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The Fed’s Monetary Dissident

Thomas Hoenig

(The Wall Street Journal) – ‘I really don’t think we should be guaranteeing Wall Street a margin by guaranteeing them a zero or a near zero interest rate.’

In the aftermath of the 2008 financial panic centered on Wall Street, it’s easy to forget that this part of America has its own bitter history of wild speculation that ended in disaster. But Kansas City Federal Reserve Bank President Thomas Hoenig remembers the 1970s all too well. It was a lesson that still shapes his thinking about the role of the Fed’s monetary policy in creating asset bubbles. Mr. Hoenig is more than just one of the 12 regional bank presidents of the Federal Reserve. Right now he’s also a voting member of the Fed’s Open Market Committee, which sets U.S. monetary policy. In recent months he’s been the committee’s sole dissident on the Fed’s promise to keep interest rates “at exceptionally low levels” for “an extended period of time.” At April’s FOMC meeting, Mr. Hoenig objected to that language for the third meeting in a row, warning that those words are inviting a kind of trouble we’ve seen before. “I’ve been in the Federal Reserve for many years, since 1973, and I started out in bank supervision here at the Federal Reserve Bank of Kansas City,” Mr. Hoenig tells me in an interview in his office. “During the ’70s, we went through a time where interest rates were low” and “through that period I saw banks and others invest [based on inflated] asset values—including farm land, including commercial real estate, including the movement in energy prices and on projections that in 1980 oil would go to $100 a barrel.” That oil and real-estate boom ended badly, with a rash of bank failures and financial ruin that set this region back considerably. Though Mr. Hoenig acknowledges that he can’t predict bubbles, “when you have an extended period of time with very low interest rates . . . those are some of the necessary conditions that will enable very rapid credit expansion leading to bubbles, perhaps. At least the likelihood of bubbles is greater under those circumstances.”

William McChesney Martin Jr., the longest serving Fed chairman, once noted that it is the job of the U.S. central bank “to take away the punch bowl just as the party gets going.” That’s probably true. But it’s also true that the Open Market Committee is not likely to vote to shutter the bar unless some members have the foresight to think about what the hangover is going to feel like. That’s where Mr. Hoenig comes in.If the ’70s were his baptism by fire, the past decade has brought him confirmation. “So then we come to2001-2002,” he continues, “and we have language that says we will have low rates for a considerable period, whatever the language was, and we kept interest rates low and real interest rates negative. The decade of the ’70s and the decade of the 2000s were the periods in which we had, over 40% of the time, negative real interest rates. The consequence of that was bubbles, high leverage and financial crisis.”Mr. Hoenig says that the Fed’s very low interest rates in response to the most recent crisis were “understandable.” Now, he says, “we’ve gotten through the crisis. We are not out of the woods, the economy isn’t booming, but we are now in a position where we ought to be thinking about the long run. That’s what central banks should do.”

In that search for “long-run equilibrium” Mr. Hoenig says “zero is not sustainable.” Instead, he thinks the Fed should move “towards a more normal monetary policy posture” as the economy allows. This, he explains, is “why I dissented. Because I think we need to be preparing. I can’t guarantee the carpenter down the street a margin. I really don’t think we should be guaranteeing Wall Street a margin by guaranteeing them a zero or a near zero interest rate environment.”

Mr. Hoenig stresses that the idea is not to make a tight policy, “but to begin to move it back to a more neutral policy.” He’s particularly concerned that, in the current interest rate environment, “the saver in America is in a sense subsidizing the borrower in America.” That’s not a good long-term environment for markets. “We need a more normal set of circumstances so we can have an extended recovery and a more stable economy in the long run.”

A classic problem in monetary policy is what to do when inflation isn’t showing up as a problem, but there do seem to be asset bubbles forming. When I ask Mr. Hoenig about whether the Fed got into trouble in the ’00s by relying on “core” inflation, which strips out food and energy prices, over “headline” inflation, which includes everything, he directs me back toward the problem of mispriced risk.’ Monetary policy has to be about more than just targeting inflation. It is a more powerful tool than that. It is also an allocative policy, as we’ve learned. In other words, when we kept interest rates unusually low for a considerable period we favored credit and the allocations related to it over savings, and we created the conditions that I think facilitated a bubble,” he says.

This is not to say that inflation isn’t on his mind, but he argues that the bank can’t pull a lever to stop it. “In an intermediate course in macroeconomics, or your first graduate course in monetary policy, you learn that monetary policy acts with long and variable lags.” In other words, today’s inflation rate is not going to tell you whether current monetary policy is right. All of this makes sense, but there is still the ugly fact that unemployment is near 10% and the economy is operating well below its capacity. Isn’t that an argument for easy money?

“I certainly agree that there is a lot of slack in the economy,” Mr. Hoenig says, though he reminds me that things have been picking up. More importantly, he argues that based on research he has seen, “output gaps [a measure of excess capacity in the economy] in most circumstances have not been particularly useful as a predictive tool. And in my own judgment, that’s correct: In the ’70s when we had a very long period of negative interest rates, we had what people referred to at the time as stagflation [inflation with little or no growth]. I think that’s a possibility. It’s every bit as much a possibility as whatever it is these individuals are talking about with this output gap.” Why? Because, he says, “we have a very, very accommodative policy, we have a very, very significant deficit, and we will have increasing pressures around that deficit and in funding that deficit.”

The mention of Washington’s spending binge reminds me that an innocent misreading of the economic tea leaves is not the only way that a monetary authority can wind up undermining price stability. Another common problem occurs when politicians get control of the central bank. So I ask whether the Fed is at risk of being politicized—particularly if Congress’s financial reform includes a new mandate to make the president of the New York Fed a political appointee, rather than being chosen by the banks’ board of directors as he or she is now. “Let me start by saying that I think it would be a tragedy to politicize the Federal Reserve system in any way more than it already is.” By that, he says, he means that Fed already has “a political element. It is called the board of governors who are politically appointed, confirmed by the Senate. They are the political entity. “Of course it also has “a private input [the regional bank presidents] that is more oriented toward assuring that the currency is stable, that credit instruments are stable. The board also has that incentive, but the balance of private/public was designed in 1913 specifically to make sure there was some independence that would allow the Federal Reserve to conduct monetary policy with the long-term in mind.”

In case you don’t speak the exceedingly polite language of the Midwest, allow me to translate: Washington had best keep its paws off the regional banks and their seats on the Open Market Committee. The U.S. twice attempted to establish central banks prior to the modern-day Fed. They failed, Mr. Hoenig reminds me, because they were “monolithic” and “they didn’t represent the broad base of input.” Something similar crops up when I bring up the congressional proposal to take supervision of community banks’ and regional banks’ holding companies away from 11 of the 12 Federal Reserve banks. He says he has no problem with the Federal Reserve Bank of New York being left with authority over large institutions. “But it is incredibly important that our banks, these other 11 banks, retain their role in supervision. “He points out that he has “800 banks in this region, some of them over $10 and $20 billion in size that may have an energy crisis, may have an agricultural crisis, may have a further commercial real estate crisis. Providing liquidity and understanding this region is extremely important. It’s not all New York, I’m sorry, it’s not all New York,” he says looking me straight in the eye, and making me feel a little bit guilty. “If you buy the logic that systemic things do happen in other parts of the world, then our role in supervision is as important here as it is in New York.”

By “other parts of the world,” Mr. Hoenig clearly means fly-over country. But it reminds me of other exotic locales, like Greece and California. One way out of a sovereign debt crisis, I point out, is printing money. Will the Fed have pressure to do that in order to deal with the U.S. deficit?

“Greece is a lesson for us,” he warns, “in the sense that we shouldn’t be so, if I may say, so arrogant to think that that couldn’t happen to us or others. We’re fortunate, we’re a much bigger economy and we’re the reserve currency.” But U.S. deficits are not sustainable, he says. There could be pressure on the Fed to print its way out of the problem, Mr. Hoenig acknowledges, and “the outcome of that will be a very strong inflationary bias.”

That is certainly a possibility. But if it happens the fault won’t lie with one stubborn voice of dissent, crying out in Missouri.

Ms. O’Grady writes the Americas column.

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