Fed hawk signals shift on unemployment

Posted on September 20, 2012

Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis©Bloomberg

The US Federal Reserve should keep interest rates low until unemployment drops below 5.5 per cent, provided that inflation stays under control, according to a senior Fed official.

The comments, which came in a speech by Narayana Kocherlakota, president of the Minneapolis Fed, mark a big shift by a policy maker who opposed monetary stimulus last year.

    His remarks suggest that the balance of the Federal Open Market Committee has shifted towards easier policy and the idea of setting a numerical condition for a rise in interest rates is gaining momentum.

    In an interview with the Financial Times, Mr Kocherlakota said that were he a voting member of the FOMC this year, he would have backed the $40bn-a-month, QE3 round of asset purchases that the Fed launched last week.

    That is striking because Mr Kocherlakota dissented twice last year when he did have a vote – opposing the Fed’s forecast of low interest rates until mid-2013 and its Operation Twist programme to buy more long-dated Treasury securities – in part because he feared the recession had caused high structural unemployment.

    “I’m putting less weight on the structural damage story,” said Mr Kocherlakota, arguing that recent research on unemployment pointed more towards “persistent demand shortfalls”. Either way, he said, “the inflation outlook is going to be pretty crucial in telling the difference between the two”.

    Mr Kocherlakota argued that the Fed should keep interest rates low provided that its forecast for inflation two years hence stays below 2.25 per cent. If structural unemployment were high, it would push up inflation and trigger the threshold, but Mr Kocherlakota said he did not expect that to happen.

    “With that commitment, households can anticipate a lower path for unemployment, and they can save less to guard against the risk of job loss,” he said in his speech. “People will spend more today and that will drive up economic activity.”

    The Minneapolis Fed president also said that recent work suggests that QE – the practice of buying securities in an effort to drive down long-term interest rates – is effective.

    “I think the magnitudes are difficult to pin down with any precision but the thrust of the work is there are benefits associated with asset purchases,” he said. That is in contrast to his own previous doubts and a paper presented at the Fed’s Jackson Hole conference by the academic economist Michael Woodford.

    Mr Kocherlakota’s proposal is similar to that of Charles Evans, the president of the Chicago Fed, except that Mr Evans suggested levels of 7 per cent for unemployment and 3 per cent for inflation.

    Mr Kocherlakota argued for “thresholds”, so the Fed could choose to raise interest rates if its inflation forecast hit 2.25 per cent, rather than “triggers” at which the rate rise would be automatic.

    He also said that using an inflation threshold like this would require the FOMC to switch from its individual economic estimates to a collective forecast. “We definitely need a consensus outlook to make this work,” he said.

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