Narayana Kocherlakota Speaks

I like Minneapolis Fed Chair Narayana Kocherlakota. He used to be one of the "hawks" on the FOMC, but recently did a "180" and now primarily argues that monetary policy has been too tight. A public official changing their mind in response to evidence showing that they were initially wrong is the correct thing to do, but it doesn't happen very often. I saw him speak last year, and thought his comments reflected clear thinking.

He commented today on the relationship between monetary policy and financial stability. A topic I have written about before. What he says makes me a little nervous about the possibility of fed tightening, but I think his analysis is correct:

One challenge with this kind of policy environment—and this is closely linked to the overarching theme of this panel—is that low real interest rates are often associated with financial market phenomena that signify instability. There are many examples of such phenomena, but let me focus on a particularly important one: increased asset price volatility. When the real interest rate is unusually low, investors don’t discount the future by as much. Hence, an asset’s price becomes sensitive to information about dividends or risk premiums in what might usually have seemed like the distant future. These new sources of relevant information can lead to increased volatility, in the form of unusually large upward or downward movements in asset prices.

These kinds of financial market phenomena could pose macroeconomic risks. These potentialities are best addressed, I believe, by using effective supervision and regulation of the financial sector. It is possible, though, that these tools may fail to mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy. However, it should only do so if the certain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis. Hence, the FOMC’s decision about how to react to signs of financial instability—now and in the years to come—will necessarily depend on a delicate probabilistic cost-benefit calculation.

As he notes, monetary tightening will certainly make things worse right away, and it should only be considered if we have exhausted all other better options, and we think the probability of a much worse financial crisis is so large that we need to just take our lumps now.

I'm skeptical that we should ever use monetary policy in this way, and believe that an aggressive macro-prudential response should be sufficient, in almost any circumstance, to alleviate this risk.