Bill Dudley Returns: Central Banking During Covid and the Turns of Economic Orthodoxy

Bill Dudley is a senior research scholar at Princeton University’s Griswold Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee (FOMC). He was previously chief U.S. economist at Goldman Sachs. 

He previously came on our show on April 2nd, 2019 to reflect on his career, and he now returns to discuss monetary policies during Covid, the efficacy and necessity of fiscal stimulus, inflation outlook for 2021, the Fed’s switch to “average inflation targeting,” Modern Monetary Theory (MMT), and some of the gravest challenges confronted by central banks today. 

We started the conservation with a review of the Fed’s unprecedented actions in response to Covid. With the exception of the Main Street Lending Facility, every new policy tool worked well, especially new facilities for public and municipal bond markets. The Fed successfully supported market function and financial stability. 

The Fed’s ability to further stimulate, however, is now very limited. What else can it do more? It can buy more asset-backed securities (ABS), mortgage-backed securities (MBS), and other long-term assets. It could also engage in yield curve control or make interest rate negative – though all FOMC members have been opposed to this proposal. But even if the Fed does all this, the effect on the real economy still won’t be too much more. 

Average Inflation Targeting was a switch of the Fed’s monetary policy framework introduced this fall in hope to further stimulate inflation. Prof. Dudley indicates how it seems small on paper but could have significant consequences. When the Fed has been missing inflation on the downside for many years, it makes the inflation expectation too anchored to the downside, and monetary policy becomes too tight. Under the new regime, the Fed won’t so easily tighten monetary policy. However, once the U.S. economy returns to full employment, the Fed would likely tighten monetary policy by more because inflation will be higher than 2%, and the Fed would then need to bring down the employment rate to the sustainable level. 

The Fed will likely keep the interest rate at zero until three conditions are met: maximum employment; the economy actually hitting 2% inflation; and the Fed expecting inflation to rise above 2% for a period of time. There are a number of reasons to worry about inflation once we get out of the current recession, but we won’t see broad-based inflation anytime soon. 

Prof. Dudley wrote in his recent Bloomberg column “Five Reasons to Worry about Faster U.S. Inflation” that “Fiscal orthodoxy has shifted: Instead of worrying about rising federal debt burdens, economists now see much greater scope for aggressive action to offset significant shortfalls in demand. As a result, the government probably won’t want to remove fiscal stimulus as quickly as it did after the 2008 financial crisis (a move that led to a disappointingly slow recovery).” Is the tide turning? Are we turning towards Modern Monetary Theory given how the low interest rates and low inflation now make full employment less likely. How does Prof. Dudley respond to these arguments? 

A more fundamental question would be: What is the role of central banks, in and outside the context of a pandemic? We saw from the Volcker period when the Fed independently took a firm stance on hyperinflation and acted against many electoral interests. We saw in the Great Moderation period that central bankers actively tried to erase volatility from the markets. We also hear critiques from public intellectuals like Nassim Nicholas Taleb that central banks should try to minimize harm rather than coming up with policies with unintended side effects. What is Prof. Dudley’s philosophy? 

Through this far-reaching conversation, we hope to shed light on some foundational issues in central banking and financial history, rooted in but also beyond the current events in economic policy and Covid-19. 

Bill Dudley