NEW YORK – A three-pronged approach to stimulus can provide the equivalent of a 100-basis-point rate cut by the Fed, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said.
Proposing a 1% permanent consumption tax that would begin in 2012, a labor income tax cut and an investment tax credit, Kocherlakota explained the consumption tax will stimulate consumption demand in 2011, while a “permanent reduction in labor income taxes ensures that this new consumption tax does not deter labor supply. Finally, the investment tax credit makes sure that the new consumption tax does not deter investment in 2011.”
Based on his rough estimates, “the plan has the potential to be fiscally responsible,” Kocherlakota explained to the National Tax Association, according to prepared text of his remarks, which were released by the Fed.
Also, Kocherlakota said since raising consumption taxes and lowering labor income taxes “would tend to redistribute the burden of taxes toward lower-income citizens, ... I believe that it would be desirable to redesign the labor income tax reduction to make it more progressive.”
Turning to quantitative easing, Kocherlakota said, by announcing plans to buy $600 billion of long-term Treasuries in the open market by mid-2011, the Federal Open Market Committee signaled it “is likely to keep its target interest rate lower for an even longer period of time,” he said.
Besides lowering long-term real interest rates by indicating an intention to keep short-term rates low, QE cuts the interest rate risk of investors, and “as a consequence, private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, and all long-term yields fall,” Kocherlakota said.
He added that since liquidity is not a problem, the banks have money to lend, nearly $1 trillion of excess reserves, and while QE will give them more in reserves, Kocherlakota said, “I do not see why they would suddenly start to use the new ones if they weren’t using the old ones.”
Responding to those who say excess reserves will cause future inflation, he said, the Fed can easily raise rates to combat inflation, and the FOMC has vowed a commitment to low inflation.
While he said he backs QE, Kocherlakota reminded that he has stated his concern that it will not be very effective.
