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Has Fed policy slowed the recovery? This former Fed official thinks it might have.

University of Rochester

In 2012, Narayana Kocherlakota did something that’s rare for a policymaker of his prominence: He changed his mind. Kocherlakota was the president of the Minneapolis Federal Reserve Bank, which gave him a rotating seat on the powerful Federal Open Market Committee. That’s the committee that decides whether — and to what extent — the Fed should use its control over the money supply to boost the economy.

When Kocherlakota took the helm of the Minneapolis Fed in 2009, the Minneapolis Star Tribune described him as “openly suspicious of government's ability to bolster economic growth.” That view was evident in 2011, when Kocherlakota cast a rare dissenting vote against a stronger Fed effort to boost the economy. He argued that the Fed’s dovish policies could create too much inflation.

But the inflation Kocherlakota feared never came, and a year later Kocherlakota’s thinking had changed dramatically. In September 2012, he began calling for the Fed to do more to boost the economy. In 2014, he dissented three times from Fed decisions, each time calling for the Fed to be bolder about growth and less worried about inflation.

Kocherlakota’s term at the Minneapolis Fed ended earlier this year. He now teaches economics at the University of Rochester and writes a column for Bloomberg. But he has continued to argue that the Fed is too cautious.

If he’s right, it could be a really big deal. The current recovery has been the slowest in decades; the economy has fallen trillions of dollars short of its pre-2007 trajectory. Kocherlakota believes inadequate monetary policy is partly to blame for this shortfall.

And his view is becoming increasingly mainstream. Indeed, in a speech last week, Fed Chair Janet Yellen suggested that stronger Fed action might be needed to boost the economy’s growth rate. The comments come at a time when the Fed is widely expected to raise interest rates within months. But Yellen’s comments — which echo Kocherlakota’s arguments — suggest that the Fed might want to keep rates low for much longer than that.

Low inflation transformed Kocherlakota from a hawk into a dove

When Kocherlakota took over as the head of the Minneapolis Fed in 2009, he believed there simply wasn’t that much the Fed could do to boost the economy. By 2011, the unemployment rate was still around 8 percent. However, Kocherlakota told me, “I was concerned that a large amount of the unemployment was due to structural forces that would be very difficult for monetary policy to influence.”

For example, workers in areas with high unemployment might find it difficult to move to other cities where jobs were more plentiful. Or it might take time for workers in declining industries to be retrained in industries where demand was rising. If these kinds of factors were responsible for high unemployment rates, Kocherlakota reasoned, pumping more money into the economy wouldn’t boost growth; it would just push up prices.

“The way that would manifest itself is by inflation rising above the committee's 2 percent target,” Kocherlakota said. “That was my concern in 2011.”

But two factors caused him to change his mind. One was that the inflation he and other hawks feared never materialized. Inflation fell in 2012 and has stayed below the Fed’s 2 percent target ever since.

Kocherlakota said he was also influenced by new economic research. In particular, a 2012 paper by economists Edward Lazear and James Spletzer convinced him that structural explanations — like a mismatch between the skills workers have and the skills employers are demanding — couldn’t explain the weakness of the labor market.

“The main conclusion was that the unemployment that was in place in 2011 and 2012 was largely attributable to non-structural influences that could be amenable to monetary policy,” Kocherlakota said. In other words, he became convinced that if the Fed pumped more money into the economy, we’d get lower unemployment and higher growth instead of just more inflation.

The conventional view says that central banks can’t do very much

Federal Reserve Begins Its Final Meeting Of The Year Photo by Win McNamee/Getty Images

In 2012, Kocherlakota’s newfound belief in the power of monetary policy to boost growth ran counter to economic orthodoxy. The conventional view held that monetary policy has the biggest effects for 12 to 18 months after a major shock like the 2008 financial crisis. After that, further efforts to boost the economy would simply produce more inflation.

This conventional view focused on the role of wage and price changes in smoothing out economic fluctuations. For example, if an industry is in decline, a fall in workers’ wages may be necessary to avoid the need for layoffs. The Fed can help this adjustment process along by boosting the inflation rate (or preventing a burst of deflation). That allows workers’ real (inflation-adjusted) wages to fall without the need for morale-destroying reductions in workers’ nominal wages.

“There's been a ton of work done in economics on trying to measure how quickly prices change. And most of the work has found that prices change pretty rapidly,” Kocherlakota told me. This means that unless the Fed totally screws up, this adjustment process should be complete within 18 months of a major downturn.

If that view were true, then it would have been pointless for the Fed to try to boost the economy in 2011, because by that point — more than two years after the 2008 financial crisis — the market’s natural adjustment process would have already run its course.

But Kocherlakota now believes this view is mistaken. He believes that especially in the current environment of low interest rates and low inflation, what really matters is the Fed’s ability to affect the market’s expectations about future growth rates.

This is because businesses take future economic conditions into account when they make today’s investment decisions. “If they see better demand conditions in the future, they're more likely to implement ideas and to engage in innovation, and we'd have faster productivity growth as a result of that,” he argued. This means that if the Fed can make a credible promise to boost growth in the next few years, it can result in a self-fulfilling prophesy where businesses invest more today.

In Kocherlakota’s view, easier money wouldn’t just help reverse the decade-long decline in Americans’ workforce participation rate. He argues that stronger monetary policy could actually increase workers’ productivity by giving companies the confidence they need to make long-term investments in technologies that boost worker productivity.

Instead, the Fed has talked incessantly about raising interest rates, a signal that it’s preparing to withdraw support from the economic recovery.

“There is a growing lack of confidence in central banks' ability or willingness to offset persistent downside shocks,” according to Kocherlakota. “That makes people less willing to spend [and] less willing to invest if you're a business owner, and that creates downward pressure on interest rates. People feel that both fiscal authorities and monetary authorities seem to lack the will or the ability to offset shocks, and that's going to make them very guarded about spending.”

Kocherlakota’s view is becoming more mainstream

Fed Reserve Chairwoman Janet Yellen Testifies To House Committee On The Regulation Of Financial System
Fed Chair Janet Yellen.
Photo by Alex Wong/Getty Images

When Kocherlakota first articulated these views in 2012, they were far outside the mainstream of economic thinking. Most people — including Kocherlakota himself just a year earlier — believed that the Fed had done plenty to support the economic recovery and that the slow growth of the post-2009 period was due to other factors.

But as the slow recovery has continued year after year, his views have started to seem more plausible. In a speech last week, the nation’s top monetary policymaker, Fed Chair Janet Yellen, floated some ideas that sound a lot like the ones Kocherlakota has been championing over the past four years.

Yellen suggested that insufficient spending as a result of weak monetary policy could have negative long-term effects on the economy’s productive capacity — for example, by causing discouraged workers to drop out of the labor force. She then asked whether these effects could be reversed by “temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market.”

“One can certainly identify plausible ways in which this might occur,” Yellen said. “Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects.”

Meanwhile, she said, “a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more efficient — and, hence, more productive — job matches.” It could also boost productivity by “prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.”

In short, the Fed might still have a lot of room to boost the economy.

Yellen made clear that she isn’t endorsing these arguments — yet. She said more research was needed, and emphasized that keeping money loose for too long could have significant downsides. Still, her speech makes it clear that these ideas are becoming increasingly mainstream, and Kocherlakota deserves a lot of credit for that shift.

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