Thursday, January 7, 2010

Vice-Chairman Kohn

The Lehmann Letter ©

Yesterday’s post discussed Federal Reserve Chairman Ben Bernanke’s January 3 speech at the annual meeting of the American Economic Association.

Vice-Chairman Donald Kohn also addressed the Association that day:

He said:

“Given the heavy costs that have resulted from the financial crisis, the question naturally arises as to whether the circumstances that caused the crisis could have been avoided…... But against this important objective we need to balance the potential costs and uncertainties associated with using monetary policy for that purpose, especially in light of the difficulty in judging the appropriateness of asset valuations.

“One type of cost arises because monetary policy is a blunt instrument. Increases in interest rates damp activity across a wide variety of sectors, many of which may not be experiencing speculative activity……..”

In other words if the Fed had raised interest rates to prevent the 2002 – 2006 real-estate bubble, it might have hurt the overall economy. Monetary policy is a blunt instrument, not a selective tool.

That gets to the heart of the matter. Expansionary monetary policy during the 2001 dot-com recession ignited the real-estate blaze. Real estate was strong when the Fed depressed rates to boost overall economic activity. The Fed’s easy-money policy could not distinguish between those areas of the economy requiring assistance and those that did not.

The point: If raising interest rates to stop a bubble is too blunt an instrument, why is it OK to risk a bubble by lowering rates?

© 2010 Michael B. Lehmann

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