C. Peter McColough Series on International Economics

Wednesday, November 28, 2007

MR. LAURENCE MEYER: Good morning, everyone. Good morning. Okay, we're going to get started. Good morning, everyone. My name is Larry Meyer, and it's my pleasure to welcome you to today's Council on Foreign Relations meeting.

Now, the meeting is part of the C. Peter McCulloch (sp) series on international economics, presented by the Council's corporate program and the Morris R. Greenberg Center for Geo-Economic Studies.

Now, the first thing I want to remind everybody is to please turn off your cell phones, BlackBerrys and other wireless devices, to be polite and not to interfere with the other electronics apparently in this room.

I'd also like to remind especially the vice chairman that this meeting is on the record. And I think we're going to follow the Meyer rule here when there are press involved. So here's the rule. The rule is, the press must stay for the entire set of remarks and all the questions. It's just a safety issue, because you see the door is fairly narrow. We don't want you all rushing out at the same time.

Okay, now, if this was an audience filled with central bankers from around the world, Don Kohn would certainly need no introduction. He probably doesn't for this audience as well. I think that if central bankers around the world could hold an election and elect a global group of Committee on Monetary Policy -- I don't know what they would do, but if they did that, Don Kohn would certainly occupy one of those chairs.

Don has served in the Federal Reserve System for almost 40 years, at the board for almost 35 years, as economist, later director of Monetary Affairs, then governor, and now vice chairman.

When I was on the board and on the FOMC, he was, without question, my most valued advisor. And while I'm not a historian, I would venture to say that he is the most important non-chairman member of the FOMC probably in its history.

So I'm going to -- Don is going to open up with about 15 minutes of remarks. I'll follow with the first set of questions, and then we'll open it up to members for your questions.

Let me introduce Vice Chairman Don Kohn. (Applause.)

MR. DONALD KOHN: Thank you, Larry. And it's a pleasure to be here. When I accepted the invitation many months ago, I didn't anticipate the circumstances. But I'm glad to be here and glad to see so many familiar faces in the audience.

In a sense, I think, in my years at the Federal Reserve, New York has been a second home, and I've had great relationships with people at the Federal Reserve Bank in New York, at the desk there and elsewhere, and with many people who work here. And I'm glad to see so many familiar and mostly friendly faces here today.

So I thought it might be useful to start this session with a few thoughts on some of the issues facing central banks as they deal with the consequences of the recent turbulence in financial markets. My list is not comprehensive. I've concentrated on a few issues associated with our roles as monetary policymakers and providers of liquidity. And even in that category, I cannot address all the issues in the short time that I'm going to be talking.

And I want to emphasize that the views I express are my own and not necessarily those of my colleagues on the Federal Open Market Committee.

Now, like every other period of financial turbulence, this one has been marked by considerable uncertainty. Central banks, other authorities, private market participants, must make decisions based on analyses made with incomplete information and partial understanding.

The repricing of assets is centered on relatively new instruments with limited histories, especially under conditions of stress. Many of them are complex and have reacted to changing circumstances in unanticipated ways. And those newer instruments have been held by a variety of investors and intermediaries and traded on increasingly globalized markets, complicating the difficulty of seeing where the risk is coming to rest.

Operating under this degree of uncertainty has many consequences. One is that the rules and criteria for taking particular actions seem a lot clearer in textbooks and to many commentators than they are to decision-makers, or at least to this decision-maker.

For example, the extent to which institutions face liquidity constraints, as opposed to capital constraints, or the moral-hazard consequences of policy actions, are inherently ambiguous in real time.

Another consequence of operating under a high degree of uncertainty is that, more than usually, the potential actions that the Federal Reserve discusses have the character of buying insurance or managing risk; that is, weighing the possibility of especially adverse outcomes.

I think the nature of financial-market upsets is that they substantially increase the risk of such especially adverse outcomes while possibly having limited effects on the most likely path for the economy.

The first issue I want to discuss is moral hazard. Central banks seek to promote financial stability while avoiding the creation of moral hazard. People should bear the consequences of their decisions about lending, borrowing, managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill-advised. At the same time, however, in my view, when the decisions go poorly, innocent bystanders should not have to bear the cost.

In general, I think those dual objectives -- promoting financial stability and avoiding the creation of moral hazard -- are best reconciled by central banks focusing on the macroeconomic objectives of price stability and maximum employment. Asset prices will eventually find levels consistent with the economy producing at its potential, consumer prices remaining stable, and interest rates reflecting productivity and thrift.

Such a strategy would not forestall the correction of asset prices that are out of line with fundamentals, nor would it prevent investors from sustaining significant losses. Losses were evident early in this decade in the case of many high-tech stocks, and they are in store for houses purchases at unsustainable prices and for mortgages made on the assumption that house prices would rise indefinitely.

To be sure, lowering interest rates to keep the economy on an even keel when adverse financial-market developments occur will reduce the penalty incurred by some people who exercise poor judgment. But these people are still bearing the cost of their decisions, and we should not hold the economy hostage to teach a small segment of the population a lesson.

The design of policies to achieve medium-term macroeconomic stability can affect the incentives for future risk-taking. To minimize moral hazards, central banks should operate as much as possible through general instruments not aimed at individual institutions.

Open market operations fit this description, but so too can the discount window when it is structured to make credit available only to clearly solvent institutions in support of market functioning.

The Federal Reserve's reduction of the discount-rate penalty by 50 basis points in August followed this latter model. It was intended not to help particular institutions but rather to open up a source of liquidity to the financial system to complement open-market operations, which deal with a more limited set of counterparties and collateral.

The second topic is the effects of financial markets on the real economy. Related developments in housing and mortgage markets are a root cause of the financial-market turbulence. Expectations of ever-rising house prices, along with increasingly lax lending standards, especially on subprime mortgages but not entirely on subprime mortgages, created an unsustainable dynamic, and that dynamic is now reversing.

In that reversal, loss and fear of loss on mortgage credit have impaired the availability of new mortgage loans. This in turn has reduced the demand for housing, put downward pressure on house prices, and this has further come around to damp desires to lend. And we're following this trajectory closely.

But key questions for central banks, including the Federal Reserve, are, what is happening to credit for other uses, and how much restraint are financial-market developments likely to exert on demands outside the housing sector?

Some broader repricing of risk is not surprising or unwelcome in the wake of unusually thin rewards for risk-taking in several types of credit over recent years. And such a repricing in the form of wider spreads, tighter credit standards at banks and other lenders, would make some types of credit more expensive and discourage some spending. These developments would require offsetting policy actions, other things equal. Some restraint on demand from this process was a factor I took into account when I considered the economic outlook and the appropriate policy responses over the past few months.

An important issue now is whether concerns about losses on mortgages and some other instruments are inducing much greater restraint and thus constricting the flow of credit to a broad range of borrowers by more than seemed in train a month or two ago.

In general, non-financial businesses have been in very good financial condition. And outside of variable-rate mortgages, households are meeting their obligations with, to date, only a little increase in delinquency rates, which generally remain at low levels.

Consequently, we might expect a moderate adjustment in the availability of credit to these key spending sectors. However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. And should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses.

Heightened concerns about larger losses at financial institutions that are now reflected in markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases but for other uses as well.

Third topic: Liquidity provision in bank funding markets. Central banks have been confronting several issues in the provision of liquidity in bank funding. When the turbulence deepened in early August, demand for liquidity in reserve pushed overnight rates in interbank markets above monetary policy targets. The aggressive provision of reserves by a number of central banks met those demands, and rates returned to targeted levels.

In the United States, strong bids by foreign banks and dollar-funding markets early in the day have complicated our management of this rate. And demands for reserves have been more variable and less flexible in an environment of heightened uncertainty, adding to volatility in the overnight rate.

In addition, the Federal Reserve is limited in its ability to restrict the actual federal funds rate to within a narrow band because we cannot, by law, pay interest on reserves for another four years.

At the same time, the interbank funding markets have remained unsettled. This is evident in the much wider spread between term funding rates, like LIBOR, and the expected path of the federal funds rate. Now, this is not solely a dollar-funding phenomenon. It is being experienced in Euro and sterling markets to different degrees. Many loans are priced off of these term funding rates. The wider spreads are one development we have factored into our easing actions.

Moreover, the behavior of these rates is symptomatic of caution among key market-makers about taking and funding positions. And this is probably impeding the re-establishment of broader market trading liquidity.

Conditions in term markets have deteriorated some in recent weeks. This deterioration partly reflects portfolio adjustments for the publication of year-end balance sheets. And our announcement on Monday of term open-market operations was designed to alleviate some of the concerns about year-end pressures.

The underlying causes of the persistence of relatively wide term-funding spreads are not yet clear. Several factors probably have been contributing. One may be potential counterparty risk, while ultimate size and location of credit losses on subprime mortgages and other lending are yet to be determined.

Another probably is balance sheet risk or capital risk that is cautioned about retaining greater control over the size of balance sheets and capital ratios, given uncertainty about the ultimate demands for bank credit to meet liquidity (backstop ?) and other obligations.

Favoring overnight or very short-term loans to other depositories and limiting term loans give banks the flexibility to reduce one type of asset if others grow, or to reduce the entire size of the balance sheet to maintain capital leverage ratios if losses unexpectedly subtract from capital.

Finally, banks may be worried about access to liquidity in turbulent markets. Such a concern would lead to increased demands and reduce supplies of term funding, and that would put upward pressure on rates.

This last concern is one that central banks should be able to address. The Federal Reserve attempted to deal with it when, as I already noted, we reduced the penalty for discount window borrowing 50 basis points in August and made term loans available.

The success of such a program lies not in the quantity of loans extended but rather in the extent to which the existence of this facility helps reassure market participants. And in that regard, I think we had some success, at least for a time.

But the usefulness of the discount window as a source of liquidity has been limited in part by banks' fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions. And this stigma problem is not peculiar to the United States. And central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress.

Now, in response to developments in financial markets, the Federal Reserve has adjusted the stance of policy and the parameters of how we supply liquidity to banks and the financial markets. These adjustments have been designed to foster price stability and maximum sustainable growth and to restore better functioning of financial markets in support of those economic objectives.

My discussion today was intended to highlight some of the issues we will be looking at in financial markets as we weigh the necessity of future actions. We will need to assess the implications of these developments along with a vast array of incoming information on economic activity and prices for the future path of the U.S. economy.

As the Federal Open Market Committee noted at its last meeting, uncertainties about the economic outlook are unusually high right now. In my view, these uncertainties require flexible and pragmatic policymaking. "Nimble" is the adjective I used a few weeks ago in a speech. In the conduct of policy, as Chairman Bernanke has emphasized, we will act as needed to foster both price stability and full employment.

Thank you. (Applause.)

MR. MEYER: Okay. Well, I hope you appreciate that that was an absolutely brilliant speech. It was incredibly forthcoming. It sounded nothing like anything you've heard since the last meeting from other FOMC members. That's not a surprise, because the only FOMC members that can change the message are the vice chairman and the chairman. And that was an absolutely brilliant speech. I'm breathless. This has answered all the questions I had, so I don't know what I'm doing up here. (Laughter.)

MR. KOHN: We can go back and eat breakfast, Larry.

MR. MEYER: Yeah, we could. But nevertheless -- (laughter) -- I want to give him a chance to just reinforce some of the things that he said.

I think, if you go back to the October meeting and the statement after that meeting, it had a tone that said, "We think we may be done. And in any case, we're strongly inclined not to move in December." You've got to read between the lines. You can look at the minutes. The minutes said it was a very close call, much closer than the markets believed, between not moving and going 25 basis points.

So I just wanted to give the vice chairman a chance to sort of reinforce what he said. Many FOMC members have taking the line that nothing has changed since the last meeting. Those in the markets would beg to differ.

So I take it that this is a recognition that there have been important changes in the market.

It's a long time for the meeting. Lots of things can happen. It doesn't give away what the policy decision is going to be, but there have been important changes in the market, deteriorations in the credit markets in particular, that are relevant when the committee sits down again.

MR. KOHN: Right. (Laughter.) May I expand on that answer?

MR. MEYER: It's not unusual that my questions turn out to be longer than the answers. (Laughter.)

MR. KOHN: So we've gotten a lot of information since the last FOMC meeting, and we have a lot of information to come in until the next FOMC meeting.

I think the economic information we've gotten about the path of the economy has been kind of mixed since the last meeting.

If I think about labor markets, I think we and many people in this room were surprised -- maybe even including you, Larry -- at the strength of the employment gain in October. And since then, initial claims for unemployment insurance have edged higher on a kind of a moving average basis, but they remain pretty low.

So I don't know if we'll get another read before the next FOMC meeting on the labor market, but I would say what we know now is that the labor markets -- employments continue to expand. This provides an important pillar -- underpinning -- for the economy, because when employment's expanding, incomes are expanding and people can consume out of those incomes. That's, I think, been on the positive side in terms of incoming data.

I think on the other side, the spending data have been maybe a little to the soft side. We'll get more data on consumption, I think, Friday. Is that right on the consumer thing?

MR. MEYER: Right.

MR. KOHN: But I would say there's been a noticeable slowing in the growth of consumption from what we know now -- the partial data we have in hand. That doesn't suggest that consumption has stopped growing. It's still expanding, but at a slower pace. It's not entirely unexpected.

I think when you looked at the surveys of household attitudes and saw people getting more concerned, when you thought about declines in housing prices -- and certainly the failure of housing prices to go up and some, many of them to decline -- folks are looking at their balance sheets and thinking that their wealth is eroding to a certain extent. Their expected wealth is eroding and they're going to be a little more cautious in spending and I think we're beginning to see that on the consumer side as well. So that was a little soft, but we expected a little softness.

I think the housing sector has continued to decline and erode at a very, very rapid rate. And while this was expected, I think it would be nice to see some early signs that it was beginning to stabilize and we haven't seen that yet. We'll get data on sales -- both new and existing home sales -- I think today and tomorrow and it would be -- and those data will also contain information about the inventories of unsold new and existing homes.

And I think it would be nice to get a clue that sales were beginning to stabilize and builders were beginning to make some more progress in working down those inventories. As long as the inventories of unsold homes are there -- and the new inventories of homes coming onto the market, particularly in the foreclosure process -- looks high, that's going to put a lot of downward pressure on the housing market. So I think we've seen weak housing data. We expected weak housing data, so it'll be hard to assess, but I don't think we've seen the bottom of that market yet.

On the inflation side, I think the core data have come in at a moderate pace -- kind of stable. On the other hand, the dollar has dropped further so import prices will under some upward pressure. And energy prices have gone up. So I don't think -- the sources of risk that the committee saw on inflation at the last meeting haven't gone away. And it's something that no central bank can afford to ignore. I think it's very important people -- that we keep prices roughly stable and people perceive that we are keeping prices stable. We cannot let inflation expectations start to rise. That would be a very bad dynamic.

You're right: The one thing I think that's really changed since the last meeting is the deterioration in credit markets and financial markets. I never expected the markets to return to normal functioning very rapidly after the upsets of August and September. I thought this was a process that was going to take some time. Credit's going to have to re-channel to new -- out of the securities markets back into the banks to a certain extent. Instruments are going to have to be restructured so they're more transparent and are better able to be understood. The housing market and the macro economy are going to have to begin to stabilize so people -- that uncertainty goes away before things can get better.

But I do think the -- and expected some year-end pressures, but I have to admit -- speaking for myself and certainly not for the committee -- the degree of deteriorating that's happened over the last couple of weeks is not something that I personally anticipated. I think the losses that have been announced that seem entrain and have been announced were greater than people expected. This raised questions about financial institutions, how much capital they had, how vigorous they would be in pursuing new loans. Financial institutions became more cautious. And I think this process is one that we're going to have to take a look at when we meet in a couple weeks.

MR. MEYER: Again, extremely responsive answer to a difficult question Let me ask you: You know, when I was on the FOMC and you were secretary of the FOMC and advising me all along the way, Greenspan evolved this view about the risk-management approach to monetary policy. You know, in the context of where we are today with asymmetric downside growth risks that I would see -- and larger tail risk than we ever like to see -- what it meant to me was that the committee should put in place a path of the funds rate that would lead to unacceptably high inflation if those low probability, high-cost events did not occur. That's what risk management is all about.

It seems to me, so far, that this committee doesn't believe in the risk management approach. Do I misinterpret the risk management approach? And do you think that the committee in September, when it seemed to think that 50 basis points was enough, was practicing the risk management approach?

MR. KOHN: I think we have been practicing risk management approach to monetary policy. When we met in September we debated the choice between 25 and 50. We went with the 50, in part because we saw downsize risk and we wanted to take -- make sure our actions got ahead of what was happening and what was coming. So we did the larger -- the larger change.

Last time, as the minutes noted, there was a question -- people thought it was a close call between -- you know, you may disagree that it wasn't a close call --

MR. MEYER: No, no. I think it was --

MR. KOHN: -- but the perception -- perceptions of the committee at that time, given that there'd been very little evidence of spillover from the housing market at that time -- on October 30th-31st -- to other sectors, given that the financial markets had been improving, particularly after our 50-basis point cut in the middle of September, committee members saw that as a close call. And they chose to take -- we chose to take the 25-basis point reduction in part out of the very risk management way of dealing with monetary policy that you were talking about.

So when we have tail risk, you go -- you lean on the side of doing a little more. I think that's how the committee perceives that it's been operating.

MR. MEYER: When the chairman began his tenure, one of the things he emphasized was that the objective of increased transparency and the goal of the communication strategy was to align market expectations with policy intentions. What that does is lets the markets anticipated future policy and build in today -- in long-term rates and equity prices -- expected future policy. And yet, it's interesting that through most of the last year and a half, there's been this persistent divergence between market expectations and policy intentions.

Now, do you think that's a problem? Does it reflect an issue in terms of FOMC communication -- as I would think it does? And if it is a problem, do you have any suggestions as to how it could be rectified?

MR. KOHN: It's a phenomenon -- whether it's a problem or not, I'm not sure. I agree with your characterization that for the last year and a half or more the market has seen lower interest rates and the Federal Reserve -- has been anticipating lower interest rates and the Federal Reserve has delivered. But this is not new. I think when we were tightening in -- beginning in 2004 and 2005, they saw us stopping before we actually started. So there seems to be -- and I don't know why and there are a lot of market people in this room and maybe afterwards they can tell me why -- the market has persistently for several years before the Bernanke era, seen a lower federal funds rate as consistent with our goals than has actually occurred.

We need to make the decisions we make -- we are given the responsibility by Congress to promote maximum employment and stable prices and we need to set the federal funds rate, as our judgment, what those -- promote those objectives. The fact that the market sees that differently is an interesting phenomenon. I look at that. When I'm thinking about my own decision, I look at market expectations. And if my going in presumption into the FOMC meeting is different from what the market expects, I ask myself a couple of questions: Why? Do those guys know something I don't know? So it's kind of a check on me. I use it as a check. And the second question I ask is: Suppose we don't do what they expect, what will the market reaction be and now how do I factor that back into my decision?

So I think we need to account for those market expectations, but not follow them blindly. I don't think the fact that the markets had different expectations from the Federal Reserve reflects a failure of Federal Reserve communication. I think we are telling you guys more all the time about how we arrive at our decisions -- certainly in October and this new forecast that we're putting out -- what our thinking is.

I think Chairman Bernanke does a really clear job of setting out the reasoning for -- in his semiannual testimonies and in the speeches he gives like up here in New York Economics Club -- the setting out how we're viewing the world and why we see things going. And I guess in an ideal world everybody would agree about where things are going and why, and everybody would be on the same page, but that's not what happens. And we can actually get information -- I think we need to keep explaining what we're thinking and why we're thinking it. I don't see any obvious deficiencies in that. The markets disagree. We'll take that onboard and see what information there is in that for us. I don't think it's a deficiency in our communication. I just think people see the world differently.

MR. MEYER: Okay. My last substantive question: Do you believe there was a Greenspan put? That is, that the Fed, while I was serving on the FOMC and you were advising the committee, would come in quickly to protect investors against losses, but sit back when investors were gaining in the markets? And if the answer is you don't believe there was a Greenspan put, why does this committee seem so intent in differentiating itself from the Greenspan Fed?

MR. KOHN: Well, I don't know that -- first of all, you're right. I don't agree there was a Greenspan put. I think the FOMC under Alan Greenspan, as under Paul Volker, as under Ben Bernanke, have kept their eyes on those congressional objectives of high employment and stable prices. I think that's the way we should operate. That's the way we have been operating.

I think part of the perception of the Greenspan put -- and we raised interest rates in 1999 when the Stock Market was rising, because we thought that was necessary to keep inflation under control. We raised interest rates in 1994, in 1990 -- in early '95, because we thought that was necessary to keep inflation under control. I think part of the perception of the Greenspan put arises from the fact that asset prices tend to go -- what is the phrase -- up in an escalator and down in an elevator.

So if you're looking at the effect of asset prices on the economy and trying to factor that into your policy decisions, naturally the increases in interest rates will look more gradual than the decreases in rates just because of the way asset prices behave. So I don't think there's a Greenspan put. I don't think this committee is acting any different with respect to its ultimate objectives than it did under the previous several chairmen.

MR. MEYER: Okay. Last very short question: Would you like to take a bow on behalf of your communications and on behalf of the FOMC for the quite extraordinary new procedure for reporting information about the FOMC's forecast?

MR. KOHN: No. (Laughter.)

MR. MEYER: You should! You should. It was as much as anybody could have expected and more.

MR. KOHN: I think it was a very valuable step. And I hope that people read it and get more information out of it about what the committee is thinking, why it's thinking and where it thinks the economy can go. That was the objective. I think it's also got valuable information about the diversity of views on the committee. And that's important. And about -- one thing that's completely new is about how we're viewing uncertainty and the risk to the forecast. So that was all kind of implied before, but now it's much more explicit.

So I think that extending the forecast, looking at the risks and uncertainty in the forecast, adding the totally CP -- oh, total PCE, as well as to the thing -- conveys quite a bit of information. So I'm -- obviously, I was very much in favor of doing this and I'm glad you find it useful and I hope everyone does too.

MR. MEYER: Now we're going to open the floor to members for questions.

QUESTION: Thank you. Kathleen Stephansen from Credit Suisse.

Just thank you very much for this very interesting speech. Just a question: You alluded to the discount rate and the stigma that it still carries. Would you think that if there was no spread between the discount rate and the Fed funds rate, whether that stigma would

MR. KOHN: I think if there were no spread, the economic incentives might overcome the stigma. I'm not sure that the stigma would entirely disappear. But I think part of what we're seeing -- if I can sort of reframe your question -- about the lack of use of the discount window is partly economic and partly non-economic or partly about the 50 basis points, but partly about the stigma. And obviously, if we take the 50 basis points away and you can simply borrow at the federal funds rate, in effect I think the funding market would come all into the Federal Reserve. I mean, everyone would be borrowing a lot, including people who don't -- it's a very -- it would be a very difficult thing to do.

There are people who don't borrow at the federal funds rate, right -- smaller, medium-sized banks. And if they saw this window, they would come in and borrow -- basically, we would be giving them funds at a subsidized rate that people don't ordinarily have access at the funds rate. And we would be creating, I think, problems for the open markets, because they would have to anticipate how many reserves are going to be supplied through the discount window, which would be very hard to anticipate, and then drain those through open-market operations.

That's not to say that circumstances might not dictate at some point that we do something more with that penalty. I don't want to take that off the table. I think it's fair to say -- as I kind of hinted at in my little section on liquidity -- that we're looking at lots of different options about how to supply liquidity to the market. But I think we need to recognize that the one you came up with has some costs and some difficulties associated with it.

Are you calling or am I?

MR. MEYER: You can call.

MR. KOHN: Somebody -- there.

QUESTION: Nick Bradstreet (sp) with Lazard Asset Management.

Given the link between weakness in the dollar and inflation, I wonder if you could talk to us a little bit about some of the deliberations on the dollar itself.

MR. KOHN: We leave -- the Federal Reserve as left to the Treasury Department to be the spokesperson for the U.S. government on the dollar itself.

I think it's fair to say, as reflected in our minutes, that the dollar -- like other asset prices -- is an important piece of information that we take into account when we are deliberating our monetary policy. So the extent that a weak dollar adds to import prices, this is -- and takes some pressure off of domestic producers competing with imports -- this has at least a temporary inflationary effect that we need to think about.

I think our job as a central bank is to keep the economy as strong as possible and inflation as low as possible. I think those two things will add to the perceptions that this is a strong, vibrant economy, where, if you're holding dollars, you can have some assurance that when you exchange them for good and services produced in the United States, you can predict how many goods and services you're going to be exchanging them for. That is, price stability is assumed. And if we in the Federal Reserve do our job well, this will help bolster the demand for dollars.

MR. MEYER: Could I just -- when you're called on to ask a question, could you wait for the mike, talk into it, and then be sure to give your name and your affiliation.

Dave, why don't you -- David?

QUESTION: David Malpass with Bear Stearns.

Thank you very much for your remarks, Governor Kohn. Could you tell us about the overall inflation, the PCE, overall and core? Has there been a change in the Fed's thinking about the balance between those two? And what is -- when you discuss price stability, is that in terms of core or overall inflation?

MR. KOHN: I don't think there's been a change in the Fed's thinking here. I think price stability naturally means overall inflation. The Congress didn't say stable prices for core goods and services; it said stable prices. So our responsibility all along has been for the overall price level.

Our emphasis over the years has been more on core, because we think that's a better predictor of future total inflation than today's total inflation has been. So if we -- if I want to look at what the underlying pressures are in the market that might cause -- how severe they might be or not severe, how -- what future price pressures might look like, I tend to look at what's happening to core inflation today because I think that tells me something about the balance of potential supply and aggregate demand in the recent past, and therefore something about inflation going forward.

But I think our responsibility is for price stability, overall inflation. I think putting the total PCE along with the core PCE in our forecast went hand in hand, in my mind, with extending the horizon of the forecast. When we were just doing a year or a year and a half, then core was what we were kind of looking at, because that was going to tell us something about inflation in years two, three and four.

Now we're telling you something about our expected inflation in years two and three, something about where we think things are going to settle out, and it's very appropriate to look at the total.


QUESTION: Peter Garber, Deutsche Bank. It's a global financial system and a global crisis, and yet the actions of the individual central banks seem to have been piecemeal and localized. So I wonder if you can characterize the degree of coordination and cooperation among the central banks and whether you think it should be stronger or it's been adequate in this crisis.

MR. KOHN: There's quite a bit of conversation among the central banks about what we're doing and why and how we analyze the situation, what we're seeing in our individual economies, what they're seeing in their individual economies and in the global economy itself. I actually think that the initial responses of the central banks were a little bit disparate in terms of how they were reacting to the oncoming pressures in the funding markets. But I think we've kind of evolved, actually, over time towards a template that's not all that different from central bank to central bank.

We, of course have eased monetary policy, but other central banks haven't taken tightening steps that people expected them to have taken before this, so there's been an adjustment in policy. And I think there's also been an adjustment pretty common across a lot of central banks, in the collateral they take, in how they're executing term operations at the window.

You've seen announcements from the ECB, the Bank of England, and the Federal Reserve just in the last few days about operations over the end of the year. I think partly we've evolved that way just because circumstance has driven that. But we've partly evolved that way because we've been doing a lot of talking back and forth and trading analyses, and I think that's helped us evolve to a place that -- in which there is a lot of commonality to our reaction.

MR. MEYER: Could I just add that this question comes up a lot, as central bankers fly around the world a lot meeting with each other, and sometimes you ask why. And it's a good question, actually.

MR. KOHN: My wife has asked that question. (Laughter.)

MR. MEYER: But what they're doing is what the vice chairman said; they're sharing information as opposed to coordinating policy.

And I used to say that as much as FOMC members might respect Jean Claude and his colleagues at the ECB, they're not going to wait for them to ease when they want to go.

MR. KOHN: Yes? Somehow my eye is at the center of the room. I promise to fan out from there.

QUESTION: John Beatty (ph) from UBS. As of next year, Basel II will be applicable to certain large financial institutions. This will effectively mean that certain large financial institutions will be required to hold less amounts of capital reserves against their existing liabilities. Do you think that this will exacerbate the current credit crisis, or do you think that the enhanced possibilities of obtaining off-balance-sheet treatment will give banks sufficient incentive to restructure the existing transactions, which should, hopefully, benefit the economy as a whole?

MR. KOHN: I think Basel II will be helpful in a number of dimensions, and one of them is this last point you made. I think that certain things that were off-balance-sheet now, particularly in Europe, will be -- there will be more capital required for those. I think there'll be an integration of some of those off-balance-sheet things onto the balance sheet; at least the capital requirements will be there. And I think in a general kind of way, by making the capital requirements more risk-sensitive, it gives an incentive to banks to become more risk-sensitive in managing their portfolios.

There's a lot of capital regulatory arbitrage that goes on under the current system. And to the extent that Basel II can at least reduce some of that arbitrage, I think it will help to reduce some of the weak points in the system that resulted from this kind of arbitrage.

Now, that's not to say that Basel II is perfect. There are people taking a look -- that will be taking a look at, in the Basel committee, at what lessons we can draw from the recent experience or fine tuning it. But I think it's really important to get this risk-sensitive capital structure in place and then to do -- and then to do the fine tuning with the lessons learned.


QUESTION: Thank you. Tim Wilson, Caxton Associates.

The Federal Reserve has emphasized the importance of transparency and disclosure to the market of information in terms of maintaining financial stability through market discipline on market participants.

Are you satisfied with the degree of transparency and disclosure that we've seen over the past several months in terms of bank balance sheets?

MR. KOHN: I think the markets are asking for more transparency, and they're getting some more. Whether we're there yet I kind of wonder. So I think part of what's happening is uncertainty. Part of what's driving the deterioration in markets of late is uncertainty about the extent of losses and where they reside. The more information that can be given out I think the better off everybody will be. So I think we -- people have moved in that direction. I think there's further to go, and the institutions will find it in their self-interest to make more information available. And I would encourage them to do that. I think that's the only way to resolve the uncertainty is to make the information available.

Part of the problem is the complexity of the instruments that people are trying to value. So in some sense there's no easy answer to -- well, I'll just reveal something and all the uncertainty will go away. You have the macroeconomic uncertainty underlying it and the complexity of the instruments and the difficulty of valuing them. I think one of the things that will happen, as I think I've said before, in response to this market turbulence is that some of these instruments will become more transparent, less complex, easier for people to value, and that will in turn promote more transparency.


QUESTION: Maurice (Campbell ?) from the -- (affiliation inaudible). To what extent does the need to continue to finance our current account inhibit or contract your options in interest rates just in case the economy -- the real economy goes in the direction we all hope it doesn't?

MR. KOHN: I don't think the existence of the current account deficit inhibits our actions in terms of monetary policy.

I do think, as we -- as I said before, that we need to be careful that people have confidence in the dollar. And that confidence will come from the performance of the U.S. economy both in economic activity and in price stability.

So I don't feel any constraint. My -- from the current account deficit. The constraint I feel or the goals that I have are for the economy, and now I think if we keep our eye on that, the current account deficit will work itself out, the dollar value will work itself out. And feeling a constraint from that or not doing as well we could possibly do for the economy, I think, would have an adverse effect on the demand for dollar assets and might create a very unstable dynamic. So I think keeping our eyes on those macro goals is what we need to do there.


QUESTION: Marc Levinson from J.P. Morgan Chase.

Obviously the recent developments have had a pretty adverse impact on the securitization markets. As you look forward, beyond the current situation, do you think that the increased cost and difficulty of securitization is likely to have an impact on the growth of consumer spending and the consumption-investment balance in the economy more generally?

MR. KOHN: I think the securitization markets have been -- obviously have been very severely affected. And I think they'll come back slowly, over time. As I said before, I think this is going to be a process of -- a healing process that's going to take a while.

I think where we'll end up in the financial sector is not where we started. We'll end up with a somewhat less leveraged financial sector. I think the cost of credit will be a little higher to households and businesses, because it was unsustainably low before.

So I think the originate-to-distribute model is a good one. It's enabled risk to be dispersed and diversified. Obviously there was inadequate attention to some of the risks that were being developed, particularly in the mortgage market, over the last couple years, and that's going to have to be remedied. But I think the basic model works. It'll continue to work, but in a less -- the credit won't flow quite as cheaply as it did before, and that's fine, because I think we should be able to compensate for that in our monetary policy.

So I don't see any reason to think that because credit will be a little more expensive, to households or to businesses, that that should inhibit the economy from realizing its full potential. I think we can -- we can make that adjustment.


QUESTION: I'm John Watts, FFTW. Thanks, again, as many people have said, for a very clear and unusually useful, I think, explanation.

One question I have is about the effectiveness of the tools that you have. You I don't think mentioned, along with your eloquence about the complexity of the markets, the increasing and long-term shrinkage of the portion of the markets that flow through banks that you have more direct control on. Is that a factor in the uncertainty of the effect of FOMC actions?

MR. KOHN: I think there's been a long-term trend away from commercial banks and other depository institutions towards the securities market. That's been going on for decades. If anytyhing, I think that might be in the process of reversing a little bit, just for the reason that was raised here, that the securitization process, the trading of risk got over- extended, over-leveraged, and there will be some withdraw, and some of that credit will rechannel back through the commercial banking system.

I don't think that process over the last several decades of moving credit into securities markets and away from depositories has impeded the effectiveness of monetary policy. We can change that overnight interest rate. The effects of changing that rate and changing the expected path of the rate are very uncertain because they are transmitted through securities markets, but they were always uncertain, even when more of it was transmitted through the commecial banking system. We cna all remember back to the Regulation Q era, how Wotenbauer (ph) wrote a nice article about when that was -- wehn Q was coming off -- right? -- and the effects that would have. That was a very uncertain environment.

So just because credit went through banks, even after Regulation QUESTION: came off, didn't mean that the uncertainty was any less than it is now. So I think we retain -- still retain the ability to affect the


QUESTION: Hi. Josh Harris from Apollo Management LP. I wanted
to ask -- in the last -- around August, in the latest financial crisis, there was a -- there were literally billions and trillions of outflows from supposedly high-credit-quality short-term money market funds, which really suffered from a lot of asset-backed commercial paper and non-transparency, and those money market funds fell in value, and Treasuries -- obviously money put into Treasuries. How much of a concern was that to the Federal Reserve at that time? And how much of a concern is it that even today that these supposedly high-credit-quality money market funds are not as high-credit-quality as they might otherwise appear?

MR. KOHN: I think the money market funds were not themselves the focus of great concern but they were symptomatic of broader problems in the market, in which people were reevaluating the risks that they had. Money market funds were very risk- -- are very risk-sensitive because of the issue of breaking the buck. So I think that kind of magnified, maybe, the initial response.

But my view is that the funds will work this out, and they have been working it out. And the deeper, broader problems of how the risk is -- what the risk is, how it's distributed, that the money funds were kind of -- their reaction was symptomatic of other issues.

So I don't -- I'm not -- I don't have a special concern about the money funds. I think they'll figure out what they need to do to remain viable repositories for people's very liquid funds.

MR. MEYER: Okay. I think we have time for one more question. We'll take one from the back of the room somewhere.

MR. KOHN: Okay.

MR. MEYER: There we go. This person.

QUESTION: Thank you. Peter Gleysteen, CIFC. I wonder if you could please comment on the linkage between mark to market, mark to model valuation, and the lack of transparency and the fact that it's so buyer- or bid-dependent, with little or no focus or linkage to fundamental value. Thank you.

MR. MEYER: Yeah.

MR. KOHN: I think -- isn't -- the basic problem is determining what the fundamental value is. Your question presumed that someone knew what it was and the problem was figuring -- getting the mark to be that fundamental value. But the situation we're in right now is one in which lots of assets aren't trading. To the extent that they trade, they're trading in illiquid markets at very high bid-ask spreads.

So I think the mark to market and mark to model concepts are just different ways of trying to get at some approximation of what this
thing is worth today and how to value it on the balance sheet. And I know the market rating agencies are working on their ratings and how to do a better job there. I think people in the market are working on the models and how to improve those.

So the fundamental issue is trying to figure what this stuff is worth and then trying to restart a market in that. And I think people are doing as well as they can, using both markets and models, to try and come up with these values.

I don't think there's anything inherently wrong with mark to model. The problem is the model and making the model really reflect reality. And I think folks are working on that. So there's no easy way to get valuations in the current environment.

MR. MEYER: Could we show our appreciation to the vice chairman for coming and -- (inaudible)? (Applause.)

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