The Federal Reserve is likely to keep benchmark interest rates near zero for a while in an economy that is pulling out of a steep decline and appears on course for a very gradual recovery, Fed Vice Chairman Donald Kohn said on Saturday.
The economy is only now beginning to show signs that it might be stabilizing, and the upturn, when it begins, is likely to be gradual amid the balance sheet repair of financial intermediaries and households, Kohn told a conference at Princeton University.
As a consequence, it probably will be some time before the FOMC will need to begin to raise its target for the federal funds rate, he said, referring to the Fed's policy-setting Federal Open Market Committee.
The central bank has cut interest rates to near zero and committed to massive lending and securities purchases to heal shattered financial markets and pull the economy out of the longest recession since the Great Depression.
Kohn said that in spite of the fragile state of the U.S. economy and the prospect for low rates for a while, the Fed must make plain its plans to pull back its lending when a recovery begins to take hold.
To ensure confidence in our ability to sustain price stability, we need to have a framework for managing our balance sheet when it is time to move to contain inflation pressures, he said.
The Fed has said it is willing to expand extensive purchases of mortgage-related and longer-term Treasury securities to support any nascent recovery.
The preliminary evidence suggests that our program so far has worked, Kohn said referring to the commitments to buy securities to date. He said he believes they have held down long term interest rates by as much as 1 percentage point.
An analyst said Kohn's remarks are a signal the Fed is ready to buy more longer-term securities.
Kohn's comments today on the effects of these actions are the most supportive to date of any Fed official and they increase the likelihood that the FOMC will extend or expand the existing asset purchase programs, JPMorgan Economics economist Michael Feroli wrote in a note to clients.
Kohn said government spending is likely to have a more powerful effect in helping pull the economy out of recession now -- with interest rates near zero -- than it would if the Fed were still in a position to lower interest rates further.
In this situation, fiscal stimulus could lead to a considerably smaller increase in long-term interest rates and the foreign exchange value of the dollar, and to smaller decreases in asset prices, than under more normal circumstances, he added.
The Fed is studying how the current crisis may have affected U.S. economic productivity and how those changes may have affected the difference between how the economy grows and its full potential, he said.
The effect of the crisis, the shifting of labor across markets, the effects on productivity have been very much one of the topics at the Fed, Kohn said in response to questions speaking.
Right now, there's no question in my mind there's a very substantial output gap, he said.
In its actions to buttress the economy through a period of crisis, the Fed has taken on some risks both from swings in interest rates as well as from the possibilities that some borrowers could default, Kohn said, adding the Fed has sought to minimize those risks.
Even specialized vehicles such as three Maiden Lane limited-liability companies set up at the New York Fed to hold so-called toxic assets from two firms the central bank stepped in to prevent from failure -- investment bank Bear Stearns and insurer American International Group, Inc -- may not result in losses, he said, since the Fed is holding the assets to maturity.
BlackRock Inc, the firm that is managing those vehicles, has told the central bank those holdings are likely to eventually turn a profit, Kohn added.