The Federal Reserve should not raise rates again until inflation is at the 2% target, unless unemployment falls dramatically, Federal Reserve Bank of Minneapolis President Neel Kashkari wrote in an essay published Monday.

“My preference would be not to raise rates again until we actually hit 2 percent core [personal consumption expenditure] inflation on a 12-month basis, unless we have seen a large drop in the headline unemployment rate signaling that we have used up remaining labor market slack, or a surprise increase in inflation expectations,” Kashkari wrote.

Federal Reserve Bank of Minneapolis President Neel Kashkari
Federal Reserve Bank of Minneapolis President Neel Kashkari Bloomberg News

Four possible explanations for low inflation — “global labor supply, technology development, more domestic labor slack and falling inflation expectations” — back his belief rates should be held, Kashkari writes. “The only explanation that would potentially call for further policy tightening is the transitory factor explanation,” he said. “But the longer low inflation persists (here and around the world), the more tenuous that story becomes.”

Rate hikes have held down “job growth, wage growth, inflation and inflation expectations” and if inflation expectations continue to decline, “we will have less powerful tools to respond to a future economic downturn. I believe these are significant costs that we must consider as we contemplate the future path of policy.”

Personally, Kashkari said he believes persistent low inflation can be blamed on “additional domestic labor market slack and falling inflation expectations.”

The Federal Open Market Committee’s removal of “monetary accommodation over the past few years is likely an important factor driving inflation expectations lower,” he said.

Expectations fell as actual inflation remained “below target for a long time, and the Fed’s actions to reduce accommodation led to a weakening of confidence that it was serious about bringing inflation back to target in a reasonable time frame.”

This wasn’t mean this as a criticism of FOMC decisions, he said, “we now know that policy was tighter and there was more slack in the labor market than the Committee realized at the time it started removing accommodation.”

Kashkari said his essay was meant to show “we should learn the lessons of recent years and proceed with caution before we tighten policy further.”

Kashkari said the Summary of Economic projections offered “very aggressive” rate paths compared to what was actually needed, “and likely had a somewhat contractionary effect on economic activity by signaling significantly higher interest rates in the future.”

The four rate hikes since December 2015 came “despite muted wage and inflationary pressures. The signal from this activity suggests a strong desire to raise rates, even with an absence of inflationary pressures,” he writes.

The removal of accommodation — through rate hikes, the end of quantitative easing and the hawkish forward guidance — was enacted “because the Committee thought it was providing more stimulus than it actually was,” Kashkari writes. The FOMC now sees the neutral real interest rate and the natural rate of unemployment “are lower than we had realized in prior years. The Committee has been gradually lowering its estimates for both over time.”

Noting that “some people” argue that “financial conditions as measured by various indexes have strengthened as the FOMC has removed accommodation. Some suggest this indicates that the FOMC has not in fact removed accommodation during this time. I don’t find this argument compelling. I believe that the apparent easier financial conditions are likely a reflection of the market’s own recognition that equilibrium long-term real rates have fallen. A lower future interest rate environment could justify higher asset prices and seemingly easier financial conditions today by virtue of markets’ discounting cash flows with a lower interest rate.”

And, responding to those who suggest inflation expectations haven’t dropped, based on the Survey of Professional Forecasters, Kashkari writes, “I don’t find this survey as compelling … because it is limited to a very small set of forecasters. We need to understand the expectations underlying millions of individual wage negotiations between employees and employers, which I believe are better captured by broader measures.”

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