NEW YORK – Gross domestic product growth is seen near 2.4% in the second half of this year and around 2.5% next year for an average of 2.5% a year for the two years, predictions lower than those made last month by Federal Reserve Bank of Minneapolis President Narayana Kocherlakota.
“Our September estimates are distinctly lower than our August estimates,” Kocherlakota told the European Economics and Financial Centre in London Wednesday, according to prepared text of his speech, which was released by the Fed. He noted that “about seven months ago, I predicted that GDP would grow around 3.0% per year over 2010 and 2011.”
The recovery, he said, is “distinctly modest ... even more modest than I expected at the beginning of this year.”
Inflation will rise to 1.5% to 2% next year, while unemployment, Kocherlakota predicted will remain above 8.0% “well into 2012.” He noted that the job openings rate rose about 30% from July 2009 to July 2010, while the layoffs/discharges rate has fallen more than 10% in that time. “Nonetheless, despite this apparent increase in the demand for labor from employers, the unemployment rate actually went up slightly from July 2009 to July 2010, from 9.4% to 9.5%.”
Other bad labor news in that time frame: the employment/population ratio fell from 59.3% to 58.4% while the seasonally adjusted labor force participation rate fell from 65.4% to 64.6%, the largest July-over-July drop in the statistic’s 60-plus year history.
Kocherlakota discussed the possible stimulus tools mentioned by Federal Reserve Board Chairman Ben S. Bernanke: buying more long-term securities; offering more forward guidance in the FOMC statement; and reducing the interest on excess reserves (IOER) by 15 or even 25 basis points.
Forward guidance, he said, could provide stimulus if the FOMC were to say it expects low rates are likely to be warranted for an even longer than its current “extended period.” This would cause a decline in medium-term and long-term interest rates, he said.
“I view lowering the IOER as another form of forward guidance,” Kocherlakota added. “I think that it is unlikely that lowering the IOER by 15 or 25 basis points will have much direct effect on loan markets. However, it is likely that investors would view this move as a signal that the FOMC is planning to keep its target rate even lower for an even longer period of time. In that way, lowering the IOER would serve to lower medium-term and long-term interest rates.”
Quantitative easing, where the FOMC buys long-term securities in the open market, crediting the sellers’ accounts at the Fed with more reserves, cuts the amount of long-term securities being held by private investors, and adds to bank reserves.
“I see QE as affecting the economy in four main ways,” he said. First, QE “represents another form of forward guidance about the path of the fed funds rate. ... Second, QE creates more reserves in banks’ accounts with the Fed. ... The third effect of QE is the one that is usually stressed: It reduces the exposure of the private sector to interest rate risk. The holder of a long-term Treasury is exposed to interest rate risk. If interest rates rise, the price of the bond falls, and the bondholder is less wealthy. ... The fourth effect of QE is less widely discussed. The Fed cannot literally eliminate the exposure of the economy to the risk of fluctuations in the real interest rate. It can only shift that risk among people in the economy. So, where did that risk go when the Fed bought the long-term bond? The answer is to taxpayers.”
“QE will have nontrivial effects over forward guidance in the context of a more realistic model in which people differ from one another in some relevant way,” he said.
“The Fed engaged in QE from January 2009 through March 2010 by buying over $1.5 trillion worth of agency debt, agency mortgage-backed securities, and Treasuries. How did this operation—termed the Large-Scale Asset Purchase, or LSAP program—affect the economy? We don’t know as much as we would like as yet.” However, based on a study, Kocherlakota estimated “LSAP reduced the term premium on 10-year Treasury bonds relative to 2-year Treasury bonds by about 40-80 basis points (on an annualized basis).”
Future use of QE, he said, “would have a more muted effect on Treasury term premia. Financial markets are functioning much better in late 2010 than they were in early 2009. As a result, the relevant spreads are lower, and I suspect that it will be somewhat more challenging for the Fed to impact them.”
