donald l kohn : the us economy and monetary policy speech by mr donald l kohn, vice chairman of the board of governors of the us federal reserve system, at the university of north carolina at wilmington, cameron school of business'business week program, wilmington, north carolina, 26 february 2008. * * * when, at the end of july, i accepted tom simpson's invitation to speak to you today on the economy and monetary policy, little did i realize the challenges i would face. for one, the economy and financial markets have taken some unexpected twists and turns over the intervening seven months, and we are still in the midst of a rapidly evolving and highly uncertain situation. for another, when we set the date, i had expected that chairman bernanke would have already given our monetary policy report to the congress, and i could simply develop some of the themes he had laid out. however, that testimony will be tomorrow, and i must emphasize that the views you are about to hear are my own and not necessarily shared by any of my colleagues on the board or the federal open market committee ( fomc ). 1 several major developments are shaping current economic performance, the outlook, and the conduct of monetary policy. the most prominent of these developments is the contraction in the housing market that began in early 2006. both the prices and pace of construction of new homes rose to unsustainable levels in the preceding few years. for a time, the resulting correction was largely confined to the housing market, but the consequences of that correction have spread to other sectors of the economy. the financial markets are playing a key role in the transmission of the housing downturn to the rest of the economy. in the first half of 2007, investors became concerned about the likely performance of many subprime adjustable - rate mortgages made from late 2005 through early 2007. lenders turned away from subprime mortgages and some other investments as the magnitude of the losses on those mortgages began to emerge, as uncertainty about the ultimate size of the losses and who would bear them mounted, and as these experiences undermined confidence in a variety of other credit instruments, especially those with complex structures. those tendencies have intensified as risks of a spillover to the broader economy have risen. the increase in expected losses along with the unwillingness of investors to fund some types of credits has led to pressures on banks and other financial intermediaries as well as on prices and liquidity in securities markets. the result

arguably, these banks are now putting in place belatedly the capital that should have been devoted to these activities all along. even if we accept that there were some genuine advances towards more optimal risk sharing through the development of securitisation and its associated structures, it cannot be denied that there was a capital saving associated with the conduct of business through off balance sheet entities : banks had to put up less capital ex ante than the risks really warranted. that earlier business advantage is now being unwound as much of the credit risk comes back to the banks. it seems a reasonable bet that more capital will be required over the years ahead. these ppp weighted growth rates reflect the results from the recent international comparison program announcement on relative prices. so the us economy is in a period of adjustment, as is the banking core of the international financial system. even with the renowned flexibility of both, and good policies, this will take a bit of time. just how long remains uncertain. the global economy the question then is how much impact a period of us weakness will have on the global economy. i think it makes sense to think about the answer along two dimensions. the first is “ spillovers ” – essentially sequential causal connections whereby slower activity in a major country like the us affects its trading partners via reduced us demand for goods and services in international trade. this would, other things equal, slow economic activity in those trading partner countries, which in turn would slow their demand for goods and services, and so on. of course, all else may not be equal – other shocks and adjustments might be occurring in the other direction in other countries. an obvious possibility is economic policy : it may be open to policy makers in those other countries to respond to weaker us demand by running more expansionary policies at home. whether it is or not would depend on their overall macroeconomic situation and their policy regime. the second dimension is the extent of commonality in the originating event that triggers the whole adjustment to begin with. so if, for example, it were the case that a “ credit crunch ” occurred simultaneously in many countries, there would be a contractionary impact around the world even before any spillover effects via trade got going. obviously, that would be a much more serious situation, since policy makers in each country would be seeking to combat declining domestic demand as well as declining foreign demand. combating credit crunches in particular can be very difficult. i think we can take it as given that there will