WASHINGTON (MNI) – The following is an excerpt of remarks by
Federal Reserve Vice Chairman Donald Kohn Thursday in which he says that
given the lags in the effects of monetary policy, the Fed will not be
able to wait until the unemployment rate is down close to its long-term
level. He also says the Feds decision to tighten will be based not on a
particular indicator or small set of indicators, but rather on forecasts
of economic activity and inflation that take account of all available
information:
Monetary Policy The picture I’ve drawn today–of a gradually
improving economy, bolstered by better functioning financial markets and
rising asset prices, but also still held back by the effects of the
previous imbalances and corrections–has had important implications for
monetary policy. Because the economy and financial markets have
improved, we have been able to wind down our special liquidity
facilities and complete our purchases of long-term assets, like
mortgage-backed securities.
But because the recovery looks as though it will be gradual, and
because it started with the economy in a deep hole, with large margins
of underutilized labor and capital resources and low inflation likely to
persist well into the future, the Federal Open Market Committee has
stated that the current exceptionally low level of interest rates is
likely to be required for “an extended period” to make progress toward
our legislative goals of maximum employment and stable prices. The
exceptionally low rates help offset the lingering restraining effects on
economic activity and prices discussed earlier.
In due course, as these restraints abate and the expansion matures,
we will need to withdraw monetary stimulus to prevent the development of
inflationary pressures. As in past cycles, our decision to begin
tightening will be based not on a particular indicator or small set of
indicators, but rather on forecasts of economic activity and inflation
that take account of all available information.
We will want to make sure the economy has enough forward momentum
to continue absorbing the unused resources and to limit disinflationary
pressure. But we will also want to be sure that we haven’t left highly
accommodative policy in place so long that economic and financial
conditions become conducive to future inflation. Given the lags in the
effects of monetary policy, that means we will not be able to wait until
the unemployment rate is down close to its long-term level.
We will be watching inflation and inflation expectations carefully.
Inflation expectations have been stable, and I expect them to remain so.
Still, one risk is that, in line with past behavior, expectations could
follow actual inflation down, imparting additional downward momentum to
actual inflation. However, another risk is that expectations could
increase, perhaps reflecting concerns about the Federal Reserve’s
balance sheet or the federal budget deficit. For the moment, the public
seems confident that the Fed will keep inflation stable over time. We do
not take that trust for granted: We monitor inflationary developments
closely and stand ready to respond quickly and vigorously should the
need arise.
Although the framework for deciding when and how fast to tighten
monetary policy will not differ conceptually from the framework used in
the past, our decision this time has some added complexities. In
particular, our assets and the corresponding bank reserves are far
larger than anything in our experience. We are developing the tools to
manage our enlarged balance sheet in support of policy tightening when
the time comes, and we will need to deploy them in ways that reinforce
our ability to achieve our macroeconomic objectives. That won’t be easy
since we’ve never had so many levers to manipulate before, but the FOMC
has been giving considerable thought to this issue, and I’m confident
that we will find the right balance and sequence of actions to support
our basic policy decisions.
Some Implications of Uncertainty As this last point illustrates, we
are still in the midst of a very unusual period in U.S. economic history
and therefore in the conduct of monetary policy. Policy always operates
in an environment of uncertainty. The events of the past three years
have highlighted to me yet again our limited knowledge of the dynamics
of the financial system, the economy, and the interactions between them.
I can be reasonably certain of only one point: My economic forecast
is highly likely to be wrong–but I don’t know how. One implication of
this pervasive uncertainty is that any statement about the future path
of monetary policy must be conditional–dependent on the economy
following the expected path. Although the FOMC has stated that the
federal funds rate is likely to remain exceptionally low for an extended
period, this statement explicitly depends on an economic outlook similar
to the one I have given today. We cannot provide a precise timetable for
when short-term interest rates will begin to return to normal because
that depends on the evolution of actual and projected activity and
inflation.
Another implication of uncertainty is that policymakers need to be
open to alternative views about how best to set policy over time to
stabilize prices and achieve maximum employment. All models of the
economy are flawed to some degree, and a policymaker cannot dismiss a
risk simply because it is improbable in his or her favorite model. I
don’t know of any formal model that predicted what we have just been
through. Rather, policymakers need to weigh the predictions of competing
models in light of both theory and empirical evidence. They also need to
be prepared to adjust these weights or even abandon some models when the
incoming data are inconsistent with the view of the world embodied in
the particular model.
In my experience, these and other considerations put a premium on
flexibility. The need to learn from and respond to news means that
policy should have a substantial discretionary component. We have
certainly needed to innovate over the past several years to contain the
damage from unprecedented events in financial markets. But discretion
has its limits as well. We must be able to explain and justify our
actions within a coherent framework–even if the elements of that
framework are adjusted from time to time as experience dictates. And to
the extent that we can act predictably, households and businesses will
be able to anticipate our actions, reinforcing their effects. Finally,
we must not be flexible about our objectives. The goals of monetary
policy–price stability and maximum employment–are stable and well
known. The flexibility relates to the actions we take to get there.
** Market News International Washington Bureau: 202-371-2121 **
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