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Federal Reserve's Low Rate Policy Is A 'Dangerous Gamble,' Says Top Central Bank Official

Fed

First Posted: 08/13/10 06:18 PM ET Updated: 05/25/11 06:20 PM ET

A top regional Federal Reserve official sharply criticized Friday the Fed's ongoing policy of keeping interest rates near zero -- and at record lows -- as a "dangerous gamble."

Federal Reserve Bank of Kansas City President Thomas M. Hoenig, the Fed's longest-serving policymaker and one of 10 people who decides what interest rates borrowers pay on mortgages, loans and other credit products, said that the Fed's policy of effectively guaranteeing zero percent interest rates for the foreseeable future is "risking a repeat of past errors and the consequences they bring."

Hoenig, who's dissented from all five Federal Open Market Committee decisions this year to keep the rate at which banks lend to each other for overnight funds between 0 and 0.25 percent, said the economy is in a "modest recovery, with mixed results" and intimated that policy makers shouldn't be beholden to "volatile monthly data" nor should "market participants... direct policy."

"Of course the market wants zero rates to continue indefinitely," Hoenig said in prepared remarks during a speech in Lincoln, Neb. "They are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases."

Meanwhile, the Fed's zero interest-rate policy "is as likely to be a negative as a positive in that it brings its own unintended consequences and uncertainty." Getting rid of Wall Street's guaranteed source of profit -- borrowing from the central bank and investing that in treasuries -- "tells the market that it must again accept risks and lend if it wishes to earn a return," Hoenig said.

Hoenig said megabanks, "even after their poor performance during this last crisis, remain financially and politically powerful institutions."

"It gives me pause, for example, that after the recent devastating experience of the global banking crisis, regulatory authorities are already backing off initial attempts to strengthen international capital requirements for these largest banks and financial firms," Hoenig said. Capital is the money banks keep to guard against losses.

An international body of bank regulators that sets capital standards for banks, known as the Basel Committee, recently announced how much capital banks should hold. It amounts to a 33-to-1 leverage ratio. In other words, banks should hold $1 for every $33 they lend out or speculate with.

"Bear Stearns entered this crisis and failed with a 34-to-1 leverage ratio," Hoenig said of the first big Wall Street firm to collapse during the crisis. "It leaves a small cushion for error and is a level of risk that I judge unacceptable."

Hoenig added that the financial reform bill President Barack Obama signed into law last month may not have ended the perception that some financial firms are too big to fail, one of the legislation's chief goals.

"The simple truth is, Too Big To Fail will not go away easily," he said. Speaking of the regulators the bill empowers -- yet doesn't fully compel -- Hoenig said the next crisis will depend on the leadership atop the regulatory agencies.

"I am hopeful but realistic regarding whether next time things will be different," said Hoenig, a longtime critic of the Obama administration's attempts to end Too Big To Fail. By contrast, Hoenig believes the nation's giant financial institutions should be broken up into several pieces.

The Fed's Board of Governors in Washington disagrees.

The Fed's policymaking body voted 9 to 1 earlier this week to maintain its current zero-interest-rate policy. It also will reinvest the proceeds from maturing mortgage-backed securities and debt from mortgage giants Fannie Mae and Freddie Mac into treasuries, keeping bond yields near record lows -- a policy that hurts savers and could create another bubble, Hoenig warns.

"Economic conditions are far from satisfactory, unemployment is simply too high, and we want a stronger recovery," he said. "But as 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 action."

Hoenig reiterated, as he did in an interview two weeks ago with the Huffington Post, that the economy is in recovery, though the monthly data will be "mixed, as is typical during recovery."

"While monthly data may be mixed, the trend data are consistently positive," Hoenig said. "Private job growth has been less than hoped for but positive nonetheless."

Indeed, private payrolls have expanded by 630,000 workers since the start of the year. Hours worked and wages are also up, as is consumption, investment in equipment and software, housing, industrial production, high tech and manufacturing, and corporate profits.

"The economy is recovering and, barring specific shocks and bad policy, it should continue to grow over the next several quarters," Hoenig said.

"In fact, we are experiencing a better pace of recovery this time than at this point in our previous two economic recoveries," Hoenig said in reference to the periods following the recessions of 1990-91 and 2001.

The economy grew by 3.2 percent during the first year of recovery following the current "Great Recession," Hoenig said. Output increased 2.61 percent after the recession of 1991 and just 1.92 percent following the recession of 2001.

The problem, according to Hoenig, is not the recovery; it's the structural issues that led to the Great Recession in the first place.

"We are recovering from a horrific set of shocks, and it will take time to 'right the ship,'" he said. "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."

The economy was "out of balance," Hoenig said. Some of the factors that may have contributed to that imbalance include:

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.


Gross federal debt increased from 60 percent to 75 percent of nominal GDP.

Consumer debt increased from 63 percent to 94 percent of nominal GDP.

Nonfinancial debt increased from 189 percent of nominal GDP at the start of the decade to 234 percent by December 2008.

Between 1993 and 2007, the average leverage of the 20-largest financial institutions in the U.S. (total assets-to-tangible equity capital) increased from 18 to 1, to over 25 to 1, reaching as high as 31 to 1.

The U.S. increased its debt to the rest of the world dramatically from 4.87 percent to 24.32 percent of nominal GDP.

"The 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," Hoenig said. "Obviously, the effect of these trends on our economy has been significant and we must accept that they will not be corrected quickly."

Hoenig wants the Fed to increase its rate from zero to 1 percent, keep it there while the economy adjusts, then raise it toward 2 percent. Then, the rate will move based on the economy.

This will lead to a "more sustained recovery," Hoenig said. Debt will be paid down and economic imbalances -- like too-high housing prices, for example -- will rebalance. The economy will grow at a modest but sustainable pace and job growth will be "stable and resilient." It's a far cry from the policy of the last decade.

To Hoenig, the Fed's policies are encouraging the kind of unsustainable practices that will lead to a cycle of perpetual booms and busts. For example, he notes that consumption had long been about 63 percent of gross domestic product. During the boom it rose to 70 percent, he said, and that needs to come back down.

Savings made for another example. Personal savings dropped from about 10 percent of disposable income in 1985 to less than 2 percent in 2007, Hoenig notes. While the current rate of about 6 percent is good, it's still far below historical levels. Households need to repair their balance sheets, and that takes time.

Businesses, Hoenig said, are in a better position. Profits are up and debt is down relative to historical levels, Federal Reserve and Commerce Department data show. "There is enormous liquidity in the market," Hoenig said. The Fed doesn't have to keep supplying the economy with cheap money.

"Monetary policy is a useful tool, but it cannot solve every problem faced by the United States today," Hoenig said. "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 shortcut."


READ Hoenig's full remarks:


"Hard Choices" - Speech by Thomas Hoenig of the Kansas City Fed


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Shahien Nasiripour is the business reporter for the Huffington Post. You can send him an e-mail; bookmark his page; subscribe to his RSS feed; follow him on Twitter; friend him on Facebook; become a fan; and/or get e-mail alerts when he reports the latest news. He can be reached at 646-274-2455.

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