Narayana Kocherlakota, in an interview with Dow Jones Newswires and The Wall Street Journal, said that if the U.S. economy grows at about 3% this year, as he expects, and underlying inflation ticks higher, as he expects, then the Fed will end its $600 billion bond-buying program as planned in June.
He expects core inflation (inflation excluding volatile food and energy prices) will rise from about 0.8% late last year, when the Fed launched its bond-buying to about 1.3% by year end, he said. As a result, lifting the Fed's target for short-term interest rates by more than half a percentage point late this year is "certainly possible." He noted that the often-cited Taylor Rule, named for the Stanford University professor who devised it, would in that circumstance call for a ¾-percentage-point increase in rates.
"If you consider monetary policy was appropriate at the end of 2010...and then you see core inflation go up by 50 basis points over the course of 2011..the usual response that we know from 20 years of thinking about monetary policy (or even more) is to raise the target rate by even more than that increase in observed inflation," he said. "So that means you should be raising the target rate by more than 50 basis points."
The Fed dropped its short-term interest-rate target nearly to zero in December 2008 during the financial crisis, and promised to keep it there for "an extended period." Trading in futures suggests markets anticipate a Fed increase to 0.5% early in 2012.
Mr. Kocherlakota is one of the five regional Fed presidents with a vote on monetary policy this year, along with the Washington-based Fed governors. He is a swing voter on the Fed's policy committee, who isn't clearly aligned either with hawkish Fed officials who tend to favor tighter credit or dovish members who tend to favor looser credit
Two other regional Fed presidents with votes—Charles Plosser of Philadelphia and Richard Fisher of Dallas—have expressed concerns about inflation and suggested they would favor raising rates in the near future.
The Minneapolis Fed president, a former academic, said he expects a "pretty big upward movement" in core inflation—that is inflation excluding volatile food and energy—which he considers the best predictor of where overall inflation is.
Mr. Kocherlakota also said that the Fed's second-round of bond buying, known as QE2 for "quantitative easing," was more potent than he anticipated when he and other Fed officials launched it last year. It raised near-term inflation expectations, then dangerously low in his view, by more than he anticipated, measured by financial market indicators.
Mr. Kocherlakota said when the Fed decides to tighten monetary policy, he favors raising short-term interest rates over selling assets by the Fed's portfolio, primarily because the Fed has a firmer understanding of how interest rates affect the economy.
The goal would be to raise the federal-funds rate, at which banks lend to each other. The means would be novel for the Fed, namely raising the rate that banks earn on excess reserves kept at the Fed. Raising that rate would pull up the fed-funds rate and bring up other short-term interest rates.
The central banker shrugged off the effect of recent global shocks, such as the crises in Japan and the Middle East, on the U.S. economy as "relatively small."
"There's a more psychological channel of how these uncertainties impact financial markets," he said, citing the European debt worries last year, but didn't appear too concerned.
A number of private-sector forecasters have recently cut their expectations for growth in the U.S. economy. Mr. Kocherlakota said he has lowered his own forecast, but not by as much as private-sector economists.
Since November, he said he has expected 2011 growth in the range of 3% to 3.5%. Earlier in the year his forecast was closer to the top of the range, he said. Now, it's "closer to the lower end of that range."
Mr. Kocherlakota praised Chairman Ben Bernanke's decision to hold quarterly press briefings, saying it will give the Fed chief an opportunity to "forcefully" put forward the message about keeping inflation under control.
The Federal Open Market Committee consists of the Fed governors in Washington—seven when all the seats are filled—and 12 regional bank presidents. Five of the presidents get to vote at meetings, the New York Fed president and four others, who serve an annual rotation. All 12 participate in FOMC deliberations, though. The committee next meets April 26-27. After that meeting, Fed policymakers will disclose their latest forecasts for the economy, and Mr. Bernanke will hold the first of his quarterly press briefings.
Last week, Mr. Plosser, Philadelphia Fed president, said, "The economy has gained significant strength and momentum since last summer and seems to be on a much firmer foundation going forward," and added, "monetary policy will have to reverse course in the not-too-distant future and begin to remove the massive amount of accommodation it has supplied to the Economy."
And Dallas Fed President Fisher said in Brussels that current Fed policy is sowing the seeds of market imbalances. "We have abundant liquidity, now there's excess liquidity, which is working through the system," Fisher said. "There are, in my view, early signs of speculative activity that I don't consider constructive."
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