Publications

NEW YORK (MNI) – The Federal Reserve has lowered interest rates to support an economy battered by the 2008-2009 recession, however the weak macroeconomic outlook suggests the central bank's actions have not been enough, and it has not lowered the real interest rate sufficiently, Minneapolis Federal Reserve Bank Governor Narayana Kocherlakota said Thursday.

In remarks prepared for the Hyman Minsky conference hosted by the Levy Institute, Kocherlakota said the Fed's policy-setting Federal Open Market Committee might have to keep rates at exceptionally low levels for many years to come.

Kocherlakota does not hold a voting position on the FOMC this year.

He noted that over the past six years, the demand for safe assets has grown, while the supply of those assets has shrunk. The global supply of assets perceived as safe has also fallen, as the value of American residential land, and assets backed by land, and investors no longer view all forms of European sovereign debt as a safe investment.

"I suggest that these dramatic changes in asset demand and asset supply are likely to persist over a considerable period of time -- possibly the next five to 10 years," Kocherlakota said. "If that forecast holds true, it follows that the FOMC will only be able to meet its congressionally mandated objectives over that time frame by taking policy actions that ensure that the real interest rate remains unusually low."

In addition, using the analogy of deciding what clothes to wear based on weather conditions, Kocherlakota argued that "the truth is that the FOMC's choice of winter garb is actually insufficient to keep the U.S. economy appropriately warm."

He pointed to the outlook for both employment and prices, which is too low relative to the FOMC's goals. Unemployment is currently 7.6%, and expected to fall only slowly, while inflation pressures are muted.

"The Committee needs to put on some more serious winter gear if it is to get the economy back to the right temperature," he argued. "More prosaically, the FOMC can only achieve its dual mandate objectives by lowering the real interest rate even further below its 2007 level."

Harking back to his comment on higher demand for safe assets, Kocherlakota said this is being fueled by tighter credit access, heightened perceptions of macroeconomic risk and increased uncertainty about federal fiscal policy. In particular, he said that restrictions on households' and businesses' ability to borrow typically lead them to spend less and save more.

"Thus, the FOMC is confronted with a greater demand for safe assets and tighter supply of safe assets than in 2007. These changes in asset markets mean that, at any given level of real interest rates, households and businesses spend less. Their decline in spending pushes down on both prices and employment. As a result, the FOMC has to lower the real interest rate to achieve its objectives," he said.

Kocherlakota predicted that over the five-to-10-year horizon, credit market access will remain limited relative to what borrowers had available in 2007, businesses will continue to feel a heightened degree of uncertainty about taxes and households will continue to feel a heightened degree of uncertainty about the level of federal government benefits.

"These considerations suggest that, for many years to come, the FOMC will have to maintain low real interest rates to achieve its congressionally mandated goals," he reiterated.

He acknowledged, however, that keeping real interest rates low for a considerable period of time will likely be associated with other "unusual financial market outcomes" - not to mention give rise to "signs of financial market instability."

The "unusual financial market outcomes" are inflated asset prices, unusually volatile asset returns and high merger activity, Kocherlakota said.

These financial market phenomena could pose macroeconomic risks, and he believes that is best addressed using effective supervision and regulation of the financial sector.

"It is possible, though, that these tools may only partly mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy," he added.

Kocherlakota counseled, however, that the FOMC should only take that action "if the certain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis."

Meaning? "The FOMC's decision about how to react to signs of financial instability will necessarily depend on a delicate probabilistic cost-benefit calculation," he said.

The FOMC, Kocherlakota said, has to weigh the certainty of "a costly deviation from its dual mandate objectives" against the benefit of reducing the probability of "an even larger deviation from those objectives."