Odd Lots - Here Are the Biggest Problems Facing the Fed Right Now

Episode Date: October 7, 2021

The Federal Reserve has a lot on its plate at the moment. Not only are "transitory" inflation pressures proving to be more stubborn than expected, but unemployment remains relatively high even as the U.S. economy recovers from the Covid-19 pandemic. Meanwhile, there are also technical challenges that the central bank now faces as it gets closer to tapering its asset purchases. Finally, there's the possibility of an imminent U.S. debt crisis as Washington continues to wrangle over raising the limits on federal borrowing. On this episode, we speak with Joseph Wang, a.k.a "Fed Guy," to talk about all the difficulties facing the Fed right now. Wang is a former trader on the Fed's open market desk and has first-hand experience in how debt ceiling brinkmanship can affect money markets. He gives his thoughts on what would happen if there were a technical default, how we should be thinking about U.S. Treasuries right now, why crypto may have changed everything, plus insights into how the central bank actually makes its decisions.See omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. Oh, and welcome to another episode of the All Thoughts podcast. I'm Tracy Allo. My co-host, Joe Wisenthal, is away. And if I could just begin the show with a small disclaimer, which is that apparently I have broken my foot in three different places. So if I sound a little bit distracted today, that is why. Now, speaking of difficult situations, you all know, our all-bots listeners are aware that the debt ceiling drama continues in the states. Joe and I just recorded an episode on the mint the coin debate, which is one idea of how to

bypass the debt limit on a temporary basis at least. But I think it's fair to say that there are a lot of challenges out there at the moment, especially for the Federal Reserve, the central bank. So not only are they still trying to navigate an unprecedented economic cycle in the wake of the global pandemic, but they're also now having to deal with higher inflation to decide whether or not it is indeed transitory. And meanwhile, they are also facing the fallout from what's going on in DC. So every time there is this sort of debt ceiling brinkmanship, we generally see some feed-through into the treasury market. You know, money market funds stop buying up short-term bills around the date, the so-called drop-dead date, that the U.S. is actually supposed

to run out of money, and the Fed has to figure out all these different ways to try to keep things going along with the Treasury while the politicians do get out. So there was a lot going on in the Fed. I haven't even mentioned the insider trading scandal, but that, of course, is an issue as well. So suffice it to say the central bank faces many, many challenges. And today I am very happy to say we are going to be speaking with the perfect person to discuss some of those issues. It's someone who actually used to work at the Fed as a trader. And he runs a blog right now called Fed Guy. And it's one of my favorite reads.

I highly suggest you check it out if you haven't been reading it already. Joseph Wang, welcome to the show. Hi, Tracy. Thanks so much for inviting me. I'm thrilled to be here. Oh, well, thank you so much for coming on. Joe and I have wanted to get you on for a long time, so I'm happy you could make it. Maybe just to begin with, could you describe your background at the Fed? What exactly were you doing there? Sure. I worked on the open markets desk at any word Fed. And so what the open market

does, it's basically the Fed's trading desk. So we conduct operations. So all the QE, all the repo operations are done by the desk. I focus on money markets. So I run the repo operations and I studied the banking system. A lot of my work has to do with studying how the financial system works. Money market funds, just the plumbing of the system, basically. So when we have something like a debt ceiling crisis, do you start getting flashbacks to previous episodes? Well, I think one of the main mechanisms that the debt ceiling does impact the markets is through the money markets. So yes, that's probably the direct way that the debt ceiling impacts. And you can see it right now, actually. If you look at the short-term bill curve, you can already

see bills that mature around the drop-dead date are selling off quite a bit. So usually you see market impacts first in the money market sector when it comes to the debt ceiling. So how do you think money markets, and I guess the wider treasury market, should feel about debt ceilings and this kind of political brinkmanship? And the reason I ask that is because, you know, we do tend to see these bouts of debt ceiling drama every once in a while, or at least, you know, in recent years, we've seen them every once in a while. But on the other hand, you know, when it gets really bad, we tend to see treasuries rally because people go into safe haven assets and treasuries are still considered that even if the cause of market turmoil is because of the U.S. itself, which is kind of ironic. But how do you think treasuries feel about these sorts of issues and has it evolved in recent years? So you're exactly right. And I think that

the way that I would think about this is that I think overall, of course, investment community understands that this is a passing thing. The U.S. Treasury has a printing press, right? So they can always make their obligations. But on a more nuts and both side, there are classes of investors that are not able or constrained in their holdings of things that are defaulted, most notably the $4.5 trillion money market fund complex. So under the regulations, they are highly constrained in holding defaulted securities. And they also don't want to be able to, they want to be able to tell their clients when the clients read about the debt selling on the news that, you know, we're not exposed to this at all. So even though I think the investment community understands that this is the

passing thing, there are mandate constraints that come into play. And that's why you still actually see sell-offs in the short-term treasury markets. In addition, I think that we've been through the debt ceiling a few times over the past decade. And what we can learn from a lot of public documents that were either disclosed by the Fed or through subpoenas, that the official sector actually has a lot of plans just to avoid a new fallout in the treasury market. So, So it would be, I think, reasonable for the Treasury market to not be too much afraid of the debt ceiling. But a lot of these backup plans, though, do have economic impacts. And so it's not a reasonable for the Treasury to actually rally in that context.

Well, so one of the things I want to ask you is how much the RRP, the reverse repo program, might make a difference this time around. So, you know, we know that the Fed has been running this. recently they upped the amount that they could take. I can't remember what it was, what the cap is now. Do you remember? Yeah, it's $160 billion per counterparty. So earlier in the year it was $30 billion and then it was up to $80 and now it's to $160. But in practice, though, I would just think of it as a full allotment facility.

So there really is no limit. So one of the reasons they've raised it is in preparation, presumably, for money market funds having to move into this thing because they have to avoid bills or they're unable to buy bills because Treasury can't issue them. So how much does that help in a scenario like this? I think it helps tremendously in terms of rate control. So heading into the debt ceiling, one of the ways that the U.S. Treasury prepares is by paying down bills. The way they manage your debt is they have, they manage under a regular and predictable issue and schedule. And in practice, that means maintaining coupon issuance as much as they can and meeting short-term cash flows through bill issuance.

If you think back last March when we suddenly had a lot of emergency COVID expenditures, what happened is that they met those expenditures issuing $2 trillion in bills. Now, in the same way, as we're heading to debt selling, and they're trying to maintain spaced under debt selling, what they're doing is they're reducing the amount of bill issuance to reduce the amount of debt outstanding. The main investors in the bill markets are the money market. funds. And now that money market funds don't have as many bills to invest in, there's a buffer there where they can invest in the overnight reverse repo operation. That helps the Fed maintain

rates, even as the amount of investments available in the money market space decreases. Without the overnight repo facility, I think short-term rates would definitely be below zero. How much doesn't matter that the Fed now pays interest on RRPs? Because I remember that was a big deal in the summer when they started to do that. I think it was an extra five basis points, something like that, five basis points, whereas previously they had been paying almost nothing. But why the need to do that and how much did that sort of change things for money market funds? So the reverse report facility is one of the Fed's key tools for short-term break control. One of the Fed's goals, or any Centriving's goals, is to control rates. In the U.S., we choose the overnight rate.

Before the crisis, it was primarily controlled by adjusting reserve balances within the banking system. After the crisis, now that we have so many more reserves, that's just not a feasible way. So in practice, the Fed controls overnight rates by paying interest on the reverse repo facility as basically boundary, lower bound rate. That means that if you're an investor with short-term funds and you can always invest in the Fed risk-free at the RRP rate, that puts a lower boundary of what's you're willing to accept in other investments. So if you can invest in the Fed at five basis points, there's never a reason for you to buy, to invest in any lower rates. And that's how that's basically a crucial tool the Fed now uses to control interest rates.

So let's say we get to, I mean, I think the consensus right now is that the U.S. Treasury could run out of money sometime around mid-October. I think the one day I've seen consistently come up is October 18th. I should just say that we are recording this on October 5th. So maybe something changes between now and then. But if we get to October 18th and Treasury runs out of money, the debt limit isn't raised, what would you expect to actually happen in the Treasury market, in money markets, and how would the Fed respond?

So this scenario has happened quite a few times in the past decade. And from public documents that have been disclosed, you can kind of see that the Fed and Treasury have basically been wargating this for the past 10 years. So the path forward is basically prioritization. But before they actually dropped that date, this is basically a political, hard of the political process, right, it's a negotiation within Congress. So the Fed doesn't really want to step in or say anything. And the administration has an incentive to maximize, I guess, fear to, encourage a compromise. But when the drop-bed date actually happens, what was discussed during 2013 was that the Fed and was that the Treasury would actually prioritize principal interest payments to

U.S. Treasury holders as well as Social Security. The thing is, when the Treasury runs out of space under the debt limit, it still has a lot of cash receipts. If you look at data from the past five years, the U.S. Treasury usually has cash receipts of about, let's say, $800 to $900 to $900 billion. during the fourth quarter. So that's pretty steady. So they have a lot of money coming in, but they don't have enough money to pay everything that's due. But if they only focus on paying principal of an interest, that's about $200 billion over a quarter of four. If they only paid Social Security, that's probably $300 billion. So they have enough money to pay some bills, but not everything. It was discussed in the past was just prioritization. So the Treasury market will actually be fine,

there will not be a default. And what would happen, I think, is that once they hit the dead sea and ceiling, the absolute drop dead date, in order to calm the markets, they will announce their plan to prioritize surgery payments and other, I guess, more humanitarian payments, Social Security, veterans benefits, food stamps, and so forth. And that should actually immediately calm the treasury market down because they know that default is off the table. Heading into it, you can already see the disruptions.

Some short-term bills are selling off. But I think once we reach the drop-dead date, oddly enough, I think that prioritization announcement will solve everything. Of course, there would be some economic impact from this because Treasury does a lot of things. They also have payments to, let's say, doctors, hospitals, pharmaceutical companies, defense companies, and those companies will have some liquidity problems. But the surgery market, I think, will be fine.

And maybe they rally, as you mentioned before, understanding that, when there is a liquidity crisis in the non-financial sector, maybe if their liquidity gets squeezed a bit, that affects the economy. Even if Treasury doesn't prioritize or they decide not to, ultimately it's a political decision by the Treasury, and it's the one that makes a lot of sense. The Fed also has a plan, just to step in case anything bad happens. Just as I mentioned a bit earlier, so a lot of investors have mandate restrictions where they can't hold Treasuries that defaulted. The biggest investor that has these mandate restrictions, these are legal, are the money market fund industry. So if by any chance there was like a technical default, a lot of the money market

fund industries will not be able to hold treasuries. And that's a huge problem because they don't just hold short-trib bills, but they are also enormous investors in the repo market. The repo market is a multi-trillion dollar market for basically overnight secured loans. And a lot of those loans are in treasuries with treasury collateral. So if you're a money market fund based on SCC data, you're probably investing a trillion dollars in treasury-backed repo every day to the private sector, excluding Fed. And because of your mandates, you're not able to accept or unwilling to accept without a waiver from your board of directors default to collateral. So a lot of people who are getting funding in the repo market using treasuries may lose access to that.

funding. And, you know, that's classic bank one-legged scenario. Because if you're buying surgeries on leverage using overnight money and suddenly you lose access to that financing, and that could be very disruptive. Effectively, I think, in practice, a default, a technical default would probably bifuricate the treasury market between those that are at risk of not receiving principal and interest in the coming months and those that are safe. Let's say their interest due dates are next year. If you do the math, the amount of treasuries that are, outstanding that have principal interest payments during this quarter about a bit over $8 trillion. So there's potential for enormous disruption when, let's say, investors have to shuffle out

of at-risk treasuries into treasuries that are not at risk. Because this has never happened before. Oh, in addition to that, once there's a technical default, I imagine the ratings agencies would have to follow up and to downgrade the U.S. And in addition to the money market funds, there were also many classes of investors that have trouble holding securities that are not, let's say, rated AAA by two or more in the agencies. Maybe they have trouble holding U.S. Treasuries. There's some discretion there depending on how their mandates are written.

So it could be a very disruptive event, and that is something that has never happened before, and no one really knows how it will happen, which is kind of why no one will allow it to happen. You have the Treasury prioritizing, and if, for whatever political reason, they don't prioritize PNI payments, The Fed has discussed in October 2013 of what their game plan would be. And they have the tools and the motivation to be able to fix everything. So what they would do is they would still accept the defaulted collateral in their repo market operations. So they would be able to provide liquidity against that, even if the money market funds cannot or do not want to. They would be able to accept defaulted collateral in their securities lending operations.

So if you had, let's say, an at-risk treasury, you could swap it out with the Fed. Or, of course, if that's not enough, they could just do outright purchases, QE-Southout to purchase out-risk collateral. So you have these two tiers of plants from the Shredgerry and from the Fed to make sure basically the Treasury market will be protected. And so going forward to Deathsling, I don't really worry about anything because there's just, this is something that happens so many times. And if you're in the market, you know that's something that people anticipate.

A risk that people anticipate usually don't materialize because they prepare for them. And I think this is one of those cases. On April 4, 2023, around 2 in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, The Killing, The Killing, of Bob Lee beginning April 16.

So, I mean, I get the point that the Fed is sort of prepared to step in as lender of last resort, you know, if it really has to. And I get that it also attempts to be politically neutral, you know, when these types of situations come up. But I'm wondering, like, what do people at the central bank actually think when politicians are arguing with each other and we sort of get to this point. Like, you know, again, you were on the open markets desk, you were a trader. Does everyone there kind of like roll their eyes and go like, oh, no, now we have to work on plan A and plan B and how is this going to affect the market? And do we have to factor this into our economic predictions and things like that? Like, I guess how do people actually think about it?

So the central bank is a very conservative organization. It's, I think, a bit more as a utility. So it wants to make sure the basic plumbing of the system works, and that includes the treasury market. Treasures are basically a full of money in our financial system. If you look at declassified documents, this scenario of payment prioritization, there were simulations of this run in 2011. And again, in 2013, and I'm absolutely sure it's being run right now. So people there, I think, don't think they worry about the market impact, but it does create an enormous amount of work for them. and so they don't like that. And I think that they understand that this is part of the political process, though.

Another declassified memo that features, let's say, someone speaking with Chair Paul, basically hints at the fact that they understand that part of this is the political process, and it's also partly trying to put pressure on Congress to do something. So even though this probably won't happen, having this in the news, talking about very bad scenarios, is something that serves a purpose. So let's shift gears slightly and talk about some other challenges that the central bank faces at the moment. And, you know, there isn't a shortage of new things, new developments to actually wrap their heads around and address. But one of the interesting things that you brought up in a recent post on your blog was this notion of wealth effects.

And maybe wealth effects that haven't necessarily been understood or taken into account. by the Fed. Could you walk us through your thesis there? And, you know, a lot of people tend to complain, well, some people complain about the Fed's emergency liquidity feeding into risk assets, like, or financial assets like stocks and bonds, and making people who are already wealthy, even richer. But you point out that not only is that happening, but there's also a sort of unaccounted for wealth effect through cryptocurrency. So could you maybe describe that. Sure. So I think the labor market is a very confusing market to analyze right now because you have lots of indications of a tight labor market with you have help wanted signs everywhere, which is

going higher. And at the same time, the unemployment rate is still pretty elevated. So I think one of the reasons just thinking about this has to do with the wealth effect. And there are actually academic papers finding something similar and common sense today. I think you should understand that the more money you have, the less you need to work, the less you're motivated to search, that you're less willing to set lower wages. And one of the things that has happened over these two years is that the wealth effect, basically the wealth people hold, has been supercharged. If you just look at residential real estate, it's up 25% over the past two years.

And a little bit over 60% of the Americans own a home, and that's your largest asset. So a lot of people have a lot more equity in their homes. If you own stocks, you know, that's, S&P is up 45% over the past two years. When you look at Fed data and you break it down, one of the things you notice is that, you know, what everyone says is true. It's really the rich people getting much, much richer. However, because the wealth effect, the growth in asset value is so extreme this time around, if you were actually just top half in wealth, you saw significant gains in your paper wealth.

So that has to have an effect on whether or not you're willing to work and what wages you're willing to accept. And that's just what you see in official data. There is also an enormous wealth boom that you don't see. And that's in the cryptocurrencies you alluded to. So cryptocurrencies, they exist on decentralized ledgers. So they don't show up anywhere in official data. But we see just from public data sources of where cryptocurrencies are trading. And no cryptocurrencies have gone from basically nothing going to

couple years ago to $2 trillion in total asset size. And we know Bitcoin and Ethereum are the most well-known ones, but just behind them, there are hundreds of these, I guess, alt coins that have also grown to a billion-dollar market caps. And none of this shows up in official data, but it's being held by the general public, likely younger people. The enthusiasm for cryptocurrencies is palpable if you look at Coinbase user data. It's just surging. And so that has to have an impact on the motivation of young people to work as well. If you can just stay at home and trade cryptocurrencies or if you held a little bit of crypto, then you are a bit wealthier than you were before. Maybe you're not as desperate for a job. Just anecdotally,

I remember that I took a cab from LA Airport from Lax and my Uber driver at the time. He was driving a 10-year-old Camry and he was telling me that he put $30,000 into Bitcoin because, you Because Bitcoin only goes up. And, you know, he did not seem to look like a wealthy person. So I actually encouraged him to diversify a bit. And he also told me he bought some Dogecoin. So this is this phenomenon. That was lucky, huh?

Yes. So this phenomenon, I think, is real. And it's something that's not captured in visual data. This wealth effect, I think, fundamentally changes the dynamics of the labor market. And if that's true, though, then, you know, maybe maybe the fact. that is actually a bit behind in raising rates. And so far as raising rates cools down inflation. Yeah, there's, I mean, there's a ton of irony in thinking that cryptocurrency might be the

reason that the Fed ends up overheating the economy, but or letting the economy run too hot. But do you think the Fed, this is kind of an unfair question, because I don't think anyone really understands crypto, but do you think the Fed understands crypto or is it making a good faith effort to understand the market? I don't think the Fed understands crypto. I think one of the things that I would take away from my time in the Fed is, I guess, how surprising how few things Fed management understands. And I think that it's kind of apparent from even if you look back, let's say, 20 years ago

during the financial crisis, the Fed was not really aware of what was happening in shadow banking either. Now, I only speak from my experience at the New York Fed, but if you really think about it, New York Fed is basically a government agency with unlimited money and no government oversight. So I think a lot of strange things happening there. In my own experience, let's say the person who ran the money markets at the New York Fed didn't have any experience or expertise in money markets at all. And that was very common throughout the open markets desk because, you know,

you don't really have any external pressure to know or do anything. So I don't think the Fed is very much in tune with what's happening in cryptocurrencies. So speaking of the Fed, not necessarily being in tune with the economy right now, I wanted to ask you also about inflation. So this is probably the biggest question currently facing central banks and investors at the moment. To what degree are these inflationary pressures that we've been seeing, some of the gridlock in supply chains and supply shortages and things like that, to what degree are they transitory? and to what degree should central banks actually be worried about them? Should central banks be responding to them?

Is an interest rate hike the appropriate way to fix, you know, the problem of not enough shipping berths in Los Angeles and things like that? So I guess my question is, like, number one, how do you think the Fed is thinking of inflation at the moment? And number two, to what extent is the flexible average? inflation target still in play? I think the Fed is really worried about inflation. After telling everyone it was transitory, you don't longer share that word anymore.

And I think that's, it's a really hard, it's a really hard question for the Fed right now because, you know, a lot of this inflation, it appears to be driven by supply side effects. You have, you know, we read about the energy crunch. We have, you know, congestion at ports, as this hasn't been discussed at this on the podcast. There is also a big demand burst as well. We kind of printed and spent a lot of money and that increases demand. A lot of the supply constraints won't be changed by interest rate hikes, but interest rate hikes do dampen demand. So if you hike rates, you can really hurt demand. And so reducing demand that lowers inflation. However, it costs your other mandate, which is full

employment. So it's a very, very difficult time for the Fed to choose right now. And I would also add, though, that just mechanically speaking, looking at the financial system, it's really hard for the Fed hike rates without having a tremendous financial impact. And the reason for that is when you have a very high level of debt in the system, your interest rate hikes are magnified in their effect. So there's interest rate risks, not in, let's say, fixed income debt. And when you hike rates, you kind of basically destroy some of that value. And when you're thinking about treasuries, you're basically kind of pulling away money out of the system. If you think about treasuries as a form of money, then what we've been doing in the past, let's say, decade, when we reduce rates, all those

high-duration assets, they become, their market price rises, they become enriched. People have more money through that, which they can repo or sell and then they can, you know, buy other stuff. Or if you're, let's say, let's say a 60-40 portfolio manager, your bonds appreciate, you have to buy more equities to balance. Then that makes equity markets go higher. But when you're hiking rates, you're doing the reverse. And because the level of debt is so much higher, then I think there's some very long non-linear impact. So that collateral channel from through which monetary policy is transmitted, that I think really sets a constraint on the Fed as to whether or not they could just hike rates like they did in the 70s because you could have very,

very large impacts on the financial markets. So I don't think they're in a position to do much. If there is a solution to inflation, I think it probably has to come from the fiscal side, maybe through taxation by, let's say, more progressive income taxes, for example. Interesting. So when it seems like we're moving towards a world where the fiscal authorities play much greater role in demand, right? They're spending trillions of dollars. And when you have a large debt market constraining the central bank, I think one of the ways that you could solve inflation is just through

taxation, basically draining away money selectively out of the financial system instead of something blunt, like an interest rate increase, just wholesale, lopping of market value of fixed income debt. That's really interesting because I always thought of fiscal as, you know, one way to boost demand, And obviously, you know, the government announces some big infrastructure spending program. And hopefully Congress passes it instead of arguing about it for a long time. And voila, you know, the economy gets a demand boost. But I hadn't actually considered that the reverse could also be true that fiscal could act as a sort of demand constraint if it has to. Yes, we can.

And I think. But the problem, of course, is that the fiscal, the Congress, you know, sets tax laws, is can't act. as quickly as the Fed. And the Fed could, you know, like last March, instantly rolled out liquidity facilities and cut rates. It's very difficult for the legislator to be able to act as quickly. So what is decision-making actually like at the Fed? Because, I mean, on the one hand, we have seen the central bank praised in recent years for putting together a very, very quick response to the market crash that we saw in 2020 and, you know, the turmoil in the treasury market specifically. But on the other hand, it does get a lot of criticism for basically

being outside the sort of democratic process. You know, it's, it operates without political oversight, I guess. And, you know, there's a perception that it's just a bunch of economists doing their own thing. So I'm curious what internal decision making actually looks like at the Fed. Is it really just, you know, one or two senior people making decisions, or is there some sort of committee-like process in doing these things? So the Fed is very, very consensus-driven. So everything is done by committee. It's just that what happens in practice is the most senior person says something and everyone just nods. So it is by consensus. And you can kind of see this on the highest levels at the FOMC, for example.

You have a Fed chair who basically, you know, says something and everyone agrees. And what's happening is behind the scenes, just lots of lobbying so that when we actually make it to the decision, everyone is on the same page. But I think, well, in practice also, I mean, the power is heavily tilted towards, let's say, the Fed chair and the two vice chairs. So in practice, those people have disproportionate amounts of power. But I think you're concerned about. Fed governance and lack of oversight is valid, especially since the Fed seems to be becoming more powerful

as over time. And you can see this, I think, in their reaches towards expanding their mandate to, say, the climate change impacts on the financial system. Because when you can make it that argument, because climate change affects the financial system, therefore we must have oversight of it. Then there's no limiting principle there then, right? Everything affects the financial system. Doesn't that mean that the Fed could have its influence on anything? It reminds me to, let's say, the early days of our country when the federal government was very limited, but then through the Commerce Clause, they vastly expanded their power because basically everything affected Interstate Commerce. Even if you were growing wheat in your own backyard for your own

consumption, that meant that you weren't buying wheat in the interstate market. So that affected Interstate Comments. So this expansion apart the Fed is doing through basically being able to touch everything that affects the financial system has no limiting principle. And if that's the way that they are going to go, then I think they do need more oversight. I'm June Grosso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases. The latest actions from Congress and regulators and the legal moves driving the markets. From corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg Law, we go

beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean. We do this every weekday, then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify or anywhere else you listen. On the East Coast, listen as you start your day. And on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today, wherever you get your podcast. Just going back to the inflation discussion, there was one more thing that I wanted to ask you, which is another big mystery that is sort of bedeviling markets at the moment is the fact that we still have relatively low bond yields and specifically nominal yields,

but we also have higher levels of inflation, even though it looks like inflation expectations haven't moved that much recently. I'm looking at tips. They've been pretty flat, I think. How do you think about this puzzle of low yields? I think that's a puzzle if you assume that bond yields are basically a reflection of economic conditions and inflation expectations. And there are definitely people who buy bonds with that framework. But there are also many people who buy bonds without that framework. And for example, if you are a commercial bank, you're receiving IOR on your reserves, 15 basis points. Under the regulations, shudgeries and reserves are considered equivalent.

So what do you do? Well, I just swap up my reserves and buy a whole bunch of shudgeries. And you see commercial banks doing that to the tunes of hundreds of billions at a time. So it's not because of any fundamental view on growth and inflation. It's just that under their constraints, you know, treasuries are better than reserves. We'll buy treasuries and we'll hedge the interest rate risk. You also have a lot of actors, let's say the Fed, buying $80 billion a month.

The Fed does not care about growth in inflation. They're buying it because it's their mandate to do so. And you have also many other, I'd say, foreign central banks are very conservative investment managers who were buying treasuries because they need safe assets. Or maybe they're regulatory bound by the regulations to do that. So I think that treasurer just the financial asset. They go higher because there are a lot of people buying it. I think it's a mistake to infer economic conditions from them. The analogy I would use is, let's say you're looking at Tesla stock. Let's say you can forecast earnings and you could put that into a dividend discount

model and you can come up with a fundamental value of Tesla, right? That's your framework. You forecast earnings, you value it based on a fundamental way. But you can't really take the price of Tesla into as an input in your model and back out supposedly market expectations for revenue growth because people are buying Tesla for momentum or maybe you're an options dealer. You got to buy Tesla to hedge your options. And in the same way, you really can't take price as an input for, let's say, treasuries and try to back out what the treasury market is saying about economic conditions, because not everyone approaches treasuries as an investment on that basis. So this is one of the areas where I kind of see overlap between some of the research you do

and some of the research, one of our other, you know, recurrent money market guest, Zoltan Pozar actually does, where, you know, he's well known for calling up banks and, you know, speaking to people in the money markets and trying to gather color on what exactly they are doing. And I see a lot of that in the posts that you do on your blog as well, like actually digging into the numbers to see what treasuries at large banks have been buying and then charting the fact that they've been buying a lot more bonds over the past year or so. How much does that sort of inform your thinking? Do you still keep in contact with a lot of people in the market and try to get as much information

as you can from that? You're right that a lot of the work that I did at the Fed was basically the same as what Zoltan did, and I have great respect for Zoltan. I read everything he writes. It's great. And I'm glad you have them on your show sometimes. I think a lot of my information, actually, I get through Twitter these days, and what I've realized is that Finn Twitter, it just has amazing resource. You can access the thoughts of some of the, I think, best managers, expert, subject matter experts in the world, and it's all available on Twitter. And you don't, get certain things that you could get, let's say if you had relationships with their treasury desk.

But I think once you understand how the system actually works, there's just enough from public data and from, let's say, anecdotal reports through outlets like Bloomberg or FinTwit, that you can actually have a very good picture as to what's happening. There's one more question that I want to ask you, which is, maybe it's a sensitive one. I don't know, but let me know if it is. But why did you ultimately decide to leave the Fed? I think it goes back to what I was mentioning about the open market sector. The Fed is a phenomenal place to work on the open markets desk.

You have access to tremendous amounts of confidential data. You can call up big banks or dealers or just hedge funds or money market funds and they'll speak to you and you get to understand. But it's a really good place to learn, but it's not a really good place to work. It's not a good place to work because, well, just looking in the money market set. no one on the management, almost no one on the management has any expertise or experience in money markets, it's kind of basically purely based on your seniority, so it's impossible to grow. It's kind of just like a, I guess, a big piggy bank for the people who got there first.

And so it's a good place to grow, but it's not a good place to learn. And we have tremendous turnover. I can tell you from just this past year on the money market says turnover was like 25%. some of them go to other divisions in the Fed, some of them go to the street. So I felt that I had learned all there is to learn, and there is really no point of being there anymore. One more question for you, and then we're going to have to wrap up. But what do you think the biggest challenge is that the Fed is facing at the moment? I think the Fed is facing a moment where they have to choose between their two mandates, employment or inflation.

And that's a very difficult choice. and it's going to be a political choice, depending on the composition of who's on the FOMC. You have inflation that you can't control, and if you raise rates or try to tamp down on demand, you're going to have higher unemployment. That's a very, very difficult choice, and there's just no good way to do it.

So they're going to have to base, it's going to be a political thing, it's going to be based on their values. What do they value more, employment or inflation? And we'll have to see the composition of the FOMC. It looks like it's changing with all these revelations, and resignations. So we're going to see how the composition of the FMC is next year to see how they might rule. Yeah, certainly a lot going on in interesting times for the Fed. Well, Joseph Wang,

the writer at the Fed Guy blog, thank you so much for coming on. And just for our listeners, if you haven't checked out Fed Guy yet, I highly recommend that you do. It's fed guy.com. Joseph, thanks so much. Thank you so much for having you, Tracy. So here's the part where I talk to myself because Joe isn't here. But I'm trying to think how to sort of synthesize that conversation. I mean, part of me is just relieved that I don't actually work at a central bank and have to be on the hook for solving a lot of these problems at the moment. And, you know, I obviously don't think the Fed is a perfect institution. And certainly we're seeing that recently with the news about the insider training scandal.

but it is clear that they are facing a number of new situations that they've been thrust into after COVID and after the big market crash. And I don't necessarily envy them having to figure out how the world works in current conditions. You know, trying to figure out whether or not hiking interest rates would actually do anything to damp down supply pressures that are caused by transportation. gridlock and supply chain issues, that just seems really difficult to me. And also, Joseph's idea of Bitcoin and a sort of unaccounted for a wealth effect may be changing the composition of the labor market. That, again, is something brand new. And I doubt that the vast majority of

central bankers, you know, many of whom are quite old at the moment and probably haven't been following Bitcoin for that long or that much, I doubt that they've really wrapped their heads around that phenomenon. So yeah, I guess the message is don't envy the people at the Fed and there's a lot going on and a lot of new challenges that they are facing. And with that, I am going to leave it there. One thing I would say is if you are enjoying odd lots, if you do appreciate the work that Joe and I put into the show and here I will just go ahead and mention that I am recording this with a triple fracture in my left foot. If you appreciate odd lots, please go over. to Apple Podcasts and give us a review, hopefully, you know, a five-star one, it would be much

appreciated and Joe and I enjoy seeing that kind of feedback. So thank you so much and I will leave it there. So this has been another episode of odd thoughts. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. You can follow my co-host, Joe Wisenthall at The Stalwart. And you can follow Joseph Wang at Fed Guy 12. You can also check out his blog at fed guy.com. And you should follow our producer, Laura Carlson. She is at Laura M. Carlson. And you can follow Bloomberg Podcasts at Podcasts.

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