The Questions Any New Fed Chair Has to Answer

Should the Fed address employment by simply focusing on price stability, avoiding the inflation and disinflation that upsets labor markets? Or should it sacrifice some price stability in pursuit of employment goals?

Price stability. The record on trading inflation for better employment is poor. Just keep the price level stable and employment will take care of itself. Avoid surges of inflation and panicked rate rises that cause recessions. Don’t repeat 1979, when inflation was allowed to climb, and you won’t repeat 1980, when the United States went into recession.

The Fed bought trillions of dollars of new Treasury debt, thereby financing the huge 2020–22 deficits with new money. It also kept interest rates at zero for a year after inflation surged in 2021. Were these mistakes? And if so, how will you avoid repeating them?

These were mistakes. I would avoid a repeat by introducing the concept that not all shocks are the same, and therefore the Fed should respond differently to supply shocks than it does to demand shocks. (The Fed is in danger right now of responding to a tariff supply shock as if it were low demand: with stimulus.)

I would also introduce the concept of fiscal inflation, which obviously was what was happening in 2021. And yes, I would pay some attention to the Taylor rule, and if inflation surges to 10 percent, I would certainly think about raising rates.

More deeply, the inflation episode needs a thorough review to determine what happened and how the Fed got it so wrong. “Supply shocks hit that weren’t our fault” is not good enough. That excuse implies that any future “shocks” will lead inevitably to more inflation.

Which economic theory do you think best describes monetary policy?

This is in part a trick question to see if a candidate is familiar with various schools of thought—Keynesian, New Keynesian, monetarist, modern monetary, and fiscal theories, all of which disagree fundamentally—evidence for and against them, and where their bodies are buried.

Just echoing, “I think high rates lower spending, which lowers output and, via the Phillips curve, lowers inflation” gets you a C-, and shows you don’t know what’s actually going on in the Fed’s own models.

The best academic theory I know of is the fiscal theory of the price level, combined with an understanding of the role of long-term debt. But there is a lot I don’t know.

However, as an economist, my loss function gives a high reward for a new theory that turns out to be right, and only a mild penalty of comfortable obscurity if I am wrong. As a policymaker, my loss function would put much more weight on making sure I am not wrong and do not make disastrous mistakes. Given our uncertainty about how the economy works, that means putting both weight and distrust in lots of economic approaches.

Making asset purchases

Did quantitative easing significantly affect long-term rates, output, and inflation? Should QE continue as a routine part of the Fed’s tools?

If QE works, should the Fed more directly target long-term rates rather than buy some bonds and see what happens?

I don’t think QE did much. If I give you two $5 bills and a $10 bill for each $20 bill, do you spend more? The Treasury sold more long-term debt than the Fed bought. QE did move markets on announcement, but price-pressure effects don’t last forever.

At most, it had information effects—shock and awe that the Fed was so desperate—and it signaled rates would be low for a long time. On the other hand, that also means QE didn’t do much damage either.

The Treasury issues long-term debt, which pays a fixed rate. The Fed buys that debt and turns it into floating-rate debt (reserves). That action makes interest costs hit the budget faster.

How should the Fed and the Treasury agree on the proper maturity of the debt? Should the Fed buy only short-term debt?

To start, the Fed chair must admit that large QE operations that buy long-term Treasurys do shorten the maturity structure of the debt. Then admit that the current Fed losses are a cost to taxpayers because they remove what little interest rate protection the Treasury had bought with its long-term debt issues.

The Fed pretends to ignore the Treasury. The Treasury pretends to ignore that the Fed undoes whatever it does. We need a new accord about who is responsible for and accountable for the maturity structure of the debt and the exposure of taxpayers to interest rate risks. I think it should be the Treasury, and the Fed should hold only short-term securities, or swap out the interest rate risk with the Treasury.

Should the Fed continue to buy mortgage-backed securities?

In 2020, the Fed announced a corporate bond–buying program, to prop up their prices. Is it proper for the Fed to prop up asset prices? Should it worry about stock prices and exchange rates?

No, no, and no. The wider the mandate, the less the Fed can be independent.

There is a case for central banks to be forbidden from holding Treasury securities and restricted to holding private or foreign securities. Doing so helps isolate the central bank from pressure to monetize the debt. My judgment is that, at present, isolating the Fed from pressure to prop up a particular interest group’s favorite assets is a more pressing concern, so I favor an all-Treasury portfolio. But that may not last, and I get to change my mind.

Regulating the financial system

Should the Fed continue to pay interest on ample reserves? Or should it stop paying interest, return to a tiny quantity of reserves, and manage interest rates by changing that small quantity?

Should the Fed continue to pay banks more on reserves than it pays other institutions? Should it follow other central banks and elastically lend new reserves to banks as they demand, rather than strictly control the size of its balance sheet?

I favor ample reserves that pay a market interest rate. I favor a flat supply curve rather than trying to control the balance sheet as a separate policy lever, as with QE. I favor a narrow corridor—the Fed should lend at rates very close to the rates at which the Fed borrows—and equal treatment for all comers.

Ample interest-paying reserves have been a great innovation of monetary policy since 2008, with many benefits. The fear they would necessarily lead to inflation was proved wrong in a great worldwide experiment. Three cheers for the Fed, and for former chair Ben Bernanke, who inaugurated this policy.

Should the Fed maintain its prohibition of banks such as TNB that hold only reserves? Or should it encourage such narrow banks, as they are impossible-to-fail institutions that can provide low-cost transactions services and large, safe, uninsured deposits?

Should the Fed allow access to reserves and its payments system to a larger range of financial institutions that aren’t banks, such as money market funds or even stablecoins?

The Fed’s denial of a master account to TNB, short for the Narrow Bank, was a disgrace. The reasoning was beyond fanciful, showing that the Fed has really no idea what “financial stability” means.

The Fed likewise ruled against “segregated accounts” that funnel deposits directly to reserves, immune from bankruptcy, in the big banks. Large uninsured depositors could have used these vehicles. They ran in the Silicon Valley Bank fiasco, and then got an ex post bailout.

None of this would have happened had the Fed allowed them access to narrow banks or segregated accounts.

The Fed worried that people would run to narrow banks in a crisis. Never in history has the Fed’s response to a crisis been, “You have to sit and hold illiquid assets.” And people can run to bank deposits and short-term Treasurys directly now.

Financial regulation should encourage narrow deposit-taking and equity-financed banking. I think a wide range of financial institutions should have access to something that looks like reserves.

Honest stablecoins are just an implementation of a narrow bank or money market fund, so it looks like we may finally have a workaround to these harmful regulations. But why work around what can easily be fixed?

Treasury markets, dominated by dealer banks, have experienced turmoil. Do you think reforms to liquidity and capital regulation will solve the problem?

Will you allow or require exchange trading of Treasurys, and allow other investors access?

Channeling my Stanford colleague Darrell Duffie here: The dealer banks got a monopoly in exchange for providing liquidity. They didn’t provide liquidity. Time to end the monopoly.

Will you end bailouts, and if so, how? Can you define “financial stability” and “systemically important” in ways that don’t mean “nobody loses money”?

If I were Fed chair, there would soon be a speech announcing the end of bailouts, and a narrow and precise definition of “systemic” as a systemic run only. Financial institutions: Get your ducks in order, issue a lot of equity, and get your liquidity ready for fire sales (er, buying opportunities). The Fed won’t front-run those next time.

Defining the Fed’s role

Should the Fed aim for “inclusive employment,” worry about left-behind areas, or include other distributional goals?

Should it view its mandate as a directive not to worry about anything else, or a starting point from which to explore other goals?

I favor a narrow approach, meaning that the Fed should not pay attention to goals not mentioned in its mandate. I also favor Fed independence. Mission creep into contentious political areas will undercut independence.

How will you improve the Fed’s decision-making processes? How will you restructure the Fed’s operations, including staff size and scope, diversity programs, and research?

I don’t want to give a full reorganization plan here, in part because I don’t have one. The question really asks: Do you think such a reorganization and review is necessary, and my answer is yes.

Should the Fed be formally accountable for its inflation performance, fulfillment of its mandate, or actions that exceed its mandate?

One could say that via regular reports to Congress, and periodic reappointments of its members, the Fed is already accountable. Congress is certainly free to grill Powell now on questions such as “How did you interpret ‘price stability’ to mean 2 percent inflation?” But a bit more formal accountability would all in all be a good thing.

Higher interest rates raise interest costs on the debt. Inflation wipes out federal debt. Should the Fed think about these budgetary implications? Should it work with the Treasury to coordinate policy?

The Fed studiously avoids fiscal policy, but we can’t avoid the fact that the inflation of 2021–23 had fiscal roots. Without $5 trillion of unfunded deficits, there would have been no inflation. With those deficits, the Fed had limited—but some—ability to control inflation.

Monetary and fiscal policy are intertwined. We should acknowledge that if the Fed can affect real rates of interest, it can affect interest costs on the debt, at least until inflation erupts. And if higher interest rates soften the economy, it results in deficits.

Separation of monetary and fiscal policy only works with small debts or with governments that adapt tax receipts and spending to monetary policy. For everyone else, some coordination is necessary, and every country with budget problems has a public debate between central bank and fiscal authorities. We really can’t avoid it. I would prefer, of course, tighter fiscal rules to control inflation rather than a subjugation of monetary policy to finance deficits.

Should financial regulation be integrated with or separated from monetary policy?

Relative to its monetary policymaking, should the Fed’s role in financial regulation be less independent of Congress and the administration, as other regulators are?

I’m torn on this one. The essential argument for independence—“time consistency,” that the government wants to precommit to low inflation that it may not want later—doesn’t really apply to financial regulation.

Monetary policy and bank regulation are somewhat intertwined, which suggests that if an independent institution does one, it should do the other. But perhaps they are less intertwined than we think: The Fed maintains a lot of separation between the two functions.

Yet the more accountable regulators (such as the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission) don’t seem to do a tremendously better job than the Fed. We must admit that for all its faults, the Fed has been a lot more successful than most government agencies.

I’m for much better financial regulation, and would listen to arguments both ways.

These questions are the tip of the iceberg. The financial and monetary systems have evolved past the current Fed, and a wise Fed chair will need answers. Obviously, anyone giving these answers wouldn’t make it past the first round of interviews. Frankly, I doubt anyone giving clear answers to these questions would.

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and was previously a professor of finance at Chicago Booth. This essay is adapted from a post on his Substack, The Grumpy Economist.