Donald Kohn’s “Less Alarmist” View

Originally published November 28, 2007

Fed vice-chair Donald Kohn spoke at the Council on Foreign Relations in New York this morning, in a session moderated by Laurence Meyer. Kohn’s prepared remarks are on the Fed’s website at:

Unsurprisingly, the text reads mostly like a standard one the one hand/on the other analysis of the sort that caused Harry Truman to demand a one-handed economist. Though Kohn would never win any public speaking awards, there were some subtleties in the delivery that might be meaningful. For example, he drew out the reading of this sentence, as if for emphasis: "Some broader repricing of risk is not surprising or unwelcome in the wake of unusually thin rewards for risk taking in several types of credit over recent years." And he emphasized the starred words in the following passage: "Consequently, we might expect a **moderate** adjustment in the availability of credit to these key spending sectors….  Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and **could** induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well." These emphases suggest that Kohn – who emphasized he was speaking for himself only and not his colleagues – holds a less alarmist view of things than do many market participants.

Meyer passed up few opportunities to flatter Kohn. He praised the prepared speech as "brilliant and forthcoming" as soon as Kohn uttered his closing "thank you." His first question was how things had changed since the October FOMC statement, which had a tone of finality about it – especially given the increase in market anxieties in recent weeks. Kohn acknowledged these, but proceeded to evaluate the information that’s come out since the end of October. He said he was surprised by the strength of the October employment report, and noted that while initial claims have crept up lately, they remain at a low level. The labor market continues to expand, providing an important "pillar" for demand. But, on a less positive note, there’s evidence that consumption is slowing – but this is hardly unexpected, given the erosion in the confidence surveys and the decline in housing. Housing, he said, is eroding "at a very rapid rate"; he’d hoped to see signs of stabilization by now, but they’re not evident yet. He’s watching the inventory numbers carefully, especially since foreclosures are likely to add to the queue of unsold houses. Core inflation remains benign, but the decline in the dollar and high energy prices mean that the sources of inflationary pressures haven’t gone away. And the Fed cannot afford to ignore these; no central bank can let inflation expectations rise. The biggest change since the October statement has been a further deterioration in the credit markets; the size of losses and writeoffs revealed in the last few weeks has been a surprise, and the FOMC will have to look carefully at what that all means.

Meyer also pointed out that Bernanke came into office hoping for greater transparency in Fed policy deliberations, and for closer alignment between market expectations and central bank intentions, yet the disparity between the markets and the Fed has been unusually wide lately. Kohn acknowledge this, and added that the market has expected looser policy than the Fed was offering for several years. Markets had anticipated the Fed would stop tightening earlier than it did when it was raising rates, and have now been expecting greater indulgence since rate-cutting began. He says he uses market perceptions as a check on his own thinking – "do they know something I don’t?" – but he made it clear that he calls them as he sees them. He said that the disparity between market perceptions and Fed policy isn’t the result of a failure of communication on their part; Bernanke has done a "really clear job" of publicizing their analysis.

In response to other questions, Kohn denied the existence of a Greenspan put (no surprise there!); said that if they get macro policy right, meaning strong growth and low inflation, the dollar and current account problems will "work themselves out"; argued that core inflation is useful as a predictor of headline inflation, even though their legal mandate and long-term interest concerns total inflation; and thought that after this crisis passes, the consumer and business credit will be a little more expensive and a little harder to get, which will be a good thing.

The overall impression he gave was that the Fed was not alarmed, and that only a significant deterioration in the credit markets and the real economy will prompt them to turn more aggressive.

– Philippa Dunne & Doug Henwood