WASHINGTON — Donald Kohn, former vice chairman of the Board of Governors of the Federal Reserve, said the Fed's exit from unconventional policies is "more difficult this time around" and stressed that communication is "critical" to obtaining the desired effects of unwinding the easy-money policy.
"The decision about when to exit will be more difficult this time around: it follows a long period of disappointing economic performance, making it hard to have confidence that adequate expansion can be sustained without unusual policies," Kohn wrote as part of the Brookings Institution publication, "Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy."
Kohn is a 40-year veteran of the Federal Reserve System and served as vice chairman of the Board of Governors from 2006 to 2010. In July, President Obama mentioned his name as a possible candidate to succeed Fed Chair Ben Bernanke, along with frontrunners Larry Summers, former Treasury Secretary, and Janet Yellen, the current vice chair of the Board of Governors. Bernanke is widely expected to step down when his term is up in January.
One issue Kohn pointed to as complicating the exit from the Fed's highly accommodative policies included the zero federal funds rate, which reduces "the room for responding to further downward shocks, unexpected changes in market rate expectations, or errors in judgment reflected in too-early exit."
Kohn, now a senior fellow with the Brookings Institution, also pointed out that "the associated long period of extraordinarily low interest rates may have induced financial investment decisions that will result in losses and possibly even threats to financial stability as interest rates are raised."
Kohn argues in the paper that "the decision to actually tighten monetary policy - to raise rates and possibly reduce or sterilize excess bank reserves - should be geared to the risk of over-heating and of a sustained rise in inflation above target."
He writes "the cost of exiting too early, of raising rates and then seeing the economy slow more than desired, would seem to exceed the costs of being too late, allowing inflation to rise more than anticipated."
The paper says the exit will involve multiple dimensions of central bank policy, but goes on to say "sales of longer-duration securities on the books of central banks are not necessary to tighten monetary policy."
"Central banks can effect a tightening of policy by raising the interest rate they pay on deposits at the central bank, which should provide a floor for short-term market interest rates and in turn, tighten financial conditions more generally as longer-term rates, exchange rates and asset prices respond to actual and expected short-term rates," it said.
Kohn also writes that it's difficult to determine the role of domestic financial stability considerations should play in the monetary policy.
"The exit from unconventional policies might be especially disruptive given rates being as low as they will have been for as long as they will have been," he writes in the paper.
"Nonetheless, individual central banks cannot be expected to steer away from the domestic objectives embodied in treaty, law, or remit - say by deliberately running inflation above or below the price stability objective - to help other jurisdictions reach their own domestic objectives."
He goes on to say Fed communications about an exit will "be critical in keeping the financial markets and the economy on track, in order to achieve the central bank's goals for output and inflation."
"We have seen in the reaction of markets to Fed statements about possible tapering down of its security purchases just how difficult clear communication can be," Kohn said. "But it is essential that central banks keep trying to clarify their intentions and how their planned actions depend on shifting projections about prices and activity."
He says if the Fed fails to communicate well, there "would be even more volatility and unintended consequences at a time when, with short-term rates already at zero, there is little room for maneuver if financial conditions tighten more than is consistent with progress toward objectives."
Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See
