Former Fed President On ‘Inflationary Boom’ And Bank Run Risks (Uncut) 01-21-2025

Former Fed President On ‘Inflationary Boom’ And Bank Run Risks | Thomas Hoenig

Several economists and agencies are now projecting steady economic growth in 2025, including the IMF International Monetary Fund, which in a recent report said that disinflation trends may also be present this year. However, our next guest believes that inflation may not be coming down anytime soon and will be reacting to the latest inflation numbers. Headline CPI up slightly to 2.9% and core inflation down slightly to 3.2%. And we’ll be talking about whether or not a financial crisis is on the horizon and what may happen to the banking sector now.

Whether or not the wildfires in LA, the tragic wildfires, may actually induce a market selloff by the insurance companies. We’ll find out with our next guest, Thomas Honig, who previously served as the president of the Kansas City Fed from 1991 to 2011 and later served as the vice chairman of the FDIC from 2012 to 2018. He is currently the Distinguished Fellow at the Mercatus Center.

Welcome back to the show, Thomas. Happy New Year. Good to see you again.

Happy New Year. It’s good to be back and I look forward to the conversation. Thomas, let’s start with some recent inflation numbers.

Why do you think that inflation is not coming down as fast as maybe the Fed would like? Well, I think there are important reasons for it. Number one, if you think about it, we’re in somewhat of an inflationary boom right now, not in terms of large inflation, but the fact that it won’t come down. And that reflects a very strong economy, several quarters, if not years, of stimulative policy, which includes subsidies for infrastructure on the deficit side, green energy, other spending programs that I think helps move the economy in terms of demand.

I think we’ve had this recent interest rate cuts, 100 basis points, I think are the cuts. Those are basically, and now I think in a more stimulative range. For example, if inflation is 2.9%, let’s just say 3% round off, and the interest rates are 4, it means real rates are 1%, that’s probably stimulative, given that the so-called equilibrium rate, natural rate, the Fed likes to call it, is above 1%.

I think it’s closer to 2. So you have a stimulative economy. The fourth quarter is going to show great growth. As we enter the year, there’s very strong plans that we’re going to continue forward with the stage of the tax cuts, other kinds of programs that are designed even to lower taxes.

So you have kind of an inflationary boom momentum going on. And I think that’s why you’re seeing the inflation number not come back down, number one. And number two, why you’re seeing the long end of the yield curve going up, as people expect a strong economy, number one.

And the deficit is certainly not going down. So those are some of the reasons. I’ll tick off for you, and then we can probe more if you would like.

Absolutely. Thomas, the priorities of the Federal Reserve are twofold, as we know, full employment, as well as inflation. Right now, sources or reports say that the labor market is steady.

For example, the IMF recently released a report, like I mentioned in the introduction, noting that the inflation rate has moved closer to the Fed’s target. Data shows a stable labor market, and the Fed could afford to wait for more data before undertaking further interest rate cuts, said the IMF Managing Director Kristalina Georgieva. Do you agree with this assessment of the economy? Well, I do, except I’m more optimistic than that would suggest.

I think the labor market is not just steady, but it’s strong. The real wages are increasing nearly 4%, an annual rate, so they’re ahead of inflation. That means there’ll be further demand on the economy, I would suspect.

The consumer is actually, leverage-wise, in pretty good shape. So there’s room for the consumer to continue to lever in their credit cards and other opportunities there, so that’ll be strong demand. So I think there’s good reason for the Fed not to be in a rush to cut rates, because number one, the labor market is strong.

Number two, the economy is strong. And number three, interest rates are fairly accommodative where they are. In this situation where inflation does come down for some reason, or we get some sort of disinflation trend, and the labor market, per your analysis, still stays very strong, what would the Fed have to do in that case? Well, I think the Fed needs to consider where it really is relative to interest rates and its balance sheet.

Where the Fed really is, is, as I said earlier, in a relatively accommodative spot. They are near neutral now. So if they’re fortunate enough to see some inflation or disinflation come forward, that’s great, but I don’t necessarily think they should ease rates.

Now, if there’s some kind of a shock, or there’s some kind of significant slowdown, I can understand considering whether they need to do rate cuts, but I don’t anticipate that at the moment. In fact, I anticipate the opposite. That means I anticipate we’ll have a strong economy well through the first half and into the second half of this year.

So then bottom line, Thomas, do you expect one to two rate cuts in 2025, which is what the current market pricing is telling us? That’s a great question. I think that the FOMC would like to cut rates. They’ve made that very clear in their actions.

I think, though, that circumstances may cause them to be unable to cut those rates without risking continuing higher inflation, because 3% is higher inflation than their target by far. So I think they have a dilemma on their hands. So possibly one or two cuts, but I would be surprised without a real slowdown in the economy if they did that, and I would be disappointed that they would do that given the strength of the economy, at least as it looks going forward.

In her outgoing speech, Treasury Secretary Jenna Yellen made the remark that the US could have kept inflation stable over the pandemic had the economy threw up up to 15 million people out of work. An important what if exercise would ask how much more unemployment would have resulted from a fiscal contraction sufficient to keep inflation at the Fed’s 2% target? She said the answer is a lot, although the exact magnitude depends importantly on some key parameter values, particularly the Phillips curve slope, which measures the sensitivity of inflation to a demand induced contraction in output. She further defended the Biden administration’s economic performance and basically agreed with what the Fed has done over the past couple of years.

Now, what’s your reaction to this what if exercise? I mean, in theory, yes, if the government had given up the idea of full employment during the last contraction, possibly inflation wouldn’t have risen to 9%. But was there another way to avoid 9% altogether, Thomas? Well, I understand her comments, and I understand that her role is to share the policies of the administration that she’s been a part of, and I respect that. I would say number one, certainly, the early immediate reaction to the COVID crisis was appropriate.

There was fiscal stimulus, and there was monetary support for that stimulus. And that was appropriate through the first stimulus package. You might even argue the second, but the third, probably not necessary, number one.

Number two, the economy was in recovery very quickly after the crisis. By that, I mean, it was in recovery in the summer of 2020, clearly in recovery in the fall of 2020, and into 2021. And yet, the fiscal programs continued on very substantially with the third fiscal stimulus.

And number two, the Fed put itself in a very accommodative expansionary monetary policy through the fall of 2020, the entire year of 2021, and into 2022, which was excessive. And that’s one of the reasons we had the breakout of inflation. So I think you have to give credit for the crisis.

But one thing the Fed has tended to do in the great financial crisis, and now in the more recent pandemic, is it steps in, it provides a liquidity in the economy during the crisis, but it always, for some reason, can’t let go, and continues those very expansionary programs well beyond the crisis. And it creates a misallocation of resources. It creates both asset, and in the second instance, price inflation.

And that’s a fairly heavy tax on the American people. And that’s where I think they have to stand up and say, we accept this criticism. Well, what alternatives did the Federal Reserve in particular have during the pandemic, if not for what you described as excessive monetary easing? Well, they could do what they’re supposed to do, and that is they provided the liquidity in March of 2020 through the summer of 2020.

And then they, I’m not saying they raised interest rates rapidly, I’m not saying that they tightened policy dramatically, but they could have slowed much more, they could have slowed sooner the very expansionary $120 billion a month purchase of government securities in terms of quantitative easing, which provided, you know, doubled its balance sheet from $4 trillion to nine, more than balanced, doubled it to $9 trillion. And that money has to go somewhere. The money growth was very extensive.

And as it did, both asset prices and consumer prices rose dramatically. And that’s the price you pay for the excess. So had they stopped sooner, that’s what I’m saying, and have that fiscal policy become more rational sooner, I think we would have had less inflation and still a strong recovery.

And one thing else, on the fiscal policy, it’s one thing to provide needed help for those who are unemployed. And clearly, I think everyone would have supported that. But that was a massive expansion in terms of putting, you know, so-called helicopter money, that is, they were mailing checks to people who were employed, who were making over $100,000, and yet you were putting $1,000 a month in their bank account.

So that’s why you have a very excessive savings and the very, I think, strong spending boom afterwards that precipitated the 9% inflation rate and beyond. So those are the sorts of things that, I mean, I’m not sure, even in hindsight, you know about, but I don’t know that there’s an excuse for not knowing it during that period. Before we move on to financial crises, what is your overall assessment then of economic growth for 2025, and then finally inflation as well? Well, number one, as I said, we’re coming off a very strong 2024.

I think the fourth quarter, GDP numbers will be strong, as was the third and the second. I think that is going to continue through the first half of the year at least. The momentum is there.

Monetary policy is accommodative in that sense. People say it’s restrictive. I think I beg to differ.

It’s probably at about the neutral rate now, so there’s not a real need for additional cuts. And in this environment where the interest rates are where they are, where the fiscal policy is where it is, and the likelihood that there’ll be extensions of the tax cuts and other expansionary moves, that will be stimulative. Now, if they are going to cut spending in some form, that could have slowing effects and perhaps restrain inflation, but we’ll have to see what those are.

But at the moment, I see a very strong first half of the year. And then depending on what policies are decided in the first 100 days or so of this administration, that boom could come even more so in terms of inflation, or it could moderate and still have a strong economy through the second half. And I think that’s an unknown quantity right now.

But overall, if you were to force me, I’d say you’ll have strong economy in the first half and a good economy through the year. When you say the cuts in spending, are you referring possibly to this new so-called Department of Government Efficiency, which aims to, well, as the name suggests, make the government more efficient? Some economists told me that’s an oxymoron, but I’ll leave it to you to discuss whether or not this could be effective. Yes.

Well, certainly this DOGE, or the Department of Efficiency, may play a role. It would trim out some of the mismanagement, they think anyway, in the government. But I think it’s more important what Congress does.

Congress has the purse strings, and that’s where the real money is being spent. And there’s real issues there. And whether they will address those strong spending, we have, for example, we have entitlements.

They’re indexed and they’re automatic. So are they going to address that? We have defense. We have strong defense needs.

Will they actually increase the defense budget? And then how will they pay for that? The Congress really will decide the spending going forward in the next year. Government efficiency may have marginal impact, but the real important fact is what will Congress do? And at the moment, it’s not clear. There’s not agreement, I think, entirely within the Republican Party.

There are those who want very strong spending reductions and those who are not as prone to do that, given the effects it will have on entitlements and so forth. So those are outstanding questions, but Congress has to decide. And if they’re going to take care of the debt and the deficit as they hold, you know, they want to cut it in half, it’s going to take more than government efficiency.

It’s going to take Congress making choices. One of the arguments for a higher deficit in the next two years at least is the fact that, one, we have tax cuts coming, but two, it will be difficult to implement some of these cuts right away. And furthermore, President-elect Donald Trump has said very clearly that he does not intend to cut Medicare, Medicaid, and the mandatory outlays on the budget.

So that in itself would be very difficult or make it difficult to reduce the deficit. Do you agree? I do agree. I think it’s going to be very difficult to reduce it.

Number one, the interest on the debt at even current interest rates, not higher, but just current interest rates means it’ll be bigger than the defense budget. People pointed that out. It’ll be a trillion dollars by itself.

And then you have all the other spending requirements and you have these issues. If you extend the tax cuts, the projections are it adds five trillion to the debt over the next decade. So that’s, you know, how are you going to pay for this? And that’s not clear at all.

So I think there is a real chance that the debt and deficit will not be cut in half, but that it will remain as much as 6% or higher of GDP. And that means the risk of inflation remain high. And I think those are things this administration has to take into account.

And this Congress has to be responsible for. The M2 money supply has been increasing, as you may be aware, as part of this rising deficit and or higher debt servicing costs that we’ve been talking about. Do you expect that the M2 money supply will have to increase further in order to accommodate some of these debt burdens that we have, Thomas? Well, I think there’s certainly a risk that the Fed will be put under pressure to monetize the debt, to keep interest rates from rising, especially at the long end, which they have, you know, which they have in history done.

And I think that’s a real risk, because what if you think about it, as they’ve cut rates since September, as I mentioned earlier, interest on the long term 10-year treasury has increased 100 basis points. 30-year bonds have also increased. So the long end of the curve is going up.

Also, as you maintain rates where they are, financing the debt at the short end is expensive. Now, if you’re going to continue with the debt, and you’re going to continue Medicare, Medicaid, Social Security, and other funds and fence, you’re going to continue to borrow. And I don’t see clearly, and maybe the proposed Secretary of the Treasury will have answers to this, but I don’t know how you cut the debt in half very quickly.

If that happens, that will put increasing pressure on the private sector to fund that debt. And that means increasing upward pressure on interest rates along the yield curve. That means even more expensive paying for the debt.

And that implies then that there’ll be more pressure on the Fed to buy that debt to keep interest rates from rising, which is what they did after the great financial crisis, and which is what they did after the pandemic. And that pressure will be intense, I believe. Is it, we’re speculating here, but is it reasonable to assume that the 10-year could go back to 5% in the next coming year? Well, it’s certainly not out of the realm of possibility.

It’s been up, I mean, so quickly here recently, no. Part of that will depend on what the Fed does, right? If the Fed says, no, we’re not going to, we’re going to keep our balance sheet coming down. We’re not going to buy this new debt.

That means more pressure on the private sector rates, the 10-year could go above five. On the other hand, if the Fed says, whoa, this is going to hurt the economy too much, and the pressure they feel from Congress on that says, well, we’re not going to let that happen, and they buy that debt, then they could suppress the interest rate temporarily, at least. When I say temporarily, I mean over the next two years.

But that’s a high-risk choice in terms of future inflation and what I’ll call the misallocation of resources going forward. So that’s a risk that the Fed has to address itself. Speaking of allocating resources, Thomas, this is part of the initiative to make the looking at ways to perhaps reduce, merge, or even eliminate altogether the banking regulators in Washington, specifically the FDIC, as part of the Doge Initiative.

This came in in December. Advisors have asked the nominees under consideration for the FDIC, as well as the Office of the Comptroller of the Currency, if deposit insurance could be absorbed into the Treasury Department altogether. Now, as former vice chairman of the FDIC, do you have a response to this, or a reaction? Well, if you eliminate the FDIC and moved it into the Treasury, it would be an administrative change.

The savings would be marginal. Number one, the FDIC is paid for by the banks who are insured, the commercial banking industry. So you wouldn’t have a big savings there.

Their salaries are paid through that fund. So I don’t know what you get. Whether you would have confidence in the ability for resolution, if it was in the Treasury, would you merely make the FDIC Department of the Treasury? Would that really reduce expenses in terms of resolution? Would you save an examination because you would put them into the Comptroller, which is in the Treasury? Or would you just add staff to the Comptroller to examine several thousand banks? So I don’t know what you get out of that.

If they were asking me, I think there’s other ways to reduce the cost in terms of bank regulation that would both save the industry money and allow all the agencies to reduce staff. And one of those, for example, is eliminating the Dodd-Frank requirement for the living wills. That is resolution plans that all these large institutions and banks, regional banks have to prepare.

That’s a very expensive process, both for the industry and for the regulators. And since it was implemented or passed by the Dodd-Frank Act, it’s never been used. When we had recent runs on regional banks and systemic, the Treasury and the FDIC and the Fed stepped in, but there was no orderly resolution under the living wills program.

So eliminate it. It takes hundreds of millions of dollars to prepare these things. You’ll save that money directly by the industry, and you can eliminate the staff who has to review that.

So there are other ways to save a lot of money, I think. Excellent. Let’s move on to what you think could happen next.

But before we talk about the future, let’s just take a look at the past here. You were a member of the Federal Reserve. In fact, you were president of the Kansas City Fed during the Great Financial Crisis, I believe.

Now, the Fed started cutting in mid-July, August 2007, before the Lehman Brothers crashed in 2008. Were there indicators of economic slowdown that the Federal Reserve observed back then that prompted a cut before the bank started collapsing, Thomas? Yes, there was. There was a lot of information regarding the increasing delinquencies in the housing market early.

In fact, I spoke about it in 2006 at that time saying, you know, there’s a lot of vulnerabilities in the banking industry. There’s a lot of risk in the industry. We need to be careful.

Now, I did not necessarily say we ought to be cutting rates then, but I knew that we had an inflationary environment that could be a problem going forward. So then when we started experiencing it, there were difficulties in some of the largest firms’ announcements of credit losses. And therefore, the Fed did begin to lower rates as you would expect.

Just out of curiosity back then, was this concern that you and other members of the Federal Reserve expressed, was that communicated to the banking sector or banking regulators ahead of the financial crisis? Oh, yes. It was brought up. In fact, I spoke about it to a large banking director group in 2006 and saying, you know, in fact, the title of my remarks was, this time is different or is it? And went through some of the practices that we were observing in the industry in terms of their leverage, in terms of their lending on collateral for housing and so forth.

So there were warnings out there. Now, I was not in favor of lowering rates at that time, but I was aware that the industry was leveraging itself pretty heavily and cautioned about that. I’m just out of curiosity.

Why wouldn’t you want to lower rates in those conditions? Well, because it would have encouraged even more speculation at the time that it was going on. So that’s the thing about monetary policy. If you do it too soon, you invite issues.

If you do it too late, you have to deal with issues. So it’s a tricky business. But when I saw the speculation going on, to lower rates then, I think, would have been only to encourage more speculation and carry it before the correction.

And when you have excess, you have to correct. And by delaying the correction, you make the correction more difficult later on. And those are the hard choices that central banks have to take.

And I will share with you advice I got from a seasoned central banker, not of this country, but of another country, who said, the central bank’s job is to take care of the long run, so the short run can take care of itself. And when it starts managing the short run and moving with every change, it actually can disrupt the economy. It can encourage speculative booms.

It can worsen declines when they finally do occur and so forth. So it’s a difficult business, but it is part of the job. And that’s why I keep reminding my central bank colleagues that keep your eye on the long run and don’t move with every little shift in the economy.

I bring this up because I’ve noticed that in the last at least three to four rate cut cycles, the cutting has preceded an official recession. Is it too simplistic to say that easy monetary policy is now a leading indicator for a contraction in the economy? Well, you can say that, but easy monetary policy, if it stays in place, and let’s define easy policy. Policy in which the interest rate is below the equilibrium rate for an extended period.

Will create bubbles. And bubbles have to be corrected. Will create excess demand, and excess demand has to be corrected.

So if you allow easy policy to be in place too long, beyond the early needs for recovery in the economy, you invite future problems. Yes. In 2000, one could argue that part of the reason for a Fed cut was the dot-com bubble bust.

Now, if, I’m not saying it will happen, but if we do get another stock market crash, or market black swan event now, despite the strong labor market, despite sticky inflation, would the Fed still react to that in the same way as it did in 2000, you think? I think it probably would, but put it in the context. Here would be the issue. Yeah.

If we have a shock, for whatever reason, even though right now the market seems strong, just as it did in 2006, 2005, you will have, whatever the shock is, that it causes unemployment to suddenly rise, demand for loans to suddenly fall, supply of loans to suddenly fall. So you have a crisis. The Fed will step in.

That’s its operating procedure. But here’s the issue. Once you settle the market down, even though employment remains high, you should not continue to increase, or should I say, continue with a highly accommodative monetary policy.

You should adjust that policy towards normal, towards a interest rate that is closer to the equilibrium, even though you can’t know for sure where equilibrium is, but zero is clearly not equilibrium. Zero is clearly not equilibrium. So back towards one or 2% real rates, and do it in a systematic fashion, and not let it sit there for a year and a half, or two years, which is what we did after the financial, great financial crisis, and after COVID.

Those are the mistakes. It’s not that you intervene during the crisis, it’s that you continue the highly accommodative policies well past the crisis that precipitates misallocation of resources, precipitates asset inflation, and eventually precipitates, perhaps, consumer price inflation. That’s the mistake you want to avoid.

On the issue of financial crisis, and we’ll end the talk on financial crisis here, Thomas. In a paper I believe you wrote in the 90s called Rethinking Financial Regulation, this one paragraph in particular, although moral hazard problems can be contained through traditional regulatory approaches, an alternative is to require those institutions that engage in an expanding array of complex activities to give up direct access to government safety nets in return for reduced regulation and oversight. What would this look like in theory? Well, for example, you would have to, for the largest institutions, let’s say, you’d have to force them to separate completely, and the regulator has to also stand up to this, no bailouts.

What that does is, if you give credibility to that, it forces those institutions to hold much more capital than they hold now. I mean, you will be told by the industry over and over again that they are overcapitalized, that they’re gold-plated. The difficulty with that is events really don’t substantiate that.

Everyone says, oh, they did so well through the pandemic. They did so well through the pandemic. But the Fed and the government bailed out those banks before they ever became a problem by the massive injections of liquidity into the system.

What I’m saying is they have to become subject to the market’s true discipline. The odds on that, I put that in there at the time because I was in favor of separating out the investment banking from the commercial banking. That would have brought more discipline to both the commercial banking and the investment banking, but that was rejected.

Now that you have the two intertwined, and you have the safety net covering commercial banking and indirectly investment banking, where it’s owned by those banks, we are now in the age of too big to fail, and that’s the age we’re going to stay with. While that seemed like a good idea at the time, I think its probabilities now are even less than they were then. Well, do you think the FDIC coverage of, I believe, up to $200,000 of your deposit should be increased now in 2025 and beyond? That’s a very difficult question because that confirms the moral hazard problem.

But the fact of the matter is most banks are insured at 100% right now. So I don’t know that it would be much of an extension. For example, there is no bank, no large bank, and I mean we’re talking regional banks now, that will be liquidated, where depositors will take a loss.

Small banks, we know from recent experience, those depositors may still take a hit. That’s a very small percentage. And even in small banks, that can be avoided because there are institutions now that arrange swap transactions among banks.

So if I get a million-dollar deposit, I could go through this, what I’ll call an intermediary, who will then redeploy those funds to other banks under the insurance limit, and you receive other funds from banks that are insured, and you have the same amount of money in your deposit account, and it’s all insured. Now there’s a cost to that, so you really can get 100% deposit insurance today. And I think one of the reasons the industry as a whole doesn’t necessarily want 100% deposit insurance, you’d have to ask the independent bankers, is that if you did that, your insurance premiums would go up pretty significantly, and who wants that? You probably get asked this quite a lot, but I’ll ask it anyway.

Suppose all the FDIC member banks were to collapse tomorrow, would all depositors be insured, actually, up to $250,000? In other words, is there enough liquidity for this potential? If all of them fail, well look, if J.P. Morgan failed, there’s a question whether the FDIC, or say Citibank, or any of the large banks, or all the banks, there isn’t enough in the fund to pay everyone off at once. There just isn’t. However, behind the FDIC is the federal government, and they would do it.

Now, let me give you an example. When Silicon Valley failed, there was a run on all kinds of banks in this country, and what happened? The Treasury Department, the Fed, the FDIC, all said, this is a systemic crisis, therefore, we guarantee all deposits, and it laid the run on the banks. That’s what will happen.

Final question before we go, Thomas. Wildfires in California, LA, as you know, very tragic. People have been speculating as to what may happen to financial markets should the insurance companies be forced to liquidate some of their stocks and bonds to raise premiums in order to meet claims.

I read somewhere that up to $20 billion of losses that the insurance companies would have to pay up, this would be the largest loss for them in history. What, if any, market impact does this have, do you think? Well, it’s hard to anticipate because the property insurance is one issue, health insurance is another issue because people were injured. I suspect that there would be a temporary blip, but I do not expect that it will be a systemic crisis or that it will be.

Now, who knows? How far is this going to go? We know the numbers are big, but we’ve had major catastrophes before, whether it’s hurricanes that came up the coast and hit New York. We’ve had other events that have happened. The insurance companies are generally able to deal with that, and I suspect, given our history in this country, that should there be a crisis of liquidity for those insurance companies, the government would probably step in rather than have the economy collapse as a result of that.

Okay, I understand. Thank you very much for an excellent discussion once again. Where can we follow your work today? I’m still at the Mercatus Center.

We still print. We have a FinReg blog that I produce on occasionally, and we still have our Discourse magazine, so always feel free to access mercatus.org. We’ll put the links down below in the description, so make sure to follow the Mercatus Center there. Thank you for coming back to the show, Thomas.

We appreciate it. Yeah, glad to be with you, and thanks for the invitation. Thank you for watching.

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