Understanding the Federal Reserve, with Louise Sheiner

Episode two of the three-part series "The Economy: Inflation, the Fed, and You."

Inflation in America is happening for the first time in forty years, and the Federal Reserve has committed to fighting it. What tools can and does the Fed use to battle inflation, and what are its other economic duties beyond keeping prices stable? Who at the Federal Reserve makes decisions, and how do they make them? Brookings Institution economist Louise Sheiner joins Liam Julian, director of Public Policy at the Sandra Day O'Connor Institute, for a discussion. Sheiner is the Robert S. Kerr Senior Fellow in Economic Studies and policy director for the Hutchins Center on Fiscal and Monetary Policy. She previously served as a senior economist in the Fiscal Analysis Section for the Research and Statistics Division with the Board of Governors of the Federal Reserve System. 

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Transcript

Liam Julian: 

Welcome to an O'Connor Institute issues and answers discussion with Dr. Louise Sheiner. Dr. Louise Sheiner is the Robert S. Kerr Senior Fellow in Economic Studies and Policy Director for the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. She previously served as Senior Economist in the Fiscal Analysis Section for the Research and Statistics Division with the Board of Governors of the Federal Reserve System.

In her time at the Fed, she was also appointed Deputy Assistant Secretary for Economic Policy at the U.S. Department of the Treasury, and served as Senior Staff Economist for the Council of Economic Advisors. Before joining the Fed, Dr. Sheiner was an economist at the Joint Committee on Taxation. She is Vice Chair of the Bureau of Economic Analysis Advisory Committee. Welcome, Dr. Sheiner. Thank you for being here.

Louise Sheiner: 

Thank you for having me.

Liam Julian: 

So, I think we start very broadly, and I'm going to ask you this really basic question. What is the Federal Reserve, and what does it do? What are its responsibilities?

Louise Sheiner: 

So, the Federal Reserve is just the name of the United States' central bank. So, you hear of central banks in other countries. The Federal Reserve is the name of ours. What do central banks do? So, the main role that the central bank has is to conduct monetary policy. It decides what interest rate it's going to lend at. So, it decides the short-term interest rate in the economy. Another way of thinking about it, it decides how much money to print. That's not how they target it, but it's basically the same thing. So monetary policy is one of its main responsibilities.

It also has supervisory responsibilities over banks, not all banks, but some banks. And it is a lender of last resort, so it helps promote financial stability in the system. And you see that it played a great role in the Great Recession, it played a big role in the pandemic, trying to promote financial stability and set monetary policy appropriate for the economy.

Liam Julian: 

Right. It's funny, you know, the Federal Reserve, as you were saying, but they don't print money. That's something they don't do, right?

Louise Sheiner: 

They do not print money. That is the U.S. Treasury and the Mint. 

Liam Julian: 

Right. Yea.

Louise Sheiner: 

They don't print the money, but they determine the interest rate, and in some sense, they are determining the money supply. Years ago, that's what they targeted, was the money supply. But they don't do that anymore. They target the interest rates. But it's the same idea, which is that we have an economy that has money in it. So there has to be a central bank that sort of determines how that money, how much money there is. And that's what the Federal Reserve does.

Liam Julian: 

Right. Are there any notable differences between the Federal Reserve and other central banks, other countries?

Louise Sheiner: 

So, you know, I think the differences are not that large. One thing you might point to is the Federal Reserve mandate. They have what's called a dual mandate, which is maximum employment at stable prices. That's sort of their legislative mandate that Congress gives them. Other countries tend to have more of a single mandate, focused on inflation. But in practice, it's not clear it matters all that much. So, I think they're very similar to other central banks. They're more important in many ways than any other central bank, because the United States economy is so much more important to the global economy than other countries. 

And so, everybody focuses on what the Fed is doing, not just Americans, much more so than we focus on what other central banks are doing. But another thing is that, I'm just going to, sorry, I'm thinking, so like in Europe, so they have the European Central Bank. It's many different countries, which is not just sort of, it's not like the, it's not the German Central Bank anymore or the French, it's the ECB. So, it's a little different that way, too.

Liam Julian: 

Right. Yeah. Good point. And so, I wanted to ask you a question about that dual, the dual mandate. So, and, you know, I'm going to show my sort of, you know, how little I know about economics. But if one were to believe in the Phillips curve and we'll put it, we'll put up the Phillips curve so our audience can see what that is. But it almost seems as if this dual mandate is somehow contradictory or at least competing. Right? So, the Fed is trying to maintain high levels of employment, but also wants to keep prices stable. And the Phillips curve tells us that these things move in opposite directions. 

Louise Sheiner: 

So, it's not always true that there's a tradeoff, but there often is a tradeoff, which is what the Phillips curve is going to tell you. And this is the classic example is right now. So right now, inflation is too high. We have a very low unemployment rate. But the question is, is how much do they have to raise the unemployment rate to get inflation to come down? Because basically, we have a very strong economy that both creates inflation and creates a higher unemployment rate. So, what they're really trying to do is to find an unemployment rate that is sustainable. So, an unemployment rate that isn't zero, because at zero, we're going to have a lot of inflation. But they're trying to get the economy to sort of the sweet spot where you're at this unemployment rate that is consistent with stable inflation. And so, yeah, there's a tradeoff.

And what they're really worried about now is sort of in trying to get inflation down, they will go too far and end up causing recession, which will make unemployment not just climb to this sort of natural rate, this sort of stable rate, but it will make it actually climb beyond it. It's very, very hard to calibrate. So yeah, that's why the dual mandate in some sense doesn't matter so much, because regardless, pretty much everybody is trying to get that stable rate of unemployment consistent with inflation. But because it is explicit for the Fed, they have to talk about both sides of the mandate, and that can kind of constrain them in like acting too fast right now, worried that they might cause a problem in the labor market or a bigger problem than they need to.

Liam Julian: 

Yeah. Yeah. Well, you know, they're meeting as we're recording this, they're meeting right now. So, you know, you're an insider, you know, maybe you could tell us, you know, what are they, who is meeting and what are they, what happens in these meetings, what are they talking about?

Louise Sheiner: 

Right.So the Federal Open Market Committee is the committee that determines monetary policy. So, first of all, who is that? It's the Board of Governors. So, the governors on the Federal Reserve Board of Governors, and some of the bank presidents of the Federal Reserve Bank. So, there's the Board of Governors, that's in Washington, D.C., and there's a number of banks around the country in different districts. And those mostly are rotating on whether or not they're on the board. New York is always on it, but the other ones rotate. So, there's this committee, and they're all there, but there's only, there's a subset of them who vote. They are discussing what to do about monetary policy.

What does that mean? So, the tools that they've been using lately are, the main tool is the interest rate that they set, the discount rate, the interest rate they pay on bank reserves. So, it's a short-term interest rate. They set that, okay? So that affects every other interest rate in the economy. It's kind of based off that. So that's their main tool.

In addition, since the Great Recession, they've been doing something called quantitative easing and quantitative tightening, which is they have treasuries on their balance sheet, and they are now, are they selling them off? Will they continue selling them off? But that is kind of being pushed to the side in terms of active monetary policy right now, and they're really focused on this interest rate. And they've raised interest rates a lot in the last year, very quickly because they kind of saw this inflation that surprised them, very high inflation coming out of the pandemic. So, they've raised interest rates a lot, and inflation has come down, but it's still higher than they want. And so, what they're discussing right now is, do we say, we've done enough for now on raising interest rates, and let's see what happens to the economy, because we know things, when we raise the interest rate, it takes a while to have an effect.

So, do we stop there and give it a chance to see, have we done enough, or do we raise one more time, or one time this time, and one time next time? And if we stop now, if we do a pause, when we communicate why we did what we did, do we indicate we are not done yet? Which I think they're going to say. They're going to say, look, inflation is still too high. We either have raised the interest rate or we have not. I think they probably will pause, but it's not clear. You know what they're going to do before a meeting, but right now it's a little uncertain.

But I think they'll probably say, we're going to keep the interest rate where it is, but we may well begin raising again the next meeting if inflation doesn't come down in between, or the unemployment rate doesn't go up. They won't speak of it that way, because they don't want to say that they want a higher unemployment rate, but they sort of do, because the view is that the unemployment rate is just too low right now, and it's creating too strong an economy that's boosting inflation.

Liam Julian: 

Right. Yeah, it seems the markets seem to believe that they'll take a pause. So, Dr. Sheiner, you had said a second ago about inflation surprising the Fed, and it surprised a lot of people. The Fed had sort of said, you know, inflation is going to be transitory, turned out not to be that way. So, I'll ask you, sort of, why do you think that they kind of missed it?

Louise Sheiner: 

So, I think, you know, it's a little early to know exactly, because it's not over. So definitely they thought it would be transitory, and what they meant was sort of transitory, but like gone by now. And so, the question is whether or not it actually, part of it was transitory, and that it's just taking a long time, or whether or not it really wasn't transitory at all, and it was completely wrong. I think it's a combination of things. So, first of all, it started showing up as supply chain problems. So, we knew you couldn't get chips for cars, you couldn't get, the cost of cargo was just going up tremendously. People couldn't get washing machines, they couldn't get appliances.

So COVID was such a big disruption, and you saw people not being able to get goods, and that led to higher prices for goods. And so that kind of looked transitory, like, well, you know, when this is all over, it'll go back down, and we don't have to worry about it, kind of a supply shock. I think they had been battling inflation on the other side for so long. So, since the Great Recession, they have a 2% inflation target, and inflation was never actually high enough. They were never able to get it to 2. So, I think they had a mindset that inflation just is always going to be low, and they hadn't seen high inflation in so long that I think they were sort of surprised by it.

One thing that they get criticism for is that when President Biden put out his American Rescue Plan, there was a lot, a lot of money in that, going to an economy that was already open, vaccines are coming out. And so, they didn't really respond to that by saying, oh, we've just put so much fiscal stimulus in the economy, so much money in the economy from the fiscal side that we should offset it from monetary policy. They didn't really change their monetary stance at all. So, they've gotten a lot of criticism for that.

And some people were saying, Larry Summers, for example, and others, like, this is going to cause inflation, and they didn't react to it. One thing that people discuss is before the pandemic, really right before the pandemic, they had this review of their monetary policy framework. And that review was really intended for a very different situation than the one we're in now, where interest rates were close to zero, the economy did not produce, as I said, even 2 percent inflation. And they basically said, we are not going to preemptively slow the economy just because the unemployment rate has fallen if we don't actually see signs of inflation.

Because we found out during, you know, in 2019 and 2018 that the unemployment rate could go quite low, close to 3.5 percent, without causing inflation, because we had an unemployment rate of about 3.5 percent in 2019, and we did not have inflation. And so, they said this framework, like, in the past, we may not have allowed the economy to actually get down to this 3.5 percent unemployment rate, and we would have preemptively cut off a really strong labor market.

And in particular, what we know is that a very strong labor market is particularly good for people at the low end of the income spectrum, for people who have disabilities, for African-American unemployment rates, for black unemployment rates, for people who are marginally attached to the labor force. And so, we think that we don't want to, if you cut that off, you're not just sort of cutting off some employment, but you're really not allowing some people to get into the labor market in a way that might have lasting impacts. 

So, they had this framework that was really intended as saying, if we don't see inflation, if we don't see it yet, we're not going to act. Then they saw it, but they were like, but it looks transitory. So, they still didn't act. And so, they got behind the curve, which they readily admit. And I think a question is, did that matter? Like if they had acted three months, five months before, and act a little more slowly, would it really have changed anything? Or was this sort of the process we were going to have to go through anyhow? And I don't think anybody really knows the answer to that.

Liam Julian: 

Yeah. Yeah, that's what some, it was the head of the Fed at one point said that the, you know, the Fed's responsibility, I'm going to misquote this, is something like you take the punch bowl away just when the party's getting started. And I think Larry Summers had said something like this Fed is waiting to take the punch bowl away until everybody's staggering around drunk. But this actually raises a question that some people have kind of raised, you know, Larry Summers was there and I think in February of 2021, as early as that saying, listen, you know, we're essentially throwing money from helicopters and Milton Friedman's, you know, and this is going to cause inflation.  I've run the numbers here. They are. And the Fed didn't act for over a year, really. And people have wondered, is there potentially when they have these meetings, a bit of group think that happens here with the Fed, where, I mean, you've got all these smart people in the room, and there wasn't one person who sort of took seriously those warnings. What do you think about that? Is that a possibility?

Louise Sheiner: 

I mean, of course, it's a possibility, because they're all human, like everybody else. And sort of things, you know, group think happens. You know, they do come in with their different forecasts. So, the Federal Reserve, the staff at the Federal Reserve produces the forecast that goes in something called the Teal Book. That's kind of the that the governors react to. But the different bank presidents also have people giving them forecasts. So, people do come in with different forecasts. The chair has a big, big influence. And so, the board itself has a big influence. And I do think that the economists at the board were much more on the like, you know, and part of it is they were much more on this idea that it's transitory. 

And at the time we were having this discussion, which was you can sort of think of inflation from two perspectives. You can think of it from top down. That's kind of what Larry was doing, which is to say, look, we have put all this money in the economy. You know, GDP can't grow that much. Therefore, all of this money in the economy is going to end up in inflation because we know it's going to increase nominal GDP. But if you can't actually produce more stuff or a lot more stuff, you're not going to get real GDP. And that means where is it going? It's going to go into prices. And so, from this top-down perspective, anybody who was doing that was saying this is going to cause inflation. 

The people who do the price forecasting at the Fed and in fact, in a bunch of banks as well, because they were trained at the Fed, are doing something that's really bottom up. So, they're like looking at every detail of the CPI release. Well, it's shelter. Well, that's something because everybody now wants a bigger house because of the pandemic. Oh, it's furnishings because they bought a house. Oh, it's supply chain related stuff. And so, if you looked at the prices that were going up, they did at the beginning seem very, very related to supply chains.

So, I think that the experience before the Great Recession of, you know, you talked about the Phillips Curve, that's relationship with the unemployment rate and inflation. And people were talking about like, does that Phillips Curve exist anymore? Like we have really low unemployment and we're not getting inflation. And so, I think people doubted sort of that, you know, they thought, look, inflation is just going to be low and the things that are high are all related to pandemics. So, I think it's transitory despite the warnings. Right.

Now what's happened is so now things have moved sort of beyond the goods. It's more broad based now. The inflation is more broad based in services a lot. So, I think that most people believe that demand had something to do with it. I think there's still a difference of opinion on how much was just it was all this fiscal stimulus. And it's not just fiscal stimulus, actually. It's all demand. So, all these people trying to buy stuff and there's not enough stuff for them to buy. And that's how you get inflation.

So, it was really two things. One, we gave people a lot of money, two, people saved a whole bunch during the pandemic because they didn't buy. They didn't buy services. They didn't leave their house. They didn't go on vacation. They didn't travel. And so that did two things. It, one, made them increase their savings. So, they were sitting on all this money.

And two, once they could go and go travel and go to restaurants, they're like, I want to do it even more than I had before. If that's the story, again, that's kind of transitory, right, which is that we have this big demand now, but after people have kind of, you know, gotten rid of some of those savings and decided, okay, fine, I've done enough traveling.

And now going back to the way it used to be, that excess demand kind of goes to. So that's why I said it's a little too early to tell. Frankly, inflation has come down quite a bit from where it was like last June even, right? It's still uncomfortably high, but it isn't as high as it was certainly not that total inflation rate. I think about core and total, and total includes energy and food and core does not. And the unemployment rate is really, really low. So, we've gotten some reduction in inflation without a rise in unemployment, which is something that Larry said we couldn't do now. And the question is, can we, how much of that will continue? And how much of are we going to have to see a higher unemployment rate in order for inflation to come down?

Liam Julian: 

Yeah. Yeah. You'd said, Dr. Sheiner, that, you know, everybody at the Fed is a person. So, my takeaway is that Dr. Sheiner calls for an AI Fed is what I'm thinking.

Louise Sheiner: 

God no, because AI is just trained on people and there's a lot of people it's trained on, I wouldn't want it to you.

Liam Julian: 

But in that AI sort of idea, I mean, the Fed, when they make these decisions, they are using a lot of models, right? There's a lot of assumptions baked into those models that they're using. Maybe you can tell us a little bit about what those assumptions are. And also, it seems to me, again, an uninformed person that these models might struggle a bit with the demand side in the sense of predicting human behavior at different, you know, is that accurate? Maybe you can tell us a little bit more.

Louise Sheiner: 

Absolutely. So, first of all, let me tell you about, so I worked at the board for many years. So, the board actually produces two sets of forecasts every time. So, they have what's called the judgmental forecast. And they have what's called the model forecast. So, and there's actually a few models. So, there's a team that runs the models, right? And they're like, when we run these models, here's what we get. And then there's this team, I was talking about the sort of price forecasters before that are less model based. They're more like, here's what I'm writing down for consumption. And here's why.

And so, I'm assuming this about consumers, and, you know, and we'll discuss it. And so, it's less like, oh, you have a model, and you're stuck with his assumptions, and you can change them, and you just hit go, right? It's much more like, let's think about what we've seen. Let's see, think about the anecdotes. Let's think about all kinds of different inputs. And so, it's what why it's called the judgmental forecast. And then they sort of put them together, and they're like, well, why are they different? And how do you know, and then you should we reconsider, or should we just present the two possibilities. And so, it's not as if it's not as model based as you think. But nonetheless, you obviously, what you need to do is not just say what inflation is now, but you need to predict where it's going, that's going to make all kinds of assumptions.

So, for example, big question was, people got a whole bunch of money from the federal government, they got checks, the federal government, they got very generous unemployment insurance payments, they didn't spend that money, it was sitting in their accounts. Will they just say, hey, I'm wealthier now. And I'm going to basically keep my keep my wealth, keep being wealthier and spend a little of it. Or they're gonna say, I don't need this much savings, I didn't have it before. In the next year, I'm just gonna spend it all, right?

Nobody really knows it was such an unusual environment. What are firms going to do? You know, if the firms were shut down during COVID, are they going to just reopen? Are they going to say, well, wait a minute, we were too, you know, we're too worried about our supply chain. So now let's do something different than our supply chains. Another big question. What about remote work? Right? So, we've seen this increase in remote work that has effects on commercial real estate, but maybe it also affects on labor supply. Maybe people will start working more, because they don't have to commute as much. And therefore, sort of that time is sort of to for any given amount of wages is lower. All of these things matter for predicting what the economy is going to do. One of the things that happened during the pandemic was labor supply shrunk, right? So not only did we want more stuff, but there weren't as many people working to produce it. So that, again, is what leads to inflation, right?

So, in 2019, we can have, you know, a demand for this much stuff, but in 2021, people have left the labor force. And so there just weren't as many workers. Also, labor force participation rate of prime age workers through 54, I think, it's basically higher than it was right before the pandemic. But the older workers, 65 plus, still have less labor force participation. What's going to happen with that? You know, those are all the elements that go in. And then finally, another element that's very hard to predict is productivity, which is like what, so these people are working, but how much are they producing? And you know, what's the other thing to remember is, it's not just that we're predicting the future is that we don't have perfect data on the present.

So, then these data get revised over time. And so, we have really mixed messages on the economy in many ways. As you've seen, like people over the past year, many people have been predicting, well, we're a recession is about to start. We're almost in a recession. We're going to be in a recession. And that labor market keeps on being so strong, producing so many jobs, more jobs than sort of we think is stable over time. But the actual GDP numbers are sort of weak. So, GDP looks kind of weak, but the labor markets really strong. We know that the data are not perfect. How do we think about that? What does it mean going forward? It's really hard. And just because the pandemic was so different than anything anybody has ever seen, you can look at historical experience, but you know, you know that that there's just a huge amount of uncertainty. 

And that's what the Fed is talking about at these meetings. What's the forecast? Do we believe it? How much uncertainty is there? Given the uncertainty, you know, should we should we act slow? Should we act fast? It's there's a lot to discuss.

Liam Julian: 

Yeah. So, we spoke earlier to an economist, John Cochran, who's got a new book called The Fiscal Theory of the Price Level, where he argues that, you know, it's it's not all monetary policy. In fact, it's it's there's a lot of fiscal policy involved in this as well and in the price level. My question is, at these meetings, is the Fed also trying to predict the fiscal situation going forward? Is that and and and how does that play out?

Louise Sheiner: 

Absolutely. I was in the fiscal analysis division section at the Fed. So that was our job, which is to to to say what's going on with with the federal government and also state and local governments. Right. And how is that going to impact the projection? And so that would be part of the discussion. What did the what's in the forecast? We assumed another fiscal package. We assume discretionary caps on spending the budget deal. We assume that they were going to be, you know, X. And then there'll be a discussion of do we believe that or not? The other element that the Fed that the Fed staff produces for these meetings is what are called alternative simulations, like which is OK, here's our baseline assumption. What if we're wrong? What if discretionary caps are cut by what if they use the House, the House deal? What if they win that? What happens then? What happens if actually, you know, what if the debt ceiling is binding like the whole debt ceiling was another thing that was obviously like on their minds?

So, everything that you might think you would have a conversation about. They will have a conversation about and and and have forecasts that sort of show how much does it matter? You know, it's nonetheless, you're still making for it. You're still having to make a decision with uncertainty about fiscal policy and all kinds of other things as well. And so, you do the best you can. And that's why they keep saying it's data dependent. And data includes like what happens with, you know, the on the Hill. So, they just keep reevaluating and deciding, OK, where do we go from here?

Liam Julian: 

Yeah. Let me ask you one last question on inflation. The Fed sets 2 percent as its as its target.

Right? Why?

Louise Sheiner: 

Why? Well, so, as I said, the mandate is actually stable prices and they have interpreted that as allowing them inflation of upper up to 2 percent. Greenspan actually said what that means is inflation is low enough that nobody really thinks about it like its kind of small is in the background. They don't want a target of zero for two reasons. One, we worry very much about what's called downward nominal rigidities, which is people don't like to lower people's wages. So, you're making 20 bucks an hour next year. It would be better if the wage were 19, because demand in the section has gone down and there's for various reasons, but they're not going to do it. So, you're not going to do it.

That means you're going to have inefficiencies in the economy. You'll have too many people in one sector. You will actually have worse economic output, worse GDP growth. So, with 2 percent, that gives you a little bit of wiggle room, which is that if you just hold wages constant, you've actually just lowered them by 2 percent. So that's sort of one reason why inflation is kind of helpful. And the other thing is what's called the problem of the zero lower bound, which is the Fed sets the interest rate. They set the nominal interest rate. So just exactly what the rate that they'll lend to banks at, or they'll pay interest on reserves at. And they can't set it below zero, really.

Some other central banks have had negative interest rates, but there's kind of a limit. So, when inflation is higher, that gives you more wiggle room. It means your actual, because your interest rate is your real interest rate plus your inflation rate. So, let's say you thought the real rate should be 2 and the inflation rate was 2, then you're going to set your nominal rate at 4. And therefore, you can lower the rate by 4 percentage points in a recession. So now, some people, because we actually have been in a situation where we've been at the zero lower bound, like it's something that in years past, people thought it was not a big deal. We were not going to hit it.

But the so-called natural rate of interest, which is where the interest rate that's going to kind of just be the one that the Fed should have when the economy is kind of in equilibrium, has been falling over time. And so, we have hit the zero lower bound, we are more likely to hit in the future. So, our higher inflation rate would help. So, some people are saying the Fed should not actually go back to 2. They should say, hey, inflation is 3, 2 and a half, we're good with that. There's two problems with that. One, it looks like you are not really committed to your inflation target. You're like, we're going to be 2, we're going to do everything we can to be 2, 2 looks like it's kind of hard to get, and 2 and a half. And what you worry about is in future recessions, that means that, OK, we see some inflation. The Fed's never going to get rid of all of it. And then inflation will creep up and creep up and creep up. Every time you have inflation, that will lead to a higher level of expectation.

So, people are worried that you'll lose credibility. And credibility has been extremely important. One of the reasons the Fed was less concerned about inflation is because they believed inflation was well anchored. People expected it to be 2. Even if they saw it temporarily high, it could go back down. So that credibility is really important.

Another thing that Ben Bernanke talks about is when they set the inflation target at 2, they talked to Congress. They got Congress to say, yeah, that's fine. And that Congress would not really be happy with a 3% inflation target or a 2 and a half percent inflation target. Actually, finally, there's one more thing, one of the things that people who, you know, people who worked at the Fed in the 70s knew and people like me who did not work at the Fed in the 70s sort of just learned recently is how much people hate inflation. Like it's kind of good, it's just prices and your wages go up. Who really cares? But, no, people really, really hate inflation. And so, I think we realize that, no, 3 is too much. 3 is something that people will really notice. So, like could they stop at 2 and a half? Yeah, maybe. But not really 3 and not 4 as some people had been advocating before.

So, 2 is something that was kind of where we had been before they decided to make it official. And now that they've done it, I think they believe they should stick with it. 

Liam Julian: 

I want to switch and ask you about another mandate of the Fed. And I think actually this was, from what I recall, this is sort of the original concern when the Fed was established, bank runs. And so, the Fed has commercial oversight over commercial banks. Okay, well, what happened? Tell us what happened with Silicon Valley Bank.

Louise Sheiner:  

So, with Silicon Valley Bank, what happened was they were holding all of these treasuries. So, these things that say I will promise to pay you X percent interest for the next 10 years or something, when interest rates go up, the market value of treasuries goes down, of existing treasuries. Like if I can get 5 percent on this new thing, I'm not paying you face value for the thing that's only paying 2 percent. So, the market value went down. Many banks are hedged against that kind of risk. Silicon Valley was not, number one.

Number two, many banks do not have the same kind of uninsured deposits that Silicon Valley Bank. So, we have the FDIC insures deposits up to $250,000 per person per bank. And so many, many banks are not worried that the deposits are going to leave when interest rates go up, because banks tend to pay terrible interest rates on deposits. But also, people don't really worry, more importantly for this, people don't really worry that when interest rates goes up, their bank will be insolvent because they're insured, so they don't care.

Silicon Valley Bank, because it was basically where a lot of tech companies park their money, didn't have that. And so as soon as any kind of rumors started that maybe their assets weren't worth as much as their liabilities or they were going to have some trouble, the money started running. When the money starts to leave, you have to actually give the people their money. How do you give the people their money? You have to sell your assets. If your assets are worth less, then that kind of, that sort of starts this thing. That's exactly what a bank run is.

And so that's what happened at Silicon Valley Bank.

Liam Julian: 

Yeah. Well, I guess my question is more, how did the Fed not see this? I mean, it's the responsibility of the regional Feds, right? 

Louise Sheiner:  

Yeah, it was the San Francisco Feds oversight role. And honestly, I'm not an expert in this, but I'll tell you what I know from reading stuff, which is that they knew there was a problem. They had grown really, really fast. They knew that they had a lot of uninsured depositors. They just didn't really act on what they knew in a strong enough way. And exactly why that happened is something like Michael Barr, who's the chair for bank supervision at the Federal Reserve, issued a report trying to understand what went wrong. Why didn't we see this and stop this earlier? And I'm sure there will be some reforms coming from that.

You know, there was this argument in the report about whether or not the previous chair had been a little bit more, you know, there's always debate, like how much should we regulate small banks and how much should we say, well, we don't want to overregulate your small and, you know, and so that there had been a move that some people think there have been moved towards just sort of an idea at the Fed, like, don't be so hard on these banks. Don't be so strict. That had kind of affected the psychology of the supervisors. And therefore, they weren't, they just weren't that strict with them. And then it went wrong.

Liam Julian: 

Yeah. It's interesting, because this kind of gets back to what we were talking about earlier, Dr. Sheiner, about these different mandates, sort of what I'm thinking of here is, you know, the Fed has to be raising interest rates because it wants to combat inflation. But as you just pointed out, if it's raising interest rates, it's essentially, you know, diluting, maybe that's the right word, the asset value of these banks. Another mandate of the Fed is obviously to keep stability in the financial system. So, it has to do these two things, but the Fed is doing some things while it's raising interest rates to help banks, is it not? It's loaning to them at preferred levels and...

Louise Sheiner:  

Right. So, it can set facilities to try to solve these liquidity problems. If, you know, what's it supposed to, what it's allowed to do is solve liquidity, but not insolvency problems. So basically, preventing fire sales because some bank's having a problem. But if a bank is really not worth what they say, then they're not really supposed to lend to them. But, yeah, financial stability is definitely a concern. And so, some people think that one of the downsides of the Fed moving so fast was that, like, you're going to break something, you know, like, and so like an argument could be if they had started earlier, they could have gone a little slower. Maybe things would have been a little smoother.

But I think they think that their mandate to fight inflation is sort of mandate number one. That's super important. They do have, as you said, these tools and there are other tools to help promote financial stability. And so, it didn't really stop them from acting. But I think it's something that people recognize as, again, a little bit of a tension.

Liam Julian: 

Yeah. Yeah. And in some ways, I think there's some people speculating that the credit crunch that occurred with these banks may actually have helped the Fed and its inflation, you know, fight. Right? I mean, we'll figure that out later down the road when we look at the data, but.

Louise Sheiner:  

Right. So, I think that the view right now is that it's really been relatively minor, the reduction in credit, that maybe it's coming in exactly right, which is right now, like things that are sort of bad for the economy in some senses are like, that's what the Fed is trying to do. So like, then they don't have to do as much. Right. Because the economy is too strong. Because it's not sustainable. Like, if we can have this strong economy and we wouldn't have inflation, fantastic. But we can't. Therefore, it's too strong.

Liam Julian: 

Yeah. Overheated. Yeah. So what are the challenges that you see in coming years, maybe even decades, that the Fed is going to really need to be navigating?

Louise Sheiner:  

I mean, I don't I don't know if I see some sort of major changes down the road. The Fed is always having to navigate sort of complex economic changes and how we view the economy is very different. So, there may be very different things down the road in how we view it. We have to see what happens to AI and productivity and automation. We know on the fiscal front, we are going to be having either, you know, big increases in spending and and potentially big increases in taxes as well. So, there's going to be fiscal policy that they're going to be having to be adapting to because we are sort of in the midst of this big increase in debt.

And you know, just that question about how much debt we can have and what that does to interest rates and what's going to happen to that natural interest rate is something that they're going to have to navigate. You know, could there be some digital currencies that are competing? Could they create a central bank digital currency? Certainly, that's something down the road.

But I think that the process that the Fed has sort of undergone for, you know, the past 50 years at least is likely just to keep on going, which is they're going to be setting interest rates or however they decide to do monetary policy in the future to try to balance these competing objectives. So, I don't, maybe I'm missing something, but I don't see like, oh, well, clearly in the future X is going to happen and it's going to be completely different.

Liam Julian: 

Yeah. No, thank you. That's really helpful. And the last question is, I asked, I asked John Cochran the same question and it's fascinating to me. So, John was an undergrad at MIT. He did physics and went on to do economics and you undergrad at Harvard, you did bio. But then you didn't go to med school, you didn't work in the lab, you did your PhD at Harvard in economics. So, could you just, Dr. Sheiner, maybe give us a little personal, like why you chose that route?

Louise Sheiner:  

Sure. So, I didn't take any economics until my senior year in college. And I started off pre-med, then decided I didn't find that interesting intellectually. And so, I moved into the area of biology that was evolutionary biology and ecology. So evolutionary biology and ecology are actually really similar to economics. So, if you think about survival of the fittest, well, that's competition. And so, I was doing a food policy course and they made me take econ 101 at the same time my senior year and I loved it. And so, I just found it to be, you know, really interesting problems.

It's logic, it's kind of the stuff that I liked and I was doing, but like my senior year I was doing a kind of last senior paper on in evolutionary biology and I spent my time in the bottom of the bio lab is counting the scales on the back of lizards and formaldehyde. And I'm like, okay, I could just go get the data from a survey that someone else has done or I could be spending all my time like, you know, and so like that shifted my view to economics. So.

Liam Julian: 

Yeah. Less formaldehyde.

Louise Sheiner:  

Yeah.

Liam Julian: 

Yeah. Okay. That's really interesting. Thanks for sharing that. And Dr. Sheiner, thank you so much for taking some time to talk to us about the Fed and our audience really appreciate it.

Louise Sheiner:  

Great. Thank you. This was really fun.