Fed Governor Kohn on the Chance of a Hard versus Soft Landing; Says Fed Should Not Hesitate to Increase Interest Rates

Here are remarks by Federal Reserve Board Governor Donald L. Kohn concerning how the imbalances in the U.S. economy came about, the chance of a hard versus soft landing, and the role of monetary policy in the coming months. At the end he makes it clear that the Fed should not hesitate to increase interest rates to contain inflationary pressure:

But, in the same vein, we should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly. Nor should we hesitate to raise rates because higher rates mean higher debt-servicing burdens for the current account, the fiscal authority, or households. In my view, our role is to anticipate as best we can the macroeconomic effects of imbalances and their correction and to respond to unexpected changes in asset prices and spending propensities as they occur. It is through such actions that we aim to achieve our objective of economic stability.

This, taken together with Greenspan’s remarks that there is little sign of stagflation make it increasingly likely that the Fed will raise interest rates in coming months. If there are signs of price instability, a .50 percent increase appears possible, though new data showing accelerating inflation would likely be required, particularly since Governor Kohn describes the Fed's posture as measured. But the posture described by Governor Kohn is more aggressive towards raising interest rates than I have described recently. This emerging vigilance towards inflation has arisen as the Fed has detected underlying strength in economic growth from recent reports on the economy. Here is a longer version of Governor Kohn's remarks, and a link to a transcript of the entire speech. Calculated Risk also discusses this speech and highlights the comments regarding current account imbalances and the housing market. Dave Altig's discussion of hard and soft landings in his series of posts here, here, and here at macroblog is also worth reading:

Imbalances in the U.S. Economy Remarks by Governor Donald L. Kohn At the 15th Annual Hyman P. Minsky Conference, The Levy Economics Institute of Bard College, Annandale-on-Hudson, New York April 22, 2005 ... I must emphasize that these views are my own and not necessarily those of my colleagues on the Federal Open Market Committee … …The United States has been doing well over the past few years by most measures of overall economic performance ... To be sure, the rise in energy prices seems to have taken a toll on consumer confidence and spending most recently. But … most forecasters expect growth to remain solid. Excluding food and energy, the rate of inflation has fluctuated around 1-1/2 percent over the past few years... Core inflation has been running somewhat faster more recently, in part because of the increases in the prices of energy, commodities, and imports that began last year. Nevertheless … core and headline inflation rates should moderate later this year. Buttressing this view, long-run inflation expectations have been, on balance, fairly stable in the face of these price gyrations. …[S]ome aspects of the current situation might be viewed as worrisome. In particular…the ... [current account] imbalance … has risen to a record level, both in absolute terms and as a ratio to GDP. Moreover, the cumulative value of past current account deficits … is also at a record high, again both in absolute terms and as a ratio to GDP. The growing current account deficit has been associated with a pronounced decline in the saving proclivities of both the private and public sectors… … [W]ith probably limited economic slack remaining, such a pronounced imbalance between national saving and domestic investment would have placed substantial upward pressure on interest rates. One also might have expected real interest rates to be high at a time when we are experiencing rapid productivity growth. But, as you know, nominal and real yields on both short-term and long-term Treasury securities are low by historical standards… …Low interest rates have, in turn, been a major force driving the phenomenal run-up in residential real estate prices over the past few years, and the resultant boost to net worth must be one of the reasons households have felt comfortable directing so little of their current income to saving. However, whether low interest rates and other fundamental factors can fully explain the current lofty level of housing prices is the subject of substantial debate. This situation raises some difficult questions. Can the aforementioned spending imbalances and possible asset-price anomalies continue without threatening macroeconomic stability? And if they cannot be sustained, how will they unwind? Will the transition be relatively benign, or will it be a rocky adjustment with deleterious effects on economic growth, inflation, and other factors? And finally, what role will government policies play in influencing the path of adjustment? On the question of sustainability, it is worth noting that these sorts of imbalances are not new ... But, the magnitude of these imbalances is increasingly moving into unfamiliar territory…The sustainability of these large and growing imbalances has become especially suspect because it would require behavior that appears to be inconsistent with reasonable assumptions about how people spend and invest … Similar considerations apply to the current low rate of household saving... given average life expectancies and the typical number of working years, a sustained saving rate of less than 2 percent is too low for households to accumulate enough wealth to maintain their standard of living after retirement--unless, of course, those households are lucky enough to receive outsized capital gains on their homes and other assets. Although many households have received such windfalls over the past few years, such gains are not likely to be continually repeated in the future … The current imbalances will ultimately give way to more sustainable configurations of income and spending ... Ideally, the transition would be made without disturbing the relatively tranquil macroeconomic environment that we now enjoy. But the size and persistence of the current imbalances pose a risk that the transition may prove more disruptive. ...I think we can identify several factors that have played an important role in the emergence of these imbalances, and in so doing gain some insight into their likely resolution. A rise in the net supply of saving in other countries, the perception that dollar assets are a relatively favorable vehicle in which to place that saving … the increased willingness of the rest of the world to hold U.S. assets, along with the jump in our productivity growth, contributed to a sharp increase in U.S. equity valuations. And the associated capital gains, in turn, caused the net worth of U.S. households to soar relative to their income and induced a reduction in personal savings rates. Then, in 2000 and 2001, ... In the United States and elsewhere, monetary and fiscal policies turned stimulative to bolster demand and to stave off unwelcome disinflation. The size of the stimulus required to accomplish our macroeconomic objectives in the United States was further increased by the sluggish economic growth of our trading partners and by continued demand for dollar assets, which further exacerbated our trade imbalance… ...What can we say about the likely path by which these spending imbalances will resolve themselves and about the effects those resolutions will have on the broader economy? … The federal funds rate appears to be below the level … consistent with the maintenance of stable inflation and full employment over the medium run, and, if growth is sustained and inflation remains contained, we are likely to raise rates further at a measured pace. By increasing the return to saving and by damping the upward momentum in housing prices, rising interest rates should induce an increase in the personal savings rate, and thereby lessen one of the significant spending imbalances we have noted. ...We do not understand all the reasons for recent low personal saving rates, and the rise in the saving rate could exceed the increase that results from likely movements in interest rates and house prices--especially as households contemplate the adequacy of their retirement income. And fiscal policymakers do seem to be more aware of the need to change the medium-term trajectory of the federal budget. To the extent that current spending behavior is built on realistic expectations … the transition should be relatively orderly ... But if current expectations are badly distorted, then the way forward may not be so smooth... Are expectations substantially distorted? …risk premiums on private securities are low by historical standards …[and] yields reflect … low actual and expected inflation … and the market's belief that … the federal funds rate will move up only gradually as the expansion proceeds… [S]ubdued expectations may reflect a belief that underlying global demand will remain damped and that the world will continue to be willing to invest heavily in the United States. A second observation concerns the housing market … Prices have gone up far enough since then relative to interest rates, rents, and incomes to raise questions … [that] the recent trend of price increases …[can] continue. Even so, such a distortion would most likely unwind through a slow erosion of real house prices, rather than a sudden crash … … Finally, there is the exchange rate … In all likelihood, adjustments toward reduced imbalances in the United States and globally will be handled well … provided … that the Federal Reserve reacts appropriately to foster price and economic stability… … [W]e cannot rule out sudden shifts in expectations, whether or not they are unreasonable to begin with, and asset prices may change suddenly... Moreover, we cannot rule out governments engaging in unwise policies… … A permanent correction to the spending imbalances must involve the restoration of fiscal discipline and long-run solutions to the financing problems of Social Security, Medicare, and Medicaid..Adjustment of global current-account imbalances could also be aided by changes over time in the policies of our trading partners… …Finally, there is the role that monetary policy plays in reacting to these imbalances and their inevitable unwinding... [A]nything that has the potential to threaten the stability of output and prices is of concern to us... we should take into account the claim on resources implied by the federal budget, ... the effect that housing wealth has on consumer spending and the economy more broadly. We should note the implications of changes in the exchange rate or borrowing rates by U.S. corporations that result from shifts in global investor sentiment. But ... we should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly. Nor should we hesitate to raise rates because higher rates mean higher debt-servicing burdens for the current account, the fiscal authority, or households. In my view, our role is to anticipate as best we can the macroeconomic effects of imbalances and their correction and to respond to unexpected changes in asset prices and spending propensities as they occur. It is through such actions that we aim to achieve our objective of economic stability.

[Update: William Polley notes his approval of the Fed's recent signs of inflation fighting resolve here.]