Capitalisn’t: Strange Fedfellows

Speaker 1: Breaking news from the Federal Reserve: Richmond Fed President Jeff Lacker resigning immediately from the Federal Reserve.

Kate: Hi, I’m Kate Waldock, a professor at Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism and what isn’t.

Speaker 2: … back to business news—some major business news by the way—the president of the Federal Reserve Bank of Richmond abruptly resigned a few hours ago after admitting that he’d leaked confidential information.

Speaker 1: … is what Mr. Lacker apparently didn’t do was tell the people at the Fed the next day or that afternoon.

Speaker 2: It is a major blow to the reputation of America’s central bank because essentially investors could profit if they know specifics about the Fed’s actions before the rest of the world.

Kate: On today’s episode we’re going to be talking about information coming out of the United States Federal Reserve. The Federal Reserve is this big, powerful, shadowy entity that’s somewhat outside of the governmental system. And it’s in charge of setting interest rates and controlling monetary policy. So we should expect to have utmost faith in this institution. And yet what we’re finding is that there actually seem to be a lot of information leaks coming out of the Fed at a regular basis. And not only are there leaks, but these leaks may even be encouraged by Fed officials.

Luigi: So let me be clear here: what Jeffrey Lacker, the president of the Richmond Fed, has been accused of is not like being Deep Throat and revealing all the secrets of the Fed to a hedge fund manager. What he is accused of is not answering properly to a question by a reporter. The reporter implied in his question some information that was confidential, and Jeffrey Lacker would have to say, ‘No comment,’ and he failed to do so. And he failed also to immediately disclose to the Fed that this conversation had taken place. So if you want, it might seem like a minor lapse except for the fact that there is a building amount of circumstantial evidence that the information of the decisions that the Fed makes seem to leak into the market before the official announcement. And this is what we’re going to discuss in this episode.

Kate: So the Fed is made up of a bunch of different leaders. First of all, there’s a few regional Feds across the country, and they oversee regional economic activity and they’re also given specific economic tasks—like they have to oversee certain segments of the economy. But there’s also this umbrella organization that’s in some sense more powerful than each of the individual regional Feds, and that’s called the Fed board. Now the group of people who decide to set interest rates are called the Federal Open Market Committee, and they’re made up of the seven members of the Fed board, the president of the New York Fed, and then some other regional Fed presidents. And they meet to determine interest rates and other parts of monetary policy, and then they announce these results in what are called minutes or notes on what happened in the meeting.

Luigi: I think it is important that our listener appreciates why these potential leaks from the Fed are so disturbing. The Federal Reserve is in charge of setting the discount rate, which is the rate at which banks can borrow from the Fed. And this has a big impact not only on the structure of interest rates in the marketplace but also indirectly on the value of the stock market. Because if the discount rate is cut, money is more easily available, and stock prices tend to go up. And if the Fed, on the other hand, increases the discount rate, then money’s less easily available and the value of stock tends to go down. So knowing in advance or potentially knowing in advance what the Fed does is a bit like knowing what the weather will be like in Florida for the price of orange juice. And if you know in advance that there’s going to be a hurricane in Florida and that oranges will go through the roof, you can buy in advance and make a lot of money. And that’s exactly the reason why there are procedures to make it difficult for these to happen. And in particular, the Fed makes the most important decisions about the discount rate in official meetings called Federal Open Market Committee meetings, and in advance of these meetings, there is a blackout period—a period in which the Fed officials cannot talk to market participants.

Kate: It’s not necessarily the case that we have no idea what the FOMC did or decided or discussed in their meetings. They have an announcement once the meeting is over. But that announcement is usually pretty short. It’s a quick summary of what happened, and then a little bit later—Luigi, correct me if I’m wrong on this—but a couple months later they have an official transcript, but the full minutes are not released until five years later.

Luigi: And what some researchers have noticed is that actually, on average, there is a big return on stock the day leading into the FOMC meeting announcement. So it’s not that after the announcement there is a big variation, but before it’s as if the market anticipates what the Fed is doing or maybe the market knows in advance what the Fed is doing.

Kate: And this is particularly shocking because the Fed put special provisions in place to prevent people from knowing what’s going to happen before the FOMC announcement is made. This blackout period exists for a week before the FOMC announcement, and during this blackout period, Fed officials are especially not supposed to talk to anybody. And yet, as Luigi just mentioned, all of the run-up in stock prices occurs before the announcement is made—like during the blackout period, which is a little concerning.

Luigi: In fact, there is this recent paper by Cieslak, Morse, and Vissing-Jorgensen showing that there is a cyclicality in stock market returns exactly around the time of these less-known discount meetings, and they attribute this to some kind of leak coming out from the Fed. But they document a number of strange—if you want—facts. For example, they show a cyclicality in articles written by journalists that are Fed experts. Until recently, probably the most famous Fed expert was David Wessel that was writing for the Wall Street Journal. The paper points out that the articles by Wessel appear with the same periodicity as the discount rate meetings take place. Now one possibility is simply that David Wessel writes when he knows decisions are made, and he’s trying to second-guess these decisions. To be fair, in the paper there is not any smoking gun that he knew what was decided inside the Fed. But the fact he writes at the same time is considered, if you want, a strange coincidence.

Kate: I mean the thing is that we don’t really know. They surmise that this has to do with the timing of the discount rate meetings, because increases in stock prices coincide with the timing of the discount rate meetings relative to the FOMC meeting. But we don’t know exactly what’s going on. Another alternative hypothesis is just maybe that there’s different macroeconomic news coming out around the FOMC meeting, and so they quantify and tabulate other sorts of macroeconomic news and they show that this isn’t describing the results, but I’m not sure that they specifically pinpoint information leakages directly from these meetings.

Luigi: Actually, yes and no. In this sense, is there a smoking gun? No. But there is a lot of circumstantial evidence in this direction. First of all, we need to remind listeners that for most of this period, the Fed has been very generous with its monetary policy, i.e. very expansive, with low-interest rates that tend to boost the stock prices. So the fact that around every meeting the stock price tends to go up is an indication that the Fed is trying to even support the stock market in its behavior—which might be wrong or right, that’s a separate question—but the interesting question is this effect does not come out at the time of announcement, but comes out before. And that is the concern of having some leakages. And they don’t prove that the leakages exist, but they do provide a lot of evidence that in many cases the information about decisions made inside the Fed was known to market participants, even reported in newsletters to market participants. And to me, the most shocking piece of evidence is actually the fact that during a meeting, the members of the Fed board asked each other whether this information has leaked to the market, and one member, which is actually Lacker, the one we heard at the beginning, asked Tim Geithner, who was then the chairman of the Fed in New York, whether he has talked to market participants about this, and he said no, I didn’t. And then Lacker comes back and says, “Wait a minute, I spoke with Ken Lewis, who is the president and CEO of Bank of America, and he actually knew about the decision we’re about to be making.”

Kate: So I think this is actually a pretty interesting transcript. It was just released.

Luigi: It was released after five years.

Kate: Yes. And it’s a pretty rare glimpse into how serious these information leaks can be. So Luigi, do you want to pretend that one of us is Lacker and one of us is Geithner, and then actually read the transcript?

Luigi: Sure. Which one do you want to be?

Kate: I’ll be Lacker.

Luigi: OK.

Kate: All right. Vice Chairman Geithner, did you say that the banks are unaware of what we’re considering or what we might be doing with the discount rate?

Luigi: Yes.

Kate: Vice Chairman Geithner, I spoke with Ken Lewis, president and CEO of Bank of America, this afternoon, and he said that he appreciated what Tim Geithner was arranging by way of changes in the discount facility. So my information is different from that.

Luigi: Well, I cannot speak for Ken Lewis, but I think they have sought to see whether they could understand a little more clearly the scope of their rights and our current policy with respect to the window. The only thing I’ve done is to try to help them understand—and I’m sure that’s been true across the system—what the scope of that is because these people generally don’t use the window and they don’t really understand in some sense what it’s about.

Kate: All right, so I don’t even really understand what Geithner’s explanation is there. I think he sort of is saying that all market participants can’t really fully process the importance of what the Fed does. And so, therefore, they need like extra explanation from him.

Luigi: I think that they’re actually to be sort of fair vis-a-vis Geithner, there is an important issue here, which is how do you do your job as a Fed board member when a lot of the outcome of what you do is mediated by the market, and you need to understand how the market reacts. So in this particular moment, I think that the question is ... Remember this is 2007, at the moment of extreme tight liquidity, and the banks are not really borrowing money from the Fed even if the Fed is cutting the rate. So Geithner wants to understand why the banks are not borrowing, and in order to do that needs to talk to the CEO of the biggest banks, and probably in the process of this talk, some information is shared.

Kate: So this notion of information exchange—the Fed and the markets and vice-versa—is actually something that the Fed has discussed before. And it’s somewhat of an open secret that the Fed actually conducts regular meetings with people at banks or with journalists. And the question is whether this is OK, whether this is encouraged, and whether it makes sense from the Fed’s perspective. And so the rationale is two things. There are two reasons that the Fed might actually want to leak some information. One is that they need information from market participants. So let’s say the Fed is thinking about cutting interest rates. They’re not sure about whether they should cut them by a quarter percent or half a percent. They want some sense of how the markets are going to react, and so they might leak a little bit of information and then see how the person at the other end of the table responds, or assuming that that information is then translated into the markets, they can then see how equity markets respond to the information leak.

And so that’s one way for them to gauge I guess the accuracy as well as the impact that their policies will have. And that, in turn, helps them fine-tune their policies. And another reason that they might want to leak some information slowly before they actually have an official announcement is that sometimes markets overreact to information and they swing around wildly, there’s lots of volatility, and so if information were only released at discrete times—let’s say eight times a year, when the FOMC announces its meetings and the results of those meetings—then maybe markets would overreact too much, and there’d be too much volatility. And so by slowly releasing information to banks or to journalists, this is a way to ease that information transfer in.

Luigi: But I see two problems. First of all, companies like to do the same or would like to do the same. If I’m a CEO of a company and there is a big change in earnings, etc., I don’t want to have my stock being too volatile. So there is at least the desire to soften it up and smooth it out and maybe sort of leak it out to some people first. But this practice, that was common until the late ’90s, now has been ruled out of existence by a regulation called Regulation Fair Disclosure. And the reason for this Regulation Fair Disclosure is to treat every market participant the same. Because if you are invited, if you are the channel through which the company provides information to the marketplace, you can make a lot of money on the side, and this creates a perverse relationship between CEOs and analysts. And I fear the same thing is happening here.

Kate: Yeah. I think that no matter what the sort of shady information disclosure ... A, it’s arbitrary. It seems arbitrary to me. Who’s the Fed picking as good journalists or bad journalists? Who’s the Fed picking as a friendly bank or an unfriendly bank?

Luigi: Can I suggest an idea?

Kate: What?

Luigi: It’s the journalist who writes very well about you.

Kate: Yeah. So that creates another problem. But on top of that, if you want to understand the actual mechanism by which information translates into stock prices moving—which, as we discussed, stock prices move very significantly with respect to these FOMC announcements—I want to know exactly how that information is being leaked and who it’s being leaked to. So, on one hand, let’s say the Fed is talking just to David Wessel. Someone calls up David Wessel like off cycle, and they give him some information. And so he then writes a news article about it in the Wall Street Journal the next day or something, and so that information goes from the Fed official to David Wessel to the public. That to me is very different than if David went to maybe a bank and gave that information to them first or maybe he went to his friends at a hedge fund and gave that information to them. And it’s also very different than if the Fed went directly to the banks, they went directly to Goldman or Citi or Bank of America and gave the information to them first. I mean then it creates this very unfair information, which basically is insider information that they can directly benefit from, and that to me seems very problematic.

Luigi: I agree. The part of the transcript we reenacted here seems to suggest that this transfer does take place. But to try to find more systematic evidence, actually, a student of mine, David Finer, had brilliant idea. The Yellow Cab Company of New York released all the cab rides in New York from 2009 to 2015. And so what he did, he went and looked at whether there was unusual cab ride activity between the Federal Reserve of New York and the major financial institutions located in New York.

Kate: The banks are Bank of America, BNY Mellon, Citigroup, Goldman, JP Morgan, Morgan Stanley.

Luigi: And what he finds is that there is a bit of an increase in direct rides, but the most shocking thing is there are coincidental rides leaving financial institutions and the Fed and meeting in the same location around noon, around lunchtime. And because there is this blackout period where the Fed is supposed not to talk to the financial markets, these meetings in a remote location at the same time seems pretty suspicious to me.

Kate: How does he know that it’s not just a coincidence? How does he know that it wasn’t just the case that someone from the Fed went to lunch at The Grey Dog café, and someone from Goldman also went to lunch at the same place, and they weren’t just coincidentally waiting in line next to each other but not interacting?

Luigi: That’s an excellent question, and to be honest, he spent basically a year doing robust statistical analysis to show to the most distrusting reader that this activity is unusual. So there is a pattern of rides that go from location to location, and this pattern changes with days of the week, with hours. So it first captures this normal variation and then looks at coincidental rides within a certain time period and space, and notices that around noontime leaving the Fed and the financial institutions there is a remarkable increase, which is outside of what we call in economics the normal confidence bounds. So there is some randomness. So can you say that you are 100 percent sure? No. But you are 95 percent sure that that outcome is not driven by sheer luck.

Kate: The most shocking thing about these findings is that there’s this increase in coincidental meetings at locations that are neither a financial institution nor the Fed during the blackout period, or the period during which Fed officials aren’t supposed to be communicating with market participants. But he also finds evidence that as soon as the blackout period is over, bankers rush to the Fed, right?

Luigi: So there is a rise in cab rides from financial institutions to the Fed. Now the irony is that the end of the blackout period is midnight. So this rise is between midnight and four o’clock in the morning. And so the reason why this researcher can identify that very well is, as you can expect, there are not a lot of rides going from financial institutions to the New York Fed that is in the financial district in Manhattan at that time of night. So it seems that a lot of people from financial institutions are trying to get some help in interpreting what the Fed announced and what the Fed has done. And the reason why I wanted to emphasize this is because again, what we are concerned with is not necessarily that there is illegal behavior; we are concerned about an excessively cozy relationship between the Fed and the financial sector, and in particular the traders. And this cozy relationship can potentially lead to a lot of distortion. And especially when then we see that most Fed governors, when they step down, they go on retainer to work for major financial companies and hedge funds.

Kate: So at this point, I think we should recap some of what we’ve talked about. So we’ve had some explicit quotations about Richmond president Lacker having resigned because of an information leak, about Geithner not being completely upfront about a potential information leak, about at least one economic paper documenting that equity returns or stock market returns are significantly timed before these FOMC disclosures, as well as around more secretive meetings, these discount rate meetings, in which there is very little information released to the public. And then we’ve also documented that your student has a paper directly tying cab rides to probably non-coincidental meeting places between Fed officials and bank officials when they weren’t supposed to be talking. So what should we be doing about all of this?

Luigi: As a policymaker, I think that’s more tricky, because as you correctly said, Kate, there is a benefit of this interchange. I personally think that this benefit is more than compensated by, number one, the cost of this policy, in particular the cost in terms of perception. A lot of people distrust the Fed, and many of them distrust the Fed for the wrong reasons. I don’t want to give them a right reason to distrust the Fed. If you’re already disposed negatively vis-a-vis the Fed, I think this could be really the kiss of death. And the Fed is an important institution of our market system, and we need to have the trust that is managed in the most honest and transparent way.

Kate: I agree. But from a policy perspective, let’s say you have some good reason to want to be sharing information slowly or to get reactions from the market. Then you should have an established mechanism for sharing information that doesn’t seem shady and arbitrary. You should have some sort of system for journalists to get a special designation so they can go to special meetings so they can be bound by some sort of rule that they don’t have to share that information or that they can’t share that information with banks and they can’t share that information with their friends. They have to go out and directly publish it in a newspaper so that everyone knows at the same time. But the system that they have where they sort of have a blackout period, it’s sort of not very well enforced, they talked to some banks but not others, some reporters but not others, that just seems like a terrible system to me.

Luigi: I agree. And I think that one way to help fix this problem is paradoxically raising the Fed salaries and restricting their ability to turn around and go work for other institutions. I think that honestly, given the level of importance of what they’re doing, they are very poorly compensated. The only solution, in my view, is to raise their salary. At the end of the day it’s not a huge cost for the government because those employees are not very many, and if that’s the price we want to pay for having a more fair system that does not allow the friends of the Fed to become rich at the expense of the rest of Americans, I think it’s a great step.

Kate: So the Fed is only a little over 100 years old. It had its hundredth birthday in 2013. I think that’s part of why the Fed ... It’s still pretty new. It still needs help and guidance from the markets. It’s not sure whether it’s doing a good job of lowering interest rates and raising interest rates and engaging in quantitative easing. And so that’s part of the explanation for why they need this, this constant interaction with market participants, because they’re still fine-tuning their policy decisions as a result of being a sort of young organization. But I’m not sure that fully gets them off the hook. I don’t know. I’m sad to be doing this episode. I’m not going to lie. I think that the people who work for the Fed are, for the most part, genuinely smart and motivated. And I agree with what the Fed did throughout the financial crisis. But these information leaks, sometimes they can be akin to insider trading, and the Fed should be doing something to stop that.

Luigi: Look, I agree with you that there are a lot of very nice and decent people working at the Fed. But I think it’s also important, in my view, to expose the problems, to fix them. And honestly, I think that the Fed should be held against higher standards than private companies. Precisely because it’s, broadly speaking, a government institution. I think that companies do have very strict rules against insider trading. They have now very strict rules about equal and fair distribution of information to everybody. I don’t know why a government institution should not be held to the same standard.

Kate: Absolutely.