Part of the unintended genius in the design of the Federal Reserve System is demonstrated by how speeches given by a once-obscure academic in small regional cities like Helena, Mont., or Mankato, Minn., can affect national monetary policy. So is the fact that that the decentralized system of 12 semi-autonomous district banks continues to generate a diversity of ideas in policy making that is lacking in any other nation’s central bank.
Narayana Kocherlakota, the soon-retiring president of the Minneapolis Federal Reserve Bank, certainly has brought distinctive ideas to U.S. monetary policy making.
As evidence, consider that after the September Federal Open Market Committee meeting, Fed Chairwoman Janet Yellen felt compelled to deny that the panel had given serious consideration to pushing interest rates into negative territory. She didn’t cite Kocherlakota by name, but everyone who follows this knows he has been the only advocate of such a move among committee members.
And indeed in speeches in Helena last May and Mankato on Oct. 8, Kocherlakota advocated substantially more easing.
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Understand that the formal role of one district bank president is small. There are 12 such presidents who, together with seven members of the Fed Board of Governors, participate in eight regular meetings of the policy-making FOMC each year.
Most such presidents, including that of Minneapolis, have a vote only every third year. Kocherlakota’s last such voting year was 2014. And he announced months ago that he did not want to be appointed to another term after six years as president. So he is a lame duck in terms of any formal power.
He still has a voice, however.
And, over most of his tenure at the Minneapolis bank, he has been an articulate advocate for greater expansion of the money supply, and hence ever-lower interest rates, with the objective of increasing employment and fostering faster growth of output.
So even though it’s unlikely to happen, Kocherlakota’s idea provides us with a real teaching moment. Just what would negative interest rates entail? Jilted savers who have earned next to nothing under seven years of next-to-zero interest rates may cringe at the prospect, but to really answer this question one much first distinguish between “nominal” and “real” interest rates.
“Nominal” rates are the ones listed in any promissory note, mortgage or credit card terms. They are the rate actually paid without any consideration of inflation. “Real” rates take what is paid and apply an inflation adjustment. If the rate on your mortgage is 4.5 percent and inflation is 1.5 percent, then the real rate is about 3 percent.
If the inflation rate is higher than a nominal interest rate, then one has negative real rates. These are not uncommon. The Fed funds rate, the one for overnight loans between banks that is the targeted indicator for Fed policy, has been around 0.25 percent for six years now. Consumer inflation, though low, has averaged 1.6 percent per year over that time. So the real overnight interest rate has been about a negative 1.35 percent.
My father died the year I was born, so my small inheritance was put into Treasury bonds until my 21st birthday. Inflation averaged 2.5 percent a year and the bonds only earned 2 percent, so the real buying power of my legacy shrank. But those who went through the great inflation of the 1970s with lower fixed-rate mortgages made out very well.
So negative real rates are not unknown. And achieving such rates could be an overt policy objective. When economist Milton Friedman and former Fed chair Ben Bernanke talked figuratively of the possibility of dropping money from helicopters to stave off deflation in a dire crisis, this is what they had in mind. Create enough money, their argument went, interest rates will fall and prices must rise.
But is this what Kocherlakota had in mind? He certainly has emphasized, especially in his Oct. 8 talk, that actual consumer inflation is running well below the Fed’s own target of 2 percent. That gives it room for further monetary expansion. And hitting that target rather than the actual level of 0.3 percent would lower the real interest rate on all existing loans. It would also make the short-term rates directly administered by the Fed more sharply negative in inflation-adjusted terms.
One could go an additional step and make some nominal rates negative. Instead of paying banks interest on reserves, or deposits not loaned out, that banks keep with the Fed, it could levy a fee on them.
The stimulus here is that banks might begin lending more freely, thus giving consumers more cash to spend and businesses more money to buy new equipment, thus spurring overall demand for goods and services.
Implementing negative nominal rates is rare, although Switzerland, now facing an influx of euros fleeing the European Central Bank’s own zero-interest rates, may impose fees on deposits and bank reserves as a last ditch effort to keep the exchange value of its currency from rising too much.
Trying to impose negative nominal rates opens myriad cans of worms, however, especially in terms of administering day-to-day bank operations. And it would be hugely unpopular with small savers.
So believe Fed Chair Yellen when she says that the FOMC as a whole is not considering an overt negative interest rate policy. But understand Kocherlakota’s argument that our central bank could and should do more to increase employment.
I am torn. Kocherlakota earned a reputation for bright and wide-ranging academic research. Only months before moving to the Minneapolis bank, he joined other conservative economists in signing an open letter opposing the Obama administration’s fiscal stimulus plan.
So when he became an outspoken advocate of using monetary policy to spur output and employment, it was a “road-to-Damascus” conversion. In my view, he moved in the right direction, but like many enthusiastic converts, he moved too far.
Yes, loosening monetary policy in the face of a recession is correct. Yes, it is vital to avoid deflation. And yes, there are several historical examples of central banks tightening too early and too much.
However, as in many other things, there is an element of diminishing returns to monetary easing. The positive effects of initial lowering in a recession may be great, but over some range, as nominal and real interest rates get lower and lower or become negative, the additional spurring of employment and output shrinks. Unfortunately, events of the past eight years show how weak our understanding of the macro economy still is. Only time will tell us who is right.
Also, Kocherlakota and other advocates of even looser money, including Nobelists Paul Krugman and Joseph Stiglitz, focus almost exclusively on consumer prices and ignore the prices of assets like real estate and stocks. As a farmland owner, perhaps I focus too much on this factor. But it seems clear that while consumer inflation remains in check, farmland, some urban housing and the stock market all contain some degree of a Fed-induced price bubble.
I deeply respect the Minneapolis president. I have a gut sympathy for his objectives. We will miss his voice after January. But I don’t think he is correct in this issue. Perhaps time will render a verdict, but this may be an issue that historians will still be debating a century from now.
St. Paul economist and writer Edward Lotterman can be reached at firstname.lastname@example.org.