“The economy is on the mend,” according to Minneapolis Federal Reserve Bank President Narayana Kocherlakota.
As evidence, he points to the “very exciting news” in the March employment numbers showing 162,000 non-farm jobs were added to the economy, the biggest increase in three years. He also cites more positive comments from businesses throughout the region, “even in the last two or three weeks,” reinforcing his expectation for a recovery in both output and unemployment while inflation remains low.
Speaking Tuesday to the Minnesota Chamber of Commerce, Kocherlakota said the nation’s gross domestic product (GDP) began to grow again in the third quarter of last year and hit a robust 5.6 percent annualized growth rate in Q4. Nevertheless, Kocherlakota believes GDP growth over the next two years will only reach 3 percent, below the 3.5 percent “consensus” rate of most economic forecasts.
He also believes that unemployment will remain above 9 percent nationally through the remainder of 2010 and above 8 percent the following year.
Kocherlakota is sanguine about the inflation outlook as well, citing the current 1.5 percent rate and the market’s belief in the Fed’s commitment to hold down inflation. An inflationary surge would require “a combination of bad monetary policy and poor fiscal management,” which he does not foresee.
He laid out a road map for the Fed to return to its traditional role after its “very active” intervention in the economy during the recent financial crisis. He also described the short-run tradeoffs Fed policy-makers face in supporting economic growth and fighting inflation. (See a transcript of the speech here.)
Despite his optimism, Kocherlakota believes several factors will hold back the rate of economic recovery. Not surprisingly, the first is trouble in the real estate sector.
Banks with exposure to troubled commercial real estate loans face “an elevated risk of failure,” which could curtail their lending to other businesses and hold down the rate of economic recovery.
In addition, said he “would not be surprised” if housing starts remain near their current historic lows “for several years,” and that also likely will dampen but not derail the rate of recovery, he believes. With direct investment in residential real estate at 2.8 percent of GDP, he said the U.S. economy “has many possible sources of growth” beyond housing.
“For a lot of reasons, our country built a lot more houses than it now needs or wants.” The U.S. economy is adjusting and reallocating resources to other sectors, which has near-term negative effects on employment as well, Kocherlakota said. Despite these difficulties, “this reallocation process is a necessary one if an economy is to regain its health and start growing again,” he said.
Even though the unemployment rate has dropped to 9.7 percent from its 10.1 percent peak last October, the last time unemployment topped 8 percent was 25 years ago, in January of 1984. The severity of the current recession has particularly stung younger workers (born since 1968) who have not experienced a severe economic downturn, he observed.
“The Fed was very active in the economy over the last two-and-one-half years. Now that the economy is on the mend,” the Fed should return to its traditional role, an opinion shared by his colleagues at the central bank, he said.
Kocherlakota noted that the Fed has more than doubled its assets since September 2008 to more than $2 trillion, including $1.1 trillion in mortgage-backed securities and an additional $170 billion in agency debt from federally backed housing lenders Fannie Mae and Freddie Mac.
He believes the Fed could sell off $15 billion to $25 billion of mortgage-backed securities a month and shrink its balance sheet to more normal levels within five years, without affecting interest rates.
Another inflation risk is posed by banks, which currently hold $1 trillion in reserves, 15 times their required level. If they begin to lend too aggressively, that could push up inflation, he warned but noted the Fed is monitoring reserve levels and can influence the rate of reserve reductions by the level of interest payments on reserves held by banks.
Federal Reserve policy is intended to maintain full employment and hold down inflation, policy goals that he believes are aligned long term. But as the economy recovers, meeting those two goals can “create difficult choices” in the short term, he said.