The Federal Reserve’s policy-making committee finally squeezed the trigger last week and raised its target for the federal funds rate, the interest rate banks charge each other for overnight loans of reserves, by a quarter of 1 percent. December 2015 marks the eighth anniversary of this target languishing at 0.25 percent.
Most people do not appreciate how extraordinary this era has been. In the history of central banking, no other major nation has pushed short-term interest rates so low for so long. Doing so required the Fed to increase the broadly measured money supply by 65 percent, while the inflation-adjusted value of all the economy’s production of goods and services grew only 9.5 percent.
Yet despite the Nobelist Milton Friedman’s warnings — which I and nearly all other economists accepted — that inflation results when money grows faster than output, inflation at the consumer level has been low, with annual increases in the Consumer Price Index averaging only 1.5 percent over these eight years.
The economy is not as vibrant as it was in the late 1990s, but it may well be that this is the best it’s going to get for some years, especially given the situation around the globe. So I’ll predict that this month’s Fed meeting will go down in economic history as a turning point, when, for better or worse, the central bank turned away from the extraordinary and sometimes panicked responses it made to the financial debacle that began to unfold in August 2007 and returned to a monetary policy regime like the one that had prevailed for the previous 30 years.
With a shift in the phase of Fed policy, it is interesting that the Federal Reserve Bank of Minneapolis is similarly shifting gears in its leadership. It is one of the smallest district Feds, but has a history of punching above its weight in its research and influence on monetary policy.
Neel Kashkari, former aeronautical engineer, investment banker, U.S. Treasury go-to man and losing candidate for governor of California, is taking over as president. Narayana Kocherlakota, once a premier academic economist and then, as a Federal Open Market Committee participant, an impassioned advocate of the loose monetary policies that his former school of thought strongly opposed, has given up his bully pulpit. Kocherlakota will take an endowed chair in economics as the University of Rochester in New York.
Kocherlakota has served only six years, a short tenure, at least compared with his predecessor Gary Stern, who served more than 24 in Minneapolis.
The backgrounds of these three cast interesting light on the evolution of central banking in our nation in the 36 years since Jimmy Carter appointed Paul Volcker to chair the Fed and end chronic inflation.
Stern typified Fed district presidents of the era. He is a Ph.D. economist who did some teaching but who spent most his career in the Fed system. He was in the research department of the New York Fed in the worst of 1970s inflation and headed that department at Minneapolis just as the U.S. economy endured the recessions of 1980 and 1982 that were engendered by the harsh monetary contraction Volcker implemented to end inflation.
Then, as a district president, he helped preside over seemingly golden years of U.S. monetary policy, with low inflation, good growth and relatively low unemployment.
Known as moderate-to-hawkish in terms of inflation, Stern gained a reputation for occasional FOMC dissents in favor of slower money growth, but never disagreed so predictably that his nay vote was automatically discounted, as was true for presidents of the Cleveland and St. Louis Feds in the 1990s.
Stern became outspoken on the “too big to fail” issue — ironically opposing what would become Kashkari’s later role as engineer of the large bank bailouts under the George W. Bush administration.
Too big to fail was the idea that some banks or other financial institutions are so large and entwined in an economy that if they collapse financially, it would throw the nation’s economy into recession or worse. Hence, when one of these institutions teeters on the edge of bankruptcy, regulators should step in and act to prevent liquidation of the business. This may involve using FDIC or Fed funds to cover some losses. The stockholders can be wiped out and perhaps top management axed. But creditors owed money should be made whole if not doing so would ignite a general financial panic.
This was the rationale for a FDIC-Fed bailout of Continental Illinois Bank in 1984 and of the Long-Term Capital Management hedge fund in 1998. Stern argued long and hard that such bailouts created “moral hazard,” the perverse incentives for large institutions to take on excess risk, because their trading counterparts know they won’t suffer loss if the risk-bearing firm goes bust. Bailouts breed more bailouts.
But Stern’s crusade was a futile one. In 2007-2009, the Fed and the Bush administration took “TBTF” to the Nth power, delegating administration of the effort to Kashkari. While the economy was pulled back from the abyss of a catastrophic depression, we still went through a harsh recession.
Using easy money and low interest rates to get the economy out of this recession and back to normal levels of employment and output became Kocherlakota’s crusade after he succeeded Stern in 2009. Although he had been an external adviser to the Minneapolis Fed, he was really an academic and Fed outsider. His “road to Damascus” turnaround in economic views once at the Fed has been described many times.
Now for five years, Kocherlakota has been an articulate and outspoken advocate of even looser money. His fellow policymakers have now rejected this (Kocherlakota was a nonvoting member on the Fed board this year), but his advocacy probably was one factor among many in the long delay in raising rates. Ultimately, like Stern, his historical identification will be that of a voice crying in the wilderness.
Enter Kashkari, who, although he has a Wharton MBA in addition to his B.S. and M.S. in engineering, is not an economist. Nor is he a Fed veteran. His claim to fame is that he was a rising, but still very junior, star at Goldman Sachs when its departing CEO, Henry Paulson, became Bush’s Treasury secretary and pulled Kashkari along to serve in the administration.
This was a good move. Paulson’s hapless predecessor, John Snow, was ill-equipped to deal with the debacle that was about to unfold. And Kashkari, as Paulson’s bright “go-to guy,” managed the politically fraught TARP bailout with great skill.
The new Minneapolis president does not have the macroeconomic or monetary policy chops of his two predecessors. But he does know bailouts, and he knows it is imperative that a nation not get itself into situations where a bailout is the least bad alternative to economic collapse.
History may look back at this appointment as a case of “cometh the hour, cometh the man.” We have weathered the financial crisis that began in 2007 and, however painfully, the recession that ensued. We did enact very flawed legislation, the Dodd-Frank Act, to avoid future debacles.
But we did not have the guts to break up the biggest financial institutions. And the response to the crisis in 2008 was to further concentrate banking and financial services into fewer and larger institutions.
So despite pious promises from presidential candidates eschewing all future bailouts, we are even more vulnerable to a financial crisis than we were in 2007. We are not that far from the rim of the abyss on which we teetered just seven years ago. Few politicians talk about this or specifically call for breaking up the big firms. One notable exception is Bernie Sanders, for whom reducing the power of Wall Street is a major component of his agenda.
Let’s hope Kashkari gets TBTF back on the policy table. As with his predecessors, he may face a futile quest. But he is a driven, energetic guy, and let’s hope he gives structural reform a try.
Economist and writer Edward Lotterman can be reached at email@example.com.