By Steven K. Beckner

STANFORD, Calif. (MNI) – Contrary to its pledge to keep the federal
funds rate near zero through at least mid-2013, Minneapolis Federal
Reserve Bank President Narayana Kocherlakota said Tuesday that the Fed’s
policymaking committee should tighten monetary policy in 2012 if, as
expected, unemployment falls and inflation remains about the same.

If, on the other hand, inflation should fall and unemployment rise,
it would be appropriate for the Fed to ease further, said Kocherlakota,
a voting member of the Fed’s policymaking Federal Open Market Committee.

His main point, in remarks prepared for delivery to the Stanford
Institute for Economic Policy Research (SIEPR), is that the FOMC needs
to improve its communications policy — providing alternative federal
funds rate policy scenarios within what he called a “public contingency
plan” and a policy “dashboard.”

Kocherlakota said the FOMC has been “inconsistent” in the way it
has made policy and said it has given the impression that its
“trade-off” between unemployment and inflation has changed in recent
years.

He noted that the FOMC is forecasting that unemployment will fall
from the current 9% to 8.6%, while inflation remains roughly unchanged
just shy of 2%. He suggested this conflicts with the FOMC’s “forward
guidance” of keeping the funds rate near zero “through at least
mid-2013.”

Kocherlakota favored a different approach.

“Suppose inflation and expected inflation rise and unemployment and
expected unemployment fall, as is often true in a recovery,” he said.
“Then, regardless of how it weights the two mandates, the FOMC should
reduce the level of accommodation.”

“In contrast, suppose inflation and expected inflation go down and
unemployment and expected unemployment go up, as is often true when the
economy slows,” he said. “Then, regardless of how it weights the two
mandates, the FOMC should increase the level of accommodation.”

Based on the FOMC’s November 2 projections, “core inflation, and
its outlook, will be about the same in a year’s time,” while
“unemployment will be lower,” he said. “These changes in the dashboard
readings suggest that, in the scenario that the economy evolves in 2012
as the Committee expects, the Committee should reduce the level of
monetary accommodation over the course of 2012.”

One way to reduce accommodation, he said would be to shorten the
duration of zero rates. “Right now, the Committee is projecting that it
will keep its target short-term interest rate extraordinarily low for at
least six to seven quarters. In my view, it would be simplest to reduce
the level of accommodation by changing that estimate to a shorter period
of time.”

But Kocherlakota said the FOMC’s projections may prove wrong, and
unemployment could rise further, while inflation falls. That would call
for a different policy response, he said.

“In this alternative scenario, inflation has fallen since November
2011 and unemployment has risen since November 2011,” he said. “These
changes imply that the Committee should increase the level of
accommodation over the course of the year.”

“Recall that the Committee is currently projecting that it will
keep interest rates extraordinarily low for at least six to seven
quarters,” he continued. “The Committee could increase the level of
accommodation in 2012 by changing the estimate of at least six to seven
quarters to some longer period of time.”

“Alternatively, it could increase accommodation by purchasing
additional long-term securities issued by the federal government or by
government-sponsored enterprises,” he said.

Kocherlakota, who dissented against FOMC easing steps in Auguswt
and September but voted with the majority in November, said he “view(s)
the Committee’s current resolution of the trade-off between inflation
and unemployment as being justifiable.” And he said he “also viewed the
Committee’s resolution of this trade-off in 2009 as being justifiable.”

“However, what I see as problematic is that the Committee’s
resolution of this trade-off seems to be changing over time,” he said.
“In particular, the Committee’s actions in 2011 suggest that it is now
more willing to tolerate higher-than-target inflation than it was in
2009.”

“If this possible drift in inflation tolerance were to persist, or
were expected to persist, it could give rise to a damaging increase in
inflationary expectations,” he warned. “Undoing such an increase in
inflationary expectations, as Americans discovered in the early 1980s,
requires drastic policy steps that have extremely painful consequences
for employment.

“The Committee’s actions in 2011 served to weaken the Committee’s
credibility,” he charged.

To clear up such confusion, Kocherlakota advocated a new
communication strategy.

“I believe that it is critical for the Committee to avoid further
drift in its resolution of the key trade-off between inflation and
unemployment,” he said. “It can accomplish this goal by formulating and
following a public contingency plan that is explicitly grounded in
metrics like the mandate dashboard … . Having a public plan, and
couching its decisions against the backdrop of that plan, will enhance
Federal Reserve transparency, credibility, accountability and
consistency.”

** Market News International **

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