WASHINGTON — Minneapolis Federal Reserve Bank President Narayana Kocherlakota Friday maintained his support for the Fed's aggressive measures to spur faster economic growth, warning that the costs of tightening monetary policy now would significantly outweigh any benefits for financial stability.
In remarks prepared for delivery ahead of a panel discussion at a management conference in Chicago, Kocherlakota also argued that given the soaring demand for safe assets — but shrinking supply — the Fed has not lowered the real interest rate sufficiently.
The Fed's policymaking Federal Open Market Committee is currently buying $85 billion a month in U.S. Treasury securities and mortgage bonds, and has vowed to continue doing so until it witnesses a "substantial improvement" in labor market conditions.
Some Fed officials who opposed to the program, such as Dallas Fed President Richard Fisher, have called for the Fed to begin scaling back its purchases — beginning with mortgage-backed securities — citing the potential threat to financial stability.
Kocherlokota countered, however, that "the gains from tightening related to improving financial stability are both speculative and slight," while "the losses from tightening — in terms of pushing employment and prices even further below the Federal Reserve's goals — are both tangible and significant."
This has led him to the conclusion that "financial stability considerations provide little support for reducing accommodation at this time."
Kocherlakota does not hold a voting position on the FOMC this year, but he said the body should only consider tightening monetary policy based on a cost-benefit analysis.
So the FOMC should act "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," he said.
"Thus, the gain to tightening monetary policy is that the FOMC may — and I emphasize the word may — be able to reduce the already low probabilities of adverse unemployment outcomes," Kocherlakota added.
The FOMC is buying bonds, and has introduced of thresholds for unemployment (6.5%) and inflation (2.5%) to force interest rates even lower, but Kocherlakota, in an echo of an argument he made last month at the Minsky conference in New York, said that the FOMC "has still not lowered the real interest rate sufficiently" in light of changes in asset demand and supply.
"The demand for safe financial assets has grown greatly since 2007," he said, while the housing meltdown in the U.S. and Europe's sovereign debt woes means "the supply of the assets perceived to be safe has shrunk over the past six years."
"The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate — that is, the interest rate net of anticipated inflation," Kocherlakota said. "It follows that the Federal Open Market Committee can only meet its congressionally mandated objectives for employment and prices by taking actions that lower the real interest rate relative to its 2007 level."
While these changes in the asset market will ease gradually, Kocherlakota warned that, based on the low real yields on long-term Treasury Inflation-Protected Securities, these changes are likely to persist over a considerable period of time — "possibly the next five to 10 years."
"If this forecast proves true, the FOMC will only meet its congressionally mandated objectives over that long time frame by taking policy actions that ensure that the real interest rate remains unusually low," he said.
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