This past week I attended the U.S. Monetary Policy Forum that was sponsored by the University of Chicago's Booth School of Business Administration. In attendance were high ranking officials from the Federal Reserve and representatives from the European Central Bank and Bank of England, along with academics and members of the financial community. The morning and afternoon sessions consisted of panels on Macro Prudential Regulatory Policy and on the experience with Unconventional Monetary Policies that I will discuss in my next blog. In this one, I highlight the luncheon remarks by Donald Kohn, recently retired Vice Chairman of the Federal Reserve, who addressed how the Fed thinks about inflation in the current economic environment.
Kohn began his remarks by stating that inflation had become a controversial policy issue in the past year, and he was aware of several criticisms of Fed policy, which he wished to address. They included four topics: (1) How robust was the Fed's model of inflation? (2) Do rising commodity prices constitute prima facie evidence of inflation? (3) Has the Fed's conduct of monetary policy "exported" inflation to the emerging economies? And (4) Should the Fed's dual mandate be changed to a single mandate of fighting inflation?
On the first topic, Kohn began by conceding that economists' understanding of the process of inflation is somewhat rudimentary. He noted that the main variables in the Fed's econometric model – the "full-employment output gap" and various measures of inflation expectations – were not directly observable and their predictive power left room for improvement. At the same time, he indicated that the monetarist model, which emphasizes the growth of the monetary base as the primary determinant, had fared much poorer in recent years. He noted, for example, that monetarists believed the huge injection of bank reserves during the financial crisis would spawn higher inflation; yet, two years later, inflation had actually fallen. He pointed out that banks were content to sit on excess reserves, rather than to create new loans; consequently, money supply growth was anemic.
On the second issue, Kohn indicated that he does not view the rise in commodity prices as a precursor to broad-based inflation, especially with the core rate of inflation that excludes food and energy running at only 1%. Rather, he believes the run-up in commodity prices is linked to supply shortages and to strong demand in the emerging economies. Consequently, he views them as a change in relative prices. He noted that unlike the 1970s, wage increases today were very moderate, and that it is more difficult for businesses to pass along cost increases. Therefore, the risk that commodity price increases will become embedded in a wage-cost spiral is fairly low.
Finally, as regards the Fed's dual mandate, he indicated that Chairman Bernanke addressed this issue in his initial address. According to Kohn, Bernanke has acknowledged that in circumstances where fighting inflation and unemployment might be at odds with one another, the goal of fighting inflation would take precedence. In this respect, Bernanke and other Fed officials wish to reassure market participants that the Fed remains vigilant about keeping inflation close to its targeted level of 2%. With core inflation well below this level and unemployment hovering around 9%, however, Kohn believes there currently is no conflict in policy objectives.
My main takeaway from Kohn's remarks is that the Fed is sensitive to criticisms that monetary policy is too lax, and it wants to reassure investors that it is not soft on inflation. At the same time, I come away convinced that the Fed is not about to alter its policy stance as long as unemployment remains elevated and inflation expectations are well-anchored.
Also, from the question and answer session that followed, it is clear that the Fed does not see a link between its policies and asset bubbles. While Kohn indicated that the policy of quantitative easing was transmitted primarily through financial markets, he also stated the main channel through which monetary policy operated was through its impact on the real economy. In this respect, I came away disappointed that the Fed does not recognize the role it played in contributing to the financial crisis. Thus, while the Fed has done a good job of keeping inflation under control for the past 30 years, I am not optimistic that it will do a better job in dampening booms and busts.