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Last updated: January 8, 2010 8:43 am
Tom Hoenig, president of the Kansas City Fed, on Thursday warned against keeping rates too low for too long.
“Experience both in the US and internationally tells us that maintaining large amounts of stimulus over an extended period risks creating conditions that lead to financial excess, economic volatility and even higher unemployment at some point in the future,” he said. Mr Hoenig rejected Mr Bernanke’s argument that the Fed decision to keep rates low after the dotcom crash did not contribute meaningfully to the housing and credit bubble. “Low interest rates contributed to excesses,” he said.
Arguing that economic data are always mixed during the early stages of a recovery, he called on the Fed to “more evenly weigh our short-run concerns against the longer run costs”.
Separately, the Financial Times can reveal that the optimal interest rate in the US has moved above zero, according to a rule of thumb for monetary policy cited by Federal Reserve chairman Ben Bernanke last weekend. The rule of thumb is a version of the so-called Taylor rule, which relates interest rates to unemployment and inflation. It was shown on a chart included in Mr Bernanke’s presentation to the American Economic Association, in which he defended the Fed’s decision to keep rates low after the dotcom bust.
The chart suggested the optimal rate moved above zero around the middle of 2009. On the same basis, the optimal rate is almost certainly above zero today – even though the Fed has kept US rates steady at zero to 0.25 per cent.
The fact that this rule of thumb suggests rates should be above zero highlights the turnround in the situation confronting the Fed since early 2009. At that time, a similar Fed staff analysis suggested the optimal interest rate was minus 5 per cent. The difference reflects the impact of the Fed’s gigantic asset purchase programme and other factors that boosted the outlook for the economy, unemployment and inflation.
The finding is notable because the version cited by Mr Bernanke is forward-looking, uses the Fed’s own forecasts and uses the central bank’s preferred measure of inflation, the personal consumption expenditure deflator. In his speech, Mr Bernanke said such a version was “a more useful benchmark” and “guide to appropriate policy” than the versions of the Taylor rule that used current unemployment and consumer price inflation.
The recommendation of a single rule of thumb does not mean that rate increases are imminent. Fed policy is based on judgment and puts weight on risks as well as the possibility that the neutral interest rate that neither stimulates nor slows the economy can change over time.
The Federal Open Market Committee reiterated in December that it expected to keep rates at “exceptionally low” levels for an “extended period” – commonly interpreted as at least six months. But the rule of thumb suggestion that the optimal rate has risen above zero does underscore the fact that it is no longer unambiguously clear that rates should stay near zero for a very long time.
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