Kocherlakota says worries on Fed move "unwarranted"

MARQUETTE, Mich Tue Aug 17, 2010 12:37pm EDT

MARQUETTE, Mich (Reuters) - The Federal Reserve's decision last week to buy more U.S. government debt should not be viewed as a sign the economic outlook is worse than investors thought, a top Federal Reserve official said on Tuesday.

Last week the U.S. central bank's policy-setting Federal Open Market Committee repeated its pledge to keep interest rates extraordinarily low for an "extended period," and took the further step of saying it would begin reinvesting cash from maturing mortgage bonds to buy more government debt.

The move took some investors by surprise.

"The FOMC's decision has had a larger impact on financial markets than I would have anticipated," Minneapolis Fed President Narayana Kocherlakota said in the text of speech to business leaders.

"My own interpretation is that the FOMC action led investors to believe that the economic situation in the United States was worse than they, the investors, had imagined," he said. "In my view, this reaction is unwarranted."

The Fed said last week its decision reflected concern over a slowdown in the economic recovery. It was a recovery the Fed had helped bring about, by cutting rates to near zero in December 2008 and buying nearly $1.3 trillion in mortgage-linked debt to shore up the housing market.

But the decision to keep steady its total long-term assets -- about $2 trillion -- instead of letting its balance sheet shrink was informed largely by publicly available data, Kocherlakota said.

"I would say that there is no new information about the current state of the economy to be learned from the FOMC's actions or its statement," he said.

With long-term rates dropping rapidly, more people were repaying their mortgages, shrinking the Fed's holdings and "leaving a larger share of the long-term risk in the economy in the hands of the private sector," Kocherlakota said. "This extra risk in private hands could force up the risk premia on long-term bonds and be a drag on the real economy."

To avert that threat, the Fed decided to stop the decline in holdings and reinvest in long-term Treasuries.

Kocherlakota said he sees a "modest" recovery under way, with U.S. economic growth at about 2.5 percent this year and 3 percent next year.

Inflation will likely edge up to 1.5 percent to 2 percent next year, and persistent deflation -- a debilitating drop in prices -- is unlikely, he said.

Kocherlakota saved his strongest words for the unemployment situation, which he called "disturbing." Currently at 9.5 percent, the jobless rate likely will stay above 8 percent in 2012, he said.

But because the high rate stems from a mismatch between job openings and the qualifications of job applicants, there's little more the Fed can do, he said.

"Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers," he said. "But the Fed does not have a means to transform construction workers into manufacturing workers."

While low rates now are warranted to keep the jobless rate from increasing even further, the Fed must be ready to act as soon as the real return on safe short-term investments, which are now negative, turns positive, he said.

"That sounds easy - but it's not," he said. "When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment."

Even though conventional wisdom might suggest the Fed continue to keep rates low, doing so could tip the country into years of deflation, he said.

But such a policy mistake is unlikely, he said.

"The FOMC and the Board of Governors have displayed exactly the required unconventionality in solving many seemingly intractable problems over the past three years," he said, adding he is confident it will continue to do so.

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