Volcker v. Kohn On Inflation

Last weekend's exchange between legendary former Federal Reserve Chairman Paul Volcker and current Fed Vice-Chairman Donald Kohn at Vanderbilt University was reported in this piece in the Wall Street Journal.

Any time Paul Volcker weighs in on monetary policy and/or the Fed, I tend to listen. The Journal article reported as follows,

"Former Fed Chairman Volcker, who along with Kohn was at a conference honoring former Fed governor Dewey Daane, questioned how the Fed can talk about both 2% inflation and price stability.

In the minutes of its January policy meeting, the Fed said that officials' long-run inflation forecasts reflect what they think is consistent with the Fed's dual mandate "for promoting price stability and maximum employment."

It then said that "most participants" thought 2% inflation, as measured by the price index for personal consumption expenditures, "would be consistent with the dual mandate."

"I don't get it," Volcker said, leading to a lively back-and-forth between the two central bank heavyweights.

By setting 2% as an inflation objective, the Fed is "telling people in a generation they're going to be losing half their purchasing power," Volcker said. And if 2% is the best inflation rate, and the economic recovery lags, does that mean that 3% becomes the ideal rate, he asked.

Kohn responded that by aiming at 2%, "you have a little more room in nominal interest rates ... to react to an adverse shock to the economy." "

Do the math, and you see Volcker is correct. A 2% inflation rate results in a nearly 50% rise over 20 years. Volcker then asked whether, in difficult economic times, the rate might drift up to 3%? Kohn cited the alleged problem-free experiences of other inflation-targeting central banks as proof that his position is both correct and safe.

It is at this point that I find myself alarmed, as I trust Volcker more than Kohn. And, frankly, don't find other central bank experiences to be quite on a par with that of the US.

But what's really alarming is that this source cites Bloomberg as reporting some additional thoughts of Volckers,

"“I don’t think the political system will tolerate the degree of activity that the Federal Reserve, in conjunction with the Treasury, has taken,” Volcker [said]

... U.S. lawmakers from both political parties have expressed concern in recent months that the central bank has overstepped its authority by creating several emergency credit programs aimed at reviving lending and ending the recession.

“I think for better or for worse we are at a point where the Federal Reserve Act, after all that has been happening in the last year or more, is going to be reviewed,” Volcker said. "

You have to understand Volcker's aversion to Congressional meddling with the Fed. Although, as a Journal article from last year noted, the Fed is a creation of populist forces early in the last century, as the Progressive movement crested with a series of Constitutional amendments in the 1910s, it has notionally and theoretically been independent of Congress.

More than any other Fed chairman, Volcker actively both tamed inflation and fended off Congressional pressure during a period of intense economic pain. It is not an overstatement to claim that, due to Volcker's inflation-fighting prowess and strong resistance to Congress, the US has enjoyed nearly 30 years of low inflation.

That Volcker is now worried about the Fed's independence, thanks to the unnecessary activism under Bernanke and Geithner, worries me. As bad as the Fed's design was, in effect parceling out monetary authority to Fed banks whose presidents are chosen by local banks and businesses across the country, it's far better than allowing Congress direct control over the nation's monetary policy.

Particularly at a time when the federal government is essentially controlled by a single, populist-leaning party. In far less economically stressful times, Congress has threatened to hold hearings, pass legislation and generally exert more direct control over the Fed. For example, we had the senseless 1978 Humphrey-Hawkins bill, the product of a misguided and naive Senator from 'progressive' Minnesota, to thank for diverting Fed attention from simply fighting inflation. Though technically expired, Congress continues to behave toward the Fed as if full employment is an equally-weighted responsibility of the Federal Reserve system, with inflation.

How much worse could it get? I don't even want to go there. But if Volcker's worried, I'm worried.