Kohn on the Economic Outlook

Don Kohn, the Vice Chairman of the Federal Reserve Board of Governors, gave a speech today on the Economic Outlook. Kohn is, in my opinion, one of the three most influential members of the FOMC (along with Bernanke and Mishkin), in terms of his ability to frame the debate, so his speeches are worth studying in detail.

When reading through this speech there are a couple important things to keep in mind, especially in light of Friday's better-than-expected employment situation report (pdf), which revised August payroll growth to +89,000 from -4,000.

The recent tightening in the credit markets affects the real economy with a significant lag, the same way an increase in the Fed funds rate would. This credit tightening is happening concurrently with a very deep housing recession, but one that so far has stayed within the housing sector and not spread to the rest of the economy. However, downturns in housing have historically almost alway spread to other sectors of the economy (read Ed Leamer's paper for the gory details). The easiest way, by far, to accelerate the housing downturn and guarantee that it leads to a full-blown recession is to cut off access to mortgage credit. That's precisely what's happened in the jumbo mortgage market (see Felix Salmon for a review). These credit-channel effects are very powerful and very predictable, but they play out in slow motion, over several quarters at least. 1990 is the right analog, not 1998. In such a situation, if the Fed sees significant downside risks to growth, one would expect the Fed to cut rates preemptively, even if current growth and inflation numbers wouldn't seem to otherwise justify a rate cut.

Now, with that in mind, on to the speech. I've quoted the meaty section of Kohn's speech in full below, with his comments on major risks to growth in black, and risks to inflation in red:

I expect that the financial market turmoil of the past few months will leave an imprint on the cost and availability of credit to many household and business borrowers. The greatest effects have been on credit related to residential real estate; in addition to the problems with nonprime and jumbo first mortgages, second mortgages and home equity lines of credit that many households have been using to finance purchases of household durables and other consumer goods and services probably will become more expensive and less available as well. Banks are likely to be especially cautious about making new loans and financing commitments while substantial uncertainty about the quality of loans and the extent of demands from previous commitments persists. So it would not be surprising to see less-generous credit for a wide variety of loans to business and households. And, the rates for some loans are tied directly to elevated libor or other rates in term funding markets.

More generally, credit will probably not be as easily available and as inexpensive for many borrowers as it was a few months ago, even after market functioning improves. In several segments of the financial markets, compensation for taking on risk had for some time seemed too low to be sustainable. In addition, more credit is likely to flow through banks, and leverage in the nonbank sectors of the financial markets will be lower. The higher levels of capital relative to assets should form the basis for a more stable system, but the spread of lending rates over the cost of funds will need to rise so that capital can earn a competitive rate of return.

Many people had expected the Federal Reserve to follow a gradual path of rate reductions in response to financial market developments--say, 25 basis points in September and another 25 basis points in October. Such a path would be in keeping with how we have often approached our policy choices, as it has the advantage of allowing us to calibrate our policy as we see how the economic situation is evolving and responding to earlier policy moves. However, given the circumstances at the time of the September FOMC meeting, there were strong arguments in favor of the larger action of a 50 basis point decrease in the federal funds rate. For one thing, it seemed that a decrease of that size could well be necessary to promote moderate growth. We had been holding the federal funds rate at 5-1/4 percent, well above the expected rate of inflation, in part to compensate for what had been very narrow yield spreads and readily available credit. We did not know how quickly markets would recover, the extent to which credit terms and standards would be tightened, or precisely how households and businesses would respond to recent or forthcoming financial developments. But, pending further evidence, a 50 basis point easing was not an unreasonable first approximation of what might be required to keep the economy on a sustainable growth path.

In addition, I thought that economic performance would be better served by the Federal Reserve taking its chances on responding too much, or too rapidly, to the turmoil in financial markets rather than acting too little, or too slowly. Sluggish or inadequate easing risked a weaker real economy that might cause lenders to pull back even more, leading to a deteriorating situation that could prove difficult to reverse. With the news on inflation relatively favorable of late and with inflation expectations seemingly well anchored, I believed that we would be able to offset the cut in the federal funds rate--if it turned out to be larger than needed--in time to preserve price stability.

Since the September FOMC meeting, we have seen some signs of improvement in some markets that were severely disrupted. For example, investors appear to be differentiating more among risk characteristics of asset-backed commercial paper programs; term funding has become a little more readily available to banks and commercial paper issuers; and the run-off in commercial paper outstandings has slowed. But spreads in these markets are still quite high by historical standards and funding maturities are very short, leaving many markets vulnerable to unpleasant surprises. In mortgage markets, spreads for rates on jumbo prime mortgage loans over those on conforming, agency eligible, loans have come down a bit, but are still elevated. Indeed, it may be a while before market participants regain enough confidence to price and trade certain types of assets and more normal liquidity conditions are restored.

Our policy action will not be able to avert all of the weakness in the economy that may be in train for the next several months. Monetary policy works with a lag, and the effects of our easing action will have their maximum effect only after several quarters. In particular, housing markets are likely to remain depressed in coming months as housing demand is restrained by the difficulty in obtaining mortgages and perhaps also by spreading expectations on the part of buyers that house prices will fall, as they already have in a number of markets. And, although builders have reduced housing starts sharply, they have made very little progress in reducing the number of unsold new homes on the market. As a result, even absent a further deterioration in sales, residential construction would probably decline further in the months ahead, imparting a significant drag on overall growth in real gross domestic product.

Beyond housing, it is too early to tell what effect financial market turmoil is having on household and business spending, though very preliminary and partial information suggest that thus far the effects seem to be limited. Moreover, the available data indicate that the economy entered this period still expanding at a moderate pace. For example, consumption held up well this summer supported by solid growth in real incomes. And, the recent data on orders and shipments of capital goods and on nonresidential construction indicated further growth in capital outlays in August. That said, credit availability is likely to be tighter than before, consumer confidence is down, and businesses will probably be a little more cautious for a while, suggesting that these components of aggregate demand could become more subdued in coming months.

Over time, however, I anticipate that the economy will move back onto a moderate growth track. The housing market should gradually recover as the cutback in production and lower prices help reduce the inventory overhang. And, as it does, the drag on growth from the declines in residential construction will abate, providing a boost to overall economic activity. To be sure, households are likely to start to save more out of their current incomes as they come to realize that they cannot count on a rise in the value of their real estate to build their retirement nest eggs. However, households have been surprisingly resilient to recent economic shocks, and any rise in the saving rate probably would be gradual. More generally, consumer spending should continue to be supported by ongoing growth in employment and income. In the business sector, balance sheets are in good shape, and most firms are not likely to face an appreciable tightening of credit availability. As a result, I anticipate that they will expand their investment spending to keep pace with rising household demands and with strength in export markets. In sum, once we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment.

But you should view these forecasts even more skeptically than usual. The FOMC emphasized the considerable uncertainty in the outlook. As I noted earlier, we do not know how financial markets will evolve, and we do not know how households and businesses will respond to financial developments. Naturally, these types of uncertainties are greatest when markets are behaving abnormally. The recovery from the problems of the early 1990s was prolonged because banks had to rebuild capital; the rebound from the market crisis of 1998 was swifter, helped along by higher productivity growth and the rise in the stock market that accompanied the optimism about high-tech profits. We will need to be nimble in adjusting policy to promote growth and price stability.

Of course, we would not have eased policy if the outlook for inflation had not been favorable. The recent data on consumer price inflation have been encouraging. Movements in energy prices have created volatility in overall inflation, but over the past twelve months both core and total prices for personal consumption expenditures rose 1.8 percent. Moreover, the near-term weakness in the economy should intensify competitive conditions in markets and reduce potential pressures on costs and prices. And, it will be critical for inflation expectations to remain well contained.

Two things to notice about his inflation comments: First, both current inflation readings and the inflation outlook are benign; Second, upside risks to inflation are not his main concern, and will not be a major consideration unless and until he sees a significant inflation uptick, which he clearly doesn't expect.

On the outlook for growth, all of the risks he cites are to the downside, and he expects those risks to persist for many months.

The Fed funds options market is now predicting no cut on Oct 31:

I think that's unlikely.

Kohn Endorses Greenspan's "Mopping-Up" Response to Bubbles (9/21/07)

Don Kohn gave a speech in Frankfurt last week at the German Bundesbank on the "Success and Failure of Monetary Policy since the 1950s." Kohn has worked at the Fed for the entirety of Greenspan's tenure, and he seems to have absorbed a lot of Greenspan's views. However, in the first part of his speech (covered in an earlier post), Kohn seems to be distancing himself from Greenspan's opposition to inflation targeting. In the second half though, Kohn returns to the fold and whole-heartedly endorses the Greenspan view of asset price bubbles, which I think of as the "Mopping Up" approach:

1. The Fed can't predict Asset Bubbles,
2. Even if we could identify a bubble, the Fed can't stop it without damaging other parts of the economy,
3. After a bubble bursts the Fed can cut rates aggressively to limit the damage to the broader economy.

The second of David's open issues--whether central banks should lean against possible asset price bubbles--was the key topic in my discussion here eighteen months ago, at Otmar's festschrift. My answer then is my answer now. A central bank should focus on the outlook for the macroeconomy and generally relegate asset prices to the subordinate role of inputs to the forecast process. I view this as the simple application of humility that David and I find so admirable. Although economic theory provides no settled answers to any topic, its predictions are especially imprecise with regard to asset pricing, which has two implications for central bankers. First, little confidence can be attached to the determination that an asset bubble exists except in the most extreme of circumstances. Second, even less confidence can be attached to predictions of the effects of policy on asset prices, and in particular on any speculative element in those prices. Moreover, monetary policy actions addressed at a perceived bubble in one sector may have undesirable effects on other asset prices and the economy more generally.

As a result, my preferred policy framework remains three pronged: First, assign the single instrument of monetary policy to its macroeconomic objective; second, rely on regulation to erect a resilient financial structure; and, third, in the event that market judgments prove to be wrong and financial prices adjust sharply, apply the tool of monetary policy to the macroeconomic task at hand [Shivers: i.e. cut rates]. That task is not always easily captured by simple statistical regularities. Relationships between financial markets and economic results are complex and nonlinear, especially when markets are not behaving normally. When investors are ebullient, their expectations of outsized capital gains can feed on themselves and back on the economy. On the way down, investors' loss of confidence, a reduction in credit availability, and a tightening of terms and conditions for credit have the potential to have pronounced effects on activity and inflation.

Kohn on Inflation Targeting (9/21/07)

Don Kohn gave a speech in Frankfurt yesterday at the German Bundesbank's 50th Anniversary conference on the "Success and Failure of Monetary Policy since the 1950s." The speech focuses on inflation targeting and asset price bubbles.

First, inflation targeting. The debate about whether the Fed should have an explicit inflation target reignited when Ben Bernanke became Chairman. Chairman Bernanke has been a strong supporter of inflation targeting. Vice-Chairman Kohn has been opposed to the idea. So it's interesting that in this speech Kohn seems to be warming up to the idea:

In many countries, ... price stability [is] pursued through the formal apparatus of an inflation target.... [T]he spread of such regimes has coincided with sustained low global inflation. In addition, no adopter of an inflation target has subsequently abandoned it....

Evidence has accumulated to suggest that stock prices, interest rates, and measures of inflation expectations seem to vary less in economies in which the central bank has an explicit long-run goal for inflation....

A formal inflation target represents a national embrace of a goal.... An important effect of such public acceptance of price stability is that it erodes the standing of those who would direct central bank action toward other ends. [I wonder who he's talking about.]

In the midst of this inflation-targeting lovefest, he interjects this caveat:

Before anyone jumps to the conclusion that Frankfurt is a stop on my road to Damascus, let this Saul state that for me the case remains open.

Wow... I'm almost giddy at what a great piece of Fedspeak that is. Doesn't it sound like he's at best noncommittal?

Note that he doesn't say "...let me state that the case remains open," instead he says, "let this Saul state..." Saul, or course, was the zealous persecuter of the early Christians in Jerusalem, who, while walking on the road to Damascus, was struck by lightning and received a revelation from God, thereafter becoming one of early Christianity's most fervent missionaries (St. Paul).

Now I may well be reading between lines that aren't there, but Don Kohn's speeches are usually very tightly written; he frequently says things obliquely, but he almost never says things unintentionally.

It sounds to me like Kohn is going do a Nixon-in-China on inflation targeting.



We'll tackle Kohn's thinking on asset bubbles in a subsequent post...

Kohn Soundbites

From Fed Board Vice-Chairman Don Kohn's last speech, Financial Stability and Policy Issues, May 16, 2007:

"We could face situations in which asset price movements are exacerbated by the actions of market participants, including dynamic hedging strategies or forced liquidations of assets to meet margin calls, and those asset price movements could feed back onto the economy....

In the extreme, price variations and other adverse developments could call into question the viability of these intermediaries, threatening a larger cumulative real effect....

We need to accept that accidents will happen--that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises....

Supplying additional liquidity and reducing borrowing costs can greatly ameliorate the effects of market events on the economy, and those types of macroeconomic interventions will carry less potential for increasing moral hazard than would the discount window lending..."

Interesting.