Kocherlakota Says Low Inflation Risks Fed Credibility

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said a widening gap between low inflation and the Fed’s 2 percent target for price gains may endanger the central bank’s credibility on meeting its mandate.

“We’re creating risks for ourselves on the credibility front,” Kocherlakota told reporters today after a speech in St. Paul, Minnesota. “If inflation continues to be persisting below 2 percent, people’s beliefs that it will get back to 2 percent will start to erode, so then their belief about what our target is for inflation will start to slide downwards.”

The personal consumption expenditures price index, the central bank’s preferred price gauge, increased 1.4 percent in September from a year earlier and hasn’t exceeded the 2 percent target since March 2012. The highest reading in the past year was 1.7 percent in May.

Low inflation damages an economy if it becomes sustained deflation, which can sap demand by encouraging consumers to delay spending in the expectation of lower prices in the future.

Fed credibility is crucial to avoiding this trap, because well-anchored inflation expectations “are the heart of what makes monetary policy effective at combating adverse shocks,” said Kocherlakota.

He voted against the last policy statement of the Federal Open Market Committee on Oct. 29, saying it doesn’t do enough to ensure inflation rises back to the Fed’s objective.

Kocherlakota in his speech today repeated that he doesn’t expect the pce price index to return to 2 percent until 2018.

‘Sluggish’ Outlook

“This sluggish inflation outlook implies that, at any FOMC meeting held during 2015, inflation would be expected to be below 2 percent over the following two years,” he said in the speech text. “It would be inappropriate for the FOMC to raise the target range for the fed funds rate at any such meeting.”

The Minneapolis Fed chief also told reporters he is concerned that declines in market-based measures of inflation expectations, as well as “slippage” in the Philadelphia Fed’s Survey of Professional Forecasters for inflation, may show belief in the Fed’s commitment to its inflation goal is fraying.

A report published yesterday by Vasco Cúrdia, a senior economist at the San Francisco Fed, suggests it’s more probable that inflation will remain below the central bank’s 2 percent inflation goal than rise above it.

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