Narayana Kocherlakota

In attempting to explain why he signed an open letter opposing the 2009 stimulus package

A No, in fact I didn't sign that with a view of being opposed to the stimulus. I viewed signing that as stating my opposition to the idea that we all agree that the stimulus was good.

Q You mean, you were opposed to this assumption that, "we're all Keynesians" now that we're in a severe recession?

A Yes. The idea that there is some kind of uniform agreement among economists that the stimulus was a good thing, or more specifically, would lead to higher output, I didn't view that as being a settled question within the academe.

But the bigger problem is one of incentives. Under the current system, if the Federal Reserve makes a bad loan through the TAF or through the discount window, that loss appears on its balance sheet. It has every incentive to do a good job in assessing the borrower quality.

Now suppose instead that some other agency were responsible for providing this information to the Federal Reserve. What exactly are this other agency’s incentives to provide the Federal Reserve with the best possible information? This other agency is not going to suffer a loss for making a bad loan—the Federal Reserve is. Indeed, one can readily imagine that in the politically charged circumstances of a financial panic, this other agency’s objective might be to keep as many banks alive as possible. In these circumstances, the Federal Reserve would have no way to obtain reliable information from this other regulatory body and would have no way to make appropriately targeted loans. As it is, the Federal Reserve has not lost any money on either TAF or discount window loans made during this period.

[L]ow borrowing capacity because of collateral constraints—may still be significant. Both short-term and medium-term real interest rates (as measured by TIPS bonds) are low relative to their historical averages. Land is an important source of collateral, and its price remains low.

[S]peaking of Congress: Its choices on financial reform will have long-lasting effects on economic outcomes. As a country, we don’t want to be regretting these choices in a decade or two. Stripping the Federal Reserve of its supervisory authority over either small or large financial institutions would be a potential source of exactly that kind of regret.

I have to say that the continued demand for economists’ forecasts is a little puzzling to me, given our track record. On that note, it’s been said that economists make predictions about gross domestic product to the hundredth decimal point for one reason: to prove that they have a sense of humor. Well, just to assure you that I am taking this all very seriously, I will keep my forecasts to the tenth decimal point.

But suppose for a moment that we do accept the claim that housing is somehow critical for an economic turnaround. I’m not sure how, if at all, it would affect my thinking as a monetary policymaker. The Federal Reserve can only influence the housing market by manipulating interest rates. But there is little evidence that interest rates have a big influence on housing starts. For example, in a 2007 National Bureau of Economic Research paper on housing and the business cycle, UCLA professor Edward Leamer estimated a relationship between current housing starts, past housing starts, and interest rates. The Minneapolis Fed banking studies group has used Leamer’s estimates to calculate the impact of a 100-basis-point permanent decrease in 10-year Treasury yields on housing starts one year from now. The group has found that housing starts would be 11 percent higher with the rate cut than without it. This effect would be barely noticeable, given that housing starts need to nearly triple to get back to their normal level.

My own forecast calls for about 3 percent growth per year over the next two years, as opposed to the consensus view among economists, which is 3.5 percent. This pessimism derives from two sources. First, our statistical forecasting model at the Federal Reserve Bank of Minneapolis is predicting that GDP growth over this period will be around 2.5 percent per year. The model is a simple one in many ways, but its forecasting track record is surprisingly good.

Deposit institutions are holding over a trillion dollars in excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling.

Why might households expect an increase in inflation? The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

Sales present an unusual challenge for the Federal Reserve, because they require us to be able to make a particular kind of credible commitment. To understand this commitment, I think that it’s useful for me to talk through a situation that I see as roughly analogous.

Suppose Sarah owns two houses on the same block. Sarah decides that she wants to sell both houses. How should Sarah accomplish this change?

Clearly, if Sarah tries to sell both of her houses at once, she’s going to suffer some serious losses. The houses are on the same block, and so they end up competing with each other. Sarah needs to sell the houses slowly over time, so that they don’t compete with each other. Obviously, how slowly would depend on the particulars of market conditions. In my neighborhood right now, selling one house per year would be about the right speed.

So suppose Sarah puts one house on the market and tells everyone that she’s not going to sell the other one until a year later. Then, she sells the first house after a month. It sells at a high price, because the buyers don’t want to wait a whole year to get a house on this particular block.

At this stage, Sarah is supposed to wait a year to sell her second house. But Sarah was only planning to wait so long to sell the second house to protect the first house from competition. Once the first house is sold at a high price, she has no reason to wait. She will not fulfill her promise to wait a year.

Now think about what Sarah’s inability to wait means for her first sale. The potential buyers of the first house will all realize that they won’t have to wait a year to get a house on the same block. They will not be willing to pay a high price for the first house. And so Sarah’s lack of credibility means that the first house will necessarily sell at the same price as if she’s actually selling both houses at the same time.

The Federal Reserve faces exactly these same problems when undertaking to sell MBSs. Like Sarah, if the Federal Reserve were to sell its holdings of MBSs all at once, the sales price of the MBSs would be low. Long-term interest rates would spike up, which the Federal Reserve doesn’t want. Like Sarah, the Federal Reserve can avoid this problem by spacing its sales out over time. But just like Sarah, the Federal Reserve faces a commitment problem. The Federal Reserve wants to sell gradually in large part to ensure that its early sales of MBSs are at a high price. But once those early sales are made, the Federal Reserve has an increased incentive to sell its remaining MBSs rapidly. And as in Sarah’s case, if the market believes that the Federal Reserve will act on this increased incentive, the Federal Reserve will only be able to sell its early MBSs at a low price. Under this story, any MBS sales—no matter how small—may have big effects on long-term interest rates.

So far, sales sound pretty challenging! Fortunately, the analogy between the Federal Reserve and Sarah is incomplete. The difference gets at the very heart of what the Federal Reserve is about. Our structure—and in particular our independence from Congress and the president—means that we are set up to act in the public’s long-run interest, not to maximize short-run political or monetary gain. This structure means that, with the right set of policymakers on the FOMC, the Federal Reserve can credibly make and keep long-run commitments. Indeed, our credibility has been critical in the past crisis. Since July 2007, the monetary base has more than doubled, and the public debt has gone up by over 30 percent. At the same time, though, long-run inflationary expectations—as embedded in the prices of 5-year and 10-year inflation-indexed TIPS bonds—have moved slightly, if at all. The public and markets trust the Federal Reserve to keep inflation under control—and we will fulfill their trust.

Our structure means too that the Federal Reserve can credibly commit to selling its MBSs slowly over time. Along these lines, in testimony before Congress in late March, Chairman Bernanke described how he expected MBS sales to work. He emphasized that the timing of initiating sales, like any other move by the FOMC, would depend on its assessment of economic conditions. But once conditions are right, he suggested that the Federal Reserve could reduce its balance sheet by pre-announcing and then implementing a slow, gradual path of sales.

With this caveat in mind, the Federal Reserve Bank of Minneapolis banking studies group has done the following illustrative exercise. The New York Fed has every MBS owned by the Federal Reserve System listed on its Web site. The Minneapolis Fed’s banking studies group obtained data from Bloomberg on the largest quintile of these MBSs by value and used those data to estimate the rate of prepayment on these MBSs over the past year. The group found that this rate of prepayment was sufficiently slow that only half of the mortgages will vanish from the balance sheet every 10 years. This estimate implies that as late as 2030, the Federal Reserve will still be holding something like 250 billion dollars in mortgage-backed securities.

So, the passive approach is a slow approach that will leave the Federal Reserve holding significant amounts of MBSs for many years to come. If the Federal Reserve wants to normalize its balance sheet in the next five, 10, or even 20 years, it needs to supplement the passive approach with an active one. In plain English, it will have to sell mortgage-backed securities...

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Our structure means too that the Federal Reserve can credibly commit to selling its MBSs slowly over time. Along these lines, in testimony before Congress in late March, Chairman Bernanke described how he expected MBS sales to work. He emphasized that the timing of initiating sales, like any other move by the FOMC, would depend on its assessment of economic conditions. But once conditions are right, he suggested that the Federal Reserve could reduce its balance sheet by pre-announcing and then implementing a slow, gradual path of sales.

For a comical discussion of the importance of credible commitments, see entry 5364.

The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

In my view, both [financial regulatory reform bills proposed by Congress] significantly understate the extreme economic forces that lead to bailouts during financial crises. Indeed, the opening language of the Senate bill actually declares that it will end taxpayer bailouts. This objective is laudable. But it is not achievable—and thinking that it is can lead to poor choices about the structure of financial regulation.

I think that most or maybe even all of the members of the FOMC and the other presidents agree that current conditions necessitate interest rates near zero. However, the sentence goes on to forecast that these kinds of economic conditions are likely to continue for “an extended period.” There has been some public disagreement about this forecast, and it is one reason given by the president of the Federal Reserve Bank of Kansas City for his dissenting from the statement at the last three meetings.

As for my own view, had I been a voter, I would have voted in favor of the FOMC statement in April. I do think that readers of the FOMC statement should pay very careful attention to its explicit conditionality. The statement says that the committee will raise interest rates if economic conditions change appropriately—whether that’s in three weeks, three months, or three years.

I am often asked about the possible impact of European difficulties and uncertainties on my forecast... I believe that a European downturn would have only a modest impact on the pace of our recovery.

[I]t seems to me that capital and liquidity requirements are intrinsically backwards-looking. We need forward-looking instruments for what is intrinsically a forward-looking problem. And that’s a key reason why taxes, based on market information, will work better.

My view is that no law can completely eliminate the kinds of collective investor and regulator mistakes that lead to financial crises. These mistakes have taken place periodically for centuries. They will certainly do so again. And once these crises happen, there are strong economic forces that lead policymakers—for the best of reasons—to bail out financial firms. In other words, no legislation can completely eliminate bailouts...

So, that’s my first point: Bailouts are inevitable during financial crises. Let me move to the second: Anticipation of bailouts creates inefficiency in the allocation of real investment...

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As in the pollution case, using taxes to discourage excessive risk saves the government from actually trying to solve the cost-minimization problem of financial firms...

Here’s what I have in mind. Suppose that, for every relevant financial institution, the government issues a “rescue bond.”  The rescue bond pays a variable coupon equal to 1/1,000 of the transfers made from the taxpayer to the institution or its stakeholders. (I pick 1/1,000 out of the air; any fixed fraction will do.) Much of the time, this coupon will be zero, because bailouts aren’t necessary and so the firm will not receive transfers. However, just like the institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In a well-functioning market, the price of this bond is exactly equal to the 1/1,000 of the expected discounted value of the transfers to the firm and its stakeholders. Thus, the government should charge the financial firm a tax equal to 1,000 times the price of the bond. Note that the “rescue” bond is only a measurement device. In particular, it is not part of the financial firm’s rescue. 

Notice that this approach could be used for a wide variety of financial institutions, including nonbanks. In principle, the government need not figure out in advance exactly which are systemically important and which are not. Instead, it could simply issue a rescue bond for every institution. Then the market itself could reveal how systemically important each institution is through the price of its rescue bonds. Of course, markets are not always perfect. It may not always be appropriate to rely only on market measures to compute the appropriate taxes. However, even in these cases, the prices of rescue bonds would contain valuable information that should be an important input into the supervisory process.

What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. 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.

Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.¹

It is conventional for central banks to attribute deflationary outcomes to temporary shortfalls in aggregate demand. 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. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. 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? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. 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. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. 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. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

[The Federal Open Market Committee’s move to reinvest proceeds from mortgage-backed securities into Treasuries] had a larger impact on financial markets than I would have anticipated... My own interpretation is that the FOMC action led investors to believe that the economic situation in the United States was worse than they, the investors, had imagined. In my view, this reaction is unwarranted.

Unlike the central banks of other countries, you’ll see that ours is specifically designed to draw upon the insights of small town businesses, farmers and ranchers, and large manufacturers, among others, to formulate monetary policy.

Good economic policy is about using the right tool for the problem at hand. The mismatch problems in the labor market do not strike me as readily amenable to the kinds of monetary policy tools currently available to the Fed. But they may well be amenable to other types of policy tools, like job retraining programs or foreclosure mitigation strategies. As Chairman Bernanke said in his Jackson Hole speech in August, central bankers alone cannot solve the world’s economic problems.

I think that the best empirical work on the question of how the LSAP affected long-term Treasury yields has been done by Gagnon, Raskin, Remache, and Sack (2010). Their paper is a thorough investigation of this key issue.  My conclusion from their work is that the LSAP reduced the term premium on 10-year Treasury bonds relative to 2-year Treasury bonds by about 40-80 basis points (on an annualized basis). (The term premium is a measure of the difference in yields that is not explained by the expected path of short-term interest rates.) This fall in term premia led to a slightly smaller fall in the term premia of corporate bonds.

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My own guess is that further uses of quantitative easing would have a more muted effect [than that of earlier action] on Treasury term premia. Financial markets are functioning much better in late 2010 than they were in early 2009. As a result, the relevant spreads are lower, and I suspect that it will be somewhat more challenging for the Fed to impact them.

The Fed’s price stability mandate is generally interpreted as maintaining an inflation rate of 2 percent, and 1 percent inflation is often considered to be too low relative to this stricture. I expect inflation to remain at about this level during the rest of this year. However, our Minneapolis forecasting model predicts that it will rise back into the more desirable 1.5-2 percent range in 2011.

I see QE as affecting the economy in four main ways. I’ll first discuss them from a theoretical perspective and then discuss what’s known about these effects empirically.

The first effect of QE is that it represents another form of forward guidance about the path of the fed funds rate. It is a way for the FOMC to signal—in a perhaps more striking way—that it plans to keep the fed funds rate low for an even longer time to come.

Second, QE creates more reserves in banks’ accounts with the Fed. The standard intuition is that this kind of reserve creation is inflationary... This basic logic isn’t valid in current circumstances, because reserves are paying interest equal to comparable market interest rates...

The third effect of QE is the one that is usually stressed: It reduces the exposure of the private sector to interest rate risk... All long-term yields fall, and so firms should be more willing to undertake long-term capital expansions or hire permanent employees.

The fourth effect of QE is less widely discussed. The Fed cannot literally eliminate the exposure of the economy to the risk of fluctuations in the real interest rate. It can only shift that risk among people in the economy. So, where did that risk go when the Fed bought the long-term bond? The answer is to taxpayers...

 

My conclusion from [the work of Gagnon, Raskin, Remache, and Sack] is that the [2009 and early-2010] LSAP reduced the term premium on 10-year Treasury bonds relative to 2-year Treasury bonds by about 40-80 basis points (on an annualized basis). This fall in term premia led to a slightly smaller fall in the term premia of corporate bonds.

These estimates are extremely useful benchmarks. My own guess is that further uses of QE would have a more muted effect on Treasury term premia. Financial markets are functioning much better in late 2010 than they were in early 2009. As a result, the relevant spreads are lower, and I suspect that it will be somewhat more challenging for the Fed to impact them.

The first effect of QE is that it represents another form of forward guidance about the path of the fed funds rate. It is a way for the FOMC to signal—in a perhaps more striking way—that it plans to keep the fed funds rate low for an even longer time to come.

Note that I’m talking about land, not housing. Theoretically, it is hard to motivate the existence of significant overvaluation in housing structures (they’re readily replaceable). Empirically, there is considerably less evidence of overvaluation for structures than for land. Here, I refer to data from the Lincoln Institute of Land Policy that separates the price of housing into the price of structures and the price of land. The data were originally constructed by Davis and Heathcote (2005, 2007), and are derived from the Case-Shiller housing price index. These data indicate that the price of housing structures rose by less than 100% in nominal terms from 1996 to 2006, and has fallen by less than 10% since that date. 

I believe that QE is a move in the right direction. However, as I have discussed on earlier occasions, I also think there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest. That’s why I would have greatly preferred for the committee to have been able to cut its target rate rather than using QE. The problem is that its target rate is already essentially at zero, and so it was not possible to cut the target rate any further.

How does QE go about lowering long-term real interest rates? QE is a sufficiently novel monetary policy tool that different economists may well give different answers to this question. In my view, QE lowers long-term real interest rates in two distinct ways. The first is that QE is a form of nonverbal communication about the FOMC’s future plans... However, QE also lowers long-term real interest rates in a second, more direct, way. The holder of a long-term Treasury is exposed to interest rate risk, because the value of that bond fluctuates as interest rates vary. When the Fed buys $600 billion of long-term bonds, the bond portfolio of the private sector is now less exposed to this kind of risk. As a consequence, private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, and all long-term yields fall.

Indeed, one could readily argue that buying $600 billion of Treasuries is a much more convincing form of communication of the FOMC’s plans than any words could ever be.

Given [the current] constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative. Their key insight is that there is a broad equivalence between monetary and fiscal policy. They argue that the essence of an FOMC interest rate cut is that it makes current consumption cheaper relative to future consumption. With that in mind, the fiscal authorities can use the time path of consumption taxes to accomplish this same change in relative prices.

I find this game of labeling people hawks and doves as being fun for the media, fun for the people who read the media. I don't find it useful in thinking about myself and the way I interact with the committee at all. I see myself as being somebody who's going to come in there and think about the theory and the evidence and make a judgment based on that.

The bar for dissent from the committee is going to be pretty high for me. But you know, in terms of the dialogue, I try to bring best available theory that I have, best available evidence and go from there.

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I think that's very important for people to take away how the FOMC operates. Person X might be in there saying, 'Hmm, you know, you've been saying the pluses about this policy, but there are also some minuses we should be keeping in mind.' And that doesn't mean at the end of the day that that person, Person X, is going to vote against that policy. At the same time, if a voting member feels sufficiently strongly the policy is going in the wrong direction, that the committee is taking the wrong steps, they should, at that point, I agree, dissent and communicate those concerns publicly.

WSJ: How have your views on structural unemployment evolved over the last few months?

MR. KOCHERLAKOTA: I was interpreted as having stronger views than I probably did when I started talking about this in the first place.

I think it's very difficult to put down, quote-unquote, a "number" for structural unemployment...

...The evidence I pointed to in my August speech was the fact that vacancies--job openings--have gone up without seeing much downward movement in unemployment. That's a piece of evidence that might suggest that structural unemployment is high.

Counter to that--people pointed this out rightly to me, some in private conversation and some publicly--there's reason to be suspicious about the intensity of how much companies are looking. When you post an opening, does it mean the same thing in 2006 as it does in 2010? Maybe the answer is no to that.

That's a reason to be cautious about putting too much weight on that one piece of evidence. At the same time, on the sectoral side, it is certainly true that many sectors took a big hit in employment during the course of the recession and remain depressed.

On the other hand, I just think the recovery is going to be uneven across sectors and across regions of the country. And that would be a reason again where you might think, boy, that 9.8% unemployment, more of it is structural than you might typically think would be structural.

I've said this and I'll say it to you again: QE2 was not going to be a big mover of markets or of interest rates. And so it--you could easily imagine that whatever effect it's having is getting lost in the waves of other economic developments that are taking place.

There's this very nice paper by Gagnon and some other people from around the system that estimated the impact of the first LSAP to be around 40 to 80 basis points on 10-year yields. This is 40 to 80 basis points out of $1.5 trillion. We did $600 billion. That's something like 16 to 30 basis points now. That's pretty small.

Another thing that happened is, rightly or wrongly, markets have downsized their expectations of what our eventual purchases might be. I say rightly or wrongly because I have no idea. I don't know if that's right or wrong in terms of what will actually transpire. But I think that some of the reaction that the Fed received--the negative feedback--I think, has led markets to downsize their expectations.

And so our view of how this is supposed to work is it's not just our announcement of $600 billion at stake. It's what do markets expect our eventual stock purchases to be. And that has come down.

I think it was a move in the right direction. Its effect was going to be small.

A huge factor in forecasting next quarter's (gross domestic product) is the last quarter's GDP. Second quarter GDP growth was something like 1.7%. We weren't seeing the same employment gains that we had been seeing in the spring. Those things together made my forecast damp downwards. What we've seen since then is an uptick in GDP growth. We have a lot of the information about what GDP growth is going to look like in the fourth quarter. It looks stronger than it did in the third, and the third was stronger than the second. So these are things that are going to push us towards a better outlook. In terms of 2011, when you just think about the fiscal policy changes that took place in December, I think those are going to be positive for the outlook as well.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it became clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly.

The population of the United States has grown about 2.6 percent from November 2007 through November 2010. This means that real GDP per person is still 2.6 percent lower than its level in the fourth quarter of 2007. Also, historically, real GDP per person in the United States grows at roughly 2 percent per year. Suppose that real GDP per person had grown at that rate over the past three years. Then, real GDP would be 8.6 percent higher in the fourth quarter of 2010 than it actually is. As you will hear, I expect this 8.6 percent differential to change little, if at all, by the end of 2011. The recession has had and will continue to have a large and persistent impact on the U.S. economy.

Even with the December changes in fiscal policy, I would say that I expect that real GDP growth will probably be closer to 3 percent than 4 percent in 2011.

The central tendency of the November FOMC forecasts is that unemployment will remain above 9 percent throughout 2011. I would agree with those forecasts. Even more troublingly, I expect too that unemployment is likely to be higher than 8 percent as late as the end of 2012.

I conclude that the current accommodative stance of monetary policy is appropriate. However, the Federal Open Market Committee will need to remain vigilant to the possibility of changes in the gap between the unemployment rate and [the natural jobless rate].

* Kocherlakota says he is inclined to finish $600 billion of bond purchases
* Kocherlakota has "high bar" for stopping second round of QE.
* Kocherlakota says he could be persuaded to taper QE purchases

Headlines from Bloomberg News coverage of the Q&A session

We’ve made a commitment to have a certain stock of purchases to be completed by June. I view the bar for not completing those purchases as being extremely high.

If you consider monetary policy was appropriate at the end of 2010 ... and then you see core inflation go up by 50 basis points over the course of 2011 ... the usual response that we know from 20 years of thinking about monetary policy (or even more) is to raise the target rate by even more than that increase in observed inflation," he said, according to the report. "So that means you should be raising the target rate by more than 50 basis points.

 [Kocherlakota] said he expects core inflation to rise to about 1.3% by year end, so raising the Federal funds rates by more than half a point late this year is "certainly possible."

I’ve argued that even if the fiscal authority borrows exclusively in its country’s own currency, the central bank can have a large amount of control over the price level. But the central bank can only achieve that control if it is willing to commit to letting the fiscal authority default. Such a commitment may expose the country to risks of short-term and medium-term output losses. How this trade-off should best be resolved awaits future research. But I suspect that it may be optimal for central banks to guarantee fiscal authority debts in some situations. If so, we again have to think of price level determination as something that is done jointly by the fiscal authority and the central bank.

I believe that as a country, we need to take this opportunity to rethink many aspects of our public policy programs in the context of housing finance. Home ownership has long been part of the American dream, in no little part because home owners have invested not just in their houses but in their communities. But, through the mortgage interest tax deduction and other programs, we are encouraging people to buy homes by taking on debt—and sometimes large amounts of debt. If we truly want to encourage home ownership, we should contemplate programs that provide incentives for individuals to save and become equity holders in their homes—and, by extension, in their communities.

“Core inflation is a much better signal of where inflation is going to go in the future,” Kocherlakota said in response to audience questions after a speech today in Helena, Montana. “There’s really not much signs of inflationary pressures building up.”

[U]nder my baseline forecast, it would be desirable for the FOMC to raise the fed funds target interest rate by a modest amount toward the end of 2011. Of course, the FOMC could also reduce accommodation by shrinking the Fed's holdings of long-term government securities... However, based on what I know now, I would prefer to reduce accommodation by raising the fed funds target interest rate. I have more confidence in that instrument of policy, based on our many years of experience with it. I suspect that this confidence is shared by the public at large.

I do think that the Fed needs to shrink its large balance sheet. But I see that as a longer-term mission that can take place over the next five or six years or so. I believe that this mission should be guided by two key principles. First, the Fed should commit itself to a viable path of shrinkage of its asset holdings. Second, that path should be sufficiently gradual that it will interact little with the effectiveness of monetary policy. Along these same lines, the FOMC should offer as much certainty as possible about the rate of shrinkage.

I have been describing how monetary policy should react to one particular scenario, my baseline forecast. As I noted, my baseline forecast about inflation was wrong last year, and could well be again this year... If core PCE inflation were to fall over the course of 2011 relative to 2010, then it would be desirable for the FOMC to ease further in response to that decline. I imagine that easing would take place through the purchase of more long-term government securities.

The standard response to {a projected 0.7% increase} in core PCE inflation would be to raise the target interest rate by a larger amount—that is, by at least 70 basis points. For example, the widely known rules associated with John Taylor of Stanford University would recommend that the response should be to raise the target interest rate by 1.5 times the increase in core inflation—that is, by 105 basis points...

However, there is an offsetting effect that deserves mention. The level of accommodation provided by the Fed's long-term securities depends on how long people expect those holdings to last. To take an extreme, if the Fed were expected to sell all of its holdings in the next day, those holdings would obviously no longer provide any noticeable downward pressure on long-term interest rates. Now, the Fed is certainly not going to sell its holdings tomorrow! But, at the end of 2011, we are presumably one year closer to the eventual normalization of the Fed's balance sheet than we were at the end of 2010. The staff research paper that I mentioned earlier provides an estimate of the consequent reduction in accommodation as being roughly equivalent to a 50-basis-point increase in the fed funds rate.

Now, let's put all of this analysis together. It implies that if PCE core inflation rises to 1.5 percent over the course of 2011, the FOMC should raise the fed funds rate by around 50 basis points. Of course, a core inflation rate of 1.5 percent is still markedly below the Fed's price stability objective of 2 percent. Accordingly, an increase of 50 basis points in the fed funds rate would still leave the Fed in a highly accommodative stance. 

Under my baseline forecast, it would be desirable for the FOMC to raise the fed funds target interest rate by a modest amount toward the end of 2011. Of course, the FOMC could also reduce accommodation by shrinking the Fed’s holdings of long-term government securities... I’m open to these approaches to reducing accommodation. However, based on what I know now, I would prefer to reduce accommodation primarily by raising the fed funds target interest rate.

On net, I do expect the unemployment rate to normalize at close to 5 percent within the next five years. However, the immediate progress will be slow: I expect that the unemployment rate will still be above 8 percent and is likely to be still close to 8.5 percent by the end of the year.

I hope that I have convinced you of three main points. First, the financial system meltdown of 2007-09 was caused by the unexpectedly large decline in U.S. residential land prices. Second, higher amounts of household and financial institution leverage leave the financial system more vulnerable to these kinds of shocks. Finally, the U.S. tax system encourages leverage by providing incentives for households to take on more mortgage debt and financial institutions to finance through debt.

I would say that the experience of the past few years has demonstrated how challenging it is to safeguard the financial system against systemic risk and how costly it can be if we fail to do so. Given this fresh experience, and my earlier remarks, I would assess the costs of providing tax incentives for leverage to be higher today than such an assessment in, say, 2006.

As always, monetary policy will need to evolve in response to ongoing shocks and new information. But I suspect that information about aggregate labor market quantities like unemployment will remain—at best—a noisy indicator about the appropriate stance of policy. Instead, I will be paying close attention to the behavior of core inflation. As the preceding analysis suggests, the changes in this variable appear to provide critical information about the empirical relevance of nominal rigidities, and therefore about the appropriate stance of monetary policy

I dissented from this change in language because the evolution of macroeconomic data did not reflect a need to make monetary policy more accommodative than in November 2010. In particular, personal consumption expenditure (PCE) inflation rose notably in the first half of 2011, whether or not one includes food and energy. At the same time, while unemployment does remain disturbingly high, it has fallen since November.

I can summarize my reasoning as follows. I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.

Going forward, my votes on monetary policy will continue to be based on the evolution of the data on PCE inflation and its components, medium-term PCE inflation expectations, and unemployment.

“I believe that undoing this commitment in the near term would undercut the ability of the Committee to offer similar conditional commitments in the future -- and this ability has certainly proved very useful in the past three years,” Kocherlakota said today, according to prepared remarks for a speech in Bismarck, North Dakota. “I plan to abide by the August 2011 commitment in thinking about my own future decisions. Of course, the case for any additional easing would have to be made on its own merits.”

Kocherlakota changed his mind by October.

In a speech last week in Bismarck, I said that I believe that any additional provision of accommodation in September or thereafter will have to be judged on its own merits. Some readers or listeners may have found this statement to be imprecise. So, let me elaborate on what I meant then, and continue to believe. I assess FOMC actions in light of the incoming data and the Committee’s communicated objective of keeping inflation at 2 percent or a bit under. With that in mind, the data in August did not justify the additional accommodation provided at that meeting. It is unlikely that the data in September will warrant adding still more accommodation.

It may turn out to be optimal for central banks to guarantee fiscal authority debts in some situations. If so, we again have to think of price level determination as something that is done jointly by the fiscal authority and the central bank

I believe that the FOMC’s ultimate effectiveness relies critically on its communication and the credibility of that communication. I’ve dissented at the last two meetings because I believe that the Committee’s decisions at those meetings diminish that requisite credibility.

In response to [improvement] in economic conditions, the Committee should have lowered the level of monetary accommodation over the course of the [past] year. Instead, through actions taken at its last two meetings, the Committee has raised the level of monetary accommodation. In this sense, the Committee’s recent actions in 2011 are inconsistent with the evolution of the economic data in 2011.

I want to close my discussion of FOMC performance by explaining why there is no longer an intrinsic connection between the size of the Fed’s balance sheet and inflation. I’ve mentioned how the Federal Reserve has bought over $2 trillion of government securities. It has funded that purchase by tripling the amount of deposits held by banks with the Fed—what are called bank reserves. The standard reasoning is that this kind of reserve creation is inflationary. Banks are only allowed to offer checkable deposits in proportion to their reserves. Economists view checkable deposits as a form of money because, like cash, checkable deposits make many transactions easier. In this sense, bank reserves held with the Fed are essentially licenses for banks to create a certain amount of money. By giving out more licenses, the FOMC is allowing banks to create more money. And if you took any economics in school you learned: more money chasing the same number of goods—voilà, inflation. Indeed, I think I’m pretty safe in saying that after four years in economics grad school, I’ve uttered this phrase—more money chasing the same number of goods creates inflation—more often than anyone else in this room.

But this connection between bank reserves and inflation is simply not operative right now. Banks have few good lending opportunities, and so they’re not trying to attract deposits. As a result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need to back their deposits. In other words, banks have the licenses to create money, but are choosing not to do so.

I’m confident, though, that at some point in the future, the economy will improve and banks will once again have good lending opportunities. Some observers are concerned that once this happens, the banks’ excess reserves will serve as kindling for an inflationary fire. This concern would have been entirely appropriate three years ago. But in October 2008, Congress granted the Federal Reserve the power to pay interest on bank reserves. Right now, that interest rate is 25 basis points, or 0.25 percent. By raising that rate judiciously, the Fed has the ability to deter banks from using their reserves to create money, and through this mechanism, the Fed can prevent inflation. The Fed’s ability to pay interest on reserves means that the old and familiar link between increased bank reserves and higher inflation has been broken.

Of course, this requires the Fed to raise the interest rate on reserves in response to changes in economic conditions. You might well ask: Will the Fed raise interest rates in a sufficiently timely and effective manner to keep inflation at 2 percent or a little less? But that’s always been the key question to ask about Fed policy, even when the Fed had a much smaller balance sheet. And that’s my point: Because the Fed can pay interest on reserves, the size of its balance sheet does not, in and of itself, undercut the credibility of its commitment to keep inflation at 2 percent or a bit under. I believe that’s why both survey and market-based measures of expected inflation over the next five to 10 years have remained remarkably stable as the Fed has expanded its liabilities.

Now, although policymakers have the primary responsibility for effectively communicating their decisions, the task becomes easier when the general public has a basic grasp of economic and financial principles. Everyone benefits from a better public understanding of basic economic concepts. It helps policymakers in their efforts to successfully convey policy decisions, and it allows voters to more effectively hold policymakers accountable.

Now, although policymakers have the primary responsibility for effectively communicating their decisions, the task becomes easier when the general public has a basic grasp of economic and financial principles. Everyone benefits from a better public understanding of basic economic concepts. It helps policymakers in their efforts to successfully convey policy decisions, and it allows voters to more effectively hold policymakers accountable.

 Like many private sector forecasters, the FOMC has overestimated the strength of the recovery over the past two years. Some have suggested that the unexpected slowness of the recovery is a justification for the FOMC’s increasing the level of monetary accommodation over the past couple of months. But I disagree with this argument. I’ve just described why the FOMC should respond to improvements in economic conditions and outlook with a reduction in the level of monetary accommodation. Logically, if the economy recovers much more slowly than expected, then the FOMC should respond by reducing the level of monetary accommodation much more slowly than expected. The FOMC should only increase accommodation if the economy’s performance and outlook, relative to the dual mandate, actually worsens over time.

"I like [Evans'] framing of the problem very much," Kocherlakota told reporters after a speech to the Harvard Club of Minnesota, although he stopped short of embracing Evans' call for more easing.

Once the central bank's policy-setting Federal Open Market Committee makes its goals clear, Kocherlakota said, it could safely allow inflation to temporarily rise above its long-term 2-percent target to help bring down unemployment.

The Committee should provide a public contingency plan—that is, provide clear guidance on how it will respond to a variety of relevant scenarios.

I believe that this kind of public contingency planning will have many benefits. Let me mention two. First, in recent statements and speeches, I have described why the FOMC actions in August and September seemed inconsistent with the evolution of the macroeconomic data in 2011. This kind of inconsistency is much less likely to occur once the FOMC has formulated an explicit public contingency plan. Second, I’ve heard from businesses that policy uncertainty is curbing their incentive to hire or invest. Similarly, I’ve heard from consumers that policy uncertainty is curbing their incentive to spend. A public FOMC contingency plan can help reduce the level of policy uncertainty being created by the Fed.

No contingency plan can ever be definitive. Inevitably, the FOMC will learn things that it did not expect to learn, and events will occur that it did not expect to occur. And so there may be conditions that force the FOMC to deviate from a chosen plan. However, having a public plan, and couching its decisions against the backdrop of that plan, will enhance Federal Reserve transparency, credibility, accountability and consistency.

The FOMC should do more than simply decide at each meeting whether or not to buy more assets or to keep interest rates low for longer. Any current decision is based on the FOMC’s forecast of the future, and no forecast can be perfect. The Committee should provide a public contingency plan—that is, provide clear guidance on how it will respond to a variety of relevant scenarios.

I believe that public contingency planning will have many benefits. Let me mention two. First, in recent statements and speeches, I have described why the FOMC actions in August and September seemed inconsistent with the evolution of the macroeconomic data in 2011. This kind of inconsistency is much less likely to occur once the FOMC has formulated an explicit public contingency plan. Second, I’ve heard from businesses that policy uncertainty is curbing their incentive to hire or invest. Similarly, I’ve heard from consumers that policy uncertainty is curbing their incentive to spend. A public FOMC contingency plan can help reduce the level of policy uncertainty being created by the Fed.

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.

How would the Committee accomplish this reduction? 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.

Two months earlier, Kocherlakota had rejected the idea of changing the guidance because it undermine future precommitment efforts.

In particular, the Committees 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.

"I would see an argument for initiating that exit [from the Fed's accomodative stance] in 2012 or 2013," Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, told reporters after a speech at Washington University in St. Louis.

Kocherlakota made a similar comment at the same time last year, arguing that rate hikes were possible in 2011.

“I don’t feel the need for additional accommodation right now,” he said to reporters after the speech. Kocherlakota said he sees the Fed beginning to withdraw monetary stimulus in 2012 or 2013 if the economy meets his forecast, including an inflation rate of 2 percent or higher during the next two years.

“That doesn’t mean I want to raise rates tomorrow,” he said. “You want to be cautious about that.”

My own belief is that we will need to initiate our somewhat lengthy exit strategy sometime in the next six to nine months or so, and that conditions will warrant raising rates sometime in 2013 or, possibly, late 2012.

My own belief is that we will need to initiate our somewhat lengthy exit strategy sometime in the next six to nine months or so, and that conditions will warrant raising rates sometime in 2013 or, possibly, late 2012.

The dates change, but the song remains the same.  See Kocherlakota's comments one year earlier.

Six to nine months down the road, we should be thinking about initiating our exit strategy.

Inflation was distinctly higher in 2011 than in 2010 and continues to run above the FOMC’s target of 2 percent.

Even core measures of inflation, which strip out energy goods and services, and food, went up notably. I see these changes as a signal that our country’s current labor market performance is much closer to “maximum employment” than the post-World War II U.S. data alone would suggest. As I’ve argued in the past, appropriate policy should be responsive to such signals.

Accelerating inflation is “a signal that our country’s current labor market performance is much closer to ‘maximum employment,’ given the tools available to the FOMC, than the post-World War II U.S. data alone would suggest,” Kocherlakota said today

"As a president, I get a lot of incredibly useful information from the bank directors that serve on our boards and I think it would be a loss to me in my policy role to lose that valuable source of information," Kocherlakota said in response to audience questions following a speech at the South Dakota School of Mining and Technology

The erosion in labor-market performance that we’ve seen in the United States over the past five years may be highly persistent, even under appropriate monetary policy.

The benefit of using risk-neutral probabilities arises from the observation that resources may be more valuable in one state of the world relative to another, equally likely, state of the world. (For example, the economy might be in a deep recession in the former state and in a boom in the latter.) In weighing future costs and benefits, the policymaker should take account of this differential valuation of resources in different states. Because they are derived from market prices, risk-neutral probabilities provide the needed information about the relative values of resources in different states of the world in a way that purely statistical forecasts cannot.

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said a reduction in the interest rate paid on reserves banks keep with the Fed is one policy tool available should the economy need more stimulus.

“There is some room to reduce that further to incentivize banks to lend,” Kocherlakota said today in response to an audience question after a speech in Minot, North Dakota. “This should be something that we think about” if further easing becomes necessary, even though a cut would have only “minimal effects on the economy,” he said.

I want to be clear about the economic mechanism by which the proposed liftoff plan generates stimulus. First, it does not generate stimulus by having the FOMC tolerate higher rates of inflation, as has been espoused by many observers. I am doubtful about the efficacy of the inflation-based approach. I suspect that many households would believe that their wage increases would not keep up with the higher anticipated inflation rates. Those households would save more and spend less—exactly the opposite of the policy’s aim. In any event, I think that this approach is a risky one for central banks to use, because it requires them to raise inflation expectations—but not too much.

My main message today is that the FOMC can provide additional monetary stimulus by making this sentence more precise in the form of what I’m going to call a liftoff plan: a description of the economic conditions that would lead the Committee to contemplate the initial increase in the fed funds rate above its currently extraordinarily low level.

I will suggest the following specific contingency plan for liftoff:

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 percent.

The fed funds rate is a short-term interbank lending rate that is the FOMC’s usual vehicle for influencing credit conditions. I’ll be much more precise later about the meaning of the phrase “satisfies its price stability mandate.” Briefly, though, 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 percent. 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 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.

This is a remarkable change of views.  See his comments from earlier this year.

 

I first described the ideas [of my "liftoff plan"] about three weeks ago, in Ironwood, Michigan. It evinced mixed reactions. Some observers felt that the proposed liftoff plan was dovish, in the sense that it seemed to put a lot of weight on the employment mandate. Others argued that the plan was hawkish, in the sense that it put a lot of weight on the price stability mandate.

I think that this dispersion of views reflects a simple fact: The plan is neither hawkish nor dovish. The terms “hawkish” and “dovish” presume that the Committee faces a tension between its two mandates. But the Committee does not see any tension between its two mandates now.

We should always judge the appropriateness of the Fed’s policies in terms of how the economy is doing relative to the two Main Street goals that Congress has set for the FOMC. Such a comparison does not suggest that monetary policy is currently too easy.

It is clear that the TBTF problem is small if living wills work so well that there is little or no likelihood of a distressed financial institution ever receiving support. But I would suggest too that the TBTF problem is also small if creditors perceive that, because of either economic conditions or capital requirements, there is little likelihood of important financial institutions becoming distressed. To use an analogy, some observers have expressed concern about emergency federal flood assistance creating a moral hazard problem. But, even if the government stands ready to provide full assistance to all in the event of a flood, I would expect the impact of the relevant moral hazard problem to be low for a house in the 10,000 year flood zone.

My own forecast, conditional on the FOMC’s current monetary policy stance, is that inflation will run below the Fed’s target of 2 percent over the next two years and the unemployment rate will remain elevated. This forecast suggests that, if anything, monetary policy is currently too tight, not too easy.

Upon hearing those two different plans for interest rates, people should have different expectations for what the paths of economic activity and unemployment are going to be. And, in particular, between the 7 percent plan and the 5 1/2 percent plan, the second suggests that times are going to be better for them in general, going forward. It means that individuals don’t need to save as much for bad times ahead. That’s the basic point of providing such forward guidance, to convey the expectation that because times will be better in the future, individuals don’t need to save as much and therefore can spend more now.

In response to a question about whether he was surprised that the public felt his views had changed radically.

In some ways, yes, I was surprised.

I was surprised by the reaction in the sense that I felt I was putting a lot of weight on the price stability mandate by suggesting that even an inflation outlook—medium-term outlook, two-year outlook—that is a quarter percentage point higher than 2 percent should be viewed as a cause for concern. I’m not saying we’re going to raise rates at that point, just to be clear. But I’m saying it’s a time to consider raising rates.

I felt that I was actually being highly respectful of the price stability mandate, and properly so. With that said, I think it is true that to suggest that unemployment could get as low as 5 1/2 percent without pushing inflation above 2 1/4 percent, that was a change in my thinking relative to where I was in April. That change in my thinking came just because of the data on inflation and reading a ton of work that had been done on the factors generating high unemployment.

…

I gave a speech about structural unemployment in August 2010 in which I pointed to the shift in the “Beveridge curve.” This is a plot of unemployment and vacancies over time. It has shifted outward, meaning that, roughly speaking, it looks like firms are having a surprisingly hard time filling their job openings given how many people are looking for jobs. There are other interpretations of this, though, as there always are in economics. So, I laid out my concerns about that shift in August 2010. That shift is still there in the data.

But what’s changed since August 2010 is that there’s been a lot of research trying to parse out what is responsible for this shift. That work goes through a number of factors. It’s summarized in a paper that Professor Edward Lazear gave at the Kansas City Fed’s Jackson Hole Conference earlier this year [2012].8 As a Fed president, I was already aware of a lot of that work because much of it has been done within the [Federal Reserve] System.

What this work usually does is look, factor by factor, at how much unemployment is caused by each structural factor. Generally, the answer is not a lot. You can get to maybe a percentage point, or point and a half, of the increase in unemployment since 2007, due to structural factors, something like that.

Those studies were very important in shaping my thinking. Another thing that happened was that inflation over the course of 2012 came in considerably lower than I had anticipated. Both of those things mattered in shaping how I thought about inflation going forward.

The liftoff plan is to sustain low interest rates—that is, we’ll keep the fed funds rate extraordinarily low—at least until unemployment falls below 5 1/2 percent, as long as the medium-term outlook for inflation remains within a quarter of a percentage point of 2 percent, the long-run target. “Medium term” meaning—I’m very precise on this in the speech—but it basically means a two-years-ahead outlook for inflation.

…

I set {the inflation threshold} at a quarter percentage point because, actually, given how high unemployment is, I think it’s unlikely we could ever get the medium-term inflation outlook to be as high as 2 1/4 percent, frankly.

…

Given the Committee’s thinking, typically, about how it views its longer-run objectives, the 2 1/4 percent/5 1/2 percent numbers were consistent with how I thought the Committee would behave in the future, basically. And you don’t want to lay out something that seems implausible for the Committee to deliver on.

I should be clear about a couple of aspects of the thresholds. First, the unemployment rate threshold is not a trigger for FOMC action. Thus, the FOMC may choose not to raise interest rates when the unemployment rate falls below 6.5 percent. Second, I see the FOMCs guidance as providing a great deal of protection against undue inflationary pressures. In particular, the commitment to keep interest rates extraordinarily low is off the table if the medium-term inflation outlook ever rises above 2.5 percent.

In its current forward guidance, the FOMC has stated that it expects the fed funds rate to remain extraordinarily low at least until the unemployment rate falls below 6.5 percent. The FOMC could provide additional needed stimulus by lowering the threshold unemployment rate from 6.5 percent to 5.5 percent—that is, by changing one number in the existing statement.

To see why I say so, consider two possible scenarios. In the first, the public believes that the FOMC will begin raising the fed funds rate once the unemployment rate hits 6.5 percent. (To be clear: This belief is consistent with, but not necessarily implied by, the FOMC’s current forward guidance.) In the second, the public believes that the FOMC will defer the initial increase in the fed funds rate until the unemployment rate hits 5.5 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity.

Thus, lowering the unemployment rate threshold to 5.5 percent would increase the demand for goods and thereby push upward on both employment and prices. Would this extra monetary stimulus result in an undue amount of inflation at some point in the future? ... To me, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, the medium-term inflation outlook will stay close to 2 percent.

Kocherlakota, speaking today in a panel discussion at the Boston Fed, reiterated a January 2012 policy statement in which the Federal Open Market Committee said its inflation and employment “objectives are generally complementary.”

“However, under circumstances in which the committee judges that the objectives are not complementary, it follows a balanced approach in promoting them,” Kocherlakota said.

I should be clear about a couple of aspects of the thresholds. First, the unemployment rate threshold is not a trigger for FOMC action. Thus, the FOMC may choose not to raise interest rates when the unemployment rate falls below 6.5 percent.

“It’s very important to protect the target both from above, which gets so much attention, but from below as well,” Kocherlakota said.

He said he’s already “in favor of more accommodation” and further declines in the inflation rate would make him “even more” supportive of additional stimulus.

As of 2007, the United States had just gone through nearly 25 years of macroeconomic tranquility. As a consequence, relatively few people in the United States saw a severe macroeconomic shock as possible. However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Workers and businesses want to hold more safe assets as a way to self-insure against this enhanced macroeconomic risk.

...

The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. It follows that the Federal Open Market Committee (FOMC) can only meet its congressionally mandated objectives for employment and prices by taking actions that lower the real interest rate relative to its 2007 level. The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

The passage of time will ameliorate these changes in the asset market, but only gradually. Indeed, the low real yields on long-term TIPS bonds suggest to me that these changes are likely to persist over a considerable period of time—possibly the next five to 10 years. If this forecast proves true, the FOMC will only meet its congressionally mandated objectives over that long time frame by taking policy actions that ensure that the real interest rate remains unusually low.

One challenge with this kind of policy environment—and this is closely linked to the overarching theme of this panel—is that low real interest rates are often associated with financial market phenomena that signify instability. There are many examples of such phenomena, but let me focus on a particularly important one: increased asset price volatility. When the real interest rate is unusually low, investors don’t discount the future by as much. Hence, an asset’s price becomes sensitive to information about dividends or risk premiums in what might usually have seemed like the distant future. These new sources of relevant information can lead to increased volatility, in the form of unusually large upward or downward movements in asset prices.

These kinds of financial market phenomena could pose macroeconomic risks. These potentialities are best addressed, I believe, by using effective supervision and regulation of the financial sector. It is possible, though, that these tools may fail to mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy. However, it should only do so if thecertain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis. Hence, the FOMC’s decision about how to react to signs of financial instability—now and in the years to come—will necessarily depend on a delicate probabilistic cost-benefit calculation.

In my view, the Committee could better achieve its goals by augmenting its communications to provide the missing clarity. For example, the Committee has not described how it will set its fed funds rate target when the unemployment rate has fallen below 6.5 percent but remains above 5.5 percent—a period of time that I currently expect to last about two years. In contrast, the policy strategy that I described above says specifically that the FOMC will keep the fed funds rate extraordinarily low over that time frame (as long as the inflation conditions are satisfied).

The title of my speech today is “A Time of Testing.” Paul Volcker, then Chairman of the Federal Reserve Board of Governors, used the same title for a speech that he gave on October 9, 1979. Chairman Volcker intended his title to underscore that monetary policymakers in 1979 were confronted with a severe test in the form of high inflation and high inflation expectations. I use the title today to underscore that monetary policymakers in 2013 are again confronted with a severe test—but this time a test created by low employment and low employment expectations. Back in 1979, Chairman Volcker said that “this is a time of testing—a testing not only of our capacity collectively to reach coherent and intelligent policies, but to stick with them”1 [italics mine]. My theme today is that his powerful phrase applies with equal force to our current situation.

I see three key parallels between the economic situation in 1979 and the economic situation in 2013. First, just like in 1979, the Federal Open Market Committee faces a challenging macroeconomic problem—although this time, the problem is stubbornly low employment as opposed to stubbornly high inflation. Second, there is a widespread perception that monetary policymakers lack either the tools or the will to solve this problem.

And third, the perception of monetary policy ineffectiveness is itself a key factor in generating the problem… If the public thinks that monetary policy is ineffective, then it will expect relatively weak macroeconomic conditions in the future. But these expectations about the future have a direct impact on current macroeconomic outcomes…

We’ve seen how the FOMC dealt with its problems in 1979 by adopting a goal-oriented approach to monetary policy. Given the parallels between 1979 and 2013, I believe that a goal-oriented approach would be useful again…

But, as Paul Volcker said in his 1979 speech, it is not enough to formulate or communicate a goal. The Committee has to stick to its formulated approach—that is, it must do whatever it takes to achieve its communicated goal. In the early 1980s, doing whatever it took meant being willing to keep money tight, even though interest rates and the unemployment rate rose to unusual heights. By doing whatever it took to achieve its goal, despite these short-term costs, the FOMC was able to bring down inflation and inflation expectations.

Basically, an unemployment rate of 7.3 percent means that the U.S. labor market is far from healthy.
But I would say that this measure—troubling as it is—overstates the improvement in the U.S. labor market… Most of the declines in the unemployment rate since October 2009 have occurred because the fraction of people who are choosing to look for work has fallen.
…
It is true that, even without the Great Recession, demographic forces would have led to some decline in the employment-to-population ratio since 2007. As the baby boom birth cohort—born between 1946 and 1964—ages, the fraction of retirees in the population grows steadily. But these demographic forces are simply too small to account for much of the decline in the employment-to-population ratio that I’ve described.

Under a goal-oriented approach, the Committee would respond to this weak outlook by providing more monetary stimulus—for example, by lowering the interest rate being paid to banks on their excess reserves.

The Committee could also promote a goal-oriented approach to monetary policy by making other changes to its communication… I’ve recommended that the FOMC announce its intention to keep the fed funds rate extraordinarily low at least until the unemployment rate falls below 5.5 percent, as long as the one-to-two-year-ahead outlook for the inflation rate stays below 2.5 percent. A recent working paper by senior Board of Governors staff suggests that this policy stance could indeed have material benefits in terms of the evolution of prices and employment.4
Beyond these changes in communication, the Committee could also take concrete policy steps to demonstrate commitment to a goal-oriented approach to policy. In its most recent statement, the Committee says that it expects the unemployment rate to decline gradually and the inflation rate to be below 2 percent over the medium term. Under a goal-oriented approach, the Committee would respond to this weak outlook by providing more monetary stimulus—for example, by lowering the interest rate being paid to banks on their excess reserves.

I do agree with these observers that the size of a financial institution is likely to be a useful source of information about the magnitude of that institution’s TBTF problem. At the same time, though, policymakers should guard against relying too much on this single metric. We should always keep in mind that the term too-big-to-fail is highly misleading. The TBTF problem is about creditor perceptions of loss protection. Creditors might well see the smaller of two institutions as being more likely to receive that protection, if the smaller institution is engaged in some kind of activity that is seen by government agencies as being especially vital. Thus, if we go back to 2008, government funds were used to facilitate the purchase of Bear Stearns by JP Morgan Chase. No such government funds were made available to facilitate the resolution of Lehman—and Lehman was certainly larger than Bear Stearns.

To a remarkable extent, Lars econometric and economic analyses dispense with these auxiliary assumptions. Doing the analysis without those assumptions requires harder math. But heres the true irony. Because the harder math allows us to get rid of the technical assumptions, the harder math gets us much closer to understanding the core implications of economics itself. And I believe that this is exactly why the generalized method of moments has become so widely used in economics and other social sciences. My own experience as a researcher was that persistence was incredibly important. Whenever I came up with a new idea, I was toldby many peoplethat the idea had to be wrong. Time would pass. And many of those same folks would come and tell me that they had decided that the idea was not wrong. Instead, they had a fresh criticismthey had decided that the idea was obvious to the point of banality. For you young researchers out there, thats called winning them over.

But the skill diversity that Ive been emphasizing is valued throughout the Federal Reserve System, not just in Minneapolis. To see this, one need not look any further than the key Research leadership positions around the Federal Reserve System. The Research director in Philadelphia is an economist with expertise in banking. The Research director in Chicago is an economist with expertise in labor economics and industrial organization. The Research director in New York is an economist with expertise in payments systems.

The FOMC has said that, under its current monetary policy stance, it expects the unemployment rate to decline gradually to desirable levels. It has said too that it expects inflation to move back toward 2 percent over the medium term. By easing monetary policy relative to its current stance, the FOMC could facilitate a more rapid fall in unemployment and more rapid return to 2 percent inflation. Hence, the Committee could do better with respect to both of its congressionally mandated objectives by adopting a more accommodative monetary policy stance.

A top Federal Reserve official known for his dovish views on policy acknowledged on Friday that monetary policymakers may need to take financial stability risks into account when making policy choices.

But Minneapolis Fed President Narayana Kocherlakota, who has repeatedly called on the U.S. central bank to ease policy further, stopped short of saying that such risks should keep the Fed from doing whatever it can to return the economy more quickly to full employment.

…

Arguably, the "large increase in yields only happened because monetary policy (QE3) had lowered yields so much," Kocherlakota said. The key question, he said, is whether that sudden rise in yields hurt overall economic growth more than the earlier decline in yields had helped. The answer, he said, is far from clear.

"There is considerable need for new theory and empirics," he concluded.

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From Market News International

Minneapolis Federal Reserve Bank President Narayana Kocherlakota said Friday that supervision is the best way for the Fed to tackle threats to financial stability, but said "residual risks" may remain for monetary policy to deal with.

Kocherlakota suggested "a framework to incorporate systemic risk mitigation into monetary policymaking" using a "mean variance framework." But he did not flesh out this suggestion, saying more theoretical work is needed.

If you’re not specific in the statement then market participants are just grasping for scraps of information everywhere, including the dots, as a way to try to formulate what is the committee really thinking. That this is just yet another example, following the examples we had last spring and summer. If you’re not specific about what your plans are – and specificity to me means numerical specificity, quantitative specificity — then market participants are going to be grasping for every piece of information that they can. That requires a lot of disciplined communication that’s very hard to live up to. A clause in an answer to a senator can be suddenly moving markets just because the statement itself has not been clear about what the committee’s intensions are.

WSJ: The policy statement says the Fed will keep the fed funds below long run equilibrium levels even after unemployment and inflation return to their long-run trends. But it doesn’t really explain why officials believe that that’s the right path. Why do you believe it’s the right path?

NK: There’s a number of answers to that question. That’s why it maybe doesn’t appear in the statement. The chair talked a little bit about this in her press conference, but I’ll speak for myself. When I talk to businesses and I talk to households you just feel the scarring effects of 2008 over and over again. Households and businesses are much more leery of spending now. They want to have resources on reserve when they can and that puts downward pressure on the amount of demand you’ll have at any given interest rate I think the interest rate that we’re going to have to maintain in order achieve our goals over the longer run is going to be lower than it would be historically. You see a diminution of this scaring effect of 2008, but it’s going to take time.

WSJ: Is this sort of the new normal? Or are you saying that this is still a dysfunctional economy and this dysfunction is going to persist longer than people realize?

NK: Right now I do not see this as the new normal but we should be open to considering that this could be a very persistent aspect of economic life. All I think this indicates is that the committee would have to follow a lower interest rate policy than you might think, that markets might think in order to achieve its objectives.

WSJ: Let’s call it a “scarring episode” interest rate. What is that rate?

NK: My own estimate is pretty low.

WSJ: Is it a negative real rate?

NK: Yes it is. That’s correct. I would see a negative real fed funds rate as being consistent with achieving our objectives.

The Federal Reserve should do more to boost both inflation and jobs, a top Fed official said on Tuesday, including possibly pushing its main interest rate even lower or cutting the rate it pays banks on excess reserves kept at the U.S. central bank.

"The key is for us to be able to demonstrate in an effective fashion that we are committed to the recovery," Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, told reporters after a speech.

So, inflation has been running too low over the past six-plus years to be consistent with price stability. The good news is that the FOMC does expect inflation to turn back toward 2 percent. However, I expect that return to 2 percent to take a long time—probably on the order of four years. And I’m not the only one forecasting a slow return to 2 percent inflation. Earlier this year, the Congressional Budget Office predicted that inflation will not reach 2 percent until 2019.

The Fed has kept its short-term policy rate between zero and a quarter of a percentage point since December 2008, and Kocherlakota told the Greater Rochester Chamber of Commerce that "we should be thinking about" pushing it even lower.
"It's really about demonstrating a commitment to stay with the recovery for as long as it takes to get the economy fully recovered," he said.
…
"We would be better off having more of a collective vision as a committee to what the change in conditions would have to be that would lead us from ending the asset purchase program to raising rates… Unless we communicate as a group about what those conditions are, then we face this instability that two words in a press conference, or two words in a speech or an answer to a Senator can end up moving financial markets participants' vision of what we are trying to do with policy."

So, whether we look over the past six years or over the past two years, inflation has been running too low to be consistent with price stability. The good news is that the FOMC does expect inflation to turn back toward 2 percent. However, I expect that return to 2 percent to take a long timepossibly on the order of four years. And Im not the only one forecasting a slow return to 2 percent inflation. Earlier this year, the Congressional Budget Office (CBO) predicted that inflation will not reach 2 percent until 2018.

Why would the FOMC want to use price level targeting? There are two reasonsand they are closely related to the concerns about low inflation that I raised earlier.

The first reason is that price level targeting makes long-term contracts safer for borrowers and lenders. For example, suppose a family took out a 30-year mortgage in 2012, under the expectation that the FOMC would deliver on its commitment to keep inflation at 2 percent. Because inflation has been so low over the past two years, the borrowers current repayments are now surprisingly expensive in real terms In contrast, if the FOMC uses price level targeting, the borrowers repayments in 2042 are likely to be close, in real terms, to what the borrower expected when originally taking on the loan.

The second reason that the FOMC might want to use price level targeting is that it would serve as an automatic stabilizer for the economy... [I]f the FOMC were to decide today to follow price level targeting, then businesses would anticipate more stimulative future monetary policy and, consequently, higher future demand. That expectation of higher demand would provide an additional incentive for them to hire and invest today. In this way, the FOMCs decision about price level targetinga decision about choices to be made several years from nowhas the potential to affect the near-term speed of the economys recovery.

Personally, I expect that, over the long run, the unemployment rate will converge to just over 5 percent. Basically, an unemployment rate of 6.3 percent means that the U.S. labor market is not healthy

I see the decline in mandate-consistent real interest rates as grounded in an increase in the demand for, and a fall in the supply of, safe financial investment vehicles. Importantly, I see these changes as likely to be highly persistent.
There are many factors underlying the increased demand for safe assets. I’ll discuss three that strike me as particularly important: tighter credit access, heightened perceptions of macroeconomic risk and increased uncertainty about federal fiscal policy.

In terms of credit access, I don’t think that it’s controversial to say that credit access is more limited than in 2007. What is less generally realized, I think, is that restrictions on households’ and businesses’ ability to borrow typically lead them to spend less and save more.

I can best illustrate this point through an example. Consider a household that wants to purchase a new home. In 2007, that household could have received a mortgage with a down payment of 10 percent of the purchase price, or even lower. In 2014, that same household is considerably more likely to need a down payment of 20 percent. These tighter mortgage standards mean that, to buy a similarly priced house, the household needs to first acquire more assets.

Thus, the demand for safe assets has risen because of tighter limits on credit access. It has also risen because of households’ and businesses’ assessments of macroeconomic risk… [I]n the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Now, more workers see themselves as being exposed to the risk of persistent deterioration in labor incomes. More businesses see themselves as being exposed to the risk of a radical and persistent downshift in the demand for their products. These workers and businesses have an incentive to accumulate more safe assets as a way to self-insure against this enhanced macroeconomic risk.

The federal fiscal situation is the third key source of elevated uncertainty. The federal government faces a long-run disconnect between its overt commitments and the baseline path of federal tax collections. This disconnect can only be resolved by raising taxes and/or cutting the long-run arc of spending… The prospect of reductions in Medicare, Medicaid or Social Security gives some households an incentive to demand more safe assets as a way of replacing those lost potential benefits.

I’ve argued that, due in part to tighter credit access and higher uncertainty, the demand for safe financial assets has risen since 2007. At the same time, the global supply of assets perceived as safe has also fallen. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. Not anymore. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. Not anymore.

Thus, the FOMC is confronted with a greater demand for safe assets and tighter supply of safe assets than in 2007. These changes in asset markets mean that, at any given level of real interest rates, households and businesses spend less. Their decline in spending pushes down on both prices and employment. As a result, the FOMC has to lower the real interest rate to achieve its objectives.2

I often hear that the FOMC has created a low interest rate environment that is harmful for savers and others. In my view, like savers, the FOMC is being forced to make unusual decisions by an unusual economic environment that is not of its own making. The FOMC has been confronted with a significant increase in safe asset demand and a significant fall in safe asset supply. Faced with these changes, the Committee can only achieve its macroeconomic objectives by taking actions to push down the real interest rate. Indeed, as I argued earlier, the subdued outlook for prices and employment suggests that the FOMC’s actions have not lowered the real interest rate sufficiently.

What about the future? The passage of time will ameliorate these changes in the demand for and supply of safe assets—but only partially. Any long-run forecast has enormous attendant uncertainties. But I expect that for a considerable period of time—possibly the next five years or more—credit market access will remain limited relative to what borrowers had available in 2007. I expect that many workers and businesses will remain more concerned than in 2007 about the risk of a large adverse shock. And I also expect that businesses will continue to feel a heightened degree of uncertainty about taxes and households will continue to feel a heightened degree of uncertainty about the level of federal government benefits. These considerations suggest that, for many years to come, the FOMC will have to maintain low real interest rates to achieve its congressionally mandated goals. I see this conclusion as broadly consistent with the April FOMC statement, which predicts that the target fed funds rate will remain low for some time after inflation and employment are near mandate-consistent levels.

Of course, my forecast is only a forecast. I am extremely confident that the actual path of inflation over the next four years will turn out to be higher or lower than what I currently expect it to be! What you should take away, though, is that I currently see the probability of inflations averaging more than 2 percent over the next four years as being considerably lower than the probability of inflations averaging less than 2 percent over the next four years. And thats why I conclude my discussion of inflation by saying that the FOMC is undershooting its price stability goal.

"You hear a lot of concerns that it is time for us to exit, time for us to start thinking about leaving the zero lower bound and raising rates," Kocherlakota told community bankers here. "But boy, it's a mistake to go too early. And we should profit from the examples of other countries on that."

…

"As long as inflation remains low, below 2 percent, below our target, we have room to be supportive and to be helpful," Kocherlakota told the Independent Community Bankers of Minnesota, citing research from his bank that increasing inflation by a quarter of a percentage point could add 1 million jobs to the American economy. The FOMC is still a long way from meeting its targeted goal of price stability.

…

Kocherlakota started his job in 2009 as a policy hawk, but abandoned that stance after the inflationary threat he thought he saw looming never materialized. "You get beaten in the head with the numbers enough and you have to change your mind, and that's what I have done," he said.

…

Citing the "disturbingly low" fraction of people aged 25 to 54 who actually have a job, and the historically high fraction of part-time workers who would prefer to work full time, Kocherlakota said he believes labor markets are still "some way from meeting the (Fed)'s goal of full employment."

The persistently below-target inflation rate is a signal that the U.S. economy is not taking advantage of all of its available resources. If demand were sufficiently high to generate 2 percent, then demand would be sufficiently high to allow the economy to make use of the underutilized resources. And the most important of those resources is the American people. There are many people in this country who want to work more hours, and our society is deprived of their production.

The minutes for the January 2014 meeting note that FOMC participants saw the coming year as an appropriate time to consider whether the statement could be improved in any way. I concur: The time is right to consider sharpening the FOMCs statement of its objectives in several ways.

In my view, inflation below 2 percent is just as much of a problem as inflation above 2 percent

The FOMC should consider articulating a benchmark two-year time horizon for returning inflation to the 2 percent goal.

Right now, although the FOMC has a 2 percent inflation objective over the long run, it has not specified any time frame for achieving that objective. This lack of specificity suggests that appropriate monetary policy might engender inflation that is far from the 2 percent target for years at a time and thereby creates undue inflation (and related employment) uncertainty.

Market-based measures of longer-term inflation expectations have fallen recently to unusually low levels, a decline that I believe reflects that kind of increased downside risk.

There are a number of possible actions that I would have seen as responsive to the evolution of the data. Let me describe two in particular. First, the Committee could have continued to buy $15 billion of longer-term assets per month. Second, it could have committed to keeping the target range for the federal funds rate at its current level at least until the one- to two-year-ahead inflation outlook has risen back to 2 percent, as long as risks to financial stability remain well-contained. These actions would have put upward pressure on the demand for goods and services and on prices. Just as importantly, these actions would have communicated that the Committee is determined to do what it takes to push inflation back to 2 percent as rapidly as is possible.

The Fed needs a framework to incorporate systemic risk mitigation into monetary policymaking. Systemic risk creates a mean-variance trade-off for policy.

I believe that the FOMC should consider articulating a benchmark two-year time horizon for returning inflation to the 2 percent goal. (Two years is a good choice for a benchmark because monetary policy is generally thought to affect inflation with about a two-year lag.) Right now, although the FOMC has a 2 percent inflation objective over the long run, it has not specified any time frame for achieving that objective. This lack of specificity suggests that appropriate monetary policy might engender inflation that is far from the 2 percent target for years at a time and thereby creates undue inflation (and related employment) uncertainty. Relatedly, the lack of a public timeline for a goal can sometimes lead to a lack of urgency in the pursuit of that goal. I believe that, if the FOMC publicly articulated a reasonable time benchmark for achieving the inflation goal, the Committee would be led to pursue its inflation target with even more alacrity.

[I]n our studies of the Bakken at the Minneapolis Fed, we have been struck by what might be called the localness of the Bakkens impact.

This localness phenomenon is depicted in terms of wages on this chart. It shows that wages have skyrocketed since 2004 within the Bakken counties. Wages have grown less strongly, but still robustly, in counties that are within 100 miles of the Bakken counties. Once we get outside that 100-mile circle, though, wage growth within a county is essentially unaffected by its distance from the Bakken.

Indeed, my benchmark outlook is that PCE inflation will not rise back to 2 percent until 2018. This sluggish inflation outlook implies that, at any FOMC meeting held during 2015, inflation would be expected to be below 2 percent over the following two years. It would be inappropriate for the FOMC to raise the target range for the fed funds rate at any such meeting.

From November 2010 through July 201431 consecutive meetingsthe FOMC was in a position to state that longer-term inflation expectations remain stable. Because of the decline in market-based measures of longer-term inflation expectations in the past few months, the Committee has not been able to make this assertion in the past three FOMC statements.

Despite these facts, the FOMC communicated its intention after this weeks meeting to continue gradually removing monetary accommodation. In my assessment, the FOMCs failure to respond to weak inflation runs the risk of creating a harmful downward slide in inflation and longer-term inflation expectations of the kind that we have seen in Japan and Europe. I see this risk to the credibility of the inflation target as unacceptable, given how hard it would be for the FOMC to respond successfully if this eventuality did indeed materialize.

Discretion is better than any rule in setting monetary policy

Kocherlakota laid out a detailed case for why rules-based interest-rate policies almost always fail to do a better job than flesh-and-blood central bankers. He said policy makers must consider information that cant be plugged into mathematical rules.

Kocherlakota said a rule-based approach would only work if it constrained a central bank that showed a clear bias toward letting inflation run too high.

In the U.S. there is little evidence of an inflationary bias by the central bank, he said.

Accountabilityin any endeavor, including monetary policyis not about what actions have been taken. Rather, its about the results those actions achievespecifically, how well performance accords with the relevant objectives. Accordingly, my discussion of FOMC performance and plans is relentlessly goal-oriented.

My goal-oriented approach to FOMC accountability differs from the approach taken in legislation about monetary policy accountability that is currently under consideration by Congress. The Federal Reserve Accountability and Transparency Act (or FRAT Act) would require the FOMC to tell Congress and the public how the Committee plans to change the level of monetary accommodation in response to macroeconomic developments. A key element of the FRAT Act is a reference policy rule that would be intended to serve as a baseline for this communication. The rule frames accountability in terms of what choices the Committee is making, as opposed to how the macroeconomy is performing relative to FOMC objectives. In my discussion, Ill explain how this approach to accountability means that the reference policy rule in the FRAT Act would be likely to degrade, rather than enhance, the FOMCs ability to achieve its objectives.
...
To be clear, the proposed legislation allows for the FOMC to deviate from the reference policy rule. However, the legislation views deviations from the reference policy rule as being undesirable. (In particular, it requires the FOMC to provide Congress with a detailed justification for any departure from the reference policy rule within 48 hours.) My point is that this perspective is flawed, because the reference policy rule does not allow for the possibility that the natural real rate of interest varies over time.

Raising the target range for the fed funds rate in 2015 would only further retard the pace of the slow recovery in inflation. It would also increase the risk of a loss of credibility, in the sense that the public could increasingly perceive the FOMC as aiming at a lower inflation target. Hence, given my current outlook for inflation, I anticipate that, under a goal-oriented approach, the FOMC would not raise the fed funds rate target this year.

The decline in the long-run neutral real interest rate increases the likelihood that the economy will run into the lower bound on nominal interest rates. Accordingly, there is an enhanced risk that the Federal Open Market Committee (FOMC) will undershoot its maximum employment and 2 percent inflation objectives. Fiscal policymakers can mitigate this risk by choosing to maintain higher levels of public debt than markets currently anticipate. I want to be clear at the outset that I am not saying that it is appropriate for fiscal policymakers to increase the long-run level of public debt. I am simply pointing to one benefit associated with such an increase: It allows the central bank to be more effective in mitigating the impact of adverse shocks to aggregate demand.

Many observers have called for the FOMC to tighten monetary policy by raising interest rates in the near term. But such a course would create profound economic risks for the U.S. economy.

Why would a near-term tightening of monetary policy be so problematic? Because given the prevailing economic conditions, higher interest rates would push the economy away from the FOMC’s economic goals, not toward them.
...
I am confident that the time will come when economic conditions will be appropriate for the FOMC to raise the federal-funds rate from its current low level. But that time is not now. Tightening monetary policy when inflation is projected to be so low is a step in the wrong direction.

There has been a lot of conversation recently about the desirability of initiating a gradual increase in the fed funds rate sometime in 2015. In my view, we should judge the desirability of such a policy decision through the lens of the FOMC’s objectives. Personal consumption expenditures (PCE) inflation has been running well below 2 percent for more than three years and is currently at 0.3 percent. My current outlook is that it will continue to do so for several years. Based on this outlook, raising the fed funds rate in this calendar year would be inappropriate, because such an action would serve to further delay the return of inflation to target.

These considerations refer only to the price stability objective. In terms of the maximum employment objective, I believe that the FOMC can best fulfill this congressional mandate by doing what it can to facilitate further labor market improvement. Again, this consideration argues against raising the fed funds rate in 2015.

Thus, under my current economic outlook, the FOMC can best achieve its objectives by keeping the fed funds rate target at its current level during this calendar year.

There has been a significant decline in the long-run neutral real interest rate in the United States over the past few years. This decline in the long-run neutral real interest rate increases the future likelihood that the FOMC will be unable to achieve its objectives because of financial instability or because of a binding lower bound on the nominal interest rate. Plausible economic models imply that the fiscal authority can mitigate this problem by issuing more public debt, although such issuance is not without cost. It is, of course, the province of the fiscal authority to determine whether those costs are worth the benefits that I’ve emphasized today.

It would be hard to formulate a quantitative metric of long-run financial stability. It would be hard for policymakers to know how to treat deviations from that metric. Finally, the lags associated with the influence of monetary policy on this metric are highly uncertain. These challenges mean that adding a financial stability mandate would likely generate more public uncertainty about policy choices and economic outcomes. In considering whether to add a third mandate, these potentially large costs would have to be weighed against whatever benefits might be identified.

In mid-2013, the FOMC announced its intention to taper its ongoing asset purchase program. We can see that this announcement represented a dramatic change in policy from the sharp upward movements in long-term bond yields that it engendered. Personally, I interpret this policy change back in 2013 as the onset of what the Committee currently intends to be a long, gradual tightening cycle. As I noted earlier, we would typically expect that such a change in monetary policy should affect the economy with a lag of about 18 to 24 months. Viewed through this lens, the slow rate of labor market improvement in 2015 is not all that surprising.

I don’t see raising the target range for the fed funds rate above its current low level in 2015 or 2016 as being consistent with the pursuit of the kind of labor market outcomes that we are charged with delivering. Indeed, I would be open to the possibility of reducing the fed funds target funds range even further, as a way of producing better labor market outcomes.

There is, of course, a risk that inflationary pressures could build up more rapidly than I (or others) currently anticipate. But the solution to this scenario is relatively simple: Raise interest rates. Given my current outlook, I believe that it would be appropriate to wait until 2017 to initiate liftoff and then raise the fed funds rate at about 2 percentage points per year.