By Steven K. Beckner
(MNI) – Minneapolis Federal Reserve President Narayana Kocherlakota
Thursday emphasized the conditionality of the Federal Open Market
Committee’s statement that it is like to keep the federal funds rate
“exceptionally low … for an extended period.”
He said the FOMC will raise the funds rates when it is
“appropriate” to do so, whether that means “three weeks, three months or
three years.”
But Kocherlakota made clear he doesn’t think that near-term
monetary tightening is likely, citing factors that could retard economic
growth and projecting continued high levels of unemployment and low
inflation.
Although the most recent employment data suggest that the labor
market is “starting to function better” Kocherlakota said he would still
be surprised if the unemployment rate falls below 9% from April’s 9.9%
by the end of this year or below 8% by the end of next year.
Kocherlakota, who will be an FOMC voter next year, said he would
have voted for the “extended period” language at the April meeting if he
had been able to. He said most — if not all Fed presidents — believe
current economic conditions warrant a near zero federal funds rate.
He also said there is a consensus on the need to reduce the Fed
balance sheet and return it to all Treasury securities, but he said
mortgage-backed securities can only be sold “slowly” and “carefully” to
avoid driving up mortgage rates. He said there are likely to still be
MBS in the Fed’s portfolio as late as 2020.
Kocherlakota read the FOMC’s policy statement in remarks prepared
for delivery to the Eau Claire Area Chamber of Commerce Altoona,
Wisconsin: “The Committee will maintain the target range for the federal
funds rate at 0 to 1/4 percent and continues to anticipate that economic
conditions, including low rates of resource utilization, subdued
inflation trends, and stable inflation expectations, are likely to
warrant exceptionally low levels of the federal funds rate for an
extended period.”
“What do we learn from this sentence?” he asked, before answering
his own question.
“Right now, the unemployment rate is 9.9% and measured inflation is
low (below 2 percent last quarter),” he said. “Inflationary expectations
are also low … expected inflation over the next five years is also
less than 2%.”
“In its statement, the FOMC is saying: We’re keeping interest rates
low to keep unemployment from going any higher, and we feel safe in
doing so because there seems to be little threat of inflation.”
Kocherlakota said “most or maybe even all of the members of the
FOMC and the other presidents agree that current conditions necessitate
interest rates near zero.”
“However, the sentence goes on to forecast that these kinds of
economic conditions are likely to continue for “an extended period,” he
continued. “There has been some public disagreement about this forecast,
and it is one reason given by the president of the Federal Reserve Bank
of Kansas City for his dissenting from the statement at the last three
meetings.”
Had he been a voter, Kocherlakota said he “would have voted in
favor of the FOMC statement in April.”
But he added, “I do think that readers of the FOMC statement should
pay very careful attention to its explicit conditionality.”
“The statement says that the committee will raise interest rates if
economic conditions change appropriately-whether that’s in three weeks,
three months, or three years,” he explained.
As for shrinking the $2.3 trillion Fed balance sheet, Kocherlakota
said the FOMC has been unanimous in wanting to “return to a much smaller
all-Treasury portfolio in the long run.”
He said, “I worry that a large balance sheet could trigger
inflation.”
As for why the FOMC wants to get out of MBSs, he said “there are
many reasons for this view, but one is certainly that we don’t want to
be seen as a long-term prop for the housing sector.”
“But what does ‘long-term’ mean?” he asked. “Many of the MBSs that
we hold won’t mature for 30 years!”
Kocherlakota said “prepayment will reduce the size of our
portfolio,” but estimated that “even 20 years out, the Fed is likely to
have something like 250 billion dollars of MBS holdings.” So, he said,
“if we want to normalize our balance sheet sometime in the next two
decades, we will need to sell some of our MBS holdings.”
“Doing so is challenging,” he said. “We want to be careful not to
cause large jumps in long-term interest rates, and especially not in
mortgage rates. But I believe that we can do so, as long as we commit to
a sufficiently slow pace of sales.”
“I’m optimistic that we can get MBSs off our balance sheet by 2020
at the very latest,” he added.
Kocherlakota prefaced his policy remarks with comments about the
economy that were only modestly optimistic.
“The recovery is well under way,” he said, but “my projected
recovery does not have the V shape that we would prefer to see. My
forecast for GDP growth is pushed downward by uncertainty along several
key dimensions.”
“First, the increase in the public debt in the United States may
well lead to an increase in future tax rates,” he said. “These increases
will retard investment and dampen GDP growth.”
Second, he cited continued contraction of bank lending, which he
attributed to “ongoing regulatory uncertainty” and “by ongoing asset
quality concerns.” Third, he said “the fiscal and financial situation in
Europe may well lead European growth to continue to be restrained over
the next year or two.”
Although the unemployment rate rose two tenths to 9.9% in April,
Kocherlakota pointed out that this was due to a return of many
discouraged jobseekers to the labor market and noted that non-farm
payrolls rose 290,000. Together, these data “actually indicate that the
labor market is starting to function better.”
However, “I believe that the (jobs) recovery will be slower than we
would like,” he went on. “I would be surprised if unemployment were to
fall below 9% before the end of 2010 or below 8% by the end of 2011 …
. The growth in productivity has allowed firms to expand production
without commensurate increases in hiring.”
Meanwhile, Kocherlakota said he expects annualized PCE inflation to
stay about 1.5% during the rest of this year. And he said inflation
expectations over the next five years, as measured by yields on Treasury
Inflation Protected Securities (TIPS) “are also under 2%.”
Kocherlakota said fiscal policy could well have a bearing on
inflation.
“Over the past two and a half years, the amount of federal debt in
the hands of the private sector has increased by over 50%,” he said.
“This extra debt can only be paid in one of two ways. First, Congress
can cut spending or raise taxes. Second, the Fed can print extra money
to pay off extra obligations and thereby create inflation.”
Defending and explaining the renewal of reciprocal currency swaps
with other central banks, he said, “We opened these lines to allow these
central banks-especially the European ones-to ease funding pressure in
dollar interbank lending markets.”
“We didn’t do so out of any special love for Europe – we’re
American policymakers, and we make decisions to keep the American
economy strong,” he continued. “But the liquidity problems in European
markets were showing signs of creating dangerous illiquidity problems in
our own country’s financial markets. We knew that the swap lines would
be a useful step in heading off that process.”
** Market News International **
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