Can Regulators Embrace Fintech While Protecting Consumers?

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Can Regulators Embrace Fintech While Protecting Consumers?
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Patrick Harker, president of the Federal Reserve Bank of Philadelphia, talks about the U.S. economy and the impact of fintech.

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The U.S. economy is growing at a good pace, and the labor market feels “really tight” with job levels running below the natural rate of employment, said Patrick Harker, president of the Federal Reserve Bank of Philadelphia, at the recent “Fintech: The Impact on Consumers, Banking and Regulatory Policy” conference. During an interview at the event, Harker told Knowledge@Wharton editor-in-chief Mukul Pandya that he sees the central bank raising the fed funds rate target in December and then three more times in 2018, “assuming that inflation comes back.” He also noted that the already low inflation rate still could be overstated, which would mean that productivity growth has been underestimated.

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As the Fed starts unwinding assets on its $4.5 trillion balance sheet in October, Harker expects the impact to be a 25-basis point increase in the fed funds rate over a four- to five-year span. “We’re not talking about a very large impact,” he said, “but we don’t know for sure.” As such, the Fed will move cautiously and see how markets react. Harker also said the Fed should continue paying interest on excess reserves, which it only started doing in recent years, because it is the “only tool” the Fed has along with the overnight reverse repo to manipulate the fed funds rate.

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When it comes to financial technology, or fintech, Harker said banks have been innovating with technology for decades. This time feels different because many innovators are not financial institutions or other incumbent players, but outsiders. He noted that the Fed is watching developments in fintech carefully but it is not ready to embrace digital currencies as yet without further study. One positive contribution of fintech is its potential to broaden access to finance for all parts of society, especially the unbanked. But a sticky issue is to ensure that the most vulnerable in society aren’t overlooked as algorithms take over many tasks. “How would you even build an algorithm to have that sense of fairness?”

 An edited transcript of the interview follows.

Knowledge@Wharton: This week, Fed Chair Janet Yellen said that the Fed may have overstated the strength of the labor market, and the rate of inflation has come down, too. What do you think is happening on the inflation front, and are rate increases justified this year or next year? What are you views?

Patrick Harker: I’ll put the inflation picture in context. GDP growth continues along just as we pretty much have anticipated according to our forecasts, running slightly above trend, around 2.3%, 2.4%. You can pick a number somewhere north of 2%. Q1 was weak. Q1 is always weak. You should recognize that we have a seasonal issue with measurement of GDP in quarter one, and so take that with a grain of salt. Q2 has just been revised up to slightly over 3% — 3.1%. So in terms of GDP, things seem to be going along just fine.

Now, of course, the devastation that we’re seeing from these hurricanes is horrific devastation. It’s obviously terrible for the people who are involved, and our thoughts go out to them. But in terms of the economy as a whole, the best estimate [of their impact] right now is that we’ll see about 100 basis-point decline in GDP this quarter, and then it will bounce back to about 1.3% in the subsequent quarter — some number around there. So it will have an effect, but it will be a transitory effect, as that works through the economy. So that’s on the GDP front.

“The labor markets feel really tight.”

With respect to employment, we’re running below what most people would think is the natural rate of unemployment. The labor markets feel really tight. And that’s not only in the data, in terms of unemployment, but you look at the JOLTS (Job Openings and Labor Turnover Survey) data — the job opening and quits data — things are really tight. You’re hearing this … over and over again, of the skills mismatch question. Companies can’t find the skilled workers. We’re not talking about Ph.D. economists and computer scientists. We’re talking about truck mechanics, electricians, plumbers. You can go down the list.

Now, we get to the inflation question. So if that’s true, where did the Phillips curve go? What happened to it? Did it just disappear? Well, the conventional wisdom is it’s flat. But it’s been flat for a while, and that relationship between unemployment and inflation, we’re just not seeing. What’s happening with wages? Well, they are flat, but some recent work that was done by our colleagues in San Francisco point out the fact that if you look at somebody who’s staying in a job through a sustained period of time, their wages are going up well above what we’re seeing on average. It may be just a compositional shift. Part of the story of the wage issue is that we, the boomers, are retiring — high-priced boomers are being replaced by lower-priced millennials. And that is keeping the average down for now. Again, there needs to be more work in this area, but we are starting to hear and see some wage pressure.

Now there’s some recent work done by Mike Dotsey and his colleagues here at the Philly Fed research department on the Phillips curve. The conclusion of that work is, whether it’s dead or not, for the last several decades, it has not been a very good predictor of inflation. There may be other metrics and other measures that are better predictors of inflation than what we’ve traditionally thought of with the Phillips curve. … If you think of our dual mandate, [the one thing] that is problematic is inflation.

The job market seems to be incredibly healthy on average. [But] there are pockets where we need to bring people off the sidelines into the labor force and help them get the skills they need. That’s something we’re doing in Philadelphia with what we’re calling the “Economic Growth & Mobility Project.” It’s working with communities, trying to do research and outreach in that area [to offer] things like apprenticeship programs. We just put out a report on apprenticeship programs that are not your mother’s and father’s apprenticeship programs. They’re no longer just in the trades. We’re seeing it in IT and health care, financial services. Apprenticeships are now becoming, as the market has gotten tight, one way for companies to get the talent they need.

“We may be overstating inflation … [and] we may be understating productivity growth in the economy.”

On inflation, we are running below our 2% target. Only for bankers and central bankers is this a concern, that, “Oh, my gosh, we’re behind on the 2% target.” The average American is saying, “I have a job. Inflation is 1.5%. Life is good.” … So, what’s wrong with this picture? Everything’s great. Well, of course there are risks — bankers would like higher margins obviously, for [their] spreads. And we have the risk of, if and when another negative shock hits the economy, having the leg room to be able to move rates down. That is a problem.

So inflation is the one area that does give us a little bit of pause. It gives me pause. And it’s a complicated story. It may be that the Phillips curve or Phillips curve-like mechanisms will reassert themselves. But there is also work being done here in Philly — led by Leonard Nakamura that is pretty persuasive — that we may be overstating inflation, even as low as it is. And as a result, we may be understating productivity growth in the economy.

Leonard’s favorite example is the iPhone [and its many features]. We no longer have [to use a separate] GPS [or get a Gameboy]. … It’s all in the phone. … But we don’t know how to capture that shift in the statistics. We can do it hedonically, in retrospect, but in real time for policymakers, we’re having a hard time figuring out how to capture that. That leads me, as a policymaker to say, “Well, given that, let’s just let things play out a little bit. Let’s just see how the data evolves over the next several periods.” [The latest] PCE (Personal Consumption Expenditures) report was weak, so we’ll have to see how this plays out.

I think hitting pause for a little bit on the Fed funds path is appropriate for two reasons. One, you see the data play out. Second, we are unwinding our balance sheet, and that process will start … in October. It’s time to just let that play out. … We want to view [the process] in a way that is as exciting as watching paint dry. We want to lay this out very clearly. The caps are very low. And the best estimate that I’ve seen is that will have an impact the equivalent of a 25 basis-point increase in the fed funds rate over a five-year or four-year period.

We’re not talking about a very large impact, but we don’t know for sure. And I think prudence would call for just letting that happen, see how the markets react. I’ve still penciled in an increase in [the fed funds rate in] December, and three increases for 2018, assuming that inflation comes back. But I do emphasize the words “pencil in.” We’ll just have to see how things evolve.

Knowledge@Wharton: To follow up on the last point you made about the winding down of the $4.5 trillion balance sheet. How long do you think the process will take?

Harker: It will take several years. The question is not so much the timing, but what are we going back to? That’s what you really need to know. And there, if you just do the math — so our currency liability, say, call it $1.5 trillion, and then we have about $400 billion in the Treasury account, plus some other foreign reverse repo, and there are little things here and there. So we get up to some number — call it $2 trillion.

The question is what do we need in order to … execute monetary policy? Well, this gets into a debate about whether you want a floor system or a corridor system, and you need to know that elasticity of the demand for reserves. We’ve been way off on that curve for now quite a while, so we’re not quite sure in this economy what that elasticity is. We’re on the flat end, for sure. And there is some view — and I’m sympathetic to this view — that a floor system makes some sense. The issue is we don’t know when we stop being in a floor system and go into a corridor system. That is when the elasticity increases.

Again, there is some recent research by some of our economists here that said,