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Thursday, February 25, 2010

The Minneapolis Fed's new president's first speech...we are not out of the woods.

Minneapolis Fed's Kocherlakota Sees Slow Recovery The U.S. economy is on the road to recovery, but healing will be slow as the outlook for the labor market remains troubling, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said on Tuesday in his first public speech as a central banker.

Kocherlakota pointed to a "nascent" recovery that he believes will continue as the economy bounces back from the worst downturn since the Great Depression. He believes, however, that the recovery in gross domestic product, or GDP, and especially in unemployment, will be slow due to uncertainties surrounding various legislative initiatives and to ongoing problems in the banking sector.

"I do think that the economy is on the mend, and should continue to recover over the next two years in terms of both GDP and unemployment," Kocherlakota said, "but at slower rates than we would like."

Fueling his belief that the economy is healing is that real GDP began to grow again in the third quarter of 2009, with the growth rate accelerating to a seasonally adjusted annualized rate of 5.7% in the fourth quarter. He predicts that the National Bureau of Economic Research will declare the recession to have ended sometime in the second half of last year.

Kocherlakota was delivering prepared remarks about the economic outlook and the Fed's role as a bank supervisor before members of the Minnesota Bankers Association. The central banker said that with the challenges that still face the economy, he believes the economy will grow only by around a 3% per year rate over the next two years as opposed to 3.5%. In November, the minutes of the Fed meeting included a summary of central bank president and Fed governor forecasts for real GDP for 2010 and 2011; their predictions are roughly around 3% growth for 2010 and around 4% growth in 2011, an average of 3.5%.

Kocherlakota is more pessimistic about GDP for two reasons, he said: One, due to the great deal of uncertainty surrounding Congress' proposals for changes in health care and financial regulation; and two, because of the risk that the commercial real estate market poses.

Banks with large amounts of commercial real estate risk exposure "face a correspondingly elevated risk of failure," he said. "This threat could well lead to continued declines in bank lending, which would curtail the recovery." Even worse, banks' near-failure have strong incentives to make poor loans, he said. "This outcome would be even worse for the economy."

The central banker called the outlook for the labor market "not comforting." The jobless rate is currently at 9.7%. In the 25-year span between January 1984 and January 2009, unemployment never topped 8%, although it reached 10.8% in the autumn of 1982.

"Though unemployment has fallen somewhat, forecasts remain uniformly troubling," Kocherlakota said, adding that unemployment is notoriously slow to recover. He would be "highly surprised," he said, to see a sub-9% jobless rate by the end of 2010 or a sub-8% unemployment rate by the end of 2011.

The central banker was positive on inflation, noting that inflation has been relatively tame and the outlook is "basically promising." However, he noted, the excess reserves of over a trillion dollars held by deposit institutions create the potential for high inflation. The Fed, therefore, must take care with its policy moves to keep inflation at bay.

In other remarks, the central banker stressed the importance of the Fed maintaining its supervisory power, noting that a healthy economy requires a Fed that actively engages banks. Without that power, it would have been more difficult for the Fed to have employed the extraordinary policy measures it did over the last few years to stabilize the financial system, he said, such as the Term Auction Facility, which allowed depository institutions to bid on loans from the Federal Reserve.

Under the existing system, the Federal Reserve can turn to its own supervisors for detailed information about a financial institution to help it evaluate how to best help financial markets in the case of an upset. That ability needs to be preserved, he said.

"My conclusion is that stripping the Federal Reserve of its supervisory role would needlessly put a Great Depression on the menu of possibilities for our country," Kocherlakota said.

Kocherlakota became the twelfth president of the Minneapolis Fed on October 8, 2009. Before that he was a professor of economics at the University of Minnesota, where he chaired the economics department. He also served as a consultant to the Federal Reserve Bank of Minneapolis and from 1996 to 1998 he worked as a research staff member at the Minneapolis Fed.

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