cc >> Jeff Mayers: Our key note
is Narayana Kocherlakota... ...the monetary policy of the
United States and influences the world economy, determines a
large part of what you pay on your bank loans.
So we want to welcome today Dr. Narayana Kocherlakota.
He became the president of the Federal Reserve Bank of
Minneapolis in the fall of 2009. Prior to that, Dr. Kocherlakota
was a professor of economics at the University of Minnesota.
We won't even talk about the game that the Badgers won and
beat and Minnesota and all that. We won't hold any of those
Minnesota allegiances against him.
A native of Baltimore, Dr. Kocherlakota earned his
undergraduate degree in mathematics from a couple of
little schools called Princeton and his PhD in economics from
the University of Chicago. So please welcome
Dr. Kocherlakota. [APPLAUSE]
Narayana Kocherlakota: Thanks very much for the introduction,
and thanks to the Wisconsin Bankers Association
for the invitation to join you here today.
I've visited Madison several times over the years and I've
always enjoyed the experience. And I've always felt that
Madison and the Twin Cities are pretty similar.
They're state capitols. Beautiful water views.
Great universities. Of course at that level
I pretty much could be describing Venice, Italy.
[LAUGHTER] But my speech today will have
two distinct parts. In the first part, I'm going to
describe my outlook for the economy in 2011.
In the second part I will look back in time to the great
recession of 2007-2009. My discussion will parallel
the classic Frank Capra movie "It's a Wonderful Life."
In that movie the hero George Bailey is granted the miraculous
opportunity to see how other lives would have been affected
if he had never existed. I will do the same for the
Federal Reserve. I will describe how I believe
the great recession of 2007-2009 would have unfolded
if the Fed did not exist. As always, I'm speaking for
myself today and not others in the Federal Reserve system.
So let me begin with my outlook. And in my outlook I'm going to
focus on the three variables that are of most interest to us
at the Federal Open Market Committee, that is the FOMC:
real gross domestic product, real GDP, unemployment and
inflation. My bottom line is going to be
that from a point of view of the macro-economy, 2011 will be a
better year than 2010 was. So what did happen in 2010?
Well in the first three quarters of 2010, real GDP growth
averaged 2.7% at an annualized rate.
Now we don't have the fourth quarter numbers in yet, the
fourth quarter just ended, but I do expect that number to be
higher. So if you put that together, I
would expect that real GDP grew at a rate of around 2.8% from
the fourth quarter of 2009 to the fourth quarter of 2010.
If that prediction ends up being right, real GDP, in the fourth
quarter of 2010, will finally have recovered to its level in
the fourth of 2007 in the beginning of the recession.
But we cannot celebrate too much.
The population of the United States has grown about 2.6%
from November 2007 through November 2010.
So over that three-year period there were more people in the
US; it's grown by about 2.6%. So if you take real GDP and
think about real GDP per person in the US, that's still 2.6%
lower than what it was in the fourth quarter of 2007.
Also, historically, we typically think of real GDP per person in
the United States growing at roughly 2% per person per year.
Suppose that real GDP per person had grown at that rate over the
past three years. Then real GDP would be in fact
8.6% higher in the fourth quarter of 2010
then it actually is. And as you will hear,
I expect that this 8.6% differential will change
little, if at all, by the end of 2011.
The recession has had and will continue to have a large and
persistent impact on the US economy.
Now at the November 2010 FOMC meetings, the participants all
submitted forecasts for real GDP growth in 2010.
And these forecasts are available online at the Board of
Governors website. The central tendency of thee
forecasts, so when we say central tendency what they do is
they drop the lowest three and the highest three and
keep the middle 12 of them. If you take the central
tendency, that ranges between, for real GDP growth it ranges
between 3% and 3.6% for the year 2011.
Now these forecasts were made, though, before we knew about the
tax changes for 2011 that ended up being instituted in December.
Nonetheless, even with the December changes in fiscal
policy, I would say that I expect that real GDP growth will
probably be closer to 3% than 4% in 2011.
I still see two major headwinds in the United States economy.
The first is that many households will continue to
strive to rebuild their net worth positions in response to
past and possibly future falls in residential land prices.
As I would explain in more detail later, I believe that the
decline in household net worth precipitated by falls in land
values was a key factor in generating the severity of the
recession, and it will remain important in the recovery.
So the second headwind is related.
Many banks in the United States face ongoing issues with asset
quality. Just to set one example, the
FDIC problem bank list still contains over 800 banks.
Problem banks are less likely to take the risk of lending to
small and/or younger firms and other entrepreneurial activity.
Instead they are more likely to preserve capital ratios by
limiting their asset growth and allocating their lending staff
to working out loans to existing borrowers.
Instead, as the economy improves, I expect this headwind
will become more severe, that it will become more important I
should say. In 2010, our information at the
Minneapolis Fed indicates that small businesses were reluctant
to expand because of ongoing uncertainties about product
demand. As a result, their demand for
bank financing remain low. In 2011, as the economy
improves, I expect loan demand to rise accordingly, but banks
with poor asset quality will continue to focus on capital
preservation rather than loan expansion.
Let me move from real GDP to talk about unemployment.
Employment data released last Friday indicated that the
unemployment rate fell to 9.4% in December
from 9.8% in November. But any decline is of course
welcome news, I do not think that this single data point
signals a rapid recovery in labor markets.
Employment growth remains disappointingly low.
Nonfarm employment increased by only 103,000 in November.
Now I want to go through and talk about this because I think
it's important to understand how unemployment fell by 40 basis
points from November to December even though employment growth
was relatively low. And here I think it's helpful to
recall how the Census Bureau actually goes out and measures
unemployment. So everybody month the Census
Bureau interviews 60,000 households that consist of
roughly 110,000 individuals. The bureau asks a host of
questions. But there are two particularly
important ones. First, have you worked for pay
or profit in the past week. If not, the second question goes
on, if not, have you looked for work in the past four weeks.
The first group, those who have worked for pay or profit in the
past week are counted as the employed.
Those who have looked for work in the past four weeks are
counted as the unemployed. And the sum of those two groups
is what's called the labor force.
Anyone who answers no to both these questions is regarded as
being out of the labor force. And the unemployment rate is
then defined to be the fraction of people in the labor force who
are unemployed. So once we go you through this
definition in this detail, we can see that the unemployment
rate can fall in two distinct ways.
It can fall the way we want it to fall which is unemployed
people getting jobs, becoming employed.
Alternatively, though, it can also fall by unemployed people
ceasing to look for work. And this second channel was
significant in shaping the employment picture in December.
In that one month the labor force fell by 260,000, which is
a large move by historical standards.
Now the available data do suggest that most the unemployed
who left the labor force were young.
So I just mentioned this number 260,000 people left unemployment
to leave the labor force entirely.
The number of people under the age of 25 in the labor force
fell by about 244,000 from November to December.
So much of that 260,000 is accounted by this 244,000.
My hope and expectation is that many of these younger people
will return to the labor force as the economy improves in 2011.
Nonetheless, I do not believe that either employment or
unemployment will improve rapidly in 2011.
Startup businesses and other young firms are a key source of
employment growth in the early stages of recoveries.
And as I've mentioned earlier, they're likely to find bank
financing more challenging to obtain than usual.
As well, 4.2% of the labor force has been unemployed for longer
than six months. And historically this group of
workers who have been unemployed for that long has a relatively
low job finding rate. The central tendency of the
November FOMC forecast is that unemployment will remain above
9% throughout 2011. And I would agree with those
forecasts. Even more troublingly, I expect,
too, that unemployment is likely to be higher than 8% as late as
the end of 2012. So I've talked about GDP growth
and I've talked about unemployment, now let me turn to
inflation. Inflation remains
extraordinarily low. In the third quarter of 2010,
overall PCE inflation, so this is personal consumption
expenditure inflation, this including all goods, not getting
rid of food or energy or anything like that, including
all goods was 0.8%. Core PCE inflation, when we
strip away food and energy, was 50 basis points, 0.5%.
PCE food inflation was 26 basis points.
And all of these figures are annualized.
So this is an annual rate this is how much inflation we would
have. And these inflation levels are
too low to be consistent with usual formulations of the Fed's
price stability mandate. More troublingly, inflation
continued to trend downward in 2010.
So in the third quarter of 2009, annualized core PCE inflation
was 1.5%. Hence in the course of a year,
the quarterly inflation rate fell by 100 basis points.
A further deceleration of the same magnitude in 2011 would
drive inflation into negative territory.
Now with that said, I'm optimistic that inflation will
actually turn north in 2011 and not continue south.
So our Minneapolis Fed forecasting model predicts that
by the end of 2011 inflation will be between 1.5% and 2%.
Now that's just our forecasting model, but we can get another
reading by looking at the prices of financial instruments called
zero-coupon inflation-indexed swaps.
And their current prices imply that for the coming year
expected inflation is roughly 1.7%.
So in that 1.5% to 2% range. So to summarize my outlook, I
expect that real output will grow slightly more rapidly in
2011 than in 2010. Household de-leveraging and bank
asset quality will remain a drag on the recovery.
Unemployment will fall but much more slowly than we would like.
Finally, as is suggested by financial market data, I am
optimistic that we will see some re-inflation in the coming year.
So let me turn now to the second part of my speech,
which is roughly titled "It's a Wonderful Fed,"
to mimic "It's a Wonderful Life."
[LAUGHTER] So the National Bureau of
Economic Research's Business Dating Committee serves as the
official arbiter of recessions. The committee has determined
that the great recession began in December 2007 and ended in
June 2009. During that time, real GDP fell
by 4% and unemployment nearly doubled.
The Federal Reserve responded to the great recession and the
associated financial crisis in a number of ways.
But I think these responses can be roughly grouped into two
classes. First, the Fed engaged in a vast
amount of lending to firms believed to be in sound
condition. It lent through conventional
vehicles like a discount window and swaps with foreign central
banks, but it also lent through relatively unconventional
vehicles like the Term Asset-Backed Securities Loan
Facility. And I'll talk about this lending
to solvent institutions, and I'll talk briefly how to
distinguish this lending from the Fed's injection of funds
into obviously nonsolvent institutions like AIG.
Second, so the first class of responses is the lending
responses, the second response is the Fed lowered the real
interest rate facing borrowers and lenders.
Now here I want to clarify some terminology at the risk of a
being a little bit overly pedantic.
The term real interest rate I'm referring to the interest rate
received by the lender's net of inflation.
So if the interest rate on a loan is 5% and lenders expect
inflation to be around 2%, then the real interest rate is
roughly 3%. And generally economists think
it's the real interest rate that matters for economic decision
making and not the nominal interest rate.
So early in the recession the Fed lowered its target for the
Fed funds rate. That's a nominal rate.
But given that inflation expectations remain stable, this
action served to lower the real interest rate.
By early 2009, when the Fed funds target essentially reached
its lower bound, the Fed used large scale asset purchases to
achieve further reductions in the real interest rate.
So I'll first discuss the lending responses and then talk
about the real interest rate cuts.
And then I'll discuss how I believe, I should say, economic
events would have unfolded had there been no Fed at all.
So I'll talk first about the lending.
So to talk about the Fed's responses in 2007-2009, we need
to step back into the second half of 2006.
Now at that point in time, firms and people around the world held
a wide array of financial assets that were ultimately backed by
United States residential land. You think about, for example, a
mortgage-backed security or any asset backed by mortgage-backed
securities, those are all examples of assets that are
ultimately backed by United States residential land.
Those holders of those assets view them as being largely free
of risk. Investors may have understood
that a fall in the value of the United States land would impose
large losses on them. But they put low odds in such a
decline taking place. Rather they seemed to believe
that US land prices would continue to rise at a steady
clip. So as I say this is in mid-2006.
By the second half of 2007, a little over a year later, that
belief began to unravel in the face of incoming data.
People were beginning to learn the hard way that United States
land was, in fact, a risky investment.
The only question that remained was how risky.
And the uncertainty about the answer to this question is what
planted the seeds for a global financial panic.
Now what do I mean by the term financial panic?
Now I'm going to do, of course only an economist can do this.
You take a term like financial panic and you define it by using
two new terms that are actually very vague and pretty poorly
defined. [LAUGHTER]
But let me work through this. So what do I mean by the term
financial panic? So financial panics are events
that blur the line between liquidity and solvency.
So those are the two new terms. So does solvency mean?
A firm is solvent if its revenues, in a discounted
present value sense, exceed its expenditures.
A firm is liquid if it is able to raise enough funds, either by
borrowing or by selling assets, to pay its current costs.
Now in a well-functioning financial market, solvent firms
are typically liquid. And it's because they are able
to borrow against that future stream of profits that they are
going to be receiving. But in contrast, during a
financial panic lenders feel unable to assess future profits
and/or collateral for borrowers. As a result, borrowing becomes
highly constrained. And even highly solvent firms
may become illiquid. Now during the mid-2000s, many
forms of collateral around the world were either implicitly or
explicitly backed by United States residential land.
As I've described, beginning in mid-2007 it became clear that
this asset had more risk than financial markets had originally
appreciated. It was not clear, though, how
much more risk was involved. As a result, financial markets
became increasingly uncertain about how to evaluate assets
backed by US land. That uncertainty translated into
uncertainty about the ultimate solvency of the institutions
holding those assets and the ultimate solvency of any of
those institutions creditors or their creditors or their
creditors and so on. Spreads in credit markets
between treasury returns and other bond returns began to
widen, at first slightly and then alarmingly.
Now I would say that most economists agree about how
central banks should respond to financial panics.
And the crux of that agreed upon response is that central banks
have to be willing to lend freely to solvent firms against
a wide range of good collateral at some kind of penalty rate.
Now this policy is a useful one for two reasons.
First, and most obviously, it provides a source of funds to
potential borrowers who are liquid but who are nonetheless
solvent. But second, and maybe a little
more subtly, it provides a floor in collateral evaluation.
Private lenders now know that they can always use collateral
seized from a defaulting borrower as a vehicle to borrow
money from the central bank. So that baseline use for
collateral helps serve to spur private lending as well.
So this is the basic operating principal, lend freely to
solvent firms against a wide range of good collateral at some
kind of penalty rate. And beginning in mid-2007 the
Fed took a number of actions that were consistent with this
operating principal. It lent money to financial
institutions through the discount window and its close
cousin the Term Auction Facility.
It injected liquidity into a broad range of central credit
markets through a veritable alphabet soup of special lending
vehicles. And as someone who joined the
Fed in October of 2009, I can tell you trying to keep track of
all these acronyms was not easy. But in some sense these
interventions were all typical ones for a central bank
operating in the context of a financial panic.
What was unusual was the size of the problem.
It meant that the operations were, to an extent,
unprecedented in their scale. And at their peak, the
interventions made up more than a trillion dollars of Federal
Reserve assets. Now there's no doubt that these
interventions saved many solvent firms from collapse during the
financial crisis. And over time, panic eased and
spreads in financial markets normalized.
Once that happened, the private sector stopped borrowing from
the Fed because it found the Fed's penalty rates too onerous.
As a result, the Fed was able to shut down its special lending
facilities in 2010. It is plausible that the Feds
loans through the various special facilities exposed it,
and by the extension of the American public, to some risk of
loss. But I want to emphasize it's
very difficult to know how much risk of involved.
The way you generally try to measure financial assets risk is
by the spread between its yield and that of a safe bench mark
like US treasuries. But in a financial panic, the
whole point is a relatively large fraction of that spread is
attributable to illiquidity as opposed to risk.
And the goal of the central banks intervention is exactly to
eliminate that panic driven illiquidity.
So we can't really gauge the Fed's risk exposure without
somehow correcting spreads for this illiquidity factor.
And this calculation strikes me as a nontrivial one.
What we can say is that the Fed in the post-sense has not lost a
penny on any of those loans, on those transactions.
So these interventions, this lending that I've described,
differs greatly from the institution specific assistance
that the Federal Reserve provided to firms like AIG.
These institution specific interventions were deemed
necessary by the Federal Reserve and the Bush Administration
because of deficiencies in the existing resolution regime for
systemically important financial institutions.
And the Dodd-Frank Act addresses those deficiencies.
And simultaneously and correctly, in my view, the
Dodd-Frank Act removes the Fed's ability to engage in institution
specific assistance. The act does leave in place,
though, the Fed's ability to engage in broad-based market
interventions of the kind that I've been talking about in some
detail, albeit with more congressional and White House
oversight. So that's the lending responses.
I want to talk now about cutting interest rates.
So I've talked about how the fall in land prices generate a
sharp increase in risk perceptions in financial markets
and how that led to the financial crisis.
But there was another key effect of the fall on land prices.
It reduced the net worth of many households and firms.
And they respond to that fall of net worth by foregoing
consumption and investment projects.
A fall in household demand for consumption and firm demand for
investment led in turn to a fall in output and employment and but
downward pressure on the price. The FOMC reacted by lowering its
target interest rate from 5.25% in August 2007 to a range of
0 to 25 basis points in December 2008.
And that's been there ever since.
Since inflation expectations remained stable during this
period, the FOMC's action has the effect of lowering the real
interest rate facing households. Households respond by saving
less and demanding more consumption.
Similarly, firms undertake more investment projects.
In this way, by lowering the real interest rate, the FOMC can
partially, and I underscore partially, offset the impact on
the economy of the loss of net worth.
Now, lowering rates, of course, may lead to undesirable
inflationary pressures within the economy.
But the recent path of inflation shows little evidence of such
pressures. And I've talked about some of
that already. But on a year over year basis,
core PCE inflation was running about 2.5% in the fourth quarter
of 2007, and it's now down to about 1%.
In fact, given the ongoing deceleration inflation that I've
mentioned and the high rate of unemployment, the FOMC would
probably have liked to respond by cutting its target interest
rate still further. The problem is that the target
interest rate, as I said, is at zero and can't go negative.
So instead, from December 2008 through March 2010, and then
again beginning in November 2010, the FOMC engaged in large
scale purchases of long-term treasuries.
The goal of these transactions is to lower long-term real
rates. And again offset the impact on
the economy of the net worth shock.
So this is how I think about the recession is that the fall in
land prices triggered an increase in risk perceptions and
a decrease in household net worth.
The increase in risk led to a major financial crisis that has
been cured, thanks in no little part to actions which the
Federal Reserve. The decrease in net worth led to
a major recession and ongoing slow recovery, and the Federal
Reserve's reduction in interest rates has lessened the impact of
that net worth shock. But now I want to turn to the
hypothetical posed in the last third of It's a Wonderful Life.
Suppose that there were no Fed. What would have happened to the
US economy in the past three years?
So what does this even mean to say suppose there were no Fed?
Well the Federal Reserve's key power is that it has the ability
to adjust the size of what's called the monetary base.
The monetary base, in turn, has to components.
The first component is currency. It's the bills and the coins
that we use for transactions. The second component consists of
what's called bank reserves. This crowd knows what I'm
talking about, but I'll go through this in any event.
These are essentially the deposits that various banks hold
with the Fed. Now the Fed is expanded the
monetary base by more than 100% from September of 2008 to the
end of 2010. So to me, an America without a
Fed means an America in which the monetary base is fixed in
size so that this kind of expansion in the monetary base
could not have taken place. So suppose the monetary base had
been fixed in the past three years at its December 2007
level, what would have happened? So one consequence is immediate.
The Federal Reserve funded its various lending programs that I
talked about in some detail by creating large amounts of bank
reserves. If the monetary base were fixed
in size, the Fed could not have created those lending
initiatives. As a result, many more solvent
financial institutions would have failed during the financial
panic. More subtly, the limitation on
the size of the monetary base would have made currency and
bank reserves scarcer after 2007.
So we know from basic economics scarcity creates value.
And their scarcity would have made these monetary assets,
currency and bank reserves more valuable in a couple of
different ways. First, they would have been more
valuable relative to other financial assets.
That means bond prices would have been lower and bond yields
higher. Second, currency in bank
reserves would have been more valuable relative to consumer
goods. So there's two senses at which
they're more valuable, one relative to financial assets and
also relative to other goods in the economy.
That would have meant expected inflation and realized inflation
would have been lower over the past three years.
So we've got higher bond yields and lower expected inflation,
those work together to generate higher real interest rates for
households. Their demand for consumption and
investment would have been lower.
So if the Federal Reserve could not have adjusted the monetary
base upward, real GDP would have fallen by even more than 4% and
unemployment would have been well above 10%.
Now, as with any counterfactual, these ruminations are
necessarily conjectural. But there are data to support
them. In the early years of the Great
Depression, the United States was on the gold standard.
And so the Fed could not easily adjust the quantity of bank
reserves. As a result, the Fed did not
engage in broad-based lending during the '29 to '33 period,
nor did it cut interest rates aggressively.
Now by 1933, hosts of financial institutions had failed, real
GDP had fallen by over 25%, unemployment was 25% and the
nation had experienced over that four year period some years with
double digit rates of deflation. So the Feds passiveness in 1929
to '33 was associated with an economic catastrophe,
and many scholars, including Milton Friedman and chairman
Ben Bernanke have argued that much of this association should
in fact be viewed as causal. Now my version of "It's a
Wonderful Life" may strike some as incomplete because it's
starts in 2007. And those listeners might be
asking to themselves, was the land depreciation in the United
States in the early 2000s due to the Fed's low interest rate
policy. If so, we're going to have to
recast the Fed as being more akin to the unfortunate Uncle
Billy than to George. But my answer to this question
is no. And I think the problem for this
story is that land prices actually started to grow at a
surprisingly fast rate when the Fed was following a relatively
tight policy. To be concrete, from 1975 to
1996 land prices grew in real terms at less than 2% per year.
So if you go from '75 to '96 over that 21 year period, land
prices are growing less than 2% a year.
Than from '96 to 2001 land prices grow by 11% per year
in real terms. While the Fed maintained its
target interest rate between 4.75% and 6.5%.
This is hardly to be considered, I think, a loose monetary
policy, especially given that the economy was entering a
recession toward the end of this period.
Now it is true that the rate of growth of land prices did
accelerate still further in the next five years from '01 to '06.
But I think that the data clearly say that the fast rate
of growth in US land prices, what's sometimes called a bubble
in land prices, originally started in 1996 without any
obvious change in Fed policy. And I have to say that this lack
of an empirical connection is not surprising to me.
At least at present there's little or no academic theory to
support a connection between monetary policy as typically
conducted in the United States and the formation of bubbles.
But if not the Fed, who or what? Who or what was responsible for
the high price of US residential land in mid-2006?
At this point my views as agnostic on this.
I've heard several plausible stories.
In general, though, I think the stories tend to be overly
focused on the United States in the 2000s.
We saw large run-ups in land prices followed by large falls
in land prices in many other parts of the world in the 2000s.
And these episodes have occurred repeatedly throughout history.
We need to develop macroeconomic models and modes of thought that
can successfully confront this broader scope of economic data.
So let me wrap up. We have come through a very
difficult recession caused in no little part by the large
fall in land prices that took place after 2006.
I believe the size of the shock meant that this recession was
going to be a painful and challenging one regardless of
the policy response. Nonetheless, it is clear to me
that the recession and its subsequent recovery would have
been significantly worse in the abscess of the actions of the
Federal Reserve. Now, and we have a couple
choices at this point, we can wrap up as in the end
of "It's a Wonderful Life." If you remember there everyone
sang together in a rousing chorus of "Auld Lang Syne."
[LAUGHTER] Or we can start
taking questions. Now, every choice confronts you
with daunting tradeoffs in life, but I think those who know me
best will tell you we should move to questions at this point.
Thank you very much. [APPLAUSE]