Narayana Kocherlakota is the head of the Federal Reserve Bank of Minneapolis and is known for an uncommon feat in high-level policy circles: he changed his mind. Originally a monetary policy hawk, Kocherlakota has become a supporter of looser Fed policy. He spoke recently at the Levy Institute’s Minsky conference in New York, and some reports of the speech–at least as rendered by headline writers–may create the impression that Kocherlakota has been reconsidering his conversion.
“Kocherlakota Says Low Fed Rates Create Financial Instability,” one publication announced. In fact, what Kocherlakota said (see the full speech below) was far more nuanced (and to be fair, most of the media reports grasped the key points. I’m told it’s fairly common for reporters not to write their own headlines). He argued that low-rate policy can create phenomena that are commonly taken to be signs of financial instability: “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.”
If low interest rates created financial crises of the sort that tanked the global economy in 2007/2008, this would be a pretty good argument for siding with the hawks. But Kocherlakota’s actual, stated views are perfectly consistent with a zero-interest-rate policy creating only signs of instability. The cost-benefit analysis facing the central banker therefore looks more like this, according to Kocherlakota (his emphasis): “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 which 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.”