By Steven K. Beckner

(MNI) – Minneapolis Federal Reserve Bank President Narayana
Kocherlakota proposed Thursday that the Fed commit to delaying interest
rate hikes until the unemployment rate falls below 5.5% — so long as
Fed policymakers expect inflation to stay within a quarter percentage
point of its 2% target.

By setting a low “threshold” for unemployment, Kocherlakota argued
that the Fed could induce less precautionary saving and more near-term
spending in remarks prepared for delivery to the Gogebic Community
College in Ironwood, Michigan.

Kocherlakota was one of three Federal Reserve Bank Presidents who
dissented against easing measures adopted by the Fed’s policymaking
Federal Open Market Committee in August and September 2011. But he
seemed to suggest that he did not oppose the FOMC’s decision last
Thursday to launch a third round of large-scale asset purchases to lower
long-term rates and to extend the anticipated period of near zero
short-term rates another six months until mid-2015.

He did, however, say the FOMC should have been “more precise” in
its revised “forward guidance” on the path of the federal funds rate.

In reaffirming its zero to 25 basis points funds rate target, the
FOMC said it “expects that a highly accommodative stance of monetary
policy will remain appropriate for a considerable time after the
economic recovery strengthens.”

Asserting that a more specific “lift-off plan” is needed, he
offered his own “threshold” proposal for defining what the “considerable
time” period should be before the FOMC raises the funds rate: “As long
as the FOMC satisfies its price stability mandate, it should keep the
fed funds rate extraordinarily low until the unemployment rate has
fallen below 5.5%.”

Kocherlakota proceeded to specify what he thinks the FOMC should
keep delay rate hikes so long as it “satisfies its price stability

“I mean that longer-term inflation expectations are stable and that
the Committee’s medium-term outlook for the annual inflation rate is
within a quarter of a percentage point of its target of 2%,” he said.
“The substance of this liftoff plan is that, as long as longer-term
inflation expectations remain stable, the Committee will not raise the
fed funds rate unless the medium-term outlook for the inflation rate
exceeds a threshold value of 2 1/4% or the unemployment rate falls below
a threshold value of 5.5%.”

Kocherlakota’s proposal is similar conceptually to one offered a
year ago by Chicago Fed President Charles Evans, by whom he sits at the
FOMC table. But Evans has urged the FOMC keep the funds rate at zero
until the unemployment rate goes below 7% so long as inflation doesn’t
go above 3%.

So Kocherlakota would be less tolerant of higher inflation than
Evans while aiming lower on unemployment. But he agreed with Evans in
saying “it may be appropriate to follow policies that lead the
medium-term outlook for inflation to deviate from the long-run target.”

Kocherlakota said his thinking “continues to evolve,” but said, “I
currently believe that allowing the medium-term outlook for inflation to
deviate from 2% by a quarter of a percentage point in either direction
would provide sufficient flexibility to the Committee, while posing no
threat to the credibility of the long-run target.”

Because monetary policy operates with a lag of up to two years and
because the Fed needs “some medium-term flexibility around the long-run
target,” he said the FOMC should consider itself to be “satisfying its
price stability mandate as long as its medium-term outlook for inflation
is between 1 3/4% and 2 1/4%, and longer-term inflation expectations
remain stable.”

Using its flexibility, the Fed “might want to defer initiating
exit” even if unemployment falls to 5.5% if some shock causes the
inflation rate to fall below 2%, he said.

Although the FOMC outlined an “exit strategy” in its June 2011
minutes, Kocherlakota recalled that “that 2011 statement said nothing
about the conditions that would trigger the initiation of this exit

“This omission is problematic,” he said, because “the current
economic impact of both forms of accommodation — low interest rates and
asset purchases — depends on when the public believes that
accommodation will be removed.”

Kocherlakota offered two scenarios — one in which the public
believes the Fed will begin raising the funds rate when the unemployment
rate falls to 7% and another in which it believes the Fed won’t start
raising the rate until the unemployment rate falls to 6%.

The Fed would achieve more monetary stimulus with a lower
unemployment threshold, he said.

“People will save more in the first scenario than in the second, to
protect themselves against these higher unemployment risks,” he
explained. “Because they save more, they spend less, and there is less
economic activity.”

“In other words, the FOMC can provide more current stimulus if
people believe that liftoff will be triggered by a lower unemployment
rate,” he added.

Kocherlakota conceded that using a lower unemployment threshold to
provide additional monetary stimulus “will give rise to more
inflationary pressures, and those pressures are problematic because they
could lead the FOMC to violate its price stability mandate.”

Nevertheless, he said the FOMC “should choose the lowest
unemployment rate threshold that it sees as unlikely to generate a
violation of the price stability mandate.”

Since the FOMC’s projection of longer run unemployment is 5.2% to
6.0%, Kocherlakota argued “there will be little upward pressure on
inflation until the recovery is sufficiently robust that the
unemployment rate has fallen back to a level that is more consistent
with historical norms.”

He said his proposed plan would “allow the FOMC to contemplate
raising the fed funds rate if the Committee’s medium-term inflation
outlook rises above 2 1/4%, but he said “recent historical evidence
suggests that this possibility is unlikely to occur…”

He said the record “suggests that, as long as the unemployment rate
remains above 5.5%, it seems unlikely that the price stability mandate
would be violated.”

Kocherlakota stipulated that the FOMC’s actual rate decisions
“would hinge on a delicate cost-benefit calculation that would weigh the
inflation increases against the employment gains.” And he said the FOMC
might have to reassess the long-run unemployment rate that is consistent
with 2% inflation at some point.

He argued that “lift-off plan” should work in theory because “with
that commitment, households can anticipate a lower path for
unemployment, and they can save less to guard against the risk of job
loss. People will spend more today, and that will drive up economic

That is essentially what the FOMC was trying to accomplish last
Thursday with its extended forward guidance, coupled with its plan to
buy $40 billion per month in mortgage-backed securities until the labor
market improves “substantially,” as Kocherlakota explained it.

At times price stability and maximum employment — the two sides of
the Fed’s “dual mandate” — can conflict, he said, but recent “data and
public communications from last week’s FOMC meeting reveal that there is
no such tension at this time.”

“The unemployment rate is elevated above a level that the Committee
sees as consistent with its employment mandate,” he continued. “Most
FOMC participants’ medium-term outlooks for PCE inflation are at 2% or
below. These observations imply that, by increasing monetary
accommodation, the Committee can better meet its employment mandate
while still satisfying its price stability mandate.”

“The FOMC’s public communications also suggest that this lack of
tension between its two mandates is likely to continue for some time to
come,” Kocherlakota went on. “Most FOMC participants currently project
that, in the long run, an unemployment rate less than 6% is consistent
with 2% inflation.”

“These forecasts suggest that violations of price stability are
unlikely to occur until the unemployment rate is considerably lower than
its current level of 8.1%,” he added.

Further explaining why the FOMC did what it did last week,
Kocherlakota said steps to put downward pressure on interest rates are
“intended to discourage firms and households from saving or buying
financial assets, and instead encourage them to spend. When firms and
households spend, their extra demand for goods and services pushes
upward on employment and upward on prices.”

** MNI **

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