NEW YORK – The Federal Reserve can’t afford to be “excessively complacent” when the economy remains stuck in neutral, Federal Reserve Bank of Chicago President and Chief Executive Officer Charles L. Evans said Monday.
“It is imperative to undertake action now,” Evans told a Ball State University Center for Business and Economic Research luncheon, according to prepared text of the speech, which was released by the Fed.
Calling recent forecasts “too optimistic,” Evans called employment and growth flat and job growth “disappointing.” Revised GDP data show little growth and “consumer spending has been particularly sluggish.”
Also, Evans added, GDP weaknesses began before higher energy prices and the tsunami in Japan caused setbacks. Inflation has been and should remain “moderate” for the “foreseeable future,” but Evans said he sees inflation at the low end of the 1.5% top 2% range the FOMC sees for 2012-2014.
“This timing, along with the continued softness of most economic indicators into the early summer, indicates that the slowing in output growth was not all due to temporary factors,” he said. “Even with slightly firmer economic data that have come out recently, the sense of building momentum seems absent. Rather, the headwinds facing consumers and businesses are even stronger than we had thought.”
These growth rates, he said, “certainly are not strong enough to make much of a dent in the unemployment rate and other measures of resource slack.”
With the FOMC projecting unemployment above 8.5% through next year and near 8% in 2013, “Without new developments or changes in policy, I don’t believe the U.S. economy is poised to achieve escape velocity anytime soon.”
These facts “pose a challenge for monetary policy.”
Realizing that policymakers have “imperfect” information – “incomplete and sometimes competing views of the forces that generate current economic conditions” – Evans said, “we should try to formulate a monetary policy strategy that carefully balances the risks associated with the reasonable alternative economic scenarios that we face and is as robust as possible to miscalculations as to which of these scenarios is predominantly true.”
Two scenarios were offered as reasons for slow growth: the “structural impediments scenario” and the “liquidity trap scenario.”
The “structural impediments scenario” suggests the recession “was accompanied by an acute period of structural change, skills mismatch, job-killing uncertainties and excessive regulatory burdens. Accordingly, these structural impediments have caused the natural rate of unemployment to increase.” Evans rejects this opinion, because “it rests on lots of conjecture about economic forces and outcomes that are not confirmed by the evidence at hand” and there are no economic models that would suggest these circumstances would produce such high unemployment rates.
“Nevertheless suppose this scenario were true,” he said. “In this case the role for additional monetary accommodation is modest at best: The economy faces a supply constraint that monetary policy simply cannot address.” By adding accommodation, inflation would rise without “a sizable impact on unemployment” and could cause stagflation.
The cure for the structural impediments scenario, is “removing excess accommodation before inflation rises above its target and inflation expectations start to creep unalterably upward.”
In the “liquidity trap scenario,” Evans said, “cautious behavior holding back spending — whether it is due to risk aversion, extreme patience or deleveraging — causes the supply of savings to exceed the demand for investment even at very low interest rates. Today short-term, risk-free interest rates are close to zero and actual real rates are only modestly negative. But they are still not low enough — because short-term nominal interest rates cannot fall below zero, real rates cannot become negative enough to equilibrate savings and investment.
“As I weigh the evidence, I find the case for the liquidity trap scenario more compelling than one for the structural impediments scenario,” he said. In this case, recovery is “usually painfully slow … for reasons that have little to do with structural impediments in the labor market and the like.”
While “rare” and difficult to manage, liquidity traps “can be vastly improved by lowering real interest rates and lifting economic activity using an appropriately prolonged and forward-looking period of accommodative monetary policy,” Evans said.
Evans holds open the possibility “I could be wrong in my assessment” and considers “how we should conduct policy when we don’t know for sure which scenario is really the one we face today,” where the cure for one worsens the other.
“Fortunately, between these two extreme scenarios, there is a robust middle ground policy approach. The Fed could sharpen its forward guidance in two directions by implementing a state-contingent policy,” he said. “The first part of such a policy would be to communicate that we will keep the funds rate at exceptionally low levels as long as unemployment is somewhat above its natural rate. The second part of the policy is to have an essential safeguard — that is, a commitment to pull back on accommodation if inflation rises above a particular threshold. This inflation safeguard would insure us against the risks that the supply constraints central to the structural impediments scenario are stronger than I think. Rates would remain low as long as the conditions were unmet.
“Furthermore, I believe the inflation-safeguard threshold needs to be above our current 2% inflation objective — perhaps something like 3%,” he said.
“And actually, this middle ground policy guidance is not as out-of-the box as one might think. Importantly, it is consistent with the most recent liquidity trap research, which shows that improved economic performance during a liquidity trap requires the central bank, if necessary, to allow inflation to run higher than its target for some time over the medium term,” he said. “Such policies can generate the above-trend growth necessary to reduce unemployment and return overall economic activity to its productive potential.”
Should the structural impediments scenario turns out to be correct, “inflation will rise more quickly and without any improvements to the real side of the economy. In such an adverse situation, the inflation safeguard triggers an exit from the now-evident excessive policy accommodation before inflation expectations become unhinged. We would not have the desired reductions in unemployment, but then again, there wouldn’t be anything that monetary policy could do about it. We would suffer some policy loss in that a 3% inflation rate is above our 2% target. But we certainly have experienced inflation rates near 3% in the recent past and have weathered them well. And 3% won’t unhinge long-run inflation expectations. We are not talking about anything close to the debilitating higher inflation rates we saw in the 1970s or 1980s. We would also know that we had made our best effort.”
