A week ago we wondered how it was that Pimco's Bill Gross, who is now rumored to be Larry Summers replacement as the QE infinity whisperer on the right side of President Obama, had an advance look into how the Fed will adjust its GDP forecast ahead of the general public. Today, we got the first half of the response: in a speech to the European Economics and Financial Centre in London, Minneapolis Fed president Narayana Kocherlakota has just lowered his GDP forecast from 3% to 2.5%. And most importantly, the Fed President's speech in decidedly QE-negative: our favorite quote on QE from a Fed president so far: "The Fed cannot literally eliminate the exposure of the economy to the
risk of fluctuations in the real interest rate. It can only shift that
risk among people in the economy. So, where did that risk go when the
Fed bought the long-term bond? The answer is to taxpayers." Thank you Fed.
Among the other things Kocherlakota has announced is that:
- the recovery in the US is underway but "distinctly modest"
- inflation will rise to a more desirable 1.5% to 2% in 2011
- unemployment will be above 7% well into 2012.
- Impact of QE will be "muted", and confirms rumors that the hawk-wing in the Fed is not likely to roll over and accept a November QE2 announcement:" My own guess is that
further uses of QE would have a more muted effect on Treasury term
We expect another Fed president to pick up the torch soon, and announce that a re-revised GDP forecast will be 2%, once again confirming that when it comes to matters Fed-related, the Oracle of Newport Beach is second to none.
Full Kocherlakota speech:
Economic Outlook and the Current Tools of Monetary Policy
Narayana Kocherlakota - President
Federal Reserve Bank of Minneapolis
Thanks for the generous introduction. I’m delighted to have this opportunity to speak with you today.
As you just heard, I became president of the Federal Reserve Bank of
Minneapolis last October. Here’s the start of a rather typical
conversation that I would have had with my friends and relatives last
fall. “Congratulations! That’s fantastic. Now, what is it that you will
As it turns out, the job has a lot of interesting aspects. But I think
I’ve been invited to speak here today because I help formulate monetary
policy for the United States. So what I plan to do is give you some
feel for how this part of my job works. In doing so, I’ll highlight the
Federal Reserve’s quintessentially American structure. Unlike the
central banks of other countries, you’ll see that ours is specifically
designed to draw upon the insights of small-town businesses, farmers
and ranchers, and large manufacturers, among others, to formulate
monetary policy. Before I proceed, I must remind you that any views I
express here today are my own, and not necessarily those of others in
the Federal Reserve System.
What do I mean by an American structure? Well, relative to its
counterparts around the world, the U.S. central bank is highly
decentralized. The Federal Reserve Bank of Minneapolis is one of 12
regional Reserve banks that, along with the Board of Governors in
Washington, D.C., make up the Federal Reserve System. Our bank’s
district extends from the Rocky Mountains on the west to the Great
Lakes in the east and borders Canada, an area roughly four times the
size of the U.K. However, the U.K. has about seven times the
Eight times per year, the Federal Open Market Committee—the FOMC—meets
to set the path of short-term interest rates over the next six to seven
weeks. All 12 presidents of the various regional Federal Reserve
banks—including me—and the seven governors of the Federal Reserve Board
contribute to these deliberations. (Actually, in the meeting last
week, there were only four governors. The good news is that the White
House has nominated three excellent candidates for the three
vacancies.) However, the committee itself consists only of the
governors, the president of the Federal Reserve Bank of New York, and a
rotating group of four other presidents (currently Cleveland, St.
Louis, Kansas City, and Boston). I’ll be on the committee in 2011.
In this way, the structure of the FOMC mirrors the federalist structure
of our government. Representatives from different regions of the
country—the various presidents—have input into FOMC deliberations. The
input from the presidents relies critically on information they receive
from their districts about local economic performance. We obtain this
information through the work of our research staffs—but we also obtain
it from people in industries and towns, in my case, across the Upper
Midwest. The Federal Reserve System is deliberately designed so that
the residents of Main Street—and not just Wall Street—are able to have a
voice in monetary policy.
As part of my contributions to recent FOMC meetings, I discussed my
outlook for GDP, inflation, and unemployment. In terms of GDP, I believe
that a modest recovery is under way and is likely to continue. In
terms of inflation, I expect a slight but welcome uptick over the next
18 months. Finally, in terms of unemployment, I see ongoing deep
problems in labor markets.
I’ll talk first about GDP. Real GDP growth has been positive in each of
the past four quarters, and the government’s second estimate is 1.6
percent for the second quarter of this year. We have recently updated
our estimates for future growth from our Minneapolis forecasting model.
Our September estimates are distinctly lower than our August
estimates. I now expect GDP growth to be around 2.4 percent in the
second half of 2010 and around 2.5 percent in 2011. Together over 2010
and 2011, I’m now predicting that GDP will grow around 2.5 percent per
year. In contrast, in my first speech about seven months ago, I
predicted that GDP would grow around 3.0 percent per year over 2010 and
2011. There is a recovery under way in the United States. But it is a
distinctly modest one—and even more modest than I expected at the
beginning of this year.
Let me turn now to inflation. From the fourth quarter of 2009 through
the second quarter of 2010, the change in the PCE price level was just
over 0.5 percent, which works out to an annual rate of just over 1
percent. The Fed’s price stability mandate is generally interpreted as
maintaining an inflation rate of 2 percent, and 1 percent inflation is
often considered to be too low relative to this stricture. I expect
inflation to remain at about this level during the rest of this year.
However, our Minneapolis forecasting model predicts that it will rise
back into the more desirable 1.5-2 percent range in 2011.
So the news about inflation and GDP is in the “OK, but certainly could
be better” category. However, the lack of vitality in the U.S. labor
market can only be termed disturbing. The national unemployment rate
remained at 9.6 percent in August. Private sector job creation remains
weak—only 67,000 net private sector jobs were created in August. I do
not expect the unemployment rate to decline rapidly, and so I expect it
to be above 8.0 percent well into 2012.
If one digs deeper into the data, the situation seems even more
troubling. Since December 2000, the Bureau of Labor Statistics has been
keeping data on the job openings rate, which is defined as the number
of job openings divided by the sum of job openings and employment. It
has also been keeping track of the layoffs/discharges rate, which is
the fraction of employed people who have been laid off or discharged in
a given month. The job openings rate rose by around 30 percent between
July 2009 and July 2010. The layoffs/discharges rate has fallen by
over 10 percent over the same period.
Nonetheless, despite this apparent increase in the demand for labor
from employers, the unemployment rate actually went up slightly from
July 2009 to July 2010, from 9.4 percent to 9.5 percent. And other
measures of labor market performance actually tell an even bleaker
story. From July 2009 to July 2010, the employment/population ratio
fell from 59.3 percent to 58.4 percent. At the same time, the seasonally
adjusted labor force participation rate fell from 65.4 percent to 64.6
percent. This was the biggest July-over-July fall in the 60-plus year
history of that statistic.
To summarize: GDP is growing, but more slowly than I expected or than
we would like. Inflation is a little low, but only temporarily. The
behavior of unemployment is deeply troubling.
With that economic outlook in mind, we can now turn to the choices
facing the FOMC if it were to choose to provide more stimulus.
Currently, the FOMC has set its target range for the fed funds rate at
between 0 and 25 basis points. It has committed to keeping the rate in
that range for “an extended period,” contingent on economic conditions
being appropriate. The FOMC is also maintaining a portfolio of roughly
$2.3 trillion. Over 2 trillion of those dollars are invested in
Treasury securities or government-backed securities issued by Fannie
Mae, Freddie Mac, and other government-sponsored enterprises.
In his address at the Federal Reserve Bank of Kansas City’s annual
policy forum in August, Chairman Bernanke described three possible
tools that are available to the FOMC if it chooses to provide further
stimulus. The first is to buy more long-term securities. The second is
to offer more forward guidance in the FOMC statement. The third is to
reduce the interest on excess reserves (IOER) by 15 or even 25 basis
points. As Chairman Bernanke indicated, using these tools does not come
without costs, and due consideration must be made of both costs and
benefits. Along those lines, I will discuss my thoughts on how these
tools impact the economy. Again, I must underscore that my thoughts are
my own and do not represent the views of anyone else in the Federal
Let me talk first about forward guidance. In part, firms make their
decisions about capital expenditures and hiring by comparing the
returns to those internal projects to the inflation-adjusted yields
available in financial markets for investments of similar horizon. Thus,
the real yields on medium-term and long-term government bonds matter
for firm investment decisions. Those yields are, in part, shaped by
current expectations of future short-term interest rates. The current
FOMC statement shapes those expectations by providing forward guidance
about its future plans for the behavior of the fed funds target.
Right now, the FOMC states that it will keep the fed funds target range
exceptionally low for as long as economic conditions warrant. The
statement also predicts that exceptionally low fed funds rates are
likely to be warranted for an “extended period” of time. In this way,
the statement influences current expectations of future short-term
rates and thereby shapes current medium- and long-term interest rates.
The FOMC could provide stimulus by saying that it predicts that low
rates are likely to be warranted for an even longer period of time than
an “extended period.” This kind of stronger language should lead to a
decline in medium-term and long-term interest rates.
I view lowering the IOER as another form of forward guidance. I think
that it is unlikely that lowering the IOER by 15 or 25 basis points
will have much direct effect on loan markets. However, it is likely that
investors would view this move as a signal that the FOMC is planning
to keep its target rate even lower for an even longer period of time.
In that way, lowering the IOER would serve to lower medium-term and
long-term interest rates.
So, the FOMC can influence the economy through various forms of forward
guidance about how long it plans for the fed funds rate to be so low.
However, the FOMC has another tool at its disposal: what is often
termed quantitative easing—QE for short. Under quantitative easing, the
FOMC buys long-term securities in the open market. In exchange for
those securities, it credits the sellers’ accounts at the Fed with more
reserves. The upshot is that there are fewer long-term securities being
held by private investors, and banks hold more reserves.
Just to be clear on one point: The FOMC is only authorized by Congress
to buy a limited set of securities. Ideas like “the FOMC should buy
corporate bonds” would require a change to the Federal Reserve Act—a
change that I for one would view as undesirable. In meetings earlier
this year, FOMC participants indicated their strong preference to
return to an all-Treasury portfolio. So, I’ll proceed in this speech
under the presumption that any new purchases would take the form of
long-term Treasuries. But, as I’ll discuss, the idea behind QE is that
the yields on those long-term Treasuries will affect yields on all
I see QE as affecting the economy in four main ways. I’ll first discuss
them from a theoretical perspective and then discuss what’s known
about these effects empirically.
The first effect of QE is that it represents another form of forward
guidance about the path of the fed funds rate. It is a way for the FOMC
to signal—in a perhaps more striking way—that it plans to keep the fed
funds rate low for an even longer time to come.
Second, QE creates more reserves in banks’ accounts with the Fed. The
standard intuition is that this kind of reserve creation is
inflationary. Banks can only offer checkable deposits in proportion to
their reserves. Economists view checkable deposits as a form of money
because, like cash, checkable deposits make many transactions easier. In
this sense, bank reserves held with the Fed are licenses for
banks to create a certain amount of money. By giving out more licenses,
the FOMC is allowing banks to create more money. More money chasing the
same amount of goods—voila, inflation.
This basic logic isn’t valid in current circumstances, because reserves
are paying interest equal to comparable market interest rates. Banks
have nearly $1 trillion of excess reserves. This means that they are
not using a lot of their existing licenses to create money. QE gives
them new licenses to create money, but I do not see why they would
suddenly start to use the new ones if they weren’t using the old ones.
With that said, I have indicated in earlier speeches that $1 trillion
of excess reserves does create a potential for high inflation
at some point in the future if the FOMC does not react sufficiently
fast when it starts to see inflationary pressures. But I do not see
this risk as being heightened in any meaningful way by banks holding
even more excess reserves than what they are holding today.
The third effect of QE is the one that is usually stressed: It reduces
the exposure of the private sector to interest rate risk. The holder of
a long-term Treasury is exposed to interest rate risk. If interest
rates rise, the price of the bond falls, and the bondholder is less
wealthy. Now think about an example of QE in which the Fed buys $1
billion of 10-year Treasuries. On the margin, the bond portfolio of the
private sector is now less exposed to interest rate risk. As a
consequence, private investors will demand a lower premium for holding
other bonds that are exposed to interest rate risk. All long-term
yields fall, and so firms should be more willing to undertake long-term
capital expansions or hire permanent employees.
The fourth effect of QE is less widely discussed. The Fed cannot
literally eliminate the exposure of the economy to the risk of
fluctuations in the real interest rate. It can only shift that
risk among people in the economy. So, where did that risk go when the
Fed bought the long-term bond? The answer is to taxpayers.
To see this more clearly, suppose hypothetically that the Treasury
wants to borrow $1 billion today and is choosing between two ways of
doing so. One way is to issue a 20-year, zero coupon, inflation-indexed
bond. The bond requires the Treasury to repay $1.5 billion in real
terms in 20 years (roughly a 2 percent real yield). Under this plan,
taxpayers face no tax risk, but the buyers of the bond can lose a lot
if real interest rates rise greatly. The other way is to issue $1
billion of one-year indexed bonds and then keep rolling over that debt
for 20 years. Now, taxpayers have to repay a lot more than $1.5 billion
in 20 years if short-term real interest rates end up being high.
Basically, if the government uses short-term debt, it exposes taxpayers
to interest rate risk. If it uses long-term government debt, it
exposes the bondholders to interest rate risk. QE is a special case of
this general principle: When the Fed buys long-term government debt from
the private market, it shifts interest rate risk from bondholders to
What is the ultimate impact on the overall economy of this shift in
risk? In the baseline models used by central banks, all bondholders are
taxpayers. In these models, QE is essentially shifting risk from one
pocket to another. As a result, the increase in tax risk (what I’m
calling the fourth effect of QE) completely undoes the decrease in
interest rate risk (the third effect of QE). QE ends up having no
effects, except for those associated with any new forward guidance that
QE will have nontrivial effects over forward guidance in the context of
a more realistic model in which people differ from one another in some
relevant way. Along those lines, we might think that some people are
active participants in the Treasury markets. Others are not. Then, if
the Fed buys long-term Treasuries, it takes risk from the former group
and imposes it on the second group. The ultimate macroeconomic impact
of QE depends on the extent to which the extra tax risk deters economic
activity on the part of this second group. We know little about this
effect, either theoretically or empirically.
To this stage, my discussion of QE has been purely theoretical in
nature. The Fed engaged in QE from January 2009 through March 2010 by
buying over $1.5 trillion worth of agency debt, agency mortgage-backed
securities, and Treasuries. How did this operation—termed the
Large-Scale Asset Purchase, or LSAP program—affect the economy? We don’t
know as much as we would like as yet. However, I think that the best
empirical work on the question of how the LSAP affected long-term
Treasury yields has been done by Gagnon, Raskin, Remache, and Sack
(2010). Their paper is a thorough investigation of this key issue. My
conclusion from their work is that the LSAP reduced the term premium on
10-year Treasury bonds relative to 2-year Treasury bonds by about
40-80 basis points (on an annualized basis). (The term premium is a
measure of the difference in yields that is not explained by the
expected path of short-term interest rates.) This fall in term premia
led to a slightly smaller fall in the term premia of corporate bonds.
These estimates are extremely useful benchmarks. My own guess is that
further uses of QE would have a more muted effect on Treasury term
premia. Financial markets are functioning much better in late 2010 than
they were in early 2009. As a result, the relevant spreads are lower,
and I suspect that it will be somewhat more challenging for the Fed to
I’ve talked about three possible tools—lowering the IOER, strengthening
the forward guidance in the FOMC statement, and quantitative easing.
As I mentioned earlier, Chairman Bernanke observed in his August 27
speech that each of these tools has benefits and drawbacks that must be
balanced against each other. With QE, I would say that the multiple
effects make the calculus even more difficult than usual.
So I’ve talked about a lot of issues today, and I could certainly
talk about a lot more. But I have a feeling that you’ve got plenty of
questions, and we are likely to hit on many key topics. So I will stop
here and happily take your questions.