London, 20 November 2009 

Donald Kohn, the influential vice-chairman of the Federal Reserve, has rejected calls for the central bank to incorporate asset and commodity price movements into its monetary strategy. 

Kohn's view represents only one strand of thinking with the Federal Reserve System. There is no consensus and the presidents of at least some of the regional Fed banks may take a different view.

But his views represent the view of the Fed establishment, especially at the Board of Governors in Washington. The headquarters establishment looks set to oppose any reformulation of policy that would see the Fed take account of commodity and equity prices explicitly.

If their views prevail, the Fed will continue to ignore the run up equity values and soaring oil prices. It will not start to remove excess liquidity from the system, let alone raise interest rates, until there are clear signs of self-sustaining recovery on Main Street and some reduction in the output gap.

That would push any monetary tightening back until H2 2010 at the earliest, even if energy and other commodity prices continue to rise in the meantime. It means that plentiful liquidity will remain a bullish factor for commodities over the next nine months.

Dean of the Fed 

As the former secretary of the Federal Open Market Committee (1987-2002) -- one of the most senior staff positions at the Fed -- in the Greenspan era, Kohn has been the keeper of the Fed's orthodoxy, a sort of Cardinal Ratzinger to Alan Greenspan's Pope John Paul II. He remains the ablest and most eloquent exponent of what might be termed the orthodox view of recent monetary history.

In a speech on Nov 16, which was clearly meant to be a definitive statement of position, Kohn rejected claims that the Fed was responsible for the crisis.

www.federalreserve.gov/newsevents/speech/kohn20091116a.htm

Kohn argued that there was no damaging asymmetry in monetary policy (with the Fed easing aggressively in response to asset price declines, but not tightening fast enough when asset prices rose) creating a one-way bet on rising asset values. Nor was policy too loose in 2003, and then tightened too slowly and predictably in 2004 and 2005, encouraging a bubble in housing prices and deterioration in credit quality.

Kohn dismissed calls to add an additional financial stability objective to the Fed's existing mandate of "maximum employment, stable prices, and moderate long-term interest rates." It would, he argued, be costly and inject extra volatility into real output, employment and inflation.

A financial stability objective might force the Fed to raise interest rates when the real economy still required them to stay low. The price of greater stability on the financial side of the economy might be more instability on the real side -- paid in the form of prolonged unemployment, lost output and more variable inflation.

Better to strengthen banking regulation (at both the institution- level and system-wide) to prevent excessive credit growth and risk-taking rather than rely on the blunt of interest rate changes to curb the build up of risk.

I see no bubbles 

Reprising Greenspan, Kohn continued to emphasise on the difficulty of specifying correct asset values to identify when a bubble is forming, and raising interest rates high enough to prick it without sending the rest of the economy into a tailspin.

He cited recent increases in equity prices, commodities and other risk assets as a case in point. While some observers discern the next bubble, Kohn argued price rises are rational as financial and economic conditions return to nearer normal after the extreme dislocation in late 2008 and early 2009.

They are also the deliberate outcome of low-interest rate policies around the world intended "to induce investors to shift into riskier and longer-term assets." Current asset prices "do not appear to be clearly out of line with the outlook for the economy and business prospects."

Kohn sees no commodity bubble. Even if there was one, it would be inappropriate to respond to a change in a small subset of prices by hiking interest rates for the economy as a whole, and risk delaying or choking off the recovery.

 Old Guard Resurgent

Kohn's views, once the dominant orthodoxy in central banking circles, are now one strand among many. The crisis has shattered the previous consensus. Other senior officials, especially in the district Fed banks as well as the European Central Bank and the Bank of England, take a less dogmatic, more nuanced view.

They would allow commodity and asset prices to be at least a factor in policy decisions. While raising rates to prick bubbles remains uncomfortable to most, there is more enthusiasm for developing other, quantitative policy instruments that would enable the authorities to control the volume and direction of credit flows without affecting the cost of borrowing for everyone.

The obstacles to incorporating commodity and asset price movements into the monetary policy decision formally remain formidable, as Kohn noted. As with the banking and markets crisis, academic and central-bank thinking has lagged behind reality, and it will be sometime before they catch up.

In the meantime, commodity and asset price movements will enter into the policy process, but only informally, as a collateral factor. The Fed has already mentioned rising energy and other commodity prices in the press statement issued after its August meeting, but subsumed into its general inflation forecast.

Recycling Old Bluebooks

Kohn prefaced his remarks with the usual disclaimer he was speaking only for himself, and not other Federal Open Market Committee members. It is not a consensus view, but it is probably the most powerful one within the Federal Reserve System, and there is no sign that Chairman Ben Bernanke or a majority of the other governors dissent from it.

If Kohn's orthodoxy prevails, rates will remain at extremely low levels and the extra liquidity provided will remain in place for many more months. Policy will remain focused on unemployment and the level of spare industrial capacity.

In fact, if the Fed did nothing wrong in 2002-2005, as Kohn maintains, when Bernanke was an influential governor, there is no reason to expect it to do anything differently this time around. Last time rates stayed lower for longer than anyone anticipated, and then rose only slowly, as the

Fed waited for the recovery to become entrenched. History may be about to repeat itself.

As secretary of the Fed, Kohn was responsible for drafting the "Bluebook" ahead of each Committee meeting outlining options for the interest rate decision and the press statement afterwards. It was his job to help the chairman and members come up with an appropriate formulation of words to express the Committee's view of the economic and interest rate outlook. Like any economical wordsmith, past phrases could be recycled when occasion demanded.

Kohn was promoted from secretary to governor in 2002, but he might want to find the Bluebooks for 2002-2005 again. They will save a lot of working explaining why the Committee is leaving interest rates low while the recovery and asset prices gather pace.

Ends --

John Kemp is a Reuters columnist. The views expressed are his own