Narayana Kocherlakota: Making monetary policy
Speech by Mr Narayana Kocherlakota, President of the Federal Reserve Bank of
Minneapolis, at a meeting with business leaders, Sidney, Montana, 13 October 2011.
* * *
I thank Doug Clement, David Fettig, Terry Fitzgerald and Kei-Mu Yi for very helpful comments.
Thank you for that generous introduction, John. As Paul Drake described earlier, the board of
directors of the Helena Branch of the Federal Reserve Bank of Minneapolis is meeting here
in Sidney to commemorate John Franklin's last meeting as a member of that board. I would
like to take this opportunity to publicly thank John for his generous service to the Federal
Reserve, as well as other members of the board, past and present. It is important for people
to realize that the Federal Reserve is represented by dedicated citizens like John and his
colleagues on all of the System's bank and branch boards. In addition, each Federal Reserve
bank has a number of advisory councils representing Main Street businesses, agricultural
producers, labor groups and community banks and thrifts, among other constituencies. As I
will describe later, the input from these citizens plays an important role in the development of
monetary policy. So thank you, once again, to John and the rest of the Helena board of
directors, as well as others in the audience who have served us so well.
I'd also like to offer congratulations, on behalf of myself and the Federal Reserve Bank of
Minneapolis, to Thomas Sargent and Christopher Sims, winners of the 2011 Prize in
Economic Sciences in Memory of Alfred Nobel. In the 1970s, in separate research, Sargent
and Sims developed systematic approaches to distinguishing between cause and effect in
macroeconomic data. Now, almost 40 years later, their thinking informs the making of
macroeconomic policy around the world. I'm especially proud that much of the work
recognized by the prize committee was done at the Federal Reserve Bank of Minneapolis
and the University of Minnesota. My predecessors at the Federal Reserve Bank of
Minneapolis deliberately fostered a research environment that could give rise to such
important work, and this tradition continues today.
In the rest of my remarks today, I'd like to touch on several topics. I'll begin with a quick
description of the structure of the Federal Reserve System and the deliberative process of
the Federal Open Market Committee, the Fed's policymaking group. Then I'll describe the
FOMC's objectives and discuss its recent performance with regard to those objectives. I'll
close with a discussion of my dissents on recent FOMC decisions. After that, I'll be pleased
to answer any questions you may have. And before I begin, I should remind you that my
comments here today reflect my views alone and not necessarily those of others in the
Federal Reserve System, including my FOMC colleagues.
The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along
with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our
bank represents the ninth of the 12 Federal Reserve districts, and by area, we're the second
largest - thanks in no small part to the great state of Montana. Our district also includes the
Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.
Eight times per year, the FOMC meets to set the path of monetary policy over the next six to
seven weeks. All 12 presidents of the various regional Federal Reserve banks - including me -
and the seven governors of the Federal Reserve Board, including Chairman Bernanke,
contribute to these deliberations. (Currently, there are only five governors - two positions are
unfilled.) However, the Committee itself consists only of the governors, the president of the
Federal Reserve Bank of New York and a group of four other presidents that rotates annually.
Right now, that last group consists of the presidents from the Minneapolis, Philadelphia, Dallas
and Chicago Federal Reserve Banks.
I've said that the FOMC meets (at least) eight times per year. But how do these meetings
work? At a typical meeting, there are two so-called go-rounds, in which every president and
every governor has the opportunity to speak without interruption. The first of these is referred
to as the economics go-round. It is kicked off by a presentation on current economic
conditions by Federal Reserve staff economists. Then, the presidents and governors
describe their individual views on current economic conditions and their respective outlooks
for future economic conditions. The presidents typically start by providing information about
their district's local economic performance. We get that information from our research staffs,
but also from our interactions with business and community leaders in industries and towns
from across our districts.
The chairman speaks at the end of the first go-round. He briefly but thoroughly summarizes
the preceding 16 perspectives. I can assure you that this is no easy task - and the
chairman's balanced and thoughtful treatment of our remarks is one of the many reasons
that he commands such respect among his colleagues. He then provides his own views on
the economy.
The Committee next turns to the second go-round, which focuses on policy. Again, the staff
begins, with a presentation of policy options. After that, each of the 17 meeting participants
has a chance to speak on what each views as the appropriate policy choice. This set of
remarks is followed with a summary by the chairman, in which he lays out what he sees as
the Committee's consensus view for future policy. The voting members of the FOMC then
cast their votes on this policy statement and thereby set monetary policy for the next six to
seven weeks.
I think that this description of an FOMC meeting highlights how the structure of the FOMC
mirrors the federalist structure of our government. Representatives from different regions of
the country - the various presidents - have input into FOMC deliberations. And, as I've
described, their input relies critically on information received from district residents. In this
way, the Federal Reserve System is deliberately designed to give the residents of Main
Street a voice in national monetary policy.
I've said that FOMC participants seek to adopt what they view as the appropriate policy
choice. That provides a natural segue into my next topic: the policy objectives of the FOMC.
The FOMC has a dual mandate, established by Congress: to set monetary policy so as to
promote price stability and maximum employment. In my view, the heart of implementing the
price stability mandate is to formulate and communicate an objective for inflation. The central
bank then fulfills its price stability mandate by making choices over time so as to keep
inflation close to that objective.
Of course, the central bank's job is complicated by economic shocks that may lower or raise
inflationary pressures. The central bank provides additional monetary accommodation - like
lower interest rates - in response to the shocks that push down on medium-term inflation. It
reduces accommodation in response to the shocks that push up on inflation. By doing so, it
works to ensure that inflation stays close to its objective.
It is not enough to have an objective - the Federal Reserve must also communicate that
objective clearly and credibly. That communication serves to anchor the public's medium-
and long-term inflationary expectations. Put another way, without clear communication of
objectives, the public can only guess at the intentions of the FOMC, and inflationary
expectations and inflation itself will inevitably end up fluctuating - and perhaps by a lot. It is
possible to undo these shifts in expectations, but doing so entails significant economic cost.
The nation saw this all too clearly in the early 1980s, when tighter monetary policy necessary
to rein in high inflation resulted in painful employment losses.
The Federal Reserve communicates its objective for inflation in a number of ways. For
example, at quarterly intervals, FOMC meeting participants publicly reveal their forecasts for
inflation five years hence, assuming that monetary policy is optimal. Those forecasts usually
range between 1.5 percent and 2 percent per year. They are often collectively referred to by
saying that the Federal Reserve views inflation as being "mandate-consistent" if it is running
at "2 percent or a bit under."
Congress has also mandated that the FOMC set monetary policy so as to promote maximum
employment. Some see an intrinsic conflict between the FOMC's price stability mandate and
maximum employment mandate. But there is actually a deep sense in which the price
stability and maximum employment mandates are intertwined. Imagine that inflation runs at 3
or 4 percent per year for three or four years. The public will then start to doubt the credibility
of the Fed's stated commitment to a 2-percent-or-a-bit-under objective. The public's
mediumterm inflationary expectations will consequently begin to rise. As we saw in the latter part of
the 1970s, these changes in expectations can serve to reinforce and augment the upward
drift in inflation. At that point, the Federal Reserve will have to tighten policy considerably if it
wishes to regain control of inflation. But we learned in the early 1980s that the resultant
tightening - while necessary - generates large losses in employment. In other words, failing
to meet its price stability mandate can also lead the FOMC, over the medium and long term,
to substantial failure on its employment mandate.1
Over the past year, the FOMC has communicated through its statements that it perceives the
current unemployment rate to be elevated relative to levels that it views as consistent with its
dual mandate. However, an important and ongoing communications challenge for the FOMC
is that it is much harder to quantify the maximum employment mandate than the price
stability mandate. Changes in minimum wage policy, demography, taxes and regulations,
technological productivity, job market efficiency, unemployment insurance benefits,
entrepreneurial credit access and social norms all influence what we might consider
"maximum employment." Trying to offset these changes in the economy with monetary policy
can lead to a dangerous drift in inflationary expectations and ultimately in inflation itself.
How has the FOMC performed relative to its dual mandate over the past three and a half
years, since the onset of the Great Recession at the end of 2007? In terms of price stability,
the answer is: remarkably well. The personal consumption expenditure (PCE) inflation rate
has averaged 1.8 percent per year from the fourth quarter of 2007 through the second
quarter of 2011. In my view, this outcome is essentially consistent with price stability.
Now, I want to be clear here about what I mean when I say "inflation." That number I just
gave you, 1.8 percent per year for more than three years, refers to what's termed headline
inflation. It includes all goods and services, including food and energy. When the Fed says
that it is committed to keeping inflation at 2 percent or a little less, it means prices for all
goods and services, including the gas we put in our cars and the food we put on our tables.
When we make reference to year-over-year core inflation - that is, inflation without food and
energy - it's only because we believe that core inflation is a helpful predictor of headline
inflation over the next three or four years.
The FOMC's admirable performance on the price stability mandate is not due to luck. Since
mid-2006, residential land prices in the United States have fallen by over 50 percent.2 Falling
land prices were at the heart of the financial crisis from 2007 to 2009 and have generated a
persistent fall in wealth and borrowing capacity for households. The associated declines in
demand for consumption goods and investment goods pushed downward on prices and
inflation.
Confronted with this enormous shock to the economy, the Federal Reserve followed an
unprecedentedly and imaginatively accommodative policy. It kept interest rates near zero. It
provided "forward guidance" by explicitly expressing its expectation that interest rates would
stay extraordinarily low for an extended period. It bought over $2 trillion of longer-term
government securities. Through these actions, the Fed provided an extraordinary amount of
monetary stimulus - and so was able to meet its price stability mandate in the face of
challenging circumstances.
Unemployment does remain disturbingly high - over 9 percent. However, I am sure that it
would be even higher without the enormous amount of monetary stimulus being provided by
the Fed. Moreover, I believe that the FOMC could only have systematically lowered the
unemployment rate further by generating inflation rates over a multiyear period that were
higher than its communicated objective of 2 percent. Such an outcome could potentially lead
the public to lose faith in the credibility of the FOMC's communicated objective and thereby
increase the probability that the FOMC would lose control of inflation. As I discussed earlier,
this scenario would require a policy response that would generate substantial losses of
employment.
I want to close my discussion of FOMC performance by explaining why there is no longer an
intrinsic connection between the size of the Fed's balance sheet and inflation. I've mentioned
how the Federal Reserve has bought over $2 trillion of government securities. It has funded
that purchase by tripling the amount of deposits held by banks with the Fed - what are called
bank reserves. The standard reasoning is that this kind of reserve creation is inflationary.
Banks are only allowed to offer checkable deposits in proportion to their reserves.
Economists view checkable deposits as a form of money because, like cash, checkable
deposits make many transactions easier. In this sense, bank reserves held with the Fed are
essentially licenses for banks to create a certain amount of money. By giving out more
licenses, the FOMC is allowing banks to create more money. And if you took any economics
in school you learned: more money chasing the same number of goods - voilà, inflation.
Indeed, I think I'm pretty safe in saying that after four years in economics grad school, I've
uttered this phrase - more money chasing the same number of goods creates inflation -
more often than anyone else in this room.
But this connection between bank reserves and inflation is simply not operative right now.
Banks have few good lending opportunities, and so they're not trying to attract deposits. As a
result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need
to back their deposits. In other words, banks have the licenses to create money, but are
choosing not to do so.
I'm confident, though, that at some point in the future, the economy will improve and banks
will once again have good lending opportunities. Some observers are concerned that once
this happens, the banks' excess reserves will serve as kindling for an inflationary fire. This
concern would have been entirely appropriate three years ago. But in October 2008,
Congress granted the Federal Reserve the power to pay interest on bank reserves. Right
now, that interest rate is 25 basis points, or 0.25 percent. By raising that rate judiciously, the
Fed has the ability to deter banks from using their reserves to create money, and through this
mechanism, the Fed can prevent inflation. The Fed's ability to pay interest on reserves
means that the old and familiar link between increased bank reserves and higher inflation
has been broken.
Of course, this requires the Fed to raise the interest rate on reserves in response to changes
in economic conditions. You might well ask: Will the Fed raise interest rates in a sufficiently
timely and effective manner to keep inflation at 2 percent or a little less? But that's always
been the key question to ask about Fed policy, even when the Fed had a much smaller
balance sheet. And that's my point: Because the Fed can pay interest on reserves, the size
of its balance sheet does not, in and of itself, undercut the credibility of its commitment to
keep inflation at 2 percent or a bit under. I believe that's why both survey and market-based
measures of expected inflation over the next five to 10 years have remained remarkably
stable as the Fed has expanded its liabilities.
Let me summarize my review of FOMC performance since the beginning of the Great
Recession in December 2007. My assessment is that, despite some profound economic
shocks, the FOMC - led by Chairman Bernanke - has successfully met its price stability
mandate by engaging in imaginative forms of monetary accommodation. These actions have
also helped lower the unemployment rate. As part of its accommodative policy, the FOMC
has greatly expanded its balance sheet. But it is important to understand that this expansion
need not trigger inflation now or in the future, because the Federal Reserve can now pay
interest on bank reserves.
With all that said, I've dissented from the FOMC's decisions in the past two meetings. As I
mentioned earlier, I believe that the FOMC's ultimate effectiveness relies critically on its
communication and the credibility of that communication. I've dissented at the last two
meetings because I believe that the Committee's decisions at those meetings diminish that
requisite credibility. I'll close my remarks today by explaining my thinking on this matter.
The FOMC's dual mandate, as I've said, is to keep inflation at 2 percent or a bit under and to
promote maximum employment - that is, to keep unemployment low. Over the past few
years, the Fed has quite appropriately provided a historically unprecedented level of
monetary accommodation. However, as inflation rises and unemployment falls, the FOMC
should respond by lowering the level of accommodation. This kind of systematic response to
changes in economic conditions is an essential part of good monetary policy for at least a
couple of reasons. First, there is a great deal of empirical evidence and theoretical support
for the idea that following a systematic policy rule, as economists call it, is what enables the
Committee to achieve its dual mandate goals. Second, and perhaps more importantly,
actions speak louder than words. The Committee can claim that it intends to make monetary
policy so as to fulfill its dual mandate. But the public will watch its actions carefully in this
regard. If the Committee fails to reduce its immense amount of accommodation in a timely
fashion, the public will begin to doubt the Committee's claims about its goals.
In November 2010, the FOMC undertook a second round of purchases of long-term
government securities - an action that has become known as QE2. This was a controversial
move in some quarters, but I supported it - and I believe that it played a valuable role in
reducing what seemed at the time to be a large risk of deflation. Let's look back at economic
conditions at that November 2010 meeting. The unemployment rate was 9.8 percent and
was expected to be 9 percent a year later. The year-over-year core PCE inflation rate was
less than 1 percent and was expected to rise to 1.3 percent over the course of 2011.
Now, fast-forward to October 2011. The unemployment rate is 9.1 percent and is expected to
be near 8.5 percent by the end of 2012. The year-over-year core PCE inflation rate is
1.6 percent and is expected to stay near that level - or even higher - over the course of the
coming year.3 So, since November 2010, the unemployment rate and the outlook for the
unemployment rate have improved. Inflation and the outlook for inflation have both risen
closer to 2 percent. As I've just discussed, in response to these changes in economic
conditions, the Committee should have lowered the level of monetary accommodation over
the course of the year. Instead, through actions taken at its last two meetings, the Committee
has raised the level of monetary accommodation. In this sense, the Committee's recent
actions in 2011 are inconsistent with the evolution of the economic data in 2011.
I want to be clear about one additional point. Along with many private sector forecasters, the
FOMC has overestimated the strength of the recovery over the past two years. Some have
suggested that the unexpected slowness of the recovery is a justification for the FOMC's
increasing the level of monetary accommodation over the past couple of months. But I
disagree with this argument. I've described how, as the economy recovers, the FOMC should
respond by reducing the level of monetary accommodation. Logically, it follows that if the
economy recovers more slowly than expected, then the FOMC should respond by reducing
the level of monetary accommodation more slowly than expected. The FOMC should only
increase accommodation if the economy's performance, relative to the dual mandate,
actually worsens over time.
To sum up: The Committee's actions at the last two meetings are inconsistent with a
systematic pursuit of its communicated objectives. It follows that these actions diminish the
Committee's credibility and so reduce the effectiveness of future Committee actions and
communications. And that's why I've dissented from the Committee's actions at those
meetings.
Thank you very much for your attention, and I look forward to taking your questions.