Is the Fed trying to pop the housing bubble?
That's the impression you get from even a cursory read of an extraordinary and largely overlooked speech last week from Federal Reserve Governor Donald Kohn.
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Mr. Kohn, one of 12 voting members of the Federal Open Market Committee, offered a novel reason for Fed interest-rate increases: to help wring out imbalances in the economy that extend from a big trade deficit to a low savings rate to surging home prices.
"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," Mr. Kohn said in a speech at the Levy Economics Institute of Bard College.
Mr. Kohn was speaking for himself, not the entire Federal Open Market Committee. But if this were FOMC policy, it would represent a potentially significant shift.
Most people probably think the Fed's job is to raise and lower interest rates to cool or heat up the economy. Mr. Kohn offers a more expansive and perhaps activist role for the Fed in curbing economic imbalances and bubbles, and says the Fed shouldn't be overly concerned with some of the potential economic fallout.
"…(W)e 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."
As much as we've seen from any Fed official in recent years, them's fighting words. The bottom line is that Mr. Kohn believes the Fed has work to do beyond controlling inflation, so even slower growth, as we've been seeing, could keep the rate increases coming.
For Fed watchers, Mr. Kohn is an important player. At 62 years old, he has spent more than half of his life within the Federal Reserve system, beginning as an economist at the Fed bank of Kansas City in 1970. Five years later, he was at work at the Board of Governors in Washington.
When Alan Greenspan became Fed chairman in 1987, Mr. Kohn was promoted to several key staff positions, including director of the division of monetary affairs and secretary of the FOMC. He became a governor in 2002. He is thought to be well-qualified to replace Mr. Greenspan, though he isn't considered a leading candidate.
Mr. Kohn's remarks are followed outright for their content because he is recognized as an expert on monetary policy. But they are scrutinized also because of his reported closeness to Chairman Greenspan. Some observers contend that a speech by Gov. Kohn can sometimes be seen as a trial balloon from the chairman for a potential shift in policy.
If that is the case with the speech at Bard, it is doubly worth the recognition. That's because the Fed governor seems, at times, to part with the chairman's previous positions in two areas: first, how gently these economic imbalances work themselves out; and second, the role of the Fed in popping bubbles.
So either Mr. Kohn is clueing us in to a change in thinking by the chairman, or he is parting with the chairman in some significant areas.
Everywhere Mr. Kohn looks, he sees imbalances in the economy. The trade deficit is too large, as is the federal budget deficit. The savings rate is too low, as are long-term interest rates. And the housing market looks clearly to be the focus of speculation. "The climate of low interest rates has in turn bolstered asset markets in some countries, especially residential real estate markets,'' he says. He also notes, more ominously, that "recent reports from professionals in the housing market suggest an increasing volume of transactions by investors …''
At times in the speech, the Fed governor is optimistic about how these imbalances work themselves out, as long as the FOMC sets the right policy.
"Ideally, the transition would be made without disturbing the relatively tranquil macroeconomic environment that we now enjoy,'' he said. This is sort of the party line. Yet in the next sentence, Mr. Kohn says, "But the size and persistence of the current imbalances pose a risk that the transition may prove more disruptive."
The reasons for these economic ills are varied, as are their solutions. Mr. Kohn suggests that greater fiscal restraint in Washington, for example, along with solutions to the funding problems for Medicaid, Medicare and Social Security, could help the economy transition to a more normal state.
But the bottom line for Mr. Kohn seems to be that higher interest rates will have to do much of the heavy lifting. Higher rates will dampen housing speculation and raise the domestic savings rate. This, in turn, will lessen the American economy's demands for foreign capital and lower demand for foreign goods (since we'll be saving more.)
It's important to note, by way of background, that Mr. Greenspan has repeatedly rejected criticism that the Fed should have done more preemptively to pop the high-tech bubble. He has argued that the Fed couldn't have known at what moment stocks were overpriced and said the best it could do, which he said the Fed has done effectively, was to let markets work themselves out and treat the symptoms of the crash.
Mr. Kohn twice mentions the high-tech bubble in his speech, both times in the context of how an imbalance abruptly and painfully ended.His conclusion -- we can say this with some confidence because this is where he ends up -- is that maybe the Fed shouldn't stand around this time. "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." (Emphasis added)
If that is, or becomes, a prevailing view at the Fed, then an end to inflation may not be enough to stop the FOMC from its appointed rounds of raising rates.
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