Fed's Kohn: Inflation Has Shifted Down; Risks Remain

Federal Reserve Vice-Chairman Donald Kohn said the economy still faced a risk from potential inflation even though the trend in prices currently appeared to be downward.

"At the last meeting of the FOMC (Federal Open Market Committee)...and in the speech that (Federal Reserve Chairman Ben) Bernanke gave earlier this week, we suggested that (the) trend seemed to be shifting and our expectations were for a gradual decrease," Kohn told a questioner who asked him to clarify what he meant when he said trends were shifting.

"But the risks around that expectation are still tilted to the upside," Kohn added, using language U.S. central bankers employ to warn that they see a greater chance that interest rates will have to rise than that they will fall.

Kohn answered questions after a Friday night address to a conference on monetary policy at the Fed that was sponsored jointly by the U.S. central bank and by its counterpart, the European Central Bank.

His remarks were academically oriented, dealing with the difficulty that policy-makers face making decisions on interest rates when many measurements of economic activity that they use are inaccurate or subject to large revisions.

"Those difficulties are especially pronounced at times like the present, when resource utilization and the rate of economic growth are probably not far from their long-run potential," Kohn said. He added that "inflation trends may be shifting" without initially specifying in what direction.

Bernanke said similarly on Tuesday that there were inflation risks. "Given the current level of inflation, a failure of inflation to moderate as expected would be especially troublesome," the Fed chief told a New York audience.

Kohn did not directly address current economic conditions in his evening remarks to the monetary policy conference. Earlier, ECB Vice-President Lucas Papademos told the group that policy-makers must monitor the impact of globalization on inflation trends within national economies.

In response to another question, Kohn said that setting a target for acceptable inflation could be useful in an economy that had experienced severe price pressures but suggested it offered less benefit for the United States.

Kohn is considered less enthusiastic than some other policy-makers, including Bernanke, about adopting such a target but he acknowledged it was under discussion.

"It's under consideration. I don't know how it's going to come out," Kohn said. "I do think in the United States, the balancing of costs and benefits is a much finer calculation. We already enjoy considerable credibility."

In offering an example of measurement difficulties policy-makers deal with, Kohn noted that indicators of economic activity "often change markedly" as additional data are received.

He said recent revisions in measurements of gross domestic product and labor input "would seem to point to downward adjustments of trend productivity, but sorting out trend from cycle in the new data has been a challenge."

Similarly, although there are more indicators of inflation expectations, "here too, the reliability and usefulness of the existing data are less than we might like."

Kohn said problems in trying to determine what drove the prices of assets like houses constituted "a significant hurdle in giving them extra weight in setting monetary policy." Trying to set up a model to accurately gauge expectations remains a central concern for policy-makers.

One lesson that policy-makers have learned is that it is essential to communicate clearly so that the public feels some certainty about how the Federal Reserve is likely to alter interest-rate policy in response to economic developments.

Sometimes the goal of being predictable conflicts with the need to move swiftly to manage risk, especially if an unusual or unprecedented event occurs, and that requires clear explanation of why the action was taken.

"This conflict is probably unavoidable, and all that policy-makers can do in such circumstances is to try to communicate as best they can the rationale behind their departure from standard practice," Kohn said.