The head of the Minneapolis Fed says consumer demand remains soft and contributes to high unemployment.
ST. CLOUD - Federal Reserve Bank of Minneapolis President Narayana Kocherlakota defended the central bank's unprecedented monetary stimulus program Thursday as a necessary measure to stimulate demand and improve job growth.
At the same time, Kocherlakota indicated that deep structural changes in labor markets could make it necessary for the Federal Reserve to eventually tighten monetary policy even if the nation's unemployment rate remains unusually high by historic standards.
Kocherlakota, a first-time voting member of the policy-setting Federal Open Market Committee, warned that inflationary pressures could start developing with an unemployment rate of 7 or 8 percent -- abnormally high by historic standards. In such a scenario, he argued, a loose monetary policy might not be appropriate.
"At times you hear the statement that unemployment is so high -- 9 percent -- that we don't have to worry about inflationary pressures developing," Kocherlakota said during a question-and-answer session after a speech at St. Cloud State University. "But we can't take comfort in looking at the unemployment rate and say we're safe from inflation."
Kocherlakota's presentation was his most in-depth public analysis yet on the link between monetary policy and labor markets. His comments are closely followed by Fed watchers because Kocherlakota, a former University of Minnesota economist, is a new member of the FOMC and his policy views are less known.
Kocherlakota reiterated his support of the central bank's plan to buy hundreds of billions of dollars in government debt, a program known as "quantitative easing," while urging his fellow policymakers to guard vigilantly against the possibility that consumer prices could rise while joblessness remains high, as happened in the 1970s.
The warning that the Fed might have to tighten policy before unemployment declines significantly is likely to unsettle people who view fighting joblessness as a more important mission than the Fed's focus on inflation. Some have assumed that the Fed would keep short-term interest rates near zero so long as unemployment stays above pre-recession levels.
In his presentation, Kocherlakota argued that the current high unemployment rate is not solely related to cyclical shifts in the economy. He said it also is the result of longer-term factors, such as expectations of higher taxes, expansion of unemployment benefits and a growing mismatch between job vacancies and employee skills.
Together, these factors could explain why unemployment has remained stubbornly high even as the economy has begun to bounce back from the most severe downturn since the 1930s.
Using formulas to support his arguments, Kocherlakota said the "natural rate" of unemployment could range from as low as 5.9 percent to as high as 8.9 percent. As a result, the Fed may have to tighten monetary policy before unemployment returns to its pre-recession levels of below 5 percent.
Joblessness rose above 9 percent in May 2009 and has stayed at or above that level for the longest period since the government started tracking the data nearly six decades ago.
"Over the last few years, we have seen things that would lead you to think that the natural [unemployment] rate has risen," Kocherlakota said.
The Fed, he argued, can no longer take comfort in assuming that a high unemployment rate would mean the economy is safe from inflation. "In the 1970s, the United States experienced high inflation and high unemployment simultaneously," he said. "That experience made clear that accommodative monetary policy may not always be an appropriate response to high unemployment."
For now, Kocherlakota remains firmly in support of the Fed's unprecedented monetary stimulus and its stance of keeping short-term interest rates near zero for an extended period.
In November, the Fed announced a plan to buy $600 billion of Treasurys through June in an attempt to rejuvenate the economy and create more jobs. This bond-buying program has come under heightened criticism in recent weeks from some Fed policy makers and economists who argue that it may fuel inflation and be unnecessary in light of a strengthening economy.
Regional Fed presidents in Philadelphia and Richmond have urged the central bank to review the program, and possibly end it early. These policy makers are at odds with Fed chairman Ben Bernanke and the FOMC, the Fed's main policy arm, which voted unanimously in January to continue the bond purchase plan.
Kocherlakota said it is difficult to measure the impact of quantitative easing but that it has had at least one desirable result -- lowering long-term interest rates. He largely dismissed concerns about a near-term increase in consumer prices, noting that "core inflation," excluding energy and food, rose at a mere 0.5 percent annual rate in the second half of 2010.
Kocherlakota said the economy still is suffering from the overhang of falling residential property values, fiscal problems at the state level, and banks that are cautious to lend because of stress on their balance sheets. "It is appropriate for monetary policy to be accommodative," he said.
However, in keeping with past speeches, Kocherlakota defended the bond-buying program while tempering his enthusiasm. He said he never viewed quantitative easing as "a panacea."
"I said it then, and I'll say it now: The effects of large-scale asset purchases were positive, but modest," he said. "The effects are likely to be muted ... but it was a step in the right direction given the situation we're facing."
Kocherlakota, 47, is a former economics professor who previously served as chair of the Economics Department at the University of Minnesota. He is a native of Baltimore who spent much of his childhood in Winnipeg before graduating from Princeton University at age 19. He has published more than 30 articles in academic journals.
Chris Serres • 612-673-4308