Kohn Says Fed May Need to Do More to Support Growth
The Federal Reserve, Congress and the Obama administration must remain “flexible and open” to additional policies to stimulate growth and cushion the financial system, Fed Vice Chairman Donald Kohn said.
“We must keep our ultimate objectives for the economy firmly in mind — sustained recovery to high levels of output and employment with price stability,” Kohn said at the College of Wooster, Ohio, where he received a bachelor’s degree in economics. “The Federal Reserve will continue to be alert to ways that monetary policy can contribute to economic recovery.”
Kohn has been at the forefront of central bank strategies to battle a deepening credit crisis that is likely to produce the longest U.S. recession since the Great Depression. While telegraphing the need for an eventual exit from government aid, the Fed vice chairman said policy makers must maintain a “posture” of providing additional assistance if necessary.
“We are not out of the woods yet,” Kohn said. “Many financial markets remain under considerable stress, asset prices have been reduced by the lack of liquidity in markets, and credit spreads and availability still reflect very high aversion to risk.”
U.S. central bankers have boosted credit and liquidity to banks and financial markets by $1.2 trillion over the past year. Total assets on the Fed’s balance sheet stand at $2.08 trillion. Kohn said the central bank must keep prices stable, avoiding either Japanese-style deflation if slack continues or expectations of escalating prices as the balance sheet expands.
Recession Worsened
Slumping home prices and the rise in mortgage delinquencies and foreclosures caused banks to pull back lending, accelerating an economic downturn that began December 2007.
“I expect that lower leverage and tighter lending standards and terms will be enduring features of the financial landscape,” Kohn said. “But current credit conditions are far tighter than these adjustments would seem to justify.”
The unemployment rate rose to 8.5 percent in March, the highest level since 1983. Employers cut 663,000 workers from payrolls, bringing total losses since the recession began to about 5.1 million, the biggest slump in the postwar era.
Gross domestic product slumped at a 5.1 percent annual rate in the first quarter, according to the median estimate in a Bloomberg News survey.
The record amount of additional government borrowing needed for the federal government’s stimulus program isn’t likely to force up market interest rates, Kohn said. “With monetary policy likely to be quite accommodative for an extended period and the margin of unused capacity extraordinarily large, crowding out of private-sector spending by the fiscal expansion should be limited,” he said.
Deflation, Inflation
Kohn said sustained economic slack and lower commodity prices could lead to expectations of further declines in inflation, which rose 1.8 percent for the year ending February, according to the consumer price index, minus food and energy.
“We are also conscious of a potential adverse feedback loop between persistent economic weakness and a continuing decline in inflation and inflation expectations,” Kohn said. “We could fall into deflation, much as Japan did for a time in the 1990s and earlier this decade.”
Countering these expectations are worries that the expansion of the Fed’s balance sheet could lead to higher inflation later, he said.
Exit Strategy
“The Federal Reserve must be prepared to exit from its various programs when the time is right,” he said cheap car insurance. The Fed “would benefit from new tools that would allow it to drain reserves from the banking system.”
Kohn said the Fed and Treasury are seeking such tools from Congress. One possibility is that the Fed issue its own securities, or “Fed bills.” Another would be for the Treasury to issue special bills, and put the cash on deposit at the Fed.
“It is important to get either of those tools exempt from the debt ceiling so that the Fed could have the power to absorb all the reserves it wanted to,” Kohn said in response to a question. “We can’t go into this without knowing how we are going to get out again.”
The Fed and administration’s response to the crisis remain subject to a number of other risks, Kohn said. There is a natural turn toward protectionist trade policies during bad times, which, if adopted, would slow recovery and lead to a “worse outcome for all.”
Seeds of Crisis
It’s also possible that the monetary and fiscal policies adopted to fight the crisis might recreate the conditions that led to the problem in the first place, he said. Policy makers have to be aware that cutting interest rates to near zero and increasing government deficits, providing increased leverage, creating loan programs that depend on credit rating agencies and off-balance-sheet entities, might sow the seeds of a new crisis.
Given the economy’s weakness at the moment, Kohn said he didn’t “think” that will happen.
That means it is vital the central bank and the Obama administration make plans for ending monetary and fiscal stimulus. “Over time, the Federal Reserve must reduce its lending; the government must put its deficits on a distinct downward track; financial institutions must retire government assistance and operate on their own,” Kohn said.
The economy may be showing some signs of bottoming. Orders placed with factories rose 1.8 percent in February, the first gain since July. Purchases of existing homes rose 5.1 percent to an annual rate of 4.72 million in February as lower prices attracted buyers.
Consumers are also benefiting from lower energy costs, and the lower mortgage rates. The average rate on a U.S. 30-year fixed mortgage dropped to 4.78 percent this week, the lowest in Freddie Mac data going back to 1971.
Fed Policies
Fed officials last month kept the benchmark lending rate in a range of zero to 0.25 percent and committed to purchasing $300 billion in longer-term Treasury securities over the next six months. The Fed also raised its target for mortgage-backed securities purchases this year by $750 billion for a total of $1.25 trillion. Federal agency debt purchases were raised $100 billion to $200 billion.
The Fed last month started the Term-Asset Backed Securities Loan Facility to provide financing and investor support for securitized consumer debt. The program could grow to $1 trillion from $4.7 billion in loans today.
Kohn, 66, is the longest-serving Fed Board member. He became a governor in 2002 after serving as a top policy advisor to former chairman Alan Greenspan. He was sworn in as vice chairman in June 2006. He started his career at the Kansas City Fed in 1970.
Filed under: economics by Forest