April 18, 2009 / 7:22 PM / 10 years ago

Two Fed officials face grilling from Volcker

NASHVILLE, Tenn (Reuters) - Two top Federal Reserve officials faced some tough questioning on their policy on inflation on Saturday, from none other than the inflation-taming former Fed chief Paul Volcker.

Fed Vice Chairman Donald Kohn and New York Fed President William Dudley, speaking at a conference at Vanderbilt University, said they were not worried the central bank’s unorthodox policies to battle the recession would set the stage for runaway inflation down the road. They then opened the floor to questions.

Volcker, sitting in the audience of an event to honor former Fed governor Dewey Daane on his 90th birthday, grilled Kohn on how the Fed can consider an inflation target of 2 percent consistent with a goal of price stability.

“Why 2 percent? I don’t get it,” Volcker, who led the Fed from 1979 to 1987 and is now a senior economic adviser to President Barack Obama, said. “If 2 percent is the best inflation rate, and the economic recovery lags, does it become 3 percent?”

Volcker is best known for stamping out inflation during his tenure as Fed chairman by dramatically raising interest rates.

Kohn responded that a policy aimed toward an inflation rate of 2 percent, rather than something lower, gives the U.S. central bank more breathing room when it faces economic shocks.

“If we had been at 1 percent inflation, then interest rates would have already been lower when the shock hit,” Kohn said.

“Your problem is does 2 percent become 3 percent or 4?” he said to Volcker, adding that that hasn’t been the case for other central banks that have an inflation target.

“But I’m not going to convince you, am I?” Kohn told the imposing 6-foot, 7-inch Volcker, who was sitting in the front row.

Dudley, meanwhile, faced questions by Volcker on his remarks that the Fed could pay interest on reserves so that banks keep more reserve funds at the central bank as a way to drain liquidity when the economy improves.

“Explain this to me,” Volcker said.

After Dudley responded that the Fed can manage monetary policy with excess reserves in the banking system, Volcker said: “Now I’m even more confused.”

Editing by Leslie Adler

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