All Hail Kocherlakota!

Includes: RINF
by: Scott Sumner

To put the following quote in perspective, let's first summarize how the Fed views the world:

  1. The Fed successfully targets inflation at 2%.
  2. This can only occur if the Fed is able and willing to steer the nominal economy, i.e. NGDP. So the path of NGDP is determined by Fed actions (or perhaps errors of omission.)
  3. Although the Fed believes it steers the nominal economy, it never takes the blame for bad outcomes, in real time. Later on it might admit that it caused the Great Contraction and Great Inflation (indeed it has admitted to those two crimes) but not in real time, not while it's committing the crimes. Thus in 2008-09 it did not admit that the failure to cut interest rates between April and October 2008 was a huge contractionary mistake.
  4. Instead, in real time the nominal economy is assumed to move of its own accord (even though the Fed's model says they drive NGDP) and the Fed is a like a firefighter who comes in to rescue the economy, when it misbehaves.

But now we have Minneapolis Fed President Narayana Kocherlakota in the WSJ admitting that on a few occasions the Fed actually causes the fire. And he's admitting this in real time, not just that they were too contractionary when the sharply cut the base between October 1929 and October 1930, or too expansionary when they cut interest rates in 1967. They are too contractionary right now.

I participate in the meetings of the Federal Open Market Committee, the monetary policy-making arm of the Federal Reserve. In that capacity, I'm often asked by members of the public about the biggest danger facing the economy. My answer is that monetary policy itself poses the biggest danger.

Many observers have called for the FOMC to tighten monetary policy by raising interest rates in the near term. But such a course would create profound economic risks for the U.S. economy.

Why would a near-term tightening of monetary policy be so problematic? Because given the prevailing economic conditions, higher interest rates would push the economy away from the FOMC's economic goals, not toward them.

Congress has mandated that the Fed promote price stability and maximum employment. The FOMC has translated its price-stability mandate into a target 2% inflation rate, as measured by the personal consumption expenditures price index. Inflation has run consistently below that objective for more than three years and is currently at 0.3%.

The outlook is for more of the same. Most private forecasters do not see inflation reaching 2% for the next two years. Government bond yields are consistent with that same subdued inflation outlook. In June the FOMC's own staff forecast was that inflation would remain below the committee's 2% target until the 2020s.

The U.S. inflation outlook thus provides no justification for policy tightening at this juncture. Given that outlook, the FOMC should ease, not tighten, monetary policy by, for example, buying more long-term assets or by reducing the interest rate that it pays on excess reserves held by banks. Along these lines, the board of directors of the Minneapolis Fed has for the past few months been recommending a reduction in the interest rate that the Federal Reserve charges banks for discount window loans.

Now, this is not to say that increasing the federal-funds rate by a mere quarter of one percentage point, as many advise, would in and of itself have a huge direct impact on the U.S. economy. But even a small change toward tighter policy would send a strong message to financial markets. [Emphasis added]

I've also said the Fed should cut rates now. Indeed I've said just about everything Kocherlakota says here. How did Kocherlakota ever get appointed to the Fed? They need to screen candidates more carefully.

PS. The 5-year TIPS spread has now fallen to 1.2%, and the 30-year is at 1.75%. Question, what's the all-time low for the 30-year spread?

PPS. So much for those who said the Fed wasn't doing enough in 2013 and 2014 because of the zero rate bound. They are about to raise rates! But while many Keynesians were a little bit wrong they can at least point to the conservatives, who have been wrong about monetary policy so many years in a row it's becoming almost comical.

HT: Michael Darda