Federal Reserve Vice Chairman Donald Kohn's question-and-answer session

NASHVILLE (Dow Jones)--Federal Reserve Vice Chairman Donald Kohn's question-and-answer session at a Vanderbilt University conference Saturday was going as countless others surely have in his years as a top policy maker.

Until Paul Volcker raised his hand.

Then, Kohn was grilled over the Fed's apparent effort to convey that it considers a roughly 2% inflation rate to be appropriate for the economy in the long term.

Former Fed Chairman Volcker, who along with Kohn was at a conference honoring former Fed governor Dewey Daane, questioned how the Fed can talk about both 2% inflation and price stability.

In the minutes of its January policy meeting, the Fed said that officials' long-run inflation forecasts reflect what they think is consistent with the Fed's dual mandate "for promoting price stability and maximum employment."

It then said that "most participants" thought 2% inflation, as measured by the price index for personal consumption expenditures, "would be consistent with the dual mandate."

"I don't get it," Volcker said, leading to a lively back-and-forth between the two central bank heavyweights.

By setting 2% as an inflation objective, the Fed is "telling people in a generation they're going to be losing half their purchasing power," Volcker said. And if 2% is the best inflation rate, and the economic recovery lags, does that mean that 3% becomes the ideal rate, he asked.

Kohn responded that by aiming at 2%, "you have a little more room in nominal interest rates ... to react to an adverse shock to the economy."

"Your problem is 2[%] becomes 3 becomes 4," Kohn told Volcker. But other central banks with a roughly 2% target haven't had that problem, Kohn said.

Fed officials, he added, "need to be clear about why we're choosing the number we're choosing." He also said that while he doesn't think deflation is much of a risk, "I can't say the risk is zero" and the Fed must be mindful of the possibility that inflation expectations fall to the point that real interest rates rise.

The two fought to a rhetorical draw, with each conceding that he wasn't going to persuade the other.

If it's any consolation for Kohn, he wasn't the only one on the business end of Volcker's barbs. Volcker told New York Federal Reserve Bank President William Dudley, who also spoke at the conference, that he doesn't understand what the Fed's trying to accomplish by paying interest on excess reserves.

"Now I'm more confused," Volcker told Dudley after Dudley addressed the topic in his speech.

That led to another back-and-forth that ended with Volcker telling Dudley, "I get the impression you're beginning to like this."

The same, it seems, could be said for Volcker.

-By Brian Blackstone, Dow Jones Newswires; 202-828-3397; brian.blackstone@dowjones.com