Why the Federal Reserve matters more than ever

From setting interest rates to keeping inflation in check, the Federal Reserve sits at the center of some of the most important economic decisions shaping our daily lives.

As the Fed prepares for new leadership, as Kevin Warsh prepares to follow the tenure of Jerome Powell, many are wondering: What's next for the Fed, especially when it comes to their financial decisions and their independence?

We spoke with Prof. Douglas Diamond, the Nobel Prize-winning economist of the University of Chicago, who explored the Fed's crucial role in our financial systemand why it matters so much for our future. One of the founders of modern banking theory, Diamond has conducted groundbreaking research on banking, particularly during financial crises. He described the lessons we can learn from past bank runs, including the 2023 collapse of Silicon Valley Bank, and warns that the Fed must remain on guard to help prevent the next financial crisis from happening.

Transcript

Paul Rand: What's next for the Federal Reserve? Well, that's the question buzzing around Washington right now.

Tape: All right. President Trump has announced Kevin Warsch as his pick for the next Fed chair. Warsch has long been on the shortlist to succeed current Fed Chair Jerome Powell.

Paul Rand: Over the past few years, Americans have been experiencing a wave of economic uncertainty, rising inflation, tariffs, and the possibility of a recession. But in times of crisis and uncertainty, Americans can usually count on the Fed to create economic stability.

Doug Diamond: The Fed is the fast moving part of the government regulatory, the government intervention system. So when there's a crisis, when bad things happen, it might take a long time for the Congress to pass a bill to deal with the problem. The Fed can do this instantly. We saw this in 2008.

Paul Rand: That's Doug Diamond, professor at the University of Chicago Booth School of Business. Diamond earned the Nobel Prize in 2022 for his groundbreaking research on bank runs and financial crises. That was months before the last major financial crisis, the collapse of Silicon Valley Bank.

Doug Diamond: They eventually then had a run on them where all of their depositors or most of their depositors were pulling their money out super fast. Basically, the Silicon Valley thing, which I wasn't aware that it was a possibility, that was exactly the kind of thing I was concerned about.

Paul Rand: The Fed resolved the crisis quickly, unlike the meltdown of 2008. But Diamond cautions that we've forgotten some of the lessons of past failures and may be sowing the seeds for the next crisis.

Doug Diamond: The 2008 stuff may be fading, but the 2022 stuff is still recent enough that the fading memory thing is a headwind that's allowing the general deregulatory and de- supervisory stuff that's going on right now to proceed faster than it would otherwise. Pretty much everybody I know who's concerned about financial stability is concerned that these new reductions in capital requirements and supervisory input into banking, that pretty much everybody in that crowd is concerned that we might be about to make a big mistake.

Paul Rand: Well, now as the Fed prepares to transition leaders, Diamond says the stakes couldn't be higher.

Doug Diamond: So the Fed needs to be credible in the future that it will fight inflation. Right now, we have a lot of uncertainty about what the Fed's going to do in the future. Will it lose its credibility? It spent a long time getting its inflation credibility.

Paul Rand: From the University of Chicago Podcast Network, welcome to Big Brains, where we explore the groundbreaking ideas and the discoveries that are changing our world. I'm your host, Paul Rand. Join me as we meet the minds behind the breakthroughs. On today's episode of Big Brains, we talk with Nobel Prize winner, Doug Diamond, about financial crises, the economy, and the future of the Federal Reserve.

Paul Rand: You've been studying financial crises for 40 odd years, and I'm wondering if we could just give a bit of a step back and say, what drew you to this work? I can't imagine it has ever been boring. Help explain to folks why this is ... It's always relevant. Why is it particularly relevant in this moment?

Doug Diamond: So an interesting thing about this moment that from the point of view of someone who's looked at banking crisis for a long time,

Is that the commercial banks are in very good shape in terms of having lots of capital, lots of equity relative to debt, which is what lots of capital is. Because of the supervision and regulation they've had, they're taking relatively low levels of risk. So right now, if you look at the banking sector, you'd say this is a time of relatively low risk. That's the good news. The bad news is the regulations and things like that that made the banking sector relatively safe have caused a bunch of these activities that they used to do to move over to the less regulated, what's called shadow banking sector.

So if you were looking at the type of research that I've done, if you want to think about where are potential vulnerabilities of the system, it's in a slightly different place than it's been for a while. In fact, if you asked me a few years ago, I would say probably the next crisis is going to be outside the banking system. Then in 2022, we got the Silicon Valley Bank, which was smack-dab in the center of the financial system. It turns out it was a very special case. So thinking about the vulnerabilities in the domain of thinking about where is there lots and lots of short-term financing used to finance long-term illiquids investments, that traditionally happened in the banking system. It's happening sort of outside the banking system right now. So with that lens, you need to take a broad set of ... Look at a broad set of institutions.

And interestingly enough, they're either regulated by very few people or regulated by a bunch of different people, like insurance companies are regulated state by state. The Federal Reserve is on top of this. They're having a meeting pretty soon to get the state banking regulators together so they can all be thinking about this problem.

Paul Rand: You did talk a few moments ago about regulations that were being rolled back. And I'm wondering, are there any of those types of things that you think are particularly worrisome?

Doug Diamond: Yes. So one of the things that happened after 2008 is that the capital requirements, the amount of your financing that is in the form of equity, the floor on that fraction, that went up quite a bit, particularly for the largest banks. The largest banks have a need for more capital for two reasons. One, they're too big to fail. So probably if they got into trouble, we would do things to bail them out. And secondly, they rely much more heavily on uninsured deposits. One's over $250,000. And the ones that run in a crisis are the uninsured ones, because as long as the government is good for it, there's no particular reason to run on insured deposits. So I'm concerned that the proposed reduced capital requirements, the proposed reduction in the importance of what are called stress tests, which are ways of measuring how big financial institutions would do in a particular type of systemic crisis that caused trouble in a whole sector, a whole type of funding, a whole industry, a whole financial system even, a whole financial system meltdown.

The fact that these things that were well thought out are being backtracked on means that even though we're not currently in a case in a situation where the big financial institutions could be problematic, it's the case that we're sort of sowing the seeds for the next one.

The other thing is sort of there's sort of a short memories problem. We haven't had a financial crisis in the last, since 2022, which is a long time ago, it seems like. So the short memory thing could be part of it. I think it's probably mainly just the view that regulation just slows down the economy in a bad way. So I think it would be better to be nuanced. There's certainly many things, many regulations that are excessive, but some of them, I think particularly these capital requirements are ones that are not excessive.

Paul Rand: Well, you spoke a moment ago about 2022, and I remember not long after you won your Nobel, you talked about all kinds of trouble if the Fed moved too fast. And since that time, there has been a lot of trouble. You mentioned the SBV collapse, there's been stubborn inflation, there's been war that's been going on, energy markets impact. Are these the kind of troubles that you anticipated and you worried might be happening?

What happened with Silicon Valley Bank?

Doug Diamond: It's a little more nuanced than what you say. So basically the Silicon Valley thing, which I wasn't aware that it was a possibility, that was exactly the kind of thing I was concerned about. Why? Because essentially interest rates had been around zero in the United States and it was clear to pretty much everyone that they had nowhere to go but up.

Inflation was above the inflation target the Federal Reserve was trying to get. So it was pretty clear that the Fed was going to have to increase interest rates soon. Okay. So that's first point. Second point, the way that the Federal Reserve supervises and regulates the large banks, or even the pretty large banks, are these things called stress tests, where they look at certain scenarios and see how the bank would do. And all the stress test scenarios they had been using were about further decreases in interest rates or the worst possible scenario they were looking at for increases in interest rates is if interest rates went up to 2%.

So since I thought it was quite possible, interest rates would need to go above 2%, that was my point is that essentially all of the work in supervision and regulation has been thinking about making sure banks were robust to interest rate decreases. If you just listen to what the Fed was saying, it was clear interest rate increases were coming. And it struck me that there was sort of a disconnect between the monetary policy part of Fed, the Fed that wanted people to anticipate future interest rate increases, which would keep inflation expectations in the future from getting too large and the supervision and regulation part of the Fed that was really not worrying about interest rate increases. So there's sort of like what's sometimes called a Chinese wall between the two parts of the Fed, the part that does supervision and the part that does monetary policy, but that's about passing private information back and forth.

It was public information that monetary policy was going to increase interest rates. And then it seemed like the Fed had also been trying to convince the market that interest rates were not going to go up before this period. Some people interpreted that as a way to signal or commit that they weren't about to raise the short term rates. So if everybody thought short term rates were going to stay low for sure, then you could lend long term and not have to worry too much about those long term interest rates going up. And if the longterm interest rates aren't going to go up, then the market value of the long term bonds isn't going to go down because bond prices go the opposite way from interest rates. So it seemed like the Fed had this, what you might call excess credibility to commit not to promise, they didn't commit, to sort of cross your fingers and promise not to raise interest rates, but then they were at a point where they needed to raise interest rates and it wasn't clear which way that was going to work.

If they were going to keep their fingers crossed promise, then they couldn't raise the interest rate. That probably would have been the thing to do is say, "Look, we're not going to raise interest rates now because we sort of promised not to and we're going to raise them gradually so people can unwind these positions." So what I was worried that they would raise interest rates rapidly, which they did. And then I wasn't anticipating something like Silicon Valley. So then Silicon Valley was an unusual case. They had a huge fraction of their assets in medium term US government agency securities. Think of like Fannie Mae or Freddie Mac and things like that. And those medium term securities dropped in value quite a bit when the interest rates went up. And the head of Silicon Valley said, "Oh, we were sort of told interest rates weren't going up." So they made this bet on interest rates not going up.

So that hurt their ... At mark to market, they were insolvent. Now the accounting that they had to use for their regulators was not marked to market. They could use what's called hold maturity accounting, which basically says, "If the market value goes down, why should you mark it down if you don't have to sell it? But they didn't have to sell it, but they eventually then had a run on them where all of their depositors or most of their depositors were pulling their money out super fast.

And that was partly the main reason that they had such a rapid run is that unlike any other bank I was aware of, they had 94% of their deposits in uninsured deposits. They had an over $1 billion deposit from Circle, the Stablecoin company. So just if that was pulled out in one day, that would cause trouble for the bank. And not only do they have uninsured deposits with one of them being over a billion, they had uninsured deposits from a set of well connected to each other firms that had venture capital funding. So when their venture capitalist told them, "Maybe you should get your money out because things don't look good," that was basically a self-fulfilling prophecy right there because that was a huge fraction of their deposits. So basically my point, I didn't know all the Silicon Valley stuff. I didn't know about the 94%.

Silicon Valley wasn't on my radar screen, but I knew that there was some institutions out there that thought interest rates weren't going up and they found it profitable to borrow at around zero, and then they could lend it around one and a half or two and a half percent and pick up a spread, but that was a pretty small spread to pick up interest rate spread between the short rate you're borrowing at and longer rates you're lending at to risk the institution. I was guessing it would be a shadow bank that did it, but it was a commercial bank that was financed like a shadow bank.

Paul Rand: I wonder if you can just help folks just make sure we understand, give a foundational explanation of what the Fed actually does and why is it that they are so much in the news these days?

What is the purpose of the Fed?

Doug Diamond: Okay. So the Fed, use a little bit of history just to set the table. So the Fed was set up in the 1910s, before the Great Depression,

With the goal of encouraging an elastic currency, providing for the supervision of banks and to be sort of a lender of last resort in times when banks needed to get to replace funding that was going away. So that was how it was set up. And it turned out an elastic currency was the wrong way to think about what the Fed should be doing. It was the bank should issue more currency and when it shrinks, they should issue less currency. So it's like saying you want the amount of currency created to equal the demand for currency and the demand from this particular source, real bills of exchange, which means basically means financing of inventory or financing of sales where you're going to sell something to somebody in California. It's going to take a month to get there from New York. So for that one month, you need the financing and then they will pay you and they'll bring the bill back.

The Fed is the fast moving part of the government regulatory, the government intervention system. So when there's a crisis, when bad things happen, it might take a long time for the Congress to pass a bill to deal with the problem. The Fed can do this incident. We saw this in 2008.

Paul Rand: That's right. Okay. So tell me, in the stage that we're in, again, folks are hearing a lot about the Fed. They're hearing some personal attacks. What is causing the current disruption and there's going to be a change in leadership coming soon, but what is it that needs to be understand about this period of time that we've been in and that we're going into?

Doug Diamond: So right now, because we're about to be between ... Take a new governor, a new chair of the Federal Reserve Board of Governors, there's about to be a change in the policy, and the Fed has lots of policies that it's responsible for. The one that most people think about is monetary policy,

And that's about inflation largely, although it has, I mentioned, if you change the monetary policy too quickly and move interest rates too much, it could have financial stability implications like it did at Silicon Valley. So there's lots of uncertainty and everybody knows that the inflation is still a little bit above the Fed's target. Right. So warning- And it's what, 2%? Yeah, 2% is the target. We've been in the two to three range for a long time. We're going to have some temporary things above three when these oil prices kick in, but that's not inflation. That's like a jump in prices that should hopefully, if the oil supply ever comes back, should hopefully revert. So the reason it's so unusual right now is we know we're going to have this big change. We have the President of the United States encouraging the Fed to cut interest rates to zero, which would be like a negative after inflation real interest rate, which would be tremendously stimulative, whereas right now the interest rates as they are sort of what you might call neutral, neither stimulating or slowing things down.

So if we thought that the Fed was going to keep interest rates at zero, even if inflation got up to four and 5%, that would cause people to expect inflation in the future, which would cause all kinds of problems today because expected inflation makes people want to get out of bonds that are set in US dollars, get either the treasury inflation protected securities that are indexed to that, to index to inflation, or get just into foreign currency denominated stuff. He's been talking about cutting interest rates, but probably my guess is the market isn't super worried because once he's the governor, he can't be kicked out by the president. If we got a huge increase in inflation, he would probably raise interest rates. So that's important to not get these expectations up. So right now we have a lot of uncertainty about what the Fed's going to do in the future.

Will it lose its credibility? It's spent a long time getting its inflation credibility. Second point, the Fed does other stuff too. It's one of the supervisors and regulators of the banks, and the Fed has been backtracking big time since Mickey Bowman has become the governor in charge of supervision and regulation at the Fed. So the Fed joining the other agencies has been sort of pushing for deregulation and desupervision. So there's a lot of uncertainty about how the Warsh Fed would do that. So

Paul Rand: That's- Let me ask you a question then. As you talk about this, how much inflation control is actually within the Fed's power? And then how much is actually driven by external forces, i.e. Tariffs, oil prices, other areas that the Fed really has no control over?

Doug Diamond: So I think the Fed has lots of control over inflation. It ties in a little bit to fiscal policy. So the money printing or interest rate setting, that's part of what the Fed thing is. But if the government is running huge deficits and the Fed sort of keeps the interest rates from going up, it's sort of indirectly financing the deficit, that's another source of inflationary stuff. But you mentioned things like tariffs and wars and things like that.

Learn more from Doug Diamond:

In Nobel lecture, Douglas W. Diamond recounts his groundbreaking career

Prof. Douglas Diamond's journey to the Nobel Prize

Douglas Diamond wins Nobel Prize for research on banks and financial crises

Paul Rand: Right.

Doug Diamond: Tariffs and wars don't cause, in my view, and I think most economists view, don't cause increases in long-term inflation. They cause prices to go up.

So if tariffs go from 5% to 10%, prices will go up. You will measure that as an increase in inflation between today and a year from today, but between a year from today and two years from today, the prices are already up. Unless they raise the tariffs again, it won't cause long-term inflation. In fact, Milton Friedman was basically made very clear to people many times that to have the market economy work, you have to let prices jump when there's excess demand relative to supply for something. So tariffs do that, tariffs raise the price of foreign goods, that's going to raise prices for everybody in the US. Wars reduce supply, strikes and things like that reduce supply, that's going to make prices go up, but that's not inflation and you got to let the prices jump and then the Fed basically is going to say, "Well, look, I have to realize that my monetary policy has some effect on supply and demand, and I got to think about my effects on supply and demand, the real effects of monetary policy." But you're supposed to sort of look through these temporary things like tariffs and wars and keep to the path you were already on, keep your inflation targeted 2%, realizing you're going to get above it, but then hopefully you'll come back below it and you'll come in back to 2%.

Paul Rand: As we're going into this change, is this period of calm dangerous from your perspective and leading up to something that we're going to be challenged with?

Doug Diamond: Potentially, yes. I think I mentioned the calm is one of the headwinds that's combining with the general view that supervision and regulation are excessive. So if we didn't have that view, we saw a potential, like 2022 wasn't that long ago,

Paul Rand: It wasn't...

Doug Diamond: We had a really short, like one week financial crisis that the Fed stepped in and basically resolved and the Fed didn't have to bail anybody out except Silicon Valley Bank eventually and the First Republic Bank who they gave them 100% deposit insurance on their big deposits. So that's pretty recent memory. So I'm guessing the 2008 stuff may be fading, but the 2022 stuff is still recent enough that the fading memory thing is headwind that's allowing the general deregulatory and de- supervisory stuff that's going on right now to proceed faster than it would otherwise. Pretty much everybody I know who's concerned about financial stability is concerned that these new reductions in capital requirements and supervisory input into banking, that pretty much everybody in that crowd is concerned that we might be about to make a big mistake.

Paul Rand: Okay. We've talked again about some of those regulations. What would that big mistake quote unquote look like based on what you just talked about?

Doug Diamond: So right now the really big institutions are super safe, so we're going to let them choose to be a little less safe. The second thing is that the way that that will work is it will basically mean that the outcome of these stress tests, which is the way of measuring this, the economy-wide risks that these big banks are subject to, we would no longer have ... The way the formulas work, if you got rid of this surcharge, probably almost none of the banks would have, the big banks would have an amount of capital they'd have to have in their capital structure, they'd have to have as a minimum. It wouldn't depend on the outcome of the stress test. So if a bank flunked stress test, it wouldn't have to raise any more capital. So the way you prevent crises from happening in advance is by making sure that everybody's damned sure that all of the relevant banks are quite solvent.

So if a bank is thought to have a run and everybody thinks there's going to be a run, if you have lots of uninsured deposits, that's true. It's a self-fulfilling prophecy. And one narrative is that we're just letting ... If we imagine that the banks are potentially insolvent, but we don't know which one's insolvent, or maybe they're all potentially insolvent, if that's a relevant narrative in people's minds, then they can say, "Oh my God, they're all insolvent. We better get our money out.

Paul Rand: Right

Doug Diamond: And now we got two reasons to get our money out. One, they're insolvent, and two, they're being run, which will make them even more insolvent. So not having stress tests and things like that, feeding into something that make the banks raise some more equity, basically is going to say that it's going to be more of a plausible scenario that there's some insolvent big banks. The big banks are the ones that mainly rely on uninsured deposits, Silicon Valley to the contrary, that was a highly unusual. They were a middle size bank, but the big banks like Bank of America or Citi or JP Morgan, if somebody thought they were potentially insolvent and they relied on all these uninsured deposits, we could have a system wide run. So I think you need supervision and regulation so that everybody can go to sleep easily saying, "Look, the banks are basically solvent."

Paul Rand: One of the things that certainly has come up in constant conversations, and it is one of those things that's being held out as a potential risk issue, is this idea of Fed independence. And I wonder if you could talk a little bit about what does Fed independence actually mean, and what is the concern over the risk of losing that independence?

What is Fed independence?

Doug Diamond: Okay. So basically the Fed's policies in the future have a big impact on what happens today. So if everybody thinks the Fed's going to allow inflation to take off to 10 or 15% in the future and not raise interest rates to slow things down, then we might get that inflation as a self-fulfilling prophecy. So the Fed needs to be credible in the future that it will fight inflation.

Paul Rand: Okay.

Doug Diamond: The Fed needs to be credible in the future that if the banks go crazy on too much risky lending, they will force the banks to raise more capital. So the Fed needs to be credible in the future. And what they want to do today, if the Fed understands the link between the President and the future, the Fed governors who understand this will say, "Well, look, I'm not going to respond to something today with a very, very short term perspective today because if I do the short term thing today, people will expect me to do the short term thing in the future and I'll lose my credibility." This is most relevant for inflation. People who say, "I will not let inflation take off today because I'll let it take off too much today. They think I'll let it take off a lot in the future and then we'll be in all kinds of bad trouble." So the Fed needs to think about its commitment to do things in the future that are for the long run and not the short run.

How does that relate to independence? Federal Reserve governors are trained in this, they're evaluated in this. Governors around the world, heads of other central banks evaluate our governor and our governor evaluates the other ones by their ability to stick with this credibility in the long run. And everybody sort of understands, everybody in the central bank community and the financial stability community, and even the heads of the big banks understand the Fed wants to be credible. So that's the reason that if the Fed loses its independence, that means that if the President could just tell the Fed what to do, they're always going to take the short run solution. The short run solution's going to ruin the credibility. Since I said the Fed is the only institution can move fast. So in a crisis, the Fed can have bracket creep, can have mission creep and intervene in new areas because that's where the new crisis was.

So independence is sort of a bad thing for that because you want political accountability about going into new areas. So that's why there's a trade off. You need some independence, but you need some rules for the Fed because they can use a bracket creep as long as you define their bracket narrowly. But suppose the Fed's mandate said, "Well, the Fed has to use its mandate to prevent climate change." You can say, "Well, look, nobody's going to do ... This is something that's an existential risk. They should deal with that. Doesn't have much to do with anything else. So you want to prevent them from dealing with climate change, but you don't want to prevent them from dealing with a run on non-banks that happened to be a little bit outside their regulatory domain, but was going to bring down their main domain, the banks.

Paul Rand: One of the things you've talked about is that we cannot eliminate financial crisis, but we They can limit their severity. And if there's things that folks are taking away from this conversation about limiting that severity and what we should be thinking about, keeping an eye on, advocating for, what is that?

Can we eliminate financial crisis?

Doug Diamond: So my point that I actually haven't had a chance to make is that the good thing that the financial system, the banks provide, the rest of the financial system and the banks provide is an increased amount of liquidity and liquid assets available for households who need liquidity, businesses, individuals to hold. And the role of the financial system is to create liquidity out of illiquid assets. How do they do that? In practice, it means they create short-term debt, short-term demand deposits, short-term time deposits, what are called repos where they have overnight borrowing against treasury securities. So one of the many good things the financial system does is produce short-term debt out of long-term assets. That's the good thing. That works fine as long as there's not a run. But if everybody starts to think that system is going to break down, either because the long-term assets have gone down in value and the financial system is insolvent, or because everybody thinks that there's going to be a run on the financial system that's going to cause the financial system to have to dump these long-term assets and make the financial system insolvent, then there'll be a problem.

So the thing that I want them to take away is that private financial crises historically have everywhere and always been about the problems caused by short-term debt. And people sometimes think it's too much short-term debt and too many illiquid long-term assets backing that short-term debt. But the short-term debt backed by long-term assets is the feature of the financial system. The runs are the bug. So when you see the Fed or the treasury or other governments, the ECB stepping in to stop runs on short-term debt, it's to preserve the good thing, the liquidity that's created in the private sector by short-term debt. So short-term debt is the good thing. Preventing runs from bringing down the financial system from runs on short-term debt is the good thing about the financial systems, supervisors, regulators, and governments. So if you see a run, don't say, "Oh my God, something awful has happened.

Something awful is about to happen, but we don't want the run to actually bring the financial system down." So financial crises are everywhere and always about the problems of short-term debt. The problems of the Fed and supervisors are about preventing that problem, putting the capital and things like that in advance to minimize the probability that that problem actually occurs so we get the good without the evil.

Paul Rand: There's not a person listening to this conversation that is not now saying, "Well, what does this mean for me? And how should I be thinking about my own financial situation and what I need to do for my family?" What advice, and I'm sure this is a not uncommon question, do you give out to folks at this stage?

Doug Diamond: So there's two types of a panic. One type of panic is you think there's a run on a system, so you better get out before everybody else kills the system. It's another type of a panic. When people see something surprising and they decide that the financial system is going to collapse to zero and they better put all their money into cash. So like on the day that Mr. Trump announced the big expansion of his tariffs, the stock market went down. I know people that sold out all their security. So basically sit tight and choose a level of risk that you're comfortable with for the long run and don't try to think that you're going to be able to outguess what's going to happen in the stock market or in the financial system better than the average person. And certainly, unless you happen to be the head of the Fed or something like that, you're not going to have much information about what's going to happen that the rest of us don't have.

So the way you prevent screwing your family up and yourself up in the future is by choosing a level of risk in your portfolio and then more or less leaving it alone, unless you get a change in your own situation. Changes in the world situation probably you shouldn't be reacting to too much. So that's my best personal advice is that basically try to, you can worry about the future, but don't take it out on your portfolio.