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Fed's Kocherlakota: Drop in neutral rate makes Fed's job harder

Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, speaks at the ninth annual Carroll School of Management Finance Conference at Boston College in Chestnut Hill, Massachusetts June 5, 2014. REUTERS/Brian Snyder

FRANKFURT (Reuters) - A significant drop in the long-run interest-rate level that marks a sweet spot for a healthy U.S. economy is making it harder for the Federal Reserve to do its job, a top policymaker said on Thursday.

Fiscal authorities can ease this problem by issuing more debt, Minneapolis Fed President Narayana Kocherlakota said in remarks prepared for delivery in Frankfurt.

Doing so would push up the so-called long-run neutral real interest rate - the level of borrowing costs appropriate for an economy with full employment and 2 percent inflation - which would give the Fed more room to maneuver in the face of what could be more frequent bouts with near-zero interest rates.

"I want to be clear at the outset that I am not saying that it is appropriate for fiscal policymakers to increase the long-run level of public debt," Kocherlakota said. "I am simply pointing to one benefit associated with such an increase: It allows the central bank to be more effective in mitigating the impact of adverse shocks to aggregate demand."

Kocherlakota, who will leave the U.S. central bank at the end of this year to take a job at the University of Rochester, has spent the last several years arguing that the Fed should ease policy further to boost inflation, which has remained stubbornly below its 2 percent goal.

Thursday's speech - which did not refer to the current economic outlook or the stance of current monetary policy - took that out-of-the-mainstream argument further.

While other policymakers have similarly noted that a decline in the long-run neutral real interest could stymie Fed policy goals, few if any have suggested so directly that increased government borrowing could be a solution.

Central banks, Kocherlakota suggested on Thursday, are worried about the costs of using unconventional tools like bond-buying programs to stimulate the economy during future bouts with zero interest rates.

"Given these costs, I anticipate that monetary policy will be insufficiently accommodative during periods at the nominal interest rate lower bound, which will lead the economy to undershoot the (Fed)’s inflation and employment objectives," Kocherlakota said. "Fiscal policymakers can mitigate this risk by choosing to maintain higher levels of public debt than markets currently anticipate."

(Writing by Ann Saphir; Editing by Leslie Adler)