The Fed Is Inflating Asset Prices and Increasing Volatility, and It Should Do More, Kocherlakota Says

Forbes, April 18, 2013. All Rights Reserved.

Admitting that the Federal Reserve is responsible for creating financial instability, and possibly brewing the next toxic asset bubble, Minneapolis Fed President Narayana Kocherlakota said they have to do more to stimulate the economy, as inflation is too low.  Kocherlakota predicted five to ten years of financial instability, as the Fed marches on with unusually low, and currently negative, interest rates, yet suggested the alternative would be “much worse.”

Going much further than Fed Chairman Ben Bernanke. Kocherlakota directly tied high levels of financial instability with the Fed’s policies designed to keep rates “unusually low.”  Interestingly, though, he didn’t suggest this was a reason to reverse course, rather, he felt it was an unwanted but tolerable side effect.

Speaking at the Levy Economics Institute’s Minsky conference, Kocherlakota spoke of “incredible demand for safe assets,” which, in conjunction with Fed policy, will conspire to keep real rates very low for possibly five to ten years.

Demand for safety has risen, as tight credit access pushes households and some businesses to increase saving.  At the same time, fears of a coming macroeconomic shock diminishes demand for businesses and workers’ products.  Add the fiscal situation, where spending and revenues are completely out of whack, and one sees a constant yearning for safety.  In part this has helped the dollar remain relatively resilient, while fueling gold’s rise during times of market stress, despite recent weakness.

On the supply side, investors knew where to find it before the crash: in U.S. real state or assets backed by it, in European sovereign debt, and in Treasuries. With the real estate sector obliterated and Europe in shambles, supply of safe assets has fallen dramatically, Kocherlakota explained.

This environment undoubtedly sets the stage for “unusual” events in financial markets.  Kocherlakota spoke of Fed policy inflating asset prices, while accelerating volatility; he also mentioned increased merger activity.  Indeed, U.S. stock markets have been trading at or near record highs for some time, while stocks in the housing sector, such as KB Home and Lennar, are up near their 52-week highs.  Financial stocks like Citigroup, JPMorgan Cahse, and Bank of America are all outperforming the market dramatically over the past six months, while gold, eternally seen as a safe asset, is down hard in the same time period.

The risk of creating another destructive bubble is there, according to Kocherlakota, but he doesn’t see it as imminent.  The Fed’s current state of surveillance is vastly superior than it was before the financial crisis, the Minneapolis Fed chief said, giving him comfort that they will be able to anticipate, or at least mitigate, any dangers.

So, the Fed has to do more.  Kocherlakota’s two-year inflation projection is well below trend, and fearing deflation, he’s ready to do more.  Even after defending quantitative easing, Kocherlakota said he prefers to use forward guidance to affect market perceptions.   Specifically, he’d like to lower the unemployment target from 6.5% to 5.5%, signaling that easing will remain in place for longer.  QE isn’t as well understood from a metric perspective, he explained.

Asked about diminishing returns, and if Fed policy was at a point where it is increasingly ineffective, while risks continue to mount, Kocherlakota was quick to reject the hypothesis.  There’s ample evidence the Fed has been effective, particularly in mortgage markets and in real rates, as seen in TIPS, while raising rates would be destructive, helping a few to the detriment of many, he said.

Kocherlakota echoed comments made by his colleague from St. Louis, James Bullard, who on Wednesday also said inflation was “too low,” arguing for the Fed to do more. While Bullard said forward guidance is ineffective, and asked for a modification in the flow rate of asset purchases (Fed code for more money printing), they both agree the Fed has to do more to stimulate the economy.