CNBC News Releases


Steffanie Marchese



Following is the unofficial transcript of a CNBC EXCLUSIVE interview with William C. Dudley, New York Federal Reserve Bank President, today, Monday, August 31st. Excerpts of the interview to air during CNBC's Business Day programming.

All references must be sourced to CNBC.


STEVE: So-- Bill, thanks for joining us.

WILLIAM DUDLEY: Great to be here.

STEVE: I thought a really good place to start would be just tell people, in short of time as possible, all of the things the New York Fed does, both in normal times and now during this time of crisis. Give me sort of-- a list of all the things you're involved in.

WILLIAM DUDLEY: Well, the New York Fed is basically the operational arm of the Federal Reserve. So we implement the monetary policy. In crisis, we develop all the special facilities and operate them like the TALF and the TAF and TSLF, all the acronyms that you hear about. We're also the fiscal agent for the Treasury, so we conduct all the Treasury auctions. And obviously as the deficit has climbed, the-- the auction cycle has gotten very intense. We cond-- we run central bank services for-- a lot of foreign central banks that do business-- through us hold-- hold a lot of securities with us. I think we have a couple trillion dollars of securities in custody. We supervise some of the largest-- financial institutions in the world. We run Fedwire, which is a large dollar payment system. There's lots of-- lots of pieces.

STEVE: There's also a little bit of gold down in your basement, right?

WILLIAM DUDLEY: Yeah. I think we have the biggest supply of gold in the world. It's not the U.S.'s gold. It's foreign gold. It sits in our basement. The building was actually built around the gold vault. They built the vault, and then they built the building.

STEVE: Do ever go down there at night just to kind of wander around?

WILLIAM DUDLEY:(LAUGH) They don't let wander around the gold.

STEVE: They don't let you wander around? Not even you?

WILLIAM DUDLEY: The security's pretty tight.

STEVE: So how big is your book right now, in terms of all the crisis stuff that's out there? I mean, how much money are you managing? I understand the Maiden Lane stuff, which is the AIG bailout book and the Bear Stearns book is all within the-- what's the right word? Supervision of the New York Fed.

WILLIAM DUDLEY: The-- before the crisis started, our-- our balance sheet, the Federal Reserve's balance sheet was about $850 billion. The Fed's balance sheet today is just a little bit over $2 trillion. We manage pretty much all of that. If you look at the balance sheet of the New York Fed, though, you'll see a smaller piece 'cause it gets allocated to the other Federal Reserve banks.


WILLIAM DUDLEY:So it's gone up dramatically.

STEVE: Is it right to call you, like, the CFO of the Fed, in a way? Is that--


STEVE: --not a bad description?

WILLIAM DUDLEY: I think that we-- we do a lot of the financial business of the Fed in terms of executing policy. And obviously policy's gotten a lot more complex over the last-- year and a half, two years since the crisis began. Because we've been introducing all these new facilities.

STEVE: So let's talk about some of those policies and-- and where they-- where they are and where they're going. Just recently, the last couple days, two Federal Reserve bank colleagues of yours on the FOMC suggest maybe we don't have to spend all of the-- purchase all of the mortgage backed securities that the Fed-- has said it's gonna purchase. Do you think that's a good idea?

WILLIAM DUDLEY: Well, I think we'll see what happens at the next FOMC meeting in terms of where the committee is on-- on that point. Obviously, as financial conditions improve, as the economy does somewhat better, which seems to be the trajectory they're on-- they're on, it's a legitimate point to consider, you know, what you wanna do in terms of your purchased programs. My own personal view is I think it's a little bit premature to be so confident that you wanna pull all these things back-- right now. Because the economy still isn't growing very fast. And we do have a very high unemployment rate.

STEVE: F-- for lack of a better way to put this, it looks like there's two Camps at the Fed, one with the itchy fingers wantin' to pull the trigger and get out now; and the other is sort of-- s-- let's stay the course and not make the mistakes of, say, 1937 in the Great Depression and the 1990s in Japan. Where do you put yourself?

WILLIAM DUDLEY: I think that the-- the-- the tension is betw-- is-- is about h-- what are the consequences of the enlarged balance sheet for the inflation outlook? My view is that we have tools to manage our balance sheet so that we're not gonna have an inflation outcome, bad inflation outcome. We have the ability to pay interest on excess reserves, which will basically allow us to keep-- inflation in check, even if our balance sheet stays enlarged. Now there's other people that I think that are a little bit less confident about that. And so they would be a little bit more nervous about the-- the-- the risks on the inflation side.

STEVE:So talk about those excess reserves. 'Cause everybody thinks there's all these excess reserves in the system, that's gonna cause inflation. But it's not quite that easy, is it?

WILLIAM DUDLEY: No. It's not c-- quite that easy. I mean, the story of how it causes an inflation is the banks have excess reserves. They lend them out. That lending causes economic activity to pick up. That drives down the unemployment rate and it causes inflation. The problem with that story is that with the Fed's ability to pay interest on excess reserves, the banks just take the excess reserves to the Fed and get paid interest. They don't lend them out. So you don't get that cycle of the excess reserves leading to a credit boom in an overheated economy.

STEVE: So let's talk more broadly about exit strategies. How advanced are you-- how advanced is the Fed right now in planning-- preparing for the peace, I guess is the best way to put it?

WILLIAM DUDLEY: Yeah. My view of it is that we have to well prepared and we have to be able to explain to people that we're well prepared because we need people to be confident in our ability to keep inflation in check. But it's a very different thing to be well prepared and actually exit. And so I think I-- I think I would wanna distinguish between being prepared to exit and actually thinking about exiting. We're-- we're far along in terms of having the interest on excess reserves and also p-- just in case, belt and suspenders, if that's not sufficient, developing other means of draining the reserves from the banking system if that turns out to be necessary. We're pretty confident it won't be necessary. But we would like to have the belt and suspenders just in case, and also to reassure people that there's not gonna be inf-- bad inflation consequence.

STEVE: When you say developing, are these things developed? And what are they?

WILLIAM DUDLEY: There's a number of things that we can do to drain excess reserves. For example-- we're looking into the idea of-- of-- of banks h-- taking the excess reserves and depositing them with the Fed on a term basis. We're looking at the idea of doing reverse repurchase operations so that we can basically take reserves by-- selling securities into the market on a temporary basis and draining reserves that way. So there's a number of different options that we have to drain the excess reserves. But the important thing I would want to stress is the ability to pay interest on excess reserves by itself is sufficient.

STEVE: When you pay interest on reserves, the banks those reserves, book-- book those payments, right?


STEVE: Am I wrong in seeing these excess reserve interest payments as a subsidy to the banking system?

WILLIAM DUDLEY: I don't think so. I mean, I think that from the taxpayers' perspective, we're actually making money on the transaction. Because the excess reserves are funding the purchases of treasuries and agency debt and agency mortgage baked securities. So right now we're basically-- essentially borrowing the money at 25 basis points, a quarter of a percent, and investing in assets that are yielding, three, f-- three and half, four, four and a half, five percent.

STEVE: So it's not--

WILLIAM DUDLEY: So-- so what-- so-- so-- now obviously that could change over time because the-- the liability is the interest on excess reserves are overnight and the assets we're buying are longer term. So we do have a bit of an interest rate mismatch in the sense that if short term interest rates went up dramatically, then the earnings would not be as favorable.

STEVE: So when is it time to pull the trigger and to start implementing these exit strategies?

WILLIAM DUDLEY: Well I think some of the exit strategies are already happening automatically. A lot of our liquidity facilities-- were introduced with penalty rates-- rates that were attractive during times of crisis but unattractive as markets-- conditions improved.So we've seen a lot of our liquidity facilities uses has declined dramatically as the economy had started to improve. So our balance sheet is basically virtually unchanged from where it was at the end of the year, even though we've been buying hundreds of billions of dollars of securities.

STEVE: Is that a failure on the Fed's part? I thought you wanted to grow the balance sheet. And the balance sheet hasn't grown, which suggests-- I think there's a couple suggestions that came off that. Among them, y-- the banks have reached a point where they no longer want excess reserve. So that when you give them more of one thing in the form of excess reserves, they seem to be selling it elsewhere.

WILLIAM DUDLEY: No. I don't think that's really how it's working. I think that-- that-- what's really happening (THROAT CLEARING) is the liquidity facilities, because the rates are at a penalty now relative to what people can do in the market, are just going to the market instead. A good example of this is the commercial paper funding facility. That's the facility where the Federal Reserve committed to buy 84 day maturity commercial paper from A1/P1 commercial paper issuers. At its peak, that was about $350 billion. Now it's well below $100 billion in size. The reason for that we-- is we charge a pretty high rate.

STEVE: Right.

WILLIAM DUDLEY: It was attractive in the fall of 2008 when we were in the middle of the crisis. It's not attrac-- very attractive today.

STEVE: So that's not a failure on y-- on the Fed's part, to--

WILLIAM DUDLEY: I don't think so.

STEVE: --grow the balance sheet? That's not-- that's not an issue?

WILLIAM DUDLEY: We want financial conditions to improve. We want our liquidity facilities to become less attractive. This is part of the healing process. So I th--- I don't think it's a problem at all.

STEVE: You had said not too long ago that you think the Fed's balance sheet could go to $2.5 trillion. Do you think that's still the case?

WILLIAM DUDLEY: It's probably l-- more likely than not. Obviously it would require us to do, you know, almost the full amount or the full amounts of what we've already committed to. What-- so what's happening is that the liquidity facilities have come down so dramatically that there's not that much more room for them to shrink.

STEVE: Right.

WILLIAM DUDLEY: Yet we still have a long ways potentially to go in terms of our agency mortgage backed security purchases. So the purchases should start to overwhelm the effects of the liquidity facilities coming down.

STEVE: I wanna probe a little bit on this MBS. It sounds like you're not certain that the Feds should go through with this.

WILLIAM DUDLEY: N-- I l-- look. I-- we're gonna go to the thing. And there-- there's gonna be discussion. And, you know, there'll be an evaluation of one, what-- what our financial conditions look like today, compared--

STEVE: Right.

WILLIAM DUDLEY: --to at the prior meeting; two, what's the outlook for the economy today, compared to the prior meeting; three, what would the implications be of us doing something different than the market expects? The market expectations are very, very important. The market expects us to complete this-- the-- these programs, to do the full-- amount. So y-- to-- to-- to-- to contradict that market expectation, I think, is a pretty high hurdle.

STEVE: So you're neutral on this right now? Or you're sort of in favor of going forward unless there's a good reason--

WILLIAM DUDLEY: I'm gonna make up my mind at the meeting.

STEVE: Okay. All right. That's fine. What about the-- when it comes to mortgage-- the m-- mortgage backed securities, whether or not-- and especially the treasuries, why don't you feel those programs have been effective?

WILLIAM DUDLEY: Well, I think the mortgage backed-- securities purchases have been very effective. You look at the spread between mortgage rates and Treasury rates, that-- that's come in very dramatically over the last six months. So I think there's no question that that has actually helped.

And the consequence of that is I think we've actually seen a housing market do so much better than we expected six months ago. We've seen home sales start to rise. We've seen home prices stabilize. Part of the whole point of the agency mortgage backed securities purchase program was to drive mortgage rates down to therefore make housing more affordable to cushion the decline in the housing market. So I think that it's been very effective.

The Treasury purchase program, I think it's more ambiguous whether that's had, you know, significant benefit. But obviously there were limits to how far we could push down mortgage rates relative to Treasury rates. So if we wanted to have more of a consequence for mortgage rates, we had to do something about Treasury rates. And that's where the Treasury purchase program came in.

Now $300 billion of Treasury purchases is pretty small relative to the size of the Treasury (THROAT CLEARING) market and relative to the federal deficit this year. So I-- I-- I think it's-- one, I would say the Treasury p-- purchase program was not-- not as big an effort. And two, I think we were always a little bit more-- ambiguous about how-- how big a benefit it would have.

STEVE: What about the charge that it was monetizing the debt?

WILLIAM DUDLEY: I don't think it was monetizing the debt to any meaningful degree. If you look at the amount of treasuries that the Federal Reserve has today in its portfolio, it's l-- lower than it was at the beginning of the crisis. If you look at our share of Treasury debt outstanding, it's much lower than it was at the beginning of the crisis. I think the way to think about--

STEVE: But its character is dramatically different, right? You used to have short term--


STEVE: Now you have--


STEVE: --long term (INAUDIBLE)?

WILLIAM DUDLEY: --it's-- it's-- it's a different composition. Look, why we were-- w-- w-- why were we doing what we were doing? We were not doing this to facilitate the Treasury's issuance of debt. We were not trying to monetize the debt. We were not trying to generate any outcome of that sort.

We were trying to ease financial conditions. Why were we trying to ease financial conditions in this manner? Because we couldn't push the federal funds rate down any lower. The federal funds rate's constrained at zero. So we have a very weak economy with a v-- rising unemployment rate. You wanna provide more stimulus to support the economy. You can't cut the federal funds rate any further. So what do you do? You intro-- in-- introduce liquidity, special liquidity facilities for individual market segments like the commercial paper funding facility and-- or the TALF. And then you do-- engage in a purchase program to try to push down mortgage rates to help support the housing market.

STEVE: Let's come back to the when. Do-- do you have a f-- a sense of when you think the Fed begins to unwind? And also, the "how" is of interest, I think, to the market. Do you see the Fed programs winding down and b-- bringing the balance sheet back in order before you begin to raise rates? Or is it simultaneous actions?

WILLIAM DUDLEY: Well, I think it remains to be seen, the sequencing. I mean, this is gonna more complicated than usual 'cause we have a lot more choices. I mean, normally at the end of a recession, beginning of a recovery when the Fed finally gets to the point where the economy has a good head of steam and the unemployment rate's headed down and the Fed decides it's time to start tightening monetary policy, they have one choice: what to do with the federal funds rate.

This time we have lots of choices in terms of-- in terms of the sequencing. You know, we're gonna have to think really hard about what part of the market do we want to affect? Do we wanna affect short term rates? Do we wanna affect longer term rates? Do we wanna affect mortgage rates? So we have a lot more options. And I think the-- you know, I don't think at this point sitting here today we're gonna prejudge that outcome. We're gonna-- base it on the facts at the time-- which I think is quite a long period away.

STEVE: I wanna go back a little bit. One of the things that's become conventional wisdom, at least a big part of conventional wisdom, is that the Fed was too low for too long, and that that helped create the bubble. And I don't ask that because I wanna go back over history. What I wanna know is the lessons that you draw from it today when it comes to policy.

If-- if you draw the lesson that the Fed was too low for too long, it leads you to the conclusion to get out quick before you create another bubble. On the other hand, you could make an argument that what we want right now is the risk taking that is engendered in a too low for too long to get this economy back. How do you put all that into context where your policy ought to go now?

WILLIAM DUDLEY: Oh, what you wanna s-- set is the funds rate at the right level to generate (THROAT CLEARING) the growth rate suf-- sufficient to drive down the unemployment rate. 'Cause the end of the day, what's the Fed's mandate? The Fed's mandate is to try to have price stability at the lowest possible unemployment rate.

And so we're gonna set monetary policy with that as our primary goal. You know, in terms of this issue about the Fed created the bubble by keeping interest rates too low for too long, I think that was a very much second order-- cause of what happened. If you look at what happened in this-- in this last-- economic cycle, we had very lax underwriting standards, extremely lax underwriting standards. We had-- shadow banking system that was not very well understood. We had structured finance products that were not well distr-- widely distributed as people thought. So the f-- the Feds passed-- short term rates maybe at the margin that contributed to the size of the bubble, but I think there would have been bubble regardless of the trajectory that the Fed had filed.

STEVE: Well, what-- let's just (UNINTEL) off on that for what you (THROAT CLEARING) do next with policy.

WILLIAM DUDLEY: Well, look. I think we have to set policy in a way (THROAT CLEARING) that we think is gonna achieve-- best achieve our-- our twin mandate of price stability and full employment.

STEVE: Let's go back to the bubble time. The-- the Fed had supervision authority. It had-- econ-- an army of economists on board. It had the macroview. I wanna ask you, do you think Americans have a right to be disappointed in how the Fed did during the bubble, at its lack of action during the bubble?

WILLIAM DUDLEY: Look, I think there are a lot of things that-- a lot of mistakes were made by lots of different parties. Things fell between the gaps, where it wasn't clear whose-- what-- whose-- whose responsibility it was. If you think about the mortgage banking business, who regulates the mortgage bankers? The individual states.

Given the state, you can just send in for a license and anybody can become a mortgage banker. So that-- there were a lot of things that fell between the cracks. Now could we have done better? Absolutely. You know, I think on the supervision side, you know, I think it's fair that we could have been tougher. We probably could have been smarter. I don't think we were aware of all interconnections of, you know, how the different banks were connected to one another. I don't think we fully appreciated the consequences of the shadow banking-- sector, you know, s-- SIVs and conduits and all the activity that was going just outside-- of the commercial banking sector. So sure, absolutely we could have done better.

STEVE: Can you turn to the American people now and say, "We're smarter. We're better. This-- this will not happen again. We've made changes"?

WILLIAM DUDLEY: Well, I think we are learning from the experience. I think the SCAP-- experience where we ran the stress test against the 19 banks was a very, very-- useful exercise, both in terms of what happened, in terms of helping people get more confidence in the banks and therefore the banks being able to raise more capital.

But it was also a very useful exercise for us in terms of understanding how we need to do the supervision process better. The thing that was so interesting about the 19 banks is we were looking at the-- we were looking at, you know, a good chunk of the banking industry simultaneously. So that, I think, gave us a little bit better insight as to who is good and who is not so good. And it also allowed us to essentially-- deal with the fact that each individual bank thinks they're above average.

But when they all come back above average, you realize that this is not really sustainable and you have to sort of enforce a consistency that sort of adds up with the macroeconomy. So the other thing about the SCAP experience, the stress test experience, that was really valuable was multidisciplinary. We had supervision--

STEVE: Right.

WILLIAM DUDLEY: --people. We had economists. We had market specialists. We brought all that expertise together. And I think in the past, we were probably a little bit too siloed. You know, we had people working on one area here, another area here. The SCAP was horizontal and I think we learned a lot from doing that.

STEVE: But one of the charges-- against the Fed, especially the New York Fed, is that you were too close to the banks. The banks wanted lax regulation. The banks wanted-- higher leverage ratios and-- and wanted-- that had these derivatives and that there wasn't enough separation between the regulator and the regulatee. Has that changed?

WILLIAM DUDLEY: Well, I can't comment on that, Steve, because I wasn't supervising the banks and--

STEVE: Okay.

WILLIAM DUDLEY: --didn't have the responsibility for supervising the banks at that time. What I can tell you is there's no way I'm gonna allow myself to be captured by the banks. No way.

STEVE: How do you ensure against that?

WILLIAM DUDLEY: Well, I think you have to be skeptical about what you hear from the banks.

STEVE: Yeah, but you hang out with the banks all day long, right? You don't hang out with the consumers--


STEVE: --on the other end.

WILLIAM DUDLEY: --I-- I don't think that's-- I don't think that's true. One of the things I did when I c-- when I came to the Fed was I-- I-- I felt very, very strongly that the Federal Reserve--

WILLIAM DUDLEY: (IN PROGRESS) --needed to talk the broad market. Not just the primary dealers, not just the large commerc-- commercial banks. We needed to talk to pension funds, private equity, hedge funds, the whole array of people that do business in the market. That was one of my number one priorities when I joined the markets group at the beginning of 2007.

So we have now a much better sense of y-- you know, what the market is than we had before. And we-- you know, some of these people are quite skeptical about what the commercial banks-- may tell us from time to time. And so we-- we get that input as part of our-- part of our analysis.

STEVE: Have you made changes to your advisory board at all, or the board of the directors, such that you have greater representation from outside the banking business?

WILLIAM DUDLEY: Well, we actually did add three-- three new people to the board of directors, or-- we're in the process of adding three new people to the board of directors. And-- and-- none of them are bankers.

STEVE: Let's talk about the changes at the Fed. One change there's not gonna be is a new chairman.


STEVE: What's your reaction to the reappointment by President Obama of Ben Bernanke?

WILLIAM DUDLEY: I'm absolutely thrilled. I think it's so well deserved. He did everything he could to lean against this crisis. Open-minded, inclusive, willing to try, you know, things that people have never done before. Just the-- the-- the right person at the right time. And he deserves the chance to finish-- the job.

STEVE: But the question has to be he did-- let's say you granted he did a good job in easing policy. How do we know he's the right guy to take away that accommodation?

WILLIAM DUDLEY: Well, we don't. But he's very bright. He's very open-minded. He's going to listen to all the people on the committees. So he's gonna get-- a whole range of views, which he's going to think about and process. So I'm highly confident that he is the right guy.

STEVE: 'Cause if you go back, he made this seminal speech in 2003 about deflation. And then, I mean, and he wasn't exactly like-- he didn't tighten in '06 or '07 when he first became chairman. I think the-- the-- the-- the-- the tightening was s-- actually done by then. So I'm just wondering are there any other reasons for confidence that at the right time, Ben Bernanke can be counted on to take the punch bowl away?

WILLIAM DUDLEY: Well, I'm absolutely certain that he was. But you know, obviously experience will-- will-- will tell the tale, rather than me sitting here telling you that. All I know is that I'm completely committed to taking away the punch bowl at the right time.

I have n-- no desire whatsoever to see inflation get out of control. And so I think, you know, I think he feels exactly the same way-- 99.9 percent of the time we're on the same page. So I have high-- every confidence that he's gonna do the right thing, that we're gonna do the right thing.

STEVE: So how will the both of you know it's time to take the punch bowl away?

WILLIAM DUDLEY: Well, we won't know with certainty. But I think what we'll see is an economy that's doing better. That the ec-- the unemployment rate is declining. We'll obviously having to pay very close attention to what's going on in inflation. Because it's very possible that inflation's actually gonna continue to decline for a while.

'Cause there's quite a bit of slack in the economy right now. The-- cap-- capitalization rate's the lowest since-- World War II. The unemployment rate's 9.4 percent. And even with recovery, we could see the unemployment rate drift up a bit further. So there's a tremendous amount of slack in the economy. So I don't think this anxiety about inflation is really gonna be something that's gonna be really a substantive issue over the near term.

STEVE: What do you make of the recent data, though, which seems to suggest there is some stabilization in some places, actually, dare we say it some growth, and even some chance of strong growth in the third quarter. Is that your forecast?

WILLIAM DUDLEY: That's great. I mean, we want a recovery. So-- yeah. The economy's turning around. There's no question about that. You know, the inventories were liquidated very rapidly during the first half of the year. That's gradually gonna come to an end.

We're getting more support from fiscal stimulus, which is helping the economy. And two sectors that performed absolutely horribly over the last year, housing and autos, are finally doing better. Now one question-- for autos is the Cash for Clunkers program-- is that just gonna be temporary? Or-- or are we gonna actually see autos continue to do better as we go forward? I think it's highly likely that we're gonna see decent growth in the second half of this year. The bigger question is what happens is what happens in 2010.

STEVE: How do you make the transition, though, from-- economy being fiscal, stimulus driven, to-- or, and even Fed policy driven, to one being actually driven by the private sector? People are really concerned that that-- the private sector just doesn't kick in on time.

WILLIAM DUDLEY: Well, I think that, you know, g-- the good news is that the fiscal stimulus doesn't just go away very quickly. It's-- it's still-- it's still actually building as we speak. So it's providing additional stimulus to the economy. So the-- the fiscal program actually has a pretty, you know, long profile to it. So it's not like the fiscal stimulus is gonna be moved away and the economy's just gonna fall flat. I think the biggest question for the economy-- there's really two big questions. One, is what are households gonna do in terms of consumption versus savings?

They've had a horrible-- net w-- drop in their net worth-- partly due to the stock market decline last year, but also obviously due to the weakness in housing prices. And so people are having to save more. And w-- what-- sitting here, economists don't really know how high the savings rate's likely to go. And that's gonna be hugely important in terms of how it affects the outlook in 2010.

We've never had-- economic cycle quite like this. So the-- frankly, we don't know where the savings rate's gonna continue to drift up and consumption's gonna be very weak or whether we're gonna get a normal sort of rebound in-- in consumer spending.

STEVE: You said two big questions. One was consumer spending. What was the other one?

WILLIAM DUDLEY: The second is the financial sector. The financial sector is, you know, still undergoing tremendous amount of-- of-- of hurt. The banking system is still going to suffer a tr-- a tremendous amount of additional credit losses, which is gonna squeeze the capital in the banking sector, which is gonna strain the availability of credit. So that's gonna take time for the banking sector to heal itself. So the credit availability is not as good as it normally would be at this stage in the-- in the economic cycle.

STEVE: How essential is it for the consumer to come on board? If the consumer saves, does that mean growth is gonna be lower?

WILLIAM DUDLEY: Well, I think it's pretty important that the consumer come on board because consumption's 70 percent of the economy. So I think that the-- you know, the coun-- what's gonna happen is we're gonna s-- see a rebound in economy over the-- this quarter and next quarter. That should generate some improvement in-- in real income growth. And then the question will be what do the consumers do with that income? Do they spend it or do they save it?

STEVE: One thing complicating monetary policy and obviously complicating the outlook for the economy are fiscal deficits. How concerned are you about them not this year and next year around the stimulus, but in outlying years? And how does that complicate monetary policy?

WILLIAM DUDLEY: Well, I think that the long term fiscal outlook is, you know, a big potential problem. It's a problem in part because, you know, at some point you have to take back the fiscal stimulus that you added or else you'll have permanently higher budget deficits. And two, the demographics: We're now at the point where the baby boomers are actually starting to retire.

And so the outlook for social security and Medicare is-- is-- is-- is-- is really poor if you look out over the next decade. So fiscal consolidation is going to have to take place-- some time in the next, you know, three, five, seven years. And, you know, if that doesn't happen it's just gonna make it much more difficult for the Fed. That said, we will do what we have to do to keep inflation in check. The fiscal problems are not going to undermine our willingness or ability to keep inflation in control.

STEVE: Well, I mean, that's what's interesting, right? Is that you right now-- are aligned with the Treasury and the fiscal authority, as they say-- in terms of policy. But there's-- right, does this c-- it's correct to say there's gonna come a time when you guys are gonna have to essentially separate and-- and go different ways here.

WILLIAM DUDLEY: There may c-- there may come a time where we raise interest rates at a time where the budget deficits are still high-- which may be unpopular. But, you know, the Federal Reserve has to do what its charter is, price stability, full employment.

STEVE: There's a lot--

WILLIAM DUDLEY: Means that-- so-- so--

STEVE: Go ahead.

WILLIAM DUDLEY: --so Steve, we are not gonna monetize the debt.

STEVE: Okay.

WILLIAM DUDLEY: We are not gonna monetize the debt.

STEVE: There's a lot of concern in Congress regarding the Fed. How concerned are you over this bill that's in Congress right now which looks for greater Congressional oversight on the Federal Reserve?

WILLIAM DUDLEY: Well look, I think the Federal Reserve has to be accountable to Congress. I mean, you know, we live in a democracy. So I have no quarrel with Congress, you know, overseeing us and evaluating us and making sure that our programs are run properly. I think that's completely appropriate.

The real question is how close is that oversight? And does that oversight start to compromise the independence of monetary policy? So my view would be Congress should have tremendous of oversight and-- and ability to look into what the Fed is up to. But it shouldn't go so far-- to the extent that it starts to con-- strain the independence of monetary policy. If it starts to do that, then w-- how are the financial market participants gonna react? They're not gonna be too happy about that. Interest rates are gonna rise. And that's gonna be bad for the economy.

STEVE: Do you think the current bill does that? Does it go too far?

WILLIAM DUDLEY: Well, I think, you know, there's been a lot of discussion about, you know, what's-- what's actually going to end up. I think the administration's proposal-- is-- you know, does not go too far in terms of, you know, accountability for the Fed. I think-- I think we're-- we're-- we're quite comfortable with that.

STEVE: And are you comfortable with this idea of being this systemic risk regulator, that th-- ought to be inside the Fed?

WILLIAM DUDLEY: Well, that's a decision for Congress to make. I would say on the systemic regulator two things. One, I think we need one. I think the crisis proved that we need one. We need to look horizontally across the system. We need to look at all the little interconnection points. We now have to make sure that things aren't falling between the cracks.

And then the question is who does it? Well, that's-- for Congress to decide. All I can say is sitting where I sit at the top of the New York Fed, we have a tremendous amount of talent, people who know things, that would be valuable as a systemic risk regulator. So I think-- I think we have good resources that would be helpful. But it's Congress' dec-- decision to make.

STEVE: But this brings me back to something we were talking about earlier. All of those resources did not enable you to see the systemic risk the last time around. And so that's why I think there's some concern out there--

WILLIAM DUDLEY: Look, I don't--

STEVE: --whether or not the Fed's the right guy for the job.

WILLIAM DUDLEY: --look, I don't think that we're ever going to, you know, eliminate crises.

STEVE: Right.

WILLIAM DUDLEY: But what we can do is build a better system, a system that's more resilient. A system that-- where the incentives are better. A system that responds better to shock so that when we-- when we have crises they don't turn into the kind of very bad crisis that we had in this-- this-- th-- this last round.

STEVE: You have some ideas that I've heard that I think are really interesting about how should some of the things that banks are required to do during good times, how can they stabilize the system during crises?

WILLIAM DUDLEY: Well, I think there's a number of things that we need to do-- with banks. And one, we have to get the incentives right. So one-- one-- one set of incentives that has-- received a tremendous amount of attention, as it should, it compensation policies. You know, you don't wanna have a situation where the-- the bond trader makes $10 million in year one and gets paid $5 million, and then in year two loses $100 million and gets paid zero.

And-- and we've seen that-- actually happen. So we need to have compensation policies that basically align the interest of the bond trader with the interest of the taxpayer. Another thing we need to do is think a little bit harder about-- capital, preservation and conservation of capital. One thing that-- that-- that upset me during the crisis, frankly, is-- is the fact that banks continued to pay out dividends, continued to buy back shares to show that they were strong when in fact they were actually dissipating their capital that we actually needed so that banks could continue to make loans.

So I think we need to think a little harder about a regulatory regime where, you know, the banks' stock price plummets and the banks aren't doing very well, then the dividends get shut off automatically. There's no question, there's no discretion in terms of, "I get to pay the dividends sh-- I show that I'm strong." The dividends just stop because you-- you know, it would have been really good if starting late-2007 if the banks had conserved more of their capital.

STEVE: What about the other idea I heard which was debt into-- the-- and what about a conversion of debt to equity?

WILLIAM DUDLEY: Well, I'm in--

STEVE: Did we already talk about that, or?

WILLIAM DUDLEY: --I'm interested in this idea of contingent capital. You know, a lot of people talk about, well, we need to raise the capital requirements for banks. And we probably do need to raise the capital requirements for banks t-- to a degree, probably less so in the United States than in some other countries where the capital ratios are quite a bit lower.

But the-- what-- when you raise the capital requirements, there's-- there's two consequences that aren't so-- so positive. One, you threaten to push that business outside of the banking system into the unregulated sector; and two-- the second thing you do is you increase the cost of the banks to do business. So the spread between loans and deposits gets wider. The cost of intermediation goes up. So the contingent capital idea is really-- goes like this. Banks during good times don't need much capital, because people are happy to do business with banks. The banks are making lots of money.

What they do need is more capital during bad times. So why not let the banks issue debt obligations that are convertible into equity capital if the stock price of the bank plummets? So it's sort of-- a convertible on the downside rather than the upside. And the value of this would be imagine how this would have worked during the last crisis. Stock prices plummet. The debt automatically conver-- converts to equity.

The banks don't have to go out and r-- actually raise any equity capital, 'cause it happens automatically. The managements are disciplined by this event, right, because they're-- they're exis-- their shareholdings are diluted. So it creates also very good incentives for the managements to avoid those kind of outcomes.

STEVE: How big does the TALF ultimately get? It's now $30 billion. What's your sense of how big it gets?

WILLIAM DUDLEY: I don't really know. I mean, you know, it depends in part on-- on, you know, h-- market conditions, you know, how attractive the TALF is relative what one can do in the market. I think the big question where we would be-- have trouble forecasting is what's the take up gonna be for commercial mortgage backed securities?

We just don't have a good sense of that yet. Because it's just starting to gear up. You know, the first offering for commercial mortgage baked securities was a little bit over $600 million. And then the next time was, you know, I think it was $2.5 billion or so. You know, we just don't have a good sense of how much that's gonna ramp up. I think more important-- than size is effect on the market. And, you know, what's happening actually to spreads? What's happening to-- you know, commercial mortgage rates? What's happening to the ability of-- consumer loans-- rates, you know, coming down? What we've actually seen, while the TALF hasn't gotten quite as bit as what we thought it might have been at this point, we've seen tremendous compression in spreads.

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