The U.S. economy looks solid and interest rates are at the right level for the “foreseeable future,” according to Patrick Harker, president of the Federal Reserve Bank of Philadelphia. What’s more, lowering them 25 or 50 basis points would probably not affect business much in any case, he said in an interview with Knowledge at Wharton. Still, economic “headwinds” remain. They include the China trade dispute, which is creating uncertainty and causing a flight to safe investments that has helped lead to the so-called inverted yield curve. “An inversion of the yield curve is a signal that is correlated with recessions. But there’s little theoretical or empirical evidence to say it actually is causal.” In this wide-ranging interview, Harker also discussed prospects for financial instability, whether central banks should consider introducing a stablecoin cryptocurrency, and the shortfall of R&D spending accompanying a decline in U.S. economic “dynamism,” among other topics.
An edited transcript of the conversation follows.
Knowledge at Wharton: On August 14, the stock markets got hammered. The U.S. administration seems to think that everything that’s going wrong with the economy is because of the Federal Reserve. Do you think that’s true?
Patrick Harker: No. There are a lot of factors, and a lot of forces pro and con in the economy. First, start with just where the economy is. Things are pretty good. If you look at the real economy, not the markets, the real economy is doing quite well. That said, there are downside risks. There are headwinds. Many of those are around trade and international policy – obviously not in the Federal Reserve’s policy wheelhouse.
Knowledge at Wharton: The Federal Reserve cut interest rates for the first time in eight years (on July 31, it lowered the short-term benchmark rate by a quarter percentage point to a range of 2%-2.25%). Could you explain the thinking behind that?
Harker: I have to give the standard Fed disclaimer. I can’t explain the thinking except my own thinking, so these remarks are mine and no one else in the Federal Reserve system. This was a situation where we were getting back to what I would see as a neutral rate. In December 2018, we raised rates by 25 basis points. At that time, I was not supportive of that move because I thought that we didn’t need to do that. So, we’re just recalibrating back to where I thought we should have been, with a 25-basis-point cut.
Knowledge at Wharton: Do you think more interest rate cuts are likely in the future?
Harker: Again, I can only state my opinion. I do not see more cuts in the foreseeable future. I’d like to stay where we are, which I believe is around the neutral rate for the economy, and see how a lot of these uncertainties and issues resolve themselves over the coming months before we’d make any other move.
Knowledge at Wharton: In addition to interest rates, what other instruments does the Fed have at its disposal to deal with all the issues and the headwinds that you said the economy is facing now?
“I do not see more cuts in the foreseeable future. I’d like to stay where we are, which I believe is around the neutral rate for the economy….”
Harker: The other main policy tools that we used during the [2008 financial] crisis, really for the first time, were large asset purchases – QE (quantitative easing) – and forward guidance. We’ve gone through a process now, led by Federal Reserve vice chair Richard Clarida, on looking at monetary policy and our framework. We’ve done this with town halls all around the country. We had a major conference at the Chicago Fed recently, and I think out of that — the academic community, the Fed economists – we have some sense of what worked and what didn’t.
All the tools worked to some extent. But one of the main tools that worked was forward guidance. That meant saying, “We’re going to keep rates low, and we’re going to keep them low for a long time, until we see certain things like unemployment move.”
Knowledge at Wharton: How has the Fed’s role changed since the financial crisis?
Harker: The main change is not in the monetary policy side, but in supervision and regulation. With the Dodd-Frank Act and other regulations, we have become much more involved in protecting and sustaining the safety and soundness of the regulated financial services industry. That’s through a variety of tools, whether it’s more capital at the banks – the banks are now very-well-capitalized – liquidity provisioning, et cetera.
Knowledge at Wharton: There has been a lot of talk recently about an impending recession. Some of the statistics that are being cited to support the downside or the headwinds that you’re talking about, are, for example, the second quarter GDP growth rate was revised down by a full percentage point to 2.1% – that is certainly going in the wrong direction.
Capital spending is weak. That portends what’s ahead. That is despite the fact that corporations are sitting on a lot of cash, after a big corporate tax cut [in 2018]. Exports are down.
Harker: Let’s look at those factors. We’ll start with the consumers. Seventy percent of GDP is the consumer. The consumer continues to be the hero of the American economy. Consumer spending continues to be quite solid. That’s due to the foundation of good jobs. We’re still producing jobs well above what we need, in steady state, which is 100,000 to 110,000 jobs a month. We’re still producing at the level of 160,000 jobs a month. Wages are starting to rise – not across all segments, but particularly in low-income areas. Inflation is stable. So, the record in meeting our dual mandate (promoting maximum employment and stable prices), continues to be strong.
Now, GDP, we have estimated for quite a while, will go back to trend growth (the long-run average growth rate for a country). Trend growth is around 2% for the American economy. The only way to move that trend growth has nothing to do with monetary policy. Trend growth is output per hour of labor productivity. We’re starting to see productivity tick up today. But the one issue we hear constantly – whether it’s anecdotally or in our survey work and our outreach work – is that companies need workers. One of the limits to their growth is, they don’t have enough qualified workers for the jobs.
Knowledge at Wharton: How is the trade dispute with China affecting the economy?
Harker: I’ll go back to your point about business investment. If you’re sitting in a corporate boardroom today, and you’re about to make a multi-billion-dollar investment in plant and equipment and it’s related somehow to trade, would you do it? I wouldn’t.
“If you look back on the Great Recession – as scholars have – the one conclusion that is not accepted universally but widely accepted, is we didn’t do enough on the fiscal side.”
Knowledge at Wharton: Uncertainty is not good for business.
Harker: That’s the fundamental problem. You just nailed it. It’s the uncertainty around this. When I talk to companies, all they want is some certainty around where we’re going. I had one contact who was carefully thinking about moving his supply chain out of China to other countries. One of those countries was Mexico. And then all of a sudden we’re going to impose tariffs on Mexico (the U.S. and Mexico subsequently reached a deal to avoid tariffs). He is exasperated. He said, “I don’t know how to make a decision in this environment, so I won’t.” That is the fundamental problem with respect to business investment right now.
Knowledge at Wharton: Do you see that changing?
Harker: I hope it does. I hope we get some certainty, because that would really help the economy.
Knowledge at Wharton: The other headwind is the global economy.
Knowledge at Wharton: China is slowing in a way that we haven’t seen for many years and is in a trade war with the U.S. Germany is now not in a recession, but they’ve just had some negative growth. If they have another quarter like that, that would be an official recession. The International Monetary Fund in July revised its forecast down for global economic growth.
Harker: Those are clearly the downside risks to the global economy. Those two examples you gave are very different. Germany is an export-led country. Exports are very important to them – much more than for the U.S. economy. This trade war is weighing on them heavily. Obviously, it’s weighing on China too, since they are in the same situation. We have to keep coming back to what these sources of uncertainty are, and how we resolve those. They’re not monetary policy issues.
Knowledge at Wharton: You alluded earlier to the neutral interest rate. That is another area where there’s a lot of controversy, whether the Fed — or maybe what Pat Harker — considers the neutral rate. Is it at the right level? Some people think it should be lower. They base that on many factors, not least of which would be inflation. You’re happy with that rate. Do you understand why critics would say that it should be a lot lower?
Harker: Oh, yes. The neutral real rate is not something we can observe. (The neutral Fed Funds rate is the level that neither stimulates nor slows output.) We can only calculate it through models, and so those estimates vary a lot. But they generally hover around zero or maybe slightly above zero. Granted, there’s a lot of uncertainty around those estimates. But if you believe that, and add on roughly a 2% inflation rate, we’re kind of there, at 2% or 2.25%.
“If you’re sitting in a corporate boardroom today, and you’re about to make a multi-billion-dollar investment in plant and equipment and it is related somehow to trade, would you do it? I wouldn’t.”
But we could be wrong. You always have to have a heavy dose of humility in these policy jobs, and recognize that we have to be watchful to make sure that we’re not over- or under-accelerating the economy. By the way, in the situation we’re in right now, moving interest rates 50 or 25 basis points is not going to have a major effect. While I think we need to adjust technically like we did in the last meeting to stay around neutral, I don’t think these small changes are going to have a demonstrable effect on the economy.
Knowledge at Wharton: For years now, we’ve been told by some economists that high inflation is around the corner, that the current inflation rate is too low, and that [very low interest rates] will overheat the economy. It was argued that if the unemployment rate falls below 5% — we’re now below 4% – that will lead to wage-inflation. So far, it’s not happening. Does that mean that the Phillips curve doesn’t work anymore? (The Phillips curve describes an inverse relationship between unemployment and inflation.) What is the new normal for interest rates based on inflation?
Harker: So, should we have a funeral for the Phillips curve? Is it dead? It’s been flat for decades now, right? People are starting to conduct research and try to understand why. What’s really happening with inflation? Clearly technological innovation and other factors such as globalization are affecting this. But also, peel back the U.S. economy and lump all goods and services into two categories – cyclical and acyclical – think of it as prices that move with the economy and with interest rates, and those that don’t.
We’re becoming increasingly dominated by big sectors of the economy where interest rate movement and the [economic] cycle doesn’t have a big effect on pricing. Take health care – almost 20% of the U.S. economy – where prices are essentially set by the government. Moving interest rates 25 or 50 basis points will have very little impact in the short-to-medium run [on the health care sector]. In the long run, it will, if interest rates move a lot, because they have to build facilities, invest in equipment and so forth. But as for that short-to-medium-term impact of moving rates, we’re not seeing it. One of the potential reasons – and I emphasize potential, there’s more research that needs to be done – is this fact that many of our goods and services in the economy right now are acyclical in terms of their pricing.
Knowledge at Wharton: About $15 trillion worth of financial instruments globally have a negative interest rate. People are actually paying governments to hold money for them to keep it safe. What’s your view on that? This is related to inflation or lack thereof and also related perhaps to lack of demand in places like Europe. Also, could that happen in the U.S.? What would be the result?
Harker: Consider the long end of the yield curve [for Treasury notes]. The most likely suspect in my mind of why the long end is continuing to be low, is that in this world where people are looking for yield and safe assets, they’re buying treasuries. It’s the natural thing to do. So, in that case, it is going to affect the long end of the curve. We don’t affect that long end in any meaningful way, given the movements of the Fed Funds rate target. Other global forces and economic forces are moving that.
So it is definitely true that we’re seeing this rush to safe assets – U.S. Treasuries. That’s a good thing, in the sense that people still see us as a safe asset. But it does limit our ability to conduct monetary policy across the yield curve.
Knowledge at Wharton: Does that mean that it’s more flight to quality than any predictor that a recession might be on the way?
Harker: Yes, and there’s some recent commentary on this that I am very sympathetic to. An inversion of the yield curve is a signal that is correlated with recessions. But there’s little theoretical or empirical evidence to say it actually is causal.
There are a lot of other measures that you have to look at, and we went through those earlier in this conversation – jobs, incomes, et cetera. They continue to be strong. I don’t think you can just look at one measure and say that a recession is on its way.
Knowledge at Wharton: The original mandate for the Fed is balancing unemployment and inflation. We’re in an economy where it at least it looks like there’s very little inflation. The latest unemployment rate is very low at 3.7%. If there’s not much risk of inflation, why not reduce rates further, and see how low can you go with unemployment?
Harker: I would ask the opposite. We don’t have a lot of room to move rates. If my hypothesis is correct, moving rates 50 basis points is not going to have a demonstrable effect. Then, it also creates other risks, because there’s a third component of the Fed, not in our dual mandate, but very important – financial stability. There is ample evidence that [interest] rates being this low for this long, start to create situations of financial instability….
“In the situation we’re in right now, moving interest rates 50 or 25 basis points is not going to have a major effect.”
These issues of basically easy money that firms can get hold of – at covenant-lite to no covenant – are being done essentially outside the regulated industry. We don’t have a direct tie to that, because we’re not responsible for those parts of the financial services industry.
But they can potentially create a situation of instability. I’m not a fan of using monetary policy to control financial instabilities and asset valuations if they go too high, because it is a very blunt instrument. I’m not a fan of that also because it’s hard to predict. That said, if we can avoid trying to create the conditions or make them even worse for such a situation, we should.
If you go back a couple of years ago when we started [monetary policy] normalization, what did we talk about? We needed policy space…. We need it, in the good times, to start raising rates so that when the bad times hit – and they will eventually — we don’t know when – we have some policy space. I don’t see the argument for moving now to reduce policy space, when in my opinion things are still pretty good.
Knowledge at Wharton: Are we asking too much of monetary policy? Is there something wrong with the way we’re trying to steer the economy by relying on just one propeller, when maybe we should have two?
Harker: Yes. One of my biggest and growing concerns with respect to the economy is not in the monetary policy space. We have very limited policy space, as you said, on the monetary side. Increasingly, we have less and less on the fiscal policy side.
If you look back on the Great Recession – as scholars have – the one conclusion that is not accepted universally but widely accepted, is we didn’t do enough on the fiscal side.
Well, think about right now. This is a good economy, and we’re adding a trillion dollars a year to the federal debt. On top of that, states have no wiggle room. State after state, given their unfunded pension liabilities, has no room to move. So when that negative shock hits the economy, how much space do we really have on the fiscal side? The evidence shows that it can be very effective. We don’t have it right now.
Knowledge at Wharton: What should be done?
Harker: Again, this is not in my wheelhouse. – There are only two things you can do – increase revenue or cut costs. Some combination of those two have to be dealt with.
Knowledge at Wharton: A couple of years ago, when you had organized a conference at the Fed about fintech, we had spoken about cryptocurrencies. One recent development in that regard has been Facebook’s launch of Libra, its cryptocurrency. How do you see the difference between that and bitcoin? Is Facebook’s cryptocurrency more acceptable to regulators than bitcoin?
Harker: The regulatory side is with the [Federal Reserve’s] Board of Governors. I can only give my opinion. Without getting into the details of bitcoin and Libra, I think there’s a real advantage in having a stablecoin. It’s hard to have a currency that’s bouncing around all the time, so when you go to Starbucks, you don’t know how many of whatever coins you’re going to have to use that day. Clearly, that is an area that will have an advantage over time.
That said – and it’s only my opinion, and I think I’m a minority opinion on this right now – I do think we, the central bank, and central banks around the world, need to seriously start thinking about central bank stablecoin currency. (A stablecoin is a cryptocurrency that has a relatively stable price, often because it is linked to the U.S. dollar.)
In my view, it’s inevitable. Technology is evolving. We’re not going to stop that. I don’t necessarily think we [the U.S.] should be the first movers in that. There can be some experimentation in other economies or in other countries, to try certain things. But we need to start thinking about it. I don’t think it’s in the immediate horizon that we would do such a thing. But I do think that it is inevitable, and we should start contemplating it now.
Knowledge at Wharton: Is this a digital version of a fiat currency, that you think central banks around the world should be trying to introduce?
Harker: Yes. Look, the vast majority of money in the world is digital right now. It’s central bank money and so it’s not a great leap. The difference is in creating this kind of a stablecoin approach. Again, I’m not sure how to do that. I’m not sure when we would do it. But at least we should start seriously thinking about it.
Knowledge at Wharton: I’d like to ask a few questions about a paper that you wrote last year about dynamism in the U.S. economy. Do you think that dynamism is in long-term decline? If so, why?
Harker: Well, it’s not “I think;” I know. The evidence is pretty compelling. We have this myth that we are this incredibly innovative, dynamic economy. Relative to many other economies, we are.
“I don’t think you can just look at one measure (an inverted yield curve) and say that a recession is on its way.”
But if you look relative to our past, we’re not. Business formation is not what it once was. Corporations are getting larger. When corporations get larger, they issue fewer patents. The research clearly shows this. Also, on the labor side we don’t move like we used to move. One issue that often perplexes economists is, if there’s a community out there where the jobs went away, why don’t they just move to where the jobs are? We don’t do that. There are a lot of social reasons why we don’t do that like we once did.
Knowledge at Wharton: What are some of the main culprits?
Harker: One is, if I have an aging parent or my mom is taking care of my kids, or my dad is taking care of my kids and I can’t afford day care, I can’t move away. There is some recent research that this mythology of dynamism with respect to people moving is really based on filling up the West and the South. But once they were filled up, and a generation or two has stayed there, people have a preference for staying where their family is, and where their roots are.
That is a preference. It’s not optimal from an economic perspective, but people have preferences, and that’s one of their preferences. An important preference is not to uproot their family from their extended family. Those factors are coming in, at least on the labor market.
On the business side, it’s a different story. The issue about competition is really important – creating competitive playing fields for companies and start-ups to succeed. Some of this is, I think, being driven by technology. There are these network effects, right? They’re not going to go away, in certain industries. But that doesn’t explain all industries.
Knowledge at Wharton: Do you see this as an American problem, or is it something that affects all mature economies?
Harker: I think it is starting to affect most mature economies. But again, we in the U.S. have believed – and rightly so, based on our past – that we have this highly dynamic economy. When you get under the hood, it’s not that way. There are things we can do to re-stimulate that, on the policy front, that I think are important.
Knowledge at Wharton: If you could wave a magic wand to restore dynamism to the American economy and other mature economies, what would you do?
Harker: Competition policy. Making sure that firms have a competitive playing field. That they can sink or swim on that, and they can succeed. On the dynamism with respect to labor markets, there are a whole host of other issues there, such as social programs like childcare and elder care, that we could think about.
“There is ample evidence that these rates being this low for this long, start to create situations of financial instability.”
Knowledge at Wharton: Could you give an example of the competitive policy that you’re talking about, that would be better than what’s going on now?
Harker: Just simply antitrust policies — reinforcing them in certain industries.
Knowledge at Wharton: So, you’re saying there’s too much concentration in certain industries.
Harker: Again, I won’t make a blanket statement that’s true across all industries. But I think in certain industries, that’s quite possible.
Knowledge at Wharton: What about research and development? Do you think that there’s enough being spent on it? Industry spends quite a bit on research and development. But over of the decades, government spending on basic R&D, which often leads to big breakthroughs, has gone down quite a bit. Do you see a role for increased government spending in R&D?
Harker: Yes, absolutely. The big shift that’s happened over the course of several decades is that companies aren’t spending as much on R&D as they once did. There’s no more Bell Labs, at that scale. Now, that was a different story – with a monopoly, you could afford to do those things. But the basic R&D shifted from the companies to universities and university funding. With the Bayh-Dole Act, universities then have incentive to want to commercialize this, because they could get an economic benefit from doing so. Before that act, they couldn’t. (The 1980 Bayh-Dole Act enabled universities to retain title to inventions and take the lead in patenting and licensing groundbreaking discoveries.)
It’s not [as if government spending in basic R&D) is not happening. I’ll give you one example where it’s happening right now. Quantum computing. The government is heavily involved, through the National Institute of Standards and Technology and other agencies, in bringing together a consortium of companies to do almost what the moon launch once did. There’s a competitive race around the globe to build these machines.
Knowledge at Wharton: It’s interesting, because another aspect of this is the trade war with China. Wharton’s dean Geoffrey Garrett has made the arguments that it’s actually a race for innovation. China can spend a lot of money on research for this long-term research that we’re not doing here. If you see that as a key aspect of the competition that is going on, increasing government R&D might be another way to level that playing field.
Harker: I absolutely agree with that. Nobody’s willing to take the risk with these long-gestation-period technologies. That’s the role of the government, because a lot of that’s just going to fail.