Friday, May 17, 2013

Narayana Kocherlakota on Safe Assets and the Natural Interest Rate

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.
Great points!


  1. Interesting, and vexing, blogging.

    I guess some would say you create more federal debt, spend the money, and give the resulting safe assets to the investing public, in the form of a Treasury bill. Like many, I do not like the idea of rising federal debt. But deficit spending does create more safe assets.

    It seems to monetizing debt to stimulate the economy will create safe assets. Yes, land went down by 30 percent but is going back up now. The public is perceiving that, and we seem to be in a commercial and residential property rebound. So monetizing debt will create more safe assets. (In fact, you may get a double--not only with new mortgages be perceived as safe but old, underwater mortgages may come up for air).

    So property is again becoming perceived a safe asset.

    I respect the fact that Kocherlakota seems to be evolving in his thinking.More than we can say for a Meltzer or Taylor or Feldstein.

    But is still seems like the premise of everyone connected to the Fed, the default position, is that money should be tight, that inflation is the concern, that that the last thing we will try to boosting the economy by printing a lot more money.

    We are reaching that last thing now. The Fed is belatedly going to terms with sustained QE.

    One note on Abenomics: Yes, it shows heavy QE works--unfortunately (in terms of experiments) it has been coupled with structural reforms and fiscal stimulus.

    So, the argument will continue....

  2. There is no safe asset shortage. There is an unlimited supply of savings accounts. It's just that the returns are extremely low on these assets. Safe assets with good yield are in short supply is all. If the Fed raised the Fed rate, these assets would be more attractive, and we would see more activity in the safe asset markets.
    Global risk is growing as interest rates of central banks stay so low. Risky assets are able to lower their interest payments because of so much demand "reaching for yield".
    The Central bank interest rates need to start rising. But economists think we need to stimulate growth. Well, low interest rates are destabilizing growth more than helping it.

  3. What is needed is more bank lending, or non-bank lending, to start ups.

    Fiscal stimulus of boondoggle projects will fail; stimulus thru tax cuts will help -- both have similar immediate effects on the high deficit, but tax cuts have a much higher rate of return than Solyndra gov't investment, or higher welfare payments, or higher health care payments to people who die within 3 years even after treatment.

    The Fed could, and should, be charging interest on Excess Reserves, rather than paying it.

    Their should also be required increases in capital at all banks and financial institutions, to reduce the bank risk.

  4. There is no risk-free resource scarcity. It has an unrestricted method of getting personal savings company accounts. It is simply that the results are really close to these types of property. Safe and sound property with higher yield are in brief provide is perhaps all. When the Fed brought up the actual Given charge, these property can be more desirable, and we would see more exercise within the safe and sound tool areas.

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