NEW YORK – The sluggish recovery has slowed recently and will not be enough to drive the unemployment rate below 8% until 2012, Federal Reserve Bank of Chicago President Charles Evans said today.
The 1.7% GDP growth rate in the second quarter was less than half the rate of the first quarter, adn Evans noted, “This is a quite moderate pace of growth given the severity of the recession we experienced and in comparison with the economy’s potential growth rate. We need stronger growth for some time before we return to a more normal level of economic activity.”
Unemployment at 9.6% “remains well above the level I consider to be consistent with the Fed’s mandate of maximum employment,” Evans said, according to prepared text of a speech he delivered Tuesday, which was released by the Fed. “To bring the unemployment rate down substantially, the economy needs to grow substantially above the potential rate. But given my outlook for only moderate growth over the next two years, I don’t see unemployment falling below 8% by the end of 2012.”
He mused that slow job growth could be a new feature of recovery, since this is the third recovery where job creation has lagged. However, he noted, “in the current environment, slow job growth is symptomatic of a generally weak recovery.”
Housing, also, will hold back job creation, as homeowners who owe more than their homes are worth will keep them in place and demand will be down despite lower prices and low mortgage rates, which will eventually lead to improvement.
Evans said monetary policy will only be helpful if the unemployment woes are not caused by structural changes in labor demand. Indeed, Evans said, there are some indications “that the natural rate of unemployment has indeed risen over the last couple of years.”
For the fist time since the Great Depression, Evans said, the U.S. may face a “liquidity trap,” where “the supply of savings continually outstrips the demand for investment, but interest rates near zero can’t fall to equate supply and demand.”
He added, “There’s a lot of evidence that we’re in a liquidity trap. Despite the accommodative stance of monetary policy, the amount of credit flowing to households and businesses has yet to expand. Undoubtedly, some of the decline in lending reflects tighter lending standards. However, standards for most loan types are no longer tightening, and anecdotal evidence suggests that credit is more readily available.”
But businesses “aren’t particularly interested in increasing spending,” he said. Consumers are also hesitant to spend.
“If this state of affairs continues, it could very well stifle any reasonably robust recovery,” he added. “Unemployment would remain unacceptably high, and disinflationary pressures would be reinforced — clearly an undesirable outcome.”
The solution, according to economic theory, is “monetary policy should aim to lower the real, or inflation-adjusted, rate of interest by temporarily allowing inflation to rise above its long-run path. My preferred way of doing so is to implement an approach called price-level targeting. Simply stated, under this approach, the central bank strives to hit a particular price-level path within a reasonable period of time.”
Evans said “such a strategy is entirely appropriate. The Fed has a mandate from Congress to encourage conditions that foster both price stability and maximum employment. Recently the Fed has missed on both dimensions of this dual mandate, with inflation running below the 2% level I associate with price stability, and with unemployment staying well above any reasonable estimate of the natural rate.
“Practically speaking, price-level targeting in the current environment would call for a series of large-scale asset purchases to recover the shortfall in inflation. At the same time, we would continue to carry a large balance sheet in order to maintain low interest rates for an extended period. Most important, we would clearly communicate the path for prices that we expect to attain, in order to enhance the public’s understanding of the Fed’s intentions.”
Noting the proposal would have its critics, Evans said, “Central bankers generally loathe the idea that even a temporarily higher inflation rate could be beneficial for, or consistent with, price stability over the longer term. We do not want to lose what the Fed under Chairmen Volcker and Greenspan won for the American people by fighting inflation and achieving price stability. The current circumstances, however, require that we fight a different battle — namely, the extraordinary instance of liquidity trap conditions not seen since the 1930s. With potentially beneficial policies that are well grounded in rigorous economic analysis available to us, I cannot stare at our current projections for high unemployment and low inflation and think that they are consistent with the best policies to address the Fed’s dual mandate responsibilities.”
