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Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the central bank’s low interest rate policies, though necessary, will probably generate signs of financial instability.

“Unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity,” Kocherlakota said today in the prepared text of a speech in New York. “All of these financial market outcomes are often interpreted as signifying financial market instability.”

Fed Governor Jeremy Stein and Kansas City Fed President Esther George are among those who have voiced concerns that an extended period of low interest rates is heightening the risk of asset bubbles in markets such as junk bonds and farmland.

While George has dissented from this year’s Federal Open Market Committee decisions because of this risk, Kocherlakota is among the strongest supporters of additional monetary stimulus on the committee.

In speeches earlier this month Kocherlakota said he sees an “ongoing modest recovery” with unemployment staying at 7 percent or more through late 2014. The slow recovery calls for “more accommodation,” he said in a speech, repeating his call to postpone consideration of any increase in interest rates. He doesn’t vote on policy this year.

“It is likely that, for a number of years to come, the FOMC will only achieve its dual mandate of maximum employment and price stability if it keeps real interest rates unusually low,” Kocherlakota said at the Levy Economics Institute’s 22nd Annual Hyman P. Minsky Conference.

Near Zero
The Minneapolis Fed chief has said the central bank should hold its target interest rate near zero until unemployment falls to 5.5 percent. That’s a full percentage point below the 6.5 percent threshold that has been adopted by the FOMC.

Answering audience questions, Kocherlakota said the recovery in the housing market is evidence that the Fed’s monthly purchases of $85 billion in Treasuries and mortgage securities are effective.

“They are having an impact on the economy,” he said. “Look at what’s going on in the mortgage market.”

“It would be nice if we did even more along those lines because I think our tools have been effective,” he said. “In the housing market in particular you’ve certainly seen direct effects of that kind of stimulus.”

In his speech, Kocherlakota said that “for a considerable period of time, the FOMC may only be to achieve its macroeconomic objectives in association with signs of instability in financial markets. These financial market phenomena could pose macroeconomic risks. In my view, these potentialities are best addressed using effective supervision and regulation of the financial sector.”