Dudley: The Fed’s Done All It Can Do, Recovery Depends On Stimulus

The Federal Reserve (Fed) has done almost all it can do to help the economy and now its recovery will rely on fiscal stimulus, said William Dudley, former president of the Federal Reserve Bank of New York in a recent online event.  

At the beginning of the pandemic and lockdown, the Fed created special liquidity facilities to make the market work.

“At this point there’s really not much the Fed has left to do that can replace the damage caused by the fall off the fiscal cliff. People expect to the Fed to keep monetary policy on hold for years, and the Fed expects to keep monetary policy on hold for years,” said Dudley, on a Zoom call with members of the New York Alternative Investment Roundtable, a non-profit organization committed to promoting education in the alternative investment industry.

Currently a senior research scholar at Princeton University, Dudley ran the New York Fed from 2009 to 2018. He also served as the vice chairman of the Fed’s policy board, the Federal Open Market Committee (FOMC). Prior to his time at the Fed he served as chief U.S. economist at Goldman Sachs (GS). 

He said the Fed’s economic projections of not returning to full employment before 2022, and inflation not hitting the Fed’s 2% objective, were reasonable. He added that the Fed saying it wouldn’t raise interest rates before 2022 is “telling markets that we’re going to be in a period of very low interest rates for a very long time.”  

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He said stocks are higher because the market has the sense that the Fed will be a backstop and last resort of reducing any illiquidity premium. 

“It’s also just a low interest-rate environment,” said Dudley. “People don’t want the return they get from U.S. Treasury notes. They want to earn more. That pushes them into the equity market and into the corporate bond market.

“In some ways the fiscal support may have painted a better picture of how things are than how they really are,” he said. “Because market participants aren’t really putting much weight on the fact that the long-term fiscal outlook for the U.S. is quite disturbing. When I look at the market, I’m not so worried about the equity market, because it doesn’t look particularly overvalued. But when I look at the 30-year Treasury bond around 1% that’s that seems pretty low. If we’re actually going to have success within a few years, the 30-year bond’s yield will have to move up quite significantly.” 

On whether it will be easier for the Fed to achieve its objective of a 2% inflation rate for an extended period during a time of reduced globalization and working from home, Dudley said there two factors driving the discussion. Over the short-term, excess capacity and the high unemployment rate will make it hard for inflation to manifest itself. However, over the medium term, there are potential sources of inflationary pressure such as lower productivity growth related to the “re-jiggering” of supply chains to make them simpler and bring activities back to U.S. 

He said the U.S. isn’t going to be as productive in terms of producing goods and services, which will increase costs. On top of that, the growing redundancy of supply chains will produce a productivity consequence that will eventually feed into inflation.

“At the end of the day, inflation’s about pressure on resources,” said Dudley. “It’s going to take a few years for that pressure to materialized. I’m not too worried about an inflation problem over the near term, but I certainly think the Fed can succeed in its 2% objective over the longer term.”

He said the reason why the Fed is so focused on inflation is that it worries that the U.S. could end up looking like Japan, where inflation expectations are significantly below the Bank of Japan’s inflation objective.

“When that happens that’s a defect of the tightening of monetary policy, because real rates of interest climb, and that’s what the Fed is trying to avoid,” said Dudley. 

On the topic of the federal government’s budget deficit ballooning to historic proportions, he said: “Obviously there’s a consequence in terms of the intergenerational cost of having to pay the interest on that debt But the common views about the federal debt have become much more benign in recent years. And that’s because real interest rates are so low. So, the cost of managing the federal debt has been much more modest.” 

He said today’s federal debt is about three times the amount prior to the Financial Crisis of 2007. Yet, debt service costs have gone up only 10% to 20%, because interest rates have fallen. This has made the debt service burden manageable despite its huge amount. This situation is possible as long as rates stay very low.

However, if in five or 10 years people start worry about the size of the debt, this will increase the premium in the bond market and the dollar will start to weaken. These factors will generate more inflation and higher interest rates, which will cause debt service costs to rise suddenly and rapidly. 

“I think at some point the U.S. is going to get to that point,” said Dudley. “A really good adage in economics is, ‘There’s no such thing as a free lunch.’  So, if you believe deficits can be as big as you want, you’re sort of believing that there’s a free lunch, and I just don’t believe that.”

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