UPDATE: Fed’s Kocherlakota Warns Low Rate World Risks Bubbles

Capital.gr, April 18, 2013. All Rights Reserved.

(Adds Kocherlakota’s comments on market imbalances, inflation)

NEW YORK–A Federal Reserve official said Thursday interest rates are likely to stay very low for years to come, which raises the prospect that chronic financial instability will be an enduring threat.

"For a considerable period of time, the [Federal Open Market Committee] may only be to achieve its macroeconomic objectives in association with signs of instability in financial markets," Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said.

"For many years to come, the FOMC will have to maintain low real interest rates to achieve its congressionally mandated goals," the official said. "Unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity," he said.

In an environment where bubbles regularly threaten to form, and other markets see prices move away from fundamentals, the Fed will be confronted with difficult choices. "These potentialities are best addressed through effective supervision and regulation of the financial sector," Mr. Kocherlakota said, although he allowed that it is possible the Fed may also have to employ the blunt tool of monetary policy to cool markets down if risks rise enough.

The official, when asked if he saw any markets devolving into a bubble, responded "the answer is absolutely not at this stage." At the current moment, "I don’t see those kind of risks out there."

But he also said that given the importance now placed on financial stability, bank regulators and supervisors face greater challenges as they do their work.

Mr. Kocherlakota’s comments came from a speech he gave at a conference held in New York by the Levy Economics Institute of Bard College. He took questions from the audience and spoke with reporters as well. The official is not currently a voting member of the monetary policy setting FOMC.

Mr. Kocherlakota has been one of the biggest supporters of aggressive Fed action to support the economy, and has argued in recent speeches the Fed is not going far enough to aid the economy, and should add more stimulus by saying it wants to achieve a lower unemployment rate before hiking interest rates.

He reiterated that he’d still like to lower the threshold at which the Fed would potentially entertain raising rates, from 6.5% to 5.5%. He said weakening inflation pressures were "definitely a cause for concern" but he hasn’t changed his outlook for price pressures. Mr. Kocherlakota said he still expects economic growth of 2.5% this year and 3% next year, and believes that will be enough to help raise inflation over time from its current very low level.

In his speech, the central banker said that the low interest rate world that could persist for "possibly the next five to 10 years" is in part the result of Fed actions over the course of the financial crisis and its aftermath. But the central banker said that other forces are also conspiring to keep rates very low.

The three that are most important beyond Fed policy are tighter credit availability, increased worry about economic risk and uncertainty surrounding the outlook for U.S. government finance, he said.

These factors are causing investors, households and firms to keep their money where it is safest, and it is also causing them to save more. At the same time, those who need better yields will go into riskier assets, creating the risk prices for those markets could go haywire, the official explained.

In as much as Fed policy has helped create the low returns savers are wounded by, so too have market forces, Mr. Kocherlakota said.

"I often hear that the FOMC has created a low interest rate environment that is harmful for savers and others," he said. "That seems about as compelling as blaming me for creating winter in Minnesota by putting on my long johns," Mr. Kocherlakota said.

The official said in his speech he expects unemployment to fall "only slowly," and he said "inflation pressures are muted."