cc
is Narayana Kocherlakota... ...the monetary policy of the
United States and influences the
large part of what you pay world economy, determines a
So we want to welcome today Dr. Narayana Kocherlakota.
He became the president of the
Minneapolis in the fall of 2009. Federal Reserve Bank of
was a professor of economics at Prthe University of Minnesota.a
We won't even talk about the
beat and Minnesota and all that. game that the Badgers won and
Minnesota allegiances against We won't hohim.ny of those
A native of Baltimore,
undergraduate degree in mathematics from a couple of
little schools called Princeton and his PhD in economics from
the University of Chicago.
Dr. Kocherlakota. So p[APPLAUSE]ome
Narayana Kocherlakota: Thanks very much for the introduction,
and thanks to the Wisconsin Bankers Association
for the invitation to join you
I've visited Madison several here today.
always enjoyed the experience. times over the years and I've
Madison and the Twin Cities are And Ipretty similar. that
They're state capitols. Beautiful water views.
Great universities. Of course at that level
I pretty much could be
[LAUGHTER] describing Venice, Italy.
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
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
if he had never existed. lives would have been affected
Federal Reserve. I will do the same for the
the great recession of 2007-2009 I will describe how I believe
if the Fed did not exist. As always, I'm speaking for
myself today and not others in
So let me begin with my outlook. the Federal Reserve system.
focus on the three variables And in my outlook I'm going to
at the Federal Open Market that are of most interest to us
real gross domestic product, Committee, that is the FOMC:
inflation. real GDP, unemployment and
that from a point of view of the My bottom line is going to be
better year than 2010 was. macro-economy, 2011 will be a
Well in the first three quarters So what did happen in 2010?
averaged 2.7% at an annualized of 2010, real GDP growth
Now we don't have the fourth rate.
fourth quarter just ended, but I quarter numbers in yet, the
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
If that prediction ends up being to the fourth quarter of 2010.
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
from November 2007 through States has grown about 2.6%
So over that three-year period November 2010.
US; it's grown by about 2.6%. tSo if you take real GDP ande
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
the United States growing at think of real GDP per person in
Suppose that real GDP per person roughly 2% per person per year.
past three years. hThen real GDP would be in fact
8.6% higher in the
then it actually is. fourth quarter of 2010
I expect that this 8.6% differential will change
little, if at all, by the end of
The recession has had and will 2011.
persistent impact on the US continue teconomy. large and
Now at the November 2010 FOMC meetings, the participants all
submitted forecasts for real GDP
And these forecasts are available online at the Board of
Governors website.
forecasts, so when we say central tendency what they do is
they drop the lowest three and
keep the middle 12 of them. If you take the central
tendency, that ranges between,
between 3% and 3.6% for refor the year 2011.anges
Now these forecasts were made,
tax changes for 2011 that ended up being instituted in December.
Nonetheless, even with the
policy, I would say that I December changes in fiscal
probably be closer to 3% than 4% expect that real GDP growth will
I still see two major headwinds in the United States economy.
The first is that many
strive to rebuild their net worth positions in response to
past and possibly future falls
As I would explain in more in residential land prices.
decline in household net worth detail later, I believe that the
values was a key factor in precipitated by falls in land
recession, and it will remain geimportant in the recovery.he
So the second headwind is related.
Many banks in the United States face ongoing issues with asset
quality.
FDIC problem bank list still Just to set one example, the
Problem banks are less likely to contains over 800 banks.
small and/or younger firms and take the risk of lending to
Instead they are more likely to othpreserve capital ratios byy.
limiting their asset growth and allocating their lending staff
to working out loans to existing
Instead, as the economy improves, I expect this headwind
will become more severe, that it
should say. In 2010, our information at the
Minneapolis Fed indicates that
to expand because of ongoing small businesses were reluctant
demand. As a result, their demand for
bank financing remain low.
improves, I expect loan demand In 2011, as the economy
with poor asset quality will to rise accordingly, but banks
preservation rather than loan continue expansion.n capital
Let me move from real GDP to
Employment data released last Friday indicated that the
unemployment rate fell to 9.4% in December
from 9.8% in November.
welcome news, I do not think But any decline is of course
signals a rapid recovery in that thlabor markets. point
Employment growth remains disappointingly low.
Nonfarm employment increased by only 103,000 in November.
Now I want to go through and
it's important to understand how talk about this because I think
points from November to December unemployment fell by 40 basis
was relatively low. And here I think it's helpful to
recall how the Census Bureau
unemployment. So everybody month the Censuss
Bureau interviews 60,000
roughly 110,000 individuals. households that consist of
questions. The bureau asks a host of
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
Those who have looked for work employed.
counted as the unemployed. in the past four weeks are
is what's called the labor And the sum of those two groups
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
people getting jobs, becoming to fall wemployed.nemployed
Alternatively, though, it can also fall by unemployed people
ceasing to look for work. And this second channel was
significant in shaping the
In that one month the labor force fell by 260,000, which is
a large move by historical
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
The number of people under the entirely.
fell by about 244,000 from age of 25 in the labor force
So much of that 260,000 is November to December.
My hope and expectation is that many of these younger people
will return to the labor force
Nonetheless, I do not believe as that either employment or011.
unemployment will improve rapidly in 2011.
Startup businesses and other
employment growth in the early young firms are a key source of
And as I've mentioned earlier, stages of recoveries.
financing more challenging to they'obtain than usual.bank
As well, 4.2% of the labor force
than six months. has been unemployed for longer
workers who have been unemployed And historically this group of
low job finding rate. fThe central tendency of thely
November FOMC forecast is that
9% throughout 2011. uAnd I would agree with thosee
forecasts.
too, that unemployment is likely Even more troublingly, I expect,
the end of 2012. to be higher than 8% as late as
and I've talked about unemployment, now let me turn to
inflation.
extraordinarily low. Inflation remains
overall PCE inflation, so this In the third quarter of 2010,
expenditure inflation, this including all goods, not getting
rid of food or energy or
all goods was 0.8%. aCore PCE inflation, when weg
strip away food and energy, was 50 basis points, 0.5%.
PCE food inflation was 26 basis points.
And all of these figures are
So this is an annual rate this annualized.
have. And these inflation levels are
too low to be consistent with usual formulations of the Fed's
price stability mandate.
continued to trend downward in More troublingly, inflation
So in the third quarter of 2009, 2010.
was 1.5%. Hence in the course of a year,
the quarterly inflation rate
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
by the end of 2011 inflation forecasting model predicts that
Now that's just our forecasting model, but we can get another
reading by looking at the prices
zero-coupon inflation-indexed of financial swaps.ments called
And their current prices imply
expected inflation is roughly that for 1.7%.oming year
So in that 1.5% to 2% range.
expect that real output will So to summarize my outlook, I
2011 than in 2010. grow slightly more rapidly in
asset quality will remain a drag Household de-leveraging and bank
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
So let me turn now to the second re-inflation in the coming year.
which is roughly titled "It's a Wonderful Fed,"
to mimic
[LAUGHTER] "It's a Wonderful Life."
Economic Research's Business So the National Bureau of
official arbiter of recessions. DThe committee has determinede
that the great recession began
June 2009. in December 2007 and ended in
by 4% and unemployment nearly During that doubled.al GDP fell
The Federal Reserve responded to
associated financial crisis in a the great recession and the
But I think these responses can be roughly grouped into two
classes.
amount of lending to firms First, the Fed engaged in a vast
condition. believed to be in sound
vehicles like a discount window and swaps with foreign central
banks, but it also lent through relatively unconventional
vehicles like the Term
Facility. And I'll talk about this lending
to solvent institutions, and
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
interest rate facing borrowers is the Fed lowered the real
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
inflation to be around 2%, then lothe real interest rate isct
roughly 3%. And generally economists think
it's the real interest rate that
making and not the nominal matters for economic decision
So early in the recession the Fed lowered its target for the
Fed funds rate. That's a nominal rate.
But given that inflation
action served to lower the real expectatiinterest rate.ble, this
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
And then I'll discuss how I believe, I should say, economic
events would have unfolded had
So I'll talk first about the there been no Fed at all.
So to talk about the Fed's lending.
to step back into the second responses in 2007-2009, we need
Now at that point in time, firms half of 2006.
a wide array of financial assets and people around the world held
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.
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
People were beginning to learn face of incoming data.
land was, in fact, a risky the hard way that United States
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
Now what do I mean by the term financial panic.
Now I'm going to do, of course financial panic?
You take a term like financial only an economist can do this.
two new terms that are actually pavery vague and pretty poorlyng
defined.
But let me work through this. So what do I mean by the term
financial panic?
that blur the line between So financial panics are events
So those are the two new terms. lSo does solvency mean?
A firm is solvent if its
present value sense, exceed its revenuexpenditures.ounted
A firm is liquid if it is able
borrowing or by selling assets, to to pay its current costs.r by
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.
financial panic lenders feel But in contrast, during a
and/or collateral for borrowers. unable to assess future profits
highly constrained. And even highly solvent firmss
may become illiquid.
forms of collateral around the Now during the mid-2000s, many
explicitly backed by United worlStates residential land. or
As I've described, beginning in mid-2007 it became clear that
this asset had more risk than financial markets had originally
appreciated.
much more risk was involved. It was not clear, though, how
became increasingly uncertain Aabout how to evaluate assetss
backed by US land.
uncertainty about the ultimate That uncertainty translated into
holding those assets and the solvency of the institutions
those institutions creditors or ultheir creditors or theirf
creditors and so on.
between treasury returns and Spreads in credit markets
widen, at first slightly and other bond returns began to
Now I would say that most economists agree about how
central banks should respond to financial panics.
And the crux of that agreed upon
have to be willing to lend response is that central banks
a wide range of good collateral fat some kind of penalty rate.t
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.
more subtly, it provides a floor But second, and maybe a little
Private lenders now know that they can always use collateral
seized from a defaulting
money from the central bank. borrower as a vehicle to borrow
collateral helps serve to spur So that baseline use for
So this is the basic operating private lending as well.
solvent firms against a wide principal, lend freely to
kind of penalty rate. rAnd beginning in mid-2007 theme
Fed took a number of actions
operating principal. that were consistent with this
institutions through the It lent money to financial
cousin the Term Auction discount wFacility. its close
It injected liquidity into a
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.
interventions were all typical But in some sense these
operating in the context of a onesfinancial panic.ank
What was unusual was the size of
It meant that the operations the problem.
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
financial crisis. And over time, panic eased and
spreads in financial markets
Once that happened, the private sector stopped borrowing from
the Fed because it found the
As a result, the Fed was able to Fed's penalty rates too onerous.
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
by the spread between its yield mand that of a safe bench markis
like US treasuries. But in a financial panic, the
whole point is a relatively large fraction of that spread is
attributable to illiquidity as
And the goal of the central banks intervention is exactly to
eliminate that panic driven illiquidity.
So we can't really gauge the
somehow correcting spreads Fed's risk exposure without
And this calculation strikes me for as a nontrivial one.tor.
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
differs greatly from the lending that I've described,
that the Federal Reserve institution specific assistance
These institution specific provided to firms like AIG.
necessary by the Federal Reserve interventions were deemed
because of deficiencies in the and the Bush Administration
systemically important financial existing resolution regime for
And the Dodd-Frank Act addresses institutions.
And simultaneously and those deficiencies.
Dodd-Frank Act removes the Fed's correctly, in my view, the
specific assistance. ability to engage in institution
though, the Fed's ability to The act does leave in place,
interventions of the kind that engage in broad-based market
detail, albeit with more I've been talking about in some
oversight. congressional and White House
I want to talk now about cutting So that's the lending responses.
So I've talked about how the interest rates.
sharp increase in risk fall in land prices generate a
and how that led to the perceptfinancial crisis. markets
But there was another key effect
It reduced the net worth of many of the fall on land prices.
And they respond to that fall of households and firms.
consumption and investment net worth by foregoing
A fall in household demand for projects.
investment led in turn to a fall consumption and firm demand for
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
And that's been there ever 2008.
Since inflation expectations since.
period, the FOMC's action has the effect of lowering the real
interest rate facing households.
less and demanding more Householconsumption.y saving
Similarly, firms undertake more investment projects.
In this way, by lowering the
partially, and I underscore partially, offset the impact onn
the economy of the loss of net
Now, lowering rates, of course, may lead to undesirable
inflationary pressures within the economy.
But the recent path of inflation
pressures. shows little evidence of such
that already. But on a year over year basis,
core PCE inflation was running
of 2007, and it's now down about 2.5% in the fourth quarter
In fact, given the ongoing to about 1%.
mentioned and the high rate of deceleration inflation that I've
probably have liked to respond unemployment, the FOMC would
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
again beginning in November 2010, the FOMC engaged in large
scale purchases of long-term
The goal of these transactions treasuries.
rates. is to lower long-term real
the economy of the net worth And again offset the impact on
So this is how I think about the shock.
land prices triggered an recession is that the fall in
a decrease in household net increase in rworth.rceptions and
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.
a major recession and ongoing Tslow recovery, and the Federalo
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
Suppose that there were no Fed. What would have happened to the
US economy in the past three
So what does this even mean to years?
Well the Federal Reserve's key say suppose there were no Fed?
to adjust the size of what's power is that it has the ability
The monetary base, in turn, has calledto components.base.
The first component is currency.
that we use for transactions. The second component consists of
what's called bank reserves.
talking about, but I'll go This crowd knows what I'm
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.
Fed means an America in which the monetary base is fixed ina
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
level, what would have happened? years at its December 2007
The Federal Reserve funded its So one consequence is immediate.
talked about in some detail by various lending programs that I
reserves. If the monetary base were fixed
in size, the Fed could not have created those lending
initiatives.
financial institutions would As a result, many more solvent
panic. have failed during the financial
the size of the monetary base Mwould have made currency andn
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
That means bond prices would financial assets.
higher. haveSecond, currency in banklds
reserves would have been more valuable relative to consumer
goods.
they're more valuable, one So there's two senses at which
also relative to other goods in relative tthe economy.assets and
That would have meant expected
would have been lower over the inflation and realized inflation
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
So if the Federal Reserve could not have adjusted the monetary
base upward, real GDP would have
unemployment would have been fallen by even more than 4% and
Now, as with any counterfactual, well above 10%.
necessarily conjectural. these ruminations are
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
double digit rates of deflation. four year period some years with
to '33 was associated with an So theconomic catastrophe, 1929
and many scholars, including
Ben Bernanke have argued that much of this association should
in fact be viewed as causal.
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
policy. If so, we're going to have to
recast the Fed as being more
Billy than to George. But my answer to this question
is no.
story is that land prices Aactually started to grow at ais
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
prices are growing less than 2% over that 2a year.period, land
Than from '96 to 2001 land prices grow by 11% per year
in real terms.
target interest rate between While the Fed maintained its
This is hardly to be considered, 4.75% and 6.5%.
policy, especially given that the economy was entering a
recession toward the end of this
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,
in land prices, originally what's sometimes called a bubble
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
conducted in the United States monetary policy as typically
But if not the Fed, who or what? and the formation of bubbles.
the high price of US residential Who or what was responsible for
At this point my views as agnostic on this.
I've heard several plausible
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
in land prices in many other prices followed by large falls
And these episodes have occurred parts of the world in the 2000s.
We need to develop macroeconomic repeatedly throughout history.
can successfully confront this models and modes of thought that
So let me wrap up. broader scope of economic data.
difficult recession caused We have come through a very
fall in land prices that took in no place after 2006.e large
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.
that the recession and its Nonetheless, it is clear to me
been significantly worse in the abscess of the actions of thee
Federal Reserve.
choices at this point, Now, and we have a couple
of "It's a Wonderful Life." If you remember there everyone
sang together in a rousing
[LAUGHTER] chorus of "Auld Lang Syne."
taking questions. Now, every choice confronts you
with daunting tradeoffs in life,
best will tell you we should but I think those who know me
Thank you very much. move to questions at this point.
[APPLAUSE]