Macroblog

Over the last year, inflation has eased meaningfully from its postpandemic peak, but it has remained above the Federal Open Market Committee's 2 percent target. Given policymakers' focus on further reducing inflationary pressures and the proliferation of news articles about the pervasiveness of automation and artificial intelligence and their impact on jobs  and wages, we wanted to examine whether automation could help firms lower their price growth.

In the most recent CFO Survey, we explore expectations for price growth by asking financial leaders nationwide for their anticipated growth in prices in 2024 and how this anticipated growth compares to prepandemic growth rates. We find that most CFOs expect price growth to remain above normal through at least 2024. We also asked about the adoption of automation and find that, on average, firms experiencing above-normal price growth and implementing automation expect slower price growth both this year and next year compared to their non-automating peers.

Firms expect above-average price growth to persist during 2024
The combination of higher input costs and wages in the aftermath of the COVID-19 pandemic led to higher price growth. While growth in unit costs, wages, and prices has moderated from their peaks in 2021 and 2022, price growth expectations among surveyed financial leaders have not returned to their prepandemic levels, suggesting that elevated price growth may be more persistent than initially thought despite a restrictive stance of monetary policy (see the chart).

In the second quarter CFO Survey, monetary policy was listed as the top concern among CFOs, though nearly as many cited cost pressures and inflation, as well as hiring and retaining qualified employees. The fact that concerns about cost pressures and inflation remain so prominent—and these concerns even increased in the most recent quarter—supports the notion that despite more moderate inflation, price growth remains a foremost concern among CFOs (see the chart).

To better understand whether CFOs expect growth in pricing to return closer to normal during 2024, the CFO Survey asked firms to compare their 2024 expected annual growth in prices—specifically, the price of the product/product line or service responsible for the largest share of their firm's domestic revenue—to growth rates prior to the COVID-19 pandemic. For the past three quarters, nearly 60 percent of respondents expect growth in prices during 2024 to remain higher than prepandemic price growth (see the chart).

Pricing pressures: what role for automation?
In our most recent CFO Survey, we asked firms whether they adopted labor-replacing automation in the last 12 months and their motivations for doing so (see the chart). These results, combined with information from our core survey module on price growth expectations, allow us to gain further insight on the relationship between automation and firms' pricing behavior.

Around 60 percent of all firms, and nearly 85 percent of large firms, implemented automation over the last 12 months. Firms that automated over the last 12 months experienced faster price growth last year but anticipate slower price growth in 2024 and 2025 relative to their nonautomating peers (see the chart). One possible explanation is that firms experiencing elevated growth in prices and wages may have sought to automate as a means of cost reduction. Interestingly, the typical automating firm anticipates a near-immediate payoff in terms of slower price growth. In stark contrast, firms that did not engage in automation see continuing and significant price growth for this year and next year.

Of equal interest is the segment of the panel experiencing above-normal price growth during 2024. For this category of firms, average price growth for both automating and nonautomating firms is higher than their "all firms" counterpart (which is reassuring from a survey practitioner's point of view). Importantly, we notice a similar differential between the expected price growth of automating and nonautomating firms. In other words, firms that have recently engaged in automation anticipate slower price growth than their nonautomating counterparts across several dimensions of the data.

Conclusion
The second quarter CFO Survey indicates that most firms expect price growth to remain "above normal" this year (relative to before COVID-19). However, we identify a notable divergence among respondents: Firms that implemented automation over the last 12 months expect slower price growth than nonautomating firms. Time will tell whether the bifurcation of price growth expectations by automation status is borne out and whether automating firms return to "normal" price growth more quickly than their nonautomating peers.

By Brent Meyer, assistant vice president and economist, and

Daniel Weitz, survey director, both in the Research Department at the Atlanta Fed

The Atlanta Fed's 2023 Financial Markets Conference (FMC), Old Challenges in New Clothes: Outfitting Finance, Technology, and Regulation for the Mid-2020s, featured policy panels, academic paper presentations, and keynote speakers who discussed recent developments that have had a significant impact on the financial system. The conference's overarching theme was the idea that many of the issues confronting policy makers are not new but are just appearing in a somewhat different form. This Policy Hub: Macroblog post offers some highlights from the conference keynote speakers, policy panels, and academic paper presentations. More information on all of the sessions is available on the conference agenda page, which has links to the sessions' videos, papers, and presentation notes.

Keynotes
The conference had three keynotes with a headline speaker and a moderated keynote session with two Federal Reserve Bank presidents. These keynote talks addressed issues related to monetary policy and financial stability. The conference started with a keynote speech by Lord Mervyn King (you can see the video here ), former governor of the Bank of England and former professor at the London School of Economics and New York University. Lord King focused on two topics of crucial importance to central banks: price stability and financial stability. He argued that in both cases central banks had fallen victim to a style of academic research that gives the impression that models can predict the future and, hence, tell us how to set policy. The main problem with this view, according to Lord King, is that the forces affecting the economy are always changing. He viewed this "radical uncertainty" as implying that although estimated models can provide useful insights into how the economy works, they are not literal descriptions of how the economy works. Instead, policymakers must combine key insights from models with an attempt to understand what is going on in the real world.

The next keynote speaker was Securities and Exchange Commission (SEC) chair Gary Gensler (written remarks and video ), who focused on the SEC's role in helping to protect financial stability and promote markets that are resilient to stress. Gensler used the financial stability lens to frame a variety of SEC's proposals and actions, including those to reform the operation of the Treasury securities market, strengthen clearinghouse governance and use of service providers, require enhanced disclosure by hedge funds, address liquidity issues at money market and open-end bond funds, and enhance cybersecurity practices and reporting. He also expressed concern about whether existing regulatory regimes designed for an earlier era of data analytics would be sufficient for addressing the potential systemic risks associated with deep learning and generative AI.

Monday evening, conference participants saw a fascinating presentation titled "Florida (Un)chained" (paper, presentation , and video ) on the Florida land boom of the 1920s by Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia Business School. Calomiris observed that southern Florida was devoid of large cities until the 1910s, when the railroad was extended from Jacksonville in the north to Key West in the south. This extension led to a nationwide promotion of Florida as a place to buy and develop land, with 20 million lots put up for sale at a time when the US population was only around 40 million. Calomiris noted that buyers had limited information about what was happening in Florida, with no aggregate data on land sales or prices. In terms of financing this development, deposits flooded into Florida banks. While most banks were relatively conservative, at the core of risk-taking was a group of banks associated with the Manley-Anthony chain and partly owned by developers. Moreover, some key state and federal bank regulators who failed to vigorously enforce prudential rules had a financial interest in the chain banks directly or through the land boom they were financing. Calomiris's oral presentation noted that the boom eventually unwound, but his presentation's slides point to negative press starting in late 1925, railroad problems, and a hurricane in the Miami area as contributory factors.

The last keynote session was a discussion of current monetary policy issues by Atlanta Fed president Raphael Bostic and Chicago Fed president Austan Goolsbee, with the session moderated by New York Times reporter Jeanna Smialek (video ). The session began with Bostic observing that although inflation had come down, it was still too high and that monetary policy work remained to be done. He also expressed skepticism that inflation will be back to the Fed's target by the end of 2023. Goolsbee generally agreed with that view, but he also noted that as someone coming from outside the Fed, he thought central bankers have a "central banking viewpoint" on the determinants of inflation. He stated that we know there was also a supply-side component from the fact that the increase in inflation was worldwide and that US inflation surged when the unemployment rate was above 6 percent. Later in the discussion, Smialek brought up Lord King's claim that the current inflation arose in part because central bankers relied too heavily on models. In response, President Bostic argued that this view mischaracterizes what they do. He agreed that models are just an approximation of reality, but he lets reality inform where he takes that approximation. He observed that the Atlanta Fed obtains a lot of input from real people in real time, such as through the Bank's Regional Economic Information Network.

Panel: What Opportunities and Risks for Financial Markets Accompany the Growing Role of Nonbank Financial Institutions?
One policy panel (video ) focused on the risks and opportunities of nonbank financial institutions (NBFIs). The moderator of the panel, Andreas Lehnert, director of the Division of Financial Stability at the Federal Reserve Board of Governors, kicked off the discussion by observing that nonbanks provide about two-thirds of loans to households and businesses in the United States. He also noted that while some nonbanks have well-known fragilities, others have less-well understood linkages to the banking system—for instance, through revolving lines of credit. These deep connections blur the distinction between banks and nonbanks.

The first panelist, Stijn Claessens, head of financial stability policy at the Bank for International Settlements, observed that NBFIs have expanded significantly around the world, especially outside the United States, in part driven by increased demand and in part by tighter regulation of banks after the global financial crisis. Claessens argued that a critical element in assessing the benefits of nonbanks for economic growth is the diversity of financing that they bring. His research shows that across countries the marginal benefit of increased bank financing starts declining at a certain level of development. By contrast, the contribution of equity and nonbank financing to gross domestic product (GDP) growth is still quite positive even at high levels of development. Claessens added that while nonbank financing is more procyclical than bank financing, nonbanks tend to recover from financial crises relatively better. He concluded by noting that a macroprudential view is still missing for nonbanks and that a systemwide perspective needs to be central in the regulatory agenda for the sector.

The next panelist, Meghan Neenan, managing director and North American head of NBFIs at Fitch Ratings, centered her remarks on the fast-growing private credit market (presentation ). The size of the market is estimated at some US$ 800 billion, or 3 percent of GDP. Key market participants include alternative investment managers and business development companies (BDCs). Neenan argued the private credit market offers financing to distressed and nondistressed middle-market firms and thus competes head-on with the syndicated lending space. In relation to financial stability ramifications, Neenan remarked that BDCs had low leverage and were resilient to credit line drawdowns during the COVID-19 pandemic. However, the passage of the 2018 Small Business Credit Availability Act allowed these entities to take on more leverage and has perhaps reduced their ability to weather future shocks.

Next, New York University professor Philipp Schnabl focused his discussion (presentation ) on bank deposits and interest rates. He emphasized banks' so-called "deposit franchise." One benefit of this franchise is that bank deposit levels tend to remain stable even if banks are not fully passing through increases in market interest rates. The deposit beta is a measure of this pass-through and can be gleaned from historical data. Schnabl showed that the average bank beta has been around 0.4 since the mid-1980s, which means that a 10 basis point increase in the federal funds rate is associated with a 4 basis point increase in the average bank's deposit rate. He went on to highlight three risks in the current environment. First, the deposit hedge only works if deposits stay in the bank. Second, deposit betas may change over time. Third, the deposit channel of monetary policy implies that price-sensitive depositors withdraw funds from banks and move them to higher-yielding accounts. In other words, tighter monetary policy moves deposits out of the banking system. In closing, he said that all these risks have manifested recently.

The last presentation, by Dennis Kelleher, the cofounder, president, and CEO of Better Markets, highlighted the growing risks in the nonbank sector, which he saw as the least transparent and regulated part of the financial system (remarks  and presentation ). Kelleher said that the "too big to fail" problem remains alive and well despite the regulatory framework put in place by the 2014 Dodd-Frank Act and despite efforts to rein in excessive risk-taking at banks and nonbanks. He argued that systemically significant NBFIs should be identified and regulated similar to banks. Elements of such regulation could include strict capital and liquidity requirements, stress testing with severe adverse scenarios, and resolution plans that enable systemically significant institutions to be resolved in bankruptcy in a way that does not involve government bailouts and support.

Research Session: Nonbank Financial Intermediaries and Financial Stability
The NBFI research session featured a research paper on the role of leverage in the NBFI sector. The paper, presented by Federal Reserve Board of Governors economist Sirio Aramonte (paper , presentation , and video ), emphasized structural shifts in financial intermediation since the global financial crisis, in particular toward higher leverage in the nonbank sector. Aramonte described a conceptual framework for the main channels of risk propagation in a setting with banks and nonbanks and highlighted the central role of leverage fluctuations through changes in margins. The main takeaway was that that leverage enables greater leverage and breeds financial instability. Aramonte also raised several policy questions, notably that policymakers must strike a delicate balance between providing backstop and "dealer of last resort" arrangements that kick in ex post while at the same time designing regulations that safeguard liquidity provision during good and bad times alike.

The paper's discussion by American University professor Valentina Bruno (presentation ) highlighted key features of the analysis––the role of leverage as an amplifier of external shocks and the dual role of prices not only as reflections of fundamentals but also as "imperative to action" by market participants. The paper shows that as these features come together, leverage feeds on leverage and market actions can be very damaging during crises. Bruno alluded to her research on value-at-risk models with leverage constraints and described three recent episodes to illustrate how risks, like viruses, migrate and morph across the financial landscape––the "dash for cash" of spring 2020, the September 2022 United Kingdom pension fund stresses, and the rise of local currency sovereign debt held by U.S. investors.

Panel: How Might Web3 Change the Financial System?
The policy panel "How might Web3 change the financial system?" discussed what Web3 is and what it means for financial services (video ). Christine Parlour, a University of California Berkeley professor, set the stage by presenting a paper on the economic benefits of Web3 (paper and presentation ). She defined Web3 as a combination of blockchains, cryptocurrencies, and tokens that provide decentralized products and services. Decentralized finance is about engaging open-source and open-access protocols, native cryptocurrencies and tokens, and blockchain technology to provide novel ways to trade assets, make collateralized loans, and make payments. Parlour argued that Web3 can improve efficiency and provide new services at lower costs. For instance, a token that allows people to express ownership of illiquid assets such as real estate can be transferred more safely than the current system allows. In another example, she said token-based digital payments can be automated and unlock value because they do not have to go through physical documentation. Similarly, reconciliation of transactions on blockchains is easier and has the added benefit that, without intermediaries, economic power is not concentrated.

Parlour then turned to stablecoins as a key innovation in decentralized finance and contended that stablecoins could be useful for reducing cross-border payments. By eliminating the need for corresponding banking relationships, stablecoins can reduce both the cost of collateral in central clearing mechanisms and the cost of participating in financial markets. She also said that having a blockchain on which all participants can see the transfer of assets improves transparency and reduces informational asymmetries, making the trading and ownership of these assets more cost effective. Parlour concluded by highlighting the challenge facing policymakers to update regulations in the face of recent innovations in financial infrastructures.

The moderator of the panel, Marina Moretti, deputy director of the Monetary and Capital Markets Department at the International Monetary Fund, opened the discussion to the other panelists, asking them to dig deeper into the benefits and use cases of Web3, as well as its potential and actual risks associated with their widespread use. In the remainder of the session, the other panelists reacted to Parlour's presentation by taking contrarian views about Web3.

The second panelist, Steven Diehl, a software engineer and blogger, said that the definition of Web3 is subject to debate, arguing that it was effectively a rebranding of crypto and a gambling product. The core idea of Web3 is to build the financial system on blockchain technology, yet he said the technology is unfit for this purpose because it requires trusting the code more than trusting financial institutions. He asserted that blockchain transfers trust in financial market participants, institutions, and regulators to a small pool of software developers and that such a system would be opaque, unaudited, corruptible, and inefficient. Diehl also proposed that the lack of human interface with the technology and the immutable ledgers from which data cannot be deleted are bad ideas. He concluded that "crypto is essentially a very antihuman technology" and a "new form of predatory investment sold to the public as a way of farming the few assets that people have."

The next panelist, Richard Walker, a partner with Bain & Company, began his comments by noting that technology adoption in banking is very slow and that innovation is critical to reduce the cost of intermediation. While Web3 and blockchain are general-purpose technologies, he mentioned that new uses of these technologies have the potential to transform all aspects of finance. He saw use cases in cross-border payments, bond issuance, syndicated lending, and the repo market, and he argued in favor of collateral (asset) tokenization. Walker said that tokenization/ digitalization of assets would improve the experience of consumers through increased trust, transparency, and immediacy, plus a better use of assets held by households. He compared Web3 today with the internet in its early stages, arguing it has the same potential to unleash a major infrastructure for finance and commerce.

In the last presentation, Hilary J. Allen, a Professor of Law at American University, argued that the claims of Web3 proponents are unachievable because technological decentralization cannot accomplish economic decentralization. She maintained that verifying transactions on a blockchain is inefficient and wasteful and can open the door to bad actors who can take advantage of it. She also expressed the concern that instantaneous settlement in financial markets removes the option of reversing mistakes or fraudulent transactions. According to Allen, Web3 technologies are a form of regulatory arbitrage. Furthermore, financial stability risks such as leverage and runs would likely be exacerbated by asset tokenization.

Panel: Mitigating Risks and Preserving Financial Stability in an Appropriately Restrictive Policy Environment
The policy panel on interactions between financial stability and monetary policy focused on the financial stability implications of rising interest rates (video ). The moderator, Dallas Fed president Lorie Logan, set the stage with three questions. First, how can financial instability be prevented? Second, when should central banks intervene for reasons of financial stability and can they avoid working at cross-purposes with monetary policy? Third, how should central banks design monetary policy strategies that mitigate financial stability risks but still achieve macroeconomic goals? Given that interventions to restore financial stability can have undesired side-effects, she proposed that central banks should conduct a thorough review of the many financial stress episodes that have occurred since the global financial crisis.

Logan argued that it is challenging, yet possible, to set monetary policy in a way that mitigates financial stability risks. She noted that the restrictiveness of monetary policy comes from the entire policy strategy, including the pace of rate hikes, the level they reach, and the time spent at that level. In addition, these levers can be adjusted gradually in a way that maintains the restrictiveness of policy but also mitigates financial stability risks. For instance, when financial conditions deteriorate suddenly and threaten damage to the broader economy, the central bank may raise rates in smaller and less frequent steps while using other dimensions of policy to maintain restrictive financial conditions. Logan used the analogy of a "road trip in foggy weather" to argue that difficult driving conditions may require slowing the car, but a slower pace of tightening should not be construed as a lack of commitment to achieving macroeconomic goals any more than driving slower would suggest you don't want to reach your destination.

The first panelist, Seth Carpenter, managing director and chief global economist at Morgan Stanley, contended that market commentators often highlight a false dichotomy between monetary policy and financial stability. The challenge facing central banks, he said, is one of calibrating monetary policy actions in a way that preserves financial stability. Monetary policy should be conducted, according to him, in way that does not trigger nonlinear tightening of credit conditions. Carpenter also emphasized that the speed of tightening is extremely important and that the difference in real economy outcomes between a gradual and a fast tightening can be much larger than predicted by macroeconomic models. In the current context, a more gradual increase in interest rates would have given more time to banks to restructure their books and would have reduced the possibility of sharp nonlinear dynamics. He also noted this tightening cycle is different than previous ones due to the presence of the Federal Reserve's Reverse Repurchase Facility, which can change the transmission of monetary policy through money markets.

The next panelist, Kathy Jones, managing director and chief fixed income strategist at Schwab Center for Financial Research, reinforced the notion that the rate of change in the monetary policy stance has been a key factor in driving market volatility. She noted that the "accelerated pace of rate hikes" has created uncertainty regarding the path of future monetary policy, exacerbated liquidity issues, and complicated investment decisions by market participants. Jones also maintained that the rapid rise in interest rates has caused deleveraging at banks and other market players. She cautioned that the financial system is very different now compared to the late 1970s and early 1980s and may transmit interest rate rises much more quickly than during the tightening cycle of that time.

The third panelist, New York University professor Viral Acharya, urged that we consider the path dependence of macroeconomic outcomes, as reflected in the Fed's many rounds of quantitative easing and attempts at liftoff since the global financial crisis. He asserted that the success of low-for-long forward guidance should be evaluated in light of this path dependence. Acharya expressed the concern that the Fed may be trying to do "too much" both by way of easing and by way of tightening, which in turn may create unexpected consequences for financial stability. He also argued that monetary policy cannot be conducted without financial stability and that central banks should aim for normal transmission of monetary policy that is not associated with sudden financial fragility. Thinking about the international ramifications of US monetary policy, he emphasized that emerging-market central banks have strengthened their institutional capacity since the global financial crisis. As a result, emerging markets today are better able to respond to the financial cycle caused by the "waxing and waning" of the Fed's balance sheet through an appropriate combination of reserve management and capital controls.

The last panelist, Brad Setser, senior fellow at the Council for Foreign Relations, picked up on President Logan's "road trip in foggy weather" metaphor to argue that the Fed may have felt it was late in starting the tightening cycle. In his view, the speed of tightening increased the riskiness of the cycle. Turning to international spillovers of US monetary policy, Setser argued that tighter monetary policy is a net positive for some countries through a standard exchange rate channel and a shift in demand away from the United States to the rest of the world. However, given the dollar's role as a global currency, higher interest rates imply tighter financial conditions for important parts of the global economy. Setser also emphasized complexities in both the domestic and the international transmission of monetary policy. On the international front, he noted that large global institutions run hedged books, which makes the shape of the yield curve as important as the level of rates. On the domestic front, he noted that institutions respond to higher interest rates not only through the usual transmission channels but also through the loss of value in portfolios (for instance, the implied marked to market on held-to-maturity securities at banks), which can hit capital and dampen risk taking.

Panel: How to Conduct Monetary Policy amid Higher Inflation and a Nonbinding Zero (Effective) Lower Bound?
The monetary policy panel addressed the question of how to conduct policy now that inflation rates are higher and interest rates are well above the zero lower bound (video ). The panel began with a review of the background by its moderator, William English, a professor at Yale University. English observed that central banks responded to the start of the pandemic by aggressively easing policy to address concerns that the recovery coming out of the pandemic would be weak. In the event, the recovery came sooner, faster, and stronger than was anticipated, but it was accompanied by an unwelcome rise in inflation and led to a rapid adjustment to policy in which monetary policy became tighter.

The first panelist, Troy Davig, chief US economist at Symmetry Investments, started with a discussion of recent weaknesses in the financial sector, especially the failure of some large US banks. He argued that these failures were outliers and that few banks are in a similarly weak position. However, he noted that banks were competing for liquidity, especially with money market funds that have been placing a large amount of funds in the Federal Reserve's Reverse Repurchase Facility. He also noted that the US Treasury was likely to issue at least $5 trillion in net new Treasury bills after the debt ceiling is raised. He also predicted that it is likely that the current Federal Reserve tightening of policy will result in a hard landing. If this hard landing comes to pass, he observed that, unlike in other recent recessions, we will not be able to count on fiscal policy to cushion the decline.

Massachusetts Institute of Technology professor Kristin Forbes (presentation ) began her discussion with a riff on the conference theme by arguing that what is needed is not new clothes but to apply three old lessons to contemporary monetary policy. First, although forward guidance may be necessary to help stimulate the economy when rates are near the zero lower bound, such guidance can inappropriately constrain monetary policy when inflation increases unexpectedly. Second, she noted that policymakers cannot take for granted that inflation expectations are anchored and that large price shocks can drive expectations away from central bank's goals. Third, policymakers have some ability to decide whether to front-load their policy moves or adopt a more gradualist approach. A comparison of the US frontloading versus the UK's more gradual approach is that the US approach more effectively controlled inflation expectations.

The next panelist, Goldman Sachs chief economist Jan Hatzius (presentation ), focused his comments on the potential for US inflation to hit the Fed's 2 percent target while avoiding a hard landing. He said that Goldman's baseline forecast is on the optimistic side that inflation can be brought down without a recession. That said, he noted that Goldman's team expects that the fed funds rate will remain higher than what the market expects. Hatzius made the interesting observation that the current job market has seen the job vacancy rate come down without an increase in unemployment, a development that he called "unprecedented."

John Taylor (presentation ), a professor at Stanford University and the author of the famous Taylor Rule for setting monetary policy based on the inflation and unemployment rates, began by observing that the Fed had flip-flopped on the role of monetary policy, and he attributed the current high inflation rates to the failure to follow an appropriate rule. In terms of the current state of policy, he said the current fed funds rate of approximately 5 percent is close to the 6 percent implied by the Taylor rule. That said, Taylor acknowledged that while policy should be based on rules that markets can understand, central banks should have contingency plans for unusual circumstances.

Research Session: Back to the 1980s or Not? The Drivers of Real and Inflation Risks in Treasury Bonds
In a final research session, University of Chicago professor Carolin Pflueger (paper  and presentation ) presented a paper that uses a New Keynesian model to help better understand the change in the correlation between stock and bond returns between the 1980s and 2000s. Her model suggests that the positive correlation of the two returns that existed in the 1980s are not easy to generate and would arise only if supply shocks are paired with fast, anti-inflationary monetary policy response. In contrast, her analysis suggests that the negative correlation between stock and bond returns in the 2000s arises because markets anticipate a less aggressive Fed response to adverse supply shocks resulting in a "soft(ish) landing."

The discussion of the paper, delivered by Min Wei, senior associate director at the Federal Reserve Board of Governors (presentation ), highlighted some strengths of the paper, but as academic discussants often do, she also drew attention to some aspects of the research that could benefit from further analysis. Among these were suggestions to use more asset prices, reassess the importance of the change in the monetary policy rule, and explore other dimensions of the data such as term premiums.

We hope this summary gives you a sense of the important matters raised at the FMC and the questions that participants will be thinking about in the future.

By Camelia Minoiu, research economist and adviser, and

Larry Wall, research center executive director, Center for Financial Innovation and Stability, both in the Research Department at the Atlanta Fed

In a 2008 paper by Satoshi Nakamoto, Bitcoin was proposed as a method of making electronic payments using a blockchain without the need to go through a financial institution. In a relatively short period of time, the basic idea laid out by Nakamoto has grown into a crypto finance world that at its recent peak in November 2021 was valued by Coinmarketcap as being worth almost $3 trillion. However, contrary to Nakamoto's original vision, financial intermediaries have provided many of the financial services needed for the crypto finance world to grow to this level. Thus, it's not surprising to see the rise of an alternative method of providing many services not reliant on institutions. This method replaces centralized finance (or CeFi), which is delivered through institutions, with decentralized finance, or DeFi, which uses smart contracts (computer code) running on a blockchain.

DeFi had shown considerable growth starting in late 2020 through late 2021 (for more discussion of this growth, see here ). The standard measures of size, total value locked—saw DeFis reaching a peak of more than $180 billion in December 2021, according to one relatively broad measure (such as DeFiLlama, a total value locked data aggregator). Although these numbers may sound large, they are still a rather small part of the global financial system. For example, four US banks have total assets greater than $1.5 trillion. Moreover, the total value locked in DeFi has dropped dramatically since the start of the "crypto winter" earlier this year, reaching values below $55 billion in September 2022. Whether DeFi can become a major provider of financial services will likely depend upon the extent to which crypto finance either integrates with the existing financial system or evolves to become a parallel system for providing a wide range of financial services—or both.

Along with coauthors Francesca Carapella, Edward Dumas, Jacob Gerszten, and Nathan Swem, I recently posted an article on DeFi titled "Decentralized Finance (DeFi): Transformative Potential and Associated Risks" as part of the Atlanta Fed's Policy Hub series. (It is also available in the Board of Governors FEDS working paper series  and as a working paper  out of the Boston Fed's Supervisory Research and Analysis Unit.) This Policy Hub: Macroblog post summarizes some key ideas in our article.

DeFi overview
To understand developments in DeFi, it is helpful to understand the how and why of widely accessible (public, permissionless) blockchains. A blockchain is a database where the data are entered in time-stamped blocks and the blocks are cryptographically chained together so that any change in a prior record can easily be detected. Bitcoin facilitates the avoidance of financial intermediaries by using a public, permissionless blockchain, meaning that anyone can obtain a copy of the database, read the database, and potentially write to the database. The problem that such an open database can create is that of "double spending." An example of double spending would be Joe first making a payment to Jane and then trying to make a payment to Mary using the same funds. This circumstance could happen if Joe has ability to rewrite blocks that had been previously written. That is, he could rewrite the block he had used to pay Jane so that it no longer contains that payment and—using the funds he took back—make the payment to Mary.

Nakamoto's solution to double spending is to make it very costly to try to rewrite existing blocks. The person who gets to add a new block to a blockchain must win a computationally intensive contest called proof-of-work (participants in this contest are said to be "mining" Bitcoin). As this mining process is mandatory for adding each block, attempting to rewrite a previously written block requires the miner to rewrite every block thereafter to the present, solving the computationally difficult problem for each replacement block—a very costly process. The result is that the Bitcoin blockchain is highly resistant to tampering (often spurring exaggerated claims that blockchains are "immutable"). However, Bitcoin's protocol also takes a relatively long time to ensure that a transaction has been processed.

In practice, DeFi is a relatively small part of Bitcoin because Bitcoin was not designed for sophisticated programming. The Ethereum blockchain stepped into this gap and added the ability to run programs as part of creating new blocks. Consider a simple example of such a program: one for delivery versus payment (a crypto asset is delivered from agent A to agent B, if and only if B simultaneously pays A). These programs are referred to as dapps (distributed applications). One type of dapp is the smart contract, which automates the execution of financial transactions among different parties. Although some other blockchains have since followed Ethereum in allowing dapps, Ethereum has emerged as the most important blockchain for DeFi as measured by total value locked, according to DeFiLlama's blockchain page.

Ethereum originally adopted a version of Nakamoto's proof-of-work protocol to deal with the double-spending problem. However, on September 15, Ethereum replaced proof-of-work with proof-of-stake, in which the party who gets to add the next block is randomly chosen from a group who have locked up (or staked) the blockchain's native cryptocurrency (called Ether). The winner of this contest is called a validator. The switch to proof-of-stake is part of a long-term project to allow Ethereum to process more transactions in a given period.

DeFi uses
Our article discusses some of the most important financial services that decentralized finance is providing. Currently, one of DeFi's most important services is that of borrowing and lending. Decentralized lending platforms bring together borrowers and lenders. Borrowers incur fees (continuously accruing interest) from the time they take out the loan until its repayment. Lenders earn interest on the funds they lend.

Loans made through a DeFi are typically collateralized with other crypto assets. Participants in crypto finance are pseudonymous, meaning they are known only by their public address on the blockchain, which prevents lending based on reputation and the threat of resorting to bankruptcy courts. Moreover, because almost all the assets currently residing on blockchains are crypto assets, blockchain tokens representing off-chain assets such as equipment and real estate are generally not (yet, anyway) legally enforceable in law courts. As a result of the requirement for on-chain collateralization, borrowers take out many loans to finance off-chain consumption while retaining exposure to the crypto asset they are using as collateral—like a stock investor taking out a margin loan to buy a new car. (Another use of such loans is to increase leverage for those speculating on an increase in the value of a crypto asset—especially a cryptocurrency.)

A second important service type of DeFi service is decentralized exchanges (DEXs), which facilitate the trading of crypto assets with a centralized market maker or centralized order books. DEXs typically solicit investors to lock funds into so-called liquidity pools, rewarding these investors with fees (essentially, interest on their deposits). Users can exchange one cryptoasset for another by withdrawing a different cryptoasset than they deposited. A protocol called an "automated market maker" controls the rate at which one asset can be exchanged for another. If the price of one asset gets out of line with the views of investors or the prices on other exchanges, liquidity providers have an incentive to step in to close the price gap.

A third use of DeFi is the provision of derivatives, or claims whose value depends on (or is derived from) another asset. DeFi derivatives allow users to obtain price exposure to other assets, and this exposure is not limited to crypto assets but could include sovereign currencies, commodities, stocks, and indices. Like DEXs, DeFi derivatives connect buyers and sellers directly using collateral pools.

A fourth use of DeFi is to facilitate payments. One example discussed in our article is that of Flexa, which facilitates timely payments to merchants so that the transaction can be quickly completed despite delays inherent in the settlement of some cryptocurrencies. A second payments DeFi is the Lightning Network, which seeks to accelerate Bitcoin transactions by moving most of the work off the Bitcoin blockchain into what is called layer 2, with only the results recorded on the Bitcoin blockchain.

A third payments system our article discusses is Tornado Cash, a so-called "cryptocurrency tumbler," which is a service that obscures the relationship between the sending and receiving addresses of a cryptocurrency payment. Tornado Cash receives cryptocurrency funds from various sources and then, with some delay, distributes the funds to the intended recipient(s). The commingling of funds from various sources makes it more difficult to trace payments from one address to the intended recipient at another addresses. Tornado Cash was developed because although most cryptocurrencies are pseudonymous, everyone can nevertheless see payments sent from one address to another even though the blockchain itself does not reveal the identity of either party. However, information linking some addresses to specific parties, and some other analysis, can lead to discovery of many participants' identities. Thus, people who would prefer to send payments with reduced risk of revealing their identity might prefer to use a tumbler such as Tornado Cash. The problem is that in many cases the individuals seeking to hide their identity are engaged in illegal activities such as money laundering, ransomware schemes, and sanctions evasion. Thus, on August 8, the US Department of the Treasury's Office of Foreign Assets Control (OFAC) sanctioned Tornado Cash. Among the consequences of this sanctioning is that Americans are prohibited from using Tornado Cash unless licensed by OFAC or the transaction has an exemption. This sanctioning has resulted in a sharp drop in the total value locked in Tornado Cash, according to Defi Llama (you can see a graph of historical values here).

The last type of DeFi service that we discuss in our article is asset management. Asset-management dapps are similar to mutual funds in that they pool investor funds so that they can be efficiently invested other assets. This ability to pool assets may be useful, for example, by facilitating investment in an index of cryptocurrency values.

DeFi risks
As noted earlier, the value of all cryptoassets and cryptoassets locked in DeFi is relatively small, given the scale of the global financial system. As such, DeFi is not yet large enough to pose a systemic risk to the financial system or to be a significant mitigant of systemic risk. Nevertheless, DeFi's potential risk implications merit careful review given its potential for growth.

In our article, we discuss how DeFi could reduce some risks but increase other risks in the financial system. Arguably the biggest potential for risk reduction is enhancing the ability of supervisors to track, in real time, major financial institutions' transactions on the blockchain, both as individual institutions and in aggregate. Having this ability would allow supervisors to respond nearly in real time. The cost, however, is that the complete record of transactions is available to everyone, and pseudo-anonymity can be broken in many circumstances. Thus, users of cryptofinance, including DeFi, have no guarantee that their transactions will remain private. This potential lack of privacy poses problems not only for individuals but also for businesses that would rather not have their financial transactions disclosed to competitors.

In terms of risks created by DeFi, many of them are like the risks that have always been part of traditional finance, including excessive leverage, maturity and liquidity transformation, and so forth. However, important operational differences exist between traditional finance and DeFi that could have significant risk implications. Some of these issues might have solutions, such as whether a blockchain can be made secure and scalable while remaining decentralized. However, many other problems are inherent in blockchains, dapps, and cryptofinance.

At the most basic level is governance of the blockchain and the individual dapps. In theory, the governance of blockchains and dapps is decentralized, with no one party exercising control. In practice, we observe a wide spectrum of governance arrangements. Some governance arrangements are de facto centralized with a small group—typically, the founders—exercising effective control (see, for example, here). Such centralized control facilitates correcting mistakes in programming and adapting to environmental changes. However, such centralization also allows those in control to change the operation of the dapp in ways that benefit themselves. At an extreme, this behavior can take the form of a "rug pull," in which the founders disappear with all the tokens locked in a smart contract. Conversely, as governance becomes more decentralized, making changes to the blockchain protocol or dapp might become more challenging, and the supervisors could have difficulty finding people to address regulatory concerns. Also, decentralization of governance does not guarantee against someone temporarily buying control to enact changes favorable to themselves, nor does it prevent a majority of the voters from taking actions that disadvantage a minority of the voters.

The process of creating new blocks introduces risks for DeFi users. New blocks typically contain multiple transactions with the miner (or validator) who "wins" the competition obtaining control over which transactions get entered in the block and in which order. One result is that the structure of blockchains allows something akin to front-running in traditional markets. The resulting profit accruing to miners (and validators) is called miner's extractable value (as discussed in detail here).

Focusing more specifically on smart contracts, this computer code is subject to two problems. First, mistakes in the programming (bugs) are common in computer code. Of course, traditional financial intermediaries' programs also have bugs. However, the resistance of blockchains to rewriting historical blocks makes reversing errors almost impossible unless the receiver of a payment agrees to reverse the transaction. Second, the code must state (explicitly or implicitly) what will happen in every possible circumstance. Yet as I have previously observed, traditional contracts are often intentionally left incomplete for a variety of good economic reasons.

A third issue related to risk is that of trust. Users of traditional financial intermediaries need to place considerable trust in their intermediary, its regulator, and the judicial system. On the other hand, cryptofinance is described as "trustless," meaning that its user can verify all transactions on a blockchain and inspect the code being used by a dapp. In practice, though, very few people would have the technical skills (or the time) needed to carefully analyze a dapp to find any programming bugs, fully understand the dapp's economic incentives, and understand how that dapp could interact with other dapps. Thus, as a practical matter, almost all users will need to trust third parties if DeFi is to become mainstream.

The issue of trust is exacerbated by something called "censorship resistance," which is a property of public, permissionless blockchains. In principle, anyone can initiate any transaction on a blockchain as long as it complies with the blockchain's protocol. This openness can have benefits, such as preventing governments from trying to financially cripple political opponents. However, it also means that the blockchain is open to every bad actor no matter where they are in the world. As a result, blockchains have been used to facilitate scams, theft, and money laundering. Although similar problems exist in traditional finance, the extent of such problems is reduced by financial intermediaries' incentive to build customer trust, regulators' ability to enforce regulations around financial conduct, and, in some cases, regulators and judicial authorities' ability to enforce the reversal of improper transactions.

One unusual feature of dapps is their interoperability, a potential advantage in that smart contract composability allows for dapps to interoperate and thus provide services and products that are not available from any single dapp. However, such interoperability also creates the risk that if a financial or operational issue arises with one dapp, the problem could spread to other parts of the DeFi ecosystem.

Another risk we discuss in the article is DeFi's interconnections with the traditional financial system. In part, this risk arises because traditional finance and DeFi simply have different mindsets and take different risk-mitigation approaches. Participants in DeFi might not appreciate the potential risks they are incurring from involvement with traditional finance, such as the risks that the investment portfolios of some stablecoins have taken. Similarly, traditional financial institutions might not fully appreciate their risks through DeFi when they interact with crypto finance. Moreover, traditional financial institutions could face greater exposure to legal risk as they—unlike almost all dapps—can be readily identified, and their deep pockets make them attractive targets.

Conclusion
DeFi is opening a new avenue for the provision of financial services and might provide significant benefits. However, alongside exposure to most of the risks incurred in traditional finance, DeFi introduces new risks that arise from its unique operational structure. While DeFi is still a relatively small part of the financial system, policymakers should try to get ahead of developments in this area and decide what regulatory controls would be appropriate.

By Larry Wall, research center executive director of the Atlanta Fed's Center for Financial Innovation and Stability

Editor's note: In December, macroblog will become part of the Atlanta Fed's Policy Hub publication.

A recent Atlanta Fed white paper titled "Shifting the Focus: Digital Payments and the Path to Financial Inclusion" calls for a concerted effort to bring underbanked consumers into the digital payments economy. The paper—by Atlanta Fed president Raphael Bostic, payments experts Shari Bower and Jessica Washington, and economists Oz Shy and Larry Wall—acknowledges the importance of longstanding efforts to bring the full range of banking services to unbanked and underbanked consumers. (For another take on the white paper and its relationship to the Atlanta Fed's mission, you can read here.) However, the white paper observes, progress towards this goal has been slow. It further notes the growing importance of digital payments for a wide variety of economic activities. It concludes by highlighting a number of potential policies that could expand inclusion in the digital payments economy for policymakers to consider.

The 2017 Federal Deposit Insurance Corporation (FDIC) National Survey of Unbanked and Underbanked Households found that 6.5 percent of U.S. households are unbanked and an additional 18.7 percent underbanked. In this survey, a household is considered underbanked if it has a bank account but has obtained some financial services from higher-cost alternative service providers such as payday lenders. The proportions are even higher in some minority communities, with an unbanked rate for Black households at 16.9 percent. These figures were down modestly from earlier FDIC surveys, but progress remains inadequate.

The white paper retains full inclusion as the ultimate goal but argues we should not let the difficulties of achieving full inclusion deter us from moving aggressively to spread the benefits of digital payments. Such digital payments in the United States are typically made using (or funded by) a debit or credit card. Yet a recent paper by Oz Shy (one of the coauthors of this post) finds that over 4.8 percent of adults in a recent survey lack access to either card. Moreover, those lacking a card tend to be disproportionately concentrated in low-income households, with almost 20 percent of households earning under $10,000 annually and over 14 percent of those earning under $20,000 a year having neither card. These numbers also vary by ethnic groups: 4.8 percent of white and 10.2 percent of Black surveyed consumers.

The lack of access to digital payments has long been a costly inconvenience, but recent developments are moving digital payments from the "nice-to-have" category toward the "must-have" category. Card payments are increasing at an annual rate of 8.9 percent by number in recent years. While cash remains popular, debit cards have overtaken cash for the most popular in-person type of payments. Moreover, the use of cards in remote payments where cash is not an option nearly equals their use for in-person transactions. Most recently, COVID-19 has accelerated this move toward cards, with a 44.4 percent year-over-year increase in e-commerce sales in the second quarter of 2020.

These trends in card usage relative to cash usage pose several problems for consumers who lack access to digital payments. First, some retailers are starting to adopt a policy of refusing cash. Second, many governments are deploying no-cash parking meters, along with highway toll readers and mass transit fare machines that do not accept cash. Third, the growth of online shopping is being accompanied by a decrease in the number of physical stores, resulting in reduced access for those lacking cards.

The last part of the white paper discusses a number of not mutually exclusive ways of keeping the shift from paper-based payments (cash and checks) to digital payments from adversely affecting those lacking a bank account. A simple, short-term fix is to preserve an individual's ability to obtain cash and use it at physical stores. No federal law currently prevents businesses from going cashless, but some states and localities have mandated the acceptance of cash.

However, merely forcing businesses to accept cash does not solve the e-commerce problem, nor does it promote the development of faster, cheaper, safer, and more convenient payment systems, so considering alternatives takes on greater importance. One option the paper discusses is that of cash-in/cash-out networks that allow consumers to convert their physical cash to digital money (and vice versa). Examples of this in the United States include ATMs and prepaid debit cards, as well as prepaid services such as mass transit cards that can be purchased for cash in physical locations.

Another option is public banking. One version of this that has been proposed is a postal banking system like the ones operating in 51 countries outside the United States and the one that was once available here. Another public banking possibility would provide consumers with basic transaction accounts that allow digital payments services. The government or private firms (such as banks, credit unions, or some types of fintech firms) could administer such services.

The paper concludes with a discussion of some important challenges inherent in moving toward a completely cashless economy accessible to everyone. One such consideration is access to mobile and broadband. This issue has a financial dimension, that of being able to afford internet access. It also has a geographic dimension in that many rural areas lack both high-speed internet and fast cellphone networks. Another dimension is that of providing a faster payment service that would allow people to obtain earlier access to their incoming funds, and result in bank balances more accurately reflecting outgoing payments. Finally, the white paper raises the potential for central bank digital currency to expand access to digital payments. However, central bank digital currency raises a large number of issues that the federal government and Federal Reserve would need to work through before it could be a viable option.

By Oz Shy, senior policy adviser and economist, and

Larry Wall, executive director of the Center for Financial Innovation and Stability, both in the Atlanta Fed's Research Department

The coronavirus and efforts to mitigate its impact are having a transformative impact on many aspects of economic life, intensifying trends like shopping online rather than visiting brick-and-mortar stores and increasing the incidence of working from home. Indeed, many tech giants have already made working from home a permanent option for employees.

Working from home, or telecommuting, is not a new phenomenon. According to a survey by the U.S. Bureau of Labor Statistics (BLS), around 8 percent of all employees worked from home at least one day a week before the arrival of COVID-19. However, only 2.5 percent worked from home full-time in the 2017–18 survey period.

Working from home has surged in the wake of social distancing and other efforts to contain the virus, and this surge brings up a good question: How many jobs can be done at home? Some careful research by Jonathan Dingel and Brent Neiman indicates that nearly 40 percent of U.S. jobs can be done at home.

While this provides an upper bound, can does not mean will, so a natural follow-up question is: How many jobs willbe done at home? To get a sense of how many jobs and how many working days will beperformedat home after the pandemic recedes, we turn to our Survey of Business Uncertainty (SBU). To preview our conclusion, the share of working days spent at home is expected to triple after the COVID-19 crisis ends compared to before the pandemic hit, but with considerable variation across industries.

In the May SBU, we asked two questions to gauge how firms anticipate working from home to change. To get a pre-pandemic starting point, we asked panelists, "What percentage of your full-time employees worked from home in 2019?" And to gauge how that's likely to change after the crisis ends, we asked, "What percentage of your full-time employees will work from home after the coronavirus pandemic?" We asked firms to sort the fraction of their full-time workforce into four categories, ranging from those employees working from home five full days per week to those who rarely or never work from home.

Chart 1 summarizes firms' responses to these two questions. It also summarizes the responses by workers to questions about working from home in the BLS's 2017–18 American Time Use Survey. For the period preceding COVID-19, SBU results and the Time Use Survey results are remarkably similar. Both surveys say 90 percent of employees rarely or never worked from home, and a very small fraction worked from home five full days per week. As reported in the chart's rightmost column, about 5 to 6 percent of all working days happened at home before the pandemic hit.

According to the SBU results, the anticipated share of working days at home is set to triple after the pandemic ends—rising from 5.5 percent to 16.6 percent of all working days. Perhaps even more striking, firms anticipate that 10 percent of their full-time workforce will be working from home five days a week.

Overall, firms say that about 10 percent of their full-time employees worked from home at least one day a week in 2019. That fraction is expected to jump to nearly 30 percent after the crisis ends (well below the upper bound estimated by Dingel and Neiman). Chart 2 gives a look at firm's working-from-home expectations for major industry groups.

The share of people working from home at least one day a week is expected to jump markedly in the construction, real estate, and mining and utilities sectors, presumably by granting front-office staff working-from-home status. It is also expected to jump markedly in health care, education, leisure and hospitality, and other services, possibly by relying more heavily on remote-delivery options (for example, online education and virtual doctor's visits). Firms in the business services sector anticipate that working from home will rise to nearly 45 percent.

For the industries we can match directly to American Time Use Survey statistics, the two data sources imply a similar incidence of working from home before COVID-19. For manufacturing, SBU data indicate that 9 percent of employees worked at home at least one day a week prior to COVID-19, and the American Time Use Survey indicates that 7.3 percent did so. For retail and wholesale trade, the corresponding figures are 4.1 percent and 4.0 percent, respectively.

To summarize, our survey indicates that, compared to before the pandemic, the share of working days spent at home by full-time workers will triple after the pandemic. Our results also say that this shift will happen across major industry sectors. These changes in the location of work are also likely to exert powerful effects on the future of cities and the demand for high-rise office space (more on that next month).

Regarding the long-run impact of the shift to working from home, there are grounds for optimism, including a potential boost to productivity—although if you're juggling kids at home and working from your couch or bedroom, we can understand if it's hard to imagine right now.

By David Altig, executive vice president and research director in the Atlanta Fed's Research Department,

Jose Maria Barrero, assistant professor of finance at Instituto Tecnológico Autónomo de México Business School,

Nick Bloom, the William D. Eberle Professor of Economics at Stanford University,

Steven J. Davis, the William H. Abbott Professor of International Business and Economics at the Chicago Booth School of Business and a senior fellow at the Hoover Institution,

Brent Meyer, a policy adviser and economist in the Atlanta Fed's Research Department,

Emil Mihaylov, research analyst in the Atlanta Fed's Research Department, and

Nick Parker, the Atlanta Fed's director of surveys