The Big Question: Does Forward Guidance Work?

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Hal Weitzman: With official interest rates near zero in many industrialized economies, in recent years central banks have turned to new, unconventional ways to promote economic growth. Among them, offering forward guidance in which they publicly share their views on issues such as when quantitative easing will be cut back, and when rates might start to rise.

Top central bankers, including Janet Yellen at the US Federal Reserve and Mark Carney at the Bank of England, are strong supporters of the policy. But not everyone is convinced. Critics say the criteria for raising rates have been changed so many times as to strain credibility. While others say forward guidance can prompt investors to take on excessive risk. Some say the whole policy is a bit like trying to play Jedi mind games with the markets.

So what exactly is forward guidance intended to do? Does it work? Does it do more harm than good? And, why is there often miscommunication between central bankers and the markets?

Welcome to The Big Question, the monthly video series from Capital Ideas at Chicago Booth. I’m Hal Weitzman, and with me to discuss the issue is an expert panel.

Eugene Fama is the Robert R. McCormick Distinguished Service professor of Finance at Chicago Booth. Well known for his empirical analysis of asset prices, and for developing the efficient market hypothesis, he was the joint recipient of the 2013 Nobel Prize in Economic Science.

Randall Kroszner is the Norman R. Bobins professor of Economics at Chicago Booth. He was a governor of the Federal Reserve from 2006 to 2009, and a member of President George W. Bush’s Council of Economic Advisors from 2001 to 2003.

And Anil Kashyap is the Edward Eagle Brown professor of economics at Chicago Booth, and a faculty director of the Initiative on Global Markets. He’s an advisor to the Federal Reserve, the IMF, the Congressional Budget Office, and the Swedish Central Bank.

Panel, welcome to The Big Question.

Randy Kroszner, let me start with you. How should we think about forward guidance? Is it just a way for central bankers to tell people what they’re thinking, or is it actually a form of intervention in itself?

Randall S. Kroszner: Well there’s a couple different purposes. One is it potentially can provide more clarity to the thinking that the policy makers have of how they’re gonna deal with data that comes in. So in principle, what it can do is help to reduce uncertainty, that would be the best outcome of having greater transparency. So if you look at, let’s say, the futures markets where people are betting on interest rates, if you can reduce some volatility there, that seems like a good thing. Rather than have fed policy increase then.

In addition, it potentially could try to be used as a way to affect interest rates down the line, rather than just short rates today, which is traditionally what central banks did. It could be trying to affect rates today, tomorrow, next year, and maybe even two or three years down the line. And I think that if you look at the market reactions to the Fed’s statements, typically those futures markets did move, usually in line with where the Fed wanted them to move.

Hal Weitzman: So in your view it’s been a success, achieved what it was supposed to achieve?

Randall S. Kroszner: Broadly, yes. But obviously there’s some bumps along the way. Nothing is perfect. No new instrument is perfect.

Hal Weitzman: OK, that raises the bigger question, Eugene Fama, whether central banks really control longer term interest rates, which, your research casts doubt on that. So tell us your view.

Eugene F. Fama: Well, longer term interest rates are pretty clear they don’t. With respect to short rates, it’s not even clear they have much effect on the short rate. The best estimate I could come up with was if you look at the response of interest rates to changes in the target fed funds rate, for example. Basically, 17 percent of the response is to the Fed’s announcement, and 83 percent of the total change in the interest rate is just the Fed following open-market rates. So I think the actual responses that have to be put in place in order to bring about a reasonably large change in rates is so enormous that they are out of the range of the Fed. I don’t know if you want me to continue—

Hal Weitzman: Sure.

Eugene F. Fama: For example, I think the last five years has been the best experiment we could have in that respect, in the sense that the Fed began to pay interest on reserves. It’s slightly above open-market rates. They basically dumped $3 trillion-worth of short-term debt on the market, and the short-term rate didn’t move at all. It should’ve gone up. They take credit for the rate being low, but in fact what they’ve been doing should’ve raised the short rate.

And then there’s lots of ambiguity about the effect that that’s actually had on this, so-called quantitative easing has had on the long rate. If you look at the term structure, the slope after 10 years is just about, the difference between the short and the long rates is just about the historical average, so it’s not clear what effect they’ve had on the long rate with all of this stuff. I think it’s all posturing basically, but.

Hal Weitzman: So does that mean forward guidance is irrelevant?

Eugene F. Fama: No, no, no I agree with Randy that if it reduces . . . These are informed economists talking, I mean, probably as good as any on these topics, so if it reduces uncertainty, and it provides information about what people think about the economy and what the Fed is likely to do in the future, even though it doesn’t have a great deal of effect, if it reduces uncertainty, that’s always positive.

Hal Weitzman: Randy Kroszner, what do you think about the longer-term effect that this has on rates?

Randall S. Kroszner: I’d be curious to see what Gene has to say, like when the Fed statements came out, let’s say when they first introduced the aspect of forward guidance of saying to a particular date, the fed funds futures market really moved pretty much directly to that, so that would suggest that there is some sort of market response, and pretty much exactly what the Fed had said that’s where the market’s moved.

Eugene F. Fama: But that’s, the maturity of the contract’s there is pretty sure. So you’re not looking out a great distance.

Randall S. Kroszner: About two years.

Eugene F. Fama: When you look at the response of the fed funds rate itself, as I said, most of it is to the level of existing rates, and then you have to look long afterwards. So there might be a particular response on a given day, but then you’d have to follow it and see whether, does it dissolve in the next week or so, or does it really stay there.

Randall S. Kroszner: I think it generally stays. So let’s say, when they first introduced the particular date and said, I think it was mid-2014, end of 2013, which is about 18 months and two years hence, you really did see a move, and it stayed there for quite some time.

Eugene F. Fama: OK, but we’re gonna have to collect a lot more data on this though.

Randall S. Kroszner: For sure. Yeah, these are just a few anecdotes recently.

Eugene F. Fama: Right, right.

Hal Weitzman: Anil Kashyap, let me bring you in. What’s your view? Does the Fed guide the market or the other way around?

Anil K Kashyap: I mean, we’re five years into this, and I think the events of the last week show how much trouble they’re having. So Chairman Yellen at her first press conference, perhaps regrettably, said I think we could start raising rates six months after we end tapering. And the market saw that as news. I think there’s been good research in the past saying that actions speak a lot louder than words, and so I think forward guidance for a while could produce uncertainty, but at some point you have to back it up, and the trouble that the Fed’s having right now is people wanna know: Are you really telling us you’ve changed your preferences, and the way you’re gonna respond to incoming data, or are you trying to clarify? And it’s getting harder and harder to keep saying, well we’re just clarifying, because if the economy’s improving, normally, they would let rates start rising.

Hal Weitzman: And that’s, sorry, I was gonna say that’s one of the problems isn’t it, with forward guidance, is it’s often very unclear to the markets what it means, and some have said that forward guidance is sort of a weak version of a rule, a firmer rule. Should we, instead, have a rule?

Anil K Kashyap: Well if you wanted to have a rule, you’d live with it in both directions. In forward guidance, we’ve had the easy part where you say we’re gonna keep things low. And we haven’t really seen what happens when you try to get out. If you had a rule, maybe it would’ve said rates should stay low right now, but at some point, it would be clear there’d be a liftoff and you wouldn’t be fighting it, and I think over the coming months they’re gonna have to decide are we really gonna fight the perception that the data are improved, and that rates should start rising? In which case, you’ll run into some of the stuff Gene said, of, you know, how much are you willing to move your chips into the table to keep reinforcing that? I don’t think talking will keep working.

Hal Weitzman: Randy Kroszner, what’s your view on the idea of having firm rules that the central bank wouldn’t be able to, you know, it will be more predictable about when rates would rise, or whatever?

Randall S. Kroszner: Well, I think there are broad guideposts that are out there, sort of a 2 percent inflation goal, and they had been, many central banks had been using an unemployment goal or threshold for a certain period of time. But economic circumstances change, and so the intentions may still be the same, but you need to talk about it differently.

For example, when the Fed has now stopped talking about a 6.5 percent unemployment threshold, part of the reason for that is because one of the things they didn’t anticipate was that the unemployment rate was coming down, but for the wrong reasons. There are fewer people working in the labor force, and fewer people looking for jobs, so smaller labor force. So the unemployment rate’s coming down for the wrong reasons.

So normally, you know, that’s a pretty good rough proxy for the state of the labor market. It hasn’t been recently. And so it was natural for them to sort of say, well, we need to change what words we’re using, because our intentions are the same, because if you use the same words, you could get confused and think that our intentions had changed.

But that was, at one time, talked about is the Evans rule, the 6.5 percent unemployment rate, so there was at least a suggestion that it was a rule, then it was changed to something that some people would say was hopelessly sort of vague and somewhat meaningless, a much broader view. So at least if you give a specific target, a specific rule-like gauge, then isn’t that clearer through the markets?

Randall S. Kroszner: Well, yes and no. Because the rule then boxes you into the unemployment rate, for example. And there could be a lot of other things that are driving the unemployment rate rather than, kind of, on average in the long run, you know, when you have more economic growth then you have a more robust labor market, you have an unemployment rate coming down. That’s natural.

But during the last few years, we’ve seen the unemployment rate come down, and it hasn’t been a sign of economic strength or labor-market strength. So I think it’s just natural in those changed circumstances to say, well, our intentions are the same. We haven’t changed our intentions, but we have to change the way we talk about it. And the Fed’s done this over time. When I was there, we had introduced the idea of extended period, fairly vague, then made it more concrete by saying particular dates, but those dates kept moving out, then moving onto an economic variable, like 6.5 percent unemployment, but now that circumstances have changed, the intentions haven’t, but you should use different words to try to convey the same kind of message.

Hal Weitzman: So it wasn’t a mistake in the first place to say 6.5 percent unemployment is the target?

Randall S. Kroszner: Well it wasn’t a target, it was a threshold. But I think it’s natural. I think people get confused about forward guidance that it’s about the words, and it’s not about the words. It’s about the intentions and a way to filter the data, and it can be helpful to use these guideposts.

But the Fed had always said they’re also looking at broader labor-market indicators, and if this is not a good labor-market indicator, they’ll look at something else.

Hal Weitzman: Anil Kashyap?

Anil K Kashyap: I think most bond market traders have attention deficit disorder and they viewed 6.5 as a promise. And, I think it’s very, very hard for the Fed to give these nuanced signals. They, at some point, will need to back them up, and then we’re gonna see where the rubber meets the road, But, I understand the logic of all this, but I think it’s very, very hard to calibrate these things, and it’s almost just too subtle by half.

I mean, when they were really deep underwater, it was easy to say this and it was a long way off, and now we’ve got into the zone where judgment’s coming in, and that just makes it so complicated.

Hal Weitzman: And another important aspect of this is credibility, right? Some people said when the Fed changed its, or updated its guidance that it was effectively losing credibility, because it sort of takes a view after the fact that, well that wasn’t quite the right kind of unemployment or whatever it is. Gene Fama, what has this done to the Fed’s credibility, this whole experiment?

Eugene F. Fama: (laughs) You’re asking the wrong person. I didn’t think they had any credibility to begin with, so. I mean in credibility in the sense of real effects, I mean, I don’t think they really have that much. So for example, if they thought they wanted the rates to rise now to 1 percent, how many trillion dollars worth of buying would they have to do as people flooded them with assets that they wanted to exchange for reserves?

That number could be $10 trillion, could be even bigger. Because what we see is basically that short-term rate is the same everywhere in the world where there are risk-free overnight assets. So there’s always this conundrum that amuses me that every central banker controls interest rates and they all agree they’re working in an open international bond market. Those two things are inconsistent, so.

I’m the class curmudgeon all the time, you gotta live with that.

Hal Weitzman: Randy Kroszner, what about credibility? How is this, I mean, how are these changes in the language? How do they affect what the markets think of what’s being said?

Randall S. Kroszner: Well, as I’ve mentioned before, the language has changed over the past five years, so it was extended period, particular dates, and a few of those were changed, then 6.5 percent, and now sort of broader labor-market indicators.

But I don’t think you’ve seen sort of an explosion of uncertainty or sort of significant market dislocation when these changes have occurred because it’s just a way, trying to provide the broader framework for the intentions for how to filter data generally. It’s not about the particulars of the words. It’s trying to convey broadly what the Fed is thinking and how it’s going to react. It’s by no means perfect, and I think it in some cases introduces uncertainty, but I think in most cases if well done, helps reduce uncertainty.

But that’s one of the challenges with this. Exactly as Anil said, it’s hard to calibrate these things, to use so many words rather than the traditional tools of just buying and selling assets. So I call it open-mouth operations rather than open-market operations. We don’t have as much experience with it, and as Gene was saying before, we don’t have the data to really be able to say, aha, this now works and this is different. I think over the last five years, we’ve seen a lot of evidence of that but we need more data to be able to say that systematically.

Anil K Kashyap: One thing that you see is that the statement they release after every meeting is getting longer and longer and longer. And so that’s the best indicator that we’re slipping into uncharted territory. I think we saw last summer the so-called taper tantrum, where the Fed hinted that maybe they were starting to get out, and you saw a big kinda risk-off event in a lot of markets.

I think until we see somebody get out of all of this and see that the interest rates don’t kinda shoot back up and essentially undo all of the polling forward of stimulus that they’ve said they’ve accomplished, we’re not going to really be able to give a grade. I still think it’s very much incomplete and until they get out, we’re not going to really know.

Hal Weitzman: OK, Gene Fama, your view is that the Fed doesn’t really control what it thinks it controls.

Eugene F. Fama: Well, you know at best what it should be doing is twisting the term structure, and I don’t think there’s much evidence that that’s happened. So getting out, if they want to, I don’t think they’ll do it, but if they want to sell long bonds and redeem the reserves that way, it’s easy to get out.

When people talk about they’re stopping quantitative easing because they’re trimming back on, instead of $85 billion a month you go down to $50 billion a month, you’re still buying. I mean it’s not, and you still have $3 trillion of excess reserves out there—I don’t know what the exact number is—but it’s way more than enough to finance any amount of borrowing that you want to do, but that’s another paper. I don’t think the Fed has anything, any control over borrowing either.

Hal Weitzman: But do the Fed’s actions, whether it’s QE or forward guidance, do they have unintended consequences that could be dangerous?

Eugene F. Fama: Well, these days it’s very risky for an economist to say that something doesn’t have unintended consequences.

Hal Weitzman: Well, tell us about what some of those might be.

Eugene F. Fama: Well, I have no idea, actually.

Anil K Kashyap: They could generate unnecessary uncertainties.

Eugene F. Fama: For sure.

Anil K Kashyap: That’s, I think, the risk on getting out is they leave people confused about, you know, are we still committed to a 2 percent inflation objective? Do we think we can permanently try to influence the labor market and kind of put into play . . . they had a long record, pretty good outcomes, and now we say OK, everything’s back on the table. I think that’s the main risk.

Randall S. Kroszner: But in some sense, it’s precisely because we’re in this uncharted territory that I think we need a little bit more guidance, because you can’t just say well, this is what the Fed always did for the last 30 years. We’ve now had five years of zero interest rates, and since as Gene said, you know, trillions of dollars of excess reserves, and the banking steps that used to work on like $50 billion of excess reserves.

So I think this is a time where you need a little bit more language . . . I don’t, I think that it’s appropriate that in a time that’s uncharted, that you need to give a little bit more guidance. If it’s just sort of business as usual, the usual way that you get out, then you probably don’t need as much.

Hal Weitzman: But to market traders, does that language really clarify, or does it confuse?

Randall S. Kroszner: Well, there was some work that [University of California at Berkeley’s Annette] Vissing-Jørgensen and [Stanford’s Arvind] Krishnamurthy had done that suggested that some of the announcements that the Fed did actually helped to reduce uncertainty and move the markets in the way that they wanted. Not all the ones, but there was not much evidence that it increased uncertainty. And so I, when I look for evidence that this forward guidance has had some success, I think the kind of work that they had done is suggestive that you can bring uncertainty down, at least some of the announcements, and move the markets in the way that the Feds seem to intend to move them.

Hal Weitzman: And yet, we do get these miscommunications as we had last September.

Randall S. Kroszner: Sure. For sure, I mean, there are gonna be bumps along the road. This is something that’s relatively new, so there’s always gonna be some difficulty in communication and need for calibration.

We’ll have to see, you know, as I think exactly as Anil said, this experiment is still going on, so to give the final grade is a little bit early. I would like to say we’re beyond the midterm, but I don’t know.

Hal Weitzman: OK, and how do we think about this internationally? We talked about the Bank of England, and the Fed, Anil Kashyap, what about in Japan, where they have a clearer inflation-targeting strategy? Or the ECB, which is much vaguer, sort of long term: keep rates low. How is the US and the UK compared to those strategies?

Anil K Kashyap: Well, the UK’s probably in front, because things are improving quite rapidly there, and they gave a whole set of conditions that would lead them to reconsider where they were heading, and they basically are on the verge of hitting them.

So they’re very quickly gonna be into the point where you might expect things to normalize, and I think what they’ll just say at that stage is great, things got better; we can step back.

Japan’s in a much worse place, because they’ve had entrenched deflation for a long time. They had a central bank that basically denied that they could do anything about it. Now they have a guy coming in, saying oh no, they were wrong. We’re gonna do something different. But you’ve got 15 years of history that you’ve gotta reverse. And the Japanese economy, I’m guessing, over the next few months is gonna slow massively. They just raised consumption tax by 3 percentage points last week and that change, the last time they did it, kinda crushed the economy because everybody pulled their spending forward to avoid the tax. And I think the next three months are gonna be very rocky in Japan. And at that stage, the Bank of Japan’s gonna be asked again to deliver: don’t talk; do something.

So we’ll see.

Eugene F. Fama: And the Fed hasn’t really faced the big problem, which would be: How do you give forward guidance when inflation and unemployment are both a problem?

They’ve been lucky about inflation and unemployment’s been the only problem they have to look at. What happens when you have to trade these things?

My guess is unemployment wins all the time, but you know, we’ll see. Because at the moment, I don’t think they have any control over inflation either, given the policies that they’ve followed. Inflation is what it is, not because of anything the Fed is doing.

Hal Weitzman: And it does raise the point about: Is forward guidance a short-term measure, is it something that you have while you’re winding up the quantitative easing program, or is it something that’s here to stay, Randy Kroszner?

Randall S. Kroszner: Well, I think getting back to what Anil had said before, I think the statement has lengthened because we’re in more unusual times, and so you need a little bit more guidance cause you can’t rely as much on just the historical experience, because we haven’t had historical experiences like this.

If, and when, we finally do get out, I think the statement can shorten again, because you won’t need as much information. But, I very much agree with Gene that this is gonna be particularly challenging if we see a spike up in inflation, not that I see that coming, but if we do see that, that’s gonna be a particular challenge for trying to talk through this.

Hal Weitzman: But, were the markets built to survive without forward guidance, I mean, would withdrawing forward guidance be a positive step?

Randall S. Kroszner: Well, I think that when things are, sort of, more smoother, more smooth and more like historical experience, you don’t need as much, and so the intentions kind of speak from historical experience, rather than from the new words. But when you can’t rely as much on the past data and you have to discount that more because it’s unusual circumstances, you’re gonna say more.

It’ll be interesting to see if that’s how you get out, and sort of the exit will be both in terms of normalizing interest rates, and maybe normalizing the statement and making it shorter.

Eugene F. Fama: Gene Fama, would it be good to get rid of forward guidance, cause at least then we would get rid of the sham of pretending that the Fed has any control?

Eugene F. Fama: Uh . . . (laughs) I guess I’d wanna know if they said they were gonna raise the interest rate paid on reserves to 2 percent, because I think you may do a lot of things in response . . . Or if they said they weren’t gonna pay any interest on reserves, and we had $3 trillion-worth of excess reserves out there, that could be catastrophic. So if they’re gonna do that, they better say so in advance.

But otherwise, I mean, maybe it reduces uncertainty, I mean, that’s the hope I think. Whether it actually does or not—and, you know, forward guidance can become so vague that it’s meaningless. And given that I don’t think that it had much effect anyway it probably is meaningless (laughs), even though they don’t think it is. So I don’t know. I’m maybe not the right one to ask that question to.

Hal Weitzman: Anil Kashyap, is forward guidance with us forever?

Anil K Kashyap: No, I think it’ll go away as soon as they can get back to normal. I agree with Randy completely that as soon as, you know, the economy goes into a growth phase where they can imagine raising interest rates, they’re gonna wanna run away from this. I think they’d like to get back to normal as best they can, and having all these situations where everybody’s hanging on exactly what you’re saying about something two and a half years off, where you’re also trying to say, but it depends, is just a bad place to be in. And the sooner they get out of that, I think the sooner they will.

Hal Weitzman: What about emerging markets? Booth professor Raghuram Rajan is now running the Bank of India, and Randy Kroszner, you just came back from India, you were speaking with Raghu. He, at one point, said that, you know, criticized the Fed for not, sort of, cooperating with other central banks around the world, and there are these big flows out of emerging markets. What’s the view outside, from the emerging markets, about the Fed and other central banks?

Randall S. Kroszner: Well, certainly this . . . it’s always convenient to say that it’s someone else’s fault other than one’s own fault, and so there’s a lot of that that goes on. That’s not to say that . . . well, I’d love to get Gene’s view on this. I think it has had, Fed policy does have an effect on flows to emerging markets, and it can be positive or negative.

And so if you’re going to have an open capital market and enjoy the benefits of the flows in, you also have to be prepared for the flows out. In order to try to prevent those flows out, you have to have good macroeconomic policy management. I mean, since Raghu has gotten in, India has been reducing its current account deficit. Raghu’s raised interest rates to try to bring down a high inflation situation, and so there are a lot of structural reforms that have been done, but that’s really helped to strengthen the rupee and stabilize things.

So I think it was much more, sort of, a warning shot about weaknesses in a lot of emerging-market economies, and the ones that have adjusted now seem to have been fine. When the most recent issues came up with the most recent Fed statement, countries like India and Indonesia, which have responded, seem to be fine.

Hal Weitzman: Gene Fama, what’s your view about the effect of Fed policy on the rest of the world?

Eugene F. Fama: Well, emerging markets, I don’t know how their financial systems differ from ours in the sense of whether the banks are much more important there in financing loans. In the US, banks are a small fraction of the total debt issues in deposit financing, against which banks have to hold reserves, is a small part of bank financing, so the total amount of stuff that the Fed can affect, in terms of lending, is very small, and there’s lots of flexibility in the system. Basically I think there’s a Modigliani-Miller there that works at the macro level.

Now, emerging markets is a different issue. I think money flows to emerging markets, in response to . . . wealth flows to—I hate to use the word money—wealth flows to emerging markets in response to the perceived investment opportunities in those places.

We used to think that the exchange rate was driven by the goods account, but it’s not clear it’s not also driven to a large extent by the capital account itself, in the presence of differential investment opportunities across areas.

But a lot of that has to do with stability, I mean, if the place doesn’t look stable, if the rule of law doesn’t look like it exists, well that’s not gonna be an attractive place for people to, for foreigners to invest in.

So some of that might have to do with policies with respect to inflation, policies with respect to, well, general policies with respect to contracting, and all kinds of things like that.

Hal Weitzman: Anil Kashyap, what’s your view on the emerging markets question?

Anil K Kashyap: Well, I was gonna say the same as Gene, that one of the reasons that the banks are the recipients of the hot money is in lots of these countries, the rule of law is weak, and so you don’t wanna try to make a direct loan into a business in India. Good luck with that. So what you will do is try to find a bank that you think you can keep on a short leash, and let the bank deal with what’s going on inside India.

In that sense, you know, Raghu’s said, I think, that he would like to reform the structure of the financial system and try to promote more competition. Let more foreign banks come in, and so on. I think that’d be a very good thing, and I think many of the emerging markets that have done things like that have benefited over time.

The transition could be a little bit rough, but I think the more you can put the financial system on a firmer ground so that you can force claims, people can go bankrupt, it’s not who you know, it’s whether you’re paying, those kinds of things, the better.

Hal Weitzman: OK, I wanna ask a question that came in on our Twitter feed @BoothCapIdeas, a broader question about the Fed: Does the Fed’s expanded regulatory role make it harder for it to focus on inflation and unemployment? Anyone wanna chime in on that, Randy?

Randall S. Kroszner: Well, certainly that has, sort of, a bigger macroprudential role, or a specific macroprudential role to think about both the regulation of individual institutions, regulation of flows across markets, and potentials for fragilities that are there, and then the full macro picture.

Obviously it’s more challenging to try to do something like that. I think the Fed has a reasonable amount of resources to try to do a little bit of both, but it can’t do everything. And there’s the Financial Stability Oversight Council—the group of other regulators that the Fed is part of. It’s getting more information than it had before. But it’s a very, very big burden to try to say, you’re gonna see where every single fire might come up.

So the traditional response of central banks was as a, say, firefighter. So the flames of crisis come, you throw liquidity on them and put them out. But with this newer role, they’re supposed to be smoke detectors, see where it might be this smoke coming up. That’s a much tougher thing to do, and can also distract you from other, your basic roles.

They’re trying to, sort of, get the balance right, and I think broadening the role out makes some sense, but we don’t wanna have too much faith that the Fed can just do it all now because it’s getting all the information. We’ll be in a situation where the smoke’s gonna turn into fire.

Hal Weitzman: And Anil Kashyap, your recent paper touches on this subject?

Anil K Kashyap: Yeah, I think, you know, forward guidance is basically an attempt to get people to take risks. I mean, to reach for yield. And so, I don’t think we can assume that that’s a freebie, that there won’t be some consequences when you signal, maybe there’s a little bit . . .you’re now facing a two way bed, you know. Interest rates can’t just stay low, but maybe they can come back up.

And so, I think there is a connection between financial stability and interest-rate policy. And the attempt to just always say well, we’ve got different tools to deal with that problem. We’ll let the interest rate do this, and then we’ll use, you know, loan-to-value or something else to fix these other problems, I think in some circumstances can work, but I think, you know, that taper tantrum is an example of where I don’t think there was much the Fed could have done about that. The market’s gonna sell off. You’re not gonna be able to change capital requirements and liquidity requirements, etc.

Hal Weitzman: Gene Fama, do you have a view on the Fed as regulator?

Eugene F. Fama: Well, I have a view on the general tendency, not tendency, but the fact that regulation will expand so dramatically through the Dodd-Frank bill . . . And you know, Chicago has a long tradition—[George] Stigler, [Sam] Peltzman, and others showing that complicated regulation basically never works.

I would prefer something simpler, and not in itself sufficient, which would say, look, what happens in catastrophes is that asset values go way down, and the first order of thing to make that less likely is to require banks to have much more equity capital in their capital structure so that they can absorb these things.

I don’t think the numbers that people talk about are anywhere near what they need, so Doug Diamond, who’s our [Booth’s] banking expert, said the catastrophes of 2008 would have been avoided if their equity capital had been 15 percent. OK, if that would have done it, then I think 25 is a good number (laughs). Because that may not be the biggest thing you ever observe.

What happens in a crisis is that what looked like a little bit of leverage turns out to be a lot of leverage, because values go way down, and the equity disappears, and that’s what you have to guard against.

I’d like to ask a question. Has anybody guessed how much bureaucracy will be added in response to this regulation? Nobody ever—

Randall S. Kroszner: Oh. Not a bit.

(panelists laugh)

This is actually one of the things I worry about a lot with exactly this complexity, so something like the Volcker rule, which the spirit of it is perfectly sensible: we don’t want others playing with taxpayer money. But the way in which they’ve gone about it, I don’t think makes any sense. So you set up a long list of things that the banks have to comply with. And so it’s not about the substance of the risk-taking; it’s about all these little metrics. And so you’re distracting the supervisors from looking at the fundamental risks. You’re saying, well, have you done this? Have you done that? And so a supervisor will come back to the Fed and say, the banks have complied with all this, but haven’t looked at the big-picture risks, and I think that’s a mistake.

Hal Weitzman: Anil?

Anil K Kashyap: I’m sympathetic to wanting the banks to hold more capital, but there’s another Chicago tradition to talk about regulatory arbitrage. And what I’m worried about with Dodd-Frank is we’re gonna make these fortress banks that are basically closed out of a lot of businesses, and we’re gonna push a lot of activity into parts of the financial system we don’t regulate at all. And that to me is the worst thing about Dodd-Frank is it’s got its eye on one part of one problem. Too big to fail.

There are a lot of other things that went wrong that they don’t really address. Think of the hundreds of thousands of person-hours wasted on the Volcker rule, which had nothing to do with the crisis. And hasn’t, probably, made us any safer.

And there are other gaps as well. So I’m just worried that because we have the infrastructure to regulate banks, we’re gonna go and look where the light is and hammer on the banks and ignore a lot of other things, and create ever stronger incentives to move stuff out of the banking system.

Eugene F. Fama: Well, I mean, there’s a huge . . . it has a big effect on competition in the financial sector.

Anil K Kashyap: Yeah.

Eugene F. Fama: Because you cannot start a financial business now in the face of the regulation that’s been instituted without a huge amount of equity capital in place. So the name that’s on all these cups [Booth] could not come into business today, given that it started with $50,000 in capital and had no compliance group.

Nowadays, if you’re gonna start a financial company, you’re gonna have to hit the ground with a fairly substantial compliance group, which implies that you can absorb a lot of expenses while you’re setting up the company, for maybe, you know, five or 10 years, and that’s just a competition stifler in the extreme. If you’re already in business, it’s great. But if you’re not, it’s not so great.

Hal Weitzman: Well, this is a much bigger conversation that I want to invite you all back for another The Big Question, but for the moment, our time is up.

My thanks to our panel, Eugene Fama, Randall Kroszner, and Anil Kashyap.

For more research, analysis, and commentary, visit us online at chicagobooth.edu/capideas, join us again next time for another The Big Question.

Goodbye.

(upbeat piano music)