Chicago Booth Review Podcast Who Does Raghuram Rajan Blame for Inflation?

Hal Weitzman: The 2010s was a decade marked in the US by extraordinarily low interest rates and low inflation. Then the COVID pandemic prompted a splurge of public spending, which combined with supply chain disruptions to unleash the return of inflation. A phenomenon barely known since the ancient days of the 1980s. The normally sober US Federal Reserve joined the party, cutting interest rates, issuing forward guidance, resuming quantitative easing, and lending trillions of dollars to Wall Street, Main Street, states, and cities. So is the Fed to blame for causing the inflation of recent years? Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking academic research in a clear and straightforward way.

I’m Hal Weitzman. Chicago Booth’s Raghuram Rajan knows a thing or two about central banking. He was the governor of the Reserve Bank of India from 2013 to 2016, and is a globally respected analyst of central banks. In the first of two conversations based on his recent book Monetary Policy and Its Unintended Consequences. We spoke about the Fed’s role in the US economy and what explains its response to the COVID pandemic. Raghuram Rajan, thank you very much for coming on the Chicago Booth Review Podcast. You’ve written this book, Monetary Policy and Its Unintended Consequences, about central bankers. Let me start with this. Have central banks become too powerful? Have we made it too easy for central banks to intervene in the economy?

Raghuram Rajan: Yes, and no. I mean, at one level, I think we have placed them in a position where they sometimes feel they’re on the only game in town and they have to do a lot. And they’ve obviously developed a whole bunch of tools over the last decade or so, some of which would’ve been frowned upon a lot in the past, intervening directly in markets, for example, to affect securities prices. On the other hand, I think there’s a lot more intolerance for elites, especially unelected elites, and so I think central banks across the world have a sense that they need to earn their legitimacy every time. And this is actually a worrisome combination of a lot of power, but increasing responsibilities to do what the public wants as opposed to what might be in the best interest of the economy.

Hal Weitzman: But where’s that power come from? Just give us a bit of the context.

Raghuram Rajan: Well, I think the power was, to some extent, some of it was seized, some of it existed. Most codes governing central bank behavior have some kind of a clause which says, basically, you can do anything if you need to rescue the system. And I think many central banks did a lot during the global financial crisis, which created a playbook for them the next time around. Now, legislatures understood that they had undertaken a lot and wanted to curb it. Congress in the US did curb some of the powers of the US Federal Reserve, but many of the programs that were initiated during the global financial crisis came back during the pandemic without much change. And that reflected the fact that the Fed had gotten used to using all this.

Hal Weitzman: Yeah, I mean, when you talk about the central bankers seizing power, how important, psychologically, was the global financial crisis as something to avoid happening again, but it’s also, as you say, it’s a playbook for how to deal with any sort of crisis?

Raghuram Rajan: Well, I think that’s right. I think what we didn’t spend enough time asking, which was very useful for the central banks, is what the liability of the central banks was for what happened, how responsible were they for the global financial crisis? How responsible were they for the illiquidity that arose with the pandemic? In all this, we sort of say, Oh, bad stuff happened without probing a little further why the bad stuff was really bad. And I would guess if we did a proper analysis, for example, into the recent events surrounding Silicon Valley Bank, you’d find the hand of the central bank not just through its lack of supervision, which is the Fed did a mea culpa, looked at its own responsibility there. What it did not look at was the role of monetary policy, including the unconventional quantitative easing in the kind of liability structure that Silicon Valley Bank had. And that’s why I say there’s a lot that goes under which is unquestioned.

Hal Weitzman: So in some sense, the central bank sets up the framework for the problems to happen and then demands that it step into correct them.

Raghuram Rajan: That’s not too far from what happens. I think what we need to do is really scrutinize the role of the central bank, not just its supervisory side, but also its monetary side. The problem, however, is monetary policy is often too complicated, especially these unconventional monetary policies, for others to opine very strongly on them. It’s some stuff, I mean, central bank money, who understands that? And so it escapes scrutiny.

Hal Weitzman: Well, you say it escapes scrutiny, but as you say, the opposite is that people just say, scrap the Fed. Get rid of central bank independence and we’ll go back to the system where governments are in charge.

Raghuram Rajan: Well, it’s not so much scrap what the Fed does, but give us what we want. What we want is no sort of intervention when things are going well. Don’t slow down the economy. What is this that you want to, you think that we need to bring down inflation, so you want to essentially maybe flirt with a recession? How’s that possible? Why don’t you just let things go? And of course, we spent many, many decades trying to understand why the central bank stepping in at the right point to slow down the economy would in fact be a good thing for longer-term growth because it would prevent these booms and busts in credit, but also booms and busts in economic activity, which could result in overly excessive inflation.

Hal Weitzman: So that relates to the excerpt that we published from your book in Chicago Booth Review, which was about the banker’s role, the central banker’s role in inflation, how they were slow to react to inflation in the early days of the pandemic, and then they responded, or maybe over responded or responded in a wrong way by buying a lot of government debt with overnight reserves. And the effect of that was to shorten the overall maturity of the public finances. Just talk us through what happened and what you think was going on in their minds when they came up with that response.

Raghuram Rajan: Central banking is a little complicated, so I’m going to try and explain some very nerdy stuff in as simple language as I can. What happened in March of 2020 is all hell broke loose in financial markets as they came to realize that the pandemic was for real and stuff would happen, you’d start seeing lockdowns. And so financial markets started blowing up. Credit became very, very hard. You saw issuances die during that month of bonds and so on, and you also saw spreads blow out, suggesting that liquidity was drying up in markets. And so the Fed soon saw that everybody was running for cash because cash is king at times like this. So in this dash for cash, the Fed basically said, look, we don’t want to create a financial panic in addition to everything else. What we’re going to do is essentially flood the market with cash as much as it wants and more.

And that’s what it proceeded to do by buying bonds from people. And when the Fed buys bonds, it essentially gives you cash, which is really what it does is it offers to pay in reserves, and you go deposit that in a bank. Now you have deposits in the bank, and the bank has claims on the Fed, but it’s like as if you have direct access to cash. Now the problem, however, with this longer term is as the Fed builds out its balance sheet by buying bonds from people and giving them cash in return, what it does is it effectively shortens its liability side because it’s overnight reserves that it’s giving people while it’s buying long-term assets on its asset side. And typically, the assets it’s buying are Treasury bonds of the government. So think about what is happening when you put the balance sheet of the government and the Fed together.

The government is essentially issuing long-term Treasury bonds to the Fed, and the Fed is issuing overnight paper to the public. So you’ve shortened the maturity of the effective debt. I mean, think of the Fed’s reserves also as debt of the combined government and the Fed. And so you’ve shortened the maturity of the debt of the consolidated balance sheet. Why does this matter? It matters because the government, when interest rates go up, has a period over which it can say, well, nothing much is going to change because I have a lot of long-term debt outstanding. All I have to do is refinance the stuff that’s maturing. If my average maturity outstanding is 10 years, it takes a long time for interest rates to show up in the government’s payments and in expanding the size of its fiscal deficit. But if a lot of it is overnight debt, it shows up almost immediately.

And that’s what we are seeing that the US government’s interest payments are starting to go up pretty strongly, partly because the Fed now is saying, look, we’re making losses because we have to pay 5% on the overnight paper that we’ve issued broadly on the reserves that we are paying interest on while we are earning only 3% on the bonds that we hold. And so that difference shows up in a loss, and the Fed has started making losses. It’s no longer paying dividends to the government.

It used to pay something like 100 billion a year. That’s gone. And so that’s about a half a percentage point of GDP, it’s accumulating more losses on its balance sheet. We don’t even want to talk about that right now, but that means no more dividends for a long time until it makes up those losses. So that’s going to create a fiscal problem. On the government’s balance sheet side, it’s already started paying higher interest rates, and it will continue to do so. So put both together, and you basically have a bigger problem than if the Fed hadn’t started doing this balance sheet expansion in the first place.

Hal Weitzman: What would you have done differently? So one of your colleagues is actually on the, Austan Goolsbee, of course, is on the Fed Board. If you were running the Fed board, what would you have done differently?

Raghuram Rajan: Well, if you want to expand the balance sheet that much, you basically have to take this cost.

Hal Weitzman: And just to go back to that, it expanded because the response to the pandemic was, let’s just throw money at everything.

Raghuram Rajan: Yeah, they could have expanded in a more careful way, and they could have pulled back before they started raising interest rates. They may not have stayed with such an expanded balance sheet for such a long time, but hindsight is 2020.

Hal Weitzman: But why did that happen then?

Raghuram Rajan: I think they just thought there was very little cost of sitting with an expanded balance sheet. Plus, they didn’t want to send the signal that they were tightening monetary policy early. And one of the problems, and this is the unintended consequences of balance sheet expansion, is it’s got so closely tied up with monetary policy that there’s a huge signal sent when you say, I’m going to start shrinking my balance sheet because it sends the signal, I’m also going to start raising interest rates. They didn’t want to send that signal. And so they said, well, let’s stay with the expanded balance sheet. Let’s not end quantitative easing. And I think they went a little too far. Maybe a much smaller balance sheet expansion would have been enough to deal with the liquidity problems. And a lot of the excess balance sheet expansion is creating some of the problems that we saw, including Silicon Valley Bank.

Hal Weitzman: But we got to that point again, because, what, they panicked in the first part of the pandemic, how did we get to that massive expansion in the-

Raghuram Rajan: You become a prisoner of what you announce. You said you’re going to expand your balance sheet at this and such rate. And once you said that any kind of change would suggest you were tightening policy, and you don’t want to send that signal when the recovery is still fragile. So they did not want to send that signal early on in the pandemic. There was probably some point in 2021 when they could have said enough, when the economy was recovering, when unemployment had come down, but they didn’t. It’s all too easy to say, look, this is not a big deal. We’ll deal with it when the time comes. Of course, that means you have a much bigger problem to deal with when the time comes. And that’s part of what we’re seeing.

Hal Weitzman: Okay. And we haven’t had a lot of institutional memory dealing with inflation.

Raghuram Rajan: We haven’t had institutional memory dealing with inflation, but even balance sheet expansion. We haven’t had anything like this kind of balance sheet expansion in the past. Just to give you an order of magnitude, the Fed’s reserves pre-global financial crisis were about 100 billion. That’s how much the banks held at the Fed. Typically, required reserves. It had gone up to four trillion, 40 times as much after the pandemic expansion. That’s a huge increase, and that’s an order of magnitude different and creates different problems.

Hal Weitzman: How much is inflation to do with the action of central banks? How much is it to do with the action of politicians? The politicians really wanted to spend money. They wanted to show that there was no gap at all. There would be no effect on the economy. So everyone was given money. We know much of that money was wasted.

Raghuram Rajan: It’s both, right? I mean, if you think of the pandemic expansion in fiscal, part of the reason it was so easy to expand spending was the Fed was buying the debt. If the Fed had been out of the market, it may have been a little more difficult to issue government debt, and maybe market signals would’ve told the government, you’re spending a little too much. We don’t know. These are just sort of informed guesses. However, with no signals coming back saying you’re spending too much, was it James Carville who said, "I want to come back as the bond market"? Well, the bond market has been anesthetized by the Fed and has had absolutely no influence on fiscal spending because it knows that the Fed is out there to buy bonds through the period of the pandemic. So you want to issue two trillion? Fine. You want to issue two trillion more? Okay.

And you want issue still more, maybe another two trillion? Still okay. So we issued massive amounts of debt. More research over time will show how much was wasted. But certainly, for example, some of our researchers at Booth have shown that during the paycheck protection program, money came in through the front door to these small businesses and went out through the back door to pay the banks, which is why banks had no losses. Now, of course, nobody is expressing outrage still at the fact that the taxpayer essentially bailed out the banks, but at some point, when we write histories of this period, we’ll start seeing that there was massive spending on bailing out anything that moved or could get a hearing in the right places.

Hal Weitzman: Okay, so bottom line, did the Fed cause the problem of inflation?

Raghuram Rajan: I think cause is too strong a word. Abetted, perhaps. I think the Fed basically thought its job was to help all responses to the pandemic, including its side of the financial sector, which is, take care of liquidity, et cetera, but also, in the process, aided the fiscal side by expanding its balance sheet and buying government debt. And the question is, was it excessively helpful? Sort of causing policymakers not to spend too much time thinking about how much debt they were putting out and whether the third iteration of the rescue was as important as the first iteration of the pandemic rescue.

Hal Weitzman: Okay, so the Fed didn’t cause the inflation, but they aided it, made it worse perhaps. Who do you think did cause it? Was it the politicians?

Raghuram Rajan: Sometimes there’s nobody, right? I mean, a whole bunch of things happened during the pandemic, including supply chains tightening up, including people suddenly substituting for their gyms with Pelotons and ordering them through the roof. I mean, these are rich people, of course. And so you had demand in certain areas just increased tremendously. And supply chains obviously couldn’t keep up. In some cases, they were disrupted. I think that was the initial source of inflation.

Hal Weitzman: Okay, Peloton people started it. The Fed made it worse.

Raghuram Rajan: Don’t make it so direct, but yeah.

Hal Weitzman: Okay.

Raghuram Rajan: Academics never like to say anything so directly.

Hal Weitzman: Well, I can say it. I’m not an academic, so I can say it. Raghuram Rajan thank you very much for joining us on the Chicago Booth Review Podcast.

Raghuram Rajan: Thanks for having me.

Hal Weitzman: That’s it for this episode of the Chicago Booth Review Podcast, which was produced by Josh Stunkel. You can find an excerpt from Raghuram Rajan’s book, Monetary Policy and Its Unintended Consequences, on our website, chicagobooth.edu/review, under the title, The Case for and against Central Bankers. If you enjoyed this episode, please subscribe, and please do leave us a five-star review. I’m Hal Weitzman. Until next time, thanks for listening. Goodbye.