August and September decisions by Federal Reserve policymakers show they are more inflation-tolerant now than they were a year ago, according to Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis.
The Federal Open Market Committee in September said it would buy $400 billion of Treasury bonds in an effort to lower long-term borrowing costs and reinvest principal payments from agency debt into agency mortgage-backed securities. The move, a departure from the Federal Reserve’s previous practice of reinvesting those proceeds into Treasurys, was aimed at lowering mortgage rates.
In August, the FOMC announced that it would keep the federal funds rate at “exceptionally low levels” at least through mid-2013.
Kocherlakota called those actions “inconsistent with the evolution of the economy in 2011” in a speech Friday to the Harvard Club of Minnesota. He was one of three Fed policy makers who dissented from the decisions; the other two were Richard Fisher, president of the Dallas Federal Reserve Bank, and Charles Plosser, president of the Philadelphia Fed.
“There is a cost to adding monetary accommodation: It increases the risk of inflation running above the Committee’s objective of 2 percent for multiple years,” said Kocherlakota. “The FOMC’s actions in 2011 suggest that the Committee is resolving this key cost-benefit tradeoff differently in 2011 from however it viewed the tradeoff in 2010.”
Inflation, and the outlook for inflation, has risen markedly since last November, while unemployment and the outlook for the jobless rate have fallen, the Minneapolis Fed president said. These changes “suggest that the committee should have lowered the level of monetary accommodation over the course of the year,” instead of increasing it, he said.
While the committee has communicated this year that it views the unemployment rate as high relative to its dual mandate to promote price stability and maximum employment, reducing interest rates to try and boost employment in the short term can lead to higher inflationary expectations and worsening unemployment in the longer term, Kocherlakota said.
“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,” said Kocherlakota. “But I disagree with this argument.” Instead, a slowdown in the pace of the recovery should be accompanied by a slower reduction in the level of monetary accommodation, he said.
The committee’s decision-making this year “has introduced a lack of clarity about its monetary policy mission,” said Kocherlakota.
To address this, the FOMC should “explain how it plans to resolve the trade-off between inflation and unemployment in making its future decisions,” he said. The committee should also “provide explicit communication about how its chosen actions are indeed consistent with its pre-announced resolution of the inflation-unemployment trade-off.”
Write to Liz Enochs.
