MNI: Transcript of Interview With Ex-KC Fed President George

The following is a transcript of an interview with former Kansas City Fed President Esther George, recorded Tuesday after the October CPI figures, as the latest episode of MNI's FedSpeak Podcast. It has been edited slightly for brevity and clarity.

What did you make of the October CPI figures? How confident are you that the recent decline in inflation will continue?

There’s no question this was a positive number and that is welcome progress when you think about where we’ve come with the highest inflation we've experienced in this country since I started at the Fed to be honest. Good news for sure. I want to just hold a bit of my cheering though for this report because I’m reminded that the Fed has not accomplished its task of getting back to 2%, and so, welcome news, we should continue to watch how inflation unfolds in the economy. But I think we need to be reminded that there is still room to go for the Fed to achieve its objective.

Is the Fed done raising interest rates? The market seems to be thinking that and policymakers seem to be setting a high bar for additional hikes.

I do expect that they have hit a peak in terms of the interest rate. And I’m supportive of the idea that pausing is a good idea at this stage because this has been a very aggressive rate hike and I’m among those that think that policy lags are real and that we have not yet seen them go fully through the economy although they did hit our interest rate sensitive sectors quickly.

Also, keeping in mind that while the Fed did come out early talking about transitory inflation, there’s no question that the pandemic brought about a supply shock to the economy that we’d not seen in a long time. That too is working its way through. So the combination of things – the lags, the imbalances getting sorted out - I think are sure to have an effect here that allows the Fed time to do that.

There are real signs in the economy that these interest rates are continuing to have a bite in terms of growth and in terms of credit conditions.

Why do you think growth and employment have remained so resilient despite the Fed’s more than five percentage points of rate increases?

You only have to look back to trillions of dollars that came into the economy from fiscal authorities. Setting aside monetary policy, which we’d gotten quite used to coming to the rescue with zero interest rates and QE and forward guidance – that was all in place, but what was new this time is this was a tremendous flow of money from the government’s balance sheet to households and businesses. That had a big impact. And that was a time when labor supply was tight, so people’s wages were rising. The combination of a tight labor market and the money from the federal government allowed not only the consumer to be resilient but the performance of the economy overall has been on a sugar high from that.

Chair Powell has said the Fed is not confident it has achieved a sufficiently restrictive stance. Is that a way to leave open the door to another hike without committing to one?

I think the FOMC has to be quite clear that it is not mission accomplished until they have 2%, and not just one data point of 2%, but sustained in a way that they are confident. In today’s world it’s really hard to say with any degree of confidence, "I’m done, I won’t do any more," until you get closer to that.

(There’s) all kinds of speculation about when rate cuts will begin and obviously as the economy cools that will be one of the most challenging issues, I predict, for this committee – is really thinking about how they move (through) this last mile. How much they buy into inflation getting back to target. As inflation falls that policy rate gets more restrictive if they don’t move it. There's not an easier path for them between now and the time they fell more confident about that 2% objective.

What does higher for longer mean in practice? Is it hard to message to the public and to markets rate cuts if it is about lowering nominal rates to keep real rates constant?

It’s very hard to message. Higher for longer by it’s very name is a relative kind of positioning for policy. So you might say higher for longer relative to zero interest rates the economy experienced for so long with relatively low inflation. For me the point is really, they will have to calibrate, and I suspect recalibrate that policy rate, as they watch the economy cooling. This has been the whole discussion behind soft landings. Will you get a gentle glide path to a good place that tells you to do that?

I’ve not been one to really embrace soft landings, not because I don’t want them or because I don’t think it would be a terrific outcome for the economy, but that is just very difficult to do when you have a blunt instrument like a short term interest rate and you’ve got a big balance sheet you’re committed to bringing down quickly. Those are a lot of moving parts - in a very generalized sense - to be able to fine-tune to something like a soft landing. So I think there could be more challenges to come as they try to see where the economy is relative to that interest rate.

Is it too soon to begin talking about the timing of an eventual rate cut? Do you have a sense of when the Fed might be pondering a cut?

I suspect as you see in the markets today, there will be a lot of pressure to talk about rate cuts. We will get a chance to see at the December meeting the dot plot and see how individual members of that committee might be thinking about the long-run path. What this committee is going to be very challenged to do is not to derail the economy, not to do damage to it, and yet not to have inflation hang around too long over target and unseat what they’ve been very proud of, and that is anchored long-term inflation expectations. That will be a balancing act. Both will require thinking about: "When can we ease off policy but not completely take our foot off the break here when we think about getting back to our target."

How much does the fact that 2024 is an election year complicate things?

I don’t think it will complicate it for the committee but I think there will be a lot of noise around that, as there always is. It is a challenging time always for the Federal Reserve in a tightening cycle. No one really comes after you when you’re cutting rates, but when you’re raising them, when policy is restrictive, that can draw a lot more commentary and consideration, particularly in an election year. I think the committee will keep its head down on that issue but there will be a lot of noise around it for sure.

As a former bank examiner, how do you view the March banking turmoil? Is it over or just dormant, given that the same issue of higher yields that hurt those banks has only gotten worse since?

One of my takeaways from the experience of the 80s and 2008-9 is a reminder of the lags of policy and how they directly affect the banking system. The last tightening cycle going back to 2005, we didn’t see much going on for a couple of years until that caught up and really hit the economy hard. It’s one of the reasons I’ve tolerated this idea that lags could still be working their way through.

If you look at the banking sector in particular, the fact that rates moved so aggressively was always one of my concerns about the side effects of this policy. Not that you didn’t need to get rates up because of high inflation but there is always an impact to that. One of the first impacts you see is the banking system came through this pandemic and was the recipient of a lot of deposits and you have to deploy those deposits and if you took the Fed at its word with its forward guidance that rates might stay low for a while, you might have been inclined to go out on the yield curve in order to a return on that money. When rates began to rise rapidly of course your portfolio is under water and they’re underwater today, which is why I’m not terribly sanguine about credit conditions.

I think banks are only one shock away from having some problems, or we are beginning to see some of the early signs of credit turning, both a tightening of their own credit policies but also some delinquencies. If you think of the real estate sector in particular, a lot of those credits are going to be coming up for renewal. It’s hard to know whether this is a macro event for the banking system. We just saw Governor Barr and his report to Congress on supervision and regulation which was again saying resilient and sound banking system. That is usually true until it’s not. Again, the vulnerabilities in our banking system are always important to watch. We saw last March some of the early effects of that but it doesn’t mean we don’t have to keep thinking about that for the banking system going forward.

The Fed intervened in March by creating the Bank Term Funding Program, do you expect them to renew the facility before it expires early next year?

That will be a very difficult decision because it will require thinking about, are we through this period, is there no reason to worry about contagion? That will be coming at a time, I predict, when credit conditions could be souring a bit, when you could begin to see, as customers renew, or come back to the table for refinancing, there being some issues there. I think there will be a lot of pressure to try to provide a support like that. Whether that can expire as the agencies did when they looked at things like the leverage ratio, I think they’ll also have to be considering that too. For small banks in particular this has been a pretty important facility for them as deposits when rushing towards, frankly, some of our too-big-to-fail banks.

What do you think is driving long-term Treasury yields higher? Does the recent retracement undermine some of the idea that higher rates were doing the Fed’s job for it?

Chair Powell mentioned in his press conference the persistence of a move like that would really be the telling factor in what it meant for monetary policy. We’ve seen an example of that proving not to be persisting yet. But when I look at the myriad of factors that everyone is wrestling with – is it term premium, is it the outlook for the economy, does it have something to do with our fiscal situation and demand for Treasuries that could be driving that? All of those I think are fair game right now. Pinpointing any one of those is an exercise in dancing on the head of a pin right now.

As an FOMC member you were considered a hawk at times, in part because of your reluctance of balance sheet expansion. What do you make the process of reversal and how long do you think QT can go on?

As an instrument of policy, there’s a lot more to learn about quantitative easing and quantitative tightening. Having said that, I’m also mindful that we don’t have many experiences with this policy instrument. Think about how it was used during the financial crisis and how slowly and gingerly the balance sheet runoff was slowed down and eventually stopped at a pretty high level because the committee shifted to having a different reserve regime for setting its policy.

When you contrast it with where we are today – nearly double the rate of runoff, double the size of the balance sheet - it’s a pretty aggressive shrinking of that balance sheet and one that I supported. I’d love to see the central bank get back to its smallest footprint in our markets.

So when you see this very rapid runoff, so far so good. We’ve seen about USD1 trillion of shrinkage in that balance sheet. It looks like there are still plentiful reserves in the system. The overnight reverse repo facility is also beginning to come down. So there’s room, it would look like, to continue that.

But I’m also mindful that we were a buyer of Treasuries at a time when we are looking around the world to say the Treasury is issuing a lot of debt, the interest expense on that debt is creating an even more unsustainable path for fiscal and the Fed is now backing away. So I think this bears watching and I look at this carefully in a tightening cycle to say, it’s not just short-term interest rates. We're pulling back on these long-term rates that were so key to the Fed’s monetary policy. This is a bit of an experiment in terms of this rapid runoff. There is a lot to be observing here and I hope a lot for economists to be researching in the years ahead.

You’re now a board member at the Center for a Responsible Federal Budget. How worrisome is the U.S. fiscal picture and how significant is the Moody’s outlook cut for the country’s AAA rating to negative?

It’s very concerning to me and I say that in the context of knowing that the dollars, the Treasuries that the world seeks are still a safe haven. So I understand that given that we are the US we have given ourselves a lot of runway for a long time of knowing that we are on an unsustainable path.

What I don’t think we can ignore anymore is that … it’s not just will something break tomorrow, it’s what we are shoving into the future on generations that will make it exponentially more difficult if not impossible to address. These are very important issues that ratings agencies are pinging their ratings right now I think is actually a worthwhile thing to get the attention of policymakers to be reminded that yes, we’re the United States, we are the world’s reserve currency but that isn’t a guaranteed position. That is a position that is hard-earned around good policies and prudent fiscal discipline. It will be critical that we get refocused on that issue in the coming months.

We are again days away from a possible government shutdown. How much does political dysfunction affect your concern about Washington’s ability to get its house in order?

It’s very important. Good governance is essential for any business I know. It’s certainly true for public authorities to think about good governance. These are hard issues, there is no question. This is not as straightforward as saying if we just cut spending we can get back there because it also is likely going to require looking at the revenue side as well. And each of those components is going to hit somebody’s preferred program, preferred view of how that should be handled. It is so challenging as the stakes get higher.

What’s important though - and you’ve seen some members of Congress sign onto this idea of a bipartisan commission - is this is one of those times when it’s going to be really important that everyone understands that there’s a sense of shared sacrifice. This is something that we’re going to have to do collectively for the greater good. The government shutdown is really unfortunate because it doesn’t accomplish anything. It provides a platform to talk about what you don’t like, but it doesn’t really move us down the path of finding something that we can do. I am hopeful this idea of a bipartisan commission can take hold.