3 Takeaways - Former CEO of New York Federal Reserve Bank Bill Dudley on Inflation and Fiscal Recovery in the US, Regulating Cryptocurrencies and Why Current Fed Policies Benefit the Rich and Not the Poor (#81)

Episode Date: February 22, 2022

We talk with Bill Dudley, the former President and CEO of the New York Federal Reserve Bank, about the US economy - where it is headed and what could happen, how the pandemic affected it, why Fed policies benefit the wealthy and what $5 trillion in government spending means for GDP. He also shares his thoughts about cryptocurrencies and how stricter regulation could bring wider adoption. Does he think the Fed is Too Hawkish, too Dovish or in “Alice In Wonderland”?Bill Dudley is an American economist - who joined the Federal Reserve on the eve of the 2008 financial crisis after a 20 year career at Goldman Sachs. This podcast is available on all major podcast streaming platforms. Did you enjoy this episode? Consider leaving a review!Receive updates on upcoming guests and more in our weekly e-mail newsletter. Subscribe today at www.3takeaways.com.

Welcome to the Three Takeaways podcast, which features short, memorable conversations with the world's best thinkers, business leaders, writers, politicians, scientists, and other newsmakers. Each episode ends with the three key takeaways that person has learned over their lives and their careers. And now your host and board member of schools at Harvard, Princeton, and Columbia, Lynn Thoman. Hi, everyone. It's Lynn Thoman. Welcome to another episode. Today, I'm excited to be with Bill Dudley, former president and CEO of the New York Federal Reserve Bank. He has said that the Federal Reserve needs to get a lot more hawkish and that it can't remain in what he calls the Alice in Wonderland fantasy land of its dovish forecasts. I'm looking forward to finding out what he means by Alice in Wonderland fantasy land and what happens if that does not change.

Welcome, Bill, and thanks so much for our conversation today. Thanks, Lynn. Bill, how do you see the U.S. economy now? Well, it's doing pretty well, all things considered. Obviously, the pandemic threw it for a loop back in 2020. But it's a combination of very stimulative monetary policy, lots of fiscal stimulus. And of course, the vaccines led to a very strong recovery. We've had a little setback right now due to Omicron.

That's obviously going to have some effects on GDP in the first quarter. But the general view is that Omicron is probably not going to have a lasting effect for several reasons. Number one, a lot more people are vaccinated, so they're better protected. Number two, Omicron is less virulent. So if you are vaccinated, you're probably not going to get as sick. And even if you aren't vaccinated, you probably won't get as sick. And so I think this is going to be something that's going to be receding pretty quickly. And we also see that in the case numbers. The places where Omicron took off very early, like New York City, are already turning down very sharply. So it feels to me like this is going to be mostly passed in a couple

months. That said, I don't think COVID-19 is going away. I think we're making the transition from pandemic to endemic as people have some protection now against the virus, but the virus will obviously keep mutating, spreading across the population. So I think it's going to be more something that is part of our environment for many years to come, but it'd be more like, I think it's going to become more like influenza, which obviously causes a lot of people to die every year. So you don't want to be dismissive of it, but not something that leads to widespread shutdowns of economic activity. Can you put some numbers in perspective? The Trump administration spent over $3 trillion,

and President Biden has spent about $2 trillion so far for a total of $5 trillion of spending. Can you put some perspective on $5 trillion of spending? And what do you think of all of this spending? Well, it's a lot. It's more than 20% of GDP. It's probably the biggest fiscal stimulus that you've ever had outside of World War II, where the stimulus was not intentional. It was due to build up the productive capacity of the United States economy to fight the war. That was quite different. So basically the biggest ever. And the thing about it was it was handed out fairly indiscriminately.

People got checks regardless of whether they really needed the checks or not. And so one consequence of this fiscal stimulus is that household balance sheets are in unusually good shape coming out of a recession. So this is very different than following the great financial crisis where balance sheets were in bad shape. People had all sorts of damaged credit histories. This time we're coming out in really good shape. People kept the money that they got from the government and about a third of it was spent, about a third of it was saved, and about a third of it was used to pay down debt. And so you're in a situation now where people have very good finances. So if COVID starts to moderate a bit, I think there's still quite a bit of support for further gains

in spending. Big wildcard, though, is that fiscal policy, which was very stimulative, is now going to turn quite restrictive. And so there's a question mark about how much that the end of the fiscal stimulus is going to impact economic activities. That's a big wild card for 2022. And how about monetary policy, which is to say the amount of money that the Federal Reserve has provided to the markets and the interest rates? How expansionary has monetary policy been? Well, the Fed has basically made it as expansionary as they could. And you can see that in terms of financial conditions. So my old firm, Goldman Sachs, has a financial conditions index. And up until about a month ago, it was as accommodative as it had ever been. The Fed cut interest rates to zero,

and then they went out and bought trillions and trillions of dollars of treasury securities and agency mortgage-backed securities. And they did this even after the economy began its recovery. Even today, as we speak, the Fed is still buying assets. They're still adding accommodation, which is quite remarkable given the fact that the headline consumer price index is up 7% year over year, and the unemployment rate is down to 3.9%. It's strange. I mean, if you look at the trajectory of the economy, the Federal Reserve is still adding stimulus at this point. Fed Chairman Jay Powell, who we both know, said with seeming certainty that inflation wouldn't be a problem, that it would only be transitory. He's been wrong so far, which he has admitted, but he still seems very certain that

going forward, inflation is not going to be a problem. How do you see his certainty in his own forecasting and his forecast of very low inflation? I agree with the notion that a lot of the inflation that we're seeing right now has been generated by transitory factors. The two transitory factors were the shift in demand away from services towards goods during the pandemic. And the second factor was just the supply disruptions caused by COVID itself. So those two things have caused a lot of upward pressure on prices, and those should mitigate once COVID starts to subside. That said, price pressures have been high enough for long enough now that the transitory component may actually have some persistence to it.

Because you see that the labor market is very, very tight right now. The ratio of unfilled jobs to the number of people who are unemployed is an all-time record. There's never been so many jobs available relative to the number of people that are unemployed right now. And we're starting to see an acceleration in wages. So even if Jay Powell is right that most of the initial impulse to inflation was things that are going to turn out to be transitory in the medium run, you still could ultimately have a bit of an inflation problem. And I think the Federal Reserve has been late, to be very blunt about it. They basically said that under their new monetary policy framework, where they're targeting 2% inflation on average, that they're targeting 2% inflation

on average, that they wouldn't begin to lift off until three things had to happen. Inflation had to be 2%. They had to be confident that inflation was above 2% sometime in the future. And they had to be at full employment. So what they essentially committed themselves to doing was not even beginning to tighten policy until we're at full employment. And that's where we are today. That's why the Fed is late. So what has been the effect of the Fed's essentially zero interest rates? Well, it has had a positive effect on the economy. I mean, you look at the interest rate sensitive sectors of the economy, they've actually responded quite well. Car sales are only restrained by the lack of supply. Housing has been extremely strong

and housing has been constrained by the lack of supply too. The demand for houses is far greater than the supply of houses. And that's why home prices are going up so rapidly. And stock prices have been very high and bond yields have been very low, all engineered by the Fed. So I think the Fed has helped support the economy through the pandemic. I think the problem is that they didn't step off the gas and hit the brakes a little bit earlier. And what happens if they don't now? Well, I think they're going to. I think they're finally going to. Jay Powell in his last press conference made it pretty clear that we're going to start tightening at the March Federal Market Committee meeting. And the Fed has said things that suggest that they're going to do

a substantial amount of tightening now in 2022, much more than what they wrote down in their projections back in December. So there's been a big shift just in the last month or two. One of the Fed policies has been essentially zero interest rates. Do you think that those zero interest rates have had an impact on inequality? Well, this is one of the unfortunate consequences of the Fed's monetary policy. It follows a very aggressive, stimulative monetary policy. It lists financial asset prices, and the beneficiaries of that increase in financial asset prices are wealthy people, not poor people. So the consequences of the Fed's policy, at least initially, benefit wealthy people a people, not poor people. So the consequences of the Fed's

policy, at least initially, benefit wealthy people a lot more than poor people. Now that's done with the idea of stimulating the economy. So the end goal is to try and get more people employed. And the Fed has been pretty successful in that in the sense that we've seen a big drop in the unemployment rate over the last six months. Last summer, the unemployment rate was 5.9%. Now we're at 3.9%. So the labor market has improved pretty sharply. If interest rates went up to 5% or even 10%, how much would the annual cost of servicing the U.S. debt increase? Can you put that in some perspective and can the U.S. afford it? I don't think interest rates are going to have to go that high, but you're absolutely correct that we've had this very benign period because even though the debt levels have gone up pretty dramatically over the last 11, 12 years, debt service costs have only gone up

trivially. So we've tripled the amount of outstanding debt, but debt service costs have only gone up on the order of 15, 20, 25 percent. That's because interest rates have collapsed. Once the Fed starts to tighten, interest rates are going to start to rise and the debt service costs of the U.S. government are going to go up pretty dramatically. I think this is going to really show up just in terms of chronic budget deficits. And there may be some pressure from Congress and the administration and the Fed, don't raise interest rates so much, that's increasing our debt service costs. But I don't think the Fed really has that option. The Fed's mandate from Congress is pretty clear.

Try to keep inflation around 2% and try to get the unemployment level as high as possible, consistent with that inflation target. There's nothing about worrying about debt service costs or worrying about budget deficits. So I think the Fed will, at the end of the day, do their job. Now, how high does the Fed have to go in terms of raising short-term interest rates? The markets, they are really optimistic about this.

They think that the peak in the federal fund rate this cycle is only going to be about 2%, which is really remarkable because if you go back through history, all the way back to the mid-1950s, the peak in every other cycle has been above that. So it'd be a little strange at a time where inflation is high and the economy looks like it's going to do quite well, that the Federal Reserve could just tap on the brakes a few times and then everything would be fine. So I think the peak in short-term interest rates is going to be considerably higher. Before I ask you more about that, can we go back to what if interest rates go up to 5% or even 10%? What would be the impact on the U.S. government deficit? How much more money would it cost the U.S. government

to pay the interest on its debt? Oh, it would go up multiple times. I don't remember exactly what the current debt service costs in the U.S. are as a percentage of GDP, but let's just for the sake of argument, say it was 2% of GDP today. If we push interest rates up to that level, it would take a little bit of time because the debt has to mature and be refinanced. But I would think you'd be seeing debt service costs in the 5%, 6%,

7% GDP range. So I would think that debt service costs would triple pretty quickly. So definitely a significant problem. Yeah. Bill, we both knew former Federal Reserve Chair Paul Volcker, who was wonderful. It was quite extraordinary that he had the courage and the fortitude to quell 9% inflation by raising the federal funds rate, the overnight money rate to over 20% in 1980. And then he held it high for several years. His high interest rates and tight monetary policy was successful. Inflation fell from 9% to less than 4%, but the cost was a recession and a rise in unemployment to a peak of about 10% before it steadily declined. Paul was appointed Federal Reserve Chair by President Jimmy Carter, a Democrat, and reappointed by President Ronald

Reagan, a Republican. If inflation remains a problem, do you think that the chair of the Federal Reserve will be willing to raise interest rates that high? And do you think the president will let him, as Presidents Carter and President Reagan let Paul Volcker? Well, I think we're a long way from the kind of inflation problem that Paul Volcker had to address for the simple reason that wage trends are much more subdued. And most importantly, inflation expectations are still relatively well anchored. When Volcker took over, people had lost confidence in the Fed, lost confidence that we'd ever get inflation down again.

And so he was forced to engage in sort of a shock and awe policy of essentially saying, hey, there's a new sheriff in town. We're going to do things differently now. And he had to do that to bring inflation expectations back down. When inflation expectations become unanchored, that feeds into wages directly. And then it becomes very, very hard to get inflation back down. I think in the current environment, inflation is lower, wages are lower, inflation expectations are well anchored. So I don't think we're going to have to see the Fed act as dramatically as it did then.

The inflation that Paul Volcker had to wrestle with was created over many, many years. It really started back in the 1960s with the Vietnam War and the Great Society programs. Then we had wage price controls, and then we had oil price shock one in 1973-74, and then oil price shock two. So it took about almost 15 years to get from 2% inflation to 10% inflation. So I think it's conceivable that we're on that journey today, but I don't think so. And if we are on that journey, we've just started. We're just in the first couple hundred yards of a mile race. I hope you're right. Bill, what are the three things that you worry about the most? Three things I worry about the most? Well, obviously, I worry

about COVID sending us another wild card in terms of a variant that's more virulent and more contagious rather than more contagious, but less virulent like Omicron. I mean, Omicron could turn out to be a blessing in disguise if it allows people to develop immunity without a huge amount of sickness resulting from that. But, you know, it doesn't have to be that way. You could have something much more horrible come out of the virus. I certainly worry about that. The second thing I obviously worry about is what's going on internationally right now. I mean, Russia invades Ukraine.

Russian relations deteriorate. You always worry when two countries get mad at you, others that both have nuclear weapons at their disposal. You never know where that's going to necessarily lead. So I certainly worry about that. I certainly worry about climate change because we're already not going to do well. And if we don't get started, we're going to do even worse. I feel somewhat lucky that I don't have children because I think they're going to have to cope with a much, much worse environment, even if we get going a lot faster than we have to date. So there are plenty of things to be still concerned about, even as we look like we're going to have a sustained economic recovery. Do you worry about the U.S. dollar losing its status

as the world's reserve currency and what happens if it does? I'm not worried about that in the very short term, because I think that there's no really great alternatives. But obviously, if we run our economic policy badly, so that the U.S. dollar is not a stable store of value, then people will look around for alternatives. And there's already a bunch of people that would like to have alternatives in the cryptocurrency space. I personally don't think that the cryptocurrencies that are outstanding are very good as an alternative to the U.S. dollar because they're not stable stores of value. I mean, look at Bitcoin. We've seen how volatile it is. Is that something that you want to pick all the prices of goods and services to? I don't think so.

But if the U.S. follows a bad set of economic policies over a sustained period of time, then I think the dollar as a reserve currency will come under question. But there's a lot of inertia to this. There's a tremendous amount of inertia to the reserve currency. We saw the U.K. hold on to the pound sterling as a reserve currency long past the time where the U.S. had already emerged as the dominant economy. And so I think that same thing is likely this time. And China would like to be competitive to the U, but the problem you have there is that China is also a little bit reluctant to have fully open capital markets, complete controvertibility of the

currency. And there's also the question of the rule of law. A currency becomes a reserve currency because people feel that they know how they're going to be treated in that particular situation. So stability, a well-defined rule of law is also very, very important in terms of supporting a currency, a world reserve currency status. What happens if the U.S. status as the world's reserve currency slowly diminishes over time? Well, if it's slow, it might be like the frog in the pan of warming water that you don't really feel it. I think it basically means that the U.S. just will lose this exorbitant privilege of being the reserve currency. The reserve currency basically means that there's lots of demand for your currency abroad and you don't have to pay any interest on it. Most of the

U.S. currency outstanding doesn't circulate in the United States, it circulates abroad. So that's essentially 0% loans that we're getting from the rest of the world because people want to hold dollars as a store of value and as a medium of payment. So you would lose that. But I think the reality is, I mean, life would go on. The UK lost the sterling as a reserve currency status, and the UK is still a viable, healthy economy. I mean, obviously they have some issues now with making the transition through Brexit, but clearly you can be still a healthy economy even if you aren't the reserve currency. And I would think that the situation wouldn't evolve from the U.S. being reserve currency to not. It'd probably be evolved to the U.S. being a reserve currency to a lesser

degree, some competitive currencies emerging, different regions of the world might transact more in dollars, other regions of the world might transact more in renminbi. I think it'd be more evolved in that way. It's probably over a 20, 30 year timeline, not something much faster than that. Before I ask for the three takeaways you'd like to leave the audience with today, is there anything else you'd like to mention that you haven't already touched upon? Or what should I have asked you that I didn't? Well, the one thing I would mention is that we need to do a lot better in terms of getting our arms around what's going on in the digital currency space. Because right now it's largely unrelevant, unregulated. It's growing really, really fast. We have hundreds of billions of dollars of

stable coins outstanding, supposedly backed by dollar assets, but there's no oversight regime. There's no requirements. There's no regular audit function that ensures that those stable coins are well-backed. I think if we don't get our arms around this quickly, there's going to be an accident. And then when people are going to be asking, well, why didn't you do something about this? Couldn't you see that this was going to be a significant problem? So I think we need to figure out a way to regulate it. But we need to regulate it in a way that we don't kill off all the innovation, all the technology. I mean, the part about the digital currency space that I find very interesting is all the technology part of it. The distributed ledger, blockchain, smart contracts.

We've got to figure out a way to regulate this, but not kill it. And that's going to be very, very challenging. So that's something that I'm very focused on. And what are the three takeaways you'd like to leave the audience with? Number one, I think that at the end of the day, people still think the Federal Reserve is going to do its job. The job might be messy, but people still feel the Federal Reserve is going to do their job. If you look at the spread between Treasury securities and Treasury inflation protected securities five years out, people still think that inflation is going to be five years from now around 2%. So that's good news that the Federal Reserve, even though they've gotten off to maybe a bad start in the cycle, that they're on the right track. The second thing I would say, the key takeaway is don't be dogmatic about what's going to happen in terms of the financial environment, because we don't have any experience emerging from a pandemic, at least none since 1918.

And I wouldn't argue that's probably not so germane to the current situation. So there's probably going to be a lot of twists and turns in the road. And anybody who says that they know what's going to happen, I think you want to dismiss them almost immediately. And the third takeaway is I'm really concerned about U.S. democracy. I am really concerned about the fact that there seems to be a contingent in the United States that doesn't have respect for our democracy, for the rule of law. And that is a very, very dangerous thing. Bill, thank you for our conversation today. This has been terrific. Thank you.

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