Evans: Need 'Even Stronger Steps' Such As MBS Buys

HONG KONG — Chicago Federal Reserve Bank President Charles Evans said Monday that the Fed needs to take "even stronger steps" — namely further asset purchases — to accelerate "anemic" growth and insulate the economy from potential recession.

What's more, he said the Fed should be willing to tolerate inflation as high as 3% to reduce unemployment from 8.3% and said it should publicly declare that it will keep the federal funds rate near zero so long as unemployment is above 7%.

Evans, who will return to the voting ranks of the Fed's policymaking Federal Open Market Committee next year, expressed a preference for buying mortgage backed securities in an "open-ended" fashion in remarks prepared for delivery to a seminar.

He said a third round of asset purchases, or "quantitative easing," needs to be carried on until the economy improves and should be done in conjunction with a clarification of the FOMC's "forward guidance" about the path of the funds rate.

It would "reassure" markets and the general public if the FOMC were to make clear that it intends to keep the funds rate near zero even after the economic growth pace picks up and that it is willing to tolerate inflation well above the FOMC's announced 2% target, Evans argued.

The Fed could stop buying assets once there is clear evidence that the economy has gained momentum, he said, but should not raise the funds rate until after the unemployment rate has dropped below 7% — even if inflation exceeds 2% by as much as a percentage point.

Allowing inflation to go as high as 3% would not be at odds with the "balanced" approach to fulfilling its statutory "dual mandate" goals on inflation and employment enunciated on Jan. 25 as part of its statement of "Longer-Run Goals and Policy Strategy," Evans insisted.

The Chicago Fed chief serves on an FOMC subcommittee on communication policy chaired by Vice Chairman Janet Yellen.

His monetary policy advice, which is consistent with what he has been giving for months, came against the backdrop of a dreary assessment of economic conditions and prospects.

Even though recent data have had a stronger tone, Evans said "resource gaps remain huge" because real GDP growth this year "may not even be enough to keep up with potential."

"Growth in 2013 is expected to be only moderately higher," he said. "Moreover, both the European debt situation and the looming U.S. fiscal cliff impart substantial downside risks to the forecast."

"Even absent any negative shocks, such tepid growth rates would close the large existing resource gaps only very gradually," Evans continued. "Indeed, I expect that we will face unemployment well above sustainable levels for some time to come."

Evans added that "economic growth is not much above stall speed." And he warned, "Another negative shock could send the economy into recession. And if a recessionary dynamic takes hold, it would be especially difficult to regain momentum."

He cited a recent estimate by the Congressional Budget Office that, if not averted, the automatic tax hikes and spending cuts due to take effect on Jan. 1, would reduce real GDP growth by about 4 percentage points in 2013.

With so much economic slack and low inflation expectations, he said, inflation does not pose a serious threat — or an impediment to vigorous additional monetary stimulus.

At its June 20 meeting, the FOMC prolonged its "maturity extension program" or "Operation Twist." Through year's end, the Fed will buy $267 billion of longer-term Treasury securities, financed by sales of a like amount of short-term Treasuries. It also reaffirmed its expectation that the funds rate will need to stay near zero "at least through late 2014."

At the July 31-Aug. 1 meeting, the FOMC decided it needed "more time" to assess the impact of the extended Operation Twist before deciding to do more, although minutes of the meeting said "many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery."

Notwithstanding better-looking data received since Aug. 1, Evans reasserted his calls for immediate, additional monetary stimulus — both QE3 and enhanced forward guidance.

While calling the second iteration of Operation Twist a "useful step," he asserted, "I believe it is time to take even stronger steps, such as the purchase of more mortgage-backed securities, to increase the degree of monetary support for the recovery."

With a bow to colleagues Eric Rosengren and John Williams, presidents of the Boston and San Francisco Federal Reserve Banks, Evans said "these could be open-ended purchases, meaning that they would continue at a certain rate until there was clear evidence of improvement in economic conditions."

Evans said such "clear evidence" might mean "a resumption of relatively steady monthly declines in unemployment for two or three quarters."

"Once this momentum was confidently established, the Fed could stop adding to our balance sheet but keep the funds rate at zero," he said. "The funds rate would remain unchanged in my thinking, until the unemployment rate hit at least 7% or the medium-term inflation outlook deteriorated dramatically and rose above 3%."

Evans said the Fed should start shrinking its balance sheet assets only "sometime after the first increase in the funds rate."

Expanding the Fed's balance sheet and thereby increasing bank reserves — something Operation Twist does not do — is not enough in Evan's view, however. Enhanced communication about Fed intentions is also needed.

"For this liquidity to be sufficiently accommodative, the public needs to expect that we will keep it in place for as long as is necessary to restore the economy to a sound footing," he said. "This is why I believe we should clarify the Fed's forward guidance with regard to the future course of policy."

Evans said "the best way to provide forward guidance is by tying our policy actions to explicit measures of economic performance." And he reiterated his 7/3 threshold framework which he has been advocating for the past year.

Announcing that the FOMC won't raise the funds rate until the unemployment rate falls below 7% "would reassure markets and the public that the Fed would not prematurely reduce its accommodation," he said.

Evans said he does "not expect that such policy would lead to a major problem with inflation," but said, "I believe that the commitment to low rates should be dropped if the outlook for inflation over the medium term rises above 3%."

"The economic conditionality in this 7/3 threshold policy would clarify our forward policy intentions greatly and provide a more meaningful guide on how long the federal funds rate will remain low," he said. "In addition, I would indicate that clear and steady progress toward stronger growth is essential."

Evans acknowledged that he has gotten a lot of criticism for his willingness to tolerate inflation as high as 3%. "Isn't this blasphemy for a central banker?" he asked rhetorically.

But he didn't back down, defending his position on the grounds that it jibes with the "balanced approach" put forth by the FOMC and elaborated on by Fed Chairman Ben Bernanke earlier this year.

"As Chairman Bernanke stated at his April press conference, the 2% inflation goal is a symmetric objective and not a ceiling on inflation," Evans said. "Symmetry means that inflation below 2% should be viewed as the same policy miss as if inflation overran 2% by equal amount."

The FOMC needs to "take symmetry seriously," Evans said. "If we disproportionately recoil at inflation a little above 2% versus a little below, then we are not symmetrically weighing policy misses. And we will not average 2% inflation, which is our goal."

Noting that some FOMC participants have projected that the funds rate will rise before 2014, even though the FOMC forecast is for inflation to remain at or below 2% and unemployment to remain above the long-run objective, he commented, "it's difficult to see how this is consistent with a symmetric inflation goal and a balanced approach to achieving the two legs in our dual mandate."

So Evans said the FOMC needs to "do better at describing our thinking with respect to tolerance bands around our long-run inflation and unemployment goals."

His preference would be "if we are missing our employment mandate by a large amount, but are close to our inflation target, then we should be willing to undertake policies that could substantially reduce the employment gap even if they run the risk of a modest, transitory rise in inflation that remains within a reasonable tolerance range of our target."

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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