Fed's Kashkari: We're in a 'pickle' over rates

Don't blame only central banks for low interest rates, Minneapolis Fed President Neel Kashkari said Wednesday.

"It's also economic conditions around the world [that] are causing interest rates to be low and necessitating low interest rates," Kashkari told CNBC's "Squawk Box," ahead of the afternoon release of the minutes from the Fed's January meeting.

"We are in somewhat of a pickle. We all want to get inflation creeping back," he said, because price pressures in the U.S. and globally remain stubbornly low.

Citing the Fed's latest projections, Kashkari said policymakers see "moderate economic growth and inflation returning to target over the medium term." The Fed's target for inflation is 2 percent.

"If that is the case, we would expect a gradual increase in interest rates," he said, but stressed the Fed's mantra of being data dependent. "Since January, the data has been mixed. We're going to keep watching the data and decide in March or beyond when is the right time to move."

In congressional testimony last week, Fed Chair Janet Yellen left the door open for a March hike while acknowledging the new year market turmoil.

In December, the Fed increased rates for the first time in more than nine years. At the time, policymakers projected four more rate hikes in 2016. Given the recent financial turbulence, market participants expect fewer if any moves in the near future.

Banks still 'too big to fail'

Kashkari also said Wednesday that banks would still need to be bailed out in another financial crisis even though post-2008 regulations have helped them to become healthier.

"The banks are stronger. They have more capital, deeper sources of liquidity," Kashkari acknowledged. "Progress has been made, but if we have a stressed economic environment and multiple banks are in trouble at the same time, the government is going to have to step in and bail them out."

"I don't think that's an answer people are going to find acceptable," he continued. "So now is the time to consider a more transformational solution." He said he's going to bring in experts to help him craft by the end of the year a plan to address the problem "once and for all."

There should be one set of rules that every American bank needs to follow, Kashkari told CNBC's "Squawk Box," a day after the newest central bank policymaker called for radical action to rein in banks and protect taxpayers. He conceded, however, that a financial crisis outside the U.S. would be a wild card.

"If other countries want to take huge risks with their financial systems, we can't stop them," he said. "'Too big to fail' is not just a U.S. problem, it's a global problem." Capital is the best weapon against shocks to the financial system, he added.

Addressing a hypothetical on China, Kashkari said: "None of us has perfect information into the Chinese government and their financial system. But from what I know of the Chinese system, they have enough capital to stand behind their banking system."

But he argued there would still be an impact on the Chinese economy, which could spread to the U.S. "It leads to great market upheaval and one of the transmission mechanisms from China to the U.S. are obviously risk premiums, obviously volatility in the markets. Even If our trade linkages may be moderate, if risk premiums go up all around the world, that could have an effect on our economy too."

Kashkari, who unsuccessfully ran as a Republican for governor of California in 2014, served as the administrator of TARP, the Troubled Asset Relief Program, at the Treasury Department during the 2008 financial crisis. After leaving Washington, he joined Pimco as a managing director and head of global equities. Before his time at Treasury, he was a vice president at Goldman Sachs.

In his first speech as head of the Minneapolis Fed, Kashkari urged Congress to consider bold rules, including breaking up the largest banks or turning banks into "utilities" by creating huge cash cushions so they can't fail. Such rules would go further than the post-crisis Dodd-Frank regulations.

PRO Talks: Banks with Neel Kashkari
PRO Talks: Banks with Neel Kashkari   

There are "economies of scale and scope" with the big banks, but also costs, Kashkari told CNBC. "If we were to restructure our financial system, I believe small and midsized banks would grow to fill some of that void."

"I think that community banks and small banks are being caught in the umbrella of what we are trying to do to stabilize the biggest banks," he continued. "So in my view, if we actually took transformational action to stabilize the biggest banks, make sure they are secure, maybe we can relive some of the regulation on some of the smaller banks that weren't part of this."

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— Reuters contributed to this report.