–Retransmitting, Shortening Headline

By Brai Odion-Esene

WASHINGTON (MNI) – It is likely that the Federal Reserve will to
have to sell a “nontrivial amount” of its mortgage-backed securities
holdings if it is to be able to normalize its balance sheet in the next
two decades, Minneapolis Federal Reserve Bank President Narayana
Kocherlakota warned Tuesday.

“Now the economy is on the mend. It is time for the Federal Reserve
to think about how to go about resuming its more traditional role,” he
said

However, such sales might cause “untoward” jumps in interest rates
unless the Federal Reserve is able to credibly commit to a sufficiently
slow pace, Kocherlakota added in prepared remarks for the Minnesota
Chamber of Commerce.

The central bank official stressed the importance of the Fed
getting its balance sheet back to normal, arguing that holding long-term
securities not only exposes the Fed to interest rate risk but that
holding the debt of Fannie and Freddie gives the impression that the
Federal Reserve is in the business of allocating credit to a particular
small sector of the economy — housing.

“We don’t want to be seen as being in the game of choosing which
sector to back among the many in the economy,” he said.

Kocherlakota is not in favor of a passive approach — no more
purchases or sales — to normalizing the Fed’s balance sheet, describing
it as “too slow.”

Warning that the passive approach would mean the Fed still holding
a significant amount of MBS for many years– maybe as late as 2040 — he
said it needs to supplement this approach with an active one if it is to
shrink its balance sheet in the next five, ten or even twenty years.

“In plain English, it will have to sell mortgage-backed
securities,” Kocherlakota declared.

Commenting on a possible plan, Kocherlakota said were the Fed to
commit to the public to sell $15 billion to $25 billion worth of MBS per
month, combined with mortgage prepayments, that “would get the Federal
Reserve of MBSs within five years after the start of selling.”

Noting the balancing act between the risk of selling the MBS at a
low price vs. the possibility that any MBS sales, not matter the size,
may have a big impact on long-term interest rates, Kocherlakota assured
that the Fed’s structure and independence means the central bank will
act in the public’s long-run interest, not short-term political or
monetary gain.

The Fed can credibly make and keep long-run committments, he said,
adding its structure also means the Fed can credibly commit to selling
its MBSs slowly over time.

Kocherlakota also gave his thoughts on the ongoing recovery in the
U.S., praising the diversity of an American economy that appears to be
gaining health without the supposedly requisite housing boost.

He said he is skeptical of arguments that the recovery will only be
sustainable if housing starts pickup dramatically. “We can — and I
believe that we will — have significant growth in output without seeing
a major turnaround in the housing market,” the central banker said.

He projected housing starts to remain low, perhaps for several years.

Kocherlakota also expects the economy to grow at a slightly slower pace
when compared to other forecasts, predicting 3% GDP growth per year over
the next two years.

This is partly the result of concerns he continues to have about
ongoing problems in the banking sector, particularly from commercial
real estate. “This threat could well lead to continued declines in bank
lending, which would curtail the recovery.”

The outlook for unemployment is also not promising, he said, adding
that he would be surprised if unemployment fell to less than 9% by the
end of this year or below 8% by the end of 2011.

On a brighter note, inflation “has been relatively tame,”
Kocherlakota said, with the Fed keeping inflation at levels consistent
with “god long-run economic performance.”

He concluded that he does not expect inflation expectations to rise
because that would require both bad monetary policy and poor fiscal
management.

“I do not foresee this combination as likely to occur,” he said.

** Market News International Washington Bureau: 202-371-2121 **

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