David Andolfatto brings a long, strong background to the Fedwatching world as the Kevin Warsh era begins. Debates over where the Federal Reserve is now and where the new Chairman should lead it next are already underway.
Professor Andolfatto made his mark on the academic side of his career in 2009 when he won the prestigious Bank of Canada Fellowship Award for his contributions in the theory of money, banking, and monetary policy.
This same year he started at the Federal Reserve where he became Vice President and then later Senior Vice President in the research division of the Federal Reserve Bank of St. Louis, where he served as Senior Policy Advisor for James Bullard, former CEO and President of the Bank. From 2021 to 2022 he was also a special advisor to Chris Waller after he left the St. Louis Fed as executive vice president and director of research to join the Board of Governors in Washington.
In 2022, he joined the the Miami Herbert Business School at the University of Miami where serves as a Professor and Chair of the Economics Department and continues to write and publish key research papers.
David joins me on the day that Warsh is officially sworn in as Fed chair, and as Fed governor Waller gives a speech saying that the Fed’s next move could be a rate cut, or a rate hike depending on the data.
We get quickly to what David sees as one of the biggest issues the Fed will face in the Warsh era: the connection between monetary and fiscal forces via the government’s consolidated balance sheet. He warns that aggresseive rate hikes to bring down inflation could be counterproductive, especially given the current U.S. fiscal condition where the budget deficit continues to grow.
He stresses that interest rate policy has direct budgetary consequences. When the Federal Reserve raises rates, the government’s interest expense on its debt increases, because “by raising the interest rate on so much of debt that is rolling over that, in fact, you're compelling the Treasury to actually print paper at an even faster clip, just to enhance the interest expense on the debt.”
This, in turn, boosts interest income for the private sector, much of which is held domestically in pension funds and corporate profits. While this mechanism can temporarily restrain demand and lower inflation, it also risks increasing nominal wealth in the private sector, which may eventually be spent, fueling inflation if the economy is at full employment.
David warns that aggressive rate hikes, especially when government debt is high, could paradoxically contribute to inflation in the long run by increasing the government’s interest burden and requiring more debt issuance.
Ultimately, he argues that the Fed cannot permanently control inflation through interest rates alone; fiscal policy must play a supportive role. He says Fed officials need to to communicate the consequences of fiscal actions to Congress, advocating for a balanced approach that avoids breaking the economy while addressing inflationary pressures.
We cover a lot more ground as we look at Warsh’s hope that “the productivity will rescue us” but “hope is not a policy.” David says supply shocks cloud the inflation outlook and could be a reason for the Fe d to wait-and-see on rate hikes, and much, much more.
So dive in hear why David says ultimately the Federal Reserve must communicate to Congress that inflation cannot be sustainably reduced until elected officials make necessary changes on fiscal policy.
“That’s what I would do,” he says. “But, by a talking in a respectful way and respecting the fact that it’s ultimately up to them, but it’s just to point out the economic consequences of their actions and what the implications are for interest rates and inflation.”
Congrats to Warsh and…Eco-assessment 00:01:54:17
It’s great to be here, as always. And, let me just say a congratulations to Kevin Warsh for his appointment and good luck to him and the entire FOMC. How is the economy looking to me? You know, I think that, you know, it looks pretty resilient, pretty robust actually. Consumer spending is surprisingly, still, relatively robust, especially in relation to the recent, Michigan consumer sentiment survey. So that’s a little bit of a surprise. Of course, we’ve got the investment side of the AI build out; the employment-population, ratio for prime age workers is remained steady.
Wages decelerate and workers losing ground to inflation 00:02:45:06 -
The unemployment rate has risen slightly but seems to have stabilized. So overall, things are looking okay… I was just taking a look at the Atlanta Fed wage tracker. You know, wage growth is decelerating and it’s been decelerating more or less steadily, as, inflation has abated. But wage growth is kind of like… around 3.8% on average, kind of right around where inflation is. And so, you know, workers on average are not really keeping up with the cost of living. And that might, might be doing something.. might be some sort of input into the sentiment surveys.
State dependent- data dependent approach? - 00:04:21:23
I don’t think so. You know, Chris has always been somebody who’s been really one to formulate policy on the basis of the data. In fact, this goes all the way back to the early… days, when I remember Jim would go to FOMC and extol the virtues of what he called state contingent policy over the calendar based policy that was in vogue at the time. So this kind of a data dependent or state contingent type of policy, very ingrained in the Saint Louis Fed’s psyche. And I think it’s permeated throughout the system as well. You see it in all the language. So, it’s really a statement. Of humility, in that it’s saying, look at we don’t… we can’t… really forecast how these shocks are going to unfold. We’re not sure what’s going to happen with the war. We’re not sure what’s going to happen with China, you know, or anything else. In the geopolitical sphere, the technology shocks, I mean, these are things they’re called shocks for a reason. I mean, shocks are things that, you know, we expect things shocks to happen, but we don’t know when they will happen, how big they will be or what how they will manifest themselves.
Waller speech: a state dependent assessment -00:05:28:05
However, what we can do is describe how we will react to these shock. Let me you know, Chris has been very clear and is that the rest of the FOMC as to, you know, how, interest rate policy is likely to react conditional on any given shock that unfolds? I see Chris’s speech very consistent with that, that framework.
Wallers view: A change; not what Warsh has been talking about 00:06:58:02
I think for better or for worse, and I’d argue probably for better, you know, Fed presidents and then all the members of the FOMC, you know, the culture is that you go out and you give your best assessment of the events as they’re unfolding in your own interpretation of what’s happening and, your own kind of humble opinion of, of how policy should, adjust to the prevailing, environment.
Even the Chair has to make the case for his view 00:07:27:00
And I think that I presume that… Warsh will… respect that. And that… he will certainly bring, a fresh perspective… to the table, which I think is very healthy. You know, he has had experience there before. But I think… whether his, views or policy recommendations take hold… he’ll have to make the case.
This is Fed culture 00:07:56:09
And I think his colleagues will be… ready to receive any type of logical argument that’s based… on logic and evidence. But in the meantime, I don’t think that he would find it odd that members of the FOMC are going out giving their speeches and espousing their views. That’s the culture of of the institution.
Fed brings inflation down by breaking things 00:08:47:01
Well…the conventional wisdom, is that… rate hikes are meant to restrict financial conditions, depress aggregate demand, and basically the way… they exert the deflationary or disinflationary pressures, kind of like breaking things in the economy. I mean we saw this very dramatically…during the Vol cker disinflation period. Yes. No one questions whether the Fed can bring inflation down by breaking things.
Shocks bring inflation but is it only transitory? 00:09:16:15
And that’s not the issue. The issue is how can we bring it down? How can the Fed bring it down without breaking things? And I think that… especially in the context of what’s happening today, which is the supply disruptions. I mean the conventional wisdom is really that these supply shocks… they might manifest themselves as inflation, but only transitory…to the extent that you believe that ultimately these shocks will dissipate, they might have some long run impact on the, the level of prices. But of course, the Fed’s mandate is over the rate of growth of the price level, the inflation rate. And so the conventional wisdom is that… you should kind of look through these transitory disturbances, just let the inflation manifest itself….
Damaging rate hikes? 00:10:02:17
You know, this happened during the pandemic too. I mean, how is raising the policy rate restricting financial market conditions depressing labor demand supposed to help out the economy in a time when it’s been disrupted by these energy, price shocks? I believe that’s the sense in which he meant that raising the policy rate now at least too aggressively to be damaging.
Fiscal and monetary policy linkages: 00:11:17:09
It’s a long standing issue in monetary theory. And actually it has some kind of practical applications, usually to kind of developing economies like Brazil… in the 1990s, for example. But to step in on the right metaphor, <to step on a rake> it’s actually not my own. It’s due to Chris Sims, the Nobel Prize winner who recently passed away. And it’s also related to, Sargent and Wallace’s unpleasant monetarist arithmetic, but it’s actually based on a very old premise that monetary and fiscal policy are inextricably linked through the government’s consolidated balance sheet. And so the one way of thinking about that is interest rate policy is going to have, budgetary consequences. And the government deficits in the government debt, actually feed into household wealth. I mean, that’s just like an accounting identity government, you know, if the government issues a whole swath of treasuries, somebody’s going to be holding them. A lot of us are holding them in our pension funds… or perhaps even directly. And so the idea here is, that normally… the idea is, that the fiscal situation, in the United States is more or less anchored.
We can count on Congress at the end of the day to do what’s necessary to either cut spending, raise taxes, to manage the long run debt to GDP ratio, or we can count on technology growth, productivity growth to kind of help save the day so that the economy can grow into the existing, stock of nominal debt.
Large foreign purchases and holdings 00:12:58:12
And lately… in the last 20 years or so, we were counting largely on the foreign sector to kind of absorb, Treasury issuance. And… the question is, what are the limits to that? And… we… as well as, many others <know> that the interest expense on the debt is rising rapidly and that recently, I think last fiscal year, I think it exceeded $1 trillion, which exceeded… the expenditure on national defense for the first time.
Fiscal interest paid becomes income 00:13:33:00
So… all this debt and all this interest, all this interest income, you know where’s it going? I mean, a part of it is held abroad, and part of the interest expense is being fed abroad. That’s true. But it’s also the majority is held domestically. And the majority of this new paper that’s been issued is flushing into our pension funds because it’s flat sheet into corporate profits. It’s… basically swelling the nominal value of the private sector as well.
The fiscal channel for a rate hike backfire 00:14:29:16
The argument goes like this. So you know normally the debt isn’t so large. The channel I’m about to describe isn’t really that operative in the sense that the interest expense that the government’s incurring is also interest income for the rest of the economy. Now, granted, a lot of this interest income is is thought to accrue to relatively wealthy people who don’t have a high propensity to consume. But eventually, you know, what are the limits for this? We can’t count on this growing debt, interest expense on the debt to just continually be financed by, an ever increasing pace of Treasury issuance. And so that the stepping on the rake argument is that it’s possible, not saying it’s going to happen, but theoretically it can be shown and we believe it has happened in other countries, that if the Fed raises the policy rate, true, it’ll have the conventional effects that we usually think it may temporarily disrupt demand and bring price level pressures down temporarily.
Yes…but…ultimately…at full employment… 00:15:34:09
But by raising the interest rate on so much of debt that has rolling over that, in fact, you’re compelling the Treasury to actually print paper at an even faster clip, just to enhance the interest expense on the debt. And there’s that that just contributes to the nominal wealth that’s been, asked to be absorbed by the price by the private sector, that nominal wealth will want to be spent. You’re not going to want to hold on this paper forever. Ultimately, you’re going to want to spend it. But if you’re at full employment, output is not going to expand, in any real, way. So the price is has to rise. That’s the argument.
An unorthodox thought 00:16:50:11
So, this is, in fact, an argument. And I know people make fun of it because they point to examples like Turkey or something like that. The idea is that, you know, lowering rates in, in this type of environment will then have the opposite effect of stepping on the rake . Right. It may cause a temporary inflationary burst, but ultimately by, by, reducing the interest expense on the debt, you could ultimately lower the long run inflation rate. But I have to be very clear. I mean, it’s very difficult to say, what’s going to happen without also specifying what’s happening on the fiscal side? You know, a lot of this all of this depends on how the Congress is going to react. And in terms of like getting the budget under control. Oh, boy.
Risky business: telling Congress about fiscal risk 00:18:26:22
You know, does he have to take it on? No. I mean, should he and other Fed members, FOMC members, do so… I believe so? I understand very well why they don’t want to, you know, they do fear that, they might, and, you know, puts their so-called independence at risk if they start to telling Congress how to manage its, budget.
Volcker did step up 00:18:53:14
But I’m very much of the view that, listen, FOMC officials should not be telling Congress what to do, but there’s certainly nothing wrong in letting Congress know what the consequences of their actions are. Without making a judgment as to whether their actions are good or bad. And we know, as you pointed out, Paul Volcker, he’s the guy on the op ed pages of The New York Times and tells secretary, treasurer, treasurer, Donald Regan, you know, if you want lower interest rates and if you want if you want those things in lower inflation, then you’ll have to do something about the, budget situation.
Let’s get fiscal?? 00:19:32:19
I see a lot of precedents for that. And I think it can be done in a manner, in a delicate manner, that kind of respects Congress’s, authority here. But at the same time, I personally would say it <would sure make>… the Fed’s job a lot easier. And in fact, I would go further and say, I don’t know of any monetary model like a model a theory that we write down mathematically that does not highlight the importance of fiscal anything. The Fed cannot slay inflation permanently just by interest rate policy. It’s crazy. It can do it temporarily. But Volcker showed that I know you can break the economy and bring inflation down. But the big question is what keeps inflation down? And, you know, arguably, what kept inflation down in the 80s was the, the growth of the 80s, but also the subsequent, tax hikes, that the Reagan administration implemented.
Slow fiscal spending- a place to start 00:20:37:24
So it wasn’t just the Volcker story back in the 80s. And it’s certainly not going to be just the Fed story here. So, yes. Personally, I would like to see… officials gently, remind our representatives in Congress that, you know, possibly slowing down the pace of, spending would be a place to start. You know, you don’t want to break things, but certainly to put some downward pressure on the spending would help, bring down the inflationary pressure. You wouldn’t be injecting so much government paper into the system.
D.C. Hold ‘em 00:22:32:02
It is very difficult. And that’s why, again, I’ll stress that, one ideally really does need, collaboration with the fiscal authority on this. But what would I say? I mean, my line of thinking is more or less, you know, you’re probably not too surprised, aligned with Chris Waller’s. I mean, who is in favor of basically holding right now?
Inflation expectations are the issue? Now? After all of this? 00:22:52:20
But he’s …. the inflation concern, is on his radar screen right now as it is mine. But it’s very interesting to see Chris, the way he thinks about things, which is turn very conventional relative to his academic writings. You know, the basic idea is that, we don’t want to get inflation expectations unanchored in some of the different measures of inflation expectation.
But, by some measures, inflation expectations are still anchored… 00:23:18:06
So they’re looking at the break evens, the market based measures. And I think that the that’s from <what we> see will be looking at inflation expectation measures very closely. Because what they fear is that even a transitory increase in inflation, might manifest itself as an increase in inflation expectations. And that these inflation expectations that can get baked into kind of wage negotiations and, you know, into the contracts… that business people are, crafting and, and so I think that if you take a look at the data now, inflation expectations continue to remain relatively well anchored.
Would not want to be hiking rates now 00:24:00:24
Yes. The real, interest rates are rising at the long end, but they’re not out of line with where they were just, you know, 20 years ago, let’s say inflation seems to be creeping up, which is a little bit concerning. But a lot of that perhaps, is a manifestation of the supply shocks. And so I wouldn’t want to be raising right now, in light of these disruptions.
Still, very concerned 00:24:26:04
But I’d be very, very concerned about the inflationary pressure. The irony is, is that, again, I would personally, if I was there-m I’m sorry. To everybody I mean, this is why I’ll probably never be appointed. If I was to, if I was to recommend or vote for a policy rate increase, I’d be adamant to Congress that more of these are coming, if you don’t get your budgetary house in order. I mean, just to let them know that these are the logical consequences of your policies, that we have a mandate. This is the tool we have to achieve our mandate. And your deficits are causing us to to raise, rates aggressively to keep inflationary pressure, in line with our mandate, which, by the way, comes from you, Congress, and therefore, not telling you what to do, but if you do want lower interest rates and lower inflation, please try to revisit your budgetary situation. Reprioritize what you want to spend the money on and cut where you can to get, you know, the fiscal situation in a, in a more kind of stable, position.
Dudley Do-Right as Fed Productivity Czar? 00:26:53:19
I actually do think they have time. I mean, the U.S. economy is tremendously resilient, despite everything that’s happening to us, especially in the global, global, environment. I do think there’s time. But of course, we can’t take that time for granted. And <if> I was Warsh. And knowing from what he’s, said in the speeches, you know, there’s other ways, other things one can hope for and one thing that the administration, and I believe Warsh, have been hoping for is that the productivity boom will rescue us. And you cannot discount that. You know, the American, entrepreneur is an amazing creature, and the American economy is very resilient. And, and it often surprises. So we cannot discount that. But, you know, hope is not a policy.
But What If: if productivity does not show up – or disappoints? 00:27:45:01
I mean, I mean, so I would, you know, ideally, you know, in a partisan free way, I would lay out a contingency plan and say, listen, I mean, if the productivity boom does rescue us, then, you know, that’s great; you know, Earth had a suddenly a global, foreign demand for the Treasury product, grows at an accelerated rate we’ve added to our fiscal capacity. And so we don’t have to raise as aggressively. So there’s a lot of things that could go right. But again, we cannot base policy on hope. You also have to base it on, other all contingencies. And one contingency is those things don’t happen. And then you’ve got the fiscal situation. And I think, you know, it’s the responsibility of the FOMC to lay out how they would react in every contingency.
Fan of the Dallas trimmed mean 00:29:41:13
Yeah. To be honest, I’ve been a big fan of Dallas trim mean because what it does, is it, my understanding is that it removes the most volatile components of, of the price level index. So it does give you, in my view, a relatively better measure of the kind of the trend. Inflation now would be very clear.
PCE is the Fed’s official target 00:30:01:08
The Fed has as its official, price level, the yes. Okay. That’s the headline. The fed often makes reference to the core PCE which strips out food and energy. And again, I think Jim Bullard actually once wrote a paper for the St. Louis Fed that said that measure is rotten to the core or something that, people, you know, do need food and energy.
Do not play three-card montee with various inflation measures 00:30:29:06
I mean, but really, that what you’re trying to do there is to get a sense of the inflation inertia. And so really, what you want is a measure of trim. That’s what these measures are about… You don’t want the fed to kind of switch across its official inflation, measures in a way that seems like opportunistic because, you know, the optics just look terrible.
Inflation is a statistic (the target is a number) 00:30:54:11
But here’s the truth. Here’s the truth. The Fed actually, especially when I was I would look at a variety of measures. I mean, we cannot be, you know, we have to remain humble. Inflation is measured very imprecisely. I mean, it’s a, you know, consumer price index… our statisticians do a magnificent job, but we do have to be careful in how seriously we take them.
Good to look at several inflation metrics 00:31:18:15
So I think it is actually a good idea to look at the variety of indices when you’re discussing and formulating policy. And I’ve seen this, at FOMC, people… don’t just look at one measure, they look at several measures. And I think looking at the Dallas trimmed mean is certainly a measure people have <likes>. And you know, but to say that this is the one I want to look at right now because actually it’s going down…<no>.
Fed regionalism was a key part of the original plan 00:32:50:04
I think it’s a good thing, to have, the regional banks have voices at the FOMC. I mean, you know, the founders of the Fed were, very jealous of the concentration of powers in Washington, in New York. And that’s why we do have regional representation. And so I think it would be a mistake, not to take seriously the input from the regional feds, you know, different regional Feds at different points in time in the history have been you know, the the counter voices… the places that kind of spoke against the conventional wisdom and been the source of… some very provocative and prescient ideas.
Google transitory for me… 00:34:07:18
Yes, of course. Of course. Inflation is always transitory if it’s above target or below target. Right. And you remember, prior to the pandemic, it was 50 basis points below, the 2% target was also transitory for ten years. Hello. And, well, you know, it kind of depends on, to be fair. I mean, what does one mean by transitory?
Fed lives in a transitory world 00:34:38:05
I mean, if one adopts the, the view that transitory means that inflation is expected at some point to revert back to its target, then of course, we’re going to believe that inflation is transitory. It could be persistent transitory. But I expect that language to be there because nobody at the Fed is going to say that inflation is not transitory in the sense that we’re not. We’re going to, hit our long run intent, the inflation target.
Must anchor inflation expectations and to the right post 00:35:57:04
I think that’s right. I mean, you know, the first instinct, the central bankers, to achieve the price, the inflation mandate and, you know, it’s one thing. I mean, when inflation was undershooting way back in, prior to the pandemic, there’s one thing'… that caused a lot of nervousness among central bankers. I wasn’t sure why. But… now that we’re above target… that just grates against the central bankers’ instincts, you know that. You know if there’s one thing that we need to do that we need to ensure is to make sure that inflation remains anchored. Because history shows that when it’s not, I mean, all sorts of bad problems happen.
Hawks will prevail 00:36:39:18
So I do expect, again, for better or for worse, the hawks to kind of, as long as inflation remains persistently above target, I believe that the hawks eventually will prevail.
How should the Fed speak to Congress? 00:37:00:13
That’s what I would do. But, in a talking to respectful way and respecting the fact that it’s ultimately up to them, but it’s just to point out the economic consequences of their actions and what the implications are for interest rates and inflation.
Badda Bing, Badda productivity boom? Or Contingency plan? 00:37:44:13
You know, what do I think? I tell you all my training as an economist, I mean, the one thing that has taught me is, how humble I have to be about forecasting these things. I… read optimistic takes and I read pessimistic takes. I personally lean on the…optimistic side, but I think it’s irrelevant. I don’t think it’s relevant. For what I or the FOMC believes will be the ultimate manifestation for productivity. What’s much more important is to lay out the contingency plan. How can the American public and businesses expect policy to behave if productivity booms, if productivity takes you know, if the fiscal situation improves, if the fiscal situation tanks, if China starts, you know, unloading all its treasuries, if China starts repurchasing treasuries, you know, all of these, I think it’s much more important for the FOMC to outline its contingency plan, how it will react in these various states of the world.
Shocks by definition are shocking 00:38:52:17
And then we’ll let the private sector, judge for themselves what the likelihood of each of those contingencies are. I mean, we’re very bad at forecasting these things. This is why we call them shocks. Can’t get shocks. We don’t know that or when Vesuvius is going to blow…Better have an escape plan in place. When it does.
A fan of scenario economics? Bernanke and Bullard 00:39:32:01
Yeah. And I think it’s not just Ben, but also Jim. And actually, I’ll point to the entire economics literature, as Jim used to argue, I know of no economic theory that writes down an optimal monetary or fiscal policy rule that isn’t state contingent. And it’s very simple to explain why because we can’t forecast the contingencies. All we know is that they’re going to happen. And the best we can do is to form a contingency plan.
DAVID ANDALFATTO
David Andolfatto received his Ph.D. in economics in 1994 from the University of Western Ontario, London, Canada. A native of Vancouver, British Columbia, he began his academic career in Canada as a professor of economics. In 2009, he was awarded the Bank of Canada Fellowship Award for his contributions in the theory of money, banking, and monetary policy. In that same year, David left Canada to become Vice President, and then Senior Vice President, in the research division of the Federal Reserve Bank of St. Louis, where he served as a senior policy advisor for James Bullard, CEO and president of the Bank. He left the Fed in 2022 to become Chair of the Economics Department at the University of Miami Patti and Allan Herbert Business School.
