Wednesday, March 24, 2010

Fed Vice Chairman Assigns Homework for Monetary Policymakers

by Calculated Risk on 3/24/2010 08:01:00 PM

From Fed Vice Chairman Donald Kohn: Homework Assignments for Monetary Policymakers

Kohn's assignments:
1) "One assignment is to evaluate the implications of the changing character of financial markets for the design of the liquidity tools the Federal Reserve has at its disposal when panic-driven runs on banks and other key financial intermediaries and markets threaten financial stability and the economy."

2) "In addition to providing liquidity on an unprecedented scale, we reduced our policy interest rate (the target for the rate on overnight loans between banks) effectively to zero, and then we continued to ease financial conditions and cushion the effect of the financial shock on the economy by making large-scale purchases of several types of securities. My second assignment involves improving our understanding of the effects of those purchases and the associated massive increase in bank reserves."

3) "Number three involves considering whether central banks should use their conventional monetary policy tool--adjusting the level of a short-term interest rate--to try to rein in asset prices that seem to be moving well away from sustainable values, in addition to seeking to achieve the macroeconomic objectives of full employment and price stability."

4) "The fourth and final assignment concerns whether central banks should adjust their inflation targets to reduce the odds of getting into a situation again where the policy interest rate reaches zero."

All four topics are interesting ... Kohn believes that the inflation target should be around 2%, and that the impact on rates from the MBS purchase program "comes mainly from the total amount we purchase relative to the total stock of debt outstanding", not the flow of purchases - suggesting little increase in mortgage rates when the Fed stops buying MBS in a week.