Ex-Fed Economist Offers Chances to Avoid Recession: ‘Less than 50-50’

Economist Don Kohn, 79, spent 40 years in the Federal Reserve system, serving as a member and then vice chairman of the Board of Governors from 2002 to 2010. He is now a senior fellow at the Brookings Institution. He lives in Washington with his wife.

The Big Picture: As a 40-year veteran of the Federal Reserve System, how do you explain why we see the inflation we see today?

Unfortunately, there is no simple answer. It’s a combination of factors. Among them are the issues emerging from covid – people leaving the workforce, supply chain issues, shortages of automotive chips, things like that – which have put upward pressure on these prices. . People were looking for more homes and further out of town, so demand for homes was high, putting upward pressure on prices.

Another issue is the Russian invasion of Ukraine, which halted grain exports until very recently, and the boycott of Russian gas and oil has dramatically increased energy prices. The economy was running very hot even before pressure from Ukraine on gas and food prices added to it. The demand was very strong. We rebounded very quickly from the pandemic and had applied many stimulus measures to the economy, both fiscally, with several large fiscal packages, culminating in the US bailout under the Biden administration, and monetary , where monetary policy reacted very strongly to the shutdown of the economy in March 2020 but kept its foot on the accelerator for some time thereafter.

You said the strength of demand was “helped and abetted” by the stimulative fiscal and monetary policies, giving the impression that you thought it was too much?

With 20/20 hindsight, yes. It was hard to see at the time. When the US bailout was passed, there was a lot of talk about how we didn’t apply enough aid to the economy from the fiscal policy that came out of the 2008 financial crisis- 2009. So people wanted to make sure – administration, certainly – that they were doing enough this time to get people back to work. It was: push anything you could think of that would help. Then, on the monetary side, the Federal Reserve had some of the same thoughts in mind: let’s not recover slowly from this. Let’s get people back to work quickly, the economy recovers quickly, the financial markets work well. So they bet everything on monetary stimulus.

Did you think that was the right level at the time?

At the time, I thought we needed all the stimulus we could get, that the economy could recover very quickly from covid when it reopened. But no one knew. And therefore, it was better to overdo it than to do too little. I think the problem for the Federal Reserve is when did it become clear that there was too much stimulus, and could it have withdrawn some of it sooner, especially given the extent to which fiscal policy was stimulating?

Even Federal Reserve Chairman Jerome Powell said the Fed’s slow start to use its tools has contributed to current inflation, and a soft landing would be quite difficult to achieve at this point.

Yes. And I agree. They could have moved a little faster, a little earlier. But one of the misconceptions about inflation is that it’s all the fault of the Fed. I think the Fed contributed to it, but there are a lot of other things going on: covid, Putin, etc. The Fed had a role to play in letting it get to that level. But, to their credit, they recognize it and have taken steps to address it.

As inflation continues to rise, what parallels do you see with the earlier period, in the late 1970s and early 1980s, when you were at the Fed under Chairman Volcker?

There are parallels, but there are really important differences. The parallels are what are called supply shocks. back at the end In the 1970s, Iran cut off its oil supplies, which drove up oil prices. Problems in agriculture have pushed up agricultural prices. And these came in an environment of already very high inflation and in which people had no confidence that the Fed would reduce inflation.

Right now, I think people have that confidence. People say the Fed has learned the lessons of the 1970s and, as Jay Powell has often said, it’s not going to let this thing get out of control again. They recognize that Paul Volcker has set an example they can emulate. And Paul Volcker wasn’t popular in some parts of Congress during [that time]. Everyone looks back now and says, “Isn’t it wonderful? But at the time, there was a lot of tension.

I read about President Volcker getting two-by-fours and things like that in the mail from people frustrated with his actions.

So the two-by-fours were sent out by the builders and had messages like, “If it wasn’t for you, it would be used to build a house.” That sort of thing. They were upset both about inflation and on the weakness in the economy that resulted from Volcker’s efforts to control inflation.

You must have been quite young at the time. What was it like for you to be on the inside when these wildly unpopular actions were being taken by the Fed?

It was exhilarating to some degree because we were living in the 1970s, and inflation was getting worse and worse, and people inside the Federal Reserve were unwilling to take the necessary steps to fix it. to face. So, as a young staff member, it was gratifying to see Chairman Volcker and the Federal Open Market Committee take these steps and do what was necessary.

It was a bit scary and worrying because there was a very, very deep recession. Looking back, this paved the way for three decades of growth. But at the time, you didn’t know that. And there were all these protests. So among the things President Volcker agreed to do with consumer groups was to send people to talk to consumer groups across the country. And I was part of it. I went to Seattle with a more experienced staff member. And it was a difficult thing. I mean, we were booed. We were asked tough personal questions about our finances. There were a lot of unhappy people there.

When you were out there talking to people and hearing their frustration, hearing their pain, how clearly did you think at the time that what the Fed was doing was right – or did you fear maybe it is, in fact, a little too much?

No. I felt it was the right thing to do. The purpose of the protests was to impress upon the Federal Reserve that there were costs to this. I knew it. I remember one day when farmers circled tractors around the Federal Reserve building to protest high interest rates. There was a lot of tension. But also a great feeling that you were doing the right thing, and the confidence that it would eventually work. But it would be nice to have it [happen] sooner rather than later.

Do you think the recent Inflation Reduction Act reduces inflation – or is the name more of a message?

I think it will have very, very minor effects on inflation. This will reduce the price of drugs and other things. I consider the “reducing inflation” part to be helpful but will not be its major effect. Its main effect will be to fight climate change, and we absolutely need to do that.

At the moment, what are the scenarios that worry you the most?

On the inflation side, I fear it will take some time, and at some cost, to bring inflation back to within glaring distance of the Fed’s 2%. [target] interval. I fear that there are further shocks on the supply side. There could be additional problems resulting from the aggression against Ukraine and other types of aggression that could occur elsewhere in the world. I’m afraid the labor market is very tight and wages are rising very quickly, which helps people catch up with inflation, but if companies start pricing in rapid wage increases, you might get an effect spiral.

How much pain do you think we’ll see? Do you think there will be a small recession?

Not necessarily. I think it’s very difficult to predict these kinds of things. As President Powell said, there will be pain. The unemployment rate needs to rise to reduce the pressure on the labor market to reduce vacancies relative to people looking for work. It’s very hard to say how much it needs to increase and a lot depends on how rigid the wage/price process is, if there are additional supply shocks, how China ends up dealing with covid and those supply chain issues supply.

I think it’s hard for people to understand that the idea that rising unemployment is a good thing.

I think it’s true. I agree. And that’s not a good thing, right? The more people employed, the better. But when you push the envelope so hard that everyone’s prices go up very quickly, then obviously that’s too much. And some of the drop in unemployment just isn’t sustainable in the context of those high inflation numbers that not everyone likes. It must therefore be dropped. And even at a bit higher unemployment — I mean, we’re at 3.5 [percent] now; if we were at 4, 4.5, it’s still a very low unemployment rate in the history of the United States. Even 5% would be a pretty low unemployment rate. And what that means is not that a lot of people are permanently laid off, but it may take them a little longer to find a new job and so on. So it’s not great. There is pain, that’s for sure. But the gain over time will more than offset the short-term pain.

We talked about what could go wrong, but looking to the future, what could possibly go wrong?

I think the best case scenario is that there is some increase in the unemployment rate, but not a big increase. Labor markets come under pressure fairly quickly, wage increases are weaker and the price increases are much lower, and this thing simmers pretty quickly over the next two years. More shocks, more bad things coming out of Ukraine or other assaults, covid effects fading and people going back to work. But that’s when all is well and nothing is wrong.

Which happens all the time. So if you were a gambler, how likely do you think this type of optimal scenario is?

Less than 50-50. Unfortunately, there are just a lot of things in the world that could go wrong. I certainly hope the best case scenario is what happens, but even in an unfavorable case, the Fed is keeping an eye out for stable prices/maximum employment targets that will come out the other side. So the worst case scenario is that it takes us longer to get there. In the best case, it takes us less time. But we will get there.

This interview has been edited and condensed.

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