Executive Summary

This document presents a structured and cleaned transcript of Deutsche Bank Research's podcast, Podzept. In this episode, Camilla Siazon from the Thematic Research Team speaks with colleague Luke Templeman about a comprehensive research project analyzing how global events impact investment portfolios.

The discussion challenges the traditional market assumption that investors simply "look through" global shocks. By leveraging structured and unstructured survey data from 500 investors across the US and UK, the research reveals a highly polarized investor base divided by time horizons, asset exposures, and geographic constraints. The conversation also explores the rise of "small volatility" events, the mechanical risks of retail leverage, the breakdown of traditional safe havens, and the long-term structural tug-of-war between worsening sovereign debt and potential AI-driven productivity gains.

Main Themes & Key Takeaways

• Polarization Over Indifference: Investors do not simply ignore geopolitical or macroeconomic shocks. Instead, they are highly polarized. The same event (e.g., conflict in the Middle East) is viewed as a severe risk by some and an investment opportunity by others, depending on their portfolio construction and time horizons.
• The "Small Vol" Threat: While markets often appear "flat on the week" after a shock, rapid intra-week swings (such as the South Korean KOSPI's 45% round-trip) cause irreversible wealth destruction due to retail leverage and automatic margin liquidations.
• The Failure of Traditional Havens: During major shocks in the 2020s, the traditional safe-haven basket (gold, USD, Swiss franc, Japanese yen, and US Treasuries) has frequently failed to hedge equity risk, weakening the market's natural cushioning mechanisms.
• The Sovereign Debt Iceberg: Sovereign debt and fiscal deficits represent a massive underappreciated risk. Despite widespread consumer anxiety about the state of the world, investors exhibit a historical anomaly: viewing the 2020s as the "least uncertain" decade for investing, largely due to the expectation of aggressive government and central bank backstops.
• The AI vs. Debt Tug-of-War: The ultimate trajectory of global markets depends on whether productivity gains from artificial intelligence can outrun the structural drags of sovereign debt, adverse demographics, and geopolitical instability.

Cleaned & Structured Transcript

Section 1: Introduction and Project Origin

[00:00] [Announcer]: Podzept, the podcast from Deutsche Bank Research.

[Camilla Siazon]: Hello, everyone, and welcome to Podzept. I'm Camilla Siazon from the Thematic Research Team, and today I'm speaking with Luke Templeman, who sits on the same team. Today we are doing something a little different. Normally on this show, we chase a single story, but today we are exploring one big idea across several pieces of research, all built around a single premise: global events matter to your portfolio—except when they do not. Let's start at the top. Where did this project originate?

[Luke Templeman]: Thanks for having me, Camilla. The starting point for this project was a common assumption in markets that investors look through global events. When war breaks out, or when there is a tariff shock or an energy crisis, the received wisdom is that markets absorb the shock, shrug it off, and move on. When you look at headline indices a short while later, that story often appears true.

[Camilla Siazon]: So, flat on the week or the month, indicating nothing to see here.

[Luke Templeman]: Exactly. But we wanted to test that assumption by finding out what people actually think, rather than simply inferring their thoughts from market movements. We asked our DB Data Insights team to survey 500 people across the US and the UK. We asked them in their own words whether and why global events affect their portfolios, and what they are actually doing about it. We took all the structured data and used AI to analyze the unstructured written text at scale.

[Camilla Siazon]: And did the findings dismantle the idea that markets look through everything?

[Luke Templeman]: I would not say they dismantled it entirely, but they definitely showed that investors are not indifferent to global events. They are actually highly polarized. When you ask people about broad investment themes, a large portion will say there is no effect either way. However, when you ask specifically about themes like geopolitics, energy prices, or inflation, that "no effect" bucket shrinks dramatically. Almost everyone has a strong view: they see these themes as either a significant risk or a significant opportunity. Very few people are genuinely indifferent.

Section 2: Investor Profiles—Risk, Opportunity, and the US-UK Divide

[05:00]

[Camilla Siazon]: Is "indifferent" the right word, or is it that they care but in opposite directions?

[Luke Templeman]: That is the more interesting finding. The same event, such as conflict in the Middle East, can be read completely differently depending on what you own and your investment time horizon. A broad equity investor sees a Middle East shock as a threat because it raises oil prices, hurts consumer spending, and pressures the market. Conversely, an energy, gold, or defensive asset investor looks at the exact same headline and sees opportunity. A long-term diversified investor might genuinely think it is just short-term noise for their portfolio, even if they agree the underlying event is major news for the world.

[Camilla Siazon]: So the investor base is not split between those who understand the market and those who do not?

[Luke Templeman]: No, it is split by time horizon and portfolio composition. That is a crucial reframing, because a lot of market commentary treats unaffected investors as naive, and views polarization as a market inefficiency. We do not think that is correct. Both the negative and positive camps can be internally consistent; they are simply operating on different timeframes.

[Camilla Siazon]: Can you walk me through these two camps? What does the negative camp say in their own words?

[Luke Templeman]: The negative responses trace out a highly consistent transmission mechanism, even when respondents do not use technical language. The logic flows like this: a global conflict disrupts energy, trade, or market confidence; energy and commodity prices rise; inflation and interest rate pressures build; corporate margins and consumer spending weaken; and this culminates in falling stock markets. No one explicitly writes "margin compression" or "equity risk premium" in the survey boxes, but that is functionally what they are describing.

[Camilla Siazon]: They are describing the economic transmission mechanism using everyday vocabulary.

[Luke Templeman]: Exactly. There is also a fascinating difference between the US and the UK here. In the US, the primary negative theme is direct military and geopolitical conflict—such as tensions involving Iran, the Middle East, or the Russia-Ukraine war. In the UK, the concerns are similar but more tightly focused on the cost-of-living channel. UK investors focus on how a distant war feeds into domestic energy prices, fuels inflation, and ultimately impacts their household utility bills.

[Camilla Siazon]: That tracks, given that the UK lacks the domestic energy production capacity of the US.

[Luke Templeman]: Yes, and the survey numbers bear that out. Energy prices are viewed as a risk by about 40% of US investors surveyed, compared to 55% of UK investors. At the same time, 40% of Americans see energy prices as an investment opportunity, versus only 29% in the UK. The US has a large domestic energy sector that investors can own, whereas the UK investor base largely experiences the same geopolitical headlines solely through the cost side.

[Camilla Siazon]: What does the positive camp look like?

[Luke Templeman]: The positive camp breaks down into three distinct types, which is one of the most useful insights from the qualitative written responses. First, you have the "optimists," who believe that technology and economic growth dominate all other factors over time. Second, you have the "sector opportunists," who own assets that directly benefit from disruption—such as energy, gold, and defense. Third, you have "tactical buyers," who view volatility itself as the opportunity. These are the investors who buy the dips when the market drops.

[Camilla Siazon]: So, they operate under the worldview that disruption creates opportunity.

[Luke Templeman]: Exactly. That phrase—"disruption creates opportunity"—appeared almost verbatim across dozens of responses. We also noticed a geographic difference in optimism. American respondents were far more likely to frame their optimism around artificial intelligence, technology, innovation, and new markets. British respondents leaned toward a more generalized optimism and long-term economic recovery—less "AI will save us" and more "things tend to get better eventually, so we should tough it out."

[Camilla Siazon]: What about the people who say none of these events matter? What is driving their perspective?

[Luke Templeman]: This "no impact" group is worth unpacking because that label serves two very different functions. The first group is "strategically insulated." These are genuinely diversified, long-term investors with holdings in defensive or locally exposed assets that shield them from global shocks. Many retirees fall into this category; their attitude is that they have constructed a structurally safe portfolio and do not need to react to every headline.

The second group is characterized by genuine uncertainty. They are not saying global events do not matter to the world; rather, they do not know how to connect macro headlines to their specific holdings. This shows up as non-committal language, such as "markets go up and down" or "I invest for the long term." While those statements may be true, they are often a polite way of saying they have not thought the transmission mechanism through and prefer not to react.

Section 3: Market Volatility and the "Small Vol" Phenomenon

[10:00]

[Camilla Siazon]: That is an uncomfortable finding for those who argue that markets are perfectly efficient and everyone is well-informed.

[Luke Templeman]: Yes, it is. There is another underweighted layer here: fiscal debt and deficits. This theme shows up far less in unstructured written responses because people do not typically write about "sovereign deficits" off the cuff; it is not top-of-mind. However, when asked directly, 38% of both American and British respondents called fiscal debt and deficits a major risk. This concern sits beneath the inflation and interest rate narratives, even if the underlying fiscal cause often goes unmentioned.

[Camilla Siazon]: So, it is an economic iceberg of sorts?

[Luke Templeman]: That is a good way to put it, and it highlights the broader polarization issue. Investors who are bullish on AI are implicitly betting that technological productivity can outrun fiscal and geopolitical drags. Conversely, those who are bearish are saying that debt, conflict, and policy instability will overwhelm technological progress. The real debate is not whether global events matter—everyone in our survey agrees they do—but which of these forces will win the tug-of-war.

[Camilla Siazon]: If I am an investor listening to this, how should I apply this conclusion regarding polarization?

[Luke Templeman]: The practical takeaway is to stop viewing global events as a single, binary directional call on the market—up or down. Instead, we should view them as a source of market dispersion. Global events change who wins and who loses far more than they move broad indices in one direction. Focusing on dispersion is a much more constructive framework for investing than simple "risk-on, risk-off" positioning.

[Camilla Siazon]: Let's use that dispersion idea to transition to another topic. A few weeks ago, you published a piece titled "Situational Awareness: Do We Have It?", which discussed how markets are failing to react to volatility as they should.

[Luke Templeman]: I understand why you say "as they should," but that might not be the most accurate phrasing. We recently saw the liquidation of the hedge fund Situational Awareness. It was heavily leveraged on AI trades that went sour during the tech sell-off, and the fund ended up unwinding most of its positions to Citadel. For a brief moment, there were genuine concerns about whether this was a systemic watershed moment. However, after a couple of days of volatility, the market stabilized and moved on.

Simultaneously, the South Korean markets experienced extreme volatility. The KOSPI fell more than 20% in 48 hours, only to rally 25% off its low, finishing the week nearly flat.

[Camilla Siazon]: Flat on the week again—the same phrase we used earlier.

[Luke Templeman]: Exactly. And focusing on that "flat" weekly finish is the wrong takeaway in both cases. An index that undergoes a 45-percentage-point round-trip in a matter of days is economically vastly different from an index that remains stable. When investors hold leveraged and margin positions, those positions are closed out mechanically and irreversibly on the way down. This happens regardless of whether the index subsequently rebounds. The portfolio loss is locked in. While the index-level performance might net out, there was real wealth destruction for individual investors, many of whom were first-time retail investors in South Korea who had leveraged up. That loss does not net out.

Section 4: Retail Leverage and Central Bank Policy

[15:00]

[Camilla Siazon]: How severe was the impact in South Korea specifically?

[Luke Templeman]: Reports indicated that over 3% of South Korea's entire adult population received a margin call within a two-week window. That is an alarming figure, driven by the massive expansion of leveraged ETFs tracking individual stocks and industries. While South Korea is an extreme example, this trend is emblematic of a broader explosion in retail leverage across developed markets in the US and Europe through new leveraged products.

In Korea, part of the issue was that retail investors leveraged heavily into newly launched funds exposed to Samsung and SK Hynix. These highly correlated, dominant stocks became vehicles for rapid retail leverage almost overnight.

[Camilla Siazon]: So when those underlying stocks fell, the leverage products amplified the downward momentum.

[Luke Templeman]: Exactly. That is the structural reality of leveraged products. They force non-discretionary, programmatic selling as prices drop; it is not an emotional panic, but a mechanical feature of the product's design.

[Camilla Siazon]: In your Situational Awareness piece, you refer to these as "small vol" events. Why is the size distinction important?

[Luke Templeman]: Because we expect these "small vol" events to occur with increasing frequency. If we use the VIX as a proxy for volatility—imperfect as it is—and look at the post-financial crisis era, the frequency of VIX spikes has risen from about 0.3 per month during the low-rate era to nearly 0.5 per month in the current rate-normalization era. That represents a 50% increase. If we only watch out for massive, systemic risks, we will miss this pattern of smaller, frequent disruptions that can cascade if market conditions are fragile.

[Camilla Siazon]: What are the fragile market conditions you see today?

[Luke Templeman]: The primary factor is the accumulation of leverage built up during more than a decade of ultra-low, stable interest rates—embedded in ETFs, margin accounts, hedge fund books, and corporate balance sheets.

There is also a specific blind spot we highlight. While market attention is understandably focused on rising sovereign debt yields, we often show clients a chart of global debt as a share of GDP, broken down into public, household, and non-financial corporate debt. Clients almost always focus exclusively on the public debt line, ignoring household leverage because it has plateaued in recent years and is not receiving the same level of scrutiny.

[Camilla Siazon]: You have also suggested that the Federal Reserve might actually want to see more volatility in the market. Can you explain that logic?

[Luke Templeman]: This is a theory that has been discussed by market commentators, including Rob Armstrong at the Financial Times. The argument is that Fed policymaker Kevin Warsh's withdrawal of the explicit, highly predictable forward guidance we became accustomed to is a deliberate effort to reintroduce an "uncertainty premium" into markets. The belief is that suppressing day-to-day volatility ultimately fosters larger financial crises. Calm, stable markets quietly encourage excessive borrowing and risk-taking by governments, retail investors, and other market participants, distorting normal price discovery.

[Camilla Siazon]: So, artificially calm markets are actually dangerous, and volatility serves as a necessary safety valve?

[Luke Templeman]: That is the theory. Of course, Warsh is communicating carefully to avoid spooking the markets unnecessarily. But if policymakers believe that routine volatility is healthy for financial stability, investors should expect more episodes like the Situational Awareness liquidation and the KOSPI swing. They should stop treating these as isolated, ring-fenced anomalies.

Section 5: The Breakdown of Safe Havens and the Fiscal Trajectory

[20:00]

[Camilla Siazon]: You also discuss safe havens—the US dollar, gold, and US Treasuries—arguing that they are failing to perform their traditional roles during these "small vol" events.

[Luke Templeman]: This is one of the more concerning and underappreciated findings we have uncovered. This decade, the traditional safe-haven basket—comprising gold, the US dollar, the Swiss franc, the Japanese yen, and US Treasuries—has frequently failed to hedge equity risk during major market shocks. We saw this breakdown during the COVID-19 crash, the 2022 rate hikes, the 2025 tariff shock, and the 2026 tensions in the Middle East. The basket has not acted as an effective risk hedge.

[Camilla Siazon]: So the traditional shock absorbers are no longer absorbing the shock.

[Luke Templeman]: Exactly. If safe-haven assets decline at the exact moment they are needed most, the cushioning effect that prevents small volatility events from escalating into systemic crises is weakened. This increases the probability that a future small volatility event could turn into a larger, uncontained shock.

[Camilla Siazon]: What are the chances of a small event becoming systemic?

[Luke Templeman]: Let's look at the Silicon Valley Bank collapse in 2023. On paper, that issue should have been contained: it was a mid-sized regional bank with a highly concentrated deposit base and a duration mismatch. Yet, the initial concern triggered a rapid confidence panic, forcing policymakers to step in and effectively guarantee deposits across the entire banking system. The lesson is not that every small event will turn systemic, but that the ones that do are often difficult to predict, requiring massive policy interventions to stabilize. If policymakers are ever constrained from implementing such guarantees, the outcome of a similar bank run could be far more severe.

[Camilla Siazon]: Policymakers play a critical role here. Kevin Warsh's recent address at Jackson Hole pushed up bond yields. How does this feed into the market volatility we should expect?

[Luke Templeman]: Jackson Hole was Warsh's first address as Fed Chair. He used it to lay out an inflation-focused case for the current macro environment, noting that "65 months of sustained elevation sits squarely with us" and explicitly stating, "we have a lot of work to do." He pointed to hot Personal Consumption Expenditures (PCE) inflation.

Markets reacted by focusing primarily on the front end of the yield curve and the near-term probability of a rate hike. However, from the standpoint of future volatility, I was much more interested in his comments regarding how "trends matter most." While many interpreted that as a comment on near-term inflation, we think he was talking about how the Fed views the long-term sovereign debt trajectory.

Section 6: Megatrends and the Technology vs. Debt Race

[25:00]

[Luke Templeman]: To put this in context, consider the broader US financial infrastructure. Treasury Secretary Scott Bessent has previously expressed a desire to target the 10-year yield, which aligns with the Treasury's buyback program. The core issue is the credibility of the US fiscal trajectory. When the next major shock arrives, the behavior of the bond market will ripple through every asset class, not just fixed income.

Our survey data shows that the average respondent in both the US and the UK currently sees more opportunity in equities than in bonds. Interestingly, this preference for equities over bonds often strengthens during periods of economic uncertainty. Specifically, 28% of Americans said they would buy equities during an economic shock, compared to only 24% who would buy bonds. We saw the same trend in the UK, where 25% preferred equities and only 18% preferred bonds.

[Camilla Siazon]: That is a complete reversal of the textbook relationship, where investors are supposed to run to bonds as a safe haven during uncertainty.

[Luke Templeman]: It is, but we do not think it is irrational. Since the start of interest rate normalization in 2022, investors have experienced bonds losing significant value at the exact same time equities were falling. This broke the traditional premise of holding bonds as a portfolio stabilizer.

When we model long-term global megatrends quarterly, we track six major forces: technology, sovereign debt, geopolitics, domestic politics, demographics, and energy. Of these six, sovereign debt is our greatest concern. The indicator has been trending downward for three decades, compounded by shrinking working-age populations that weaken the tax base.

This ties directly into Warsh's speech. He raised a question we have been analyzing for some time: can productivity gains from artificial intelligence outweigh the worsening trends in sovereign debt? Warsh noted that Fed task forces are actively studying whether AI can sustainably boost economy-wide productivity, whether AI is complementary or competitive with labor, and whether the next generation of AI models will be capital-intensive or capital-light.

[Camilla Siazon]: Why is the capital intensity of AI so important to the sovereign debt story?

[Luke Templeman]: Because almost all other global megatrends—sovereign debt, geopolitics, domestic politics, and demographics—are highly negative. While capital availability is currently high across private markets, corporate balance sheets, and money market funds, this capital buffer could be run down rapidly if the AI build-out proves highly capital-intensive.

[Camilla Siazon]: Is there a historical precedent for an economy digging itself out of a debt hole of this magnitude?

[Luke Templeman]: There are two historical parallels. The first is the Long Depression in the US during the mid-1870s, which followed a financial crisis triggered by speculative overbuilding of railroads. Railroads were a highly capital-intensive, general-purpose technology that went from being investment darlings to deeply distrusted assets. Despite minimal government intervention and high unemployment, the underlying railroad technology eventually integrated into the broader economy. Combined with other positive macro trends, this led to a period of remarkable economic growth.

The second parallel is the post-World War II era in the US, when debt-to-GDP exceeded 100%. What followed was 35 years of steady deleveraging alongside robust economic growth. This deleveraging was heavily aided by tailwinds: accelerating globalization, stable domestic politics, and advancements in energy and technology all pulling in a positive direction simultaneously.

Today, technology is the only clearly positive megatrend. Debt, demographics, domestic politics, and geopolitics are all structural negatives. This means technology has to do far more heavy lifting this time around than in previous historical periods.

Section 7: The Paradox of Certainty and Key Investor Guidelines

[30:00]

[Camilla Siazon]: I want to bring up the concept of uncertainty. Between normalized interest rates, rising populism, global conflicts, and key trade disruptions like the closure of the Strait of Hormuz, this feels like the most uncertain investment environment in decades. Yet, your research suggests investors do not see it that way.

[Luke Templeman]: Yes, it has been a decade of major shocks: a pandemic, the largest land war in Europe since World War II, the fastest rate-hiking cycle in a generation, tariff disputes, and Middle East conflict, all within a six-year window. Strangely, when we surveyed people in the US and UK about the most uncertain decade for investing since World War II, the 1960s and 1970s were popular choices, but the 2020s was rated as the least uncertain decade. Consequently, investors across all age groups reported a strong willingness to take on more investment risk.

[Camilla Siazon]: That is highly counterintuitive, given how low general consumer sentiment has been running.

[Luke Templeman]: It is a striking paradox. Traditional surveys of consumer sentiment and general outlook are at multi-decade lows; people report feeling highly anxious and discontented about the state of the world. Yet, they are simultaneously highly confident about the investment environment.

When we looked into this discrepancy, we identified three main drivers. First is the "government backstop." The scale and speed of government and central bank interventions demonstrated this decade have convinced investors that a safety net will always be deployed to protect households and markets. Second, while the frequency of shocks has risen, individual disruptions have remained relatively contained rather than compounding into a prolonged depression. Third, technology has acted as a massive buffer in people's professional and personal lives, particularly during and after the pandemic.

[Camilla Siazon]: But you are not entirely reassured by this prevailing sense of market certainty.

[Luke Templeman]: No, because this stability is not free. Every fiscal and monetary intervention is added directly to sovereign balance sheets, where the long-term trend is sharply negative. The very backstops that provide today's market certainty are generating tomorrow's structural risks. If a major shock arrives at a moment when fiscal capacity is severely constrained, the system will face a very difficult test.

[Camilla Siazon]: What should investors monitor to determine if this regime is starting to shift?

[Luke Templeman]: I would watch three main indicators:

Do not assume traditional havens will protect you. In the next shock, traditional assets may fail to hedge equity risk. Investors should look to genuinely uncorrelated assets, particularly within private markets, to achieve true diversification.

Monitor policy response speed as a key variable, not a guarantee. Today's calm depends on fiscal and political capacity, both of which are being steadily eroded by sovereign deficits.

Watch the technology megatrend. This is the ultimate swing factor. Current market confidence rests on the assumption that AI-driven productivity gains will offset all other structural negatives. We expect a strong ramp-up in AI adoption and productivity over the medium term, but any stalling or disappointment in this area would remove the primary buffer preventing global shocks from compounding.

[Camilla Siazon]: We have covered a vast amount of ground: polarized investor views on global events, "small vol" shocks acting as potential warning signs, a Fed Chair intentionally reintroducing volatility, the race between sovereign debt and AI productivity, the certainty paradox, and a generation of investors taking on more risk. If you had to distill this into a single closing thought, what would it be?

[Luke Templeman]: Global events matter. They do not necessarily move entire markets in a single direction, but they create substantial dispersion, rewarding certain positions while punishing others based on time horizons and asset exposure.

Events like the Situational Awareness liquidation and the KOSPI swing are the canaries in the coal mine; they are contained manifestations of a broader leverage problem. While the policy backstop makes markets feel secure, that safety net is more fragile than it appears.

[Camilla Siazon]: So the single unifying warning across your research pieces is that the very mechanisms making the world feel manageable today are the ones quietly increasing the systemic stakes for when the next major shock arrives.

[Luke Templeman]: Exactly. That is not a call to panic, but a recommendation to price in the structural asymmetry. We simply cannot assume that the current relative calm is free.

[Camilla Siazon]: Luke, this has been an excellent conversation. Thank you for joining us.

[Luke Templeman]: It was a pleasure, Camilla. Thank you.

[Announcer]: Podzept, the podcast from Deutsche Bank Research.

This podcast has been produced by Deutsche Bank and may contain research as defined in MiFID II. The information discussed is believed to be reliable and has been obtained from public sources believed to be reliable, although Deutsche Bank makes no representation as to its accuracy or completeness. Opinions, estimates, and projections discussed constitute the current judgment of the speaker at the time of recording. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. For further important information, please visit research.db.com.

Disclaimer

This transcript has been generated using artificial intelligence and may contain minor inaccuracies or omissions. For complete accuracy and context, please refer to the original podcast recording here.

Executive Summary

This document presents a cleaned, structured, and professionally formatted transcript of the Deutsche Bank Research podcast, Macro Matters on Podzept. Hosted by Matt Luzzetti (Chief U.S. Economist) and Matt Raskin (U.S. Head of Rates Research), the episode features guest Loretta Mester, former President and CEO of the Federal Reserve Bank of Cleveland (2014–2024) and long-time Federal Open Market Committee (FOMC) participant.

The discussion centers on the Federal Reserve’s recently established Inflation Task Force. Mester provides a unique insider perspective on the historical evolution of the Fed's 2% explicit inflation target, the mechanics of inflation expectations, and the limitations of traditional forecasting tools like the Phillips curve. She also shares insights on current macroeconomic challenges, including persistent structural supply shocks, the inflationary and productivity implications of Artificial Intelligence (AI), and her expectations for the task force’s leadership and eventual recommendations.

Key Takeaways

1. Preservation of the 2% Target: Former Cleveland Fed President Loretta Mester strongly advocates for keeping the explicit 2% inflation target. Changing the target or shifting away from it while inflation remains above target would damage the Fed's credibility by looking like "changing the goalposts in the middle of the game."
2. Value of an Operational Range: While maintaining the 2% point target is critical for anchoring expectations, establishing an "operating range" around it could serve as a valuable communication tool. It helps convey to the public that short-term fluctuations in inflation are normal and expected over the business cycle.
3. Endogeneity of Inflation Expectations: Policymakers must not become complacent when long-term inflation expectations remain stable. Expectations are anchored precisely because the public trusts the Fed to take the necessary, restrictive policy actions to bring inflation back down.
4. Limits of the Unemployment Rate and Phillips Curve: Traditional Phillips curve models have broken down due to structural shifts in labor supply (e.g., demographics and immigration changes). Leading indicators of labor market tightness and wage pressure—such as JOLTS job openings, quit rates, and job-switching metrics—are currently more useful than the aggregate unemployment rate.
5. A New Era of Persistent Supply Shocks: In a more fragmented global economy with highly concentrated supply chains, supply shocks are becoming more frequent, persistent, and compounding. Consequently, the historical policy response of "looking through" supply shocks is increasingly invalid.
6. AI’s Dual Impact on Policy Rates: In the near term, massive investment in AI infrastructure is driving up capital equipment costs and contributing to localized price pressures. Over the long run, even if AI boosts productivity and has a disinflationary effect, it will likely raise the equilibrium real interest rate (R*), meaning the neutral nominal policy rate will be higher.
7. Task Force Expectations: Led by Gregory Mankiw, Thomas Sargent, and William White, the Inflation Task Force is highly esteemed. They are expected to introduce fresh, mainstream, and practical recommendations, focusing heavily on policy-making under high uncertainty, the implications of fiscal dominance, and the nexus between monetary policy and financial stability.

Cleaned & Structured Transcript

Section 1: Introduction and Welcome

[00:00]

Announcer: Podzept, the podcast from Deutsche Bank Research, with interviews on current economic and financial topics. Listen as economists and analysts from Deutsche Bank present their views.

[Matt Luzzetti]: Welcome. You are listening to another episode of Macro Matters on Podzept, a series where we discuss some of the best ideas coming out of Deutsche Bank Research. I'm Matt Luzzetti, Chief U.S. Economist, and I'm once again joined by Matt Raskin, our U.S. Head of Rates Research. Welcome again, Matt.

Matt Raskin: Thanks, Matt. Good to be here. So, Matt, we're back for another in our series on the Fed task forces that Chairman Warsh announced back at the June FOMC meeting. As a reminder for the audience, DB has produced a set of research notes on each of the five task forces where we outline the considerations we think they might take up and some of our expectations for where they might land. We are also recording podcast episodes on each of those where we're joined by outside experts and get their perspective on things. We've done that so far for communications and for the balance sheet.

Today, we're going to talk about the inflation task force. As outlined on the Fed's website, the task force will "revisit how the Federal Reserve understands and responds to the drivers of inflation" and "examine the drivers of inflation, first principles, and weigh the full range of ideas for delivering price stability in a changing economy." That seems like a pretty important, central topic for the Fed.

Matt, we are honored today to be joined by Loretta Mester. Loretta was President and Chief Executive Officer of the Federal Reserve Bank of Cleveland from 2014 to 2024. Of course, she was a participant and member of the FOMC for that crucial decade. I should also note that during her time running the Cleveland Fed, they established a Center for Inflation Research, which is a forum for economists who specialize in inflation to produce commentary, research, and analysis on that topic. Prior to joining the Cleveland Fed, Loretta had a long career at the Philly Fed, where she worked as an economist and ultimately served as research director. She's currently an adjunct professor at Wharton and serves as a director, trustee, and fellow on a wide range of organizations and boards. She is an incredible guest to have today—not just on this topic of inflation, but to help us think about and understand the task forces more generally. She brings an incredibly valuable and unique perspective having served on the FOMC. Loretta, welcome and thanks so much for joining us today.

Loretta Mester: Thank you very much for having me. I'm looking forward to the conversation.

Matt Luzzetti: Thanks, Loretta. I'll add a personal note there. My first job coming out of undergraduate was working at the Federal Reserve Bank of Philadelphia when Loretta was leading the research effort at that point in time. It was an honor to work with her then, and it's a great honor to have you with us here today to walk through inflation forecasting at the Fed, the Fed's inflation task force, and the other task forces that the Fed has ongoing at this point.

Loretta Mester: You were a great research analyst. Thanks so much.

Matt Luzzetti: Thank you. I wanted to begin by outlining how we're going to proceed. We will begin with some background topics on inflation, how the Fed thinks about and models inflation, and so on. We will then dive a little bit more deeply into questions around the Fed's inflation framework and get into the Fed's inflation task force, but only after we first discuss some current issues related to the inflation environment—given that inflation is still well above the Fed's objectives and remains the critical driving force for monetary policy decisions at this point in time.

Section 2: Historical Evolution of the Fed’s Inflation Framework

[04:00]

Matt Luzzetti: To start, through your career at the Fed, what were the key features of how the Fed and you thought about inflation dynamics during your time at the Philly Fed and in various leadership positions within the Federal Reserve?

Loretta Mester: I would say that the way the Fed has approached inflation hasn't changed that much, but there have been periods of pretty big changes. I was the research director of the Philly Fed when the Fed ultimately established the 2% target explicitly as a numerical target, and I had the opportunity to be a staffer on that project. When Charles Plosser, who was president of the Philly Fed, became a member of the Subcommittee on Communications, I staffed that as well. That was when we made changes to the Summary of Economic Projections (SEP) and included inflation measures.

As president of the Cleveland Fed, I was also on the communications subcommittee and participated as an FOMC member in the first review of the framework—the framework established in 2012—which took place from 2019 to 2020. Then, of course, I was on the FOMC during the post-pandemic inflation surge, which tested some of the changes made to the original framework.

It took a long time to get the committee to actually establish that explicit target. Ben Bernanke wanted to do that from the get-go of his confirmation hearing in 2005; he said that was where he was aiming, but the financial crisis delayed it. When they started bringing it up again, it was reminiscent of now in that they really thought that once interest rates had hit zero and they were moving into what they called a new regime, they needed to establish that 2% target explicitly.

When Quantitative Easing 2 (QE2) was starting to be discussed, they actually held a special FOMC meeting in October 2010 to talk about the need to establish a regime. Part of that regime was making the 2% target explicit, even though the Fed had implicitly targeted that level for a long time. They wanted to do that, but they couldn't get there immediately.

If you go back and look at the transcript of that October special meeting, Kevin Warsh wasn't convinced they needed a new regime, nor was he convinced they needed to make the target explicit. He said he always thought the old commitment to 2% inflation was "pretty serious" and was confident they would get to 2% inflation and keep it there without being explicit about it.

In any case, the Fed did eventually get to the point of establishing that in 2012 and laying out what their strategy would be. Even though you could argue they had a 2% target implicitly, actually having that explicit point target really did help anchor inflation expectations. Ben Bernanke was very clear that being explicit would help ensure inflation would eventually pick back up to 2%. That was in the low-inflation era, and especially when they had to move away from using interest rates as a target and use the balance sheet instead, he wanted that explicit target because he thought it would give the Fed more flexibility without undermining the committee's credibility to maintain 2%.

Then, in the 2019–2020 review of that strategy, the experience of the Great Recession—with inflation under-shooting the target for a long period—loomed large in the committee's thinking. That was when the strategy introduced Average Inflation Targeting (AIT). You could argue that was a slightly different way of thinking about inflation on the part of the FOMC. It was still focused on trying to keep inflation from moving below target with a makeup strategy: if it allowed inflation to run below target, it would allow it to run above target for a little bit of time. To be fair, the committee was not thinking about massive overshoots of 2%; we were thinking that if inflation went down to 1.5%, we would allow it to run up to 2.5% for some makeup. That was also a time when the Phillips curve tradeoff between unemployment and inflation was very flat, so that relationship was rethought.

Rolling forward to 2024 and 2025, the Fed again reviewed that strategy. This time, instead of being informed by the low inflation after the Great Recession, it was informed by the high inflation after the pandemic. That is where we saw changes coming into the framework, and I think some of those changes were actually very good. It is more symmetric regarding inflation and how policy will react. I think more changes could be made, and I expect the task force to be thinking about those, but that was one of the changes we saw. I am pretty positive about the task forces and think they could do things that would really help the Fed.

The other historical change is that the Fed's goal is now framed in terms of Personal Consumption Expenditures (PCE) inflation. In the past, they focused on the Consumer Price Index (CPI) at some points, and they also focused on core measures. Alan Greenspan was the one who brought in core inflation as an important indicator. They have gone back and forth on that, but right now, it is a 2% PCE inflation target. The Fed then looks at a number of other indicators to get a sense of underlying inflation.

Matt Luzzetti: Thank you for that. It is great context for where we are today. You probably do not remember this, but my first job at the Philly Fed from 2006 to 2008 was actually reviewing what other central banks were doing in terms of inflation targeting strategies. It was the first project I worked on. It is notable that it took until 2012 to officially adopt 2% as the official inflation objective, showing it was a very well-thought-out, well-studied project over an extended period.

Loretta Mester: Yes, it certainly was something Ben Bernanke focused on from the get-go, and while the economy derailed it at certain points, they eventually got there.

Section 3: The 2% Target vs. Inflation Ranges

[11:15]

Matt Luzzetti: Digging deeper into some of the things you mentioned, specifically the Fed's inflation objective of 2%: can you give us some perspective on why 2% is the right number? Additionally, is a precise 2.0% target preferable to a target range? This seems to be a topic of discussion for the task force. We know Chair Warsh has said at times that he was not worried about numbers to the right of the decimal point, so I am wondering about your perspective and how the broader committee might be thinking about it.

Loretta Mester: The 2% target was chosen because it allows for some upward bias in measured inflation. Research shows that measures of PCE inflation are estimated to be about half a percentage point above actual, true inflation. True inflation is lower than what is measured, so you want to adjust for that, and 2% does so. Rather than 0%, which one could argue is true price stability, you target 2% because actual inflation is below that measured rate.

I think it also balances the benefits and costs of higher versus lower targets. A 2% rate is low enough that people can safely ignore it when they make long-term decisions. Alan Greenspan's definition was that price stability is when people do not take inflation into account when making long-term decisions. At the same time, it is high enough to provide a buffer against deflation and gives the Fed room to lower interest rates in a recession before hitting the zero lower bound (ZLB). Many countries target 2%, so the U.S. is not unusual in that regard. New Zealand was the first to establish that 2% target as far back as the late 1980s, so they were well ahead of us. In fact, the U.S. was late to establish a numerical target.

More important than the actual target is the fact that we have a numerical target. The idea of a range is very interesting to me because I have advocated for keeping the 2% target while considering adding an "operating range" around it. Several central banks have this. The range would be useful in terms of communication; I think of it more as a communication device than something that would fundamentally change how the Fed operates. It would help convey the idea that it is normal for inflation to vary and that the FOMC is not going to keep inflation exactly at 2% at every single point in time.

A range provides flexibility in operating the balance between the Fed's dual goals of price stability and maximum employment. This was a topic we discussed in the first framework review. In 2012, we set a point target, and then we looked at whether there would be benefits to moving to a range. If you look at the January 2020 FOMC meeting transcript—right before the pandemic—you will see that this was discussed. When the target was first introduced in 2012, the idea was to anchor inflation expectations, and a point target does that more effectively than a range. Now, however, the public is accustomed to the numerical target, so it is worth talking about. The task force may very well consider an operating range.

I do not think they should get rid of the point target, but this operating range could be a good communication device. The Fed would not have to be indifferent to inflation being in or out of the range. Some people worry that the Fed would not take any action if inflation stayed within that operating range, but that is not true. The Fed has to be forward-looking. You could communicate that in an economic downturn, inflation will probably be on the lower side of that range, while during expansions, it may be on the higher side, even though the Fed is always trying to achieve 2% over time.

Matt Raskin: Is the notion of moving toward an operational range more challenging to execute in an environment where inflation is still meaningfully above the 2% point target? In other words, do they have to get back to 2% first before making any meaningful changes along these lines?

Loretta Mester: I totally agree with that. This is not the time to either change the target itself or introduce a range. Some people advocate that the Fed should change the target from 2% to a higher number, but this is not the time to do that. I hope one of the things that comes out of the task force is a reaffirmation of the 2% target. They can discuss other ideas, but changing the target now would look like changing the goalposts in the middle of the game. The Fed has to get back to 2% first. However, they can still utilize the notion that we do not expect to be at 2% at every single point in time. Shocks hit the economy, causing deviations, but we are always aiming to get back to 2%. That is the message the Fed wants to give, especially given how long we have been above target.

Section 4: Role and Measurement of Inflation Expectations

[17:00]

Matt Raskin: Much of the history you went through regarding adopting the 2% target and the 2020 framework review was about managing inflation expectations. How do you think about the importance of inflation expectations and the role they play in the inflation formation process? How do you measure them, and what issues are you most mindful of?

Loretta Mester: Conceptually, inflation expectations are incredibly important because they reflect the credibility of monetary policy. If they remain stable at a level consistent with the target, it helps the Fed return inflation to that target. I am convinced that because long-run inflation expectations remained basically consistent with 2% after the pandemic, it helped the committee bring inflation down from its peak of 7% to 9% (depending on the measure used).

The difficulty is that there are many different measures of inflation expectations. The theory is very compelling, but the practice is difficult because inflation expectations are not directly observable. You have to measure different views across different actors, including business surveys, consumer surveys, professional forecasters, market-based measures (like TIPS versus nominal Treasuries), and model-based measures. There is no single measure that everyone agrees is the measure, so I always looked at all of them. The Cleveland Fed’s Center for Inflation Research produces several of these measures, which provide a broad perspective.

When looking at surveys, you want to get not only a point estimate of inflation expectations but also a sense of how stable or anchored they are. Are they becoming fragile? You can evaluate the distribution of responses from surveys to see if there is rising instability.

Another point that some people miss in the current environment is the assumption that because medium-to-long-run inflation expectations have been stable, the Fed does not necessarily have to address the inflation problem as aggressively—as if inflation expectations are entirely exogenous to the process. The reason expectations are stable is precisely because the markets and consumers expect the Fed to do the right thing with monetary policy and get inflation back down to 2%. It is crucial for policymakers not to get too complacent just because long-run expectations are consistent with 2%. Once expectations actually start to move and become unanchored, it is already too late. You want to use policy to keep them stable and anchored.

Matt Raskin: Are there any specific aspects of measured inflation expectations that you think are particularly useful for giving an early read on whether they are becoming unanchored? Ricardo Reis’s research showed that during the 1970s, the higher moments of the distribution of inflation expectations began to move first. How do you approach that?

Loretta Mester: I like Ricardo's work very much because he looks at things like the dispersion in 5-to-10-year inflation expectations from the Michigan survey. I used to look at that as well, because if expectations are going to unanchor, you will see it there first.

The Cleveland Fed publishes a 10-year expected inflation rate and a term structure. If you want to look at a 5-year, 5-year forward measure, it tries to adjust for the inflation risk premium and is not tainted by liquidity differences between TIPS and nominal Treasuries, blending survey evidence. Those kinds of measures can be very helpful.

Additionally, regional Feds are conducting more surveys than they did in the past. Asking firms questions like, "How have your margins adjusted?" and "Are you poised to raise prices?" can give you an early idea of what businesses are thinking regarding their pricing power. This helps in determining future inflation and gauging what inflation rates businesses expect to see, which in turn spurs them to raise their own prices. There is a wide array of survey evidence that can be brought to bear on this.

Matt Luzzetti: Your point on adjusting market-based measures is really important. Matt Raskin and I have written a lot recently about how 5-year, 5-year inflation swaps seem overly sensitive to energy prices and risk asset moves in a way that might not reflect actual, long-term inflation expectations. We look at the Cleveland Fed's metrics and the DKW model decompositions, which actually show a more notable rise in longer-term inflation expectations recently, which I think is an important development.

Section 5: Labor Market Slack and the Phillips Curve

[23:00]

Matt Luzzetti: Aside from inflation expectations, Phillips curve models often embed some measure of labor market slack. I wanted to get a sense from you on how you think about economic or labor market slack. What is the most useful measure of that slack in predicting inflation, and are there potential non-linearities that make you cautious about using that framework for forecasting?

Loretta Mester: A lot of research suggests it is very difficult to predict inflation using measures of slack. This is partly because, at least until the post-pandemic period, the Fed was highly successful in keeping inflation near its goal, making it harder to extract a clear statistical relationship.

The unemployment rate used to be the measure most people looked at, and it was relatively successful and received the most focus. However, it does not perform well at turning points. It is particularly problematic now because changes in labor force participation have been sizable, heavily influencing the unemployment rate measurement. If you think about the pullback in immigration and ongoing demographic changes, those factors have constrained labor supply. Therefore, a low unemployment rate does not necessarily have to be inflationary.

Because we now have a longer history of data from JOLTS (Job Openings and Labor Turnover Survey), those metrics seem to do a better job. Looking at the ratio of job openings to the number of unemployed gives you a direct measure of whether supply and demand in the labor market are in balance. Job-switching rates and quit rates also give an early indication of wage inflation, which then leads to price inflation.

The fact that the slope of the Phillips curve changes over time and at different phases of the business cycle makes it hard to use as a primary forecasting tool, especially in this environment. During the Great Recession, the Phillips curve was flat, but post-pandemic, it steepened quite a bit. That is the non-linearity you are referring to.

If you step back and ask why you get that non-linearity, it goes back to the microeconomics of pricing decisions by firms. When I was talking to firms right after the pandemic, they were doing all they could not to pass along their cost increases to consumers. But as their costs continued to rise, they reached a threshold where they felt they had to do it. Those pricing dynamics feed into whether you can use a simple relationship between slack or tight labor markets to predict inflation.

We know there are threshold effects; research shows resource utilization has to be above or below a certain threshold before it can be used to forecast movements. The difficulty is identifying exactly when the economy is shifting from linear to non-linear dynamics. That is where anecdotal information, surveys, and pricing behavior come into play. As the Fed experienced after the pandemic, traditional models for predicting inflation did not work well. We likely held on too long to typical Phillips curve modeling when it was not a good model for an environment where prices and costs were rising as rapidly as they were.

Section 6: Monetary Aggregates and Alternative Data

[27:50]

Matt Luzzetti: That raises the question of what else you might want to bring into an inflation forecasting model. One area that Chair Warsh might advocate for is a reconsideration of monetary aggregates—the money supply—and whether that is a useful explanatory factor for inflation that the Fed should monitor. It was reintroduced in the latest Monetary Policy Report, so I wanted to get your perspective. How useful can measures of the money supply be for thinking about the inflation outlook?

Loretta Mester: There is a long-run relationship between money and inflation, but the question is whether a monetary aggregate is a reliable predictor of inflation in real time or over shorter horizons. Yes, they mentioned M2 in the July Monetary Policy Report, although it was in passing and not a major section.

M2 has not been a reliable predictor of inflation for decades, partly because financial innovation has made the velocity of money (nominal GDP to M2) unstable. You cannot use it well for short-run forecasting. Could you develop a monetary aggregate that is a better predictor over shorter horizons? Probably. But unless you understand the transmission mechanism of how money drives inflation in the short run, it is not going to be reliable enough to use as a primary indicator. It can be part of a dashboard of indicators.

Some people point out that if you looked at monetary aggregates, the Fed would have known inflation was going to be a problem. But that was not clear in real time, and the Fed was already looking at other measures and knew inflation was a problem. The question was what the best way to address that inflation was, and I am not sure monetary aggregates are the ultimate solution.

Other research suggests that if we could get better measures of firms' marginal costs and firm-level inflation expectations, that would help us predict inflation much better. It is remarkable that even though firms are the actual price setters, we do not have many surveys that ask them about their pricing behavior. That is changing now, but we still need more data on firm pricing behavior rather than just relying on theoretical model assumptions. That could be taken up by the inflation task force, or perhaps a data task force will look at developing those measures.

Matt Luzzetti: Those initiatives seem very useful, but the constraint is that they do not have a long historical series, making it hard to empirically test them against other indicators.

Loretta Mester: I am glad you brought that up because the Fed uses a lot of non-official statistics, develops its own surveys, and looks at private sector data and anecdotal information from the Beige Book. Official statistics sometimes get a bad reputation because they have been subject to larger revisions lately, partly because response rates to the underlying surveys are lower. It often takes until the third revision to get complete data.

However, the experts at those statistical agencies have very high quality standards and collect data in a consistent way over time. As you pointed out, one of the great things about those data is that a large body of academic research is built on them. We need to look at both, and we should not discount the importance of official statistics even if they are lagged and subject to larger revisions.

Section 7: Current Inflation Environment: Supply Shocks and AI Demand

[32:30]

Matt Luzzetti: Transitioning to the current inflation situation, which is the key driver of monetary policy at the moment: the way I see it, there are two key drivers of inflation right now. One is a variety of supply shocks that continue to hit the economy, from tariffs to the recent energy price shock. The second is a new, emergent factor: AI-related demand, which is starting to put upward pressure on prices across the supply chain and impact consumer electronics. If you were at the Fed, how would you be thinking about both of those drivers? Can you "look through" the supply shocks, as is the traditional central bank response, and how worried would you be about the AI-driven inflation story?

Loretta Mester: Those are good questions. Over the past couple of decades, the standard view was that the underlying structure of the economy was slow-moving and supply shocks were relatively infrequent and short-lived. In that world, the standard response was for monetary policy to look through supply shocks for two reasons: supply was expected to realign with its longer-run trend quickly, and monetary policy actions operate with a lag. If policy took time to affect the economy and supply had already normalized, taking action would have been a mistake.

We are in a different environment now. Disruptions to supply are more frequent because the global economy is more fragmented. These supply shocks are lasting longer, and because supply chains have become more concentrated, a shock to a critical input can have a much larger, compounding effect. The assumption that supply is stable around a long-run trend is no longer valid. We are dealing with persistent, compounding shocks that can have a highly persistent effect on inflation, and the FOMC has to think through the appropriate response when supply shocks do not quickly dissipate. We like to think of impulse response functions where a shock hits and then dissipates back to the baseline, but I do not think we are in that world anymore.

Matt Luzzetti: Interestingly, if you look at the San Francisco Fed's decomposition of supply and demand, supply-driven inflation is actually more persistent than demand-driven inflation. That remains true even if you exclude the 1970s and the COVID-19 period. Even in the intermediate period, supply-driven inflation shows greater autocorrelation, which surprised me.

Loretta Mester: That is an interesting observation. It could very well be true. We talk a lot about supply shocks being the dominant factor during the post-pandemic inflation surge. While we are on the topic of frameworks, the Fed was accused of letting average inflation targeting cause that inflation surge.

However, as an FOMC member at the time, I can say that we missed how accommodative fiscal and monetary policy actually was. Supply was constrained, and it stayed constrained longer than we expected, but there was also a major miss on how strong demand was. That imbalance was driven by both supply and demand, and we did not fully appreciate the impact of the fiscal side. It took a long time for the committee as a whole to decide to raise rates. Some of us were calling for rate hikes early on, but once the committee decided to act, they had to raise rates very aggressively. It was not solely a supply issue; it was also a traditional mismatch where demand outpaced supply. This feeds directly into the AI discussion.

Matt Raskin: Before we get to AI, you mentioned two features that argue for looking through supply shocks: their persistence and policy lags. Has your thinking about the transmission of monetary policy and its lags evolved due to the COVID-19 experience?

Loretta Mester: I have seen a lot of work on that, but nothing definitive showing that policy is working so much faster through financial markets that we should change how we think about it. We have always said lags are "long and variable," meaning we do not have a precise sense of how long they take to act. I have not changed my view on that, even though others have.

Matt Luzzetti: Getting back to AI, how are you viewing AI-related price pressures today, and how should a central bank view them? Are they worrying?

Loretta Mester: We are already seeing it. If you look at AI investments in data centers and energy technology, equipment and technology inflation is moving up. The real question is whether that will become a broader source of inflation or remain a relative price change. In an environment where inflation has already been above 2% for a while, it could easily become a source of broader inflation, and policymakers need to think about that.

Those who argue we should not be concerned are focused on the long term, where AI is highly likely to increase productivity growth, creating efficiencies and a disinflationary impact. However, that does not necessarily mean interest rates can then be cut. If higher productivity growth is associated with a higher level of potential growth and consumption growth, the equilibrium real interest rate of the economy (R*) goes up as well. Wherever nominal interest rates are, policy becomes less restrictive. It could very well mean nominal rates have to be higher because the equilibrium real rate has risen. You have to think through the entire structural story, not just the disinflationary part. Even if AI is disinflationary in the long run, its ultimate implication for the neutral Fed funds rate is not yet clear.

Section 8: Expectations for the Inflation Task Force and Future Policy

[41:00]

Matt Raskin: This is certainly a challenging environment for the FOMC. If we can pivot directly to the task force itself: what does the appointment of N. Gregory Mankiw, Thomas Sargent, and William White as co-leads tell us about the proposals or recommendations they might bring to the committee?

Loretta Mester: Those are excellent, highly esteemed economists. What is great about all of these task forces is that they bring a blend of deep academic expertise and practical policy experience. Kevin Warsh's idea of bringing in a group of experts to provide a fresh set of eyes is very important.

Mankiw, Sargent, and White are well-respected, mainstream economists. They will frame issues within that context, grounded in economic theory but with a practical bent that will make their recommendations useful to the FOMC. Kevin has explained that while the task forces will make recommendations, the FOMC itself will deliberate and decide which ones to adopt.

Regarding the inflation framework, all three co-leads have expressed concerns about the fiscal side of the economy and the threat of fiscal dominance. One of the things they will have to think through is not just supply shocks, but structural factors that the Fed must take into account when setting policy.

While we are not in a state of fiscal dominance yet, understanding that environment is crucial. Tom Sargent has done extensive work on decision-making under high uncertainty when you do not know the exact model of the economy. What is the best way to chart policy in that world? I think they will tackle this because we are in a much more uncertain world now. Structural relationships that once seemed stable are no longer stable, and we face significant geopolitical and policy uncertainty.

William White, who was deputy governor of the Bank of Canada, focuses heavily on the nexus between monetary policy and financial policy. He is not necessarily a fan of strict inflation targeting because he views the financial cycle as highly relevant for the macroeconomy. In the framework review I participated in, we wanted to include more in our strategy document about the nexus between monetary policy and financial stability—specifically, whether the Fed should take policy actions when it sees emerging financial stability risks—but we could not reach an agreement. It was too broad.

With William White on the task force, I suspect he will want to provide guidance on how to address those risks. He has written about the importance of monetary policy "leaning against" excesses in the financial cycle, pointing out that many major business cycle fluctuations have been driven by financial cycles rather than traditional macroeconomic cycles.

Matt Luzzetti: We do not yet know what these experts will recommend, but standing here today, is there one thing you would like the Fed to keep regarding how they model and track inflation, and one thing you would like to see changed?

Loretta Mester: I want to keep the 2% target. It is important and has served the committee well. Given that inflation has been above target for so long, changing it now would be highly damaging. The Fed can and will get back to 2%, and this task force will provide recommendations on how to keep it there.

What I would like to see changed is for the Fed to develop a better way to react to structural changes in the economy, such as persistent supply shocks and high uncertainty. This also links to communications. Consistent with Tom Sargent’s view that we do not know the exact model of the world, the Fed needs to utilize scenario planning—specifically, evaluating different scenarios that could result in very different economic outcomes and require different policy paths.

If the FOMC had done a better job of mapping out alternative scenarios, we might have moved away from the "transitory" inflation narrative sooner. That would have helped us raise interest rates faster, and perhaps we would not have had to raise them as much in total.

Matt Raskin: Given your extensive experience, what are your thoughts on the task forces more generally? Are there specific aspects or potential changes regarding communications or the balance sheet that you are focused on? Also, we often talk about the "congestion" the committee will face when taking in all of these proposals at once. How do you think that will play out?

Loretta Mester: The good news is that the committee has already discussed many of these issues over the last several years, so they will not be entirely brand new. Even in the first framework review, communication and balance sheet strategies were heavily debated, even if they did not result in immediate strategy changes.

I am highly interested in the communications task force, particularly because we have seen a pullback in the amount of information the Chair is sharing. I do not know if that is permanent. He is clearly not a fan of explicit forward guidance. However, explaining the Fed's reaction function to the public and financial markets is not forward guidance; it is simply explaining the basis for policy decisions, and you want the Fed to do that. Perhaps the communications task force will provide a framework that makes the Chair more comfortable doing so.

On the balance sheet task force, both current and former FOMC members would like to see a smaller balance sheet. Work is already underway to reduce commercial banks' demand for reserves to help shrink the balance sheet, and it will be important to see what recommendations come out of the task force on how best to achieve that.

Matt Raskin: Thank you so much, Loretta. This has been a fascinating discussion. The committee has a lot of work in front of them given the breadth of these task forces. The inflation task force is central to the conduct of policy, and we really appreciate you bringing your perspective and insight to share with us today.

Loretta Mester: Thanks for the discussion. I really appreciate it.

Matt Luzzetti: Thanks so much, Loretta. It was great having you today to discuss the inflation task force and provide your insights. If you would like more information on anything discussed here today, please reach out to your Deutsche Bank sales representative. This is Matt Luzzetti and Matt Raskin: , and you have been listening to Macro Matters on Podzept.

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