Kocherlakota Prescribes Unemployment, Inflation Targets

In a speech today at a college in Michigan’s Upper Peninsula, Minneapolis Federal Reserve President Narayana Kocherlakota proposed what he called a “liftoff plan: a description of the economic conditions that would lead the [FOMC] to contemplate the initial increase in the fed funds level above its currently extraordinarily low level.” Kocherlakota’s proposal:

As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5%.

That’s a pretty simple sounding plan, but it packs a lot of unusual — and some would say — risky assumptions and outcomes.

Kocherlakota thinks that the FOMC should commit to not raising the fed funds rate “unless the medium-term outlook for the inflation rate exceeds a threshold value of 2.25 percent or the unemployment rate falls below a threshold rate of 5.5 percent.” He is careful to point out that neither threshold is a trigger. To the FOMC, medium-term means two years.

Kocherlakota, widely thought of as something of an inflation hawk, has proposed a plan much like that outlined by Chicago Fed President Charles Evans, a noted inflation dove. The two plans differ only in target points. Evans would allow inflation of up to 3% until the unemployment rate falls below 7%. Kocherlakota noted that the medium-term outlook for inflation has not risen about 2.25% in 15 years.

Unlike the FOMC announcement from Fed chairman Ben Bernanke last week or Evans’s proposal, Kocherlakota’s plan, as he says, “only applies when the FOMC satisfies its price stability mandate.” Economic stimulus is provided by the belief among Americans that unemployment will fall as long as inflation stays under control, leading people to spend more because they will have more confidence in the economy.

Maybe. Evans’s approach, which threatens more inflation, is a more direct way to encourage people to spend more now. For now, though, the FOMC has resisted targeting a specific level of either inflation or unemployment or GDP.

Paul Ausick