By Neil Irwin
Washington Post Staff Writer
Tuesday, March 2, 2010; A01
The No. 2 official on the Federal Reserve Board said Monday that he will retire, opening a third seat on what may be the world's most powerful economic body and giving President Obama a historic opportunity to reshape the central bank.
Fed Vice Chairman Donald L. Kohn announced his plans to step down in June as one of seven Fed governors who help to set U.S. monetary policy and oversee financial-system regulation. Two others already have been appointed by Obama, meaning that soon, five seats -- including the chairman's -- will have been filled by him.
The changes come at a time of epic transformation in, and intense scrutiny of, the Fed's mission. During the past two years, the Fed has taken extraordinary actions to contain a financial crisis and prop up the economy. Now the institution must decide how and when to wind down some of those emergency measures.
The Fed's governors will also be involved in reshaping the central bank's regulatory approach to try to prevent future crises. And they will work to fend off congressional attempts to enact greater oversight of monetary policy and yank away the Fed's power to supervise banks.
"It is a pivotal point in the history of the Fed," said Diane Swonk, chief economist at Mesirow Financial. "You need somebody who has credibility and can defend the Fed's independence in a way that doesn't offend Congress. They need finesse on regulatory policy. There will be a lot on their plate."
The White House has taken preliminary steps to draw up lists of candidates for the Fed jobs, but no appointments are imminent, said sources who have been in contact with the administration. Fed watchers name Council of Economic Advisers Chairman Christina Romer and San Francisco Fed President Janet Yellen as potential candidates for vice chairman.
For the three openings, sources said, the president is seeking one or two strong macroeconomists -- people well qualified to judge how the economy is evolving and how and when to make monetary policy less supportive of growth -- and one person with a strong financial-markets background. The financial crisis showed how breakdowns in obscure corners of the financial world can endanger the broader economy, and the administration wants someone attuned to those risks.
Obama's picks to the Fed so far have been governor Daniel K. Tarullo, a banking law expert who advised his campaign, and Ben S. Bernanke, reappointed as chairman. Both have led efforts to make the Fed's bank oversight more effective and focused on broad risks to the economy that arise out of banks' decisions. Bernanke has said he wants to keep interest rates low for an "extended period" and to move cautiously in removing Fed supports for the economy.
Kohn, 67, has been a crucial figure in the Fed's response to the financial crisis and recession in the past two years. A 40-year veteran of the central bank, he was a close collaborator with Bernanke in a series of dramatic actions that helped stabilize the economy and have transformed the role of the Fed.
In particular, he took the lead last year overseeing the stress tests of major banks that helped restore confidence in the banking system and has led internal efforts at the Fed to release more details about its operations. He was a chief aide to then-Chairman Alan Greenspan, serving as director of the Fed's division of monetary affairs from 1987 to 2001, before President George W. Bush named him a governor and then vice chairman.
With Kohn's departure, Bernanke will be losing a vast amount of institutional memory and a colleague who commands respect across the Fed system.
"The Federal Reserve and the country owe a tremendous debt of gratitude to Don Kohn for his invaluable contributions over 40 years of public service," Bernanke said in a statement.
"On a personal note, I would like to express my deep appreciation for Don's friendship and counsel during some very difficult times," Bernanke added.
The Fed is in particular need of PhD economists at its highest ranks. Bernanke would be the only economist on the Fed board if no new ones are in place before Kohn's departure. In addition to Tarullo, Fed governors include Bush appointees Kevin Warsh, a former investment banker, and Elizabeth Duke, a former commercial banker.
Newly appointed governors will probably have even more power than usual to influence economic policy. When the time comes to end the extreme support for growth, Fed leaders intend to use an unconventional tool -- raising the interest rate paid on bank reserves -- to pull money out of the economy.
Decisions on that rate are made by the board, not the Federal Open Market Committee, a bigger group that includes presidents of regional Fed banks and makes most monetary policy decisions.
"The stakes are now higher for new governors," said Vincent Reinhart, a former senior Fed staffer who is a resident scholar at the American Enterprise Institute.
At the moment, Fed officials are unified behind a policy of ultra-low interest rates to support the economy. But as the economy improves, some officials, especially presidents of regional Fed banks, are likely to be more eager than Bernanke to raise interest rates and drain the money supply, even at the risk of slowing the recovery. There are early signs of those pressures emerging, including a decision by Kansas City Fed President Thomas Hoenig to dissent at the last policymaking meeting, preferring not to promise to leave rates low for an "extended period."
New Obama appointees could push the center of gravity of the committee in the president's preferred direction. Fed watchers generally expect the president to favor appointees who would be in line with Bernanke's thinking or perhaps even more tilted toward worrying about unemployment as opposed to inflation.
Some liberal economists argue that the president should quickly appoint Fed governors who would be inclined to leave rates low for longer to try to get growth going again, even if it comes at the cost of mild inflation.
At the same time, an appointee who is viewed as too soft on inflation or too close to the administration could cause problems. If financial markets doubt the Fed's willingness to combat inflation, either because of appointees' economic views or because of a perception that they want to boost growth in the run-up to the presidential election, interest rates could rise. That would slow the economy.