Wisconsin Public Television University Place Wisconsin Bankers Association  "Wisconsin Economic Forecast 2011: Narayana Kocherlakota"  January 11, 2011 UP539   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]