By Steven K. Beckner
SANTA BARBARA, Calif (MNI) – Minneapolis Federal Reserve Bank
President Narayana Kocherlakota said Thursday that, if inflation and
unemployment follow the trend he expects, the Fed should raise the
federal funds rate “a modest amount” — 50 basis points — by year’s
end.
However, Kocherlakota emphasized that his forecast could be wrong
and said that if the economy slows and inflation falls, the Fed would
need to “ease further” — by purchasing more long-term securities.
On the other hand, Kocherlakota, a voting member of the Fed’s
policymaking Federal Open Market Committee, said that if core inflation
rises more than he expects, the Fed would need to raise the funds rate
by more than 50 basis points.
He said he would prefer to tighten policy via funds rate hikes
rather than through shrinking the balance sheet in remarks prepared for
the 30th Annual Santa Barbara County Economic Summit.
Kocherlakota projected that, despite growing just 1.8% in the first
quarter, the GDP will grow a real 3% to 3.5% this year; that the
unemployment rate will fall to 8% to 8.5% by the end of the year, and
that core inflation (as measured by the price index for personal
consumption expenditures) will continue to run at the 1.5% rate recorded
in the first quarter.
He cautioned that there are two economic “headwinds” — the
continued struggle of households to rebuild their net worth and the
constraints on credit due to asset quality problems. He said the latter
headwind “will become even more important” as the economy recovers,
making it more difficult for small business to get credit.
Despite the decline in unemployment from 9.8% in November to 8.8%
in March, Kocherlakota observed that the employment-to-population ratio
“has improved only slightly,” and he said it will take nearly five years
to “normalize” the unemployment rate around 5%.
Nevertheless, as the Fed gets closer to its “dual mandate” goals of
price stability and maximum employment, he said the Fed must adjust
monetary policy and reduce its “formidable amount of monetary policy
accommodation,” keeping in mind that policy acts only with “long and
variable lags.” So he said the Fed must make policy in a way that
anticipates keeping headline inflation at no more than 2% “over the next
three to four years.”
Since unemployment is lower and inflation higher than when the FOMC
launched a second round of quantitative easing last November, he said
the Fed must prepare to tighten later this year.
Based on various “Taylor Rule” models, Kocherlakota estimated that
projected inflation and unemployment would call for at least 105 basis
points of tightening. But he said that does not allow for the
“offsetting effect” of market anticipations of diminishing Fed
securities holdings.
“Now, the Fed is certainly not going to sell its holdings
tomorrow!” he said. “But, at the end of 2011, we are presumably one year
closer to the eventual normalization of the Fed’s balance sheet than we
were at the end of 2010.” He cited research showing that this offsetting
effect is “roughly equivalent to a 50-basis-point increase in the fed
funds rate.”
Allowing for that offsetting effect, and assuming that core
inflation continues to run at 1.5% over the course of 2011, Kocherlakota
said “it would be desirable for the FOMC to raise the fed funds target
interest rate by a modest amount toward the end of 2011.”
He defined that “modest” amount of tightening as 50 basis points
and said “an increase of 50 basis points in the fed funds rate would
still leave the Fed in a highly accommodative stance.”
“First, the fed funds rate would be extremely low — between 50 and
75 basis points,” he continued. “As well, the Fed’s holdings of
long-term assets would continue to provide significant
accommodation.”
Kocherlakota acknowledged that “the FOMC could also reduce
accommodation by shrinking the Fed’s holdings of long-term government
securities” either by halting reinvestment of maturing securities
proceeds or selling assets. But he said the FOMC should hike the funds
rate rather than shrink the balance sheet and in turn bank reserves.
“I’m open to these approaches to reducing accommodation,” he said.
“However, based on what I know now, I would prefer to reduce
accommodation by raising the fed funds target interest rate. I have more
confidence in that instrument of policy, based on our many years of
experience with it.”
“I do think that the Fed needs to shrink its large balance sheet,”
he went on. “But I see that as a longer-term mission that can take place
over the next five or six years or so.”
Balance sheet reduction should be guided by two key principles, he
said. “First, the Fed should commit itself to a viable path of shrinkage
of its asset holdings. Second, that path should be sufficiently gradual
that it will interact little with the effectiveness of monetary policy.
Along these same lines, the FOMC should offer as much certainty as
possible about the rate of shrinkage.”
Kocherlakota emphasized that his call for a 50 basis point funds
rate hike is highly conditional on his forecast being right, and noticed
that his forecast last year was wrong. It “could well be again this
year,” he said.
“On the one hand, my forecast for core PCE inflation might well be
too high,” he said. “If core PCE inflation were to fall over the course
of 2011 relative to 2010, then it would be desirable for the FOMC to
ease further in response to that decline.”
“I imagine that easing would take place through the purchase of
more long-term government securities,” he added.
“On the other hand, my forecast for core PCE inflation might be too
low,” he went on. “For example, core PCE inflation might rise to 1.8
percent over the course of 2011. But incoming data would reveal such a
rapid increase to the FOMC early in the third quarter of 2011. I would
recommend raising the target fed funds interest rate shortly
thereafter.”
** Market News International **
[TOPICS: M$U$$$,MMUFE$,MGU$$$,MFU$$$,M$$BR$]
