Monetary policy needs to remain accommodative, as policy benefits continue to outweigh risks, Federal Reserve Bank of Chicago President and Chief Executive Officer Charles L. Evans said Tuesday.
"However, we aren't out of the woods yet," Evans told the Detroit Economic Club, according to prepared text of his comments, released by the Fed. "Balance sheet scars from the financial crisis are still weighing on the economy. Fiscal policy is a restraint on economic growth. And economic activity abroad is not robust."
But, he continued, those "headwinds appear to be dissipating. But risks remain." Evans mention "large resource gaps," including an unemployment rate still higher than the 5.25% it should be long-term, and inflation is about half of the Fed's 2% target. "Accordingly, monetary policy is highly accommodative, and needs to remain so for some time," Evans said.
"I think that the benefits of our policy choices continue to far outweigh the potential risks," he said. "However, we must repeatedly think long and hard about two risks that are mentioned often - namely, that our expanded balance sheet and prolonged period of low rates raise the risk of financial instability and also the risk of producing higher inflation."
While it is unlikely that high inflation will be a problem, Evans said he worries "inflation will not pick up quickly enough." With inflation at about 1% since early last year, and little indication it will spike anytime soon, Evans noted, "Low inflation is just as economically costly as high inflation. When we set an inflation target of 2 percent, we need to hit our target without too much delay. Simply put, we need to average 2 percent inflation over the medium term. Accordingly, the current 1 percent inflation situation calls for extended policy accommodation. More restrictive monetary policy conditions would work to reduce inflation to further unacceptably low levels."
He added, with low inflation and high unemployment "appropriate monetary policy dictates that low real interest rates should prevail until the economy is further along a sustainable path to its potential level. This assertion is made from a mainstream macroeconomic perspective. Nonetheless, it is common to hear the argument that these highly accommodative monetary policies might sow the seeds of financial instability."
Low interest rates, he said, could spark "excessive risk-taking by some investors," which would threaten financial stability.
If stable, low interest rates have the potential to threaten financial stability, it "creates a seeming paradox for policymakers. The existing large shortfalls in aggregate demand call for highly accommodative monetary policies and historically low interest rates. Yet, such policies have the potential to raise the likelihood of financial instability in the future," he said.
Evans said raising rates is not the answer. "I think the inference that persistently low interest rates pose a danger to financial stability is based on a narrow view of the economy and is unlikely to survive a broader analysis that takes into account all the interactions between financial markets and real economic activity. If more restrictive monetary policies were pursued to generate higher interest rates, they would likely result in higher unemployment and a sharp decline in asset prices, choking the moderate recovery. Such an adverse economic outcome is unlikely to set a favorable foundation for financial stability. Moreover, our short-term interest rate tools are too blunt to have a significant effect on those pockets of the financial system prone to inappropriate risk-taking without, at the same time, significantly damaging other markets, as well as the growth prospects for the economy as a whole. Therefore, stepping away from otherwise appropriate monetary policy to address potential financial stability risks would degrade progress toward maximum employment and price stability. This approach would be a particularly poor choice when other tools are available, at lower social costs, to address financial stability risks."
He explained that financial stability concerns are relevant and policymakers need to act to stave off "developments that threaten financial stability." Also, "the macroprudential tools available to policymakers are better-suited safeguards to addressing financial risks directly. These macroprudential actions can be dialed up or down given the appropriate setting of monetary policy tools, so undesirable macroeconomic outcomes are less likely than if we were to resort to premature monetary tightening."
Economic growth met or exceeded Fed predictions in 2013, allowing the U.S. to enter 2014 "with much better momentum." It also allowed the Fed to start adjusting "the mix of its monetary policy tools modestly," tapering asset purchases, while vowing to leave the fed funds rate "near zero for quite some time - quite likely well into 2015."
Highly accommodative policy is essential "to ensure we make adequate progress toward maximum employment and price stability," the Fed's dual mandate from Congress.
