The conscience of the Fed: first he rose to become the Federal Reserve's top staffer. Now he helps set the pace as one of Washington's newest Fed governors. TIE's exclusive interview with Donald Kohn.

• Position: The United States - Interview

TIE: How have you found being a Fed governor different than being a member of the senior staff?.

KOHN: I've enjoyed the transition. I was ready for it; I had worked on monetary policy issues particularly during the last fifteen years, and I was ready to diversify my portfolio into other things. I have become involved in payment systems issues, internal governance issues, and representing the Fed before international bodies such as the Organization for Economic Cooperation and Development. I've also liked the change in perspective from preparing the materials to having responsibility for the decisions that are made. Now I try to convince other people, and I realize people are going to look at how I vote, and I will need to take responsibility for how things turn out.

TIE: Has this changed your relationship with Fed Chairman Alan Greenspan?

KOHN: To some extent. I don't interact with him as frequently as I did when I was a staff member and he would call me for specific information anywhere from three times a week to three times a day. But I've maintained a nice back-and-forth relationship with him. I'm very comfortable exchanging views on the economy and the appropriate stance of monetary policy. I'm no longer involved in the preparation of his speeches and his testimonies, and that very intense working through of the details.

TIE: Who replaced you as director of the monetary affairs division at the Fed?

KOHN: Vincent Reinhart, who's very good, and very smart. He's much more tooled up in very recent economic and financial research. He's also taken over the responsibility of secretary of the Federal Open Market Committee, and the division is flourishing under him. It gives me a lot of pleasure to see the division that was created for me--my baby--grow into adolescence and survive and thrive under new leadership.

TIE: Let's begin with a general question about the transmission of monetary policy. How difficult is it now, with interest rates so low and the prospects of disinflationary pressure increasing? What concerns do you have that you didn't have in the past?

KOHN: My concerns aren't about the transmission of monetary policy right now. The same transmission mechanisms have been at work over the last few years. We've seen lower interest rates feed through to the housing markets and to support consumer spending. To some extent the lower interest rates have kept the equity markets from falling quite as much as they might have. They've helped households and businesses rebuild their financial strength and get ready to support greater spending in the case of businesses and actually support spending in the case of households, especially the mortgage market and the mortgage refinancing process.

The lower interest rates have probably contributed to the dollar's decline, which will feed through over time to stronger exports and strengthen total demand in the United States. So far, the fact that the federal funds rates have gone all the way down to 1.25 percent hasn't impaired the transmission of monetary policy.

Our problem so far has been the deficiency of demand. Businesses in particular, despite a very low cost of capital, don't see a lot of profitable investing opportunities, at least as much as in other expansions. Monetary policy has already had to try to bolster household demand to make up for the lack of business demand.

TIE: Well, at some point you move into the non-traditional policy, which is uncharted territory for the Fed.

KOHN: That's right. We still have some room in our conventional monetary policy, whether it's all 125 basis points would need to be examined, but a considerable amount of space in any case, and I expect that to work through markets the way it always does. If we go through our conventional policies, we'll need to think about other ways of stimulating the markets. A couple of channels might work to bring down long-term interest rates, including an expectations channel. We can convince people that we intend to keep short-term interest rates low for quite a while.

TIE: A lot of people saw your hand in the Chairman's recent efforts through public statements to initiate a kind of verbal ease. Are we seeing the beginnings of "virtual monetary policymaking"?

KOHN: I wouldn't take credit, but I thought it was effective, and that's a good example of how the FOMC can still bring down longer-term interest rates using a combination of words and actions. It was primarily a case of giving people information that led them to push off the time at which they thought we probably were going to tighten. Should we begin to exhaust conventional policy actions, our words will become all the more important. They will have to describe how we see the situation and what we're looking for in terms of the economy, allowing inferences on how long we intend to keep policy in a very easy mode. Then there'll need to be actions that will back up those words.

The other channel through which monetary policy can work in such situations is what people call imperfect substitution--just buying a large amount of assets, whatever they are, and affecting the relative supply and demand for those things and hence their price.

TIE: Would you take a neutral approach to buy various securities as you move out the yield curve? Or would you start at the short end or immediately move to the long end?

KOHN: I actually haven't made up my mind. This is very much a work in progress, and we are studying this question right now. This subject has come under intense discussion both publicly and within the Federal Reserve, and as the possibility has drawn closer, my ideas on these issues have changed over time. It's not something we've dealt with before. The Japanese experience gives us some pointers on what not to do, but we will probably make our own mistakes as well. I can see arguments for buying along the yield curve. I can also see arguments for working out the curve to help convince people at least for the near term that we're going to keep interest rates at a very low level and let that feed through. There are arguments pro and con for just setting a rate at a two-year level, for example, or doing a lot of buying and letting the market sort it out to a certain extent.

One of the lessons I take from other countries' experience is to think about these things ahead of time and have a plan, obviously subject to revision. We should have some conviction behind the plan and have good public communication about the plan's general scope. We can't say exactly what we're going to do, but we ought to be able to tell the public the options we're considering and why we think they would be successful so we don't appear to be...