bernanke had a lot of consultations with Congress.

Lacker: Yes, sure did.

Beckworth: He had buy-in from Congress, whereas the 2020 FAIT reform wasn't much buy-in. [There] is not much evidence of discussion going on like there was in 2012. So, they said, "Look, you need to report discussions. Just make it very transparent." What do you think about their proposals?

Addressing Andy Levin and Christina Skinner’s Proposals for Fed Governance Reform

Lacker: I like their proposals a lot. I think that they're well-grounded in the governance reality of the Federal Reserve, the Fed's role within our federal government structure, and I think that they're all very constructive. I think Congress could use help with either a one-time external body of experts to come in and review the Federal Reserve, its operations, and practices and to review recent episodes and conduct. I think that would be really useful, or something— a standing body on an ongoing basis. I think their analogy to the intelligence services after World War II is very apt. I think that the Fed has tended to use the need for secrecy and confidentiality, which is an obvious value to ward off criticism and inquiries and ward off more full discussion of what they've done. The Fed has a culture of not really looking back very often. This is one of the things that I mentioned in that talk.

Lacker: And I think they could do well to accept an open, fair, and honest inquiry into recent past conduct, much less the '70s. I think that analogy of constructing a congressional mechanism like that to share confidentially with a key gang of eight or whatever from the two houses and the two sides— I think that makes a lot of sense. A lot of their other suggestions are on point. I think that the IG being independent would be useful. I had a little experience with that. GAO reports, I don't see as intrusive. People talked about Audit the Fed, and I campaigned against the bill that was advanced for that, back in 2010, to so-called allow auditing the Fed.

Lacker: But it was more of a bill constructed to allow congressional gotchas after each meeting, to subpoena all of the documents the day after the meeting. That wasn't constructive. But I think GAO reviews, expert reviews— the Fed is reviewed by the GAO all of the time. I remember, at the time, there were a dozen open audits, GAO audits of the Fed at the time, of things outside of the monetary policy realm. So, it's not something that should be terribly intimidating or scary for the Fed. But yes, I like their proposals very much.

Beckworth: So, one that I did not mention was that they also wanted to have the Fed stress test their own balance sheet, when they're doing QE programs, in particular. Just be honest and say, "Look, if rates go up when this is all said and done, we're going to be hurting, we're going to be losing, but we think it's worthwhile." Just be upfront and say, "Look, we're doing this now to stabilize the economy. It's worth any future costs we may incur as we lose income."

Lacker: I think that's right. I think, as a general matter, the Fed should do more public discussion of things that could happen as opposed to the thing that they think is most likely to happen. I think they are just preoccupied with their baseline projection at times, and I think that inhibits the public's ability to understand that data could come in different ways. And it doesn't do much to enhance how policy's going to depend on data. The Fed says it's data-dependent all of the time, but it doesn't tell you much about how, besides maybe sign restrictions.

Beckworth: So, one more reform proposal, and there's a lot that we could do, but, for the sake of time, just one more that I'm going to throw out there, and then we'll move to lessons learned from the inflation surge. And this is a proposal I've heard from many people, and it deals with the fact that the Fed has so many responsibilities, and one of them is regulating banks, being a bank supervisor. In fact, it’s probably the most important one. Is that fair? The most important bank regulator in the US?

Lacker: I think so, yes.

Beckworth: Okay, so, one of the concerns is that it's one thing to have budgetary independence when you're doing monetary policy. You're not dependent upon Congress to fund your operations because it might get politicized. But some people worry that when you're the bank regulator, maybe it is useful to go get appropriation from Congress. The FDIC, Comptroller of the Currency, they are all subject to this democratic accountability, because when you start doing— Those issues tend to be more fiscal. There's issues at stake that aren't necessarily at stake with monetary policy. So, there's been some calls to at least take some of the bank regulatory responsibilities out of the Fed, and maybe move them to another agency. There's been different forms of this, but what is your sense of that? Is that practical? Is it a good idea?

Altering the Fed’s Responsibilities as a Bank Regulator 

Lacker: So, when I look at proposals like that, I think that the core issue is the discount window. If the Fed's going to be a lender to these institutions, it needs some insight. It needs some ongoing monitoring. So, think of the discount window as a line of credit, and think about a private commercial bank entering into a line of credit arrangement with some company, some client, a borrower. And so, they get a lot of financial information upfront. There [are] covenants in the line of credit that require the borrower to file financial statements. There [are] other covenants that tell the borrower that they have to meet certain financial ratios, a certain amount of liquidity, a certain amount of capital, they can't borrow too much.

Lacker: They have to get permission to borrow more. All sorts of things that align incentives, control the risk, and at the end of the day, there's a material adverse change clause that says, "Alright, you have a line of credit with us that says you can, at your discretion, borrow at this rate, a spread above some market rate. But if there's a material adverse change in your condition, not covered by any of these covenants, we can pull the line, we can deny that credit." So, in comparison, the Fed doesn't look too good, and to weaken its hand by making it jump to another agency for the information.

Lacker: I've seen how that works in cases in which troubled institutions are looking for credit. For the Fed to have to go to the FDIC or the Comptroller or the Currency for information, or some other agency for information about potential borrowers— It's problematic at times. You get into turf considerations and misalignment of the agency's incentives. To me, evaluating those proposals depends on, well, what do you do with the discount window? Now, some have said that you could shut it down. Anna Schwartz, for example, in 1992, said, "It's out outlived its usefulness."

Beckworth: Would she not have it moved somewhere else, or it would just completely shut down?

Lacker: No, they can borrow from another bank if they want. Let it go to the market.

Beckworth: So, I don't think that's ever going to happen.

Lacker: Yes, I don't think so either.

Beckworth: But that's a very compelling counterpoint, that if you're going to do the discount window, you need to be able to know who you're lending to, and if they've got good credit, good collateral, will they behave themselves? Avoid some of the risk. Okay, so, good point, fair point. Have some other central banks not tried this, where they try to wean off some of the responsibilities, and then they say, "Oh, maybe not. We need to bring them back on."?

Lacker: Well, the UK is the big example of having hived off so-called financial stability and prudential regulation and then brought it back in. Yes, that has to do with deeper questions about central bank responsibility for financial stability, and that could be a whole other podcast.

Beckworth: Alright, well, we’ll put it on hold there. Maybe we'll come back and visit it with you. Now that you're an affiliated scholar, we'll have you back on in the future. But let's switch gears and go to a presentation that you gave recently at UC San Diego. The title of your presentation was, *What Lessons Should the Federal Reserve Learn from the Recent Inflation Surge?* And I was excited to hear that this was arranged by Jim Hamilton.

Lacker: Yes. Jim Hamilton invited me out to UC San Diego.

Beckworth: So, for those who are as old as I am, they'll remember Jim Hamilton's textbook, the Bible of time series econometrics. It's really big and thick, and, honestly, it was a little intimidating, in graduate school, to get it. But back then, VARs were a big deal. I know [they are] maybe less so today, but we really learned VARs with the help of Jim Hamilton. In fact, he came on the podcast a few years back, so we will provide a link to that show. So, you and Jim, you go way back, huh?

Lacker: Yes, I saw his job market talk at Wisconsin in 1982 or ‘83 or something, and it was this JPE paper that he did where he showed that there were oil price spikes before all of the major post-war recessions in the United States. And it was this immense puzzle, because oil didn't seem big enough as a sector to cause a response, and it's still a little bit of a puzzle, I think. I don't know what the literature has done with that since then.

Beckworth: Yes, so, his argument is that oil price shocks actually cause recessions, or at least help contribute to them.

Lacker: Well, so, he was a good, honest researcher in saying, "Look what I've uncovered. I'm not quite sure what to make of this.” He had some ideas, but he didn't come down in favor of a definitive interpretation.

Beckworth: He didn't come down, but the implication is that, since oil was such an important input to the economy, if it suddenly becomes more scarce, it can actually have a supply-side recession, a negative supply shock to the economy.

Lacker: Yes, well, there's this other argument that what was going on before OPEC in '73 was that the Texas Railway Commission chose when to allow prices to go up, and that Texas was setting oil prices, and that they did that selectively. They did it when supplies were tight, and they knew they could make it stick. And so, the oil price change was correlated with the business cycle in a way that made it come just before a recession, so, not that it caused it, but it's like a leading indicator.

Beckworth: Well, another explanation that I'm sympathetic to— and I think it's Ben Bernanke, a co-author, wrote that the oil price shocks, that the Fed responds to and tightens, causes the recession. So, the Fed sees inflation going up, driven in part by oil prices, and it makes a mistake, and it tightens when it should have looked through them, and that was Bernanke's— one of his, I think, [favorites].

Lacker: Well, in my dissertation, I did some empirical research using VARs, naturally, which was the style in the mid-1980s. And you can see that oil price shocks are correlated with subsequent monetary policy tightening. So, that's in the data for sure, but a lot goes on.

Beckworth: Yes, so, anyhow, Jim Hamilton is the individual who orchestrated-

Lacker: He was my host.

Beckworth: -your talk. So, tell us about this talk. You cover several areas, and, eventually, I want to wrap this into your recommendations for the Fed's framework review, but walk us through your presentation.

What Lessons Should the Federal Reserve Learn from the Recent Inflation Surge?

Lacker: Well, I took, as a premise, that this was a very bad performance on inflation. If you just look at a chart of inflation going back several decades, you can see this price stability period that began in 1995, when the Fed secretly adopted a 2% target and continued after it announced its target in 2012. I mean, there are fluctuations, but headline and core inflation just wiggled around 2%. Maybe they got up to 4 or down to negative, to zero on the headline, but there's a huge surge in 2021, up to 7%. It's unprecedented. We don't have anything like that going back to the early '80s.

Lacker: The Fed clearly delayed responding in 2021. A host of indicators in the middle of that year showed that interest rates ought to be lifting up off the floor, but the Fed didn't move until March 2022. And so, I just took a look at what the Fed ought to learn from that. So, I think there's five things, five reasons why the Fed might have delayed— might have contributed to the Fed delaying. And I think, in my view, the Fed's delay is the clear culprit for inflation getting so high. I think it seems pretty clear that if the Fed had responded with more alacrity, inflation wouldn't have surged as much in 2022, and we'd be closer to 2% right now.

Lacker: So, I take that as a premise. I don't prove that or anything, but I just take that as a premise, I think, just looking at the data. So, why did the Fed delay? I think that one contributing factor is that the Fed adopted this revised policy framework in August 2020, and the way they implemented that at the September 2020 meeting was also involved. Broadly speaking, the revision shifted the emphasis towards the employment mandate and away from the inflation mandate. They, essentially, said that they'd be willing to tolerate inflation running moderately above 2% for some time, motivated by the 2010s experience of a few [basis points], a few tenths below, averaging 1.7 or 1.6 for a few years. And it was asymmetric, that they don't intend inflation to underrun to offset overshooting. And, arguably, this diminished their perceived propensity to resist inflation above 2%. They had an escape clause. This is a paragraph at the end, and I'll read from the statement.

Lacker: It says, "In assessing the appropriate stance of monetary policy, the committee will continue to monitor the implications of incoming information for the economic outlook. The committee would be prepared to adjust the stance of monetary policy, as appropriate, if risks emerged that could impede the attainment of the committee's goals.” And so, this is their longstanding formulation for, “We provided forward guidance, but if something else happens that we don't anticipate, we reserve the right to alter policy accordingly.” But they didn't invoke that. Instead, they treated it as boilerplate, as inessential.

Lacker: I think that their forward guidance language in September 2020 was something they should have invoked the escape clause to suspend. That guidance said that, "The committee will aim to achieve inflation moderately above 2% for some time, so that inflation averages 2% over time, and longer-term inflation expectations remain well anchored at 2%,” and, “The committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.” And the committee decided to maintain the target rate at zero to a quarter percent for the federal funds rate, and to maintain that target range “until labor market conditions have reached levels consistent with the committee's assessment of maximum employment,” and “inflation has risen to 2% and is on track to moderately exceed 2% for some time.” So, they basically held tightening hostage in that formulation to reaching maximum employment.

Lacker: In the middle of 2021, whatever they thought maximum employment was, they should have— I think [they] would have been well advised to suspend this forward guidance, invoke this escape clause, but they didn't do that. So, that's one lesson, and I think the lesson is that preemption remains important. I think that, in the framework review that they have coming up, it would be useful for them to discuss a comprehensive array of alternative inflation scenarios. The 2020 framework just discussed this “running a little bit over” scenario, but they should spell out that, if it runs well over, they're likely to do X, or policy is likely to require to do X, or if it runs under, what it should do as well.

Lacker: They should provide a more comprehensive discussion of various inflation scenarios, now that we've had one that wasn't even envisioned in the August 2020 statement. I think that they will, but I think they should avoid linking forward guidance tightly to maximum employment. And in the future, I think that they should take the escape clause seriously. I think they'd be well advised, in the new framework, to specifically provide for preemptive policy responses to incipient inflation pressures that emerge. That should be on the table, something they might do if they found [it] necessary, rather than rule it out. I mean, August 2020, relative to the January 2012 framework— it basically took the September guidance, forward guidance— just took preemption off the table. And I think, in hindsight, that's a mistake. So, that's the first lesson.

Beckworth: Let me ask a few questions about that.

Lacker: Sure.

Beckworth: Do you think that the problem in the new statement was the FAIT part, where they'll make up for undershoots below 2%, or was it more this new approach to maximum employment? Because now it's shortfalls from maximum employment, not deviations. It's not symmetric. There's two asymmetries. One is, they'll make up for undershoots, but not on the other side, which you noted. But also, [with] this maximum employment, they really put a lot of weight on shortfalls, and they also had this term "inclusive" maximum employment. I don't think the “inclusive" played much of a role.

Lacker: No, it doesn't seem to. 

Beckworth: It was just a bone they threw, I think, to political constituencies. But, shortfalls, did that really change the game? Was that the problem?

The Issue of Maximum Employment

Lacker: I don't think so. What I think is more central here is, the notion of maximum employment—it's something they'll admit is measured with uncertainty, but just the conceptualization of what they're trying to measure, I think, is something that the Federal Reserve is very confused about. There was this old idea from the '60s of full employment, that full employment was an unemployment rate of 4%. Now, maybe, people think it's 3.5%, or something like that, but it was some fixed number, and that persists. So, what we learned in the '70s and '80s— and then this coalesced in the '90s with the new classical synthesis, or these new Keynesian models that are now the mainstream workhorse for macroeconomic analysis— is that you have a real business cycle model in which you've added some stickiness of prices and wages, but you still have this real business cycle model that's subject to disturbances.

Lacker: And those disturbances move around this shadow variable, this latent variable, this unobserved variable, maximum employment, that's relevant to this gap that goes into inflation dynamics. That entity, in theoretical models, responds to virtually all of the shocks in the economy, virtually all of them, and so put yourself in the position of the Fed in the first quarter of 2011. How low can they make the unemployment rate in the second quarter of 2011, without causing inflation?

Lacker: That's the relevant notion of maximum employment, not the level of the unemployment rate that we're ultimately going to get to, as the economy recovers. And the intuition of this is pretty clear. In the recession in 2008 and 2009, a tremendous number of residential construction, building supplies-related workers were thrown out of work. So, what's the economy going to do with them? Well, what the labor market tries to do is absorb them into other lines of work, find other things for them to do. That's a process that takes time, and it takes effort. It takes learning new skills. It takes moving, in some cases. It takes investment. It takes innovation in firms to do new things that are now possible, and so we have this overhang of unused resources. That process just takes time.

Lacker: I'm struck by the research of Robert Hall and Marianna Kudlyak, the latter [being] a former colleague of mine at the Richmond Fed— former, of course, the esteemed macroeconomist at Stanford— showing that the unemployment rate comes down in recoveries at about the same rate every time. So, it seems as if we're not in a world where the unemployment rate goes up, and then goes down to full employment, and then we stay there a while. It's one where the unemployment rate is bumped up for some reason, because of some shock, and then we work at getting it down. The economy works at moving that down, and it takes place over time in markets subject to search and information frictions, and what the Fed can do about it in 2011, 2012 is relatively limited. And so, the notion of maximum employment that's relevant to monetary policy and the inflation process is one that moves around with all of the developments in the economy. It should be contingent. It should be dated T. It should be a function of all the recent shocks in the economy.

Beckworth: You keep referencing 2011, 2012, that's when that first statement was written.

Lacker: Right.

Beckworth: Is that when maximum employment was put in, [but] not well-defined, though?

Lacker: Yes, so, there's a paragraph in that statement that is a masterpiece of obfuscation, in some sense. So, the first half of the paragraph says, "Maximum employment is determined by real forces. The Fed can't control those, and we can't influence those." The second half of the statement said that— so, let me back up a little bit. At the time, we had just started issuing these Summaries of Economic Projections, and that's the story where we were all asked to submit our projection for the unemployment rate, fourth-quarter GDP growth, fourth-quarter headline and core inflation, for the end of this year, for the fourth quarter of the next year, and then the year after that. Then, there was a column at the end for the long run, and what people put down for the unemployment rate in the long run is this sort of thing.

Lacker: I mean, we were asked to put down what we think it's going to average. So, in a classic 3-equation model, where you'll linearize around the steady state, it's the average unemployment rate. But in this Hall and Kudlyak world, where you've got these disturbances, a plucking model— you have disturbances that shoot the unemployment rate up, and you slowly come down— I was kind of at a loss. I didn't quite know what to put down. It's clear that what people had in mind, the unreconstructed Keynesians on the committee, or only partially reconstructed Keynesians, had in mind was the old Solow-Samuelson, 1960s— And the CBO still publishes a series based on this idea, the non-accelerating inflation rate of unemployment, as just a fixed parameter that varies with nothing but demographics. But in a real business cycle world, with some price stickiness, it's not obvious what to put in that last column for the unemployment rate.

Beckworth: So, would you have them drop it altogether, like not try to define maximum employment? How do you handle it in a practical sense?

Lacker: That's a really good question. I think that they need to educate themselves, but I think [they need to] take on board in their own internal deliberations and their own internal presentation materials. I don't know, maybe since I've been there, they've done this, but they don't talk about this publicly, as if maximum employment is anything but the best unemployment rate that you're going to get in the expansion. So, it's like the best you're going to do over the next 10 years, that's the maximum employment— unemployment rate

Beckworth: So, I'm sensing from you that we need some humility in thinking through the real side of the economy. We want to get to full employment, whatever that is, but the best we can really do is maybe alter the trend path of inflation. So, it sounds like, to me, that you'd be very sympathetic to a proposal from Athanasios Orphanides, where he has the natural growth rate, which is kind of a variant of nominal income targeting. Look, we kind of have a sense of where potential real GDP is going, add 2% to that, and there's deviations from the forecast. Are you sympathetic to that?

Lacker: I think Athanasios is right that monetary policy has, and still does, place too much weight on its estimate of maximum employment, or the unemployment rate that goes with maximum employment. Whether his proposal doesn't get around that by placing too much weight on some other parameter, like the natural growth rate, I'm not sure. I need to think that through.

Beckworth: Well, he says— his argument, and, of course, I'm sympathetic [to it], because it results in a nominal GDP target of sorts. His argument is that the errors on potential real GDP tend to be less than the errors on R-star or U-star, these other estimates. It tends to be the least error-prone real measure, so run with it. And his argument, I think, is also intuitive. Potential real GDP, typically, is not going to change dramatically over a short period of time. A war, okay, a pandemic, you kill half the population, sure, but generally, it's slow moving, so you can roughly get it right. Now, maybe you can make that same argument for U-star and R-star, I don't know.

Lacker: I'm open to his line of thinking. He and John Williams did great research on the '70s, and the misestimating of maximum employment back then. But, for me, I think that a broader agenda for the Fed is to convey to the public that, in circumstances like the first quarter of 2011, they're not going to get to maximum employment by the fourth quarter of 2011. It's not going to happen, and in their own analysis, not taking that variable in the 3-equation model too seriously. In some sense, this was relevant to the framework discussion leading up to 2020, because there were some in the Fed that beat up the Fed for not being able to achieve a more rapid expansion in the 2010s, but it's not obvious that the economy was capable of a much more random rapid expansion, given fiscal policy, and even more stimulus, fiscal stimulus, might not have done it either.

Beckworth: So, let me go back to the FAIT framework again, in the time we have left. We've been focusing on the maximum employment side, but let me go back to the average inflation targeting side. I think that some of the blame you can put there in the following sense. The Fed was still convinced of transitory inflation for a long time. I think it was November of '21 when they finally dropped it. So, they were still [saying], "Oh, it's transitory, it's transitory, it's transitory," which is understandable, because it's standard or conventional wisdom [that] you look through supply shocks. And if, in fact, the inflation in '21 was driven by the pandemic, by residual global disturbances in supply chains, [then] okay, you look through it. The challenge, though, in real time, is what is driving inflation?

Beckworth: Is inflation being driven by these problems on the real side of the economy, supply shocks, or are they being driven by fiscal policy and monetary policy that's too loose? And I think the challenge is that, in real time, it's hard to know. So, I think that the FAIT framework kind of relaxed the inflation constraint on them, and then, they're trying to figure out in real time, "Well, is inflation being driven by these demand forces, or supply forces?" What weight would you put on those?

Evaluating the Fed’s Response to the Recent Inflation Episode

Lacker: I was never persuaded that if supply shocks, disturbances to supply, were relevant to inflation, that policy should respond differently, just prima facie, should respond differently.

Beckworth: So, they shouldn't look through supply shock inflation?

Lacker: This goes back to Marshall and the blades of the scissors, right? It's always supply relative to demand and demand relative to supply, and it was clear that there was a huge increase in nominal demand by the beginning of 2021.

Beckworth: Oh, preach it.

Lacker: It was gigantic, right?

Beckworth: Yes.

Lacker: And so, what would you expect? You'd expect that demand to wash over all of the goods and services that people, if they had more income, would want to buy. Would you expect some of those sectors to have steeper supply curves than others? Yes, you would. And so, it's not a surprise that you're going to get some sectors that are affected by supply chain difficulties and constraints when demand surges like that, when nominal spending surges like that. But the question at the end of the day about transitory— it’s not obvious that that implies transitory, that inflation is going to be transitory. Sure, supply will catch up, but in the meantime, you've got this wash of nominal spending. If the sectors that are constrained are able to expand supply, and get around those constraints, well, [then] that just allows people to spend on other stuff instead. So, the demand will just wash out somewhere else too, and drive up inflation, so—

Beckworth: I'm with you on that, and I've done some work showing that if you looked at the nominal GDP forecasts by spring of 2021, it was showing that it would be far above the pre-pandemic trend path for total dollar size of the economy. So, clearly, things were overheating, and you could have seen [that] looking at other indicators. I guess my question, though, more fundamentally, is, do you think the Fed fell behind the curve because they got confused by looking at inflation and trying to divine, in real time, "Oh, it's supply side or demand?" And, if that's the case, maybe if they had just looked at what you said, nominal spending, looked at something really simple— I mean, that's going back to Athanasios' proposal. Look at something really simple, at least as a cross-check. I'm not saying go all-in on nominal GDP targeting, although I would love that. But as a cross-check, look at forecasts of nominal GDP, aggregate demand. That to me would make life—

Lacker: Yes. That was the obvious thing—

Beckworth: -a lot easier than trying to figure out, supply shock, demand shock, what's driving inflation?

Lacker: Yes, which is transitory, what's not. Yes, I agree. But if you look at what the Fed said over the course of 2020, it looks as if they were terribly reluctant to pivot away from the very accommodative stance they had adopted. And if you think through the high-level optics, you can blur your eyes and think about Joe on the street, and cable news watchers, and everything. So, here, the Fed has been an active participant, from the beginning of the pandemic in 2020, in crafting credit market programs. They encouraged policymakers to think big. There was a famous quote, Powell telling Pelosi to think big about fiscal stimulus. Then, there's another round of stimulus in 2021. For them to raise a cautionary note would have been wise, given the analytics, like, "We're not sure, but it looks like this might be a little too much."

Lacker: I don't know what they were thinking, but that would have been a cautionary note that they could have sounded. But for them to be the first one in Washington to hop off the stimulus bandwagon, and pivot towards, "We need less stimulus, and we're going to have to take away the punch bowl now," I think, politically, the optics are a little uncomfortable for them. So, I think that that had to have made them a little reluctant to abandon the hypothesis that it was transitory.

Beckworth: Okay, so, there are maybe some political pressures. So, maybe give us your recommendations, then, for the Fed's framework review. What should they be addressing?

What Should the Fed Be Addressing During the Next Framework Review?

Lacker: Well, as I said, maximum employment— they need to rethink that from the fundamentals up and recraft their communication around that. We were talking about this magic paragraph in the 2012 statement, as a compromise, to get it through the whole committee, or to try and get it through the whole committee. The second half of the paragraph talks about the long-run forecast, as if it's maximum employment, but it doesn't say that it's the same thing as maximum employment in the first half of the paragraph.

Lacker: So, it's this illusion that just leads you to believe that it is, and a lot of financial market reporters, people who cover the Fed, treat that long-run forecast as the Fed's estimate of [U-star], when it's not, and it shouldn't be treated as that. They need to communicate more clearly about what they can and can't do, because now it looks like, in 2021, they thought they had more of a gap, an output gap, than they really did. I think, more broadly, they should think about two things. One is, the diversity of views that were brought to the deliberations in, at the very least, [the] September timeframe in 2021, and whether they robustly consider alternatives to the point of view that they seemed to cling to that fall. I've talked about this elsewhere, but I think there have been some longer-run trends.

Lacker: I think that the Fed seems to— since Bernanke, [they] have pulled back from welcoming diverse views among the reserve bank presidents, for example. And public statements, I think, should more candidly acknowledge diverse points of view, and diverse perspectives on the decisions that they're taking, and the direction that they're going. I think that a broader lesson is that the Fed should place more value on learning from experience. In my tenure there, what Allan Meltzer said about the Fed has rung true, that they tend not to look back at their mistakes, they never admit their mistakes, [and] they move forward as if they omnisciently did the best job they could. In contrast, the US Armed Forces make learning more of a priority. They routinely conduct after-action reviews, after significant military operations.

Lacker: They invest in historians and historical research on their past experiences. I think that this recent review that led to the 2020 framework— I think that that was a notable instance of reflection aimed at improving policy. I didn't think it was well-grounded, and I didn't like the outcome, but they did try and review things, and they promised to review every five years. But I think that they should make it a review that's robust, that really is candid and critical about this past experience.

Lacker: With the benefit of a great deal of time, people are very critical in the Fed about the '70s, and how that turned out, and Bernanke famously took responsibility for the Great Depression, in 2002, with a time lag of, what, 70 years? I think that they should telescope that timeframe a bit more, and be a little more candid about this recent inflation surge, and invest resources in retrospectively reviewing past policy actions. I think that's going to butt up against the tension with that, and is going to be the The Wizard of Oz phenomenon that public officials are often attracted to, of projecting omniscience and omnipotence.

Lacker: But, in this episode, I think it would be welcomed by the political world and the public for the Fed to admit that it wished it hadn't done what it did and delay in 2021. It hasn't quite gotten up to do that. It said that it regrets things that happened, in hindsight, but to admit that maybe it made a mistake at the time, and ignored some signs that it shouldn't have ignored— I think that would be a welcome breeze from the Fed.

Beckworth: Okay, with that, our time is up. Our guest today has been Jeff Lacker. Jeff, thank you for coming on the program again.

Lacker: My pleasure.