Fed's Kocherlakota Advocates 50 bps Interest Rate Hike After Q3

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Just out from Minneapolis Fed's Kocherlakota: "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. First, the fed funds rate would be
extremely low—between 50 and 75 basis points.
As well, the Fed's
holdings of long-term assets would continue to provide significant
accommodation. Using estimates from the staff research that I mentioned
earlier, we can conclude that the total monetary policy package of the
two forms of accommodation would be roughly equivalent to maintaining a
fed funds target rate of negative 1.5 percentage points. Such a stance
can only be described as being easy monetary policy—just not as easy
as late 2010." That said, someone please remind us just how many of these so-called hawks voted against the FOMC action at the last meeting? Yeah, that's what we thought. And yes, Narayana, we will be closely watching your vote during the next FOMC meeting, because we can't shake this nagging feeling that you, just like all other Fed presidents, are mostly full of nothing but hot air.

Some Contingent Planning for Monetary Policy
Narayana Kocherlakota - President
Federal Reserve Bank of Minneapolis

Thank you very much for that generous introduction. I am delighted
to have this opportunity to be part of this year's Santa Barbara County
Economic Summit. Over the past 25 years, monetary policymakers all
over the world—including here in the United States—have become more
transparent about their deliberations and their thinking. Speeches like
this one play a huge role in that process. So I thank you for your
invitation to join you here today and for the opportunity to share my

As was mentioned in the introduction, I am the president of the
Federal Reserve Bank of Minneapolis. The Federal Reserve Bank of
Minneapolis is one of 12 regional Reserve banks that, along with the
Board of Governors in Washington, D.C., make up the Federal Reserve
System. Our bank represents the ninth of the 12 Federal Reserve
districts, and our district includes Montana, the Dakotas, Minnesota,
northwestern Wisconsin, and the Upper Peninsula of Michigan.

The Federal Open Market Committee—the FOMC—meets every six to seven
weeks (eight times per year) to set the path of monetary policy. All 12
presidents of the various regional Federal Reserve banks and the seven
governors of the Federal Reserve Board participate in these meetings.
(Right now, there are only five governors—two positions are unfilled.)
However, the actual policy decisions are made by the Committee itself.
It consists only of the governors, the president of the Federal Reserve
Bank of New York, and a group of four other presidents, which changes
annually. Currently, I'm a member of the Committee (along with the
presidents of the Federal Reserve Banks of Chicago, Dallas, and

At each FOMC meeting, there are two go-rounds, in which each
president and every member of the Board speaks in turn. The first
go-round concerns current economic conditions and the economic outlook.
The presidents typically say something about economic conditions in
their own district, as well as talk about national economic conditions.
The governors speak about national economic conditions, although they
often focus their remarks on particular slices of the overall economic

In the second go-round, we each speak in turn about our views on the
current monetary policy choices. However, those discussions often range
well beyond the confines of the next seven weeks. There is no sensible
way to talk about current policy choices without linking them in some
fashion to future policy choices. Hence, meeting participants may
sometimes describe (as briefly as they can!) how they expect (or would
like) policy to evolve over the coming months or even years.

My remarks today will be structured along the lines of an FOMC
meeting. I will first discuss my outlook for the U.S. economy. I will
then move on to talk about the key issues that I see affecting the
FOMC's policy choices over the coming months and years.

Before going further, I should say that my views are my own and not
necessarily those of others in the Federal Reserve System or of others
in the FOMC. This disclaimer is a standard one—but let me provide a
little more detail about what it will mean about the remainder of my
speech. I'm a member of the FOMC this year, and so I vote to determine
the course of monetary policy at each meeting. Given my position, I
believe that it is valuable for the public to know what economists
would term my monetary policy reaction function—that is, my
views about how monetary policy should react to various economic
scenarios. Of course, the FOMC is made up of 10 different individuals,
with 10 highly related, but nonetheless distinct, policy reaction
functions. The ultimate reaction function of the FOMC is a collective
one, and may well differ from that of any given Committee member. My
remarks are only about the nature of my reaction function, and not the collective one of the FOMC.

With that context in place, let me move to my outlook. I'll focus on
the three variables of most interest to us at the FOMC: real—that is,
inflation-adjusted—gross domestic product (GDP), unemployment, and
inflation. My bottom line is that, from the point of view of the
macroeconomy, 2011 will be a better year than 2010.

Recently, the Bureau of Economic Analysis released its advance
estimate for real GDP in the first quarter of 2011. This estimate
implies that real GDP grew at a 1.8 percent annual rate during the
quarter. This growth rate is a bit slower than what we've seen since
the end of the Great Recession: In the seven quarters since June 2009,
real GDP growth has averaged just below 3 percent. This rate of growth
is slow compared with the recovery in real GDP that took place after
the recession of 1981-82. However, it is similar to the recoveries that
took place after the recessions of 1991 and 2001.

Despite this somewhat slow start, I do expect that real GDP growth
will be slightly faster in 2011 than in 2010—something between 3
percent and 3.5 percent. Given the depth of the recession that we
experienced, this rate of growth is disappointing. I do still see two
headwinds in the U.S. economy. The first is that many households will
continue to strive to rebuild their net worth positions in response to
past—and possibly future—falls in residential land prices. As I have
discussed elsewhere,2
I believe that the decline in household net worth, precipitated by
falls in land values, was a key factor in generating the severity of
the Great Recession. It will remain important in the recovery.

The second headwind is related. Many smaller banks in the United
States face ongoing issues with asset quality. For example, the FDIC
problem bank list contains over 800 banks. Problem banks are less
likely to take the risk of lending to small and/or young firms and
other entrepreneurial activities. Instead, they are more likely to
preserve capital ratios by limiting their asset growth and allocating
their lending staff to working out loans to existing borrowers. Indeed,
as the economy improves, I suspect that this headwind will become even
more important. In 2010, our information at the Minneapolis Fed
indicates that small businesses were reluctant to expand because of
ongoing uncertainties about product demand. As a result, their demand
for bank financing remained low. In 2011, as the economy improves, I
expect loan demand to rise accordingly—but banks with poor asset
quality will continue to focus on capital preservation rather than loan

Let me turn now to the labor market, where I see conditions
improving slowly. The unemployment rate has fallen from 9.8 percent in
November to 8.8 percent in March. However, unemployment can fall in two
ways: People can find jobs or people can stop looking for work. Along
these lines, it is worth keeping in mind that the
employment-to-population ratio—the fraction of those over 16 with a
job—has improved only slightly since November and remains near
quarter-century lows.

I see the future course of unemployment as being shaped by two
conflicting forces. On the one hand, the growing economy should
generate more jobs and therefore lower unemployment. On the other hand,
the growing economy will also lead more people without jobs to look for
them. 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 be
between 8 percent and 8.5 percent by the end of the year.

Finally, I turn to inflation. The FOMC is mandated by the Federal
Reserve Act to keep prices stable. This mandate is typically translated
quantitatively into a 2 percent rate of inflation, or a bit under.
Here, by inflation, I'm referring to headline inflation—that is, the
rate of price increase of a bundle of all consumer goods and
services, including those related to food and energy. The problem is
that monetary policy operates with relatively long lags. Hence, out of
necessity, I view the Committee's price stability mandate as requiring
it to follow policies that will guide the economy toward 2 percent
headline inflation over the next three to four years.

I believe that the Fed can best achieve this medium-term objective for headline inflation by responding on an ongoing basis to movements in what's called core inflation.
Core inflation is a measure of inflation that strips out food and
energy products. I like core inflation as a measure of medium-term
inflationary pressures because demand and supply conditions in food and
energy markets are volatile, and so their prices tend to have
relatively large transitory fluctuations. Responding aggressively to
these fluctuations would lead to bad monetary policy. For example,
increases in energy prices pushed headline personal consumption
expenditure (PCE) inflation, when measured over the preceding year, up
to 4.5 percent in July 2008. With hindsight, we can see that it is good
that the FOMC did not raise rates in response to what proved to be a
temporary increase in headline inflation.

From the fourth quarter of 2009 to the fourth quarter of 2010, core
PCE inflation was 0.8 percent—the lowest annual inflation rate in the
50-plus-year history of that series. Inflation was low—but
disinflationary pressures were still strong as core PCE inflation
trended downward over the course of 2010. Over the last six months of
2010, the annualized core PCE inflation rate fell to 0.4 percent. That
is the second-lowest 6-month core PCE inflation rate ever recorded.

I don't expect this kind of disinflationary pattern to continue in
2011. Core PCE inflation from the fourth quarter of 2010 to the first
quarter of 2011 was 1.5 percent at an annualized rate. Similarly, I
expect that core inflation will be 1.5 percent over the remainder of

To summarize: I expect real output to grow slightly more rapidly in
2011 than in 2010. Household deleveraging and bank asset quality issues
will remain a drag on the recovery. Unemployment will fall—but more
slowly than we would like. Finally, inflationary pressures are
currently low. I expect core PCE inflation to grow slowly over the
course of 2011, while remaining under 2 percent.

What sort of faith should you put in these forecasts? Well, my
history of making forecasts is short so far, because I only took over
as president in October 2009. However, in February 2010, I gave my
first speech as bank president and offered forecasts about 2010 real
GDP, unemployment, and inflation. My forecasts for unemployment and GDP
ended up being pretty accurate. However, my forecasts for 2010
headline and core inflation were both about a percentage point too

I encourage you to keep this forecasting error in mind as I move on
to what would be the second go-round in the FOMC: the discussion of
policy considerations. I'll first discuss where we are now and then
talk about possible monetary policy changes over the coming year. Just
as is true in many actual FOMC policy go-rounds, you will see that my
discussion will necessarily spill into choices and decisions to be made
over the next five years.

The Federal Reserve currently has two forms of accommodative monetary
policy in place. The first is that the FOMC is targeting a low fed
funds rate of between 0 and 25 basis points. This kind of
accommodation—keeping short-term interest rates low—is an entirely
conventional response to unduly low levels of core inflation and unduly
high levels of unemployment. By keeping market interest rates low, the
policy encourages companies to invest their resources into hiring and
business expansions, and it also encourages households to engage in
more spending.

The second kind of accommodation is less conventional. The Fed has
bought about 2.1 trillion dollars of longer-term government securities,
and the FOMC has committed itself to buying an additional 0.2 trillion
dollars of these securities by the end of June. The thinking behind
this form of accommodation is that the FOMC's holdings of 2.3 trillion
dollars of longer-term securities raises their prices and lowers
longer-term yields. In so doing, more long-term investments—like
building factories or hiring workers—become more attractive to

Together, the low fed funds interest rate and the holdings of
long-term government securities provide a formidable amount of monetary
policy accommodation. We can quantify their joint effect using results
in a recent research paper by Federal Reserve staff.3
That paper estimates that if the Fed buys 200 billion dollars worth of
long-term government securities, the Fed provides stimulus to the
economy equivalent to that achieved by lowering the fed funds rate by
25 basis points. This translation implies that, at the end of 2010, the
FOMC's total amount of monetary accommodation was roughly equivalent
to what it could achieve by maintaining a fed funds rate of negative
2.5 percentage points.

This level of accommodation was adopted in November 2010, when the
FOMC committed itself to buying 600 billion dollars of longer-term
Treasuries by June 2011. The decision was nearly unanimous. I was not a
member of the Committee at that time, but I did support the decision.
We had seen a rather sharp fall in core inflation over the course of
2010, compared with what we had seen in 2009 and compared with what I
had expected earlier in 2010. I believed that it was appropriate to
ease policy in response to this fall in inflation. For myself, I would
have preferred to have been able to lower the fed funds rate—but that
option was not available.

Notice that the FOMC could have chosen a greater degree of
accommodation by buying more long-term Treasuries. It could have chosen
a smaller degree of accommodation by buying fewer long-term
Treasuries. My conclusion is that, in late 2010, this level of
accommodation was neither too tight nor too loose, given prevailing
economic conditions.4

But economic conditions change, and monetary policy must adjust to
those changes. Here's a metaphor that may be helpful. We can think
about the level of monetary accommodation as being akin to a gas pedal
on a car and the Fed's dual mandate as being a target speed. Right now,
the car is going too slowly, and so the Fed has its foot on the

There is one tricky part with the metaphor: with a car, a driver can
just keep his foot on the gas until he hits his target speed. Monetary
policy operates with long and variable lags—it's like driving a car in
which the car's rate of acceleration responds 10 to 20 seconds after
the driver adjusts the gas pedal. A driver of such a car will have to
ease up on the gas as he gets closer to his target speed—or he will end
up going too fast. In the same way, the Fed needs to lower its level
of accommodation as it gets closer to fulfilling its price and
employment mandates. Of course, like driving, monetary policy is an
exercise in scenario analysis. If the car starts going uphill and its
speed falls, then the driver needs to put more pressure on the gas.
Similarly, if the economy were to move further from the Fed's dual
mandates over the course of 2011, then the FOMC would need to put more
pressure on the monetary gas pedal and increase the level of its

When I engage in monetary policy scenario analysis, I find it useful
to start—but not finish—with my baseline economic forecast that I
described earlier. When the FOMC adopted its current level of
accommodation in late 2010, year-over-year core PCE inflation was 0.8
percent. My baseline forecast is that, by the end of 2011, core PCE
inflation will be 1.5 percent—that is, 70 basis points higher than in
the prior year. The Fed would then be closer to its price stability
mandate—and so should ease the pressure on the monetary gas pedal. The
standard response to such an 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.

Monetary policy should also adjust in response to changes in labor
market slack. These changes are typically hard to measure. However, like
many other economists' forecasts, my baseline forecast is that the
unemployment rate will be at least one percentage point lower at the
end of 2011, relative to November 2010. This kind of fall in the
unemployment rate would generally be viewed as signaling a decline in
slack, as would the increase that I expect to see in core inflation.
This fall in labor market slack would argue in favor of raising the fed
funds rate by even more than the 105 basis points that I mentioned

So far, my analysis implies that my baseline forecast should trigger
an increase in the target fed funds rate of at least 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. First, the fed funds rate would be
extremely low—between 50 and 75 basis points. As well, the Fed's
holdings of long-term assets would continue to provide significant
accommodation. Using estimates from the staff research that I mentioned
earlier, we can conclude that the total monetary policy package of the
two forms of accommodation would be roughly equivalent to maintaining a
fed funds target rate of negative 1.5 percentage points. Such a stance
can only be described as being easy monetary policy—just not as easy
as late 2010.

Thus, 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. Such a
reduction could take place in one of two ways. First, the FOMC is
currently investing any principal payments from its securities holdings
into long-term Treasuries. The Committee could decide to stop all or
part of these reinvestments.Alternatively, the Committee could reduce
accommodation by choosing to sell some long-term assets.

These two approaches of reducing accommodation operate on the Fed's
balance sheet. I'm open to these approaches to reducing accommodation.
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. As a policymaker, I need to be prepared for that
possibility. In terms of inflation, there are two kinds of errors to
contemplate. On the one hand, my forecast for core PCE inflation might
well be too high. 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.

On the other hand, my forecast for core PCE inflation might be too
For example, core PCE inflation might rise to 1.8 percent over the
course of 2011. But incoming data would reveal such a rapid increase
to the FOMC early in the third quarter of 2011. I would recommend
raising the target fed funds interest rate shortly thereafter.

Let me wrap up. My goal today has been to lay out my outlook for the
economy and give you a sketch of how I believe monetary policy should
react to changes in economic conditions. Under my baseline forecast, I
believe that it would be appropriate for the FOMC to raise the fed
funds target interest rate by a modest amount at the end of 2011.
However, that forecast—like all forecasts—is subject to error. I've
also discussed how my policy choices should and would react to those
errors—that is, I've discussed my policy reaction function.

I began this speech by broadly describing the makeup of the Federal
Reserve System and its policymaking body, the Federal Open Market
Committee, as well as my role on that Committee. I raise this point
again at the end to underscore the independent—yet collaborative—nature
of the FOMC. As I described, each member of the FOMC has his or her
own policy reaction function, grounded in our distinct but related
views. I believe it is our responsibility to describe those views to
the public. In that respect, I hope you found this speech enlightening,
and I am happy to take your questions to provide fuller explanation on
these and other matters. Thank you once again.