Kocherlakota Warns of Consequences of ‘Mandate-consistent’ Lower Rates

CentralBanking.com, April 18, 2013. All Rights Reserved.

The president of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota, said today that the Federal Open Market Committee (FOMC) will have to live with a "considerable period" of financial instability as the price of meeting the targets of its dual unemployment-price stability mandate.

Speaking at the 22nd Annual Hyman P Minsky Conference, held at the Levy Economics Institute of Bard College, New York, Kocherlakota said the "unusually low" interest rates that he advocates are likely to cause "inflated asset prices, high asset return volatility and heightened merger activity" – all of which "are often interpreted as signifying financial market instability".

However, Kocherlakota – who does not sit on the FOMC in 2013 – said that low interest rates in the US are as necessary a response to poor economic indicators as is putting on a coat when the weather is cold.

He said: "…when I decide what coat to wear, my goal is to keep myself at a temperature that I view as appropriate, given prevailing conditions that I cannot influence. Similarly, when the FOMC decides on a level of the real interest rate, its goal is to keep the macroeconomy at an appropriate ‘temperature’, given prevailing conditions that it cannot influence."

Given unemployment is currently significantly above target levels, and inflation is running below the target of 2% per annum, Kocherlakota said the FOMC "needs to put on some more serious ‘winter gear’ if it is to get the economy back to the right temperature".

"It seems likely", he said, "that the mandate-consistent time path of real interest rates could be unusually low for a considerable period of time".

Volatile prices and more mergers likely
Kocherlakota then discussed three likely financial market outcomes of a sustained low interest rate environment: inflated asset prices, unusually volatile asset returns and high merger activity.

He said mergers will become more common because they "typically involve enduring current costs in exchange for a flow of future benefits". When credit is relatively cheap, businesses "will be more willing to pay the upfront costs of a merger in exchange for the anticipated flow of future benefits".

Asset prices will experience more volatility, he said: "When the real interest rate is very high, only the near term matters to investors. Hence, variations in an asset’s price only reflect changes in investors’ information about the asset’s near-term dividends or risk premiums.

"But when the real interest rate is unusually low, then an asset’s price will become correspondingly sensitive to information about dividends or risk premiums in what might seem like the distant future."

Cost-benefit calculation
Kocherlakota said the FOMC has to confront "an ongoing probabilistic cost-benefit calculation" as "raising the real interest rate will definitely lead to lower employment and prices" while "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, he said, "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."