By Steven K. Beckner

Kocherlakota said “the pace of the recovery is more modest than I
would have anticipated,” noting that “we are four quarters into the
recovery, and real GDP per person is still about 3.2 percent below its
level in the fourth quarter of 2007 when the recession began.”

“In some sense, this number actually understates the economic
problem,” he went on. “Typically, real GDP per person grows between 1.5
and 2% per year. If the economy had actually grown at that rate over the
past two and a half years, we would have between 7 and 8.2% more output
per person than we do right now.”

Kocherlakota said his forecast “is such that we will not make up
that 7-8.2% lost output anytime soon.” He projected real GDP growth of
2.5% in the second half, rising to 3.0% in 2011.

He was even less upbeat about the job picture, saying “the lack of
vitality in the U.S. labor market can only be termed disturbing.”

“Even more troubling,” he said is the relationship between job
openings and unemployment, which he said has “been shattered” over the
past year.

Between June 2009 and June 2010, the job openings rate has risen by
about 20%, yet the unemployment rate rose slightly, he noted. He
attributed this to a “mismatch.”

“Firms have jobs, but can’t find appropriate workers,” he said.
“The workers want to work, but can’t find appropriate jobs.”

There is not much the Fed can do about this mismatch, Kocherlakota
said. “Monetary stimulus has provided conditions so that manufacturing
plants want to hire new workers. But the Fed does not have a means to
transform construction workers into manufacturing workers….Most of the
existing unemployment represents mismatch that is not readily amenable
to monetary policy.”

Kocherlakota predicted that the PCE inflation rate will rise from
1.0% to between 1.5% and 2.0% next year.

As for the risk of “persistent deflation,” he said, “I don’t see
this possibility as likely. It would require the FOMC to make the
surprising mistake of ignoring the long run in its desire to fix the
short run.”

But he said the Fed could be courting deflation if it holds the
funds rate near zero indefinitely.

“It is conventional for central banks to attribute deflationary
outcomes to temporary shortfalls in aggregate demand,” he explained.
“Given that interpretation, central banks then respond to deflation by
easing monetary policy in order to generate extra demand. Unfortunately,
this conventional response leads to problems if followed for too long.”

“Long-run monetary neutrality is an uncontroversial, simple, but
nonetheless profound proposition,” he went on. “In particular, it
implies that if the FOMC maintains the fed funds rate at its current
level of 0-25 basis points for too long, both anticipated and actual
inflation have to become negative.”

“Why?” he asked. “It’s simple arithmetic. Let’s say that the real
rate of return on safe investments is 1% and we need to add an amount of
anticipated inflation that will result in a fed funds rate of 0.25%. The
only way to get that is to add a negative number — in this case,
-0.75%.

Hence, Kocherlakota said, “over the long run, a low fed funds rate
must lead to consistent — but low — levels of deflation.”

But he said the Fed can avoid that fate “through smart policy
choices.”

“Right now, the real safe return on short-term investments is
negative because of various headwinds in the real economy,” he said.
“Again, using our simple arithmetic, this negative real return combined
with the near-zero fed funds rate means that inflation must be
positive.”

“Eventually, the real economy will improve sufficiently that the
real return to safe short-term investments will normalize at its more
typical positive level,” he continued. “The FOMC has to be ready to
increase its target rate soon thereafter.”

It won’t be an easy policy decision for the Fed, though, he said,
because “when real returns are normalized, inflationary expectations
could well be negative, and there may still be a considerable amount of
structural unemployment.”

“If the FOMC hews too closely to conventional thinking, it might be
inclined to keep its target rate low,” he warned. “That kind of reaction
would simply re-enforce the deflationary expectations and lead to many
years of deflation.”

But Kocherlakota said this scenario is “highly unlikely.”

“The FOMC and the Board of Governors have displayed exactly the
required unconventionality in solving many seemingly intractable
problems over the past three years,” he said. “I am confident that the
Federal Reserve will display that same attribute if this deflationary
challenge should ever arise. I am sure too that households and financial
markets will share my confidence-which would actually eliminate the need
for the Fed to ever confront hardened deflationary expectations.”

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** Market News International **

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