Narayana Kocherlakota: Low real interest rates
Speech by Mr Narayana Kocherlakota, President of the Federal Reserve Bank of
Minneapolis, at the Ninth Annual Finance Conference, Carroll School of Management,
Boston College, Boston, Massachusetts, 5 June 2014.
* * *
I thank Ron Feldman, David Fettig, Terry Fitzgerald and Kei-Mu Yi for many valuable comments.
Introduction
Thanks for the invitation to speak at this great conference.
In my talk today, I will provide some perspectives on appropriate monetary policy and
financial stability. I start by arguing that, over the past seven years, we have seen dramatic
changes in the demand for and supply of safe assets. Given those changes, the Federal
Open Market Committee (FOMC) is only able to achieve its congressionally mandated
objectives of maximum employment and price stability by taking actions that serve to keep
the real - that is, net of inflation - interest rate well below its 2007 level. I suggest that these
changes in asset demand and asset supply are likely to persist over a considerable period of
time - possibly the next five years or so. It follows that the FOMC will only be able to meet its
objectives over that time frame by taking policy actions that ensure that real interest rates
remain unusually low.
I then point out that low real interest rates are often associated with financial market
phenomena that are seen as signifying instability. It follows that, for many years to come, the
FOMC will only be able to achieve its congressionally mandated objectives by following
policies that may result in signs of financial market instability.
Finally, I discuss how the FOMC should take those signs of instability into account when
formulating monetary policy.
Before proceeding I need to stress that my remarks today reflect only my views and not
necessarily those of any other FOMC participant.
Low real interest rates
Economists generally distinguish between nominal and real interest rates. The nominal
interest rate is the interest rate reported on a typical savings account or mortgage. It tells you
how many dollars a saver or a lender will get in the future for giving up a dollar today. The
real interest rate adjusts those future dollars for the anticipated rate of price increases - that
is, for the anticipated rate of inflation. This means that the real interest rate tells you how
much purchasing power a saver or lender will get in the future for giving up a dollar of
purchasing power today.
When I was a student, back in the seventies and eighties, the real interest rate was a
somewhat mysterious, unobservable object. That's no longer true. Treasury
inflationprotected securities - bonds that are colloquially called TIPS - make coupon payments that
are indexed to the inflation rate. This indexation means that TIPS coupon payments provide
a fixed amount of purchasing power to the bondholder, not a fixed amount of dollars. As a
result, TIPS yields provide a useful measure of the real interest rate.
When we look at TIPS yields, we see that real interest rates have fallen sharply over the past
six years. In the first half of 2007, five-year TIPS had a real yield of about 2.5 percent and
10-year TIPS also had a real yield of about 2.5 percent. By 2012, both real yields had fallen
well below zero, and while they have risen slightly, real yields continue to be low today. The
five-year real TIPS yield is still below zero, around negative 0.3 percent. The 10-year real
TIPS yield is only slightly positive - around 0.4 percent. Note that, together, these market
prices imply that the five year-five year forward real interest rate is around 1 percent. The
10 year-10 year forward real interest rate is only slightly higher.
Why have real interest rates fallen so much? At one level, the answer is obvious: monetary
policy. Certainly, over the past seven years, the FOMC has taken a number of actions
designed to put downward pressure on nominal bond yields. With inflationary expectations
well-anchored, these actions tend to push downward on real interest rates.
But I think that the obvious monetary policy answer is actually deeply misleading. It is true
that the FOMC takes monetary policy actions so as to influence the real interest rate. But,
ultimately, these actions are designed to allow the FOMC to achieve its dual mandate of
price stability and maximum employment. In 2007, the macroeconomic outlook was broadly
consistent with the Committee's mandated objectives. In this sense, we can say that the real
1
interest rate of 2.5 percent was mandate-consistent in 2007.
The situation is different in 2014. As I've argued in previous speeches, the outlook for both
employment and prices is too low relative to the FOMC's goals. For example, Personal
Consumption Expenditure inflation - the Fed's preferred measure - is currently at
1.6 percent. I expect it to remain below the FOMC's inflation target of 2 percent for several
years. This subdued outlook for both prices and employment suggests that the current path
of real interest rates is actually too high to be consistent with the FOMC's mandated
macroeconomic outcomes. Hence, I would argue that the mandate-consistent real interest
rate is even lower than is suggested by the current yield on TIPS.
What happened?
I've argued that the mandate-consistent path of real interest rates has fallen since 2007. I
now turn to a discussion of why this has happened. I see the decline in mandate-consistent
real interest rates as grounded in an increase in the demand for, and a fall in the supply of,
safe financial investment vehicles. Importantly, I see these changes as likely to be highly
persistent.
There are many factors underlying the increased demand for safe assets. I'll discuss three
that strike me as particularly important: tighter credit access, heightened perceptions of
macroeconomic risk and increased uncertainty about federal fiscal policy.
In terms of credit access, I don't think that it's controversial to say that credit access is more
limited than in 2007. What is less generally realized, I think, is that restrictions on
households' and businesses' ability to borrow typically lead them to spend less and save
more.
I can best illustrate this point through an example. Consider a household that wants to
purchase a new home. In 2007, that household could have received a mortgage with a down
payment of 10 percent of the purchase price, or even lower. In 2014, that same household is
considerably more likely to need a down payment of 20 percent. These tighter mortgage
standards mean that, to buy a similarly priced house, the household needs to first acquire
more assets.
Thus, the demand for safe assets has risen because of tighter limits on credit access. It has
also risen because of households' and businesses' assessments of macroeconomic risk. As
of 2007, the United States had just gone through nearly 25 years of macroeconomic
tranquility. As a consequence, relatively few workers or businesses (or macroeconomists!) in
the United States saw a severe macroeconomic shock as a relevant contingency.
However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is
different. Now, more workers see themselves as being exposed to the risk of persistent
deterioration in labor incomes. More businesses see themselves as being exposed to the risk
of a radical and persistent downshift in the demand for their products. These workers and
businesses have an incentive to accumulate more safe assets as a way to self-insure against
this enhanced macroeconomic risk.
The federal fiscal situation is the third key source of elevated uncertainty. The federal
government faces a long-run disconnect between its overt commitments and the baseline
path of federal tax collections. This disconnect can only be resolved by raising taxes and/or
cutting the long-run arc of spending.
Of course, this tension between revenues and expenditures predated the 2007 downturn.
However, it is at least arguable that the fiscal debates of the past few years have made more
Americans aware of the uncertainties associated with resolving this long-run disconnect. And
these uncertainties affect the demand for safe assets. The possibility of higher future taxes
on corporate profits gives businesses an incentive to demand safe short-term financial
assets as opposed to engaging in long-term investments. The prospect of reductions in
Medicare, Medicaid or Social Security gives some households an incentive to demand more
safe assets as a way of replacing those lost potential benefits.
I've argued that, due in part to tighter credit access and higher uncertainty, the demand for
safe financial assets has risen since 2007. At the same time, the global supply of assets
perceived as safe has also fallen. 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. Not anymore. Similarly, investors around the world
viewed all forms of European sovereign debt as a safe investment. Not anymore.
Thus, the FOMC is confronted with a greater demand for safe assets and tighter supply of
safe assets than in 2007. These changes in asset markets mean that, at any given level of
real interest rates, households and businesses spend less. Their decline in spending pushes
down on both prices and employment. As a result, the FOMC has to lower the real interest
rate to achieve its objectives.2
I often hear that the FOMC has created a low interest rate environment that is harmful for
savers and others. In my view, like savers, the FOMC is being forced to make unusual
decisions by an unusual economic environment that is not of its own making. The FOMC has
been confronted with a significant increase in safe asset demand and a significant fall in safe
asset supply. Faced with these changes, the Committee can only achieve its macroeconomic
objectives by taking actions to push down the real interest rate. Indeed, as I argued earlier,
the subdued outlook for prices and employment suggests that the FOMC's actions have not
lowered the real interest rate sufficiently.
What about the future? The passage of time will ameliorate these changes in the demand for
and supply of safe assets - but only partially. Any long-run forecast has enormous attendant
uncertainties. But I expect that for a considerable period of time - possibly the next five years
or more - credit market access will remain limited relative to what borrowers had available in
2007. I expect that many workers and businesses will remain more concerned than in 2007
about the risk of a large adverse shock. And I also expect that businesses will continue to
feel a heightened degree of uncertainty about taxes and households will continue to feel a
heightened degree of uncertainty about the level of federal government benefits. These
considerations suggest that, for many years to come, the FOMC will have to maintain low
real interest rates to achieve its congressionally mandated goals. I see this conclusion as
broadly consistent with the April FOMC statement, which predicts that the target fed funds
rate will remain low for some time after inflation and employment are near
mandateconsistent levels.
Financial market outcomes associated with low real interest rates
I have argued that, for some time to come, the FOMC will only be able to achieve its dual
mandate outcomes if the time path of real interest rates is considerably lower than in 2007 -
as much as two full percentage points lower.
I now turn to the consequences of these unusually low real interest rates for broader financial
market conditions. My main point is that unusually low real interest rates are likely to be
associated with other unusual financial market outcomes. I'll discuss three of these outcomes
in some detail: inflated asset prices, unusually volatile asset returns and high merger activity.
The first consequence of low real interest rates that I mentioned - higher asset prices - is the
most obvious. Long-lived assets are somewhat substitutable for each other. Hence, investors
generally respond to low real yields on bonds by bidding up the price of other long-lived
assets - including gold, land, stocks or machines. It follows that when real interest rates are
unusually low by historical norms, asset prices will typically be unusually high relative to
historical norms.
The second consequence of low real interest rates is that asset returns should be expected
to be highly volatile. When the real interest rate is very high, only the near term matters to
investors. Hence, variations in an asset's price only reflect changes in investors' information
about the asset's near-term dividends or risk premiums. But when the real interest rate is
unusually low, then an asset's price will become correspondingly sensitive to information
about dividends or risk premiums in the distant future. This new source of relevant
information should be expected to induce more variability into asset prices and returns.3
Finally, I believe that when real interest rates are low, we should expect to see more
mergers. Mergers typically involve enduring current costs in exchange for a flow of future
benefits. For example, to initiate the merger, the acquiring firm has to search for an
appropriate target, and that search can be costly. As well, after the merger, it may be
necessary to undertake a one-time costly reorganization of people and materiel to achieve
the anticipated gains in revenue. Businesses will be more willing to pay the upfront costs of a
merger in exchange for the anticipated flow of future benefits associated with the merger if
the real interest rate is low.4
In this way, unusually low real interest rates should be expected to be linked with inflated
asset prices, high asset return volatility and heightened merger activity. All of these financial
market outcomes are often interpreted as signifying financial market instability. And this
observation brings me to a key conclusion. I've suggested that it is likely that, for a number of
years to come, the FOMC will only achieve its dual mandate of maximum employment and
price stability if its actions are able to keep real interest rates unusually low. I've also argued
that when real interest rates are low, we are likely to see financial market outcomes that
signify instability. It follows that, for a considerable period of time, the FOMC may only be
able to achieve its macroeconomic objectives in association with signs of instability in
financial markets.
Financial stability and monetary policy
These financial market phenomena could pose macroeconomic risks. In my view, such
potentialities are best addressed through effective supervision and regulation of the financial
sector. It is possible, though, that these tools may only partially mitigate the relevant
macroeconomic risks. How, if at all, should the FOMC adapt monetary policy in response to
any residual risk?
In remarks that I gave earlier this year, I described an analytical mean-variance framework
that the Committee could use to answer this question.5 Today, I'll simply sketch the elements
of that framework. Basically, the FOMC will need to confront an ongoing probabilistic
costbenefit calculation. On the one hand, raising the real interest rate will definitely lead to lower
employment and prices. On the other hand, raising the real interest rate may reduce the risk
of a financial crisis - a crisis that could give rise to a much larger fall in employment and
prices. Thus, the Committee has to weigh the certainty of a costly deviation from its dual
mandate objectives against the benefit of reducing the probability of an even larger deviation
from those objectives.
In my view, this cost-benefit assessment is relatively clear right now. As I mentioned earlier,
employment and prices are expected to be quite low over the medium term. In these
circumstances, the cost of tightening policy has to be seen as great. At the same time, the
Survey of Professional Forecasters reveals that forecasters see little chance of a large
downward movement in employment and prices. These forecasts suggest that there would
be little gain, in terms of forestalling adverse macroeconomic outcomes, from monetary
policy tightening.
However, I expect this assessment to become more difficult for monetary policymakers in the
future. Eventually, the outlook for employment and prices will improve to be broadly
consistent with the FOMC's objectives. As I've described, I expect that the real interest rate
will still be unusually low at that juncture. In these circumstances, I anticipate that financial
stability considerations are likely to play a substantial role in the determination of the
appropriate level of monetary accommodation.
I should stress that the Committee is in a better position to carry out this kind of probabilistic
cost-benefit analysis in 2014 than it was in 2007. The Federal Reserve System now
dedicates a significant amount of our best staff resources to financial system surveillance.
The Federal Reserve Bank of Minneapolis contributes to these efforts in a number of ways,
including our ongoing monitoring of the risk-neutral probability distributions of future asset
values.6 As a result of these efforts, the FOMC has a lot more information, on an ongoing
basis, about the extent of financial system risks.
Nonetheless, as always, there is more to be learned. We need to understand better, in light
of the current state of supervision and regulation, which residual financial system risks have
the potential to translate into macroeconomic risks. And we need to understand better to
what extent monetary policy tightening can in fact temper those residual financial system
risks.
Conclusions
Let me wrap up.
Over the past seven years, there have been big changes in the demand for and supply of
safe assets. These changes seem likely to be persistent, and they mean that the FOMC may
need to keep real interest rates unusually low for years if it is to achieve its objectives of
maximum employment and price stability. I see this conclusion as broadly consistent with the
last sentence of the FOMC's April statement.
It follows that, to attain maximum employment and price stability over the same long period
of time, Americans will likely face the consequences of low real interest rates. I've
emphasized consequences related to financial market instability, like inflated asset prices,
volatile asset returns and heightened merger activity. Even in the presence of effective
supervision and regulation, these phenomena could pose residual macroeconomic risks. The
FOMC's decision about whether to respond to those residual risks using the rather blunt tool
of monetary policy will necessarily depend on a delicate probabilistic cost-benefit calculation.
Thanks for listening. I look forward to taking your questions.
References
Campbell, John Y., and Robert J. Shiller. 1988. The Dividend-Price Ratio and Expectations
of Future Dividends and Discount Factors. Review of Financial Studies 1 (3): 195-228.
Cochrane, John H. 1992. Explaining the Variance of Price-Dividend Ratios. Review of
Financial Studies 5 (2): 243-80.
Kocherlakota, Narayana R. 2012. Incomplete Labor Markets. Federal Reserve Bank of
Minneapolis working paper.
Moran, Pablo. 2013. Anticipation and Timing in Merger Waves. University of British Columbia
working paper.