A small cadre of Federal Reserve officials is pushing to start tightening monetary policy, even if ever so slightly. Dallas Fed President Robert Kaplan was the first to speak up publicly.
Previously a professor at Harvard Business School and a 23-year veteran of Goldman Sachs, Kaplan isn’t a voting member of the Federal Open Market Committee (the central bank’s policy-setting arm) this year, but he will be in 2023. Kaplan is wary of rising inflation, which he views as more persistent than do some of his colleagues, and he is warning of excessive risk-taking and the unintended consequences of policy that is too loose for too long.
Kaplan is also a reminder that everything is relative: He may be one of the most hawkish Fed officials, yet he says it’s too soon to talk about raising interest rates. He advocates gradual tapering and, on balance, sounds more worried about economic growth beyond this year than runaway inflation. Barron’s spoke with him about the direction of the economy, monetary policy, and financial markets. An edited version of the conversation follows.
Barron’s: Walk us through the much hotter-than-expected inflation data we’re seeing.
Robert Kaplan: Our estimate right now at the Dallas Fed is that headline inflation, as measured by the personal consumption expenditure [PCE] index, will end this year at 3.4%. That’s a highly elevated number, [but] if you look ahead to 2022, that headline PCE reading will moderate to something in the neighborhood of 2.4%.
That’s still well above the Fed’s longstanding 2% target. Does this point to more persistent inflation?
Some of the price pressure will moderate as we work through these labor supply/demand issues. Some of these pressures will be more persistent, and you will see some broadening, or what we call “bleed.” If raw-material prices are higher this year, that could bleed into goods and services. Elevated home prices will eventually bleed into higher rents.
Investors are trying to understand what Fed officials mean by “transitory” or “nontransitory” inflation.
I’ve avoided those terms. I prefer to refer to them as impacts that are cyclical and relate to the reopening, or others that are more secular, more structural, and therefore more persistent.
So, is the current level of inflation concerning? Or cyclical?
I guess a little bit of both. I’m very mindful that monetary policy and the work we do needs to be forward-looking. If you could just call timeout and stop the music right now, it looks to me that inflation expectations are manageable, and not inconsistent with our 2% mandate.
But what has happened up to now isn’t as relevant as what happens in the future. And I’m sensitive to the fact that you have several more months of elevated inflation prints. That could start to seep into inflation expectations, and that’s why it’s also important that the Fed emphasizes that we’re vigilant to these trends and committed to anchoring inflation expectations and inflation at 2%.
You’ve said that the Fed should begin to gently take its foot off the accelerator, in order to lower the probability of having to hit the brakes later. What does that mean?
I would start with the $80 billion of monthly Treasury purchases and $40 billion of monthly mortgage-backed securities purchases. Those purchases were highly appropriate in 2020, when we were in the middle of a crisis, in the same way that, in the aftermath of the Great Recession, we were very concerned about a lack of demand.
As we now move from early 2021, we’ve had accelerated vaccinations. We’re expecting very strong GDP growth this year. We are making progress in not only weathering the pandemic, but on our employment mandate and our price-stability mandate. I, for one, think that these purchases are less suited to the current situation, where we have plenty of demand and all evidence suggests the consumer is very strong.
With your preference to begin tapering sooner rather than later would you have dissented at the last FOMC meeting, had you been a voter?
Let me answer this way: We’re in a much better place now that we are having an active, open debate about our adjustment of asset purchases.
Do you worry about the market’s reaction to tapering?
We’ve got to be very sensitive to the lessons of 2013, and when we start tapering, it has to be well-telegraphed and it has to be gradual. We also must keep in mind the substantial amount of pension-fund money in the U.S. looking for fixed income. For many of them, there’s a core investment in the Treasury curve. Globally, our rates are relatively high, so there’s a bid for U.S. dollars and for Treasuries. I think we’re fortunate, and we’ve got the ability to successfully execute this.
Are there more risks in tapering too early, or too late?
Doing these purchases for longer than necessary creates excess imbalances in the economy, in financial markets, and certainly in the housing market. It would be healthier to be weaning off these extraordinary measures sooner rather than later. That would give us more flexibility down the road.
You don’t want to be so preemptive that you suffocate growth and getting to full and inclusive employment, but you don’t want to be so late as to be reactive and having to take more abrupt or severe actions. That’s the trade-off we need to be debating.
Given that the Fed has said it would like to see “substantial further progress” in meeting its inflation and employment mandates, what do you mean by “sooner rather than later?”
I’ve been careful not to give a calendar date, but we are going to achieve “substantial further progress” sooner than people think. If I’m driving and see potential obstructions and risks on the road, I’d rather tackle those risks going at 55 miles an hour than I would at 80 miles an hour.
I’m very glad we’re now having the discussion about adjusting these purchases. And yes, I’m deliberately saving my specific comments on the calendar for my Fed colleagues in the privacy of an FOMC meeting. But I think people can tell what I mean when I say sooner rather than later.
Are you concerned about the housing market, and the impact of mortgage-backed bond purchases?
Home prices are historically elevated. We know that. And in addition, we’re hearing more and more that the winning bidder for many of these single-family homes isn’t a family: It’s a fund of some type, not domiciled in our district, buying sight-unseen and planning to rent it. More and more families are being squeezed out of purchasing a home, particularly first-time home buyers and across at-risk communities. This is having ripple effects, in terms of higher rents and higher property taxes.
What do you say to would-be first-time home buyers? Will prices come back down, or is it over for a lot of these people?
In this job, I’ll stay away from predicting where markets or home prices are going. But I will say this: At this stage, the unintended side effects of these asset purchases are starting to outweigh the benefits. I certainly don’t think housing needs the type of Fed support we’re providing right now. We’re buying a substantially large percentage of net new issuance of agency mortgage-backed securities, and the option-adjusted spreads are historically low, and sometimes negative.
In the last tightening cycle, before the pandemic and with unemployment at a 50-year low, the Fed wasn’t able to raise rates above 2.5%. Since then, households, businesses, and the U.S. government have accumulated more debt. Why would the Fed be able to tighten now?
I don’t think it’s appropriate yet to be talking about rate increases. As we get through this crisis, we’re going to have very strong growth in 2021. It’s going to moderate to some extent in 2022 and in 2023, and we’re going to gravitate back down to trend growth—something like 1.75% to 2%.
Is the Fed boxed into ultralow interest rates forever?
I do worry about excess risk-taking. I’m not smart enough to know whether certain markets are in a bubble, but I focus on investors moving out on the risk curve. Savers are unable to earn on savings, and they’ve got to take more risk.
When the stance of monetary policy is such that people need to move out on the risk curve—even people who probably otherwise really shouldn’t be taking that much risk—I worry about the impact of that. When they [eventually] want to derisk, it makes them vulnerable to a scenario where you could have a severe tightening of financial conditions, a widening of spreads [between higher-yield and investment-grade bonds] as people realize they are overrisked and [need to deleverage].
That’s something you have to tolerate when you’re in the middle of a crisis, but it’s healthier when people can have more-balanced risk profiles.
What do you say to criticism that the Fed has become too beholden to the financial markets?
Our main focus needs to be doing what’s right for the economy. But it’s wise to acknowledge the impact that our asset purchases can have on financial assets, and some of that criticism is healthy for us to acknowledge.
One of the things that comes with these extraordinary monetary-policy actions is the positive effect on financial assets. It’s also the reason why, as you emerge from the crisis, you want to wean off these extraordinary actions sooner rather than later.
Thank you, President Kaplan.
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