Separating the Plumbers from the Pilots: A New Framework for Fed Crisis Response

Exploring how the Federal Reserve's 2020 market interventions evolved from emergency plumbing fixes into prolonged monetary policy, and why institutional separation could improve future crisis responses.

Key Takeaways

• The Fed's March 2020 Treasury purchases began as financial stability interventions but morphed into 18 months of monetary policy within weeks
• Communication around the same bond-buying program shifted from "market functioning" in March to purely "monetary policy" by September 2020
• The Bank of England's 2022 gilt crisis response demonstrates how to execute rapid financial stability interventions while maintaining monetary policy independence
• A proposed "Purchase Facility Committee" could separate technical market-fixing decisions from broader monetary policy considerations
• Fundamental questions about monetary policy transmission remain open despite decades of research and recent economic performance
• The economy's resilience to 500 basis points of rate hikes challenges traditional understanding of how monetary tightening works
• Financial stability interventions should only be deployed when traditional lending facilities prove insufficient for market dysfunction

Timeline Overview

• 00:00–08:30 — Jackson Hole Context: Setting up the Federal Reserve's annual economic symposium theme on monetary policy transmission and Tracy/Joe's discussion of unusual central bank tools deployed since 2020
• 08:30–18:15 — Anil Kashyap's Research Background: How academics get invited to Jackson Hole, the structure of panels, and introduction to research on "market maker of last resort" operations
• 18:15–28:45 — Fed's Evolving 2020 Narrative: How Fed communications shifted from financial stability rationale in March to monetary policy justification by September while purchasing identical amounts
• 28:45–38:20 — Bank of England Model: The 2022 gilt crisis response as template for rapid intervention and exit, buying for 13 days and selling everything in 12 days
• 38:20–48:15 — Institutional Reform Proposal: The case for a "Purchase Facility Committee" to separate technical market-fixing decisions from monetary policy considerations
• 48:15–58:30 — QE Transmission Mechanisms: How quantitative easing theoretically works through duration removal and portfolio balance effects, plus the disconnect between theory and practice
• 58:30–01:08:45 — Monetary Policy Mysteries: Why the economy avoided recession despite aggressive tightening, role of fiscal policy interactions, and anchored inflation expectations
• 01:08:45–01:18:20 — The Great Moderation's False Security: How 25 years of stability created overconfidence in central bank models that recent shocks have challenged
• 01:18:20–01:25:00 — Future Research Directions: Kashyap's upcoming work on money laundering as a laboratory for understanding state compulsion of private sector compliance

The Mission Creep Problem: From Plumbing to Policy

The Federal Reserve's 2020 Treasury market interventions illustrate how emergency financial stability operations can inadvertently become prolonged monetary policy tools, creating communication challenges and potential policy conflicts.

• Kashyap traces the evolution of Fed communications starting March 15, 2020, when officials said "we've got to stabilize the markets this is a financial stability intervention we're going to buy this stuff because we think that there are kind of Plumbing issues in the financial system"
• Within a week, "their next unscheduled meeting they said and this is also going to support monetary policy by April you know now we're 6 weeks later they they've got monetary policy and Market functioning side by side completely there"
• By September 2020, the Fed had "dropped the financial stability rationale now they're talking about a monetary policy operation by coincidence buying exactly the same amount of bonds"
• The transformation demonstrates how crisis responses can evolve beyond their original scope, with Kashyap noting that "at least some people in the FED system that will say you know we carried on then for another 18 months buying this stuff and looking back do we wish we' stopped sooner maybe"
• Unlike the rapid corporate bond purchases that were "got rid of pretty quickly," the Treasury and MBS purchases "kept going for much much longer" illustrating the difficulty of exiting once interventions become integrated with monetary policy
• This mission creep creates analytical confusion since "if it's the exact same group of people who make all the same decisions and you want to call this is a financial stability that's a monetary policy decision I think it just muddles the communication"

The Bank of England Template: Swift Intervention and Exit

The Bank of England's response to the 2022 gilt crisis provides a model for how central banks can execute financial stability interventions while maintaining clear separation from monetary policy objectives.

• During the Liz Truss budget crisis, the Bank of England managed to conduct financial stability purchases while simultaneously executing quantitative tightening, demonstrating institutional capability to pursue conflicting balance sheet operations
• The intervention was remarkably brief: "there was 13 days over which they bought and they actually the thing people done not to know is that they sold it all in 12 days so they really got in and got out"
• Kashyap emphasizes the apparent contradiction: "here you've got these two things wait you're buying you're selling which which way do you want to have it but they managed to pull it off pretty gracefully"
• The success stemmed from clear institutional separation where the Financial Policy Committee made stability decisions distinct from the Monetary Policy Committee's inflation-fighting mandate
• This separation enabled transparent communication about objectives: financial stability interventions addressed pension fund liquidity crises while monetary policy continued targeting inflation through QT
• The Bank of England model demonstrates that "if you do face a bank of England situation that you've got you know a recipe for dealing with it and that you've thought it through and people can kind of understand the way it's going to work"

Institutional Reform: The Purchase Facility Committee Proposal

Kashyap proposes creating a specialized committee structure within the Federal Reserve system to handle financial stability interventions separately from monetary policy decisions, improving both technical expertise and public communication.

• The proposed "Purchase Facility Committee" (PFC) would leverage existing expertise since "for the financial stability decisions there are experts in the Federal Reserve System that you might want to consult and actually give them a voice"
• Legal constraints would preserve FOMC authority since "the fomc owns every decision about the fed's balance sheet so I recommended this purchase facility committee a PFC and I don't think the PFC could legally order the FED to do anything they could make a recommendation"
• The separation would improve market understanding because "if you want to convince everybody this is separate then having a whole separate Playbook that you point to I think would be valuable"
• Technical planning would include pre-determined exit strategies where "ideally you would have announced the rules under which you would sell you know how how are you going to determine how much you're going to sell who are you going to sell to"
• The PFC would provide clearer mandates for intervention since "asset purchases for financial stability should only be deployed when a lending facility won't work" as lending represents traditional central bank tools
• Market confidence would improve through institutional credibility: "you never know when the next Plumbing problem is going to going to show up and what the circumstances are and I think you would like the market to believe that if you do face a bank of England situation that you've got you know a recipe for dealing with it"

QE's Theoretical Mysteries: Why It Works in Practice But Not Theory

Quantitative easing remains one of the most poorly understood tools in central banking, with significant gaps between theoretical models and observed market effects during crisis periods.

• The Fed's official theory operates through portfolio balance effects: "you take duration you're buying longer term Securities you're taking that out of the market there's people that crave duration that want to have that in their portfolio"
• This creates cascading effects where "that lowers interest rates to some extent but it also probably changes term Premia because people have to now pay a premium if they want to get the treasuries that you've taken away"
• Spillover effects theoretically occur because investors seeking duration "are going to go find it somewhere else so that they think that that's going to spill over into adjacent Market"
• However, empirical evidence remains weak: "it's incredibly contentious as to how wide the spillovers are we know the best evidence for QE comes when markets were very dysfunctional"
• The causation problem persists: "whether this was just a signaling thing that's the fed's got your back or whether it was really this complicated Theory I just gave you is very hard to to know"
• Ben Bernanke's famous observation captures the dilemma: "the problem with QE is that it works like in practice but not in theory" highlighting the disconnect between theoretical understanding and practical effectiveness

The Resilient Economy: Why 500 Basis Points Didn't Crash Everything

The Federal Reserve's aggressive tightening cycle raised fundamental questions about monetary policy transmission mechanisms when the economy avoided recession despite historically rapid rate increases.

• Traditional transmission channels were disrupted by lingering pandemic effects: "Auto industry normally gets crushed when the FED hikes interest rates 500 basis points people still can't get cars from the shortages from four years ago so the auto market hasn't tipped over"
• Fiscal policy interactions complicated standard models: "construction normally gets crushed well the inflation reduction act apply named has generated all kinds of construction spending so that hasn't tipped over"
• These represent "two of the engines that normally tightening would work through that haven't been uh crushed" demonstrating how fiscal and supply-side factors can offset monetary tightening
• Inflation expectations remained anchored despite the initial price surge: "chairman poell today talked about inflation expectations being anchored and because people kind of trust the FED they're content to go back for asking for normal raises"
• The absence of wage-price spirals proved crucial: "we haven't seen these second round effects where because you discover your grocery bills higher you go to your boss and say I need a raise and then he gives you a raise and he has to raise his prices"
• This resilience challenges fundamental assumptions about monetary policy effectiveness and suggests economic relationships may be more complex than traditional models assume

The Great Moderation's False Confidence: Lessons in Humility

The period of economic stability from the 1980s to 2020s created overconfidence in central bank capabilities and economic models that recent shocks have fundamentally challenged.

• The stable period created illusions of control: "we got lulled into a sense of false security by 25 years of pretty good luck where we didn't have big shocks and where central banks built a theory of the case of this is how the economy works we know we can find tune"
• Traditional relationships broke down during crisis periods: "that kind of got blown up in the global financial crisis where the simple models the Phillips curve and all that didn't work out so much because if you saw the size of that recession you should have had massive disinflation it didn't happen"
• The inflation shock surprised everyone: "then we didn't see this inflation Spike coming it came now it's dissipated again no recession" demonstrating the limits of forecasting models
• The stable period may have been historically anomalous: "the period between about 1984 and now has been an anomalous period we didn't have deep recessions we didn't have these wild external shocks to deal with"
• Limited data variation hampers understanding: "that also means that it's really hard to do empirical work because there's not a lot of variants and so there's lots of theories that work just about as well"
• Simple persistence models prove surprisingly effective: "like I think inflation is going to be what it was last year that model is incredibly hard to beat" highlighting how little we may actually understand about complex economic relationships

Communication Revolution: From Greenspan's Mumbling to Powell's Clarity

The Federal Reserve's approach to communication has undergone a dramatic transformation from deliberate opacity designed to maintain market surprise to systematic transparency and predictability.

• Historical Fed strategy emphasized deliberate confusion with Greenspan telling colleagues in 1991: "the journalists are going to be watching you at Jackson Hole the tilt of your head which way you look and how you answer a question we can't let them know what we're thinking"
• The old approach explicitly "prized their ability to surprise" markets as a tool of monetary policy effectiveness
• Modern Fed communication emphasizes systematic predictability, with one panelist "pointing out how much more predictable fed policy has been which I thought was quite interesting showed just how systematic is"
• The transformation extends globally: "it's not just the FED all the central banks have gotten away from this we got to surprise them" approach
• Recent rate hiking demonstrated both transparency and adaptability: "if you looked in December somebody raised this at the meeting in December of 2021 if you asked how much higher interest rates were forecast to be I think at the end of 2022 it was something like 75 basis points well they blew through that"
• The evolution shows "tremendous courage hiking uh interest rates as fast as they did" while maintaining clear communication about objectives and reasoning

Future Research: State Power and Private Compliance

Kashyap's upcoming research on money laundering provides insights into how government agencies compel private sector compliance with national security objectives, offering lessons for broader regulatory frameworks.

• Money laundering laws represent a unique regulatory experiment where "we compel the private sector to deal with moneya laundering and so if you look at the history of how moneya laundering laws have evolved there's a lot of lessons in there"
• This differs from traditional regulation because it's not about externalities: "when you think about most regulation that the government engages and it's to correct an externality it's some adverse spillover you know private incentives don't align this isn't that"
• Instead, it represents state power: "this is like okay we think there's a risk of another 911 we're going to compel you to do a bunch of stuff it might cost you half a billion dollars but you got to do it"
• The research has broad applications for emerging policy challenges: "think about the way we did Russian sanctions it's kind of pulled out of the air made up you look at often their competing aims"
• Economic fragmentation will increase these issues: "my guess is there's going to be more fragmentation there'll be a lot of stuff on sanctions there's going to be friend Shoring there's going to be all these forces"
• Traditional cost-benefit analysis breaks down: "economists don't have a great way of thinking about problems of that sort because you can't do cost benefit if you know you think about the value of a human life you could try to start adding this stuff up but it's not very satisfying"

Conclusion

The Federal Reserve's crisis response capabilities require institutional innovation to maintain clear separation between financial stability interventions and monetary policy objectives. Anil Kashyap's proposed Purchase Facility Committee offers a framework for preserving the Fed's ability to act as market maker of last resort while avoiding the mission creep that characterized the 2020-2021 bond purchases. The Bank of England's swift 2022 intervention demonstrates that institutional separation enables both effective crisis response and clear public communication about objectives.

More broadly, the recent economic cycle has revealed fundamental gaps in our understanding of monetary policy transmission, suggesting that the Great Moderation period created false confidence in central bank models and capabilities. As economic fragmentation increases and new types of shocks emerge, central banks need both better institutional frameworks for crisis response and greater humility about the limits of economic knowledge.

The evolution from Greenspan's deliberate opacity to modern transparency represents progress, but institutions must continue adapting to handle the complex intersection of financial stability, monetary policy, and national security objectives in an increasingly fragmented global economy.

Practical Implications

• For Central Bank Design: Institutional separation between financial stability and monetary policy functions improves both technical decision-making and public communication during crisis periods
• For Financial Markets: Understanding the distinction between emergency market interventions and monetary policy helps investors better interpret central bank actions and likely duration of programs
• For Academic Research: The persistent gaps between theoretical models and practical effectiveness suggest need for more empirically grounded approaches to monetary economics
• For Crisis Planning: Pre-established frameworks and communication strategies for financial stability interventions reduce confusion and improve market confidence during stress periods
• For Regulatory Policy: Money laundering enforcement provides lessons for how states can compel private sector compliance with national security objectives across various domains
• For Economic Forecasting: The economy's resilience to aggressive tightening suggests traditional transmission mechanisms may be weaker or more variable than models assume
• For Communication Strategy: Modern central banking requires balancing transparency about objectives with flexibility to respond to unexpected developments
• For International Coordination: Different institutional structures across central banks create both opportunities for learning and challenges for coordinated crisis response