June 5, 2014 / 5:00 PM / in 4 years

Fed's Kocherlakota urges five more years of low interest rates

BOSTON, June 5 (Reuters) - The Federal Reserve should keep U.S. borrowing costs low for another five years to ensure the economy returns to health, even if doing so generates worrying signs of financial instability, a top U.S. central bank policymaker said on Wednesday.

With the current outlook suggesting U.S. inflation and employment will undershoot the Fed’s goals for years to come, “the (Fed) will only be able to meet its objectives over that time frame by taking policy actions that ensure that real interest rates remain unusually low,” Minneapolis Fed President Narayana Kocherlakota said in remarks prepared for delivery to Boston College’s Carroll School of Management.

For “possibly the next five years or so,” he added, the Fed may need to keep real interest rates as much as two-percentage points below its 2007 level of 2.5 percent.

One of the Fed’s most dovish policymakers, Kocherlakota has pushed strongly for more accommodative monetary policy in the face of unemployment that remains well above normal levels, and inflation that remains well below the Fed’s 2-percent goal.

With Wednesday’s speech, Kocherlakota appeared to be pushing the envelope considerably further, calling for rates to stay low well beyond the timeframe envisioned by most of his colleagues, and suggesting that, at least for the time being, the costs of raising rates to reduce vulnerabilities in the financial system are much greater than the benefits.

Real interest rates, which subtract out inflation, are currently below zero, but are set to rise once the Fed starts raising interest rates, probably sometime next year.

Kocherlakota acknowledged that keeping rates low for so long can lead to conditions that signal financial instability, including high asset prices, volatile returns on assets, and frantic levels of merger activity as businesses and individuals strive to take advantage of low interest rates.

But that is a risk, he suggested, the Fed should be willing to take.

“For a considerable period of time, the (Fed) may only be able to achieve its macroeconomic objectives in association with signs of instability in financial markets,” he said.

The Fed should address those risks with regulatory and supervisory tools, because the risks of using the “blunt” tool of monetary policy - for instance, by raising rates - has clear and large costs and few clear benefits, he said.

That calculus, Kocherlakota said, will change over time, and as the economy heals the Fed will need to navigate an ever more difficult balance between boosting the economy and risking bubbles and other potential crises-in-the-making.

The Fed has said it expects rates to be below their historical norms even after unemployment and inflation return nearer to healthy levels.

At that juncture, Kocherlakota said, “I anticipate that financial stability considerations are likely to play a substantial role in the determination of the appropriate level of monetary accommodation.” (Reporting by Richard Valdmanis; writing by Ann Saphir; Editing by Chizu Nomiyama)

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