By Steven K. Beckner

Basically, if the government uses short-term debt, it exposes
taxpayers to interest rate risk,” he explained. “If it uses long-term
government debt, it exposes the bondholders to interest rate risk. QE is
a special case of this general principle: When the Fed buys long-term
government debt from the private market, it shifts interest rate risk
from bondholders to taxpayers.”

“What is the ultimate impact on the overall economy of this shift
in risk?” he asked. “In the baseline models used by central banks, all
bondholders are taxpayers. In these models, QE is essentially shifting
risk from one pocket to another.”

“As a result, the increase in tax risk (what I’m calling the fourth
effect of QE) completely undoes the decrease in interest rate risk (the
third effect of QE),” he continued. “QE ends up having no effects,
except for those associated with any new forward guidance that it
signals.”

But Kocherlakota said “QE will have nontrivial effects over forward
guidance in the context of a more realistic model in which people differ
from one another in some relevant way.”

He said “the ultimate macroeconomic impact of QE depends on the
extent to which the extra tax risk deters economic activity on the part
of this second group. We know little about this effect, either
theoretically or empirically.”

Moving from the theoretical to the practical, Kocherlakota
estimated that past Fed securities purchases totalling more than $1.7
trillion, reduced the term premium on 10-year Treasury bonds relative to
2-year Treasury bonds by about 40-80 basis points (on an annualized
basis).” And he said “this fall in term premia led to a slightly smaller
fall in the term premia of corporate bonds.”

But he was skeptical whether a new round of Q.E. would have the
same impact.

“My own guess is that further uses of QE would have a more muted
effect on Treasury term premia. Financial markets are functioning much
better in late 2010 than they were in early 2009. As a result, the
relevant spreads are lower, and I suspect that it will be somewhat more
challenging for the Fed to impact them.”

He concluded on an ambivalent note, declining to say what his
threshold for renewed Q.E. would be.

“I’ve talked about three possible tools-lowering the IOER,
strengthening the forward guidance in the FOMC statement, and
quantitative easing,” he said. “Chairman Bernanke observed in his August
27 speech that each of these tools has benefits and drawbacks that must
be balanced against each other. With QE, I would say that the multiple
effects make the calculus even more difficult than usual.”

Kocherlakota’s personal expectations were relatively gloom for
growth and jobs, less so for inflation.

“Our September estimates are distinctly lower than our August
estimates,” he said. “I now expect GDP growth to be around 2.4% in the
second half of 2010 and around 2.5% in 2011.”

“Together over 2010 and 2011, I’m now predicting that GDP will grow
around 2.5% per year,” he continued. “In contrast, in my first speech
about seven months ago, I predicted that GDP would grow around 3.0% per
year over 2010 and 2011.”

“There is a recovery under way in the United States,” said
Kocherlakota. “But it is a distinctly modest one-and even more modest
than I expected at the beginning of this year.”

On the job front, he said “the lack of vitality in the U.S. labor
market can only be termed disturbing” And he added, “If one digs deeper
into the data, the situation seems even more troubling.”

“I do not expect the unemployment rate to decline rapidly, and so I
expect it to be above 8.0% well into 2012,” he said.

Kocherlakota indicated, however, that he does not expect further
disinflation, much less deflation.

“From the fourth quarter of 2009 through the second quarter of
2010, the change in the PCE price level was just over 0.%, which works
out to an annual rate of just over 1%,” he said, noting that “the Fed’s
price stability mandate is generally interpreted as maintaining an
inflation rate of 2%, and 1% inflation is often considered to be too low
relative to this stricture.”

“I expect inflation to remain at about this level during the rest
of this year,” he said. “However, our Minneapolis forecasting model
predicts that it will rise back into the more desirable 1.5-2% range in
2011.”

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