By Steven K. Beckner

(MNI) – Minneapolis Federal Reserve Bank President Narayana
Kocherlakota said Thursday that, as far as he is concerned, the Fed
should be making monetary policy less accommodative, not more so, and
warned that recent Fed easing measures put the Fed’s credibility in
jeapordy.

Kocherlakota, a voting member of the Fed’s policymaking Federal
Open Market Committee, dissented against the FOMC’s Sept. 21 decisions
to buy $400 billion of longer-term securities, financed by selling
short-term securities, and to reinvest principle payments in
mortgage-backed securities.

He had also dissented, along with two other Fed presidents, on Aug.
9 against the FOMC’s announcement that it expects to keep the federal
funds rate near zero through at least mid-2013. He explained his
reasoning in remarks prepared for delivery in Sidney, Montana, in terms
of the need for the Fed to protect the credibility of the way it
communicates its commitment to the Fed’s “dual mandate” to promote
maximum employment and price stability.

“I’ve dissented at the last two meetings because I believe that the
Committee’s decisions at those meetings diminish that requisite
credibility,” he said.

Kocherlakota said that “over the past few years, the Fed has quite
appropriately provided a historically unprecedented level of monetary
accommodation,” but added that “as inflation rises and unemployment
falls, the FOMC should respond by lowering the level of accommodation”
in a “systematic” way.

He observed that since November 2010, when the FOMC launched a
second round of quantitative easing, unemployment has fallen and
inflation has risen.

“In response to these changes in economic conditions, the Committee
should have lowered the level of monetary accommodation over the course
of the year,” he maintained. “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,” he added.

Kocherlakota noted that “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
said, “I disagree with this argument.”

“As the economy recovers, the FOMC should respond by reducing the
level of monetary accommodation,” he said. “Logically, it follows that
if the economy recovers more slowly than expected, then the FOMC should
respond by reducing the level of monetary accommodation more slowly than
expected. The FOMC should only increase accommodation if the economy’s
performance, relative to the dual mandate, actually worsens over time.”

While disagreeing with the recent stimulus measures, Kocherlakota
downplayed the inflationary risks of the Fed’s large balance sheet,
which the FOMC’s reinvestment policy prevents from shrinking. Thanks to
the Fed’s ability to pay interest on excess reserves, he said the old
link between bank reserves, money creation and inflation has been
severed — provided the FOMC raises the IOER in a timely fashion as and
when bank lending increases.

“This connection between bank reserves and inflation is simply not
operative right now,” he said. “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.”

Kocherlakota said he is “confident, though, that at some point in
the future, the economy will improve and banks will once again have good
lending opportunities.” But he said this need not mean that “the banks’
excess reserves will serve as kindling for an inflationary fire,” as
some have warned.

By raising the IOER “judiciously,” he went on, “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,” he added.

Kocherlakota said that, prior to the most recent FOMC meetings, Fed
easing was appropriate and kept the unemployment rate from going even
higher. But he said, “I believe that the FOMC could only have
systematically lowered the unemployment rate further by generating
inflation rates over a multiyear period that were higher than its
communicated objective of 2%.”

“Such an outcome could potentially lead the public to lose faith in
the credibility of the FOMC’s communicated objective and thereby
increase the probability that the FOMC would lose control of inflation,”
he said.

** Market News International **

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