'Monetary Policy is Currently Not Accommodative Enough'

Via a speech by Minnesota Fed president Narayana Kocherlakota, something that is too often forgotten in discussions of monetary policy, the long (and variable) lags between policy changes and the impact on the economy:

...The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When the FOMC raises interest rates, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. Similarly, when the FOMC lowers interest rates, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

However, these pressures on employment and prices from lower interest rates are not felt immediately. Instead, it typically takes a year or two for the effects of monetary policy adjustments to manifest themselves in inflation and unemployment. Hence, the FOMC’s decisions about appropriate monetary policy necessarily hinge on the members’ forecasts of the evolution of prices and employment over the next year or two—what we typically call our medium-term outlooks for inflation and unemployment. ...

Given these lags, and the forecast for recovery, is policy too tight or too easy?:

I’ve described the Fed’s current monetary policy stance in some detail, and I’ve emphasized that the Fed’s stance is much more accommodative than it was five years ago. That observation alone might suggest that the Fed’s policy is too accommodative. But there have been big changes in the economy since 2007. ...

As you will hear, my main conclusion is that my outlook implies that monetary policy is currently not accommodative enough. ...

He concludes his speech with:

Monetary policy affects the economy with a lag of one or two years. Hence, a policymaker’s views about the appropriate level of monetary policy accommodation depend on his or her forecast for how the economy will evolve over the next year or two. My own outlook is that growth will remain moderate over the next two years. As a result, under current policy, my outlook for inflation is that it will run below the Fed’s target of 2 percent over the next two years and that the unemployment rate will be above 7 percent over that same period. Hence, the FOMC can better promote price stability and promote maximum employment, as mandated by Congress, by adopting a more accommodative policy stance. It can provide that extra accommodation by lowering the unemployment rate threshold in its forward guidance to 5.5 percent from the current setting of 6.5 percent. ...

I was highly critical of Narayana Kocherlakota in the past, especially over his view that the unemployment problem is largely structural and hence out of the reach of Fed policy. But he deserves credit for changing his views in light of the evidence, and his call for even more accommodative policy makes him one of the more dovish policymakers at the Fed. If only other policymakers were as open-minded.