Fed's Kohn sees spillover effects in slowing economy and rising inflation UPDATE

Tue, Feb 26 2008, 18:30 GMT
http://www.afxnews.com

(updates with Q and A)

WASHINGTON (Thomson Financial) - The financial markets are transmitting the housing downturn into the rest of the US economy and the rising cost of energy, food and imports are spilling over into the core inflation rate, Federal Reserve Vice-chairman Donald Kohn said today.

The Fed can mitigate but not eliminate those effects. "We have the tools" and "we will do what is needed, he said. However Kohn also pointed out the Fed's limits in his address at the University of North Carolina in Wilmington.

"What policy can do is attempt to limit the fallout on the economy," he said, "but easier monetary policy will not forestall a period of economic weakness in the near term."

The housing correction has further to go, Kohn said and the financial markets "are playing a key role in the transmission of the housing downturn to the rest of the economy."

Recovery in the financial markets is likely to be a "prolonged process." It involves not just improved confidence and liquidity but changes in the way some markets do business.

For example, many people "got caught by surprise" when a AAA-rated tranche of a mortgage pool did not behave the same way a AAA-rated corporate bond did. The investment instruments were opaque, investors placed too much reliance on credit rating agencies, and the agencies "got it wrong".

The fallout is that credit is tighter for consumers and businesses across the board. Reduced home and equity wealth, higher energy prices and uncertainty about the economy "seem to be weighing on business and household spending," Kohn said. The 2.25 percentage point reduction in the Fed funds target rate was "intended to counteract the effects on the overall economy" of those factors.

On inflation, Kohn believes the recent core data suggest that "higher costs of energy, a pickup in the prices of imported goods (as the dollar declines), and perhaps, the persistent upward price pressures in commodity markets may be passing through a bit to core consumer prices."

However, he does not expect the "elevated inflation rates to persist." He sees sluggish consumer and business spending, rising unemployment and stabilizing energy prices to reduce the inflation pressure.

Overall, Kohn is predicting what all the other Fed speakers have been predicting lately, a slow first half of the year with the beginnings of a recovery in the second half.

The Fed Vice-chairman was also asked about the role of Sovereign Wealth Funds (SWFs) -- foreign government-controlled investors -- in the US economy. They should be "welcome," he said, as an important source of "recycling a lot of the dollars that have gone overseas," whether to China, oil producing countries or elsewhere.

However to dissipate the suspicion surrounding them, the SWF's need to be much more transparent he said.