A Conversation with Thomas M. Hoenig

Wednesday, March 2, 2011

Thomas M. Hoenig, president and chief executive officer of the Federal Reserve Bank of Kansas City, discusses the risks in a real market economy and the need to develop a long-term, post-recovery monetary policy.

This meeting was part of the C. Peter McColough Series on International Economics.

PAUL E. STEIGER: Good morning. I'm Paul Steiger, the editor in chief of ProPublica, and I'm your presider today. So welcome.

Today's meeting is with Thomas Hoenig, who is the president of the Kansas City Federal Reserve Bank. He's an economist, his doctorate from Iowa State. And he has risen through the staff of the Kansas City Fed -- started in the early '70s in supervision, has been president since 1991. And I had either never known this or had forgotten it, but Missouri is the only state with two Federal Reserve banks, one in St. Louis and one in Kansas City. And back in the '70s and '80s, the St. Louis Fed was a font of maverick monetary information. Some of you may remember the focus on the money supply in M-1 and M-2 and M-3 and all of that stuff in the inflation-ridden years of the '70s and early '80s.

Well, in keeping with that Missouri maverick tradition, President Hoenig has -- during his time on the Federal Open Market Committee, which is the closest way that the Federal Reserve controls short-term interest rates, I think you had three dissents in blistering succession from the stimulative monetary policies of the Federal Reserve under Chairman Bernanke. You've rotated off the Open Market Committee, so hopefully you can be very candid with us about interest rates today.

In addition, Mr. Hoenig has spoken out against the excesses of some of the big banks.

And I want to talk -- start our conversation with those two subjects. Why don't we start with monetary policy?

You've been calling for a beginning of tightening of monetary policy for I think almost a year; I remember an interview with Mary O'Grady, one of my former colleagues at The Wall Street Journal. Yet it looks like things are, at least on the surface, going pretty well. You know, the economy is recovering, you know, better than Germany in some respects, better than Britain in some respects. You really want to take away the punch bowl before the party has really gotten started?

THOMAS M. HOENIG: I really want to take away the punch bowl before the room gets drunk -- (laughter) -- because this punch is, I think, a little bit spiked. And you know, my view is -- and I think it's important -- that I'm not for tight monetary policy. I'm not for non-zero interest-rate policy. And I am -- I have observed that I -- very cautious and reluctant to ease into a recovery, and that central banks have -- part of the reason they have some independence is that they are really assigned to look at the long run. And we need to be looking far enough out to see where a highly accommodating monetary policy ultimately leads.

And that you need to be thinking in the fact that you have a recovery in train, and yet you have a policy right now that in my opinion -- and it is only my opinion -- is still couched in the terms of the crisis that occurred over two years ago. And so you need to be thinking about recalibrating your policy to get in sync with the recovery so that you renormalize and do not induce or introduce instability by going on too long with a highly accommodative policy.

And so that's my argument. And I feel pretty comfortable with it, actually.

STEIEGER: Okay. I want to quickly ask a follow-up question on that. But before I do that, I neglected to mention that this session is part of the C. Peter McCullough Series on International Economics. It's on the record. And please, folks, turn off -- off -- your electronic devices because it messes with the recording system.

Okay. So we've had essentially zero -- a target of zero to a quarter point on the federal funds rate for short-term rates. We've also had the language in the Fed's statements -- I forget what the specific language is, but --

HOENIG: "Extended period."

STEIEGER: Extended period of keeping interest rates this low. So if you were back on the Open Market Committee, what would you be advocating? Would you be advocating just changing that language? Or would you actually be advocating moving the target up?

HOENIG: At this point, I'm quite sure. And I've spoken about this. But I would -- I wouldn't do it all at once, obviously, but I would begin sooner rather than later. And I would remove the language of "extended period" because I don't think it is necessarily wise to give the markets such a signal in a recovering economy that -- there is risk in markets, and you cannot be guaranteeing a yield curve. I can't guarantee -- in the real economy, I can't guarantee a business a revenue stream. So I really shouldn't be, once you're past the crisis, trying to guarantee someone a yield-curve return.

And so you need to bring and allow the markets and the institutions within the market know that there's risk. There is no certainly here. Things can change. So you want to do that.

And then, secondly, you really need to get off of zero, in my opinion. Because I ask people, do you know of any -- do you know of any market -- energy market, agriculture market, services market -- that functions very well at zero? And I don't think credit markets are necessarily different than that. So you need to be allowing the market to signal as it would when conditions are back to normal. And that is really what our goal should be as the economy itself has weathered this crisis and then moves towards an improving and a strengthening economy.

So we have to take this very highly accommodative policy and reformulate it back towards a more normal policy.

STEIEGER: Okay. Unemployment is still at -- over 9 percent, which, you know, below the peak, but still very high by postwar standards. So the next meeting of the Open Market Committee, you would remove the language. Then how soon would you start raising rates? And would you do it a quarter=point? Would you do it at half a point? What would you do?

HOENIG: Well, I -- if I were -- if I had my druthers, I would prepare the market for moving back towards 1 percent. And if -- you know, what the exact timing would be, I don't know. I am not going to say here. But I would move -- be thinking of moving it back towards 1 percent. And then, as I've said, I would pause then. I would say we're at 1 percent, let's see -- let's let the market settle out. Let's see where things are, and then move back towards even higher rate over time, towards 2 percent. And then, again, that's nominal rate, so you still have a very accommodative policy, and let the market adjust. And I would do that.

I wouldn't -- I would avoid -- I think, given my experience with 17 moves at quarter-point, which has its own consequences, I would try and move to the 1 percent and then hold for awhile more quickly. Other central banks -- a couple of central banks have done that. I think it's been relatively successful for them. And I know we're a larger, more complicated economy, but still, I think markets -- if you set that out -- can accept that pretty readily.

STEIEGER: Okay, so without trying to nail you down to, you know, like a specific date, would you -- would you get us to 1 percent by the summer, by the fall, by the end of the year? What's a reasonable time frame?

HOENIG: Well, I think -- I think it was a little more than a year ago -- no, it was about a year ago I said by the summer, late summer. (Laughter.)

STEIEGER: Last summer?

HOENIG: (Laughs.) Yeah. So I'm a little behind schedule, but my point is to move it there in a systematic fashion more quickly rather than less quickly. And I did say by the end of the summer then because I thought the markets could handle it.

And you -- now, remember, at the end of this -- and this is what people tend to forget. They think, well, that means tight policy. But remember, it's still a very accommodative policy. It was 1 percent at our last move in 2003 when we went to 1 percent and left it there that then got the credit markets moving very rapidly.

And so I don't consider 1 percent a particularly tight policy in any sense. It's highly accommodative and continues to be. So that's why I'd like to get there quickly to get it off zero so you can begin to let the market (signals ?) work.

STEIEGER: Can I ask you -- you know, I mean, there have been some signs in the commodities markets. You know, we've seen oil move up. We've seen some commodity prices move up. But in general, inflation in the U.S. is still moderate. And you have some people continuing to worry about deflation. That, after all, was what was the big driver of the Great Depression, where prices not only didn't grow, they plunged. And the result is that it dragged everybody down. We had unemployment rates of 25 percent.

HOENIG: Right.

STEIEGER: And that's a fear that some people have. Do you -- do you think that that's an overblown fear?

HOENIG: I think it's -- I don't want to say "overblown," but I think it's incorrect. I understand the history of the Great Depression and the falling prices, but I also remember the great inflation. And I remember how it started. And, you know, it actually started in the mid-'60s, and it takes -- you know, took over a decade to build a little bit at a time. As you -- as you focus on unemployment -- which everyone cares about, but there are limits to what monetary policy can do without other consequences. And that's what we're trying -- I'm trying to be alert to.

And in the decade of the '70s that I'm talking about, as I've noted to others, real interest rates were negative about 40 percent of the time. In the decade of the 2000s, real interest rates were negative; that is, the Fed funds rates sort of environment was negative about 40 percent of the time. And the consequences in both cases were dire.

Now we've had negative real interest rates since the crisis or before. And we need to be thinking not about continuing that but how we extract ourselves from that. Unemployment is coming down slowly, but we've had this -- a tremendous shock. And if I thought going to zero would give you full employment overnight without a whole host of unintended consequences, I'd be in favor of it.

But I think what you ended up with after the 2003 -- when we went down to 1 percent and we left it there -- when we did that, we thought unemployment was too high at 6 1/2 percent. So we managed to keep it low until we had a crisis that brought it up to 10 percent.

So we -- my whole point is, let's think longer term, let's be cautious; let's not, you know, shock the economy, but let's get it back to a little more normal so then monetary policy can do its role within bounds and the markets can function.

And I think markets, you know, are not perfect. You have ups and downs, but you let those work their way out and you not be part of the -- I think, part of the factors that can actually introduce instability by going with interest rates too low; and then you start seeing inflation, you wait, and then when inflation comes you kind of overreact, so you get the Fed funds rate very high. And then when you get the recession, you come back down. So you're introducing instability rather than giving yourself boundaries that then lets the market operate as it -- as it should.

There are no guarantees. That's the whole point.

STEIEGER: Understood. We've seen in the last several years an increasing intensity of political feeling in this country on both sides, passionate demonstrations from the right and more recently from the left in places like Wisconsin.

And in the aftermath of the financial meltdown in 2008, there were some calls for, you know, greater political control over the Fed. Do you worry at all about unleashing some of those forces, or would having more political control over the Fed be not such a bad idea?

HOENIG: Well, I do worry about political control with the Fed, and I think it would not be -- it would not lead to good outcomes because the reason that the Federal Reserve is given some degree -- most central banks now are given some degree of independence, and they're not completely independent by any measure -- is so you can take a look at the longer term. Politics tends to be the moment, and it's understandably that way, but that's why you want these central banks to be somewhat independent and then be able to make or -- make longer-run decisions.

Now I do worry about that. When we were in the Dodd-Frank bill -- I'm a very strong, as -- obviously -- I'm from Kansas City -- very strong advocate for the regional structure. I get a very different perspective in mid-America than I think I sense when I come to Wall Street, and I think that feeds into it. And having those banks that have that role and that input helps the longer-run perspective.

So I think that's essential. I think we are accountable, and we should be, but there should be this ability to act for the long run. And while we may not all agree in the committee, I think the ability to debate it and to take a longer-run view is essential.

STEIEGER: Okay. Why don't we shift gears and talk about the big banks --


STEIEGER: -- and regulation. You've called for shrinking the size of the five biggest banks, banks like Bank of America, Citi, JPMorgan Chase and so on. Why do you think that's a good idea? And how would you go about doing it?

HOENIG: I think part of the -- well, I think it's a good idea because they are so large that we cannot -- the -- they cannot be allowed to fail. And my experience in supervision over the years is that we have broadened the safety net and we continue to broaden it. And the issue is, t's not that they're good or bad; it's that this it not capitalism. This is a -- I hate to say it, but this is very much a socialism system. That is, you cannot fail. You are so big that, should you make a mistake, we will bail you out, and everyone knows it.

Now we've had this new law. It strengthened supervision.

STEIEGER: The Dodd-Frank --

HOENIG: The Dodd-Frank -- strengthened supervision. We did that after the crisis of the '80s. It has some capital strengthening. We did that after the crisis of the '80s. It has some resolution. We did that after the crisis of the '80s.

But the problem is, they're so large and so influential that will fade. And when you have a situation where you are too big to fail, then -- and everyone knows it, your cost of capital is below everyone else's. That means you have then even more momentum to become ever larger, which they have. They're 20 percent larger than they were before the crisis started.

Now if I could pull the safety net away and take those advantages away, then I'd say let capitalism work, and we would see some fail and some not. But that's not what we have.

So what -- so can we do it by strengthening capital? Temporarily, but not over the long run.

So what's your -- what's your final -- what is your solution? I mean, where do you come out on this? What's the -- do you just say, well, we'll live with it? Or do you begin to think, as they did after the Great Depression, maybe we can do something else? And that something else is separate out those activities that are speculative and highly risky, and you go from there.

Now they say, well, where do you start? I say, well, you start with what the fundamental mission of the commercial banking is, and that is payment system, which is so critical to the -- not only to the United States but globally. Our banks are critical to that. That's why we give them the safety net.

And the second is as the trusted intermediary with those funds that come through that payment system. So that's your core business.

And anything that moves beyond that should have a justification related to that. That in and of itself will contain their size and contain their risk. And then you move those highly risky activities outside into smaller groups.

Now they talk about hedge funds. Hedge funds can be very large, but some of them failed and we didn't notice it. Before we removed Glass-Steagall, we had investment banks who failed -- Drexel, for example. And, yes, I remember how intense it was at the time, but the effects were relatively temporary.

So can we go back to -- can we go back? Well, I don't know, but I do know -- I can see pretty clearly what the future is if we don't -- if we don't take another step and bring this down to a manageable size where we no longer have to protect them against all risk that they take on themselves.

And one of the outcomes -- one of the reasons we had this crisis was that even though we had Basel II and we had Basel I, we had leverage ratios that measured their assets against the real capital of over 30-to-one -- a very small margin of error, as it turned out, as many predicted. And we paid a dear price. So we need to go back and take the final step, in the sense of bringing back some form of Glass-Steagall -- extension of the Volcker rule, whichever -- whatever you want to call it -- to begin to limit their size that way, and limit that risk profile.

STEIEGER: So you would reimpose the Glass-Steagall separation of commercial banking with insured deposits and traditional lending --

HOENIG: Right.

STEIEGER: -- from investment banking and speculative trading for your own account --

HOENIG: Hedge fund activities and these sorts of things.

STEIEGER: That sort of thing. But just for banks of a certain size, or how --

HOENIG: No, for all banks. For all banks.

STEIEGER: For all banks?

HOENIG: Right. For all commercial banks; not all investment banks, but for all commercial -- and, you know, that's primarily for the largest banks, because most banks below them are not that heavily involved in the investment-banking side of things.

Now, you know, the issues around do you allow hedging when you have a customer who you need to protect and those sorts of things, are difficult but can be worked through. But I think the degree of speculative activity, based on insured and the federal safety net, is, I think, a prescription for a repeat of what we've experienced in the recent past.

STEIEGER: So Goldman Sachs, which has now got a commercial bank, would have to spin it out?

HOENIG: Bingo.

STEIEGER: Bank of America, which owns Merrill Lynch, would have to spin it out?

HOENIG: Correct.

STEIEGER: But you wouldn't put restrictions on size?


STEIEGER: In other words, JPMorgan Chase, Bank of America, could have as many branches --

HOENIG: Right.

STEIEGER: -- as big a share of deposits in the country as it could achieve.

HOENIG: As long as it was -- as long as it was confined to its primary mission, which is the payment system and intermediary activities. And then, I think then your other three components -- that is, your capital standards, your supervision -- become much more effective under those conditions. And that's why you, I think, have a more stable -- now, where we have -- where we have recessions, of course; where we have some degree of crisis, of course. But I think it would be much more manageable than this past one was, with less of an impact on the real economy over time.

STEIEGER: Now, if the structure you're talking about had been in place during the runup of the real estate bubble, if I think about it, it would not necessarily have prevented that bubble, because you could still have had these mortgage mills -- you know, Countrywide, IndyMac, the one up in Seattle -- churning out mortgages and then dumping them on Wall Street, and then Wall Street turning around and creating ever-more complicated derivatives on derivatives on derivatives. The structure you're talking about would not have cut into that.

HOENIG: Well, but you don't -- you don't --

STEIEGER: So are you looking for more aggressive regulation?

HOENIG: Well, you don't know that. For example, one of the issues, I think, was that when you got rid of Glass-Steagall and these larger commercial institutions, they were able to accumulate insured deposits and deploy those in fairly risky activities, including some of those mortgage activities. And they were able to manage that side with ease and, even though they were off the balance sheet, have an understanding that they would bring them back, because they had access to all these insured deposits.

So when you would limit that -- now, you would have -- yeah, would you may have -- may you have had some kind of a bubble in some areas? Perhaps, but I don't think it would have been near as dramatic. And I don't think the funding would have been as -- near as available in those circumstances as they were because you had insured deposits being funneled and then refunneled back out.

STEIEGER: But let me pursue the --


STEIEGER: -- supervision area, because that's where you started.

HOENIG: Right.

STEIEGER: You know, there's a sort of an argument -- and I don't think it'll ever be resolved; it's almost philosophy -- that what caused the bubble, you know, it was -- some people say it was, you know, it's monetary phenomenon.


STEIEGER: Just like they used to say about inflation. We had so much money sloshing around that we were -- it was guaranteed that we were going to have a huge bubble.

Other people say, yes, that certainly was the groundwork, but that the crash would have been much less severe, the excesses would have been much less huge if the Fed and the other bank supervisory agencies had been more aggressive: if they had not allowed the enormous expansion of mortgage activities where the banks had no skin in the game; if they'd not allowed the creation of not just simple mortgage-backed securities, but mortgage-backed securities sliced and diced a million times and repackaged together; if they had not allowed the creation of these special investment vehicles, the SIVs, that allowed banks to push -- push these risky assets, risky activities off their balance sheets and in essence hide them from the public.

Could supervisors have done a better job here?

HOENIG: Well, they're not all knowing, all seeing, all doing, so they could not have done all that you've just described, in my opinion -- having supervised a lot of institutions in my career. But here's how I look at that, just -- first of all, the conditions -- you create the conditions for a credit expansion, and you have to take responsibility for that. So when you have an extended period of very low interest rates that carry forward, you are creating an environment where you can extend credit and you do grow the balance sheets. And we saw that. So there is that -- there is that responsibility of monetary policy that we have to be mindful of.

And then supervision. Supervision works best when you have clear rules that don't require the examiner to be more -- to be able to see through the crystal ball and see the future better than the bank management. When you say that here's the leverage standard and it is a firm standard, you can't go to 34 to 1, because it's nonsense; 3 percent margin of error is unacceptable. You can't have a concentration in a particular area of more than -- of 400 or 500 percent of your capital. They can do that. But they can't see the future.

Now, they also -- let's say it's real estate, or let's say it's commercial real estate, or let's say it's farmland today. And let's take farmland, because it's in process right now -- in my part of the world, but it's national. There's $2 trillion of this out there, and it's not just in the Midwest.

Now, you've seen the value of the --

STEIEGER: Two trillion dollars of farmland?

HOENIG: That's the value -- that's the estimated value right now. So it's not a small number in the United States. So it matters. And we're seeing it increase in value dramatically. High commodity prices around the world. We've seen land values double, in some places even more. And we've seen implied cap rates on that fall from historic numbers around 7 percent, to 3 and 4 percent.

Now, you're the examiner. You walk into the bank. The bank's making a very conservative 70 percent loan to value. Now, you might argue whether that's conservative, but many people think that is.

Now, the value has doubled. You make a 70 percent loan on a 3 percent implied cap rate. Now, I might be able, as an examiner, to make an argument with you that that's not a particularly sound loan. Now, it's paying, the cash flow is tremendous, it's a tremendous credit, others are lending against it, so I say you don't make the loan?

Now, so you make the loan and you put these on your balance sheet. Now it's 3(00), 400 percent of capital, and you're making money like crazy. the bank examiner says you can't do that.

Now, what are the conditions? You've had easy credit, you've built the case.

Now, finally something gives, interest rates go back, you go back to the mean of the cap rate. The value of the land falls a third immediately, or nearly so. Now your 70 percent loan to value is --

STEIEGER: Under water.

HOENIG: Under water. Now the examiner is saying, ah, write it down. And the post-cyclical effects kick in. That's why it's a combination. You have to have the rule saying, you know, if you're going to concentrate, you can't concentrate more than X percent. Or if you're going to have capital, it's going to be a capital ratio that's firm and it's going to be real capital.

I'm not a strong supporter of Basel III -- or I wasn't at Basel II. And part of the reason is it's so complicated, I can game it. Anything that that's complicated can be gamed. And it was. And it will be.

So I want simple, understandable, enforceable rules. And then I want a -- my monetary policy to be normalized reasonably. And I want my supervision to be driven by standards that are firm. And I will still have variations, but I will have, I think, smaller variations over time. And that's the goal of supervision. And that's, I think, the goal of policy broadly.

STEIEGER: Okay, we're going to ask one follow-up question; and then, please, members, be ready with your questions.

Does the Fed, the controller, the other regulators -- do they have the authority to move in this direction, or do they require legislation to do that?

HOENIG: Well, I think they have the authority, but it's -- you know, they have the authority, but it's very difficult to do in the -- in the sense of, for example, capital standards. I think we have the authority and I think we should move quickly, but there is already an enormous push-back because -- and very logical. If you impose higher capital standards -- even anything significant, which to me historically would still be a fairly modest capital standard -- you're going to slow growth, you're going to cut off loans to people who need it, you're going to slow the recovery.

So that becomes very difficult to do over time, but that's -- now, that's where the supervisor has to step up to the challenge and say, yes, but here are the consequences of not doing so and we are going to implement this. So we have a -- we're going to bring the leverage standard down to 10 or 12 to one. Equity -- book value, not write-ups. And compared --

STEIEGER: Where -- what is it?

HOENIG: Well, it was as high as 30 to one. Now it's back down to about 20 or 18 to one. And I'd keep pushing that.

Now, remember, though, you're going to push back. The broad public may push back because -- and I understand that. Are there enough loans available to small business? And if you're building your capital, can you make loans? And those are all things that have short-term impact. And that's why the long run is such an important concept as we go. And we are improving as an economy. So we want to make sure we stay on this, but I don't think we necessarily can have a boom economy and rebuild these capital levels in these commercial banks and others.

STEIEGER: Questions? Right here. Microphone.

QUESTIONER: Thank you.

STEIEGER: Please identify yourself.

QUESTIONER: Steve Roberts -- (inaudible) -- Foundation. I know the Fed doesn't set fiscal policy, but nevertheless it must pay a lot of attention to fiscal policy because it's going to influence decisions you make.

HOENIG: Correct.

QUESTIONER: We have this enormous deficit, which is somewhere around 10 percent of GDP. It seems to be getting bigger for the moment, not smaller.

What is your view of, one, what the government is likely to do over the next few years? Will there be a plan to materially bring that down? Right now, we're trying to eliminate it by dealing with 12 percent of the budget, which doesn't make an awful lot of sense.

The -- so what's your view of how that's going to play out? And how might that affect future Fed policy? If we don't get it reduced or we do get it reduced, how might that affect Fed policy?

HOENIG: Okay. Well, first of all, I think -- I think we have as good an opportunity in this country today to address and begin to deal with the debt and the deficit as we've had in some time, because the broad base of American people understand this. I think they have to get through a couple of things, because you're right. We have to -- entitlements has to be part of the consideration. They are so large a part, and their future unfunded liabilities are so large. So that has to come on. And I think there are opportunities to begin to do that.

Now, one of the issues, I think -- it maybe tracks back to some of my earlier comments -- I think the American people understand this very well. I've talked to many of them. But one of the issues is a sense of fairness: Who's first? And some of it has to do with the very experience of "too big to fail": you know, these folks were taken care of, and they're walking away, and now I'm expected to make the sacrifice, and my Social Security is -- it's only this big. So there has to be a real -- there has to be a real explanation, and therefore an agreement that it is a shared sacrifice. And I think once you can do that -- and that means a plan, and maybe the Bowles-Simpson is the starting point that says, okay, we have it; it's bipartisan; and here is the 10-year to 15-year to 20-year plan, and we will stick to it; and there are penalties for failing to meet our goals within that. I think people would -- I think people would begin to accept that and be willing to see the deficit addressed, if there's a sense of fairness.

If not, and it falls apart and it continues to grow -- because I can go to the ag industry in my region or elsewhere, and they will say: Yes, we've got to take care of the deficit, but not me first.

STEIEGER: (Laughs.)

HOENIG: And I can go to the housing, and they can say: Yes, I want -- we need to take this -- but not the -- not the deduction first. So we have to get past that, and that means a real sense of a fair deficit plan over a long period of time that is firm, that is legislatively enforced with penalties for failure to achieve.

If we don't do that, then I am worried about monetary policy, because in the -- in history, what you see is when you have debts and deficits that run very rapidly up over time and build, real interest rates do rise; because as your economy builds and you're competing for that, real interest rates rise. And when that does, it has the effect of slowing down investments, slowing down the economy. And what happens? Inevitably, you turn to the central bank: You should take care of this by lowering nominal interest rates; and therefore, print more money. And then that has the pernicious effect of bringing inflation forward, and then you create even worse crisis.

So we have to address it now. We have to do it in a way that convinces the American people -- and the American people do understand this -- that it's fair, and that it'll be administered fairly, and penalties will be imposed on ourselves, either by tax increases within sectors or spending cuts to bring the deficit into line. And I think the American people will get behind that. They know -- they understand this better than we sometimes realize, in my opinion, in terms of the conversations I've had.


QUESTIONER: (Off mic.)

STEIEGER: Can't year you. Get -- fair enough.

QUESTIONER: Sy Jacobs, Jacobs Asset Management. About a year ago, Dick Fisher was here talking about -- at that time, the topic de jour was the mechanics of the exit strategy from QE1. And he was talking rather hawkishly about how necessary it was, and if they don't, it will give the appearance of monetization of the debt, with its inflationary consequences. So I asked the question: Aren't we already monetizing the debt by buying in a trillion dollars or more of our own debt with printing-press money? And his answer was: Not if it's temporary.

So now, a year later, we can look back and see that apparently it wasn't temporary, and in fact they didn't exit, didn't shrink the balance sheet, and in fact did the opposite with QE2. Are we not monetizing the debt? And doesn't that explain the inflation in asset prices -- gold prices, commodity prices -- that we've seen since then?

HOENIG: Well --

STEIEGER: "QE" stands for "quantitative easing."

HOENIG: Quantitative easing. Well, the answer is, yes, we are monetizing debt. I mean, that's how you -- that's how you do it. You buy bonds, directly or indirectly, and you monetize debt.

Now, right now, a lot of that's going into excess reserves, so it's not having an immediate effect on inflation. But it will in -- if it's allowed to remain, it will in time have what I call -- it'll initiate inflationary impulses. It takes time. And that's what fools you sometimes, because you don't see it immediately, so you say, yeah, this is -- this is fine. But it does.

Now, would I take it all out at once? No. I mean, one of the great -- I think one of the great mistakes of the -- of the Depression era was when excess reserves built up then, in 1936, in that period, and you more than -- more than essentially doubled the reserve requirements, which is a huge shock. So what I'm saying is, do it in a systematic fashion.

STEIEGER: And that resulted in an echo recession.

HOENIG: In an echo recession, because they were -- wanted liquidity, so they built their liquidity up, and that drew funds out. So we don't want to do -- we don't want to do shock therapy here.

But we do want to begin to show how we're going to withdraw that in a way that doesn't shock the economy, but also takes the future ability for the inflationary impulse to be carried through.

So, yes, we need to be thinking that now and how we will deal with that so that the -- and we need to explain it. That's my point about bringing the -- get off of zero, bring it to 1 percent, see these bonds come down, and then watch the economy and then move again, so that you can do it and explain it, so people aren't saying, "Well, what's going on?" and then become uncertain. And with uncertainty becomes fear, and fear becomes pulling back. And that's what we have to avoid. And I think we can do that. I think we can do that.

STEIEGER: Over here.

QUESTIONER: Nisa Abouaf (sp), Pace University.

I would like you to shed light on the following question, please. As you know, the balance sheet of the Federal Reserve has more than tripled, whereas M1 and M2 growth is in the single digits or in the low teens. If we assume that money supply stimulates economic activity, what is the Fed thinking? Why is the Fed not doing something about M1 and M2?

HOENIG: Well, I think M1 and -- what has taken place is that we have first targeted the Fed funds rate as the tool, and now quantitative easing. And M1 and M2 are consequences. And right now, with the reserves built up the way they are, they are not growing -- even in the teens, though, I think is a pretty good growth number. But they're targeting it. They haven't for years, because they changed the policy towards an interest-rate targeting regime. And that's the model we follow. And it's as simple or as complicated as that. And it would -- you know, it doesn't mean we couldn't change it, but at this point there's no -- to my knowledge, no discussion of changing it.


QUESTIONER: I wanted to get into the issue of commodities, if I may, since you're our aggie, but also our commodity person, even before the oil shock that we're experiencing now because of the fear in the Middle East.

I'm Carole Brookins. I was USED on the board of the World Bank, representing the United States for several years.

We've achieved part of our goal. We're going to have 7 billion people on the planet. More than the billion people who live in the industrial countries are now demanding goods and services. So even before this happened, you've had very strong demand for metals, minerals, a range of basic commodities. And agriculture is now impacted by more erratic weather. Whether it's due to climate change is another question, but it's more erratic and more exaggerated.

The chairman of the Federal Reserve, when he was asked about this several months ago before Congress, said, "Well, what happens in fires in Russia isn't really my interest. It doesn't really affect our policies that we do here."

How do you feel about this? And is this more than just monetary easing that's happening? Are we dealing with a whole new structural commodity demand base?

HOENIG: Well, I'm never one to contradict someone who's the chairman. But at the same time, let me answer your question this way. I think -- again, my opinion -- that any economic event can -- is more than one thing. And so what you do have in the globe today are a growth in income in emerging markets, and even more broadly than that, and that does increase demand for goods and it does increase the demand for improved diet.

So you do have real factors in play with the movement in demand. And there have been some disruptions in supply, which occurs in history, that have -- and I think the disruptions in supply have caused some spiking there. So that's part of the story.

And I think part of the story, too, is if you engage in a highly accommodative policy and you are the world's reserve currency, and you're therefore putting that out, that that does facilitate the demand side of that. And so you do have -- now, how do you break it out? What are the regressions and the complicated equations? Even they can't estimate it exactly. But we know that both have a role to play.

What we want to see, I think -- this is a value judgment, I guess, more than anything -- but that is, you do want, as you said, to see the world's incomes grow and demand pick up gradually, and the productive capacity accommodate that. And so it's the supply disruptions you want to see smoothed out and then have the others grow, but you can do that without enormous increases in prices if the supply side of this develops. And I think it is.

I mean, if you look at the increases in productivity in agriculture worldwide -- in our part of the world, we used to talk a hundred bushels an acre; then it was 200; now they're talking 300; the same thing in South America. And I think even in some of the wonderful bread baskets in the eastern part of Europe and so forth are under development. And you see land in that part of the world very, shall we say, ripe for development as well.

So I think that the long-run solution will smooth these out, and then we have to be, in another sense, on the policy side, sensitive to our monetary policy actions, not only here in the United States, because we do have impact on the rest of the world, but for selfish reasons, the (rest of the world ?) then has impact back on us. And so that's how I look at it, as an interactive part of the -- we are very interactive with the rest of the world, and should be.

STEIEGER: Yes, sir.

QUESTIONER: (Off mike.)

Just shifting a little bit from what should happen to what you think will happen, it seems that Chairman Bernanke is very tied to his approach and seems very driven by -- (inaudible) -- or a long time until employment really comes (down ?). It seems like that would lead to zero rate for a year or longer. And I'm curious whether you think he is tied to that and whether you've had some influence in shifting him toward -- (inaudible).

HOENIG: I don't know if everyone heard the question. If not, it's basically -- did they hear the question?


HOENIG: Okay. The question is if we're tied -- if we're concerned about unemployment and so forth, that the chairman is tied to zero rates for a long period, what's my view on that? Is that likely? And, you know, honestly, you have to ask the chairman. I just don't interpret for him, because I don't know how the -- you know, the intricacies of that for him.

But my own view is that, you know, everyone is well-intentioned. The goal is to bring the economy back. And we just have different views on this. And my view is that we have an accommodative monetary policy. If we took rates above zero and let the markets begin to see the signal, we still have an accommodative policy and we still move towards a growing economy -- 2, 3 percent, 3, three and a half percent, in those ranges -- and we do bring the unemployment rate down. But we do it in a way that's more sustainable, in my opinion.

And I don't -- you know, I base that on my experience of being involved in a variety of financial crises over time and economic events. But other people have different views, and only time will tell. That's the only way I can answer that.


QUESTIONER: Jacob Frenkel, JPMorgan.

I have what may sound a technical question, but still it has some substance, I hope. You already mentioned that the Fed has changed significantly the modus operandi, namely expanding the balance sheet significantly and also going into a different quality of assets than what we used to think about some years ago.

You already said that the problem today is not lack of liquidity. In fact, much of the money goes into bank access reserves. So the argument has been said that really what the Federal Reserve is doing should not be just thought as extending liquidity, but rather buying specific type of assets that are of a longer maturity so that you impact the yield curve on a specific area that is allegedly supposed to enhance investments and growth.

Now, you have been in business long enough. Isn't that what was used more than a quarter of a century ago, when we called it Operation Twist, twisting the yield curve? And wasn't the verdict then was that it was a dismal failure?

HOENIG: Yes, I mean, that's Operation Twist in that period of time, and it was not considered successful. I won't say it was a dismal failure, but it was not considered successful.

STEIEGER: Just to explain the technicality, the Fed normally focuses on very short-term rates. This is supposedly a way, by operating at the long end, to bring those rates down.

HOENIG: Right. And that's a view. I mean, people feel we should -- some people feel we should do that. My view is monetary policy should be very limited and have a very careful, in terms of what sectors, what maturities, what industries it gets involved with. It's a broad, blunt instrument for a reason. And when you start trying to manage the yield curve for someone's benefit, you invite requests for helping other groups out.

Now, in the middle of the crisis, or in the height of the crisis, when mortgage-backed securities were purchased, you know, there was justification given around that, but it was temporary, and that was done. And now you're thinking about going out the yield curve to lower long-term rates or to do something else.

Now you've invited -- and I think my concern has been that you've set precedent. So with an earlier question was asked about the deficit. If you are in the business of buying long-term bonds or bonds broadly, and you now have the federal government at an increasing debt that needs to be financed, would you not see the pressure to buy up the yield curve or buy bonds of a variety of -- so you've now introduced another use for the central bank that becomes monetizing the debt in a sustained manner. And I think that has very significant risk to the independence of the central bank over time, and we need to be mindful of that.

It's not that I don't want to see good outcomes. I want to see the economy continue to improve. But I think history has shown that if you start using monetary policy for different sectors and different parts of the yield curve, you are going to invite, I think, a lot of pressure to do that again in the future for less valid reasons than the major financial crisis that we just suffered through. So I'm very cautious about doing that and would like to see us remove ourselves from that as quickly as possible.

QUESTIONER: Andrew Gumlonk (sp), Arnold -- (inaudible).

Could you address, please, the dollar and the term structure of U.S. interest rates? In response to Steve's question, you worried, quite correctly, about increasing pressures on interest rates from competition for funding. But in addition to that, we haven't been able to convince our creditors to buy longer-term paper.

So you've got the rolling -- and to some extent it's self-financing, but it's not necessarily the case -- so what is it that we can do to convince our external creditors to buy 30-year paper at 3 percent and not 30-day paper at zero? And obviously that plays into the dollar as well. I'm curious to see your views.

HOENIG: I won't comment on the dollar, for obvious reasons. But I will tell you that here's the way I look at your issue. As the -- my view is as the U.S. economy gives confidence to the rest of the world that our recovery is sustainable, that our monetary policy is long-run-focused, I think those issues go away.

You know, I've always found that strong, vibrant economies attract capital. And that's what we need to be focused on as an economy. And addressing the deficit, addressing our debt, giving the American people confidence that we're addressing it, will give the rest of the world confidence that we're addressing it, will make our future look much brighter to the rest of the world, and we'll become -- they'll be more than willing to buy our paper along the yield curve. Those are the steps, I think, that are necessary.

I don't want to -- I don't think it's necessarily useful to try and manipulate outcomes. I think you have to have the long-run view. Let -- I've always said strong economies are -- solve so many problems. And that's what we need to focus on.


QUESTIONER: David -- (inaudible).

I was just wondering if you have any concerns about the raising of the debt ceiling in the near term and what you think should be done to hinder that going forward, perhaps once we're coming out, as you say, in a stronger economy.

HOENIG: Do I have concerns? Well, I have -- my concerns are more about the long-term implications of debts and deficits. And the -- you don't want to get into a situation where you have -- you're into some kind of a game of chicken around that. I think that's why I go back -- I noticed the House approved the extension. And there's some good-faith compromises in that. I think that's probably healthy. And now let's focus on the long run. And those are tough questions.

And as I said earlier, I mean, you cannot -- as unpopular as it may seem, you cannot ignore entitlements as part of the areas that have to be addressed. And those entitlements will be, I think, successfully addressed when the American people feel it's done fairly.

I've talked to many individuals who are, let's say, middle-aged, and they don't necessarily expect that there'll be -- it'll be exactly the same for them as it was for their parents. So they want to -- they understand that. But they want to make sure it's done fairly. And whatever fairly is, the Congress can define. And I think that's why we need to start with, like, a Bowles-Simpson bipartisan commission. It's done better than anyone thought it would do, and I think it can be a very good starting point going forward.

And then the issues of debt ceilings and that become secondary, as they should be, to the longer-run goals of bringing our debt down -- bringing our deficit down and then our debt down as a percentage of GDP and allowing our economy to expand through the private sector successfully.


QUESTIONER: Good morning. Brian O'Neill with Lazard Freres.

You've been very clear with us this morning, including your views on Basel III or the desirability of it. When Dick Fisher was here a year ago, I think it's fair to say that he shared some of those same reservations. As a director of a European bank, however, I see the commitment of the continental Europeans, at least, to Basel III.

What do we do on the global scale? What do we do with our regulators, giving them two different toolkits, two different sets of standards? Where does that leave us?

HOENIG: Well, I think it leaves us with a basic leverage ratio, and then that's when supervision becomes very important as a tool itself, because I think if you're gaming Basel III, I think you still get the inequities.

And, you know, the history on Basel I is you had -- you have these competing banks in different parts of the world, whether it was Asia or Europe or the United States, and so you were trying to bring some kind of level playing field forward. But what you brought forward was a very complicated and easily gamed and distorted outcome, with undesirable consequences.

My view is, as a person who was involved in the examination, I almost can tell you clearly, if I found a bank that was highly leveraged -- all right, 30 to 1 -- the likelihood of that bank being in trouble was a heck of a lot bigger than the bank that was 10 to 1, even though the bank 10 to 1, you might say, had more risky assets. And if I went in -- if I saw that, I'd prioritize the banks in terms of where you go look. And I go into that bank and I find trouble, I can begin to address it.

Thirty to 1 with these kind of assets, you need more capital now or else. And I have grounds. And if I go into the bank that has a 10 to 1 -- and I won't go into it as frequently, but I start finding that they're taking higher risks -- I say, "Your risk profile, even with this 10 to 1, is too high. We need to begin to address this," so that you have a common -- much more difficult-to-game system with clear leverage.

And that is, I'm talking book value. I'm not talking, you know, write up for this and write around for that. I'm talking pure book value. And I can tell you, highly leveraged, you're going to have more problems than low leverage. Low leverage, you may have them, but you'll find them when you go in. But the odds are with me on the numbers there.

Now, you give a complicated equation that the risk weighed on residential real estate is only 10 percent, because of course only real estate goes up, right?


HOENIG: You get bad outcomes. You get really bad outcomes. And that's where I worry.

STEIEGER: We have time for one more. Right here.

QUESTIONER: Thank you. Lester Wigler, Morgan Stanley.

Just to follow up on the last question, if one were to put simple capital requirements and debt-to-equity ratios in place, wouldn't that potentially change the business model of a bank to sell the loans that they originate in order to free up their balance sheet to continue to make additional credit available?

HOENIG: Well, if the leverage is endangering the institutions, as we just went through, is that a bad outcome? In other words, if you're going to make credits -- and you shouldn't be making them with a 10 percent risk weight, and you don't -- I don't know that that's a bad outcome from that change.

And if you -- if they are good loans and the examiner comes in and you get a good return for it, I think you are better off. But I think, otherwise, you get bad outcomes. And history is on my side. I mean, Basel -- the crisis we just went through, with real leverage ratios of 34 and 35 and 36 to 1, was not healthy. And, yeah, we had tremendous growth for a while. At what cost? And we weighted things because we thought we knew the risk. At what cost when we didn't really know the risk?

So the analyst has to be very careful. And when you have very strict, understandable rules and you know that they're going to be coming in and looking at those, I think you make more careful loans. And that's why I say one of my concerns is how it will be interpreted, and that is, "Well, you're going to stunt growth because you're demanding more capital." And the fact of the matter is, temporarily you probably will.

But before there was a safety net, ladies and gentlemen, capital ratios in this country and worldwide were significantly higher than they are today, where they have been in the last 25 years.

STEIEGER: That's a good place to stop.

I have two things I would like to do. The first is to remind the members that the next session in this series is a week from this coming Friday, March 11th, from 7:45 to 9:00. And the guests will be Miguel Fernandez Ordonez, the governor of the Bank of Spain, and Elena Salgado Mendez, minister of economy and finance of Spain.

The second thing I want to do is to thank our guest, who's been terrific today. Thank you very much.

HOENIG: You're welcome. My pleasure. (Applause.)











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