By Steven K. Beckner

(MNI) – Minneapolis Federal Reserve Bank President Narayana
Kocherlakota Wednesday reiterated his belief that the Fed will probably
have to raise the federal funds rate a “modest” 50 basis points before
the end of the year.

But Kocherlakota, a voting member of the Fed’s policymaking Federal
Open Market Committee, carefully conditioned such a rate hike on a
forecast of inflation remaining at first quarter levels and unemployment
declining.

If instead inflation falls, the Fed may have to “ease further,”
Kocherlakota repeated.

Alternatively, if inflation worsens, he said the Fed might have to
raise rates “more aggressively.”

As before, Kocherlakota said the FOMC should raise the funds first
before selling assets — a preference he shares with most policymakers,
according to minutes of the April 26-27 FOMC meeting released last
Wednesday.

Kocherlakota, delivering prepared remarks to the Chamber of
Commerce of Rochester, Minnesota, was reprising a speech he gave
recently in New York City and Santa Barbara.

Kocherlakota’s views contrast sharply with those of some of his
colleagues, such as Chicago Fed President Charles Evans, a fellow voter
who last Thursday said he could not foresee circumstances in which the
FOMC would want to hike the funds rate this year and said he believes
“substantial accommodation” is still needed.

Explaining his prescription for higher rates, Kocherlakota
projected that GDP will grow a real 3-3.5% this year; that the
unemployment rate will fall to 8-8.5% 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.

Looking solely at reduced labor market slack and higher inflation
than prevailed last year, Kocherlakota said an argument could be made
for raising the funds rate by at least 100 basis points.

However, he said a third factor has to be brought into the
equation: market anticipations of reduced Fed securities holdings over
time, which will have the effect of tightening financial conditions.

“By putting these three elements together, I arrive at my
conclusion: if PCE core inflation rises to 1.5% over the course of 2011,
the FOMC should raise the fed funds rate by around 50 basis points,” he
said.

Since a core inflation rate of 1.5% is “still markedly below the
Fed’s price stability objective of 2%,” Kocherlakota 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 said. “As well, the Fed’s holdings of long-term assets
would continue to provide significant accommodation.”

Drawing on Fed staff research, Kocherlakota estimated that, even
after raising the funds rate by 50 basis points, “the total monetary
policy package of the two forms of accommodation” — a low funds rate
and large securities holdings — “would be roughly equivalent to
maintaining a fed funds target rate of negative 1.5 percentage points”
at the end of 2011.

“Such a stance can only be described as being easy monetary
policyjust not as easy as late 2010,” he added.

But Kocherlakota was not certain the FOMC will raise the funds rate
at all.

“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.

Kocherlakota also allowed for even bigger rate hikes under certain
circumstances.

“My forecast for core PCE inflation might be too low,” he said.
“For example, core PCE inflation might rise to 1.8%t over the course of
2011.”

“The FOMC should respond to evidence of such a large increase by
raising the target fed funds rate even more aggressively than I have
suggested,” he said. “I would recommend raising the target fed funds
interest rate shortly thereafter.”

But “under my baseline forecast, it would be desirable for the FOMC
to raise the fed funds target interest rate by a modest amount toward
the end of 2011,” Kocherlakota reiterated.

He said the FOMC “could also reduce accommodation by shrinking the
Fed’s holdings of long-term government securities” — either by
discontinuing its practice of reinvesting principal payments from its
securities holdings into long-term Treasuries or by selling assets.

But, while saying he is “open” to shrinking the balance sheet at
some point, he said he regards that method of reducing the balance
sheet, he said he “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,” he said. Besides, he said he sees
shrinking the balance sheet as “a longer-term mission that can take
place over the next five or six years or so.”

** Market News International **

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