By Steven K. Beckner

NEW YORK (MNI) – Richmond Federal Reserve Bank President Jeffrey
Lacker expressed strong concern Tuesday evening that the Fed’s latest,
two-pronged monetary stimulus program sets up an unachievable employment
objective and, in the process, risks an acceleration of inflation
expectations.

The relevant unemployment rate for monetary policy is not the Fed’s
“longer run” unemployment forecast but a more variable “natural” rate of
unemployment adjusted for economic and financial shocks, he said.
Currently, his colleagues are aiming for too low a rate of joblessness
and warned that could have unpleasant consequences.

Lacker, a voting member of the Fed’s policymaking Federal Open
Market Committee, dissented last Thursday when the FOMC’s launched a
third, open-ended round of large-scale asset purchases to lower
long-term interest rates and extended the expected period of zero
short-term rates through at least mid-2015.

In remarks prepared for delivery to the Money Marketeers of New
York University, he said he dissented because the FOMC actions risk
higher inflation; because it signaled too much willingness to tolerate
higher inflation; and because the FOMC’s decision to buy mortgage-backed
securities is an unwarranted venture into credit allocation.

Lacker’s “hawkish” views on inflation are well known, but he broke
new ground with his analysis of what the Fed can realistically achieve
on unemployment.

In the revised Summary of Economic Projections released with the
FOMC announcement last Thursday, the 19 FOMC participants projected the
longer run rate of unemployment should be 5.2% to 6.0% compared to the
current 8.1%, which down from 8.3% in August but only because of a
substantial decline in labor force participation.

In announcing its two-pronged stimulus program, the FOMC said it
would continue to buy $40 billion a month of MBS indefinitely so long as
“the labor market does not improve substantially.”

Lacker suggested the FOMC is aiming too high (or too low) on
unemployment, although he did not say by how much.

Monetary policy should not be based on some theoretical long-run
rate of “full employment” or some “dubious,” “non-accelerating rate of
unemployment,” but rather on a more realistic rate that changes
depending on the circumstances, he said.

Currently, the circumstances dictate a different, higher goal for
unemployment, given the “shocks” affecting the economy and the
structural “mismatches” in the labor market, he argued.

“In evaluating the current stance of monetary policy, the long-run
unemployment rate would appear to be an attractive yardstick, since it
provides a sense of where one ultimately would like to be,” he said.
“But for assessing monetary policy on a month-to-month or
quarter-to-quarter basis, the long-run unemployment rate can be very
misleading …”

“(W)hile an economy is adjusting to significant economic shocks,
what constitutes ‘maximum employment?'” he asked. “Surely not the
long-run rate, because how far we are away from that rate does not, in
general, tell us how fast we should be returning.”

For example, an oil shock might raise both unemployment and
inflation, but “an attempt to reduce unemployment too rapidly is likely
to spark more inflation; conversely, allowing disinflation to emerge may
cause unemployment to decline too slowly,” he said.

“In other words, there’s a reference unemployment rate that is
relevant for monetary policy, and until the real economic adjustments to
the oil price shock have taken place, it will be above the long-run
rate,” he said.

After citing other examples, Lacker said the Fed should have “the
unemployment yardstick for monetary policy vary with economic
conditions.”

“Monetary policy is simply unable to offset all of the ways in
which various frictions impede the economy’s adjustment to various
shocks,” he said. “The term ‘maximum employment’ should therefore be
thought of as the level of employment that currently can be achieved by
a central bank, taking into account its long-run objectives and the very
real impediments to a more rapid adjustment to recent economic shocks.”

Using long-term, theoretical concepts such as the NAIRU “will fail
to capture important variations in the natural rate, especially
variations over the business cycle,” Lacker said. “Thus they will be
incomplete and potentially misleading guides to policy and inflation
dynamics in the short run.”

Lacker said the “critical” reason why he dissented last Thursday is
because the FOMC failed to distinguish between the longer-run rate of
inflation in its projections and the shock-adjusted, attainable rate of
unemployment.

“This distinction between the unemployment rate relevant to current
policy and the unemployment rate we can expect in the longer run, absent
further shocks, was critical to my decision to dissent from the most
recent FOMC decision,” he said.

Lacker acknowledged that “the journey back to the long-run rate of
unemployment is taking longer than we may have anticipated, and
certainly longer than we would like” and that this is causing
“significant hardships for many American families.”

However, he said the Fed has to face the reality that “there are
several impediments to more rapid growth” that monetary policy cannot
redress. He cited continued problems in the housing market, skill
mismatches in the labor market and uncertainties about fiscal and
regulatory policy.

He said “labor market conditions have been held back by real
impediments that are beyond the capacity of monetary policy to offset.”

As a result, “the natural rate of unemployment that corresponds to
the Fed’s maximum employment mandate is now relatively elevated,” he
said.

Given his disagreement of what is really achievable in the labor
market, Lacker said he concluded last Thursday that “further monetary
stimulus runs the risk of raising inflation in a way that threatens the
stability of inflation expectations.”

He acknowledged that inflation has been running about 2% and that
“measures of inflation expectations have been remarkably stable over the
last two decades.”

However, he cautioned, “that confidence should not be taken for
granted.”

The FOMC is running the risk of undermining stable inflation
expectations, he warned.

“Perceptions that the Committee was focused on reducing
unemployment at the expense of maintaining price stability would
undercut that confidence and destabilize inflation,” he said. “The
consequences could be devastating, as we saw in the 1970s, when
policymakers attempted to push unemployment below an estimate of the
natural rate that was, in hindsight, mistakenly low.”

Referring to the FOMC’s decision to extend the expected duration of
zero short-term interest rates by six months to at least mid-2015 and to
keep monetary policy “highly accommodative” even after the recovery
strengthens, Lacker said this sends a bad signal — that the FOMC is now
willing to tolerate inflation above its 2% target.

“I disagreed with this statement because I believe a commitment to
provide stimulus beyond the point at which the recovery strengthens and
growth increases implies too great a willingness to tolerate higher
inflation and would be inconsistent with a balanced approach to the
FOMC’s price stability and maximum employment mandates,” he said.

Lacker said he also opposed purchasing additional agency
mortgage-backed securities because “these purchases are intended to
reduce borrowing rates for conforming home mortgages” and as such
“distort investment allocations and raise interest rates for other
borrowers.”

“Channeling the flow of credit to particular economic sectors is an
inappropriate role for the Federal Reserve,” he said. “Central banks
abuse their independence when they promote some borrowers at the expense
of others.”

** MNI **

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