Narayana Kocherlakota, President of the Minneapolis Fed, recently participated in a panel where he discussed the key challenges facing central banks. He viewed the safe asset shortage and the related inability of the Fed to push the actual market rate down to its natural interest rate level as problem number one. Readers of this blog know I completely agree with his assessment. I also agree with him that the reason this problem persists is that the zero lower bound is preventing the safe asset market from clearing.
Where we part ways is whether the Fed can solve this problem and its implications for financial stability. First, Kocherlakota does not seem to think there is much more the Fed can do where I believe the Fed through a “shock and awe” program could solve the safe asset shortage. The early results of Abenomics appear to support my view. The Fed, in conjunction with the U.S. Treasury Department, could also resolve this problem through a “helicopter drop”. Though not my first choice, I would be fine with this approach as long as it were tied to a NGDP level target or some other nominal anchor. So the Fed is not helpless here, but has just failed to do all it can.
Second, he believes the Fed’s attempt to push rates down to the neutral rate level may create financial instability. I disagree. The Fed is not causing financial instability because it is not the reasons interest rates are now low. The weak economy and resulting safe asset shortage is the reason interest rates are low. The Fed’s share of marketable treasuries, for example, has been and is about 15%. That means most of the run up in public debt has been funded by you, me, and our financial intermediaries. If the low interest rates are causing an unnatural reach for yield, then blame us not the Fed. The Fed simply is playing catch up to the low interest rate environment we have created. Financial instability is more likely to emerge if the Fed were somehow able to temporarily lower the target federal funds rate below the natural interest rate as it did in 2002-2004. We are far from that situation now.
Okay, enough of my views. Here is Kocherlakota (my bold):
In my view, the biggest challenge for central banks—especially here in the United States—is changes in the nature of asset demand and asset supply since 2007. Those changes are shaping current monetary policy—and are likely to shape policy for some time to come.
Let me elaborate. The demand for safe financial assets has grown greatly since 2007. This increased demand stems from many sources, but I’ll mention what I see as the most obvious one. As of 2007, the United States had just gone through nearly 25 years of macroeconomic tranquility. As a consequence, relatively few people in the United States saw a severe macroeconomic shock as possible. However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Workers and businesses want to hold more safe assets as a way to self-insure against this enhanced macroeconomic risk.
At the same time, the supply of the assets perceived to be safe has shrunk over the past six years. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. They no longer think that. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. They no longer think that either.
The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. It follows that the Federal Open Market Committee (FOMC) can only meet its congressionally mandated objectives for employment and prices by taking actions that lower the real interest rate relative to its 2007 level. The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.
This piece is cross-posted from Macro and Other Market Musings with permission.