Federal Reserve Bank of Minneapolis president Narayana Kocherlakota warned Tuesday that even though inflation is "relatively tame" now, the large volume of excess bank reserves creates "the potential for high inflation" if the Fed does not make "good policy choices."

At the same time, Kocherlakota was pessimistic about the economic outlook, particularly with regard to unemployment, saying he would be surprised if it drops below 9% by the end of this year or below 8% by the end of next year.

Kocherlakota said he sees real gross domestic product growth of little more than 3% over the next two years and warned the "nascent" recovery could be "curtailed" if problems in commercial real estate lead to a further contraction of bank lending.

In remarks prepared for delivery to the Minnesota Bankers Association in St. Paul, Kocherlakota said uncertainty about government health care and other policies are also hindering recovery and job creation.

He stressed the need for the Fed to retain its role in banking supervision at a time when proposed legislation on Capitol Hill is threatening to end or limit that role.

"The positive news in this economy is that inflation has been relatively tame," Kocherlakota said.

But he added: "Here's the caveat — deposit institutions are holding over a trillion dollars of excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation."

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