Can Central Banks Rescue Us from High Interest Rates and Rising Debt? | Steven J. Davis, Raghuram Rajan | Hoover Institution

Steven J. Davis (0:09)

I'm your host, Steven Davis, and I'm here right now with Raghur Rajan, Professor of Finance at Chicago Booth, former Governor of the Reserve Bank of India, and both of us are senior fellows at the Hoover Institution. Thanks for joining, Raghur.

Raghuram Rajan (0:25)

Well, thanks for having me.

Steven J. Davis (0:27)

So we've had a pretty exciting day so far at the symposium, starting with a speech by Warsh. I'd like to get your thoughts about his speech as one former central banker assessing the nature of another, a very consequential speech, kind of setting the tone for his term. So what did you think?

Raghuram Rajan (0:49)

Well, I thought it was a very good speech, especially when it came.

So Kevin had basically, I think, two objectives. One was to reiterate his intent to get inflation under control. He's been saying that pretty loudly. But the second was to match that intent with a program of action without actually going into forward guidance and even specifying what the reaction function of the Fed would be, which I think is wise because reaction functions are hard to specify when a lot of stuff is moving around.

Steven J. Davis (1:30)

I was struck by that.

His disavowal of forward guidance was no surprise. That was just a reiteration of something he said over and over again. But he could have said nothing about a reaction function. Instead, he went out of his way to explicitly say, we're not going to abide by a mechanical reaction function. He did not say, oh, but we're going to use it as a benchmark, which has been coming out of the fed lot in recent years.

Raghuram Rajan (1:56)

I think that was wise only because the next question to, okay, you're not going to give us forward guidance is, what about your reaction function? It does seem a little mechanistic when just said without all the accoutrements that we're going to watch all these other indicators, and it's going to be a complicated decision. Otherwise, we just put it into a computer and let it run. I think reaction functions tend to, as you said, academics understand what they're about. But if the public thinks, this is mechanistic, it's problematic.

I think it was very important for him to state very clearly that he was going to take action.

He couldn't tell you when because that would amount to some semblance of forward guidance. But he was very worried about where inflation had been. So put those two together and the natural interpretation the markets have is, oh, they're going to tighten. I think that intent was very important to send the market because there was a feeling either he doesn't know what his job is about or he doesn't have the will to do it. He dispelled both those notions.

Steven J. Davis (3:14)

He did. As you said, he didn't say this is the decision. He explicitly said, we have a discipline, I'm announcing a discipline, not a decision. But the overall tone that one came away with was higher likelihood of a hike than you would have thought before his speech. Exactly. I took that for two reasons. One, he explained why he was not so reassured about recent inflation numbers.

And earlier in the speech, he gave a pretty optimistic assessment of what AI will mean over the medium or long-term. Right. Strong economy, hence kind of another reason why you probably wouldn't want to lean towards easy now. Is that how you read?

Raghuram Rajan (3:59)

I think that's right. I think he allowed for the possibility down the line that there might be room to have more moderate interest rates if the supply effect takes in of AI and so on. But he wasn't making any promises and he wasn't saying, that's going to deter me.

Because there's a sense that, oh, he's waiting for long rates to go up, to tighten, for it to naturally tighten financial conditions, or he's waiting for AI to bring the supply kick in to lower inflation. And he was quite clear that those weren't things that he was banking on. So I think he did a very good job in communication at a time when there was a lot of questions being asked by the Central Bank, of the Central Bank.

Steven J. Davis (4:47)

I must say he knows how to deliver a speech.

Raghuram Rajan (4:51)

He does. He seems to be very practice. But it was a good speech at the right time.

Steven J. Davis (4:59)

So he did not say anything, at least that I heard, picked up on about relationships between the Fed and the Treasury.