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Federal Reserve Vice Chairman Donald Kohn spoke at the Kellogg School on Nov. 16.

Don Kohn

Kellogg Distinguished Lecture Series: Donald Kohn

The Federal Reserve vice chairman argues that oversight, not monetary policy, is the best fix for immediate market problems

By Amy Trang and Matt Golosinski

11/18/2009 - The Federal Reserve should avoid micromanaging individual market challenges. In fact, its arsenal of policy options is not even designed for the job, according to Donald Kohn, the Fed’s vice chairman who spoke at the Kellogg School on Nov. 16.

Don Kohn

Describing monetary policy as a “blunt” tool, Kohn said its optimal role generally is to cultivate favorable long-term economic prospects. To remedy more near-term concerns in the credit and asset markets, Kohn said, “the best approach is to strengthen supervision and regulation.”

“It seems to me that under most circumstances monetary policy is not the appropriate tool to use to address asset-price developments or growing vulnerabilities in financial markets,” Kohn stated, adding that he does not believe the U.S. economy is currently at risk from an asset bubble. He delivered his remarks as part of the Kellogg Distinguished Lecture Series.

Kohn discussed various challenges at the intersection of monetary policy and financial stability. While he said that the Fed’s role is to help the country achieve long-term financial objectives — maximum employment and stable prices — Kohn acknowledged that the recent global liquidity crisis has inspired widespread reflection among his peers.

“After a serious setback to economic stability such as we have recently experienced, monetary policymakers must ask whether the strategies and tools they have been using need to be adapted to fulfill their responsibilities for price and economic stability in modern financial markets,” Kohn said.

For his part, Kohn continues to see prudential regulation as the preferred tool to address acute market problems, with the Fed’s resources best deployed to consider strengthening the overall financial system.
Answering the concern of some who believe that recent Fed policy may be fueling another asset bubble in the U.S., Kohn said the evidence did not support the worry.

“The prices of assets in the U.S. financial markets do not appear to be clearly out of line with the outlook for the economy and business prospects as well as the level of risk-free interest rates,” he said. What’s more, even if the country were experiencing a bubble, Kohn said it would be unwise to try to offer a strong corrective now.

“Tightening financial conditions at a time when an economic recovery has just begun, when labor markets are continuing to weaken, when inflation is below its optimal level for the longer run, and when significant strains persist in the financial system would incur a considerable short-run cost in order to achieve possible long-run benefits whose extent is, at best, quite uncertain,” Kohn said.

Kohn said the evidence was inconclusive about the effectiveness of direct use of monetary policy to promote financial stability. He cited other situations where monetary policy had little effect on the outcome. For example, tightening policy had no effect on the magnitude of the dot-com bubble in 1999, and the housing bubble was created by other factors before the Federal Reserve began raising rates in 2004.

Kohn also addressed questions from the Kellogg audience about the emergency government funding that several large corporations recently received. Kohn said that bailing out certain so-called “too-big-to-fail” institutions was inefficient and helped to exacerbate the liquidity crisis. He contended that the system would benefit from devising an orderly way to resolve these institutions’ finances, using some “in-between steps” that could be followed in these situations.

Kohn observed that in the midst of the recent financial crisis, government agencies were in tandem, communicating effectively: “There was extraordinarily good coordination among the different agencies. We all pulled together to move into the same direction.”

Kohn’s address was part of the Kellogg School Distinguished Lecture Series, which brings real-world leaders to campus to share their insights with students. His visit was sponsored by the Kellogg Office of the Dean and Northwestern University’s Center of International Economics and Development.