Narayana Kocherlakota, a former president of the Minneapolis Fed, thinks the Fed is making a “$2 trillion mistake.” It is shrinking its balance sheet when it should instead raise interest rates while keeping its large balance sheet. He argues that his course would leave the Fed better prepared for the next recession. Higher interest rates would leave the Fed with more room to stimulate the economy by lowering those rates. If the Fed keeps relatively low interest rates, on the other hand, it will be able to stimulate the economy only by buying assets again—which is politically difficult.
I’d prefer an altogether different strategy to prepare for the next recession (involving the adoption of a monetary-policy rule committing the Fed to correct for temporary fluctuations in nominal spending). But even given the choices Kocherlakota presents, I think he is misreading the politics.
His higher-rate, larger-balance-sheet strategy will force the Fed to pay more money to banks in the form of interest on excess reserves. That includes foreign banks. Presumably someone in the political system will both notice and take exception. Moreover, Kocherlakota notes that his strategy would require the Fed to expand its balance sheet regularly to keep up with a growing economy. But his own argument presupposes that asset purchases are politically difficult even in a recession. Of Kocherlakota’s two options, the Fed has picked the right one.