[This is a pretend interview with Narayana Kocherlakota based on his speech today, Planning for Liftoff, laying out an exit strategy for the Fed.]
Hi. Good to see you again. What are you going to say in your speech?
In my remarks today, I’ll briefly discuss the objectives of the Federal Open
Market Committee, or FOMC, which is the monetary policymaking arm of the Federal
Reserve. Next, I’ll present a pictorial review of the evolution of macroeconomic
data over the past five years.
With that background, I will then turn to a discussion of monetary policy. My
jumping-off point is a phrase in the FOMC statement issued last Thursday. In
that statement, the Committee said that it “expects that a highly accommodative
stance of monetary policy will remain appropriate for a considerable time after
the economic recovery strengthens.” My main message today is that the FOMC can
provide additional monetary stimulus by making this sentence more precise in the
form of what I’m going to call a liftoff plan: a description of the
economic conditions that would lead the Committee to contemplate the initial
increase in the fed funds rate above its currently extraordinarily low level.2
So if I understand correctly, now that the Fed has eased further -- something
I would not have expected you to support given your past remarks -- your main
goal is to be clear about how soon the Fed can begin reversing policy? Your goal is to clarify the exit strategy?
I will suggest the following specific contingency plan for liftoff:
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 percent.
The price stability part seems to be a bit of a catch. This appears to say that
the Fed will only continue with stimulative policy so long as it is not worried
about inflation. That doesn't seem much different from current policy, except
it's dressed up with a few numbers and some bolded text. What's new here?
I’ll be much more precise later about the meaning of the phrase “satisfies its
price stability mandate.” Briefly, though, I mean that longer-term inflation
expectations are stable and that the Committee’s medium-term outlook for the
annual inflation rate is within a quarter of a percentage point of its target of
2 percent. The substance of this liftoff plan is that, as long as longer-term
inflation expectations remain stable, the Committee will not raise the fed funds
rate unless the medium-term outlook for the inflation rate exceeds a threshold
value of 2 1/4 percent or the unemployment rate falls below a threshold
value of 5.5 percent.
Wait a minute. I asked you very specifically last spring why the Fed had an
asymmetric aversion to inflation -- there seems to be much more tolerance of
inflation below target than inflation above target. In fact, 2 percent
inflation looks more like a hard ceiling for than a central value. At
that time, you insisted that the Fed had a symmetric tolerance -- it was just as
willing to tolerate inflation above target as below. Now you're telling us a
hard ceiling of 2.25 percent is needed? How is that consistent with the symmetry
you claimed in the past?
Note that neither of these thresholds should be viewed as triggers—that
is, once the relevant cutoffs are crossed, the Committee retains the option of
either keeping the fed funds rate extraordinarily low or raising the fed funds
Thus, my proposed liftoff plan contains a specific definition of the phrase “a
considerable time after the economic recovery strengthens.” In my talk, I will
argue that this specificity—about an event that may not take place for four or
more years—will provide needed current stimulus to the economy.
I'll listen closely when you get to that part. But can you explain a bit more
A key question is: How much leeway around 2 percent is appropriate?
The Committee has made no formal decision about this issue, and my own thinking
continues to evolve. But I currently believe that allowing the medium-term
outlook for inflation to deviate from 2 percent by a quarter of a percentage
point in either direction would provide sufficient flexibility to the Committee,
while posing no threat to the credibility of the long-run target. I’ll provide
more details on my thinking about this issue later in the talk.
To sum up, the FOMC defines its price stability mandate as a 2 percent inflation
target over the longer run. When operationalizing this definition, though, it is
necessary to take into account the lags associated with monetary policy and to
allow for some medium-term flexibility around the long-run target. Given these
considerations, in my view, the FOMC can be said to be satisfying its price
stability mandate as long as its medium-term outlook for inflation is between 1
3/4 percent and 2 1/4 percent, and longer-term inflation expectations remain
So you basically have a hard 2 percent target, and only allow tolerance
around that due to technical constraints that prevent tighter bounds? I suspect
some people are going to think you have increased your tolerance for inflation,
but you really haven't, have you?
Let's talk a bit more about your "liftoff" plan. Can you summarize how it
I think that it is safe to say that, relative to historical norms, the current
stance of monetary policy is quite unusual. In June 2011, the FOMC released a
statement describing its exit strategy—that is, the sequence of steps involved
in returning monetary policy to a more normal stance. However, that 2011
statement said nothing about the conditions that would trigger the initiation of
this exit strategy. This omission is problematic. The current economic impact of
both forms of accommodation—low interest rates and asset purchases—depends on
when the public believes that accommodation will be removed.
To understand this critical point, consider two possible scenarios. In the
first, the public believes that the FOMC will initiate liftoff once the
unemployment rate hits 7 percent. In the second, the public believes that the
FOMC will defer initiation of liftoff until the unemployment rate hits 6
percent. The higher unemployment rate in the first scenario means that monetary
policy will be tightened sooner, which, in turn, will lead to the unemployment
rate being higher for longer. Foreseeing that, people will save more in the
first scenario than in the second, to protect themselves against these higher
unemployment risks. Because they save more, they spend less, and there is less
economic activity. In other words, the FOMC can provide more current stimulus if
people believe that liftoff will be triggered by a lower unemployment rate.
So what is the specific plan?
The proposed plan is the following:
As long as the FOMC is continuing to satisfy its price stability
mandate, it should keep the fed funds rate extraordinarily low until the
unemployment rate has fallen below 5.5 percent.
As discussed earlier, by “satisfy its price stability mandate,” I mean that
longer-term inflation expectations are stable, and the Committee’s outlook is
that the annual inflation rate in two years will be within a quarter of a
percentage point of the target inflation rate of 2 percent.
Why so much sensitivity to inflation? Why not, say, a 3 percent threshold
Why is this liftoff plan an appropriate one? I argued earlier that the FOMC can
provide more current stimulus by using a lower unemployment rate threshold for
liftoff. Of course, additional monetary stimulus will give rise to more
inflationary pressures, and those pressures are problematic because they could
lead the FOMC to violate its price stability mandate. However, in my view, the
Committee should choose the lowest unemployment rate threshold that it sees as
unlikely to generate a violation of the price stability mandate.
This seems far too sensitive to inflation to me. Why such a low tolerance?
The proposed liftoff plan does allow the FOMC to contemplate raising the fed
funds rate if the Committee’s medium-term inflation outlook rises above 2 1/4
percent. However, the following
chart shows that recent historical evidence suggests that this possibility
is unlikely to occur. It documents that the medium-term inflation outlook has
not risen above 2 1/4 percent in the last 15 years.6
Thus, this historical evidence suggests that, as long as the unemployment rate
remains above 5.5 percent, it seems unlikely that the price stability mandate
would be violated.
I'm not asking about the likelihood of inflation rising above 2.25 percent,
I'm asking why you have such intolerant bonds on the inflation rate.
The liftoff plan does not say that the Committee will raise the fed
funds rate when the medium-term inflation outlook exceeds 2 1/4 percent—only
that it could. The Committee’s decision in this context would hinge on
a delicate cost-benefit calculation that would weigh the inflation increases
against the employment gains. That policy conversation would, I conjecture, be a
challenging one. Among other issues, it could well involve a reassessment of the
long-run unemployment rate that is consistent with 2 percent inflation.7
So your policy, in a nutshell, is that the Fed should be accommodative, but if
inflation rises above 2.25 percent, or threatens to do so, the Fed should have a
In the same vein, the unemployment rate of 5.5 percent should be viewed as
only a threshold to initiate a policy conversation, not as a trigger for
action. For example, it is possible that macroeconomic shocks could lead the
Committee’s medium-term outlook for inflation to be below 2 percent when the
unemployment rate falls below 5.5 percent. At that point, the Committee might
want to defer initiating exit, and the liftoff plan allows the Committee to
consider doing so.
One thing I don't understand, how is this supposed to work if you won't allow
inflation to rise above 2.25 percent -- basically the minimum technical tolerance
associated with a hard 2 percent medium run target?
I want to be clear about the economic mechanism by which the proposed liftoff
plan generates stimulus. First, it does not generate stimulus by having the FOMC
tolerate higher rates of inflation, as has been espoused by many observers. I am
doubtful about the efficacy of the inflation-based approach. I suspect that many
households would believe that their wage increases would not keep up with the
higher anticipated inflation rates. Those households would save more and spend
less—exactly the opposite of the policy’s aim. In any event, I think that this
approach is a risky one for central banks to use, because it requires them to
raise inflation expectations—but not too much.
Thus, the liftoff plan that I’ve discussed only applies when the FOMC
satisfies its price stability mandate. How then does the proposed liftoff plan
generate stimulus? The plan recommends that the FOMC clearly communicate its
intention to pursue policies that are fully supportive of much higher levels of
economic activity. Thus, the plan commits to keeping the fed funds rate
extraordinarily low until the unemployment rate is much nearer historical norms,
as long as inflation remains under control. With that commitment, households can
anticipate a lower path for unemployment, and they can save less to guard
against the risk of job loss. People will spend more today, and that will drive
up economic activity.8
So because it might end up as too much inflation, your answer is none at all? You're saying that some inflation
would, in fact be useful, but one is too many and a hundred not enough? One
taste of inflation, and it rips out of control? I have more faith in you and
your colleagues than that. The Fed can allow inflation to, say, go to three percent without risking that it spirals out of control, I think, but you don't seem to have much faith in your colleagues.
You are likely to get a lot of credit for dropping your inflation hawkery,
but I don't see it. The target is still 2% + min possible error of .25 percent,
so I don't see that you've loosened much at all relative to the past (and even if the "min possible error" interpretation is incorrect, plus or minus .25 percent is hardly the definition of tolerant). You
certainly have not embraced a transmission mechanism for policy that runs
through elevated inflation expectations, the way most economists think these policies work. How would you respond to that?
I’ve spent much of my time describing what I see as an appropriate liftoff plan.
I’ve proposed that, given current Committee thinking about the economy’s
productive capacity, the Committee should plan on deferring exit until the
unemployment rate falls below 5.5 percent. Critically, there are important
inflation safeguards embedded in the plan: The Committee could consider
initiating liftoff if its medium-term inflation outlook ever exceeds 2 1/4
percent. The evidence from the past 15 years suggests that this event is
unlikely to occur.
President Charles Evans of the Federal Reserve Bank of Chicago has also proposed
what I’m calling a liftoff plan. As I said last year in answer to a media query,
I very much liked his approach to thinking about the problem. Those familiar
with his plan will see that my thinking has been greatly influenced by his. This
is perhaps hardly surprising, since he sits next to me at every FOMC meeting!
My building on President Evans’ creative proposal in this fashion is, I think,
indicative of how the Federal Open Market Committee operates. The making of
monetary policy under Chairman Ben Bernanke’s leadership is a distinctly
collaborative process. Obviously, we don’t always agree with one another. It
would be surprising if we did in such unusual economic conditions. But we learn
continually from each other’s points of view. In that way, I believe that we can
start to make progress on the challenging economic problems we face.
I hope you continue to sit by Evans, I sat by him not too long ago at a
conference and I learned from him as well. You are still a ways from him -- you
remain far more hawkish than he is, at least in my assessment -- but maybe, just maybe your
views will continue to evolve towards his. One last thing. I know Jim Bullard respects you a
lot, can you bring him along as well?
Perhaps not, but in any case, thanks for allowing me pretend I'm interviewing
Update: After posting this, I tweeted:
Pushback on previous post: Significance of Kockerlakota's speech is his
changed view of structural vs. cyclical unemployment, not inflation.
Couldn't ask about that in pretend interview since he didn't say much about
it in his speech.
But not so sure he's changed his mind, though he has allowed for the chance
he's wrong. If it is structural, inflation will rise above 2.25 ... as QE proceeds, and he'll favor tightening even if unemployment > 5.5%. Only
difference I see is that he isn't insisting it's structural ... as he was before. Perhaps the paper by Lazear at Jackson Hole raised some doubt.