Fed's George: Recovery May Well Warrant Low Rates for Extended Period

OMAHA - Kansas City Federal Reserve Bank President Esther George Tuesday said the ongoing economic recovery in the United States may well warrant exceptionally low interest rates for an extended period, but warned that such a policy risks long-term financial and price stability.

George holds a voting position on the Fed's policymaking Federal Open Market Committee this year, a group that has vowed to keep short-term interest rates at exceptionally low levels so long as unemployment remains above the 6.5% threshold and inflation doesn't hit 2.5%.

On the subject of current monetary policy, George stressed the need for "a healthy dose of humility" as the Fed crafts measures to boost growth.

"To be clear, I agree that the depth of the recession that we just experienced warranted a highly accommodative monetary policy response," George said in remarks to students and faculty at the University of Nebraska Omaha.

"And in fact the recovery, that has been marked by high unemployment and low inflation at this point, may well warrant that we keep interest rates low for a longer period than we might otherwise," she added.

However, George said while she has agreed with keeping rates low to support the recovery, doing so "has its own set of consequences."

These include creating risks to the economy that over time could cause an increase in long-term inflation expectations and affect financial stability.

George said a key issue of concern is the emerging shift in strategies by individual and institutional savers as well as banks to re-gig their portfolios in this "untenable" low-rate environment.

Their strategies entail greater risk, she warned, moving towards riskier lending and non-investment grade financial securities.

"It is very difficult to identify the point where a healthy shift towards risk becomes excessive and potentially damaging," she warned.

On the inflation front, George voiced her concern that the 2.5% threshold now makes it appear that the FOMC has a greater tolerance for the inflation outlook to exceed 2%.

"A willingness to let inflation rise above the 2% goal of the FOMC carries with it the risk that longer-term inflation expectations may slip above levels consistent with the committee's 2% goal and could cause the market to question the Federal Reserve's commitment to its inflation goal," George said.

As for the central bank's large scale bond buying, George said the pace and composition of the asset purchases could also risk price stability and complicate the Fed's eventual withdrawal of monetary stimulus.

The Fed will need to shed its large holdings of both Treasury and agency mortgage-backed securities sometime in the future, she said, and an active sale of these assets could potentially prove "disruptive to markets and market functioning ... and could cause an unwelcome rise in mortgage interest rates."

George, nevertheless, was bullish regarding the economy's performance to date.

"I am optimistic about the recovery as it unfolds, however slowly" she said, "because you can see improvement - and I would argued meaningful improvement in how the economy is recovering."

Even the 7.9% unemployment rate is lower than "where we thought we would be in the third quarter of 2011," she said, which "suggests that we are making progress."

"While the labor market of course still has a long way to go, these examples highlight that the pace of improvement has been well above what we expected," she added.

Another example is the improvement in the housing sector, George said.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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