Fed can promise low rates, low inflation: Kohn

22/08/2009 - 20:20

By Mark Felsenthal

JACKSON HOLE, Wyoming (Reuters) - U.S. Federal Reserve Vice Chairman Donald Kohn said on Saturday there is no inconsistency between the Fed's pledge to keep interest rates low for an extended period while also keeping inflation low.

"Speaking for this policy maker, the commitment to low rates is designed to keep inflation from falling and falling persistently below what we might want it to be for a long time," Kohn said, discussing a paper at an annual Fed conference.

"It's not designed to raise inflation expectations," he said. The paper, by University of California, Santa Cruz economist Carl Walsh, said the low-rates pledge could conflict with the Fed's desire to avoid an undesirable pick-up in inflation.

The Fed chopped benchmark U.S. rates to near zero last year and pumped hundreds of billions of dollars into the economy to help boost economic activity during a severe financial meltdown and a painful recession which started in December 2007 and is only now showing signs of ending.

Kohn further defended the Fed's decisions to buy long-term securities as emergency measures to spur growth after it had cut interest rates as far as it could. Economists, including officials at the Fed, have questioned whether those purchases are successful in lowering rates.

The Fed vice chairman said investors still put a premium on the ability to easily raise short-term funds. In that environment, a central bank has considerable scope to step in and affect asset prices, he said.

Kohn cited market reaction to the recent Bank of England decision to expand long-term securities purchases as an example.

"The markets must perceive that there's some effect there," he said.

A European Central Bank official said that that institution is not likely to deviate from its inflation targeting strategy and warned that pulling benchmark euro zone rates down to near zero, as the Fed has done, may unsettle markets.

"The zero lower bound may interfere with the functioning of financial markets, thereby upsetting the stimulative impact of very low rates," ECB Executive Board member Juergen Stark said, commenting on the same paper.

The ECB, which has avoiding bringing rates down as far as its U.S. counterpart, is expected to keep them on hold at a record low 1 percent at its September policy meeting as it waits to see the impact of efforts already undertaken to revive the economy and spur credit flows.

Rates near zero may set the stage for financial and economic imbalances and new instability, Stark said.

There is no reason why the ECB should shift from its current monetary policy strategy as the financial system rebuilds after the crisis, he said.

"We in continental Europe have introduced ... a rather robust strategy, so there is no need to make any adjustment, to move from inflation targeting, to flexible inflation targeting, to price level targeting," he said.

(Editing by James Dalgleish)

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