Evans: Confident to Ease Enough to Close Gaps

The Federal Reserve's new communications strategy should reassure financial markets that the Fed will provide sufficient monetary stimulus to close "large resource gaps," Chicago Federal Reserve Bank President Charles Evans said in remarks to be delivered Monday morning in Hong Kong.

Evans, who will be voting on the Fed's policymaking Federal Open Market Committee this year, defended the unconventional monetary easing steps the FOMC has taken up until now as justified by the "quite slow" pace of U.S. economic recovery and the many obstacles to future growth.

At the same time, Evans said markets should be confident that the FOMC will not "wait too long" to tighten monetary policy. But he suggested the FOMC could stay in a lax monetary stance until inflation became a "substantial concern" in remarks prepared for the Asian Financial Forum in Hong Kong.

Evans has been an exponent of aggressive quantitative easing for more than a year. He also led the charge for a system of economic condition "thresholds" for signalling when the FOMC would start considering moving the federal funds rate up from zero.

Thresholds of 6.5% unemployment and 2.5% inflation were approved by the FOMC at its Dec. 12 meeting. At the same time, the Fed extended $85 billion in monthly asset purchases -- $45 billion of outright Treasury bonds and $40 billion of outright mortgage-backed security purchases.

Evans said the FOMC did not restate its 2% inflation objective when it announced last month it would keep the federal funds rate near zero so long as inflation does not go above 2.5%, provided inflation expectations stay "well anchored" and unemployment remains above 6.5%.

But Evans said the threshold scheme does mean the FOMC is prepared to allow inflation ro run "modestly above 2%" for awhile.

The Chicago Fed chief did not indicate whether he thinks the Fed needs to do even more "quantitative easing" or give any sense of how long the current pace of asset purchases should continue. But the main thrust of his comments strongly suggested he will not be one to support an early halt or scaling back of "QE3."

Acknowledging the Fed is "maintaining a highly accommodative monetary policy well after the end of the financial crisis and steep recession," he said, "We have had to do so because the economic recovery has been quite modest by any standard and because we continue to face numerous near-term obstacles to growth."

Among the "obstacles" he cited is the plight of households, which "will continue to be challenged by a debt overhang and large losses of wealth that were incurred during the financial crisis."

"Together, these factors point to lower rates of personal consumption in the United States," said Evans, who warned other nations that "the U.S. consumer is no longer in a position to be the engine of world growth."

Evans also pointed to recession in Europe and weak growth in other advanced countries as impediments to faster recovery and called on emerging markets to spur consumption.

Citing forecasts developed by him and his FOMC colleagues in December, Evans said U.S. GDP growth is apt to be "only modest above potential," implying there will be "only a small decline in the unemployment rate from the current 7.8%." Inflation should run "a bit under" 2%," he added.

He said fiscal developments since the December FOMC meeting have not significantly changed the outlook.

Against that backdrop, Evans emphasized the conditional nature of Fed easing. Echoing the FOMC, he said asset purchases "will continue until there is substantial improvement in labor markets, subject, of course, to a continued environment of price stability."

Evans said the FOMC's additional pledge to stay "highly accommodative ... for a considerable time after the asset purchase program ends and the economic recovery strengthens" is justified by "what modern macroeconomic theory tells us is the optimal policy response to the extraordinary circumstances we have faced over the past four years."

"Because short-term rates are constrained by the zero lower bound, modern theory says a central bank should promise that once economic activity recovers, it will for a time hold rates below what they typically would be," he elaborated. "This makes up for the period when it was constrained from taking rates negative."

"In other words, the average path for rates is closer to being right over time," he added.

Evans said the FOMC tied eventual tightening to economic conditions because "we cannot foresee all of the developments affecting the outlook" and so "we simply can't commit firmly to a date when those economic conditions will be achieved."

He said using a calendar date had the additional disadvantage that "some may still interpret a far-distant date for the policy liftoff as a forecast that economic conditions will remain poor for a long time, rather than an intention to keep rates near zero even after the recovery is firmly entrenched."

Evans insisted that "the 2 1/2% inflation threshold is not a restatement of our long-run inflation goal -- that goal is still 2%."

"The slightly higher threshold value simply captures how our symmetric view of that long-run goal allows for inflation at times to run modestly above 2%," he said.

Evans suggested that the threshold system actually acts as a form of monetary stimulus itself -- certainly as a form of reassurance for markets hungry for continued low rates.

"Given more explicit conditionality, markets can be more confident that we will provide the monetary accommodation necessary to close the large resource gaps that currently exist," he said.

"Additionally, the public can be more certain that we will not wait too long to tighten if inflation were to become a substantial concern," he continued. "More explicit forward guidance provides additional accommodation by reducing longer-term interest rates through a lower expected path for short-term rates."

"Also, clarifying conditionalities can help households and businesses better plan for the future, and so boost the effectiveness of our current policies by reducing risk premia," he added.

In other comments, Evans said fiscal policymakers "must find the appropriate balance" between budget deficit reduction and economic growth. Deficit reduction should take place only "gradually," he said.

Fiscal policymakers are "confronting the immediate challenge of not imposing too much austerity on our fragile economies," he said.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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