Darrell Duffie is a star in the world of finance. He is a Stanford theoretician well known and admired in policymaking, academic, and investment circles for his work on financial risk and on what needs to be done to fix the “pipes and valves" of modern finance.
As Darrell joins me at the Hoover Institution at Stanford University, Kevin Warsh awaits the final vote in Congress to put him in the Federal Reserve chair, and Hoover is getting its annual monetary policy conference underway.
One of Warsh’s biggest policy plans is to reduce the Fed’s balance sheet, a step he has long argued for and which has produced an ever louder debate among Fed officials and financial economists like Darrell as Warsh is on the verge of taking over at the Fed.
”It's foremost on the mind of the Federal Open Market Committee…and when most people think about that question, they're thinking about how many assets the Fed needs to own and what kinds of assets,” he says. “And the Fed's come under some criticism for quantitative easing programs and purchasing assets other than Treasury securities.”
”Kevin Warsh… recently gave a speech at the IMF criticizing the Fed’s balance sheet policy,” he adds. “In my research, though, I’ve been focusing not on the assets that the Fed has, but on the liabilities that it has. That is, the deposits that banks keep at the Fed.
Duffie explains that the connection between the availability of reserves and market interest rates is only relevant when reserves are scarce. In today’s environment, with abundant reserves, banks’ opportunity cost is set by the interest rate paid by the Fed on their reserve balances. He states:
“When there is not enough reserves, there’s a scarcity value to those reserves, and market interest rates go up.”
However, Duffie notes that the Fed has largely avoided using reserve scarcity as a monetary policy tool, preferring to keep reserves ample so that market rates are driven by administered interest rates rather than reserve supply.
Darrell is emphasizing the importance of not starving banks of liquidity. “You shouldn’t make banks scrounge for money; that’s inefficient... you shouldn’t try to kind of starve them of that liquidity just in order to get the balance sheet down.” Rather than simply constraining supply, he recommends approaches that reduce the demand for reserve balances rather than simply constraining supply.
Duffie identifies three main areas for structural reform: liquidity regulations, payment systems, and tiered remuneration of reserves. He explains:
“The payment system, which turns out to be very demanding of reserve balances the way that it’s constructed,” he says. “It’s a plumbing issue.”
He suggests that adopting liquidity savings mechanisms, as used by other central banks, could reduce the need for reserves by 20-30%.
“As the Treasury market has gotten so big because of fiscal deficits, financial markets have to deal with a lot more Treasury securities. And it does take a larger Fed balance sheet to manage that situation.”
He warns that if fiscal authorities do not address deficits, the U.S. could face a debt crisis, which would be far more consequential than balance sheet concerns, saying we are focusing our attention on the wrong things.
So dive in and hear why Duffie says if a Warsh-led Fed does decide to cut the balance sheet, it won’t happen quickly. He notes that when Warsh was testifying recently in his confirmation hearings to the Senate Banking Committee, he was asked, what about the balance sheet? Are you planning to reduce it?”
“And I don’t remember his exact words, but he said it, words to the effect that it would be a very deliberative, careful process, meaning he’s not just going to go in and on day one, say, sell a bunch of reserves.”
So dive in and get what is, in effect, your Darrell Duffie tutorial on the Fed’s balance sheet, the payments system, and the reforms that will be needed to safely and effectively shrink that sheet.
Duffie- Cochrane interview on Hoover website (background) 00:01:08:09
Of course, I want to mention you just did a recent interview with John Cochrane over here at Stanford/Hoover. He interviewed you, and you guys just broke down the balance sheet. How it works: Darrell: It’s on the Hoover website.
Fed Balance sheet: how it works 00:01:26:13
Well, there’s this relationship between the availability of reserves and the price of money, meaning market interest rates, which is no longer relevant when there are lots of reserves. That’s called abundant reserves, because in that case, banks are using just their opportunity cost, being the interest rate paid by the Fed, on their reserve balances. But when there is not enough reserves, there’s a scarcity value to those reserves, and market interest rates go up.
Administered rates drive market rates not reserve quantities. 00:01:58:19
So there is a relationship with monetary policy. But the Fed has been avoiding the use of that relationship by and large, and it tries to keep reserve balances ample, meaning, primarily, in the words of the FOMC. Market rates are driven by their administered interest rate on reserve balances, not by the supply of reserves.
Balance sheet size will not ‘conduct’ monetary policy. 00:02:27:12
I think, well, first of all, they’re not going to cut the balance sheet in order to conduct monetary policy. They’ve basically sworn off that approach. They might cut it so that they have a smaller balance sheet. And the incoming chair, Kevin Warsh, who is poised to be the chair of the Fed very soon, has suggested that the Fed’s balance sheet is too large, and he would like to see it smaller.
What cut balance sheet size? 00:02:52:12
And I think that’s not particularly related to monetary policy but more related to the perception of the Fed as an independent agency setting monetary policy.
What is Fed Independence? Why is a large balance sheet a danger? 00:03:13:04
Well, that’s going to be front and center at the Hoover conference that we’re attending. This week. In the view of some, including some on the FOMC, as you can see from their minutes, a very large Fed balance sheet is kind of a lightning rod for politics.
Irony: Today’s Fed balance sheet is about as small as it can be. 00:03:42:01
Some that don’t understand monetary policy get the impression that a large balance sheet means the Fed has been overly adventurous in buying assets. They don’t realize that in today’s environment, the balance sheet is about as small as it can be and still conduct monetary policy well. But again, some might not understand that and point to the balance sheet and say the Fed has been buying too many assets, and it should, you know, be; it should be constrained in its purchases.
QE policies caused things to shift 00:04:22:00 - 00:04:49:06
Quantitative easing. Before the financial crisis, the Fed’s balance sheet was mainly determined by the quantity of paper money in the economy. But then during the financial crisis, the Fed had to buy a lot of assets to support the financial system, which expanded the balance sheet, and there’ve been multiple rounds of that ever since. In fact, that’s one of the big disagreements between Kevin Warsh and the Fed.
It was also the reason Warsh left 00:04:49:08
He left the Fed, saying that the Fed had been overly, you know, using too much quantitative easing.
QE: more impotent than important. 00:05:09:05
I think, almost everyone looking backward would say that quantitative easing has not been as powerful a tool for monetary policy as the Fed had hoped when it conducted quantitative easing. The first round of it, during the depths of the financial crisis, was basically to rescue the financial markets from dysfunction that wasn’t so much monetary policy as just making sure there was enough market liquidity.
…and buyer’s remorse. 00:05:39:17
But there have been subsequent rounds of quantitative easing that were designed to compensate for the fact the Fed couldn’t lower short-term interest rates because they were already at the zero lower bound. And so they lowered long term interest rates by buying assets. As I said with some, that’s a there’s buyer’s remorse. They wish they hadn’t done as much of that.
No Ozempic for the balance sheet… 00:06:00:12
But now that it’s very big, it’s turning out to be hard to get it back small again. It might surprise some of your viewers to know that before the financial crisis, let’s say in early 2007, the whole financial system was running on about $10 billion of Federal Reserve deposits, which is a lot for you and me to have in our pocket.
Balance sheet bloat 00:06:23:02
But now it’s gone from 10 billion to $2.9 trillion. So, you know, more than 200 times more. And, you know, there are a lot of causes for that, but it’s turning out to be difficult to get it back down below that level at this point. In fact, the Fed decided late last year that it had gotten as small as it could get, and they were going to start buying assets again in order to keep enough reserve balances in the system.
Did the Fed really ‘have to’ buy those assets? 00:06:55:07
<had it not…> Money markets would be very disrupted at some point. You know, we don’t know exactly when. And the Fed has been quite conservative about making sure that we don’t have another bout of what happened in September 2019 when something bad did happen. There weren’t enough reserve balances and money markets. One company… Yeah, yeah. Giant, giant, intraday jumps in interest rates.
And… THEN came Covid. 00:07:23:14
Well yeah. Then even more reserves were created because the Fed again rescued the economy by buying a lot of assets. Reserve balances got up to about 4.5 trillion, with all those purchases. And now, the Fed has been reducing the balance sheet ever since. And it’s down to about as small as it can get at this point, with 2.9 trillion of reserves, unless the Fed really restructures the way that it does monetary policy and the payment system. And those would be the subjects of my recent Brookings paper. Those <reductions> would be difficult to do, but they would allow the Fed to further reduce the balance sheet.
The Brookings paper… 00:08:22:06
<The Brookings paper> …It’s more clinical... I’m not taking a view on whether the Fed should or should not reduce its balance sheet. However, given the interest, including Kevin Warsh’s interest, in a smaller balance sheet, it seemed wise to look into what would be the methods that would allow that if the Fed were to choose to reduce its balance sheet.
Need to make adjustments to shrink balance sheet. 00:08:43:08
And so I basically go through a list of approaches that, you know, with some work, would allow the Fed to reduce its balance sheet, not by constraining banks on how much reserve they can put at the Fed, because that would not be productive. Again, it would cause disruption in money markets, but rather by reducing the needed quantity of reserve balances, reducing the demand for reserve balances so that the banks wouldn’t need as much. I think I asked. I’ve got, I’ve got a list of things that you could do from relatively easy, to moderately impactful, to much harder and much more impactful
Choices… the easiest 00:09:27:12
Okay. So probably the easiest one to do would be temporary open market operations that would smooth out the bumps that are caused by the supply of reserves by various, unintended impacts, like at the end of each quarter, when foreign banks try to reduce the quantity of balances they hold because they want to dress up their balance sheets for capital requirement purposes. And that causes a rather large and sudden drop in reserve balances on one day every quarter. The Fed could fill in those bumps, and then on average, it could lower the path of reserve balances by that amount, which is on the order of, let’s say, the low hundreds of billions, maybe, let’s say, 100 billion.
Small impact 00:10:15:13
We’re not even in the committee category with this one. It’s the low hundreds of billions. Another way that the supply of reserve balances gets buffeted around is the fact that the Treasury Department has a deposit account at the Fed. It’s called the TGA or Treasury General Account, and it’s the Treasury’s account balance. Whenever it goes up a dollar, reserves go down a dollar, and vice versa.
Treasury accounts Drain reserves at tax time. 00:10:39:05 -
So when you pay your taxes, you take money out of your account. You instruct your bank to pay the treasury. The Treasury ends up getting paid out of that bank’s reserve balances, and so mechanically, every dollar of that that comes out of reserves goes into TGA and vice versa. And that amounts to a lot of taxes. <That period> just ended. And reserve balances are down by about 100 billion. Just recently, those bumps could also be taken out by temporary open market operations. And these operations would be the Fed temporarily buying assets, that create reserves and fill in those potholes.
Reserves no longer matter for rate determination. 00:11:28:18
Yeah. The New York Fed has a market operations group that buys and sells securities or does repurchase agreements that supply reserves to the system. And before the financial crisis, that was the main method for controlling interest rates. Since the financial crisis, that activity has reduced a lot because the Fed uses a different method for controlling interest rates.
Administered rates rule 00:11:51:06
It uses an administered interest rate that it pays on reserve balances. And so those temporary open market operations are not nearly as frequent. But they could be. And you know, reactivated, if the Fed again wanted to reduce its balance sheet with the proviso, I mentioned that it’s not going to make a huge difference.
Reserve scarcity – why bother? The peril of adjustment 00:12:26:09
Well, you know, over overarching this whole conversation is the remark that Federal Reserve Governor Chris Waller made about, you know, why would we go to all these efforts to minimize the quantity of reserves that banks have to the bare minimum? He said? That would be—and I’m pretty close to verbatim—that he said that would be like making banks search under the couch cushions for money. He said that would be massively inefficient and stupid. Yeah. Because why would you? Note the whole premise of we don’t want to reduce the balance sheet“ vs. the idea that you shouldn’t make banks scrounge for money because it is inefficient. The reserves that they need to conduct their business—it’s valuable to have that liquidity. And you shouldn’t try to kind of starve them of that liquidity. Just in order to get the balance sheet down to 100 billion or 200 billion. What you really want to do is work from the demand side, reducing their need for reserve balances. And that’s where some of the bigger structural approaches in my Brookings paper come in.
Great conference at Stanford 00:14:05:03
So this monetary policy conference at Hoover, in my view, outside of conferences held in the Fed and at the ECB or outside of central banks, it’s the most important central banking conference anywhere in the year.
Reducing the pressure on reserve demand: what can be done? 00:14:39:10
I have a list of more bigger structural, ideas that would allow the balance sheet to go down, and they fall into three areas, and we can go into each of them. So one of them is in the area of liquidity regulations, the way that they’re interpreted, and the way that they’re supervised. The second category is the payment system, which turns out to be very demanding of reserve balances the way that it’s constructed. It’s, it’s a plumbing issue. And we can, I can, discuss how other central banks reduce the need for reserve balances by using very clever mechanisms called “liquidity savings mechanisms” so that banks don’t load up, so heavily on reserves. We’ll get into that one. And then the latter, and those are, those are both pretty difficult to do for reasons we’ll discuss. And the last one is probably the most difficult. It’s something that other central banks are using and the Fed has experimented with. It’s called tiering. The remuneration of reserves. What does that mean?
Rate Tiering 00:15:50:14
Okay. So, today, or ever since, you know, 2009, the Fed has paid an interest rate to banks on their reserves. It’s called the interest rate. Now it’s called the interest rate on reserve balances. And that’s the primary monetary policy tool that the Fed uses. We don’t think about the fact that there’s no need to really pay that full interest rate, no matter how much a bank has deposited at the Fed. For example, if a bank has far more reserves than it actually needs to run its business, the Fed could lower the interest rate on the excess reserves. That would be called a second tier or a lower tier. That’s why we call it tiered remuneration. The remuneration is the interest rate. And one could have two tiers. Or the Bank of Japan has actually had three tiers in the past. And this lower tier would discourage banks from holding more balances than they need. A bank would say “wow” on these extra balances. We’re only getting 75 basis points less than the market interest rate. We should try to eject those extra balances because we could use them to buy interest-bearing assets that pay full market interest rates. And so banks would basically try to get rid of the balances that they don’t need for business purposes and stop using those as an investment asset. And that would cause a dramatic reduction in the demand for balances. Well, I’m not taking a stand on whether it’s good or bad for banks to be profitable. If the Feds were to say, “We really want our balance sheet to go down a lot.” What would you do? And I would say, well, this is one method that would work; it would be hard to convince some banks to go along with this, and it would also be hard to implement because you would have to decide what a reasonable need of a bank is for balances to run its business operations.
Assessment: 00:19:07:23
So that’s not an easy thing to do. But other central banks have done it. The Fed has actually done this besides, oh, the Reserve Bank of New Zealand, the Reserve Bank of South Africa, and Norges Bank, which is the central bank of Norway, and a lot of central banks did for other reasons related to negative interest rates.
Changing Liquidity regulations 00:19:39:10
Well, all of the ones that I’ve mentioned are challenging, and let me go through them in a little bit more detail because I have listed all three of the relatively challenging things to do. The first one is changing liquidity regulations or the way that they’re monitored and supervised so that banks don’t feel that they need so many reserves or desire so many reserves to meet their liquidity regulations. The story goes back to the financial crisis, when it was found that banks were not sufficiently capitalized and liquid. Congress and regulators, including the Fed, decided we need those banks to be self-sufficient. We don’t want them to be in a position where they need to come to us for more capital or more liquidity, so they put into place rules that require banks on the liquidity side to have enough liquidity to run their operations no matter what, including even if they were to fail and need to be resolved in an insolvency process. And that is a lot of liquidity. Now that the regulations don’t say specifically that you have to have reserves to do this, the way that the regulations are being interpreted and implemented by the banks makes them want to meet those regulations a lot by using reserves. And so they have a high demand for reserves, and they’re reluctant because of those regulations to go to the Fed when they need more reserves, like in the middle of the day.
Discount window shyness 00:21:07:03
And they’re running low, and they want to run an overdraft, or they want to go to the discount window and get more reserves, because going to the Fed would effectively be an admission that they’re not self-sufficient. So the banks, the largest banks that are subject to these rules, only for the globally systemically important banks, are subject to these rules. The largest banks are much happier to just hold a lot of reserve balances than to hold less. And then go to the Fed for more when they need it. Because going to the Fed, as I said, would be contrary to the spirit of some of these regulations. And in my paper I explained that if some of these liquidity regulations were reinterpreted not to water them down, but to make banks more open to going to the Fed for more reserves than they do, then the banks wouldn’t desire to have so many reserve balances.
Not wholly a new phenomenon 00:22:26:08 -
Bill Nelson has written a lot on this. And he’s been describing the fact that for decades, well before the financial crisis, banks were already stigmatized by using funds from using the discount window. And for that reason, the Fed has introduced since 2019, since the blowup in money markets that I mentioned earlier, a new facility called “standing repo operations” that would allow banks or the dealer affiliates of banks to go to a new facility from which they could get reserves. Banks have been beginning to use that a bit, but they’ve also been stigmatized to some extent from going to that facility. And so it hasn’t been 100% success.
Maybe it is a human issue more than a precise regulation. 00:23:25:09
You mean to interpret the regulations so that banks are afraid to go? Yeah. Well, I don’t know if they just let it happen or it just happened. And it was a confluence of supervisors at the Fed wondering what was going on when banks used these facilities, on the one hand, and on the other hand, the managers inside the bank saying, “You know what, I’m not sure what the reaction in the Fed would be, but let’s not take a chance. Let’s just make sure we have plenty of reserves and not have to go to the Fed, which means a big demand for reserves. It’s resulted in an unfortunately large demand for reserve balances, unfortunate if you’re interested in getting a smaller balance sheet.
Some progress made. 00:24:21:02
I believe it can. We’re already seeing some green shoots there. At the end of last year, $75 billion was drawn from standing repo operations by the largest banks. As it turns out, that was not as much as the pothole that was created by the year-end. Window dressing that I described. But it still was a good sign that some banks were going to the Fed for balances.
Optimistic on change prospects. 00:24:49:15
But I am optimistic. If you look at the Bank of England, they have been quite successful at reducing their balance sheet by getting banks to go to their analogous operations. Now at the Bank of England, that comes along with more volatility in markets. If you’re going to put banks in a position where they feel they must go to the Bank of England to get more sterling settlement balances, then that’s probably happening when market interest rates are fluctuating a lot more. And indeed in sterling markets, you’re seeing quite a lot of fluctuation and wholesale market interest rates. But that’s in my view; that’s okay as long as they’re not, you know, giant spikes and market dislocations.
Some volatility is good. 00:25:56:20
Well, there are also perceptions to deal with because when market interest rates are volatile, some, for example, some in the press—I’m not sure you’re including yourself—are in this category of people that might criticize the Fed for allowing market interest rates to be quite volatile. Now, you know, again, a certain amount of volatility is good. But commentary in the press that questions the volatility is not a good look. And that’s one issue. Another issue is whether the Fed, you know, how much volatility the Fed wants to deal with. And at what point do they say enough is enough where we need to cool some of these, some of this volatility, by supplying more reserve balances? And when they do that, you know, this demand-based system where banks feel that they must go to the Fed to get more balances that’ll be dampened if they know the Fed is going to rescue them by putting more balances in the system. So it’s a tricky transition to a world in which you rely on banks to overcome the stigma and go to the Fed and get more balances, and that would be a good world to be in.
Two More: Reducing Demand 00:27:26:10
Two more in more detail. Well, I talked about hearing, I think, in enough detail, but I haven’t talked about how you could reduce the demand for reserve balances by retooling the payment system. So if you don’t mind, I’ll go into that. So the largest payment system in the world is called Fed Wire. It’s right now a real-time gross settlement system.
Waiting for good dough… 00:27:49:06
The handle’s about $4.5 trillion a day of payments by banks. Huge volume of payments. And, you can imagine that it’s pretty hard to do that many payments unless you rely somewhat on the payments you’re getting from others each day to make your own payments to others each day. So let me let me review that. Suppose you start the day with 100 billion in balances at the Fed, but you need to make 500 billion in payments. It sounds tricky, right? Yeah, well, that’s roughly the ratio that the largest banks in the US face. They have to pay out on the order of 505 times what they start the day with. How do they manage that? Well, they wait for other banks to pay them during the day before they make some of their outgoing payments. So you can pay out 50 and then get 50, and then pay out 75 and get 25 in, then pay off ten and get 50 so on through the day.
But here, Zero is an effective lower bound—00:28:45:14.
But they have to make sure they don’t go below zero. Yeah. Because that would be overdrawing. And since then that would run against our liquidity regulatory discussion where when you overdraft, that means you ran out of your own balances and you crossed that line of being self-sufficient or self-reliant on your own liquidity. So that that intersects with the liquidity regulation issue. So they don’t want to go below zero. And the largest banks have not been going below zero ever since. These modern liquidity regulations have come into place with extremely rare exceptions. So whereas before the financial crisis in 2007, for example, the largest banks were running intraday overdrafts that were very large, 130 billion was not uncommon on a given day. Today, if you’re not going to run overdrafts because you’re afraid of that bad luck, you’re going to stash a lot of balances up at the beginning of the day in order to make all of these outgoing payments.
Liquidity Savings Mechanisms—some already exist 00:29:43:01
Okay. So that sets the stage for a liquidity savings mechanism. Other large central banks like the Bank of Canada, the Bank of England, the European Central Bank, and the Bank of Japan have recognized that waiting for others to pay you before you pay out during the day is going to require a lot of reserves. And they’ve introduced liquidity savings mechanisms. These mechanisms are facilities into which the banks report and queue their outgoing payments, but they don’t pay them until other banks have queued their payments at multiple cycles a day. All of these queued payments are analyzed by the liquidity savings mechanism. And, say… Kathleen’s bank is paying Bob’s Bank 50 billion in this cycle. But it turns out that Darrell’s bank is paying Kathleen’s bank 60 billion in this cycle. So, Kathleen, you don’t need to take 50 billion off your shelf of reserve balances because Darrell’s bank is going to be paying your bank more than you need to pay out. So you’re not going to use any of your balances. Darrell’s bank is going to have to use some of its balances to manage, but not as much as you would without this liquidity savings mechanism.
The model? Matter meets antimatter? 00:31:04:22
So basically, it’s a way to cancel incoming and outgoing balances, you know, in a manner in which you don’t need as much of a balance to start with to manage all your payments. So it’s a much more efficient way to run a payment system if you’re interested in conserving your reserve balances, because you don’t need to make all of the payments out of your stash. You can make them out of queued incoming payments to your bank. It’s very efficient. And it’s been shown at other central banks to reduce the need for balances by, let’s say, 20- to 30-percent.
Some ‘buzz’ about this idea/Great idea/Dangerous, too. 00:31:52:20
Oh, there’s been a couple of recent papers that came out since my Brookings paper that mentioned this idea. One is by Dallas Fed President Laurie Logan. And her coauthor, Sam Schleifer. And one is by the Federal Reserve Board governor. Steven Miran. Okay. So they both mentioned, you know, they didn’t advocate for this. They just said this is on the list of things that could be considered. Well, if you could have it and not have to build it, in the first instance, that is, if you could magically wave a wand and the Fed could have this, it would definitely be a valuable thing to have. Okay. Because it gives the Fed a lot more options on, how much reserve balances it wants to have… On the other hand, it would be very costly to implement. You can imagine that you’re not just going to write a few lines of code and let it run loose in the world’s largest payment system.
Live at five, or six, or seven or… 00:33:02:19
Yeah. So, I mean, you’d have to, first of all, design it and test its effectiveness. Then you’d have to advise all of the largest banks how to use it. They’d have to retool their internal payment systems. And you’d want to test the heck out of this before you flip the switch on going live. And that would take years.
A promising idea 00:33:57:23
Oh, I don’t know. I don’t know how that would be implemented. You know, I’m just an academic. I’m just me. Oh, yeah. Throwing out these ideas. But… other
Other central banks found that they were very demanding of balance sheet space at the central bank. They required a lot of reserves to run. And they introduced these liquidity savings mechanisms very effectively. And they’re not looking backward. They like them well. So, you know, that’s a sign that it might be a good idea for the Fed.
Liquidity savings mechanisms and tiering 00:34:49.00
And that one is I’ve been doing some research on, on both these liquidity savings mechanisms and <tiering> a new paper that’s just finished with Professor Chowdhry and one at the University of Pennsylvania, Wharton School, and Shristi Singh at the University of Toronto. On the tiered remuneration. That’s research in progress with two of my PhD students here, Francesco Spitz, Loco, and Fanon. What sort of money? And that paper hasn’t appeared yet, but it will soon, I hope.
Fiscal deficit link to deficit size 00:36:06:17
Well, I’m not sure if you’re referring to the fact that, as the Treasury market has gotten so big because of fiscal deficits, financial markets have to deal with a lot more Treasury securities. And it does take a larger Fed balance sheet to manage that situation. So there is a connection that way. But the fiscal issue of fiscal deficits is not something for the Fed. It is something for the government. Congress to worry about. And, in my view, they’ve way overspent.
The Fed has kept its distance from fiscal folly. 00:36:50:23
Well, you know, there are suspicions that central banks, not just the Fed, could use their balance sheets to support the fiscal authority and buy government bonds when others won’t buy them at a sufficiently high price. And the Fed has not done that. It’s actually reduced its balance sheet to the extent that it can without blowing up money markets. So it has not been indulging in, you know, fiscal support for the government, but for those that are not educated on this, they could look at that large balance sheet and say, oh, I am suspicious that the central bank is supporting the government.” But in the United States, that’s not happening today.
US fiscal deficits are far more important than the Fed balance sheet. 00:38:03:07
The issue that you’ve raised today is the fiscal deficits of the U.S., which are far more consequential than anything related to the Fed’s balance sheet. If the fiscal authority doesn’t get its act together, the US is going to end up eventually in a debt crisis. And that, you know, that would be the worst possible thing for the US economy and US households.
The fiscal deficit, the ignored priority 00:38:22:14
So that’s number one on the priority list. That’s not something that you know. Well, actually, I’m doing some research on that as well, but it’s not even close to being ready. On the balance sheet issues and on other issues facing the Fed. Well, we know that they’re based on the recent FOMC meeting and the sense that there is some dissension at the Fed on monetary policy. Not related to the balance sheet, just related to the extent to which inflation is under control and therefore rates could be lower.
Job one at the Fed—not what you expect. 00:39:03:10
Interest rates should not be lowered or even should be raised. And so I expect that that’s going to be job one at the Fed. And is now and will be for some time. I think that’ll be the primary concern of the entire reform. See, including Kevin Warsh and these other issues will, you know, have to buy their time until the FOMC resolves its disagreements over monetary policy.
The Fed can walk and chew gum at the same time… Carefully 00:39:33:12
Of course the Fed can do many things at the same time. So maybe they can afford to study some of these other issues, like the balance sheet. But I don’t expect any movement on the balance sheet. Very, you know, very quickly, when he was testifying in his confirmation hearings in the Senate Banking Committee, he was—Kevin Walsh was asked, “What about the balance sheet? Are you planning to reduce it? And I don’t remember his exact words, but he said it, words to the effect that it would be a very deliberative, careful process, meaning he’s not just going to go in on day one and, say, sell a bunch of reserves.
Darrell at the Stanford Conference 00:40:27:21
…I’m planning to talk about the balance sheet, the same issues that you and I have discussed. And I only have 15 minutes. You’ll have a lot more on my views about this than I will be able to express on the panel, but I have a few slides.
Darrell Duffie
Darrell Duffie is the Dean Witter Distinguished Professor of Finance at Stanford University’s Graduate School of Business, a professor (by courtesy) at the Department of Economics, and a Senior Fellow (by courtesy) at the Hoover Institution.
Duffie is a fellow of the Econometric Society, a research fellow of the National Bureau of Economic Research, and a fellow of the American Academy of Arts and Sciences. He was the 2009 president of the American Finance Association. From October 2008 to April 2018, Duffie was a member of the board of directors of Moody’s Corporation. From 2013 to 2017 he chaired the Financial Stability Board’s Market Participants Group on Reference Rate Reform.
Duffie’s recent work focuses on the design and regulation of capital markets. His research is published in Econometrica, Journal of Political Economy, and Journal of Finance, among other journals. His most recent books are How Big Banks Fail: And What to Do about It (Princeton University Press, 2010), Measuring Corporate Default Risk (Oxford University Press, 2011), and Dark Markets: Asset Pricing and Information Trasmission in Over-the-Counter Markets (Princeton University Press, 2012).
