From Burns to Powell

A Macro Musings Transcript

David Beckworth: Our guest today is Donald Kohn. Don is a senior fellow at the Brookings Institution and currently serves as an external member of the Financial Policy Committee at the Bank of England. 

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Don is also a 40 year veteran of the Federal Reserve System, including serving as a governor and then vice chair of the Board of Governors from 2002 to 2010. 

David Beckworth: Don joins us today to discuss his career, as well as some of his recent work. 

David Beckworth: Don, welcome to the show. 

Donald Kohn: Thank you David for having me on. I'm looking forward to this. 

David Beckworth: It's a real treat to have you on, you're quite the all-star. You worked your way through the Federal Reserve System, you started at the Kansas City Federal Reserve Bank, and then to the Board of Governors. I want to start there with your career at the Board of Governors. 

David Beckworth: You came in there in 1975, which means you were there when Arthur Burns was chairman of the Fed. So, please tell us any insights into that period? 

Donald Kohn: So, I was at the Kansas City Fed from 1970 through the middle of 1975. 

David Beckworth: Okay. 

Donald Kohn: I had several of my colleagues at the Kansas City Fed had migrated to the Board of Governors, people that I was close to in Kansas City and people that I respected a lot and liked interacting with and they kept saying, "It's really cool back here in Washington. There are so many people at the Board that know a lot. There's nothing you can think of that someone hasn't already thought about. And, this is a really great place to work right at the center of policymaking." 

Donald Kohn: So, they convinced me that this was a good place to come and they were right. It was great fun. 

Donald Kohn: Of course, 1975 and the latter part of the '70s were an excited and interesting time for the US economy- 

David Beckworth: The great inflation, right? 

Donald Kohn: The great inflation at the Federal Reserve, and the Fed was wrestling with how to get control of this thing. What to do, what it had to do. 

Donald Kohn: Arthur Burns was a very demanding person to work for. Now, I was a lowly staffer, but in that position I briefed the Board on recent financial developments every couple of weeks. There was a weekly briefing for the Board of Governors. Someone would brief on non-financial developments. People would brief on the money supply and credit growth, and people would brief on financial markets and I had the financial market piece. 

Donald Kohn: He was very exacting and he knew the data very well and he held your feet to the fire and, he could be very dismissive if he didn't believe what you were telling him and you couldn't support what you were doing. It was a very scary experience. There was one person whose name I fortunately forget that I was told that before this person came down to brief Arthur Burns and the Board, he had to take a little courage from his desk, a little liquid courage… 

David Beckworth: Some spirits, huh? 

Donald Kohn: …to do this. And, it wasn't a good time for the Federal Reserve, and I think Burns himself gave a talk called “The Agony of Central Banking”. He didn't feel the Fed ... there were forces outside the Federal Reserve that were contributing to this inflation. He didn't want to take the very hard steps necessary to deal with those forces. My impression, maybe from my briefing of him was that he didn't tolerate alternative views very well. 

Donald Kohn: He was dealt a bad hand, I mean there were oil price shocks, a lot of union wages were indexed, and- 

David Beckworth: Sure. 

Donald Kohn: Tied to CPI's, so there's certain momentum to this thing. 

Donald Kohn: But, I also think ... the cards he was dealt, he didn't play very well. And it took Paul Volcker to come in and demonstrate that when a central bank wants to achieve price stability, a central bank can achieve price stability. 

David Beckworth: Let me ask what Athanasios Orphanides research on this period. He has some really, maybe provocative, but nonetheless interesting work on this period. 

David Beckworth: And, he argues that ... And, contrary to John Taylor's work and others. 

David Beckworth: He claims that if you look at real time data from this period. The Federal Reserve actually was following a Taylor Rule fairly closely. The only problem was is that the potential real GDP or output gap was really bad in real time. 

David Beckworth: So, that's part of the story, was just ignorance and not having good data. 

David Beckworth: As a staffer, what is your take on that literature, his work? 

Donald Kohn: I think that certainly contributed, and remember the Friedman-Phelps thing was from the late '60s, so it was just permeating the profession, the expectations augmented Philips curve was permeating the profession through the 1970s and identifying the NAIRU, which is what Athanasios was talking about, the output gap was ... wasn't entirely new, but it was getting new emphasis with respect to inflation and then the inflation expectations part also was so important. 

Donald Kohn: So, I think that undoubtedly contributed. And, I've had discussions with Athanasios about this, it seems to me that when you're trying something and you see that it's not working. That inflation is rising faster than you thought it would. Then you should go back and question your premises. Maybe more quickly than they did. 

Donald Kohn: So, I can see that this might've contributed, but I think as Paul Volcker demonstrated that it doesn't have to control your behavior and when you see that it's not working the say you thought it should, you need to take very decisive steps to deal with the thing. And Arthur Burns or G. William Miller, who followed him for a year and half or so, wasn't willing to take those steps. 

David Beckworth: Let's talk about Paul Volcker, so you worked with him, you worked through a very tough time to be a central banker. 

Donald Kohn: Right. 

David Beckworth: One of my first forays into macroeconomics, I read William Greider's book, Secrets of the Temple. The name sounds worse than the book. It's actually fairly understanding to read of this time, this period. He gives these accounts of how these governors were really stressed out because of the double dip recession of the '80s. They were thinking long-term, politicians were thinking short-term. 

David Beckworth: He tells that Volcker got death threats. What is your take on that time? 

Donald Kohn: It was a very difficult time, and Paul Volcker exhibited enormous courage to stick with what he knew was right for the American people over the long run. 

David Beckworth: Yup. 

Donald Kohn: So, we had ... I remember one day when tractors, the farmers, came to town and they surrounded the building with tractors. 

David Beckworth: Really? 

Donald Kohn: Yes. And then, there were consumer activists who also were demonstrating. Not infrequently, demonstrations outside the Federal Reserve Board. 

Donald Kohn: Volcker invited the consumer activists in to talk to them, or I think he maybe went out on the steps and interacted with them. Itself I think a great thing to do. 

Donald Kohn: He agreed with, and the woman who was running this consumer activist outfit was Gale Cincotta was her name and he agreed with her to send staff and governors out to various locations. 

Donald Kohn: She said, "You're not feeling the pain. You're not connecting with the people." So he said, "Okay. You set up meetings, and we'll attend them and you can let us know what it feels like out there." 

Donald Kohn: So, the meeting I went to was in Seattle and it was difficult I would say. So, I was there with the person who was the head of the Consumer Affairs Division at the time. And they put us in a class, it was in a Catholic school on a Saturday morning, they put us in a classroom and kind of whipped the crowd into a frenzy and then we entered to "Boos" and "Hisses" and they tried to elicit personal, financial information. This person who was with me was very good at resisting this. But, it was very difficult and some other people in other locations had even a tougher time than I did. 

Donald Kohn: Chairman Volcker awarded everybody who went out to these meetings a Purple Heart, a little cloth Purple Heart, and unfortunately I've lost mine. I wish I still had it. 

Donald Kohn: And then at the end, they came in and he was subject to the same things we were. 

Donald Kohn: But, I think the story here is, it was very difficult and we knew people were suffering. The other anecdote is builders sent in little pieces of 2x4's with the message ... with a stamp on it. With a message, "If it weren't for you, this would be used in building houses." 

Donald Kohn: So, everybody was upset. It was a tough time. The unemployment rate got to ten percent or so, which seemed high at the time. It was a stop/start situation. I remember there were credit controls put in, in 1980 I think, with the Carter administration trying to short circuit the tight monetary policy. By short circuit, I mean attack the problem of over borrowing and overspending in a more direct way through credit control. So to reduce the pain, it didn't work. It just made everything worse, but it also interfered with the signals monetary policy. So, we stopped for a while, and then we had to tighten again. So, it was kind of a double dip recession, and it wasn't until the middle or late of '82 that you could see that inflation really was receding, the pressure on the financial system was very intense. That was, Mexico started having problems in the middle of '82. 

Donald Kohn: And the money supply, we were using the money supply as a very strong signal for what should happen to interest rates. It was feeding through the demand for reserves, and that was allowing the federal funds rate to get up to 20 percent, 22 percent. But, you know…now we worry about the zero lower bound. 

Donald Kohn: There we were testing infinity on the upside and it varied over quite a wide range, several percentage points sometimes between meetings, because it was being driven by the demand for reserves, which was in turn tied to the behavior of M1 Money Supply. 

David Beckworth: Okay. 

Donald Kohn: Now, part of what happened in the early 1980s was deregulation. And, deregulation changed the character of deposits and demand for deposits. So, I think the pressure on the financial system, the deregulation, the fact that inflation was coming down pretty dramatically meant that we kinda backed off of the tight policy at the second half, particularly the fall of 1982. 

David Beckworth: One thing I've wondered about Paul Volcker is all the pressure he went through and all the threats he got, I mean the intense suffering, all of you, you went through. Could he have done it in a more modern age? But, that I mean, today there's like 24/7 cable news, there's Twitter, social media, I mean I want to give him credit for what he did and the spine that he had, but do you think it's harder to be a central banker today? A chair today versus then, given the constant scrutiny? Or is it just as intense back then? 

Donald Kohn: I think it was just as intense back then. It might be louder now in some sense. But, the Congress was upset, someone I think was Henry Gonzalez introduced an impeachment thing against Volcker. 

David Beckworth: Really? 

Donald Kohn: Yes, so I mean it was ... I mean it was not easy times. And, I think if you read Paul Volcker's book, Keeping At It, I think it's called, you'll see his focus on price stability is absolutely undiminished and unchanged- 

David Beckworth: Yes. 

Donald Kohn: -Over the decades. And he doesn't like the two percent inflation target, it's too high, too precise and too high. And, I've had this discussion with him many times trying to convince him that it was okay and there are reasons for having a two percent target- 

David Beckworth: So what would he prefer, like a zero percent with a band around it? 

Donald Kohn: Yeah, I think zero to two would be- 

David Beckworth: Is ideal? 

Donald Kohn: -Would be from him something there, but he probably wouldn't even be so precise, I mean he's the one that started inflation should be low enough that households and businesses don't have to take it into account when making decisions, Greenspan also had that definition independently. So, I think it's get it low enough for that, and I think Paul Volcker would say two percent is doubling every 36 years, that's not low enough. You can argue with him about distortions in a price index. It doesn't matter, but I think his book shows his focus that the job at the central bank is price stability, and from that will flow good economic performance, and in fact, from Paul Volcker's performance in '79 to '82 we had the Great Moderation. 

David Beckworth: That's right. 

Donald Kohn: From the early '80s to 2006, and I think a lot of it had to do with getting inflation down, anchoring those expectations. Alan Greenspan took the foundation Paul Volcker laid and built this structure on top of it, of getting inflation expectations and anchoring them even further. 

Donald Kohn: And, I can tell you from personal experience dealing with Greenspan, that he paid a lot of attention to inflation expectations in the early '90s, when the Bush 41 administration was unhappy with interest rates, they wanted them lower, because we had a jobless recovery and they were worried he had his eye ... Alan Greenspan had his eye on inflation expectations and he said, "We've paid ... The economy had paid a big price for getting them down, they're not gonna rise, we want to, if anything, keep that progress." 

Donald Kohn: So, I think the two of them together established the price stability that we've lived with since 2000. 

David Beckworth: It's interesting, Paul Volcker is still with us, do you think all of that would've taken a toll on his health or ... Maybe it did and he's just got great genes, and can live a long life. 

Donald Kohn: Well is health actually isn't good. But- 

David Beckworth: Oh okay. 

Donald Kohn: -I don't think that has anything to do with the stress that he was under. He's a public servant and he loves public policy. If you read his book, and I recommend it to all the listeners, a lot of it has to do with international financial developments. 

Donald Kohn: He was in the Treasury Department under the Kennedy, Johnson, Nixon administration dealing with international financial developments and trying at first to save Bretton Woods and then to reform it in a way that would provide a more stable basis for international finance. So, that was a big part of his life. 

David Beckworth: Even, you mentioned '82 the Mexico crisis was a big part of his life at the Fed too. 

Donald Kohn: Right. 

David Beckworth: I can say that because fresh out of grad school, my first job was at the US Department of Treasury, International Affairs where he used to work. But in the event, one of my mindless jobs they gave me with my PhD, I had to go through and they're getting rid of some old documents. And we had to go through and read which ones we could get rid of or save, and some of them were from the early '80s and they were Paul Volcker and Treasury Secretary at the time, they were discussing what to do with Mexico and it was actually a very fascinating read. 

David Beckworth: The discussions they were having, what to do with the big crisis coming out on Mexico. 

Donald Kohn: That's right, and Volcker from his perch at the Fed was very involved in dealing with the banks and dealing with Mexico. Trying to solve this and cooperating closely with US Treasury Department, which he recognized on an international financial crisis, would be the lead agency, but he had a lot of expertise and ideas about how to deal with it. 

David Beckworth: We'll make sure to have a link on our web page for the book. 

David Beckworth: You mentioned Alan Greenspan, one of the things he's known for is being a sage when it comes to productivity numbers, being ahead of the curve. What can you tell us about that story? 

Donald Kohn: So, I think ... I really enjoyed working with Alan Greenspan, and he likes to say I was his mentor, when he came to the Federal Reserve, I'm not sure I want all that credit, and I remain close to him since he left, and I left the Federal Reserve. 

Donald Kohn: He's an intensely analytic guy, very empirical. And, from his days at Townsend-Greenspan as a consultant in the private sector. And even ... Yes, had a very deep knowledge of statistical series, and from all sources, both private and public series. 

Donald Kohn: [He] had done modeling himself, so he knew how this process worked, and he liked to delve into these various series, look for clues that something unexpected was happening underneath. I used to kid him that he could take one bad series and divide it by another bad series and come up with an interesting statistic that meant something. 

David Beckworth: Nice. 

Donald Kohn: But, this is the productivity thing. He felt like the aggregate data on productivity, profits, something wasn't adding up, and he dug underneath using the staff of the Federal Reserve, Larry Slifman was a staff member very involved in this and research and statistics. 

Donald Kohn: And looked at, eventually, I think non-financial corporate profits and productivity trying to find the series that did have good data that were based on less assumptions the way service sector and government stuff and agriculture is more estimated. 

Donald Kohn: So, he dug down and he thought he could see in the behavior of profits and the behavior of productivity that something deeper was going on and something more lasting was going on. 

Donald Kohn: So yes, he saw that and it was greeted with considerable skepticism including inside the Federal Reserve. 

David Beckworth: Really? 

Donald Kohn: Yes, so I think Larry Meyer, who was a governor at the time and Janet Yellen, office is two down from me here now. To tell a story, I think Larry in his book tells a story about going ... The two of them going to Greenspan and saying we need to raise rates because we think the unemployment rate is dropping and the economy is growing too fast. And, he's saying, "Be patient, this is a productivity boost that is gonna come through in the numbers. So unit labor costs aren't rising so fast, there won't be the pressure on inflation you're afraid of, you're concerned about." And, prevailing in that argument because the data ended up supporting his proposition, but he got it by digging underneath the aggregate data that most of us rely on. 

Donald Kohn: And, knowing those data very, very closely and where they came from, the strengths and weaknesses. 

David Beckworth: Very interesting. This takes us up to your period in 2002 now. You're appointed as a governor. What big changes did you experience going from a staffer to a governor? 

Donald Kohn: There were changes and I think one of the things that I missed going from staffer to governor were some of the really vigorous discussions we used to have on staff putting the forecast together. 

Donald Kohn: And, it's hard when you're in the decision making position, what I discovered was that the staff would put the forecast together and I knew that there were disagreements, but once the forecast was put together they kind of united behind it. 

Donald Kohn: So, I felt a little isolated in some sense from some of the discussion that was going on and I worked hard at regenerating that, being part of that very intense examination, what's happening? What could be causing it? And whatnot. 

Donald Kohn: So, I actually ... Of course, I was interacting with staff a lot, but I missed some of the give and take that happened as I moved from staff to governor and of course you're in a different ... it's a different flavor, you're a decision maker and you take responsibility for your decision. No longer can you say, "Well, I told them what to do, but those… whatever did do what I told them to do." Now, you're those whatever, right? You're doing it, and you're taking responsibility. 

Donald Kohn: So, it feels different, and I mean I enjoyed it. 

Donald Kohn: The other difference was the public aspect of being a governor. So, I think very appropriately the staff participates in academic conferences all the time, comments on papers, gives little papers, and things like that. 

Donald Kohn: As a governor, as a policymaker, you are appropriately expected to go out and explain your policy to the wider public. That was new for me. I think I relaxed into that role as the years went on. But, it was a big difference, and one I had to embrace over time, and I was also, as a staff member, you don't have newspaper people hanging or cable news people hanging along your every word. 

Donald Kohn: They don't care what the staff says or for all practical purposes, but when you're a policymaker, then they're paying a lot more attention to you. So getting used to that public spotlight, getting used to testifying in front of Congress. Advocating and defending what the Fed was, and explaining what the Fed was doing. This public role was a different one for me. 

Donald Kohn: And one that took a little while to get used too. It didn't feel natural to me at the time, it feels much more natural now, but it didn't then. 

David Beckworth: It seems like that would be one of the hardest transitions because you have to be more guarded now don't you? You can't just say, "Hey, what's up?" Call your friend and shoot the bull about markets, because then they could quote you and market could- 

Donald Kohn: Right. 

David Beckworth: -And I feel bad for all the chairs for regional presidents that have gotten in trouble because of things that have slipped. Especially, when they're on the job first as the chair. I think it would be tough for anyone to always get it right. 

Donald Kohn: Right, and I think people should give more scope or give consideration when policymakers are speaking off the cuff. So it's one thing to have something in a speech that's thoroughly vetted by sometimes your fellow policymakers. If you're testifying for the system, for the Federal Reserve Board. 

Donald Kohn: Then other board members will read the speech and obviously the staff works very hard on those testimonies. The staff helps you with the speech, but when you're speaking off the cuff, you may not say exactly what you want to say and think at the time and those words can be misinterpreted. 

Donald Kohn: It's interesting talking about transitions among chairmen. So, in the '90s some staff members went to Alan Greenspan and said "The head of the Bundesbank has a press conference, I think after every policy meeting, would you consider doing that?" And Greenspan said, "No." I think he felt like the potential cost of not saying quite the right thing outweighed the benefits of explaining it. 

David Beckworth: Interesting. 

Donald Kohn: Now, when Ben Bernanke came into office, one of his main goals, objectives for his term in office, was to increase the transparency of the Fed. So, he instituted press conferences four times a year and now Jay Powell is gonna go to eight times a year, press conferences. 

Donald Kohn: I was told the other day by the way that the ECB, which took up the Bundesbank press conference after every policy meeting, has gone back to four a year. 

David Beckworth: There's some fine tuning potentially. 

Donald Kohn: But, the press conference is a good innovation. It gives the chair a chance to present the collective judgment of the committee and where it came out and explain why it came out the way it did. 

Donald Kohn: Before other committee members and the newspapers and the cable channels interpret things. So, he or she can shape the interpretation the way the market sees things. 

David Beckworth: Speaking of transparency, it's my understanding it was the mid '90s before the Fed began to release its target officially. Is that right? Or some kind- 

Donald Kohn: Either early '93 or early '94, one of those two I can't remember. 

David Beckworth: Yeah, so I'm curious as a staff member, were you aware of the targets ... So, when the Fed wasn't released, so you guys knew what it was, you just couldn't say anything? 

Donald Kohn: Well, I think ... that's right, so in effect, the targets were released after the next FLC meeting when the minutes came out. But, everybody knew, everybody in the market knew almost the next day and this became even more refined after 1989, I think. There was something that became known inside the institution as the "Thanksgiving Turkey". 

Donald Kohn: This was a situation in which the day after Thanksgiving, the New York Fed in executing open market operations executed an operation that the market interpreted as ... Because markets were figuring out what the Fed wanted to do by looking at the operations that the New York Fed did. What were the type of operations? How strong were they relative to expectations etc.? 

Donald Kohn: And, they did something that the market interpreted in a particular way that wasn't consistent with the committee's desire and they moved rates. 

Donald Kohn: Now, there's a lot of discussion that things, staff's, the money market firms were understaffed on the Friday after Thanksgiving. 

Donald Kohn: But anyhow, after that the desk signals about what was going on, were very precise. So, I would say yes the Fed started announcing, I would say early '94. It was a February either '93 or '94. But, well in fact it was when the first increase happened when the Fed fund rate at been stuck at three for many years. But, even before that everybody knew, so it was really- 

David Beckworth: The open secret. 

Donald Kohn: It was an open secret. 

David Beckworth: Okay. 

Donald Kohn: Well signaled by the New York Fed’s actions in the market, but it was the first time this thing had been announced right after the committee meeting. 

Donald Kohn: The announcement started out as Chairman Alan Greenspan announced, so it was really a Greenspan announcement and then the announcement was pretty short, and in fact sometimes I think at least to the initial few, I'd like to go back and review didn't even say what the funds rate was, but it would say, "tightened slightly", or "eased slightly", and that would mean 25 or ... There was coded language that everybody knew and that gradually evolved to much more precising. 

Donald Kohn: And it also evolved in the way that the open market committee said after a couple of years, "Well, wait a second this is obviously an extremely important piece of transparency by what we're doing. We wanna have some say in here. So, we would like to help Alan Greenspan compose these things." 

Donald Kohn: In the mid to late '90s, so I was the staff member in charge of monetary policy. And he and I would put these things together over the weekend, I'd faxed to his fax, we'd do a test fax first to make sure we had to ... we didn't put a wrong number in. 

Donald Kohn: And, we'd talk a little bit on Monday morning and that would be the thing. But, it was way too important to leave to- 

David Beckworth: To one person. 

Donald Kohn: To one person. Yeah. 

David Beckworth: It's interesting. So this week on the show, we're recording this January 17th, but this week on the podcast, I have Craig Torres from Bloomberg News. He actually tells about when he started following the Fed in the late '80s that actually at Bloomberg, they actually ... Maybe he was with someone else, but he started covering the Fed. They had market guys in the newsroom with them, who would interpret, like you were saying, repo-market actions. 

David Beckworth: Then he could write down what can happen. They needed a market guy in the newsroom. 

Donald Kohn: Yeah. 

David Beckworth: So, reporters today have it very easy compared to them. 

David Beckworth: Well, let’s talk about your time as Vice Chair. You became Vice Chair in 2006. Were you appointed at the same time Bernanke was appointed then, or at different times of the year? 

Donald Kohn: So, he was appointed and became Chair on February 1st, 2006. And, I think Roger Ferguson was the Vice Chair at the time, and Roger ... I don't think his term was up, I think he just left, I can't remember whether his term was up or he just left. 

David Beckworth: Okay. 

Donald Kohn: Then, asked me, "Would I be his Vice Chair?" And, I was very flattered and said, "Yes, of course, I'd be happy to help you out in any way I can." 

Donald Kohn: And that started in June, so I think my term started in June, but I had to go through another senate ... I had to be nominated by President Bush, again, he had nominated me in 2002, and then confirmed by the Senate. 

David Beckworth: Well you picked a great time to become Vice Chair, huh? 

Donald Kohn: I did, they were interesting times. 

David Beckworth: You became Vice Chair just at the early signs of the great recession were beginning to show. 

Donald Kohn: That's right. 

David Beckworth: Tell us about that experience? I mean, many sleepless nights I imagine. Much stress, I mean and going back to the early '80s. 

Donald Kohn: Right. It was a very stressful period. So, it was really August of '07 when, I guess BNP Paribas said there was so much uncertainty about subprime mortgages, they couldn't price their funds that specialized in that. 

Donald Kohn: That followed in June a Bear Stearns thing in which they stepped back from one fund, but made good on another fund. So, this thing had been building all year. But, what started in Europe actually in this French bank quickly spread to interbank markets everywhere. 

Donald Kohn: So, people realized that it was impossible really to know what the value of these subprime, particularly derivatives and tranches were. They didn't know who was holding them, and all of a sudden the Interbank funding markets became disrupted and banks were holding back on lending to other banks in these funding markets. 

Donald Kohn: And that happened in August of '07 and our first response was, "Well, this is a liquidity problem for these banks that are having trouble borrowing. The money markets aren't working very well, it's a classic thing where the Central Bank should intervene and make liquidity available." 

Donald Kohn: So, our first response was to reduce the penalty on the discounted rate and encourage banks to borrow at the discount window. I can remember being part of a conference call with the New York clearinghouse at the time with Tim Geithner and our mantra was, "Borrowing from the Fed is a sign of strength, not of weakness." It didn't work. 

Donald Kohn: So, the stigma of borrowing from the Fed, even though the Fed didn't publish who was borrowing, people could see by district, by district and could almost by a process of elimination figure out that bank X might be borrowing from discount window, which meant that it was facing higher charges in the private market, which meant that it was weak. So, no one wanted to come in and borrow from discount window. 

Donald Kohn: The stigma was inhibiting the ability of the Federal Reserve to add to the liquidity of the system. At the time, the liquidity was being constrained. At the same time we could see that, this constrain on liquidity and the interference with the free flow of credit around the banking system was gonna have adverse effects on households and business access to credit, particularly mortgage credit, but not only mortgage credit as lenders became concerned about perceptions of their credit worthiness. They would withdraw into themselves and be extra safe in order to maintain their own access to markets. So, we did ease monetary policy in several stages through the fall of '07. 

Donald Kohn: And in December of '07 we opened a new type of discount window facility called the TAF. The Term Auction Facility that auction credit to banks on a regular basis over a longer time. It was like 30 days, 60 days, etc. 

Donald Kohn: And, that facility overcame the stigma because everybody was coming in for the auction, it wasn't just one or two. You didn't get the funds that day, you got it the next day which meant even if you got the funds, it didn't mean you were gonna run out of money that day. That wasn't the signal. So, that was more successful. 

Donald Kohn: But, the economy peaked in December '07 as the NBR told us a year or so later and it started to slide pretty quickly in '08. We cut rates massively in January of '08. We did 75 basis points between the December meeting and the January meeting, and another 50 I think at the January meeting. 

Donald Kohn: So, in one month we cut interest rates 1.25 percent. And then, we cut them again after the Bear Stearns episode of early March. 

David Beckworth: One of the challenges you faced, all officials faced is this data, you mentioned NBR told you, you're late. 

David Beckworth: But, GDP numbers for example the 3rd or 4th quarter GDP in 2008 didn't show the severity until like the revisions the following year. 

David Beckworth: So, if you could play God with economic data, and you could wave a wand, and get real time data. What would you have wanted in 2008 that you could see in real time if it were possible? 

Donald Kohn: I don't know, I mean I think you've pointed to ... It wasn't only the data that lagged and then were revised. In the 3rd quarter of 2008 is a great example because in the summer of 2008 at the Jackson Hole Conference, Stan Fischer, who was head of the bank of Israel stood up and said, "Why is it that we can see this ... This seems like a very severe financial crisis that's not being reflected in the data." 

Donald Kohn: Now, we know several revisions later that the 3rd quarter was already on a downward slide which of course was accelerated in the post Lehman freezing up of markets. 

Donald Kohn: I think inherently the data are gonna be revised. I don't think there's a magic wand here. But, the other thing to say about coping with a crisis situation like this. It's not only the incoming economic data, but it's interpreting what's happening in the financial markets and knowing, trying to get good information from people in the markets about what they're seeing, who's frozen out, who's got access, who do they expect to be in trouble next, how might the authorities react to that. 

Donald Kohn: Interpreting the incoming information is very, very hard, and you have to keep in mind that everybody you're talking to has an agenda. And they want you to think in a particular way because their firm is in trouble, or maybe their firm is strong and the other firm is in trouble and they see a business opportunity. 

Donald Kohn: And you have to have knowledgeable people around you. 

Donald Kohn: So, I would say, one thing to say about this period is there was a triumphant at the Fed. So Chairman Bernanke, myself, and Kevin Warsh met daily, often multiple times a day trying to figure out what was going on, what the right next steps were. 

Donald Kohn: And, Kevin Warsh was really important to this because he had had experience in Morgan Stanley and financial markets, he had great contacts and financial markets, and he helped us interpret ... figure out what was happening. 

Donald Kohn: Also, important in this, is that in my view is to have bank supervisors around. So, the bank supervisors inside the Fed were familiar with a lot of the banks and their problems. 

Donald Kohn: Now, remember the Bagehot’s dictum is to lend that penalty rate to lots of folks, but solvent folks. So you could turn to the supervisors and say, "Do you think bank X is fundamentally solvent? That once this crisis is through they'll be back on their feet? Or are they so sick and so impaired that they'll never recover and we need to think of other ways of dealing with this?" 

Donald Kohn: So, having those folks, Kevin among the triumphant and the bank supervisors with knowledge of what was going on and it was really important to operating the discount window, and to making monetary policy. 

Donald Kohn: But, it's the fog of war absolutely. Things are much clearer in retrospect than they are at the time. 

David Beckworth: So, in the time we have left, I want to switch to a talk you gave recently at a conference that I attended as well in January. The paper deals with the strategy tools and communication of the Federal Reserve. 

David Beckworth: One of the backdrops to this is this reexamination, the Board of Governors, the Fed is gonna have internally. Also, apparently they're gonna bring outside input into it and then in June this year they're gonna have a big conference. 

David Beckworth: So you had some great thoughts to share on that. Let's just begin by talking about strategy. What were your thoughts on strategy? 

Donald Kohn: First thing to say is I really welcome the impetus, the innovation really of the Federal Reserve Board, and the Federal Reserve System, it's not just the Board, it's the- 

David Beckworth: Entire system. 

Donald Kohn: To run an open process, invite outside comments. I mean the Fed always getting outside comments. But, this case, the Fed is organizing the thing, bringing outsiders in, and presumably will respond to what they hear. 

Donald Kohn: So, I think this is a good innovation run by Chairman Powell and Vice Chairman Rich Clarida. So, that's the first thing to say. 

Donald Kohn: I think on the strategy, a really key issue as you know David, is what to do about the zero lower bound. 

David Beckworth: Yeah. 

Donald Kohn: So, we have nominal interest rates that look like they're going to be secularly lower than we're used to. 

Donald Kohn: So, we're used to equilibrium rates of 2 to 2.5 percent and then inflation on top of that, so that gives you the 4 to 5 percent, and before the Fed even tightens so you might be up at 6 percent or 7 percent when a recession hits, or at least at 5 percent or so when a recession hits. 

David Beckworth: Right. 

Donald Kohn: And in the past when recessions have hit. The Fed has had to ease 4 to 5 percentage points to fight the recession. To keep inflation from dropping below its target and to keep unemployment from rising excessively. 

Donald Kohn: Now, with many people thinking that the real equilibrium interest rate might be in the neighborhood of one, with a 2 percent inflation target. That gives you a nominal rates in a resting spot, and equilibrium spot of three. 

Donald Kohn: Now, I think when the next crisis hits, it might be from a position when the Fed is a little tighter because it's fighting inflation. But, it doesn't really matter. There's a risk that the next time there's a recession the Fed will get to zero pretty quickly, then what do you do? 

Donald Kohn: And so, I think a key, that's a very important strategy issue and it's a particularly even more important than it might've been 10 years ago because fiscal policy is hamstrung. It's hamstrung by the fact that US is running massive deficits in the best of times. 

David Beckworth: Right. 

Donald Kohn: That the GDP going up, given the tax cuts and spending increases the last Congress and president put into place. So, that all hamstring people and the political environment is so toxic. 

Donald Kohn: So, I worry that fiscal policy won't be there to move in the same direction as monetary policy in the next recession, you need to rely more on the Fed. 

Donald Kohn: There are a couple of avenues here that the Fed will be exploring. One is, what about these unconventional monetary policies that we, because I was inside at the time, used in 2008, 2009, 2010 taking rates to zero, but also giving very strong guidance that they would remain at zero for quite some time. 

Donald Kohn: So, that helps to reduce expectations about future rates and long term rates and helps bolster asset markets and reduce the cost of capital. And also, QE, what we officially call large scale asset purchases. 

David Beckworth: Right. 

Donald Kohn: Buying intermediate and long term treasury bonds, or in the case of last episode because it was mortgage market. Mortgage market centered, mortgage max securities as well. 

Donald Kohn: So, I think the Fed needs to say, "When we get down towards zero, here's how we're going to structure our unconventional monetary policies again, the next time. We've learned some lessons from our experience.” So the next set of QE's, the next forward guidance might look something like this, “Here's how we're gonna do it, or how we're thinking of doing it and the order of which we'll do it." 

Donald Kohn: I think they should also explore some supplemental things, could they reduce rates below zero? So we went to 12 basis points. We had a zero to 25 range. Could you take rates lower as the ECB, Swiss National Bank, and others have done? What's the lessons from that? What are the costs and benefits, it's not a slam dunk, but it's a good thing to do, you need to think about it. Could have an effect on banks, etc. 

Donald Kohn: And what about schemes like the Bank of England ran, which gave banks incentives to make loans tied to the cost of their funds from the Bank of England. So, ... I think you can supplement the decline from say three to zero with these unconventional policies, they would be worth something. But, even that may not be enough. So, lots of people including you David, have thought about how to structure monetary policy strategies under these situations. 

Donald Kohn: One option is to go for a higher inflation rate. 

David Beckworth: Right. 

Donald Kohn: So, go for four percent, so you have higher nominal rates when you begin. I think that's not consistent with congressional mandate for price stability. 

Donald Kohn: Paul Volcker thinks two is too high. Surely four would be way too high. That would not be good for his health. 

Donald Kohn: So, let’s rule that out, and my impression is that the Fed isn't seriously considering that, but there are other things such as your nominal income target, price level targeting, that have different characteristics. And the characteristic they often have is you get to the zero lower bound and you want the level of prices, or the level of nominal GDP to return to the previous trend, the two percent trend for prices, or the 4 whatever percent trend for nominal GDP. 

Donald Kohn: That dictates that the funds will be held at zero. The target rate will be held at zero for much longer. 

Donald Kohn: And that you'll have a period for the most part of somewhat higher inflation. 

David Beckworth: Right. 

Donald Kohn: That doesn't mean that the long term two percent goal has to be abandoned, but you'll have some short term increases inflation. 

Donald Kohn: So, I think the attractiveness of those plans are that they give you a systematic way of saying what are the conditions under which I might rise from zero. Those conditions are delayed relative to ordinary Taylor Rule type monetary policies, the expectations of low rates get built into financial markets and maybe the expectations of higher inflation also get built in and that's helpful to you as well. 

Donald Kohn: I think the problem with those things is they're complicated. They're difficult to ... I just tried to explain it, I'll leave it to the listeners whether that was successful. But, they do imply a fairly complex messaging, and when would you tighten? And, where did that trend come from? And, how long will inflation have to overshoot? And, what are the risks of inflation overshooting? 

Donald Kohn: So, I think there are pros and cons to all these plans, and there are other plans of a similar nature. I guess where I came out in the talk I gave for the Institute for Humane Studies and Mercatus was, I wonder whether the Fed can't just double down on risk management. So, when you get close to zero to say, "The risks of getting caught at zero are very high. I'm gonna ease rapidly, I'm gonna hold that easing for quite a long period of time. Take some chances that inflation will rise above two without explicitly aiming for inflation above two." 

Donald Kohn: Folks have said to me, "Yeah, but that won't be enough, you need to do more. I think this is an empirical question." 

Donald Kohn: Another issue that I raised in the talk that I'd like to add here is that I think the financial stability aspects are important. How do we get stuck at zero in 2008? Because there was a shock to the economy. House prices fell, and that shock was multiplied and amplified tremendously through the financial system. 

Donald Kohn: So, I think strengthening the financial system helps to mitigate and reduce the odds on getting stuck at zero. So, I'd like to see the Fed pay more attention to so called macro prudential policy. 

David Beckworth: The capital buffer. 

Donald Kohn: The capital buffer that builds up in good times, that can be released in bad times because it's high enough in good times that even releasing, reducing the regulatory requirements in bad times, the capital is still high enough that people who lend to banks and wholesale markets have confidence that they can continue to lend. And the banks have confidence that they can continue to make loans. 

Donald Kohn: I mean, what made the recession so bad was not just the collapse in house prices and subprime lending, it was how it spread to the whole financial system. 

Donald Kohn: So, even households that had good jobs and were gonna keep good jobs businesses that had good prospects that were going to continue couldn't get funding for buying a new house or a new car in a case of a household. A capital project that might expand the business in the case of a business. 

Donald Kohn: So, when those credit markets froze up, that's what really caused the problems, so I think we need to pay more attention to structuring regulatory policies that keep the credit markets from freezing up in bad times. 

David Beckworth: We are almost out of time, but I have one last question. At this conference where we were at, both Joe Gagnon and George Selgin in different ways both proposed expanding the type of assets the Fed could purchase. 

David Beckworth: Now, George is more ... kind of like a term auction facility, where any counterpart, not just a primary dealer, any counterparty can bring an asset, you could put a haircut on if it wasn't great. 

David Beckworth: And, Joe just in general was arguing I think go beyond government securities. 

David Beckworth: What thoughts do you have on those proposals? 

Donald Kohn: I think the Fed has already expanded its counterparties in a reverse RP. 

David Beckworth: Okay, that's fair. 

Donald Kohn: Reverse RP facilities, but it hasn't expanded the collateral. So, that's an open market operation, open market operations are confined to treasury and agency securities. 

Donald Kohn: So, the counterparty point I think they've already dealt with to some extent. 

Donald Kohn: The Federal Reserve Act doesn't allow them to do open market operations and corporate bonds and whatnot. I think that's a tough, difficult step to take because then you get into the Federal Reserve making judgements about the credit quality of the assets it's buying. Having real effect on allocation across firms and taking fiscal risks. I mean your listeners who buy corporate bonds, or even commercial papers we saw in 2008 are taking risks. 

Donald Kohn: When the Bank of England buys corporate bonds they do it with an agreement with the treasury, with Her Majesty's treasury about risk sharing and they wouldn't undertake it because they are taking fiscal risks. So I think it raises ... I wouldn't rule it out, but I think to expand the array of assets into riskier, credit risk, I think would take working closely with the treasury and making sure that the Fed any monitor, any fiscal policy the Fed was indirectly undertaking by putting taxpayer money at risk would be done knowingly, cooperatively, openly, with the fiscal authorities as well. 

David Beckworth: So your proposal, then this talk to summarize it is stick to a flexible inflation targeting, and you stretch the flexible part. So it's truly symmetric. Be willing to use negative rates if needed and use macro potential regulation, and better risk management in general and run with it? Is that a fair summary? 

Donald Kohn: Yes, in terms of the strategy, yes. 

David Beckworth: Okay, so with those tools- 

Donald Kohn: And specify ahead of time, look carefully at your tools. Specify ahead of time what you're gonna do. And then my last set of recommendations is about communication. I like the way Jay Powell and the Fed have gone to communicating in plainer English with more people and I think they should continue ... I think it's really important to build up public understanding of the Federal Reserve. 

Donald Kohn: If I think back to your question about the crisis and our response. If I think there was a deficiency, somewhere, it wasn't in the response in what we did, I think we did what we had to do and we were successful in limiting the damage. But, we didn't explain it as well as we could have and we didn't reach out as well. 

Donald Kohn: I think that fed back on a decline in confidence in the central bank. 

David Beckworth: Alright. So better communication. That's what we're doing here. We're communicating with the former Fed official Don Kohn. Don, thanks for being a guest in the show. 

Donald Kohn: Thank you David, it's been fun. It's been fun reminiscing with you. 

David Beckworth: Macro Musings if produced by the Mercatus Center at George Mason University. 

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David Beckworth: Thanks for listening.

Photo credit: Brookings Institution/Flickr

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.