The Federal Open Market Committee will need to keep real interest rates "unusually low" for the next five to 10 years as a result of "dramatic changes in the demand for and supply of safe assets," Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said Thursday.
"Over the past six years, there have been big changes in the demand and supply of safe assets," Kocherlakota told the Minsky Conference, according to prepared text released by the Fed. "I suggest that these changes in asset demand and asset supply are likely to persist over a considerable period of time-possibly the next five to 10 years. It follows that the FOMC will only be able to meet its objectives over that time frame by taking policy actions that ensure that the real interest rate remains unusually low."
He continued, "I then point out that low real interest rates can be expected to be associated with financial market phenomena that are seen as signifying instability. It follows that, for many years to come, the FOMC will only be able to achieve its congressionally mandated objectives by following policies that result in signs of financial market instability."
Time will partly ease these changes in the demand for and supply of safe assets, but credit market access will be affected "for a considerable period of time-possibly the next five to 10 years."
As a result workers and businesses will continue to worry "about the risk of a large adverse recessionary shock" and businesses will still face "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."
The Fed responds to "strong forces well beyond its control when making its decisions about the real interest rate," Kocherlakota said, much as individuals choose what clothes to wear based upon the weather. "I often hear that the FOMC has created a low interest rate environment that is harmful for savers and others. But, to return to my winterwear analogy, that seems about as compelling as blaming me for creating winter in Minnesota by putting on my long johns."
A low interest rate environment could spur inflated asset prices, volatile asset returns and heightened merger activity, which "could pose macroeconomic risks." Kocherlakota suggested "supervision and regulation of the financial sector" could curb these phenomena.
Should supervision and regulation not be enough, he said, "The FOMC's decision about whether to respond to those residual risks using the rather blunt tool of monetary policy will necessarily depend on a delicate probabilistic cost-benefit calculation."
