Regional President Speech

Disclaimer The views expressed in this talk are my own. • They may not be shared by others in the Federal Reserve System ... • Especially my colleagues on the Federal Open Market Committee (FOMC). • Acknowledgements I thank Ron Feldman, Terry Fitzgerald, Samuel Schulhofer-Wohl and Kei-Mu Yi for comments. Long-Run Monetary Policy Stance in the US FOMC prediction range for long-run fed funds rate: between 3.25% and • 4.25% — My prediction is the lowest: 3.25%. — Note: 10 year-10 year forward Treasury yield is around 3.25%. Also: FOMC expects US to reach maximum employment and target infla- • tion BEFORE fed funds rate rises back to long run level. I expect low interest rate policy for several (maybe many) years. Monetary Policy and Financial Stability Given expected future monetary policy stance, policymakers will need to • be aware that: Low interest rate policy could create risk of financial instability. My view: It is preferable to mitigate such risks using supervisory tools. • But in reality: Supervision may leave residual systemic risk. • How should this residual risk affect monetary policy? This Talk A framework to incorporate systemic risk mitigation into monetary poli- • cymaking. Main theme: Systemic risk creates a mean-variance trade-off for policy. • A MEAN-VARIANCE FRAMEWORK Simple Model Monetary policymaker (MP)’s goal is to set a gap  equal to zero. • — For example:  could equal inflation minus target Note well:  is determined by MP’s macroeconomic goals. • MP can increase  by raising accommodation  • After MP chooses ,  is also affected by a number of shocks, including • shocks to the financial system. The Central Banker’s Problem 2 MP’s loss is given by the square of the gap (that is,  ) • Recall:  depends on shocks realized after  is chosen. • MP chooses  so as to minimize the mean loss associated with : • 2 ( ) | Usual Approach Mean loss equals squared mean gap + variance of gap: • 2 [( )] +  ( ) | | Typical assumption: MP can’t influence variance of shocks. • Then, minimizing expected loss is same as minimizing squared mean gap: • 2 [( )] | Solution is to choose accommodation  that eliminates mean gap: ∗ • (  ) = 0 ∗ | Incorporating Financial Stability Risks Suppose higher  increases the risk of financial instability that lowers  • — Note: This supposition will be true only in some circumstances. Then, higher  increases  ( ) • | MP’s problem is to choose  so as to minimize: • 2 [( )] +  ( ) | | Now: MP’s choice of  trades off mean versus variance. • Mean-Variance Trade-Off Trade-off means that MP’s appropriate choice  will result in: ∗∗ • (  )  0 ∗∗ | That is, on average, the gap is negative under appropriate policy. • MP gives up some mean  in order to get less risk in . • But exactly how much mean  should MP give up? • Comparing Two Monetary Policy Alternatives It is appropriate for MP to choose  over  if  reduces risk sufficiently ∗ • relative to  : ∗ 2  (  )  ( )  ( ) ∗ | − | | Central banks know a lot about assessing the RHS — that is, the mean of •  given choice  Key question is about the LHS: • How do we assess the difference in the risk implied by policy choices? A Possibly Helpful Simplification Suppose that a crisis causes the gap  to fall by ∆ • Suppose that monetary accommodation  implies that the probability of • a crisis is () Then (assuming statistical independence of the crisis from other shocks): • 2  (  )  ( ) [( ) ()]∆ ∗ ∗ | − | ≈ − Then: Given any policy choice  or  , we need to assess: ∗ • The implied probability of a crisis and its impact ∆ on  CONCLUSIONS Financial Stability Framework: What We Need To Know Mean-variance framework implies that policymakers need to assess: •  ( )  (  ) 0 | − | Possibly could simplify this problem to gauging: • 2 [() ( )]∆ 0 − Progress Has Been Made ... Key measurement question: what is the probability of a crisis, given cur- • rent policy? Federal Reserve System has made good progress on this question. • — Intense scrutiny of financial system risks/vulnerabilities My own current assessment is that in the US: • Crisis probability is too small to affect monetary policy choices materially. ... But More Has to Be Done Needed: Better models/measures of impact of monetary policy on crisis • probability. — That is, better models/measures of () Needed: better models/measures of crisis impact on macroeconomy. • — That is, better models/measures of ∆.

Narayana Kocherlakota (2014, November 6). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20141107_narayana_kocherlakota

@misc{wtfs_regional_speeche_20141107_narayana_kocherlakota,
  author = {Narayana Kocherlakota},
  title = {Regional President Speech},
  year = {2014},
  month = {Nov},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20141107_narayana_kocherlakota},
  note = {Retrieved via When the Fed Speaks corpus}
}