Central Banks Are Losing Control of Inflation | Global Macro | Ep.100

Summary

• Macro Framework: The guest advocates Nominal GDP Targeting to handle supply shocks without misdiagnosing inflation drivers in real time.
• AI: Discussed as a potential positive supply shock; if it delivers real productivity, it likely pushes up real rates over time and could justify mildly falling prices.
• Policy Implications: Inflation targeting at a strict 2% could amplify asset booms during productivity surges, whereas NGDP targeting may better stabilize the cycle.
• Fed Balance Sheet: Deep dive into QE/QT mechanics, the reserves “ratchet effect,” and proposals like a T-bill for bond asset swap to shrink the Fed’s footprint with less market disruption.
• Stablecoins: Seen as supportive for dollar reach and T-bill demand, but net impact likely modest versus the scale of U.S. debt; implementation and interoperability remain hurdles.
• Fiscal Dominance: Rising structural deficits and entitlement pressures could eventually force the Fed toward market support or yield-curve control, posing long-run risks.
• Market Outlook: Near term, the Fed may “look through” supply shocks while watching inflation expectations; oil/geopolitics vs AI productivity create offsetting forces.
• Credit Landscape: Private credit growth is noted but not yet a systemic concern; banks’ liquidity, LCR rules, and reduced interbank lending reflect post-QE plumbing shifts.

Transcript

I do think there'll be some real net gains there because it's easier and some of it will displace currency, some of it will be net new, but I I guess I I'm hopeful for it. There are real challenges though in this implementation, you know, financial stability concerns, this uh logistical concerns, but we get past all those hurdles. The question is it's an empirical one. How much does it really matter? And I'm not sure at this point. Welcome to Top Traders Unplugged. In markets, success doesn't come from predicting what happens next. It comes from being prepared for what you can't predict. In each episode, we go deep with some of the world's most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world. No noise, no shortcuts, just real conversations to help you think better and invest with confidence. Today I'm delighted to be joined by David Beckart. David is senior research fellow at the Mercus Center at George Mason University. He is a researcher focused on the Federal Reserve and its operating uh policy system. He has previously served as a international economist at the department of treasury and also hosts his own weekly podcast uh macro musings which I definitely recommend for people who want to delve deep into all things macroeconomics. David, great to have you on. How are you doing? >> Great. Thanks for having me on the podcast. >> Great. Not at all. No, I enjoy listening to yours. You get really into the weeds on a lot of really big macroeconomic issues. So, anybody who's that way inclined, I definitely recommend uh listening in. We probably won't go as deep, but we we'll probably try and keep it as broad as well as deep today. But uh more so to get the uh implications of what all of this might mean for markets and investors. But one thing we do like to start off with is to get a sense on how our guests got interested in their chosen field in the first place. So what got you interested in economics? I took a class as at an as an undergraduate in college, principles of macroeconomics, and it was just to fulfill a requirement, but it just lit my fire. I and at the time I didn't think I could do this for a career. It didn't even cross my mind. But I remember studying in macroeconomics, the first class in it. And it's like, wow, this makes so much sense. That helps explain many things in the world. And then later, I was working on a master's degree. And I I took a few more econ courses and finally it just all clicked. Hey, I could do this for a career for a job and went back to grad school and my first job out of grad school was at the US Department of Treasury as you mentioned and then I went to the academic world. Now I'm at a think tank. But it's all been just a great fun journey. Feel incredibly blessed to do what I do and to talk to people like you. And you also have the benefit of talking to lots of interesting uh guests on your own podcast and macroeconomics. I mean, do you find that helps your own thinking? I know you write your own substack as well, having that uh kind of um that platform to to to share ideas and and I guess to to to get the insights of experts. >> Absolutely. I call it my continuing education because as you know, as you host your own podcast, it takes preparation to do a show, right? So you got to read what they've done, their works, and like you mentioned, we tend to go in deep. So it it it's a lot of preparation on my part, but it also keeps me attuned to what they're thinking. And it has it has influenced my thinking. One concrete example is um my thinking on the Fed's balance sheet has evolved and changed over time as I've talked to a number of guests. Um so that that's just one example, but other examples talking about the role of the dollar in the world. all those things. I've been informed by talking to other people. They bring up arguments I hadn't considered. You know, I I try to be gracious on the podcast, but I get pushed sometimes and it's good. It's it's good for me. I've I've definitely have learned a lot and it it just opens up new conversations. So, even when I'm not doing the podcast, I could go somewhere. I go to a conference and people know me because of the podcast and I want to say something or add a thought, you know, of course, I get lots of email feedbacks as well. So it's it's a great opportunity for I think for networking as well as growing um and I think in this day and age of AI where some of our work can be replicated by smart machines I think it's incredibly important that the the people connection the networking is probably of increasing value for folks like us. >> Absolutely. Yeah. Yeah, no, I definitely find it very very helpful and as you say >> macroeconomics is endlessly interesting and and the debates are never solved and maybe that's a good jumping off point because uh it's interesting the transition we've had in markets in the last month or two you know in February AI was all the chat this inflation positive supply shock then obviously we've had the situation in Iran and that's an an adverse supply shock >> so maybe that's a good starting point I mean >> what's the what's the appropriate policy response to this uh adverse supply shock that we're seeing now in Iran. Well, the textbook answer is and I'll give you my my version of the textbook answer. I have I have a specific answer as you know but I I'll give the textbook kind of central banking dogma view on this and that is if you have inflation expectations anchored if you are a credible central bank and in the past you've proven yourself you've earned the trust that you do fight inflation you do stabilize inflation over the medium run then the uh goal is to look through a temporary burst of supply side or you know productivity driven uh inflation Um and the reason being is you the Feds or a central bank of any kind cannot really solve oil shortages. They can't solve you know pandemic shutdowns. So anything that affects the productive capacity of supply side of the economy is something that the Fed in the near term really can't deal with whether it's positive or negative. Now in this case we're talking about negative supply shocks. So the best thing is just to kind of step back do no harm. It's kind like a medical doctor but we're you know we're central bankers. do no harm and and let that go through. Now, that works again only if you've got credible inflation fighting credibility. So, you think of like, you know, there's there's a bank where you've earned up you've saved up your credit and you can start to spend that down and you know, as you have more and more supply shocks. So, this is the challenge is even if you are viewed as credible, if you have enough supply shocks, eventually people begin to question, well, are they really going to get inflation back down? because the average person on the street is not going to distinguish between demand driven inflation and supply. But if again it's credible and you think the the Fed or the ECB or the Bank of England is going to do their job, then you look through it. So that's the standard story. Look through it as long as you have the ability to keep inflation expectations anchored. So that that's kind of the standard story for emerging uh I'm sorry for advanced economy central banks. Emerging central banks don't have that privilege because they don't have that credibility. So, how what's a practical way to do this? And and this is where kind of one of my hobby horses I'm known for. And to me, a way to implement this would be through something called nominal GDP targeting. It's also been called nominal income targeting because every dollar spent a dollar earned. So, however you want to think about it, but the idea is this. So if we accept that central bank standard view look through supply shocks the challenge is how do we know in real time what is inflation caused by a supply shock or a demand shock and we don't we might have a sense but it's really hard to know I mean go back to 2122 right there's the debate is this supply driven is it transitory or is this too much fiscal stimulus and you're trying to thread that needle it's it's difficult it's it's impossible unless you're a god you don't know what's driving it So acknowledge that we don't know much about the economy real time and just aim on stabilizing total spending or aggate demand. And what that does is aggate demand or nominal GDP. It's it's it's comprised of real GDP and inflation. So if there is a negative supply shock, real GDP would go down, inflation would go up. But long as you keep aggreate demand, the sum of those two on its target, say 4% in the US, then that's all you need to worry about. It's a nominal anchor. It keeps the dollar size of the economy on a path. And and what it does is it allows supply shocks to kind of fall wherever they may. And so all the central bank has to do is to keep the the the dollar size or the euro size or the pound size of the economy anchored, grow that, and allow supply shocks to to cause short-term price variation. So you get the long-term anchor, but you don't have to play God. Try to define is it supply or is this demand? you kind of step back and let the chips fall where they may. >> And why have central banks struggled so much with supply shocks, do you think? I mean if you look you know here in Europe we've got the ECB and obviously the >> the instance that is always pointed to is 2008 that you know tightened with oil prices uh had a run up at that point and then obviously they were easing later in the year with the global financial crisis and then as you say 202122 they were slower to respond. Is it this issue that it's just hard to to dis entangle supply and demand uh dynamics? Um is that it? >> I think that's that's part of it is just in real time it's hard to know. But the second part is central bankers it's in their blood to respond to inflation, right? They tend to be conservative. They want to you know they want to be aggressive. I mean I think the typical DNA of a central banker is hawkish. Even you get some who might be more doubbish who but on in general they want to be known as central as the person the central banker who kept inflation low. They don't want to be known as you know the the person who led to the a repeat of the 1970s inflation. So I think it's in their DNA and and as a result because they think in terms of inflation targeting again this is where I think nominal nominal GDP targeting kind of releases this constraint. I I think it's in their nature to say hey we got to heir on the side of being cautious. We don't want inflation expectations to be unmmerred. 2008 is a great example both in Europe and in the US inflation was going up but it was going up because of commodity prices which would be a textbook story of supply shock and yet we saw in the ECB they tied in and and in the US from like the summer of 2008 up until the fall they were actually talking up rate hikes which is is crazy right in retrospect why would you be talking up rate hikes as we're about to go over this cliff of the economy and I just think It's it's confusing. It's it's hard to know in real time and you want to do it. So, here's the thing. A central banker, you ask anyone at the ECB, Bank of England or or the Fed or any central bank, they'll tell you, "Oh, yeah, we got to look through supply shocks." But in practice, they tend to heir on the side of let's just let's just hammer down inflation. No matter what the causes, we don't know. And what I'm suggesting is nominal GDP targeting would allow them to automatically look through supply shocks without having tried to figure it out. But that's a long journey. That's a long story. And and no one yet has adopted this vision. >> So we've talked about what what you think they should do. I mean, what do you think is likely to be the response in this um scenario? >> Well, I think in the case of the Fed or or EC >> maybe the Fed. Yep. Yep. In the case of the Fed, I I do think it's probably wise right now just to kind of sit back and see where this is going. Um, the Fed does have some challenges. So, so let me list the challenges then I'll tell you why I still think they should sit through it at this point. Look, try to look through what I think are supply shocks. Um, the challenges are we went through the code inflation we just talked about. So, if you look at many measures of consumer measures of inflation expectations, they're elevated. If you look at measures of like the Gallup poll or other surveys of what's the top problem, >> inflation is still much higher than unemployment. There there are other problems, but inflation is persistently a problem. One of my favorites that I like to look at, those are surveys, right? So you can question surveys. Look at revealed preferences. If you go to Google Trends >> and you put in the term inflation, at least in the US, it spiked. It went way up and spiked during 2122. It's come down, but it didn't come down all the way. People are now searching for inflation at a higher structural level, higher than pre2020. And recently, it's picked up. And and so what all that means is I think consumers, households are much more price sensitive. You know the saying um one spitting twice shy. I mean, they're going to be much more c they're much more price sensitive. So before, you know, 2020, you could maybe have inflation go up and it wouldn't budge. But I think there's a much quicker um reaction now. So the Fed has to be mindful. They have to be weary that you know what we don't have as much grace as we we did before. The inflation credibility is it's there but not as much. So they have that as that's something they got to worry about. But I I do think if if depending on how long this war goes on, they could sit and look through it because there are counterveailings forces. So we mentioned you mentioned the uh the oil shock, the war shock that is pushing prices up. We also have AI which would be be a positive supply shock pushing it down. So I I do think it's probably wise just to wait and see. However, you know, some of the recent developments, it it could get worse. And if you if you persistently have negative supply shocks, the spate of negative supply shocks that persistently keep inflation elevated, then your inflation credibility gets eaten up. your credibility is shot and then the Fed would have to step in and and and bite the bullet and and tighten because there will be more long-term consequences if they don't. >> Yeah. I mean the whole area of inflation expectations is interesting and there was this Fed paper Fed staffer a few years ago I think it was RD um he wrote it kind of I guess questioning the whole academic interpretation of inflation expectations and how consumers build their expectations and I guess it you know when you go to university there's the the adaptive expectations hypothesis various mechanisms for how I mean do do you think are central bankers overly upset obsessed with inflation expectations or do they have the correct model for how inflation expectations are actually formed or what are your thoughts on that? >> I I do think it's a bit mysterious what is the the right way to do this for sure. So I think it's important to look at a like at a range of measures. So it's look at household surveys which again by themselves aren't going to tell you everything but also look at the bond. What is the bond market telling you? They got skin in the game. Now, those measures are, as you know, they're they're clouded by term premium, risk premiums that come off of uh you know, treasury securities or government bond securities. But look at all of that and I I would say I remember that paper. I mean, I think one thing at a minimum you can say is, you know, inflation expectations do tend to track actual inflation at some point. So, if inflation starts to go up, then inflation expectations will go up as well. So if if you prefer adaptive expectations, you can still tell a similar story. It's like you don't want to jump the gun, but you you know if it's supply shock, but you you do want to you don't want to see a persistent updrift of of actual inflation. And again, to me, this is one reason I like going back to that Google Trends because this is no one's telling people to go look up inflation on Google Trends. >> If people are thinking about it, they're searching it. And so that that to me gives a better sense of where people where their mind is. So I I think in an ideal world, we look at revealed preferences, some measure of revealed preferences. Here's another one that was really fascinating. I have not looked at this in some time, but it it shot up during um the pandemic inflation. So the US Treasury Department offers a saving bond. I believe it's called the savings eye bond, but it's basically this. It's a savings bond, but it it actually adjusts for inflation every six months. So, it's kind of like a tips, but it's it's a savings bond that adjusts for inflation. And if you look at the time series, there's, you know, very stable low uptick, man. Comes 20 late 2122 that thing it shoots up and it's it's revealed preferences. People are beginning to really worry about inflation and they start buying these inflation hedge savings securities. So things like that I think would probably be you know your safest bet. Unfortunately we don't have a lot of them. >> So we were yeah central bankers rely on imperfect measures. So um and again for me that's why I fall back on something like nominal GDP. Now because nominal GDP is it's the is the currency size of the economy. You keep that anchored. You don't have to have the precise measure of inflation expectations. You don't have to have the precise precise measure of of inflation. The the flip side is GDP is not measured precisely. There's data revisions. And so my answer to that would be is it's better to look at forecast to nominal GDP, get consensus forecasts. Um and should a central bank ever go into a nominal GDP targeting regime, I suspect there would be new data collecting methods. The data would become indogenous to what we were targeting. But that's why I think it's important to look at a broad measure of of nominal activity as opposed to a narrow measure. So yes, all of this is as much an art as it is a science. >> You touched on AI a little bit and as I said, you know, the markets, if you went back to February, were were kind of uh transfixed, I think, with AI. There's a Catrini report that came out. I think it was the last week in February. And at that stage, you know, bond yields were falling and, you know, people were talking about this uh parallel with the 1990s and Greenspan and maybe the Fed could cut rates to accommodate a productivity boom. Um, so a few things to get into on this like one is obviously we've got this adverse supply shock meeting a positive supply shock. does that, you know, presumably that makes it, as you've kind of alluded to, extremely tricky for for central banks. Um, if if the kind of adverse supply shock goes away, if the if the war in Iran settles down and we're back to the kind of the base scenario, I mean, on on the positive supply shock, how be deep and meaningful do you think that that's going to be over time? Well, if it lives up to the expectations of some of his biggest fans, it sounds pretty dramatic. I mean, I think the evidence is very weak right now. We don't see really strong robust productivity numbers, a lot of enthusiasm. I mean, there's there's a lot of investment spending. Sure. >> Um, but >> I don't think we've seen evidence that it's truly like profound. And maybe it takes time like all major technological innovations take time to disseminate widely. But if you're asking what happens if it does really up GDP, if we really see fundamental changes, well then in that case, I would argue that that's going to push up real interest rates. That's actually going to raise. It's not going to it's not going to give you room to cut rates. It's going to be the other way. I mean, you you can tell simple stories. If if this productivity boom from AI really takes off, we're all much more productive, then the return to capital is going to go up and that's going to push up, you know, other rates across the economy. Or alternatively, if you tell a more macroeconomic story, people they they they have less incentive, you know, to save, you know, you can tell several stories, but if productivity goes up, the bottom line is that we would expect real rates to go up and the Fed have less room to cut. Now that might again this would probably over the medium run this wouldn't be immediate. You wouldn't see anything like that in the short term. >> Well that's the standard um economic textbook approach I guess and um I mean people you know I did talk about the Greenspan area. I mean other economists point to that era and say you know in 96 you know uh Greenspan held off on raising rates but then obviously by 1990,000 because of the productivity um and an investment boom it was raising interest rates which is in line with what you're saying. Um, but I I heard you speaking to some other economists before and and drawn the parallels um back with the 1800s in the late 1800s and and I suppose that was the the guilded age and it was the the industrial revolution and it was a productivity boosting era positive supply shock >> and prices went went down and obviously um that was a I suppose that's that's called a favorable disinflation or positive deflation which is not something we've had too much of Now if we get that kind of given that we have you know inflation targeting would would central banks whole models have to be re reworked you know their whole policy frameworks uh if they were if they weren't going to respond to that? Great question. And and this is definitely an area of interest to me because yes, I I do think one way to share the benefits widely of rapid real economic gains like from AI is through a gently mildly falling price level. So that Centrini uh paper you mentioned that made a big splash. I mean this that's amazing. This paper was is kind of a thought piece a white paper and it rattled markets, right? I mean anybody would love to have that kind of success with their writing, right? Um but that that paper I think missed some important things and and you know to the extent again we have such rapid gains one way that everyone can share in it is through lower prices gently falling and the problem is most central bankers most macroeconomists I say when they think of deflation they think of the great depression which is which is fair it's recent in terms of it's it's it's vivid um but that's a collapse in aggate demand but what we're talking about would be an increase in aggate supply. So if you could here's the thing if you could stabilize like in my approach stabilize total nominal income growth or aggreate demand you so so imagine we could stabilize you know the in in the case of the US the dollar wage growth at at a right now it's around 4%. we keep that and then you have such rapid gains prices fall real wages are effectively going up >> and and so I I think I think you could more easily implement something like what you've just suggested with a nominal GDP target because you could say hey we're keeping the nominal size stable and growing. Um, but with inflation targeting, yeah, I I do think you could actually have some problems because inflation targeting, it wires our brains to think that 2% inflation is always in everywhere an optimal inflation rate. There there's lots of research that shows, you know, in certain environments, a mildly negative inflation rate is optimal. >> Now, people there there's reasons people don't like it. They think, you know, wages are sticky on the downward side. Um I again I I think you could have downwardly wage uh nominal wage stickiness but still have real wage growth. There's some evidence from this postbell and this this period of the late 1800s that way nominal wages weren't sticky downward. I mean downward wage stickiness might be just a phenomenon of the world we're in where we typically have higher rising inflation. Maybe it would change. I don't know. But I want us to be dynamic and open to the possibilities. Um, but I so let me give you a scenario where things could go wrong. And there was actually a great paper and I I have to think of the author's name. Um, Larry Cristiano from Northwestern and some co-authors and this was at a Jackson Hole conference I think 2010 somewhere around there. But they did a paper where they took a typical Taylor rule that is inflation targeting and they show if there is going to be higher productivity growth, particularly higher expected productivity growth. They make this point that that would imply higher real rates with the low inflation, this tailor rules would actually lower rates. And and what they said is you you could actually create some imbalances. you could actually have asset prices go really really high and you could you could have some destabilizing asset booms. So it, you know, it's not just a a question of do we prefer 2% inflation versus a 1% mild deflation. It's a question of maintaining stability in the macro economy. So I do think um we need a a a monetary policy framework that's robust to any situation. And again, I I hate to sound like a, you know, I'm on my soap box here, but nominal GDB targeting does that. Now, maybe central bankers could adjust their inflation target, but I I do worry if you if you're doctor, it has to be 2% everywhere and always, you're going to have you're going to facilitate asset price booms if you have rapid productivity growth. >> Yes. I mean, that is the obvious implication and and this is obviously very relevant now because we've got a new Fed chair coming in and Kevin Walsh >> Yeah. has said lots of different things, but one thing he has very explicitly said is he seems to be a believer in in AI and he's I saw him on CNBC last summer saying it AI makes things cheaper and we're on the verge of a big boom and policy has to facilitate it or words to that effect which sounded to me like um lower rates and a potential asset boom. Um what's your take on what Kevin Walsh is likely to bring to the Fed? Well, I I think he probably wouldn't say that now given the you know, I think since circumstances have changed and you know that that was said I believe you know back when AI was hot and taking off and and yeah I I would I would push back on that argument as I did earlier. I think if anything it would be higher rates. I mean you you could to be charitable here you could say at a minimum if if if we have productivity growth real rates go up inflation comes down maybe you keep nominal rates where they are. you could tell that story but I I think where he will make a big difference so you know I I don't think the rate conversation is as salient as it was you know when this this came out but today I think his his big um contribution and we already seen evidence of it is in rethinking the Federal Reserve's operating system and its balance sheet >> I think that's where he's going to make a big contribution he already is there's Fed officials who are changing their tone speaking a little bit differently about this issue. Um he still has to come in know and and it's a committee and convince members that hey we need to do something different. So that that is the one you know thing I think you and your listeners know is that the Federal Reserve and the FOMC is a committee. It's not one person. I think the president of the United States has this impression you pick a chair and boom he does your bidding. >> And I suspect you know Kevin Walsh would not do the bidding as much as President Trump would like. But moreover it's a committee. he can't just, you know, get everyone to to vote the way he wants to. There's going to be conversations. So, I do think there's some builtin protection against some of the political pressures. >> Yeah. I mean, the way he described it in that interview last summer as well. I mean, he's I don't know if he's thinking has moved on, but it was again broad sense, it was the balance sheet is too big. It's influencing financial markets. we should reduce the the balance sheet which is a form of tightening and that would facilitate lower rates and it it kind of has a nice story because that's going to help Main Street and not Wall Street. It's kind of how it's couched but I mean is that I mean a lot of economists say it sounds great but that's not how it works in reality. What what would you say to that? >> Yeah, I don't think it would have much of an effect on interest rates. It might have effect on financial conditions during the transition period. Yeah. >> But I I think what it it would do is it would definitely reduce the Fed's uh footprint and financial system. I mean right now the Fed is one probably the biggest >> you know um counterparty in repo transactions, treasury markets. >> The Fed is the largest single holder of Fed uh US treasuries. Um it would also I mean I' I've made this point repeatedly if you could shrink the Fed's balance sheet. sufficiently. Now, I'm not saying you go back to the size it was in 2008, but if you reduce it sufficiently, you could also bring back interbank uh overnight lending in the US, which I think is an important missing market right now. There's price discovery. There's you want banks to go to each other before they go to the central bank. You want the central bank to be available, but you want banks to actually discipline each other and such. And so, I do think he he had some of that flavor. Now, you're right. he was talking more about rates, but I I I do think he would say more generally that the the Fed's the Fed's presence in financial markets is too large. And those are just three examples. Repo, uh, treasuries, and then also if you shrink the Fed's balance sheet, you pull out reserves, banks aren't just sitting a bunch of liquidity. They have to go find it or go to the Fed itself. >> Maybe take a step back. I mean, as you say, it wasn't always like this. So, maybe before the financial crisis, the Fed's balance sheet was much lower. So, just get curious to get your thoughts on on kind of QE in general. I mean, QE came in in as a policy response to the financial crisis and then became kind of a normal part of the Fed's operating policy tools. Then obviously, you know, they they rolled it out again heavily in in um co and I mean I'm sure I've read some of the Fed people I think it might have been been Waller kind of suggesting that you know when they do QE that has a positive impact. It's stimulatory but when you do QT doesn't really have an impact kind of goes along in the background. You can kind of take it back. It's kind of like some analogy like it's like uh the fire brigade come to the house or something like that. But anyway, it see it seemed a bit, you know, um best of both worlds kind of thing. And and and I mean the other thing is QT QE is still a bit of an experiment. We're still not sure of the long-term implications. Obviously, uh you know, they're still struggling to unwind it in terms of the size of the balance sheet. >> I mean, of all the people you speak to, your own thoughts, I mean, what's the what's the verdict on on QE now? Is it is it is it so questionable or is it here as part a core policy tool now? >> I think it's definitely a part of the regular toolkit now and and I would personally want to use it should the occasion arise should there be a necessity in the future. I think it's an important toolkit when you hit the zero lower bound. >> Yeah. >> Um so I think you want to keep it but what you want to have is an operating system that's robust to it. One that can completely unwind it that and that's what we don't have right now. So yeah, let's keep QE as a tool. Let's use it only when necessary. When we do use it, we reverse it. Does QE matter? I think it I think it it definitely has an effect on long-term yields. It has has some ability to to lower things. It's not huge, but it's something. I mean, I had a recent guest on who, you know, and I think this is pretty a consensus view, like the QE1 through QE3 lowered 10-year Treasury yield by about one percentage point, 100 basis points or right around maybe a little bit more, but somewhere around there. Um and part of it is is just the im you know the immediate kind of you you step into the market you buy things up kind of a mechanical story that and and that would also be tied to the portfolio balance channel but in general just stepping in but part this one recent guest mentioned that it's it's it's the expectations it creates it's it's financial markets come to expect this and so he estimated you know about twothirds of that 1%age decline was due to kind of this expectation this kind of insurance this built-in insurance and he argued that if you do QT you are actually re it's not just a benign experience you are actually reversing that that built-in insurance so >> but I do think it is important to completely undo it because there are effects that build up and we can talk about those if you want I I do think there's a ratcheting effect that's balance sheet and it has long-term um effects that aren't optimal for the US economy Yeah, I mean this ratchet effect is something you've you've written about. I know you've spoken to Rajur and Rajan about it as well. I mean it's it's slightly technical. I mean how would you describe the the the ratchet effect and and should investors be worried about it? Well, the ratchet effect and it's a bit tricky because if you look at the total asset size of of the Fed or even this liability side, it it did it was at close to 9 trillion came down to about six and a half or 6.7, you know, it so it did shrink, right? So, hey David, give the Fed some credit, you know, but the issue is look at reserves. All right, so look at bank reserves or settlement balances as they're called in other places. It did come down some, but the key the key thing to note is reser bank reserves or settlement balances are now higher than they were before you know the pandemic covid pandemic started and we did QE QE4 and after every QE it's it's got higher so as much as we try we are not able to reverse the Fed's footprint in the banking system and therefore the financial system. So if you can't undo reserves you're not going to be able to completely undo your your asset side. this treasuries is holding as well. So why does this happen and why does it matter Dave? What's the big deal? So what? Well, the big deal is is this. The reason that this ratchet effect occurs is because when banks are flooded with with all this liquidity from the Fed, and to be clear, it's a two it's a two-way transaction. They're not forced, but you know, banks will eventually their balance sheets will hold a lot more um reserves. And from a bank's perspective, that's deposit at the Fed. It's highly liquid. It's overnight. It pays now. It pays decently, but it's a highly liquid asset. That affects them behaviorally on their funding side, on their liability side. When banks think about how are they going to fund their operations, they can do a longerterm funding, term deposits, CDs, or they can do short-term runnable deposits. And those, of course, are the riskiest, right? If you if you fund with short-term runnable deposits, there's a chance that the depositors will quickly get up and leave. And what QE does is it think of this the banks they get flooded with all these assets that are highly liquid. They're very safe. It makes them complacent or comfortable. Well, we can just fund with more runnable, you know, uh sources of of liquidity ourselves. And so it actually changes the funding structure of banks in the US and then they become because they change their funding structure, they become dependent upon those reserves the Fed injected. If the Fed tries to reduce those reserves, it causes problems for banks. We get short-term rates shooting up. And that's that's why QT can never undo itself is because it affects banks. So if you look at reserves, you might think, man, all this liquidity in the financial system must it must be great. Well, a lot of that liquidity is think of it is relent out through the banking system or tapped. And so net aggregate liquidity might actually be less than what appears on the surface. And this creates fragility. So, so the Fed can't shrink its balance sheet. It has to get bigger and then it grows bigger. Now, of course, this is not just QE. It it interacts with uh regulations that were introduced after 2008, particularly the liquidity coverage ratio, which says you have to hold 30 days of of of liquid assets if you had a run. And so, between the two of those, banks are just they're sitting on and they're hoarding lots of liquidity. And this affects everything from again we mentioned earlier that banks don't lend to each other as much. They also don't do as much lending to the real economy. They're sitting on reserves versus investing in the real economy. So there are real costs to this. Liquidity is less than meet. There's less real lending through banking. Now there there's lending through other channels in the aggregate. I'm not saying credit has gone down. Um in fact maybe we'll talk about later but there's private credit has stepped in and filled some of this gap but through the banking system there's a real cost. And I I I think you know it would be better to to >> try to move away from that. >> Okay. So I mean there's a lot of I mean for I guess for lay people or even market participants who are not experts in the plumbing of of the the banking system there's a lot to digest there but I think I think as you said the point is interesting because QE has had this effect that banks now have a lot of reserves um on their balance sheet and and that they're safe assets and that encourages them to be a bit riskier with their their funding structure. Um, which is kind of ironic because, you know, it was a kind of a bank run or the the global financial crisis in the first place was a bank run. The interbanking lending dried up, but now we've created that risk again. It sounds like um I mean a few things there, but but one thing I'm kind of curious about, people will often talk about liquidity and saying, "Oh, we've still markets are still a wash with liquidity." um is how you know obviously terms like money liquidity financial conditions they are often sound similar >> but I mean would you say liquidity conditions are still ample in global markets now or is there too much liquidity in the system or how do you think about that >> I would say it's probably close to neutral I mean again it looks like there's on the surface it looks like there's plenty of liquidity lots of reserves lots of liquid assets that's out there. >> Yeah. >> But those liquid assets are effectively like accounted for, tapped into. So, um, banks are sitting on them. They aren't they aren't really functional. Maybe that's the way they're they're sitting on bank balance sheets. And I I don't think it's it's as much liquidity as as one would would think. And in fact, this is why the the Federal Reserve itself is now doing um what they call temporary management purchases. The Fed is now actually adding more. It's buying more treasuries. It's injecting more reserves bills. >> Yeah. Yeah. Buying more T bills and it's injecting more reserves because they are worried that liquidity isn't as ample or or flush as otherwise would be. And so we saw this I think late last year overnight overnight market rates they they went above the Fed's range. So one way so there's different ways to ask that question or to answer that question. One way is to say our interest rates, overnight interest rates within the um the corridor the Fed has set, you know, has has an upper bound or a lower bound. And what we saw late last year is we're doing QT is short-term rates begin to go above that. So repo rates and for the from the Fed's perspective, this is probably a fair one, that means liquidity conditions are tightening. And so it had to stop QT and even this year it did some um in you know, it added a little bit more liquidity into the system to offset that. So, I would say maybe we're a little bit on on the positive side, but we're not that far from neutral and even though there's lots of safe assets, lots of like apparently it looks like things are flush, but it's all a counterpart, it's all being used up. Governor uh Michelle Bowman, the vice chair of the Federal Reserve for supervision. She talks about how the liquidity coverage ratio. We talked I mentioned earlier, it's supposed to be something that gives banks like a an an a chest of treasure they can use should there be a panic or a run. But what effectively it does is it it tells banks you got to hold this much whether good times or bad times. And it ends up being a minimum buffer. They they don't even want to tap into it. and and then having that all that cash on their balance sheet, it's assigned to supervisors to other people and they don't want to shrink it. So, it's supposed to be something you tap into, but they won't even tap into it. And so, there there's talks of reforms we can talk about, but it's this kind of perverse outcome where as we add more liquidity, it it gets baked into the system. So, I again, this is maybe from the US perspective. I'm not as informed about maybe in Europe and from the Fed's perspective I I I think they're probably right that we're just a little bit past you know what would be you know neutral. >> Yeah. I mean the question is does is this whole technical detail or does it matter? I mean if it is the kind of thing that you will hear people in the market saying oh you know the markets have got addicted to Fed liquidity that the Fed's footprint has got too big. they can't get out every time they try and come back uh from from from asset purchases. You know, they have to they have to unwind it and and that basically that we've moved into this system, this ample reserve system where yeah, the markets are are are addicted to to the Fed's liquidity hasn't caused a problem yet, but but potentially could do. Is that overly dramatic or is there any substance to that kind of argument? >> I mean, there there's an element of truth to it. But I don't want to overstate it. Again, the element of truth is after liquid the Fed injects liquidity for, you know, during crisis times and and I would argue even in the most recent period QE4, they they they continue to inject reserves probably well past what I think any reasonable outside observer would say, right? So I think it's again QE is important tool when you need it, but they they could have stopped much sooner than they did. that liquidity it goes into the system and again banks begin to fund with with riskier assets. So now they they they need the reserves themselves to be you know to hedge themselves to protect themselves. Then we have the liquidity coverage ratio which they interpret as a minimum buffer not something you tap into and and those things they again they they they compound and then the third thing would be supervisors. supervisors say, "Oh, you have this much reserves. You need to keep that much." And and so then it if they want to grow like they if they want to get more vulnerable deposits, they need to get more reserves otherwise interest rates go up. So it does create this ratchet effect which again if the Fed wants to control rates and this supply driven ample it's reserve system, it is it's the Fed didn't mean this to happen and and it's not as if there's some nefarious motive here. It's just the way this is set up, it tends to grow on itself and that's why we need some serious reform on the Fed's operating system and its balance sheet. So it's so your question is it a big deal for the from the Fed's perspective if they want interest rate control it is a big deal. Is is it a big deal overall? I mean my own philosophy I I think it is because it means a bigger footprint for the Fed. You don't have to agree with that. You know people might say that's fine. You know what what's the big deal? maybe more interventions optimal, but I philosophically I think it's a big deal and I think practically it's a big deal for the Fed and its operations. >> Okay. Um want to just talk about bonds in a bond market and debt sustainability and you know there's been a lot of concern about this for a while. Um but you know by and large bond markets are still stable. Obviously yields have risen with inflation expectations in the most recent uh period. But you know not withstanding the fact that um you know the fiscal deficits are at extremely high levels which would typically be associated with with a recession and that they've become the norm. Bond markets have been stable to date but there is a lot of talk about that we will ultimately get to the point of fiscal dominance and that will eventually impact the uh the conduct of monetary policy. um what's your thoughts on that? >> Yeah, I think fiscal dominance or fiscal unsustainability is probably the biggest challenge over the medium to long run for central banks. Um I I I do think it's something that we don't take seriously enough. I also understand that the incentives aren't there to be addressed in a meaningful way at least in the US and Congress has no incentive to touch. The biggest most important part of that is entitlement. So there's no no one wants to do entitlement reform. Um there's only so much you can do if you you could tax you could increase taxes, but that's only going to get you so far. There's only so much you can do cutting discretionary spending like defense. At the end of the day, the biggest part of of this unsustainable path the CBO is projecting is entitlement. So there there needs to be some kind of entitlement reform, but no one wants to touch that. So, what that means is we're going to continue to see fiscal large fiscal um primary deficits for a long time. And I do think that's going to at some point force the Fed's hand. And by that I mean the Fed's going to have to, you know, step in to keep Treasury markets stable. It's going to have to buy more debt. It's going to have to maybe at some point do yield curve control. We're not there yet. Now, some would argue we are there. I mean, some would say we we are there. I I was a little more worked up earlier this year about this. If you go back my substack, I was I was concerned because of some of the rhetoric from the president. You know, the president was saying, "Hey, you need to cut rates." And his initial reason was not to stimulate the economy, but to keep the price of our financing costs down, you know, which is pretty stark example. So, I I think there are symptoms of of this problem. I mean, >> I love stable coins and I I think they're great innovation. They have some challenges, but one of the motivations was it'd be a way to buy up extra debt, right? the president's rhetoric about cutting interest rates. Um the these to me are are signs that there's problems. Also, there was um talk about ending the Fed's ability to pay Anderson reserves to banks. >> Um that also, oh, we'll add a trillion dollars over 10 years. I think that's wrong. It wouldn't. But all of this rhetoric is is to me echoes that people are getting concerned about the looming fiscal uh challenge we have. Now, skeptics say people have been worried about this for a long time, but but actually the problem is much bigger. I mean I mean people remember James Carville's comment about the bond market and I think the debt to GDP ratio was about 40% back then. So you'd wonder what were they worried about? Now it's you know over 100. Um I suppose what we've heard now is maybe you know we'll have some kind of greater coordination between the Fed and the Treasury and Wars is obviously uh you obviously knows Scott Bessant uh via the the hedge fund world. Is that um is that a concern if we had some kind of Fed Treasury accord or would that be sensible or and what might it look like? I'm not positive what it would look like, but I I think one thing a Fed Treasury Accord could look like would be better coordination on who manages the debt. So, because the Fed is the largest single holder of debt, um you know, it has an influence on what happens to the maturity structure that the rest of the the world holds. So you can think of the Fed is effectively having a putting its thumb on the scale of what the maturity and and and the cost structure of the US debt is inadvertently. It's not trying to do that, but because it holds so much debt and it's, you know, again, we mentioned it. It it shrank from about 9 trillion down to about 6.7 and now it's going to continue to grow. Um that means the Fed's going to be holding a large share of treasuries. As those things roll over, they have to buy new ones. as a result, the Fed's going to be having effectively a say in the structure of our debt. I think that's not ideal. I don't think that's the Fed's job. So, one way this accord could work, and this is something I've recommended, but others have recommended as well, is to do some kind of uh Treasury Fed asset swap. So, have the TR here's one example. The Treasury could issue a bunch of new Treasury bills, swap them for the Fed's Treasury bonds. So now the Fed has only Treasury bills on its balance sheet and the bonds go to the Treasury. You do this asset swap, there's no net effect on aggregate debt, so there's no debt sealing issues, >> but it it puts the Fed back where it should be. It just holds Treasury bills. Those things can run off faster. They're more liquid, and you allow the the term structure to be completely determined by the Treasury. That to me is one concrete way I think things could go. And I think there'd probably be a constructive way and it might be something he's imagining. But if you're are you suggesting maybe a more worrisome where >> Yeah. I mean obviously more worrisome obviously direct financing etc. which is kind of ironic because Wars has also been critical obviously of the expansion of the balance sheet and he's kind of said they've been complicit in in the the deficit expansions but yes I don't know what it would mean but I'm just curious with the with the asset swap that you're talking about would that have a market impact in terms of um Treasury markets it would have some but I think it would be a much milder effect than if if if we try to like just roll off Treasury bonds from the Fed's balance sheet So yeah, let let me step back. Part of my proposal is Washington wants to shrink the Fed's balance sheet dramatically. >> One way to do that would be to sell off Treasury bonds. That would be hugely, you know, trouble. It would it would shake markets up. It would bring back to mind the the uh the event in 2013 when we we had similar conversations. So what I'm suggesting, and this is something that's actually been done in an emerging market. So I got this idea from a guy named Peter Stella. He used to work at the IMF and he traveled to emerging markets and this is what they did in order to deal with the situation. If you can get the Treasury bonds off the Fed's balance sheet and back to the Treasury, these aren't treasury bonds that are in the market. >> They're on the Fed's balance. So, you're not changing the supply that the rest of the world has. You're just changing the structure the Fed has and the Treasury has. >> And you're now you are injecting Treasury bills to the Fed. The Fed could roll those off. They could sell those. So you could affect, you know, the short-term rates could be affected by that. But treasury bills are much more liquid. It it could handle that shock more than if you rolled off the bond. So it's it's a way to minimize disruption. >> It just smells a bit suspicious in that the the the Fed has bought these long-term bonds to kind of keep interest rates down and now it's going to give them back to the very people who issued the bonds in the first place. Is, you know, it feels like somebody's benefited there a little bit. Um, has somebody lost out? >> Well, I I'll say this. It's so right now those, as we know, those long-term bonds are why the Fed has experienced operating losses, right? So, those long-term bonds pay 1% and and then um, you know, we're paying like four four to 5% on the reserves to banks. So, what So, the Fed has all this interest rate risk right now. It's pay we're losing money. Now I guess right now to be clear it's it's it's it may have stopped losing money but the point is it's been losing money because of this this issue that interest rate risk is being borne ultimately by the taxpayer right we're giving the Fed is not sending money or remittances or profits back to the tax to the Treasury which then you know keeps it helps shrink the deficit which then is not is better for the taxpayer but it's it's very obscure it's very like they have this strange accounting trick they do deferred assets so It's kind of like we don't really think about it because we don't see it. What this would do is it would say look the government and then therefore the taxpayers we are taking a hit right now because of this interest rate risk. Let's transfer this interest rate risk back to the Treasury. So it's explicit. The Treasury is not going to bear it and as is the taxpayer. Let's don't hide it on the Fed's balance sheet. So I I I don't think it's going to affect again the rest of the treasuries out in the market longterm because again the Fed hold I forget how many long-term bonds it holds right now but those have already but they they didn't pull out of the market already. So I don't think we're going to affect the structure of the remaining debt at least in the near term. Now if if the if the Treasury refinances and does more bonds that's a different story. Um, but you're not disrupting the the amount of bonds in the market, but you are transferring interest rate risk from one part of the government, the Fed, to another. And I think it's the more transparent way to do it. >> Okay. Interesting. I mean what what we've seen in markets last year was you know concerns about you know US policy credibility >> posted tariffs and that you know at various times the dollar selling off US equities >> and bonds selling off and and concerns around um you know the reserve status of of the dollar over the longer term. Now you touched on stable coins as well. You know, stable coins have then appeared as this other mechanism which might boost the uh dollar's uh international standing as people would buy stable coins which would be backed by um by by dollar assets. So I mean do you think um which of those effects might dominate over time do you think? >> Well I was very enthusiastic about dollar stable coins. I still am but less so my my enthusiasm has been dialed down a little bit. So I I was like, look, it this was a great way to um extend the runway for the the finan for the fiscal problems in the US. It gives us a little more breathing room. It doesn't solve our fiscal problems and and maybe you could argue it it allows us to kick the can down the road instead of addressing immediately. We we have more time. I mean, look, you you mentioned already, you know, the uh Treasury markets don't seem very worried about our fiscal problems, right? Let's check this morning at the time of this recording the 10-year Treasury's at 4.3%. Which blows my mind given that the the outlook and stable coins would continue to support that. That was that was my early one of my early perspectives as well as yeah it will spread the footprint of the dollar. Now I guess I'm I'm less certain of how big this effect will be both the reach of the dollar and its effect on the on on treasuries for this reason. Right now, you know, we we have a little over 30 trillion in marketable US debt. Let's go out 10 years. All right, let's go out 10 years. Let's grow the economy four or 5%. We're getting close to 50 trillion in in in in debt, I believe, if I did my calculations right. If then if you look at the amount of projected growth in stable coins and the most aggressive forecast over the next decade is about 4 trillion. Now maybe it'll be more than that but 4 trillion out of this big number you know close to 50 trillion that's it's not it's it's it's something but it's not like going to make a huge dent in the growth of of debt that we face. So it's it it yes on the margin it helps it's not going to solve our problems. Moreover, that four trillion number really should minimum divide that in half because some of the treasury bills that are that support stable coins, they may have been supporting bank accounts. There might be some substitution. M >> so really what you want to know is what is the net new demand for treasury bills that stable coins will create and as opposed to if if a stable coin you know people start using it and previously they had regular bank accounts so now simply that you know the the treasury bills go from the behind a bank to a stable coin so it's it's you know once you start doing those calculations you're like well maybe this isn't that big of a a deal it's something it's it's a nice innovation I think it's Great. It's great for people overseas who have maybe unstable currencies. Um, and there there's there they use physical currency. I do think there'll be some real net gains there because it's easier and some of it will displace currency. Some of it will be net new. But I I guess I I'm hopeful for it. There are real challenges though in its implementation with you know financial stability concerns this uh logistical concerns. But we get past all those hurdles. The question is it's an empirical one. How much does it really matter? And I'm not sure at this point. >> And who do you think will be the big issuers of stable coins? And what will that look like? Will will banks have their own stable coins? Will big corporates issue their own stable coins? Will some traded pars some trade at a discount? Is that what the world would look like? Expect that in the US we're not going to see a whole lot of stable coins like retail use. It's going to be tokenized deposits. I think tokenized deposits will be what >> if anything will be the substitute. I think we'll see stable coin issues being done overseas. I mean I I do think there will be companies. I mean tether is the largest stable coin issue. It's it's outside the US circle in the US. We now have stable coins that are you know a part of the US regulatory umbrella because of the Genius Act. I I I don't think you know maybe some banks have them you know many Visa has stable coins many many payment providers are now doing stable coins I suspect there's going to be you know there's going to be network effects first mover advantages tether and tether go a lot of emerging markets one of the challenges stable coins we I just mentioned logistics is interoperability I mean you want to have a a digital dollar that I can go from me if you're on circle I'm on tether we need technology ology allows us to easily you know transfer across us and then also from crypto world into regular off on-ramp. So there there are challenges but I I suspect it'll be more emerging world activity than say advanced economies. >> Okay. Um I mean one thing um that we have heard a lot of it in the past but maybe less so in the the recent times is the whole shadow financial system you know the the operations of of hedge funds etc. Now obviously private credit if you if you include private credit in that then then that has been to the four. Um I mean has has the growth of c private credit made the system more or less risky? I I guess the the the the consensus view is maybe you know if when banks had problems and they suffered losses on their balance sheet then that that had a big economic impact if they retrenched on lending but you mightn't see the same effects from in the private credit world or is that reasonable or are there other um dynamics that we need to think about with private credit? >> Well, I think we shouldn't be surprised that there is this thing called private credit or shadow you know credit creation because we we shut down the banks from doing it. So, it's going to go somewhere and so private credit's doing it. I'm not worried about it yet. I mean, there's been several reports that come out that say it's growing. Maybe there's some risk, but it's not sizable enough. We don't know enough. And to be fair, we really don't know enough. There could be interconnections that might raise some concerns. Um, but at this point, I am not overly worried about it. And I suspect even if it did become an issue, the Federal Reserve would be there. So, you know, I suspect if especially if these are dollar, you know, dollar credit creation, I think the Fed would the Fed doesn't want to step in, but I think it probably would. But at this point, I I just don't see the evidence that it's overwhelmingly a problem. I mean, there's there's it's it's something we need to pay attention to, but it it's something I'm not losing sleep over at this point. >> Okay. Yeah. Yeah. I think ironically a lot of the private credit funds have credit facilities with the banks. Uh you know, so it's kind of like >> Yeah, exactly. >> Explain that. Yeah. >> Yeah. >> Um okay. Um yeah, just just uh conscious of time and we always like to get some perspective before we wrap up, you know, for you know, reflecting on your own career. Obviously, you've been had the podcast as a source of learning, but for people who are earlier in their career or want to learn more about macroeconomics, what what would you recommend? Any particular books that have been particularly influential for you or any other sources of of learning that that that you would highlight? >> Well, I would recommend um books by George Selen. He he was one of my professors in in in grad school and he's still in he's actually engaged online. He's semi-retired now. He was he was also at the think tank, but he's written a lot about the stuff we talked about. So, he has a book I would highly recommend. It's called less than zero, the case for a falling price level in a growing economy. And it's a great discussion of what we we touched on like should AI explode and it's a nice accessible a very accessible treatment of this and and there's been more serious work along these so I'd recommend that he also has great histories of of the of the US uh financial system the arrival of the Fed he's talked about the gold standard he he's expert on a number of areas if you want someone who's covered a lot of ground I would re I start with him I I would also recommend you know going back to the point I mentioned earlier It's I think it's important as a young scholar or market person just to build networks, you know, and that's why I think it's as as awful as online social media can be at times, I do think it's important to be online, to get on X, to get whatever platform you're on to to develop networks, friends, people who aren't in your immediate office. So go to conferences, get out, you know, get in the real world and and make connections. I think that's probably important. you learn from people who have insights that you don't have. >> Very good. Well, appreciate that and thanks very much for for coming on and and taking us through all of those issues. Felt like we went through a lot of stuff very quickly and uh trying to get as much out. But, uh, for people who want to, I guess, delve into it macro in much more detail, your own podcast is is a great source to macro musings. Um, so if people want to follow your work, that's probably the the best uh the best opportunity. Uh, but from all of us here at Top Traders Unplugged, um, thanks for tuning in. We'll be back again soon with more content. Thanks for listening to Top Traders Unplugged. 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