WASHINGTON (MNI) – The following is the text of prepared testimony
to be delivered by Kansas City Federal Reserve President Thomas Hoenig
Tuesday before the House Subcommittee on Domestic Monetary Policy and
Technology:

Chairman Paul, Ranking Member Clay and members of the subcommittee,
thank you for the opportunity to discuss my views on the economy from
the perspective of president of the Federal Reserve Bank of Kansas City
and as a 20-year member of the Federal Reserve System’s Federal Open
Market Committee (FOMC).

The Fed’s mandate reads: “The Board of Governors of the Federal
Reserve System and the Federal Open Market Committee shall maintain
long-run growth of the monetary and credit aggregates commensurate with
the economy’s long-run potential to increase production, so as to
promote effectively the goals of maximum employment, stable prices, and
moderate long-term interest rates.”

The role of a central bank is to provide liquidity in a crisis and
to create and foster an environment that supports long-run economic
health. For that reason, as the financial crisis took hold in 2008, I
supported the FOMC’s cuts to the federal funds rate that pushed the
target range to 0 percent to 0.25 percent, as well as the other
emergency liquidity actions taken to staunch the crisis. However, though
I would support a generally accommodative monetary policy today, I have
raised questions regarding the advisability of keeping the emergency
monetary policy in place for 32 months with the promise of keeping it
there for an extended period.

I have several concerns with zero rates. First, a guarantee of zero
rates affects the allocation of resources. It is generally accepted that
no good, service or transaction trades efficiently at the price of zero.
Credit is no exception. Rather, a zero-rate policy increases the risk of
misallocating real resources, creating a new set of imbalances or
possibly a new set of bubbles.

For example, in the Tenth Federal Reserve District, fertile
farmland was selling for $6,000 an acre two years ago. That land today
is selling for as much as $12,000 an acre, reflecting high commodity
prices but also the fact that farmland loans increasingly carry an
interest rate of far less than the 7.5 percent historic average for such
loans. And with such low rates of return on financial assets, investors
are quickly bidding up the price of farmland in search of a marginally
better return.

I was in the banking supervision area during the banking crisis of
the 1980s, when the collapse of a speculative bubble dramatically and
negatively affected the agriculture, real estate and energy industries,
almost simultaneously. Because of this bubble, in the Federal Reserve
Bank of Kansas City’s district alone, I was involved in the closing of
nearly 350 regional and community banks. Farms were lost, communities
were devastated, and thousands of jobs were lost in the energy and real
estate sectors. I am confident that the highly accommodative monetary
policy of the decade of the ’70s contributed to this crisis.

Another important effect of zero rates is that it redistributes
wealth in this country from the saver to debtor by pushing interest
rates on deposits and other types of assets below what they would
otherwise be. This requires savers and those on fixed incomes to
subsidize borrowers. This may be necessary during a crisis in order to
avoid even more dire outcomes, but the longer it continues, the more
dramatic the redistribution of wealth.

In addition, historically low rates affect the incentives of how
the largest banks allocate assets. They can borrow for essentially a
quarter-point and lend it back to the federal government by purchasing
bonds and notes that pay about 3 percent. It provides them a means to
generate earnings and restore capital but it also reflects a subsidy to
their operations. It is not the Federal Reserve’s job to pave the yield
curve with guaranteed returns for any sector of the economy, and we
should not be guaranteeing a return for Wall Street or any special
interest groups.

Finally, my view is that unemployment is high today, in part,
because interest rates were held to an artificially low level during the
period of the early 2000s. In 2003, unemployment at 6.5 percent was
thought to be too high. The federal funds rate was continuously lowered
to a level of 1 percent in an effort to avoid deflation and to lower
unemployment. The policy worked in the short term.

The full effect, however, was that the U.S. experienced a credit
boom with consumers increasing their debt from 80 percent of disposable
income to 125 percent. Banks increased their leverage ratios–assets to
equity capital– from 15-to-1 to 30-to-1. This very active credit
environment persisted over time and contributed to the bubble in the
housing market. In just five years, the housing bubble collapsed and
asset values have fallen dramatically. The debt levels, however, remain,
impeding our ability to recover from this recession. I would argue that
the result of our short-run focus in 2003 was to contribute to 10
percent unemployment five years later.

That said, I am not advocating for tight monetary policy. I’m
advocating that the FOMC move to carefully move to non-zero rates. This
will allow the market to begin to read credit conditions and allocate
resources according to their best use rather than in response to
artificial incentives.

More than a year ago, I advocated removing the “extended period”
language to prepare the markets for a move to 1 percent by the fall of
2010. Then, depending on how the economy performed, I would move rates
back toward more historic levels.

I want to see people back to work, but I want them back to work
with some assurance stability. I want to see our economy grow in a
manner that encourages stable economic growth, stable prices and
long-run full employment. If zero interest rates could accomplish this
goal, then I would support interest rates at zero. In my written
testimony, I have included three speeches that describe in more detail
my position on monetary policy.

Monetary policy cannot solve every problem. I believe we put the
economy at greater risk by attempting to do so.

Thank you Mr. Chaiman. I look forward to your questions.

** Market News International Washington Bureau: 202-371-2121 **

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