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Monetary Policy at a Crossroads: Donald Kohn on Controlling Inflation, Ukraine Effects, Volcker-Era Lessons

Enrique Martínez-García

Donald Kohn is a 40-year veteran of the Federal Reserve System, serving from 2002 to 2010 on its Board of Governors, first as a member and then as vice chair. He played a key role in the Fed’s response to the Global Financial Crisis of 2008–09 as a top adviser to Chairman Ben Bernanke. He currently holds the Robert V. Roosa Chair in International Economics at the Brookings Institution.

Kohn participated in a Federal Reserve Bank of Dallas-sponsored policy panel during a recent meeting of the Society for Computational Economics at Southern Methodist University. Appearing with Kohn were Christopher J. Waller, a member of the Fed Board of Governors, and Olli Rehn, Bank of Finland governor and a member of the European Central Bank (ECB) Governing Council. Waller’s remarks can be found on the Board of Governors website and Rehn’s on the Bank for International Settlements website.

Kohn discussed the challenges of reining in inflation as well as lessons learned from former Fed Chairman Paul Volcker and from the Global Financial Crisis. The following excerpts are from his prepared remarks, edited for clarity and style and presented by topic.

On How Inflation Became Elevated:

I think bad luck produced a set of adverse shocks to supply and a difficult policy environment. I think policy misjudgments contributed to that reduced supply being met with very strong demand, so let’s look at the bad luck.

I think it’s critical to remind ourselves of the extremely difficult circumstances facing policymakers. We had two nearly unprecedented events. COVID-19, a global pandemic unprecedented for at least 100 years, and a reduction of food and energy supplies resulting from a war of aggression [Russia’s invasion of Ukraine].

The COVID stuff was very difficult to predict as it evolved. COVID initially shut down the economic system. Both supply—the production side—and the demand side shut down. The policymakers were dealing with an unpredictable virus and unpredictable behavioral and governmental responses to that virus.

As people learned to live with COVID and the vaccines became more widely available, [aggregate consumer] demand bounced back more quickly than supply. As constraints came off, there was a natural tendency to resume activity, including purchasing activity.

But waves of variants produced continuing supply-side constraints on labor force participation in the U.S. and on supply chains from China and other places. Those supply-chain disruptions affected the supply of goods, which was where much of the demand was focused for some time, exacerbating price pressures early on.

Demand strength was certainly aided and abetted by stimulative fiscal and monetary policies.

On the Impacts of Russia’s Invasion of Ukraine:

Into the COVID policy-led imbalance came the invasion of Ukraine, with its cutoff of major sources of food and fuel supplies from both Russia and Ukraine. We need to keep in mind that a lot of what’s driving gasoline prices, inflation expectations and inflation itself right now is the result from that invasion.

These higher prices are eroding real incomes. That was ongoing before the invasion, but it certainly has gotten worse. The Fed or the administration can’t do much about these prices. Many of them are determined on global markets insensitive to financial conditions and the response of the West—of Europe and the U.S. and others—to the Russian aggression.

Often a central bank can look through these sorts of supply shocks—view them as a price level change, not inflation per se. But when things like the food and energy increases that have occurred recently occur in the midst of already inflationary conditions, they raise the risk of second-round effects on expectations, wage and price setting, and that adds to the imperative to do something about inflation.

On Policy Misjudgments:

Looking back with 20/20 hindsight is not entirely fair to the policymakers. They were working with the data they had. In the case of both fiscal and monetary policy, policymakers were reacting to lessons learned from the recovery from the Global Financial Crisis of 2008–09.

There, we had sluggish, persistent high unemployment. The recovery was hampered by restrictive fiscal policy after the initial round of stimulus right after President Obama took office [in 2009], and I think, hence, the double down on the fiscal stimulus, particularly early in the Biden administration. That also gave them [the Biden administration] a chance to initiate some programs favored by the newly empowered Democrats.

So why didn’t the Fed counterbalance this extra push from fiscal policy? First of all, the data coming in didn’t suggest a need to counterbalance until very late in the period, until very recently. I think the Fed was also taking its lessons from the 2010s from the response to the rebound from the Global Financial Crisis.

Not only was there a weak recovery, but inflation in Europe and also in the U.S. fell well short of the 2 percent target. You had persistent, low interest rates that threatened to constrain any response to future recessions or negative shocks. So the concerns about inflation are that it’d be too low and not too high.

On the Fed’s Interest Rate Framework:

This concern about low interest rates and low inflation was reflected in the framework review that the Federal Reserve did of [its] policy strategy. That framework review contained a number of asymmetries. The strategy is symmetrical around 2 percent (meaning the Fed seeks a target “around” 2 percent) but has a number of asymmetries that tilt in favor of high inflation, partly to offset the disinflationary asymmetries of the effective lower bound and the experience of the 2010s.

First of all, the new framework was going to make up for undershoots of inflation from 2 percent but apparently not for overshoots of inflation. That’s one asymmetry. Secondly, under the new strategy framework, the Fed was not going to act preemptively against high inflation, just low inflation. They would [preempt] inflation declining when employment fell below full employment, but not inflation rising when employment was above full employment until inflation was already high. Between the dual mandate of price stability and strong labor markets, there was much more emphasis on strong labor markets and the use of broad-based and inclusive measures of labor market strength.

I think the Fed’s view of how to measure labor-market full employment evolved over time, so there was a lot of emphasis on labor force participation, which was held back by COVID at the beginning, and unemployment rates. The Federal Reserve only gradually began to focus on vacancies and the churn in the labor market and the very rapid increase in wages.

We need to stress-test strategy frameworks and forward guidance [about the path of monetary policy] against unusual developments and be prepared to pivot and to think in advance what would happen if things didn’t come [to pass]. We—the Federal Reserve and other authorities—stress test banks against highly unusual outcomes. I think stress testing your own policy against highly unusual outcomes would have been helpful.

On Escaping a High-Inflation Environment:

I think the role the [Biden] administration and Congress play is very limited. They can work around the margins on supply, including increasing legal immigration, taking down some of those tariffs, reducing some of the tariffs that President Trump put in place, and not make inflation worse by pushing expenditures that aren’t paid for. Make sure that as you’re regulating, you weigh the costs and benefits. Among the costs might be a disincentive for expanding production, so get out of the way on the supply side, increase it where you can.

But primarily this [fighting inflation] is on the Fed, and the Fed is the one that has a responsibility for price stability and, in my view, it is now on the right track.

How many government agencies stand up and say, “We were wrong”? But the Fed did and engaged in a vigorous and open debate about what needed to be done. I think the culture of the Federal Reserve helped to foster the kinds of steps that they have taken to deal with the problem. They’ve narrowed the focus to inflation. They’re not worrying about the labor market. They changed their announcement to make that very clear that they are really just focused on inflation now.

The labor market is exceptionally strong in any event. They’re moving expeditiously to remove the extraordinary degree of monetary accommodation put in place when the pandemic hit. They allowed the portfolio [the Fed’s holdings of Treasuries and mortgage securities] to decline. They’ve raised interest rates toward less clearly-accommodative levels and, I think importantly, in the last set of projections [the Summary of Economic Projections] they are realistic and transparent about what’s required to damp demand to relieve pressure on labor markets and reduce inflation.

Realizing [that] getting inflation back into the 2 percent area, as the projections have by 2023 and 2024, requires inflation expectations to remain anchored and some help from the supply side—at least no repeated supply disruptions.

They [Fed policymakers] have a reaction function where the very big changes in their policy rate are keyed to incoming inflation data. Incoming inflation data lag the effects of monetary policy, and that [reaction function] is exactly what’s required right now. But if that kind of reaction function is maintained, it practically guarantees overshooting and unnecessary weakness in the economy, especially if there are further supply-side disruptions.

On Paul Volcker’s Policy ‘Moments’:

Everybody talks about the Volcker moment of Oct. 6, 1979, when the strategy and structure of implementation of policy was changed to fight inflation, and that was critical to establishing several decades of strong growth in the United States—strong price stability and strong growth.

I think there was a second Volcker moment that gets less publicity but is also important, and that occurred in the summer and fall of 1982. Paul Volcker said, “We’ve already got the economy in recession; inflation is down.” It was only down, I think, to about 4 percent, so it was still pretty high. But he said, “Enough. We’ve accomplished a lot, the costs of continuing on this process outweigh the gains.” There were problems with Latin American debt—they were feeding back on U.S. banks—as well as a very high unemployment rate.

I think it requires judgment and confidence to know when to back off [as Volcker did], and that’s going to be the next challenge for the Federal Reserve.

About the Author

Enrique Martínez-García

Martínez-García is a senior research economist and advisor at the Federal Reserve Bank of Dallas.

The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

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