MNI INTERVIEW: Fed Needs To Hike Rates Past Neutral–Ex-VC Kohn

The Federal Reserve will likely need to get interest rates to positive levels in real terms, to a point where they start constraining economic activity, in order to get ahead of an inflation surge that has broadened to worrisome levels, former Fed Vice chair Donald Kohn told MNI.

“The odds favor rates are likely to be above what the market expects than below. I think (rates) will go higher than 2%,” Kohn said in an interview. “It does seem like you need to signal and/or actually move rates up pretty quickly here.”

Two percent is the ballpark level considered a “neutral” rate of interest for the U.S. economy given its current growth potential, one that neither stimulates nor retards growth.

“Even if they want to get real rates to zero, I think that inflation, without more tightening, is probably going to come in at 3% not 2%, at least for a while. So just to get real rates to zero they’ll need to be at 3,” Kohn said.

“It’s quite possible that even then they’ll still have enough tightness in labor and product markets that they’ll need to have at least positive real rates in order to contain things.”

Kohn said runaway inflation has definitely left the Fed behind the curve in monetary tightening.

CAN’T RULE OUT 50 IN MARCH

Officials had probably been hoping a quarter-point March rate hike along with a hawkish Summary of Economic Projections might have been enough to do the task, he said. (See MNI: Fed To Frontload Hikes But Keep Eye On Jobs--Ex-Officials) But surprisingly strong jobs and inflation reports for January raise the odds of a 50-bps move, which markets are now partly pricing in, and St. Louis Fed President James Bullard has said he favors.

“A dot plot that signaled approximately 25 bps every meeting, would that be enough to convince people they were reacting sufficiently strongly to inflation?” asked Kohn. “An alternative would be 50 in March. I don’t think that’s the default here. But if they get to March they have one more CPI and more labor market report. So I wouldn’t rule it out.”

UNDERLYING INFLATION PRESSURES

One key concern for the Fed is the broadening of inflation pressures beyond pandemic-related, supply-chain-type disruptions, Kohn said.

That means that even as Covid hopefully ebbs and its effects on both labor force participation and good production eases, inflationary pressures may remain high.

“What the recent inflation data suggests is that the underlying pressures of demand on sustainable supply once those supply effects have gone away could be pretty intense unless the Fed gets the interest rate up closer to neutral pretty quickly or gets people to anticipate it’s going up there pretty quickly,” he said.

“That is, having a negative real interest rate in this environment seems like it’s not going to be sufficient to get control of the inflation situation.”

YIELD CURVE BENDING

Kohn also downplayed the notion that a flat yield curve, with long-term Treasury yields just around 40 bps higher than their short-term counterparts, could present a major constraint for policy tightening.

The central bank can use balance sheet runoffs to steepen the curve even as it raises the short-term interest rate, he said.

“They shouldn’t obsess on the slope of the yield curve – it’s a signal, there’s information there, but it’s not going to put a ceiling on rate increases,” said Kohn.

“You can put some upward pressure on those long-term rates by letting the portfolio run off and then the Treasury sells longer-term securities into the market. So that substitutes to some extent for interest rate increases.”