Instability is stability. Got that?
Good, because it will be key to understanding the future of financial markets if Narayana Kocherlakota is right.
The Winnipeg-raised president of the Federal Reserve Bank of Minneapolis says that the U.S. Federal Reserve will have to maintain unusually low interest rates for the next five years to keep prices stable and encourage employment.
Of course, Mr. Kocherlakota acknowledges, low interest rates breed jitters in stock and bond markets. As a result, "for many years to come, the [Federal Reserve] will only be able to achieve its congressionally mandated objectives by following policies that may result in signs of financial market instability," he writes.
If that strikes you as verging on Orwellian double-speak, join the club. But it's not the only intriguing thing Mr. Kocherlakota had to say in a speech delivered at Boston College on Thursday.
For instance, he argued against the notion that central banks are forcing low interest rates on the world. It's mostly the other way around, he said – the world's growing demand for safe assets leaves central banks with little choice but to live with low interest rates.
One factor driving the demand for safe assets is the tighter credit limits that have resulted from the financial crisis, Mr. Kocherlakota said. Before the crisis, someone could buy a house with little or no money down. Today that same person would be asked to put down a substantial down payment. To get that down payment, most people have to save. As they do so, the demand for safe assets shoots up.
The hunger for such assets also reflects a new sensitivity to risk, according to Mr. Kocherlakota. Before 2008, Americans had enjoyed "nearly 25 years of macroeconomic tranquility," and many people saw no particular reason to build up a buffer against calamity. The Great Recession tore apart the complacency and prompted many workers to self-insure against risk by building larger piles of safe assets.
But finding the right piggy bank is getting tougher. "The global supply of assets perceived as safe has … fallen," Mr. Kocherlakota said. Investors no longer regard all forms of European government debt as particularly secure, and, in the wake of the U.S. housing collapse, they're equally skeptical of assets backed up real estate. So the demand for the dwindling supply of safe assets has become even more intense, fuelling a stampede into U.S. Treasuries and other secure savings vehicles.
Since bond yields move in the opposite direction to bond prices, the recent buying binge in U.S. government bonds has resulted in an environment of persistently low yields that is likely to endure for many years, with big consequences for financial markets.
One consequence of low interest rates will be higher prices for long-lived assets such as stocks and land. Another will be a wave of corporate mergers. Still another will be unusual volatility in financial markets.
"When the real interest rate is very high, only the near term matters to investors …," Mr. Kocherlakota said. "But when the real interest rate is unusually low, then an asset's price will become correspondingly sensitive to information about dividends or risk premiums in the distant future. This new source of relevant information should be expected to induce more variability into asset prices and returns."
But isn't it part of a central bank's job to quell market volatility? As Mr. Kocherlakota tells it, the Fed has no choice. "These changes in asset markets mean that, at any given level of real interest rates, households and businesses spend less. Their decline in spending pushes down on both prices and employment. As a result, the [Fed] has to lower the real interest rate to obtain its objectives" of stable prices and high employment. And those low interest rates, in turn, cause fragile markets.
So instability is stability. Got it.
Ian McGugan