Is the Fed’s Medicine Really Poison?

Bloomberg View, April 22, 2013. All Rights Reserved.

It’s not every day that a central banker admits that his medicine for curing the last crisis may be laying the groundwork for the next. But that’s exactly what Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, said last week at the annual Hyman P. Minsky Conference at the Levy Economics Institute of Bard College.

Kocherlakota said low real interest rates are necessary to achieve the Fed’s dual mandate of maximum employment and stable prices. He also said that low real rates lead to inflated asset prices, volatile returns and increased merger activity, all of which are signs of financial market instability. Listen to what he calls his "key conclusion"—and what I’d call a true conundrum:

"I’ve suggested that it is likely that, for a number of years to come, the FOMC will only achieve its dual mandate of maximum employment and price stability if it keeps real interest rates unusually low. I’ve also argued that when real interest rates are low, we are likely to see financial market outcomes that signify instability. It follows that, for a considerable period of time, the FOMC may only be to achieve its macroeconomic objectives in association with signs of instability in financial markets."

Just think about that for a minute: What the Fed needs to do in order to achieve its macroeconomic objectives will create instability in financial markets. There’s more:

"On the one hand, raising the real interest rate will definitely lead to lower employment and prices. On the other hand, raising the real interest rate may reduce the risk of a financial crisis —- a crisis which could give rise to a much larger fall in employment and prices. Thus, the Committee 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."

Damned if we do, damned if we don’t. Other Fed officials have warned about froth in asset markets, but none to my knowledge has been as forthright in describing the Fed’s life-saving medicine as systemic poison.

Like his colleagues, Kocherlakota believes effective supervision and regulation of the financial sector are the best ways to address threats to macroeconomic stability. Yeah, and the tooth fairy leaves money under your pillow if you’re good.

For central bankers to believe regulation is the answer, they have to ignore history and disregard the tendency for regulators to be co-opted by those they are assigned to regulate, a phenomenon known as "regulatory capture."

The Minsky Conference was the ideal place for Kocherlakota to deliver his remarks. Minsky observed that, during periods of prosperity and financial stability (the Great Moderation), investors are lulled into taking on more risk with borrowed money.

At some point, investors are forced to sell assets to repay loans, sending asset prices into a downward spiral as cash becomes king. This is what’s known as a "Minsky moment."

Kocherlakota seems to be saying such an outcome is inevitable. If only he could tell us when.