As several news outlets reported yesterday, Federal Reserve Bank of Kansas City President Thomas Hoenig yesterday again blasted the zero interest rate policy and "extended period" language of the `Federal Reserve in a speech entitled, "Hard Choices". Hoenig says, "These are trying times for the U.S. economy. The unemployment rate is almost 10 percent, our financial system remains under stress, community bank failures have become weekly news and the central bank is printing money to such an extent that zero interest rates bring little return to those who choose to save. Not in decades has the Federal Reserve seen such challenges in how it conducts monetary policy. With this in mind, this morning I will give you my sense of the issues we face and the hard choices that must be made."
Hoenig's speech first discusses Financial Reform and "Too-Big-to-Fail," but then says, "I want to spend my remaining time on monetary policy.... [A]s much as I want short-term improvement, I am mindful of possible longer-term consequences of zero interest rates and further easing actions. Rather than improve economic outcomes, I worry that the FOMC is inadvertently adding to 'uncertainty' by taking such actions. Remember, high interest rates did not cause the financial crisis or the recession."
He explains, "[W]e are experiencing a better pace of recovery this time than at this point in our previous two economic recoveries.... While we are not where we want to be, the economy is recovering and, barring specific shocks and bad policy, it should continue to grow over the next several quarters. We are recovering from a horrific set of shocks, and it will take time to 'right the ship.' Moreover, the financial and economic shocks we have experienced did not 'just happen.' The financial collapse followed years of too-low interest rates, too-high leverage, and too-lax financial supervision as prescribed by deregulation from both Democratic and Republican administrations. In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-91 and 2001. If we again leave rates too low, too long out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring."
Hoenig tells us, "The real fed funds rate averaged 1.6 percent between 1991 and 1995, 0.37 percent between 2001 and 2005 and -1.0 percent from 2008 to the present, hardly a tight policy environment.... In my view, maintaining an accommodative monetary policy is necessary at this time, but a clear policy path toward a less highly accommodative policy will encourage a more sustained recovery. Under such a policy, financial deleveraging will evolve slowly and many of the remaining economic imbalances will rebalance. Under such a policy, the economy will expand at a sustainable moderate pace with similar moderate job growth, but job growth that will be stable and resilient. There may be ways to accelerate GDP growth, but in my view, highly expansionary monetary policy is not a good option."
He says, "To be clear, I am not advocating a tight monetary policy. I am advocating a policy that remains accommodative but slowly firms as the economy itself expands and moves toward more balance. I advocate dropping the 'extended period' language from the FOMC's statement and removing its guarantee of low rates. This tells the market that it must again accept risks and lend if it wishes to earn a return. The FOMC would announce that its policy rate will move to 1 percent by a certain date, subject to current conditions. At 1 percent, the FOMC would pause to give the economy time to adjust and to gain confidence that the recovery remains on a reasonable growth path. At the appropriate time, rates would be moved further up toward 2 percent, after which the nominal fed funds rate will depend on how well the economy is doing."
Hoenig's speech continues, "I believe the economy has the wherewithal to recover. However, if, in an attempt to add further fuel to the recovery, a zero interest rate is continued, it is as likely to be a negative as a positive in that it brings its own unintended consequences and uncertainty. A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty."
He also says, "Of course the market wants zero rates to continue indefinitely: They are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.... The summer of 2010 has seemed strikingly familiar to me. I recently went back and looked at news reports for the spring and summer of 2003, just prior to when the FOMC lowered the fed funds rate to 1 percent, where it remained until 2004.... With the low rates very low for a considerable period, credit began to expand significantly and set the stage for one of the worst economic crisis since the great depression. In my view, it was a very expensive insurance premium.... That's why I believe that zero rates during a period of modest growth are a dangerous gamble."
Finally, he closes, "[T]he recent financial crisis and recession was not caused by high interest rates but by low rates that contributed to excessive debt and leverage among consumers, businesses and government. We need to get off of the emergency rate of zero, move rates up slowly and deliberately. This will align more closely with the economy's slow, deliberate recovery so that policy does not lag the recovery. Monetary policy is a useful tool, but it cannot solve every problem faced by the United States today. In trying to use policy as a cure-all, we will repeat the cycle of severe recession and unemployment in a few short years by keeping rates too low for too long. I wish free money was really free and that there was a painless way to move from severe recession and high leverage to robust and sustainable economic growth, but there is no short cut."
