Fed Vice Chairman Bolsters Rate-Cut Hopes

Policymakers must be 'flexible and pragmatic,' Donald Kohn says.
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Updated from 9:39 a.m. EST

Federal Reserve

Vice Chairman Donald Kohn gave hope to the rate-cut camp Wednesday, saying that the current state of the financial markets means the central bank must be "flexible and pragmatic."

Speaking in New York, the Fed's No. 2 banker behind Chairman Ben Bernanke acknowledged that the level of uncertainty surrounding the economy is unusually high at the moment, given the unrest being caused by questions about subprime mortgages and asset-backed securities.

"In my view, these uncertainties require flexible and pragmatic policymaking -- nimble is the adjective I used a few weeks ago," he said.

Fed members, knowing that everything they say will be dissected repeatedly, tend to choose their words carefully, and Kohn's use of "nimble" regarding policy moves will bolster those in the market who want to see more rate reductions.

The Fed has cut overnight lending rates by a total of 75 basis points at its last two meetings, taking the fed funds target rate down to 4.50%. A number of officials, including Philadelphia Fed President Charles Plosser and Chicago Fed President Charles Evans on Tuesday, have recently hinted that additional easing isn't a guarantee, especially as long as they consider inflation a threat.

Still, Fed bankers have consistently stated that they will act as needed in order to ensure price stability and full employment, and Kohn echoed that sentiment.

Kohn also offered an interesting take on the potential for Fed actions to create a "moral hazard" -- that is, bailing out investors who took risks that are now coming back to haunt them.

"People should bear the consequences of their decisions about lending, borrowing and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill-advised," he said. "At the same time, however, in my view, when the decisions do go poorly, innocent bystanders should not have to bear the cost."

"In general, I think those dual objectives -- promoting financial stability and avoiding the creation of moral hazard -- are best reconciled by central banks' focusing on the macroeconomic objectives of price stability and maximum employment," he continued.

Kohn conceded that cutting rates to keep the economy intact when the financial markets are suffering will likely reduce the penalty incurred by certain investors who made bad bets. "But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson," he said.

Because of the mess in the market for mortgage-backed securities, some of Wall Street's biggest banks have taken billions of dollars in writedowns, and there's little doubt more are on the way.

Kohn said "the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses."

He also noted that the heightened worries about added losses at financial firms have hurt equity prices "and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses, as well."