donald l kohn : monetary policy and imbalances speech by mr donald l kohn, member of the board of governors of the us federal reserve system, at the banking and finance lecture series, widener university, chester, 1 april 2004. * * * interest rates in the united states have been very low for some time. the federal reserve targets the overnight federal funds rate, and for almost a year this rate has stood at 1 percent. by comparison, the funds rate averaged more than 5 percent during the 1990s, and was last at 1 percent in the 1950s. similarly, the yield on a ten - year treasury note now stands near 4 percent - a level not seen since 1963 and more than 3 percentage points below the average of the past twenty years. these low rates are no accident. the economy began to weaken in late 2000, and aggregate activity began to contract in early 2001. starting in january of 2001, the federal reserve moved to counter this weakness by lowering the funds rate to its present level in a series of steps that ended last june. this prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record. the federal reserve recognizes that the federal funds rate is currently lower than it can be on a sustainable basis : at some point, as the economy moves back toward higher levels of employment, policy accommodation will no longer be needed and the funds rate will be raised. but it does not appear that we are as yet at that point. the federal reserve has opted to keep its policy rate quite low and has said it can be patient in removing the degree of accommodation. although the economy has indeed strengthened over the past few quarters, job growth has been anemic and considerable slack persists in labor markets. at the same time, inflation has been quite low and shows few signs that it is in the process of picking up. recently, some observers have been calling for the federal reserve to begin the tightening process sooner rather than later. in a few cases, the reasoning appears to be that we are risking a major increase in inflation by waiting. but most of the calls for a prompt policy tightening are instead based on the concern that the federal reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. in particular, these critics worry that a continued environment of low interest rates is giving rise

t face immediate problems, we should ask : what if something went wrong? below i consider a few possibilities. bis central bankers ’ speeches if the thing that goes wrong is a major financial event emanating from europe, the most damaging potential transmission channel would be if there were a complete retreat from risk, capital market closure and funding shortfalls for financial institutions. let me emphasise, importantly, that this is not occurring at present and if it did occur it would be a problem for a great many countries, not just australia. but in that event, the australian dollar might decline, perhaps significantly. we might find that, in an extreme case, the reserve bank – along with other central banks – would need to step in with domestic currency liquidity, in lieu of market funding. the vulnerability to this possibility is less than it was four years ago ; our capacity to respond is undiminished and, if not actually unlimited, is not subject to any limit that seems likely to bind. an alternative version of this scenario, if it involved the sort of euro break - up about which some people speculate, could be a flow of funds into australian assets. in that case our problem might be not being able to absorb that capital. but then the banks would be unlikely to have serious funding problems. if the thing that goes wrong is a serious slump in china ’ s economy, the australian dollar would probably fall, which would provide expansionary impetus to the australian economy. but more importantly, we could expect the chinese authorities to respond with stimulatory policy measures. even if one is concerned about the extent of problems that may lurk beneath the surface in china – say in the financial sector – it is not clear why we should assume that the capacity of the chinese authorities to respond to them is seriously impaired. and in the final analysis, a serious deterioration in international economic conditions would still see australia with scope to use macroeconomic policy, if needed, as long as inflation did not become a concern, which would be unlikely in the scenario in question. if dwelling prices in australia did slump, then there would be obvious questions about how that dynamic could play out. in such circumstances people typically worry about two consequences. the first is a long period of very weak construction activity, usually because an excess of stock resulting from previous over - construction needs to be worked off. but we have already had a fairly protracted period of weak residential construction ; it ’ s hard to believe it will get much weaker,