Fed’s twin targets—are negative real interest rates needed?

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Kocherlakota—real rates must be kept low over the next five years (Part 2 of 5)

(Continued from Part 1)

Dr. Narayan Kocherlakota discusses mandate-consistent rates for the U.S. economy

Minneapolis Fed president and chief executive officer (or CEO), Dr. Narayana Kocherlakota, spoke on the subject of low real interest rates at the Ninth Annual Finance Conference, held at Boston College in Boston, Massachusetts on June 5, 2014. Real rates of interest are the reported rates of interest, net of inflation.

In his speech, Dr. Kocherlakota mentioned that real rates of interest, as measured by Treasury Inflation Protected Securities (or TIPS) yields, had fallen sharply below 2007 levels, and five-year TIPS yields were currently in negative territory. In this section, we’ll discuss why Dr. Kocherlakota believes the “mandate consistent path of real interest rates” has fallen since 2007.

Factors affecting the demand for and supply of safe assets

Dr. Kocherlakota believes that the decline in the values of real interest rates are primarily due to the “increase in the demand for and a fall in the supply of, safe financial investment vehicles.” According to Dr. Kocherlakota, this trend will likely persist for some time. He identifies three major factors to account for this trend—an increase in lending standards or tighter credit conditions, increased perceptions of macroeconomic risks, and increased uncertainty with regards to the government’s fiscal policies.

Tighter credit standards have meant that households must save more in order to acquire more assets (for example—higher down payments required for acquiring mortgages on homes). Also, due to the financial crisis and Great Recession, the perceptions of risk conditions for both households and businesses have increased. This is largely due to the depressed labor markets and the prospect of declining wages for workers. Businesses are also affected by macroeconomic risks (for example—the prospect of reduced demand for their products). These risks have induced both businesses and households to save more and invest in safer assets as a way to “self-insure” against these risks.

The Federal budget deficit (the difference between budget collections and the government’s commitments) has also been a key source of uncertainty to both businesses and households. According to Dr. Kocherlakota, “The possibility of higher future taxes on corporate profits gives businesses an incentive to demand safe short-term financial assets as opposed to engaging in long-term investments. The prospect of reductions in Medicare, Medicaid, or Social Security gives some households an incentive to demand more safe assets as a way of replacing those lost potential benefits.”

Along with rising demand, the worldwide supply of assets that are thought to be safe, has fallen. Dr. Kocherlakota cites the examples of U.S. residential real estate and European sovereign debt that isn’t considered “safe” anymore due to the fall in their asset values.

Dr. Kocherlakota’s take on why the real rate of interest isn’t low enough

The accumulation of safer assets by households and businesses in a reduced asset supply environment, implies a decline in spending and investments for any given level of real interest rates. Reduced spending levels in turn affect the demand for goods and services in the economy, which affects business profits, job creation, and price levels.

“Faced with these changes, the Committee can only achieve its macroeconomic objectives by taking actions to push down the real interest rate. Indeed, as I argued earlier, the subdued outlook for prices and employment suggests that the FOMC’s actions have not lowered the real interest rate sufficiently,” said Dr. Kocherlakota.

Why the Fed would keep real interest rates low for “many years to come”

He also maintained that “credit market access” or lending standards were likely to remain tight compared to 2007, maybe for the next five years or so, as households and businesses would be wary of the “risk of a large adverse shock.”

Increased uncertainty about the federal government’s future actions regarding benefits for households and corporate tax rates for businesses would continue to fuel demand for safer assets. Also, the current inflation rate at 1.6% was below the Fed’s long-term 2% target. Dr. Kocherlakota expected it to “remain below the FOMC’s inflation target of 2% for several years.”

As a result, the Fed would be forced to keep low real rates of interest for many years to come, so that the Federal Open Market Committee (or FOMC) could meet its Congress-mandated goals. He said that this was also consistent with the Fed’s April FOMC statement, which mentioned that the base rate would likely stay low for a considerable period after employment and inflation were near mandate-consistent levels.

In the next section, we’ll discuss the consequences of low real rates of interest and their impact on both bond (AGG) and stock (VOO) markets and ETFs like the iShares 7–10 Year Treasury Bond ETF (IEF) and the Vanguard Intermediate-Term Government Bond Index Fund (VGIT) as well as companies like Sprint (S). Please continue reading the next section of this series.

Continue to Part 3

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