“The situation in financial markets and the economy would have been far worse if the Federal Reserve hadn’t taken the actions.”

TO BE NOTED: From Bloomberg:

"Kohn Says Emergency Loans Unlikely to Harm Taxpayers (Update1)

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By Vivien Lou Chen

April 18 (Bloomberg) -- Federal Reserve Vice Chairman Donald Kohn said that while the central bank’s emergency lending programs aren’t creating a significant risk for U.S. taxpayers, they may be channeling credit to some lenders more than others.

“We are not trying to favor some sectors over others,” Kohn said in a speech today in Nashville. Still, “we have recognized that the resulting effects can be uneven” across credit markets and “this outcome is not a comfortable one for the central bank.”

Fed policy makers are taking unprecedented steps to revive the economy, including direct support of consumer finance and mortgage lending. The Fed plans to buy as much as $1.25 trillion in agency mortgage-backed securities this year to support the housing market, and is providing financing for securities backed by loans to consumers and small businesses.

Kohn said the Fed would disclose more details on its loans and borrowers involved in central bank programs “in coming weeks.” The Fed’s refusal to provide such information prompted a lawsuit by Bloomberg News in November, and criticism from U.S. Republican Senator Richard Shelby of Alabama and other lawmakers.

“We are not taking significant credit risk that might end up being absorbed by the taxpayer,” Kohn said in a speech at a conference at Vanderbilt University. “For almost all the loans made by the Federal Reserve, we look first to sound borrowers for repayment and then to underlying collateral.”

Kohn made an exception for financial institutions such as Bear Stearns Cos. and insurer American International Group Inc. that would cause widespread disruption in markets should they fail. Such companies would “probably have higher credit risk,” he said.

‘Sharp Increase’

“Understandably, given the sharp increase in loans to new institutions and markets, the public is naturally interested in our lending practices,” the vice chairman said. Determining the effectiveness of the Fed’s actions “is a difficult question without a ready answer.”

In an unusual public exchange between a current and former U.S. central banker, former Fed Chairman Paul Volcker asked Kohn to explain the merits of a 2 percent inflation goal, instead of a 1 percent or 3 percent objective.

“By aiming at 2, you have a little more room on nominal interest rates, a little more room to react to an adverse shock to the economy or better odds of stabilizing the economy,” Kohn said. The vice chairman also said that he doesn’t expect deflation over the next five years, while not ruling out the possibility.

Tapering Off

Economic data released earlier this week indicate the longest U.S. recession in the postwar era may be tapering off. The U.S. is “moving to a place of better balance” as consumers rebuild savings, Kohn said after his speech.

The Fed’s Beige Book business survey, released April 15, indicates that the contraction slowed across several of the biggest regional economies last month, with some industries “stabilizing at a low level.”

Confidence among U.S. consumers rose to the highest level since the bankruptcy of Lehman Brothers Holdings Inc. pushed the economy deeper into the recession. Claims for U.S. unemployment insurance unexpectedly dropped last week, the Labor Department said on April 16. Single-family housing starts stabilized in March, and manufacturing in the Philadelphia region contracted in April at a slower pace than forecast, according to data released the same day.

The Fed’s efforts “have helped ease financial conditions, though they can’t address all the problems in financial markets,” Kohn said today. “The situation in financial markets and the economy would have been far worse if the Federal Reserve hadn’t taken the actions.”

“We are in the midst of very difficult times for world financial markets and economies,” Kohn said.

Wise words from the Fed's Kohn. Just not in this WSJ post:

"Kohn did say that certain Fed programs including currency swap arrangements with other central banks as well as credit auction facilities “might be part of our permanent toolkit.”

Much of Kohn’s remarks dealt with past innovations in the financial sector and their effect on productivity and macroeconomic stability.

“Certainly, as financial innovations accelerated, we had solid reasons to believe that those advances were contributing to the pickup in overall productivity and, possibly, to the moderation in fluctuations of economic activity,” Kohn said.

While those innovations “did produce lasting gains,” Kohn noted that “these gains were clearly accompanied by increasing vulnerabilities,” especially in the housing market and the mispricing of risk.

“Ironically, an important contributor to these misalignments in spending and lending was the long period of economic expansion and low inflation over the past 25 years, interrupted only a few times by mild recession,” Kohn said.

“This good economic performance provided skewed data and bred complacency,” Kohn said.

Meanwhile, economic models used by central banks “are clearly inadequate” when it comes to the economic effect of the expansion and contraction of credit, Kohn said.

He also said it is unclear whether higher official interest rates a few years ago would have done anything to prevent the speculative bubble in housing or the erosion of lending standards. –Brian Blackstone

Here's my comment:

“This good economic performance provided skewed data and bred complacency,” Kohn said.”

For all I know this is true, but it sounds to me like saying we drove for miles and miles and miles and then we hit a wall. The skewed data bred complacency and so we stopped looking out the windshield.

Most of the proposed solutions like higher capital standards, etc., are very basic. I just don’t buy this line of explanation.

Comment by Don the libertarian Democrat - November 12, 2008 at 11:41 am