Critical Dialogues
Setting Monetary Policy
Image by Matthew Gilson
Professor of economics Randall Kroszner tells dean Edward Snyder about his work on the Federal Reserve Board of Governors , capital regulation, and the conquest of inflation.
Snyder: How long have you been on the job?
Kroszner: For 10 months and 75 basis points.
Snyder: Can we project those forward?
Kroszner: No, I make no comment about what will happen going forward. We had our Federal Open Market Committee (FOMC) meeting yesterday, so you can read our statement. And our minutes will be out soon.
Snyder: This isn’t your first stint in public policy in Washington.
Kroszner: From 2001 to 2003, I was a member of the president’s Council of Economic Advisers. It was quite a time. I arrived the summer of 2001. Then we had 9/11, and the corporate governance scandals, and the worst stock market performance since the Great Depression.
Snyder: Then they invited you back?
Kroszner: Fortunately, past performance doesn’t predict future performance. In fact, I was on the council as a graduate student in 1987–88, and remember what happened in October 1987? Fortunately, I think it has nothing directly to do with me.
Snyder: Give us a primer on what the Fed does, and what you do on the board of governors.
Kroszner: The Fed is an unusual organization in government because it has regional representation plus the full board in Washington. The voting roster of the FOMC, which is the interest rate–setting body, consists of the seven members of the board in Washington—appointed by the president and confirmed by the U.S. Senate—and then on a rotating basis, five of the other 12 regional Federal Reserve Bank presidents. There’s a board made up of local people—bankers and business leaders as well as some nonprofit and union officials—who play a key role in selecting the local reserve bank president, although we have to approve that person in Washington. The head of the New York Fed is always a voting member and also becomes the vice chairman of the FOMC.
When we meet, the 19 of us discuss the state of the economy —regional and national issues plus the international context. Although only a subset of the regional bank presidents actually vote, everyone is treated equally. You wouldn’t know who’s voting until the roll call.
One of our key responsibilities is monetary policy, and that’s done through the FOMC. We meet roughly every six weeks. We can decide to make changes to our market interest rates between meetings, but that’s relatively rare.
In preparation for that, it becomes clear how important good research is to a good discussion. We have a superb staff, many of whom are Chicago-trained, including a former student of mine who was hired before I arrived. We need them telling us, “Here’s what we don’t know, and here’s what you need to think about. Here are the factors that are important.” They’re great at knowing what’s useful based on systematic correlations or systematic modeling, and what you need to use judgment on, and putting all that out for an honest and open discussion, not trying to hide behind something or push a particular view.
Snyder: The thing that gets so much attention is the FOMC, and you refer to it as the body that changes interest rates.
Kroszner: Yes, that’s really where monetary policy is made.
Snyder: That’s what people who study banking and economics think is really important, along with reserve requirements. But am I right that the FOMC doesn’t look at reserve requirements—that’s a factor that’s held pretty constant over time?
Kroszner: It hasn’t been used recently, and the board has formal control over the reserve requirements rather than the FOMC. Another instrument—the discount rate—is used for making loans to banks. Rather than going into the markets and borrowing from another bank or another financial institution, they can borrow from the Fed directly. The regional Federal Reserve bank boards make recommendations to us about whether that should be changed. That’s something the board itself, rather than the FOMC, decides—though the practice in recent years has been to change the discount rate in coordination with changes by the FOMC in the Fed funds rate.
Snyder: What’s that rate now? Is that the overnight rate?
Kroszner: The overnight rate is the Fed funds rate: 5.25. The recent practice—which is a change from before—is that the discount rate has been held above the Fed funds rate, the rate for which the FOMC sets a target. Typically the discount rate is 1 percent above the Fed funds rate.
Snyder: Does the Fed do things that the board doesn’t oversee? Meaning the Fed as a whole entity, and then the board, putting aside the FOMC.
Kroszner: We are the board of a roughly 20,000-person organization.
Snyder: It’s not like this board has oversight over only some parts of the Fed; you run the whole Fed.
Kroszner: We’re all part of the system, and ultimately the board has the policy-making responsibility and a lot of approval responsibility. But there’s still some autonomy of the individual regional Federal Reserve banks. Regulatory policy is typically made at the board, but through so-called delegated authority, we then give the authority out to the regional Federal Reserve banks to enforce and actually implement capital regulations. There’s a real back and forth between the two, and it’s not always clear where the lines are.
Snyder: A lot of people recognize that, in addition to having responsibility for monetary policy, the Fed regulates and supervises banks. Being on the board of governors, you’re involved in that as well.
Kroszner: Definitely. The board has seven people, and there are subcommittees. I’m on the committee on supervision and regulation. [In March, Kroszner was named chairman of this committee.—Ed.] The research I’ve done at Chicago makes it a natural fit—it’s fun to be making the policies that I was teaching students about.
Other committees include one on payment systems, which is about the plumbing of the system. It sounds boring but it’s incredibly important. For instance, when 9/11 happened, maintaining Fedwire—a payment system that allows large value transfers to go on behind the scenes—was key for the system to function.
It’s exciting because that’s where a lot of risk analysis is done, thinking about whether there could be a broad shock to the system. How do we protect the payment system? How do we make sure financial flows can continue?
Snyder: In this domain, is there an overall shift that you would try to affect?
Kroszner: I wouldn’t say it’s a shift; it’s more an emphasis that comes from being a University of Chicago economist. When you think about any action, you want to push people to analyze, “What are the costs and benefits of doing something this way? Is there a better, more efficient way to do this?” One of our responsibilities is safety and soundness of the banking system; we take that seriously. But sometimes there can be regulations that, although well intentioned, can undermine that. I think we’ve gone a long way to addressing those concerns. We saw some of that with the savings and loan crisis; we’ve made a lot of changes to the regulatory structure in the U.S. to dramatically improve the incentives, reduce the negative effects of regulation, to try to improve that cost-benefit trade-off. More can be done, but that’s the framework I bring.
Because we’re in a global context, we always have to realize that if we impose a particular regulation, there’s always competition from the global markets and from people going offshore. We have to be mindful of that. You don’t want to cause an inappropriate shift elsewhere, because you may get much less information, and there could be things that are much more dangerous out there than internally. Getting that trade-off right is not easy.
Snyder: Is there an example you can give now where you’re trying to look at the consequences more broadly?
Kroszner: One of the big things we’re doing is capital regulation. There’s the old approach to the so-called Basel capital accord from more than 15 years ago, which was a step in the right direction, but a baby step. The markets have become so much more sophisticated. A lot of major banks have been transformed from deposit-taking and -lending organizations to risk management organizations that are involved in a lot of different markets. They’ll still take deposits and make loans, but that’s part of a broader risk management function they’re undertaking, and that requires sophisticated tools of PhDs and MBAs from analytic business schools like the University of Chicago.
The old framework was very simplistic and not good for going forward. We’ve been trying to work out a framework that uses the most sophisticated techniques to figure out, “What is an appropriate capital requirement?” We want it to be risk based; we don’t want to use some arbitrary risk buckets like what have been used in the past—a very simple approach to say, “This is risky so this gets a particular risk weight, and this is not so risky so it gets a lower risk weight.” Let’s actually use the data, use the models to try to see, “Well, if you’re undertaking this activity and undertaking that activity, how do those two things work with each other? Do they form a kind of hedge and maybe reduce risk?” The old system looked at each individual activity, and even if they were offsetting each other, you couldn’t get any benefit from that. You had the perverse result that a capital requirement that was supposed to ensure safety and soundness could give incentives for not doing the right thing. We want to minimize those bad incentives, give the right incentives to do the right thing, and make sure that firms have appropriate capital for the risk they are taking, that the safety and soundness of the system is never in question. Basically we’re moving into the 21st century, and it’s a very big task.
By putting it on the front burner, we’ve been able to lead a lot of institutions to improve their risk management and make the system safer and sounder even before we’ve implemented these new regulations.
Snyder: That’s a great example, because the mantra “risk-based capital requirements” has been around for a long time. But if you don’t keep up with the actual ways that innovative entities, private entities, manage risk, you’re not going to be able to keep up. And as you say, you may end up having perverse incentives by labeling things as “this is bad” and not taking into account that maybe there’s some underlying correlation between those two things that make them less bad or even potentially neutral.
Kroszner: Yes. Or also take into account correlations that could make them even worse when you put them together. I mean, just make sure that you understand the whole rather than just look at individual risks. And also have a much more sophisticated view about the risk they can be generating rather than just base it on some sort of arbitrary number like, “this gets a 50 percent risk weight, this gets a 35 percent risk weight.” In very simple environments, that’s not unreasonable as a first approximation, and that’s fine for 20 years ago. For major institutions that are competing internationally, that framework is one that I just don’t think is adequate to properly address the risks. And investment banks and other institutions are doing this; there’s no reason we should be behind.
Snyder: You’re a member of the board of governors; tell me about the actual members at the top level. You have a PhD in economics; so does Mr. Bernanke.
Kroszner: Chairman Bernanke, myself, and Frederic Mishkin, who came from Columbia and had been a professor at Chicago a number of years ago, have recently been in academia. Then there’s Donald Kohn, a PhD economist who’s worked at the Federal Reserve about 30 years. Although he’s not been in academia, he’s got as much academic firepower as the best of them. He worked his way up at the Fed and knows every nook and cranny of every model and approach that’s been taken over the last 30 years, and he’s absolutely superb.
Then we have Susan Bies, who also has a PhD in economics and was at First Tennessee as CFO of the high senior officials there, who has a very good analytic foundation for seeing how banking actually works, which is extremely valuable.
There’s Kevin Warsh, who has a law degree and worked in investment banking and has an extremely good feeling for how the financial markets work.
A few of us also had prior policy experience. Chairman Bernanke was chairman of the Council of Economic Advisers; I’d been a member. Kevin had worked inside the White House on the National Economic Council. We bring a good combination of different things to the table. And all of us have tremendous respect for the analytics that are necessary for proper decision making.
Snyder: I’d like to talk about current affairs and get into some of your speeches. Bernanke came in with a well-understood position that he wanted to make things more transparent. How transparent can you and your colleagues be about the issues surrounding transparency? Have you come up with a position on this? Are you skeptical about being more transparent, or do you think, “We have to be thoughtful but certainly we can move in that direction”?
Kroszner: There’s been a great evolution at the Fed over the last 12 years. People forget that before 1994, when the FOMC would meet, there would be no public statement. People would have to “try to read the tea leaves,” as they say, because the FOMC would give directions to the trading desk in New York to buy or sell securities to try to manipulate interest rates to get it to a particular target.
Now we produce a statement on the day of the meeting and minutes three weeks later. There are more speeches to explain our thinking. I think all of us at the Fed are committed to a continued evolution for more transparency. You don’t want to upset the apple cart by suddenly doing something dramatically different, but I think continuing to provide more insight into how we think about things is valuable.
Snyder: Let me ask you about a few issues. In your speech last November, “The Conquest of Worldwide Inflation: Currency Competition and Its Implications for Interest Rates and the Yield Curve,” you said, “In the United States—and in virtually every country around the world—inflation has declined, and in most countries, dramatically so.” This is one of the huge successes of economics. If you go back even 20 years ago, when people talked about inflation concerns, they were thinking about the potential for inflation to go up by 5 points. And now it seems that economic policy has been able to give a framework where monetary policy can actually do a very good job of keeping inflation in a quite narrow range. Obviously we don’t have data on all the states in the world, and a lot of bad things can happen. But I thought it’d be worthwhile to pause on that. It is a very important observation.
Kroszner: We certainly had higher inflation in the U.S., and we brought it down. But it is not unique to the U.S.; this has happened globally. What’s interesting is that it is worldwide. Just as an aside, before I fully answer your question, one thing I’ll always remember about that speech is that I delivered it the day Milton Friedman died.
Snyder: And he identified inflation as a scourge on the economy and on everyday people.
Kroszner: That speech implicitly is about the benefits of the ideas Milton Friedman put forward on inflation. One of his key ideas was that high inflation is highly problematic, it’s bad for everyone, and should be avoided. He said that from the 1940s and 1950s on. His book with Anna Schwartz on the monetary history of the U.S. was key in getting people to understand the role that the Fed plays and mistakes it can make. We’ve learned a lot since then. I gave that speech, and about an hour later it was announced that Milton Friedman had passed on. And it just happens that the speech was on the conquest of inflation, something I think Friedman was very happy about.
Snyder: His prediction about stagflation in the 1970s was one of those bold predictions. Will there be any more, or are the days of double-digit inflation in a modern economy probably gone?
Kroszner: There are a lot of reasons to think this low-inflation regime in the U.S. and around the world is likely to persist. But there always could be challenges, so one can never be complacent. It’s amazing to see countries like Brazil that had multiple, enormous bouts of inflation. The value of the Brazilian currency—they’d had so many currency reforms—would be something like one five-hundred-trillionth of what it was in 1973, when the Bretton Woods fixed exchange rates ended. It’s astonishing what mischief can be done with money.
I think there are good forces there. This currency competition makes it much less likely that it will happen. Because what happened in Brazil after the bouts of high inflation was a lot of financial innovation that made it much easier for people to switch out of the depreciating currency.
Also there were a lot of U.S. dollars that went down to Latin America. When the Iron Curtain came down and there was high inflation in Eastern Europe, a lot of physical dollars went to there. Then they developed the electronic payment systems that made it much easier to switch into other currencies. That really short-circuited the ability to raise a lot of revenue through the so-called inflation tax, so it changes the incentives.
One of the benefits of globalization and greater effective competition among the currencies is that it puts more discipline on central banks, because if they start behaving badly, people are going to switch out. In the old days, you didn’t really have much choice. But now that it’s so convenient to switch to another currency, that puts a real discipline on the central banks. And so when Brazil broke with its peg to the U.S. dollar during the crisis of the late 1990s, everyone had predicted high inflation. I didn’t, and I made a bet with one of my colleagues here at the GSB about that, and it turns out, they didn’t have it.
I won that bet, and I had a hunch, but I didn’t fully understand why. That led me to write a paper while I was here at the University of Chicago, on which this speech is based. At that time, I didn’t fully understand why I won that bet, and now, I think I gained a better understanding of it by writing that paper on currency competition.
Snyder: Always important to figure out why you’re right!
Kroszner: Sometimes you know in advance, and sometimes you can rationalize it afterward.
Snyder: Are you comfortable with the following statement: “A good understanding of monetary policy and its effects on inflation and deflation is necessary but not sufficient in terms of actually keeping inflation in check”?
Kroszner: Yes. It’s necessary to understand all the things that can go wrong. In some countries the central banks are not independent and can be pushed around by the executive branch or the ministry of finance. Even though there may be some short-run benefits of trying to pursue some other goal that a finance ministry might want to pursue, people have realized that’s just not a winner. Inflation can be controlled by the central bank, and controlling inflation is a good thing.
That’s been an enormous benefit, and it has made the world a better place for economic growth. That’s one of the reasons why we’ve been seeing relatively good economic growth around the world over the last three or four years. Actually, since Raghu [Rajan] was at the IMF, the world really took off and we’ve seen very high growth rates everywhere. We’ve gotten into a better situation with regard to macroeconomic policy. Central banks are behaving much better, and I think a lot of that has to do with globalization.
Snyder: So those short-run benefits are smaller and more short-run because of the ability to switch out.
Kroszner: Yes, it becomes so costly to pursue those sorts of policies that people see that it’s better to pursue these other good policies. But you’d asked the question earlier, is this going to persist forever? I hope it will, but we can never become complacent.
Snyder: I think there are a lot of pressures on globalization and markets around the world. I don’t know if they would negatively implicate this competitive constraint you’re talking about, but I think it’s important to think that through and to be aware of it. Let me ask you about things that maybe you can’t talk about, like . . .
Kroszner: You can always ask!
Snyder: There’s definitely concern that the U.S. is sort of running out of degrees of freedom with monetary policy because we have objectives that are potentially coming into conflict. And a lot of it has to do with how strong the dollar is relative to the euro and the yuan. There’s concern about people holding dollars who no longer want to hold them. There are issues with making the U.S. more competitive in terms of global trade, especially with manufacturing. And then you have the question of potential recession in the U.S. The economy’s done so well for so long, but some of the more pessimistic people would say, “Yeah, well, it’s going to hit the fan soon because the Fed has no more rabbits to pull out of the hat,” so to speak. To what extent do you think about these issues and that they’re brought into the discussions?
Kroszner: As you can tell from that speech I gave about worldwide inflation, I always try to put things in the global context. I try to look at things that are happening in the U.S. to say, “Is this a unique U.S. phenomenon—you know, lower inflation? I’ve seen it around the world.” So maybe there are some broader factors rather than U.S.-specific factors that are important for that. Another thing I’ve looked at are yield curves, which are relatively flat in the U.S.; that is, the difference between the short rate and the long rate—let’s say the three-month rate and the 10-year rate. Yield curves in the U.S. are flat and actually somewhat inverted. But that’s a worldwide phenomenon; that’s not something that’s unique to the U.S. And in trying to analyze the meaning of these things, it’s very important to put it in that context. Is there some sort of common factor or global thing that’s happening, or is it something that’s U.S.-specific?
Snyder: A lot of people would say, “Every time that you’ve said the U.S. has had an inverted yield curve, this has happened.” So some people look at that and want to look historically at the U.S. You’d be much more inclined to put weight on what’s happening around the globe to understand that and look at it, in effect, from a fresh perspective?
Kroszner: Just because something historically has had one sort of relationship doesn’t mean that in a different context, it will have that same sort of relationship. I think if you see that this is not a unique U.S. phenomenon but one that is worldwide, then you start to think, “What does it mean? The rest of the world is growing fairly strongly and is predicted to continue to grow strongly. Does it really have that meaning that some people have suggested from limited data in the past in the U.S. for today?” That’s why I think it’s very valuable to have that open global context; you make much better decisions that way.
Snyder: It’s part of the Chicago approach, right?
Kroszner: Of course! Always be open to constantly questioning your theories, constantly questioning the data. And that’s what’s great about working with all the governors and other people at the Fed. There’s constant pushing, constant questioning. That’s the only way to make decisions. And that’s the Chicago way.
Snyder: This school turns out a lot of MBAs who are in markets where what you do matters. Do you have any advice for them in terms of how they should observe the Fed and what they should look at?
Kroszner: The best way to be a good Fed-watcher is to look at the speeches that are made by the members of the FOMC, the interest rate–setting body. Look at the statements and the minutes, which give a good feeling for the discussion of where people think the economy is going. Our FOMC statement is a brief summary of the committee’s consensus, and the minutes give a sense of the range of views on the committee.
You also can review the full verbatim transcripts with a five-year lag, which is very interesting. I’d just joined the board in early 2006, and I attended the first FOMC meeting with Ben Bernanke as chairman. As a member of the Council of Economic Advisers, I would have lunch with Chairman Greenspan and other members of the board monthly, but I’d never been to an FOMC meeting. In preparation, I reviewed transcripts of the early meetings under then-Chairman Greenspan to understand the dynamic and how things operated. Since I’m on the board, I could look at the most recent transcripts, too.
People don’t realize those resources are there. The minutes really reveal how we’re thinking about things. The speeches also are revealing. Although some don’t seem to have immediate policy relevance, they give a framework for thinking about how a certain topic might affect our forecast.
People should not overreact to any single piece of data. Think about data as part of a mosaic. Some pieces are missing; some will be taken out and revised and will look a bit different. The construction of the mosaic is our analytical framework that you can see from the minutes and speeches. So when new data comes out that, say, might revise people’s views of productivity, you can see how that’s going to change the shape of the mosaic, change how each of the different pieces may be interpreted.
Snyder: You mentioned being new and doing this homework. Is the best strategy for somebody new to listen and learn, then become more active over time? Or is it fine to jump in and take a relatively high profile, given the structure?
Kroszner: It’s important to understand what you know and don’t know and learn from other people. Be open to different perspectives. There are many people who aren’t PhD economists who have a lot to say, and sometimes in academia, you lose that perspective. Effective policy people learn from others, so you have to go in with an open mind.
But you shouldn’t be afraid to say, “I’ve been thinking about this for a while, and this is what I think. What’s wrong with that?” rather than “I’m right.” That’s the best way to be effective—put ideas out there and let them be debated. And be flexible to say, “Maybe things could be improved.”
Fortunately, I can say whatever I want. There’s no set of talking points or themes. One can certainly give high-profile speeches, but there are also things that can be done internally and not be seen immediately by the outside world that can have significant effects.
Snyder: It’s been fun to talk. I think it’s one of these special times for Chicago where it’s evident that we have faculty who can make policy better, because of you, Raghu, and Dennis [Carlton]. Of course, George Stigler never liked the idea that you should actually get involved in politics and try to affect policy, but certainly Milton thought that was perfectly okay.
Kroszner: They may not have done that themselves directly, but they had so many students who did—and still do.
