September 10, 2009 / 8:34 PM / 10 years ago

Fed's Kohn says no exit for extended period

WASHINGTON (Reuters) - Federal Reserve Vice Chairman Donald Kohn said on Thursday the U.S. central bank was developing tools to move away from its extremely loose monetary policy, but such an exit would not happen any time soon.

“Any combination of these tools, in addition to the payment of interest on reserves, may prove very valuable when the time comes to tighten the stance of monetary policy,” Kohn said in discussing a paper presented at the Brookings Institution.

“As the FOMC has said, that time is not likely to come for an extended period,” he said, referring to the Fed’s monetary policy-setting Federal Open Market Committee.

The paper, on the Fed’s track record since the failure of investment bank Lehman Brothers at this time last year, noted the central bank’s massive expansion of its balance sheet would not lead to inflation due to its ability to pay interest on reserves that are held with it by commercial banks.

“Paying interest on reserve balances also has important benefits and will play a key role in our exit from unusually accommodative policies when the time comes,” Kohn said.

Critics say the doubling in size of the Fed’s balance sheet to around $2 trillion since last September will lead to higher consumer prices when growth picks up and banks begin to lend out these excess reserves, fueling another credit bubble.

But the Fed argues that its ability to pay interest on reserves will break this linkage.

“Raising the interest paid on those balances should provide substantial leverage over other short-term market interest rates because banks generally should not be willing to lend reserves in the federal funds market at rates below what they could earn simply by holding reserve balances,” Kohn said.

This position was supported in the paper by Columbia University economist Ricardo Reis.

However, he did caution that the increase in the balance sheet was not without risks, and warned that if this led to credit losses at the Fed, it could force the Fed to go hat in hand to the U.S. government, compromising its policy independence.

Kohn added this outcome “seems extremely remote,” and he argued that the Fed would continue to earn substantial net profits on its balance sheet for the next few years in all but the most distant scenarios.

“Short-term interest rates would have to rise very high very quickly for interest on reserves to outweigh the interest we are earning on our longer-term asset portfolio. With the global economy quite weak and inflation low, a large and rapid rise seems quite improbable,” Kohn said.

Reis also argued that the Fed could target higher inflation in order to lean against the risk that the severe U.S. recession pushes the country into a Japan-style deflation, where falling prices inflicted a decade of stagnation.

Kohn said this might work in the perfect environment of an economic model, but was a bad idea in the real world.

“A policy of achieving “temporarily” higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable. Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high,” he said.

“The anchoring of inflation expectations has been a hard-won achievement of monetary policy over the past few decades, and we should not take this stability for granted.”

Kohn, however, rejected warnings from other conference participants that the attention being paid too inflation meant that central banks were ignoring the risk of deflation.

“We are doing this on a two-sided basis,” he told the conference in response to a question, adding Fed policies were aimed at keeping inflation and inflation expectations from falling too low as well as from rising too high.

Reporting by Alister Bull; Editing by Gary Crosse

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