Fed’s Kohn warns on interest rate risk

By Reuters Staff
January 29, 2010

By Karey Wutkowski

ARLINGTON, Va., Jan 29 (Reuters) – A senior U.S. Federal Reserve official warned on Friday that the uncertain path of interest rates poses risks for banks inattentive to the match of durations among their assets and liabilities.

Federal Reserve Vice Chairman Donald Kohn told a conference sponsored by the Federal Deposit Insurance Corp that the usual uncertainty about interest rates in coming months is compounded in the current situation by the fact that rates are near zero and the Fed has massively expanded the amount of reserves in the banking system.

“Borrowing short and lending long is an inherently risky business strategy,” Kohn said. “Intermediaries need to be sure that as the economy recovers, they aren’t also hit by the interest rate risk that often accompanies this sort of mismatch in asset and liability maturities.”

The Fed has pledged to keep benchmark rates exceptionally low for an extended period, and renewed that promise on Wednesday at its regular policy-setting meeting.

Kohn said the Fed would stick to that commitment if the economy follows the the trajectory expected by the Fed.

When and how fast rates rise depends on the outlook for growth and inflation, Kohn said. Economists expect only modest growth accompanied by a slow decline in the unemployment rate over the next few years, he said.

As part of its efforts to help the struggling economy, the Fed began buying longer-term Treasury and mortgage-related securities. Those purchases are winding down, and the impact of the end of the buying on interest rates is likely to “modest,” Kohn said.

The Fed vice chairman suggested that longer-term interest rates may well rise as the Fed raises borrowing costs. The stability or decline in longer-term rates in 2004 and 2005 during a Fed tightening cycle reflected in large part strong demand for dollar-denominated assets, he said.

International leaders are focused on better balances in trade and investment flows among economies and foreign capital is likely to be “less plentiful” for the United States, Kohn said.

“Banks and other investors cannot count on a repeat of the most recent experience — the absence of capital losses when short-term rates rise,” he said.

How the Fed absorbs the massive amount of reserves it has pumped into the financial system will also affect short term rates and the relationship between shorter-term and longer-term borrowing costs, Kohn said. (Writing by Mark Felsenthal; Editing by James Dalgleish & Theodore d’Afflisio) ((mark.felsenthal@thomsonreuters.com; Tel: +1 202 898 8329; Reuters Messaging: mark.felsenthal.reuters.com@reuters.net))

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