Charles L Evans: Monetary policy normalization - if not now, when?
Speech by Mr Charles L Evans, President of the Federal Reserve Bank of Chicago, at the
BMO Harris and Lakeland College Economic Briefing, Plymouth, Wisconsin, 8 October 2014.
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Introduction
I would like to thank Lakeland College for inviting me to speak this morning. It's always
refreshing to reach directly into the communities in our District to gain valuable personal
insights into what is going on in the economy and pick up information that sometimes get
missed in dry reports and statistics. Opportunities such as this also give me a chance to talk
to you about the state of the economy, the progress we have seen in repairing the damage
from the Great Recession, and how Federal Reserve policy fits into the picture.
Of course, to gauge progress, we must measure economic performance. It's natural for us at
the Federal Reserve to do so against the objectives that Congress has set out for us - what
are known as the Fed's dual mandate. Namely, the Federal Reserve is charged with
fostering financial conditions consistent with full employment and price stability.
Needless to say, the past seven years have been very challenging and we have struggled to
achieve both our employment and inflation objectives. To accomplish our goals, the Federal
Open Market Committee (FOMC) cut its traditional policy tool, the target federal funds rate,
essentially to zero - what economists refer to as its zero lower bound, or ZLB. And when
achieving the dual mandate called for additional monetary policy accommodation, the FOMC
turned to other less conventional approaches, such as large-scale asset purchase programs
- what many of you have heard referred to as "QE," or quantitative easing - and forward
guidance about how long the fed funds rate is likely to remain near zero. I believe these
efforts have been very beneficial in helping the economy make significant progress and
bringing us back closer to our policy goals.
Today, with economic conditions much improved, many people are asking when Fed policy
will return to normal. That is an excellent question. So in my remarks this morning I will
discuss my outlook for the economy and how that outlook and the risks around it shape my
views about the appropriate timing and pace of eventual policy normalization.
In particular, I expect that there will be further improvements in economic activity over the
next three years and that these will be accompanied by additional declines in the
unemployment rate toward more normal levels. At the same time, I expect inflation to rise
gradually toward the FOMC's 2 percent target.
These forecasts are predicated on maintaining a highly accommodative stance of monetary
policy for a considerable time. Indeed, given our recent experience, I feel that before the Fed
raises rates, we should have a great deal of confidence that we won't be forced to backtrack
on our moves and face another painful period at the ZLB. And once we start, at least initially,
we should raise rates slowly to make sure the economy can weather less accommodative
financial conditions. In sum, we should be exceptionally patient in adjusting the stance of
U.S. monetary policy - even to the point of allowing a modest overshooting of our inflation
target to appropriately balance the risks to our policy objectives.
Before I expand on these thoughts, let me note that the views I express are my own and do
not necessarily represent those of my colleagues on the FOMC or within the Federal
Reserve System.
Outlook
Improving growth but slack remains
After many years of false starts, the economy now seems to be in the midst of more
sustained solid growth. My forecast is that real gross domestic product (GDP) will increase at
an average rate of about 3 percent over the next year and half.
The incoming data support this outlook. In the second quarter, consumer spending grew at a
solid but unspectacular 2-1/2 percent pace, and it appears to have risen at roughly the same
rate during the third quarter. The news from the business sector generally has been good.
Reports from our business contacts have been improving for some months and are now
almost uniformly positive. Underscoring this more positive sentiment, the data on new orders
and shipments of machinery and other capital goods have been increasing at a good clip and
surveys of business purchasing managers point to growth in both the manufacturing and
nonmanufacturing sectors.
However, there are still some sectors - such as single-family housing markets - that
continue to struggle. Starts of new single family houses are only about half of the way back
to where they were even before the housing boom. In part, the weakness here reflects
continued fallout from the financial crisis, as it is still the case that mortgage credit is hard to
come by for those without the most pristine credit ratings.
So what does this economic outlook mean for the achievement of the Fed's dual mandate
objectives?
Underutilization in the labor market
Let's consider labor markets first.
Output growth is key for producing healthier labor market conditions. Although the economic
recovery generally has been weak, there has been enough cumulative progress to generate
considerable improvement in the labor market. So where do we stand today? How much
further do we have to go to fulfill our employment mandate?
We can point to several measures to mark the progress we have made to date. Employment
has been growing over 200,000 per month for quite some time. With expanding employment,
the unemployment rate has fallen relatively rapidly. In fact, now standing at 5.9 percent, the
unemployment rate has fallen about 4 percentage points from its high - and a full percentage
point over the last year. Other measures of labor market health also suggest significant
improvements: Notably, layoff rates are low and job opening rates are back to their
prerecession levels.
But we still aren't back to full labor market health. At 5.9 percent, the unemployment rate
remains above what most people think of as its long-run neutral level. For example,
according to the central tendency in the FOMC's latest Summary of Economic Projections,1
the estimate of the neutral unemployment rate is between 5-1/4 to 5-1/2 percent, with my
own judgment at the bottom of this range. This leaves a significant gap between our goal and
current conditions.
Moreover, the labor force participation rate has dropped a good deal. Most of the decline in
labor force participation since 2000 is due to demographic trends, such as baby boomers
moving into retirement age, and long-running trends, such as reductions in male and teenage
labor force participation. These trends are structural in nature, and monetary policy is not the
appropriate policy tool to address them. Nonetheless, the labor force participation rate has
fallen somewhat more than what would be expected given these structural trends. And it is
also lower than what would be expected from its historical relationship with the
unemployment rate. Other indicators - such as long-term unemployment, the rate of
involuntary part time work, and the job finding rate - also point to more slack in labor markets
than that indicated by the unemployment rate alone.
In addition, it is hard to imagine a robust labor market without solid growth in wages. With
productivity growth of around 1 to 2 percent and an inflation target of around 2 percent, we
should be seeing wages and benefits rising at around a 3 to 4 percent rate. But that is clearly
not the case. Although some in-demand occupations may be experiencing stronger wage
growth, overall compensation growth has been around 2 percent over the past six years.
Taken altogether, these and other measures lead me to conclude that there remains
significant underutilization of labor resources - and likely somewhat more slack than what is
indicated by the unemployment rate alone. So, while good progress has been made, we
have yet to achieve our full-employment goal.
Too-low inflation
The other element of our dual mandate is stable prices. The Fed defines its target as
2 percent inflation over the medium term, with inflation being measured as the rate of change
in the Personal Consumption Expenditures (PCE) Price Index. Earlier in the year, the
inflation rate had been well below that target, at 1-1/4 percent. It has moved up a little since
then, but inflation is still only 1-1/2 percent, still leaving a significant gap from our 2 percent
target.
Of course, there are alternative measures of inflation, such as the widely reported Consumer
Price Index (CPI). The FOMC has set its inflation target in terms of the PCE Price index
because relative to the CPI it covers a wider range of items that households consume and
because it better adjusts for changes in the spending patterns of households. CPI inflation is
currently around 2 percent. But CPI inflation generally runs three to five tenths of a
percentage point higher than PCE inflation, and so the CPI's performance should be
measured against a higher inflation objective, such as 2-1/2 percent. So, an inflation gap
remains for the CPI as well.
Looking ahead, I am concerned about the possibility that inflation will not return to our
2 percent target within a reasonable period of time. First, recent monthly inflation numbers
have been low, so there is not much upward momentum. Second, as I mentioned earlier,
wage growth has been relatively low for some time. While wages don't predict future inflation,
the two often move together. So the subpar growth in wages we see today is consistent with
continued subdued inflation. And, third, it does not appear as if inflationary expectations are
exerting much of an upward pull on actual inflation at the moment.
That said, I expect inflation to rise slowly over the next three years toward the FOMC's
2 percent target. And as I mentioned earlier, I am expecting further improvements in
economic activity, with real GDP growing at around 3 percent over the next 18 months and
the unemployment rate declining further to a little over 5 percent by the end of 2016 - in line
with what I think is its long-run neutral level. So I do see us getting back close to our policy
goals over the next two to three years.
A balanced approach to monetary policy
It is important for me to say that this forecast is predicated on the assumption that the FOMC
takes a very patient approach to reducing policy accommodation. Let me elaborate on why I
think this is appropriate.
I see two important and divergent ways my forecast could go wrong. One is that I may be
overestimating the underlying strength in the real economy, so that a successful and
sustained exit from the ZLB may be more difficult than I currently believe. Guarding against
this risk calls for a more patient removal of accommodation. The second is that I may be
wrong about the inflation outlook, and we could be poised for a much larger rise in inflation
than I am forecasting. This risk calls for more aggressive rate hikes.
How do I think policy should balance these divergent risks? How should they affect the
FOMC's strategy of pursuing a balanced approach to achieving our policy goals?
In my mind, current circumstances and a weighing of alternative risks mean that a balanced
policy approach calls for being extraordinarily patient in reducing accommodation - that is,
being patient about when we first increase the federal funds rate and being patient about
setting the pace of rate increases once we have begun to move.
Proceed cautiously in normalizing policy
The first factor entering my analysis is that I see a number of downside risks to the growth
and inflation forecasts.
For instance, as I look around the globe, I see many economies facing slow growth and low
inflation. Europe and Japan are well-known cases among the advanced economies. Of
course, slow or stagnant growth in advanced countries has negative spillovers onto emerging
markets that are highly dependent on exports for their growth. Indeed, today China is
confronting slower growth, and the Brazilian economy has fallen into recession.
For the United States, slower growth abroad reduces demand for our exports and, with it,
U.S. production. In addition, weakness abroad could translate into a higher exchange value
for the dollar against other currencies, further reducing net exports. A higher dollar also
would result in lower prices for imports, which, in turn would hold down inflation and delay
progress toward our 2 percent inflation target.
While the risks to the U.S. outlook emanating from abroad are worthy of notice, they are not
the biggest thing on my mind. For me, the biggest and costliest downside risk is that in our
haste to get back to "business as usual" monetary policy, we could stall progress and
backtrack to the economic circumstances of recent years - an economy mired in the ZLB.
To say the least, conducting monetary policy at the ZLB has been a difficult experience that
we all want to avoid repeating unnecessarily. In the winter of 2009, with the unemployment
rate soaring to double digits, the Fed would have very much liked to lower the nominal
federal funds rate an additional 300 basis points; but we couldn't because the rate was
already at zero.
Faced with a pressing need to provide additional accommodation, we were forced to turn to
innovative, but controversial, unconventional monetary policies. These policies have been
extremely helpful. But there is no denying that they were second-best options; the ZLB had
made lowering the fed funds rate, which is our first-best interest rate tool, infeasible.
Everyone will welcome a return to more normal times and a reliance on the traditional policy
framework of adjustments to the federal funds rate. But the decision about when to begin to
raise rates shouldn't be made prematurely. Rather, the decision for policy liftoff has to be
made for the right reasons - that is, it should be dictated by economic conditions.
Like my colleague Minneapolis Fed President Narayana Kocherlakota.2 I think that policy at
all times must be goal-oriented. Our experiences since the crisis began and current
economic conditions are highly unusual. The FOMC should not simply set its policy
instruments by mechanically aligning them with historical norms if those norms are not
currently relevant for the conditions needed to attain both of our dual mandate goals. Rather,
our policy instruments should be set to achieve our ultimate goals as efficaciously as
possible given current and prospective economic conditions, all the while with an eye on
managing against important risks to the outlook.
I believe that the biggest risk we face today is prematurely engineering restrictive monetary
conditions. In this scenario, the FOMC could misjudge the presence and magnitude of
economic impediments and misread the recent progress we have made as evidence of
sounder economic trends. If we were to presume prematurely that the U.S. economy has
returned to a more business-as-usual position and reduce monetary accommodation too
soon, we could find ourselves in the very uncomfortable position of falling back into the ZLB
environment. Such an outcome could be a serious setback to the timely attainment of our
dual mandate policy objectives.
This risk consideration means that the decision to lift the funds rate from zero should be
made only when we have a great deal of confidence that growth has enough momentum to
reach full employment and that inflation will return to a sustainable 2 percent rate. We should
also proceed cautiously and keep the path of rate increases relatively shallow for some time
after we begin to raise rates. This approach will allow us time to assess how the economy is
performing under less accommodative financial conditions and reduce the odds of
overaggressive rate hikes choking off progress toward our policy goals.
History shows that premature exit is a risk
Past experience with the ZLB also counsels patience. History has not looked kindly on
attempts to prematurely remove monetary accommodation from economies that are in or
near a liquidity trap. Three occasions come readily to mind: the Great Depression (which was
resolved only with the massive fiscal expansion of World War II), Japan over the past
20 years, and the recent European experience. Indeed, both of the more recent episodes are
ongoing today, though Japan finally appears to be making important headway toward raising
inflation and eventually exiting the ZLB.
The U.S., Japanese and European lessons from monetary history strongly suggest that there
are great risks to premature liftoff from the ZLB or near-ZLB conditions. Unless the economy
is fundamentally strong and the previous impediments to growth have receded sufficiently,
the odds remain high that some unforeseen shock could cause the monetary authority to
retreat right back into the ZLB.
And the costs of being mired in the ZLB are simply very large. The ZLB prevents using our
very best policy tools to address negative shocks. The ZLB means that interest rates cannot
fall low enough to equate the supply of saving with the demand for investment, which, of
course, significantly impedes capital formation, future economic growth, and the health of
labor markets. And the ZLB often comes hand in hand with undesirably low inflation or even
a falling price level, carrying with it the associated costs of debt deflation on the real
economy.
The risk of too-high inflation
What about the other risk to our policy goals that I mentioned - the risk that the U.S.
economy could face pricing pressures that accelerate rapidly and ultimately leave inflation far
above our 2 percent target for an unacceptably long period?
At some point, when the economy has clearly overcome the remaining impediments from the
largest economic and financial downturn since the Great Depression, the odds of inflation
rising noticeably above target could become palpable. But such a breakout is just not at all
very likely today. Indeed, many Fed critics have been voicing this concern since 2009, and it
hasn't even come close to happening.
What if inflation just ran moderately above target for some time? Well, I see the costs of this
outcome as clearly being much smaller than the costs of falling back into the ZLB. First, I
believe the U.S. economy could weather the modest increases in interest rates that would be
needed to keep inflation in check. Such rate increases would be manageable for the real
economy; this is particularly true if industry and labor markets have already made the most
difficult reallocations of jobs and overcome other factors so that productive resources are
more efficiently and fully employed. Second, as I've noted many times in the past, a
symmetric inflation target means we should be averaging 2 percent inflation over time. We've
averaged well under that 2 percent mark for the past six and a half years. With a symmetric
inflation target, one could imagine moderately above-target inflation for a limited time as
simply the flip side of our recent inflation experience - and hardly an event that would impose
great costs on the economy.
The murky state of inflation expectations is another factor that enters my risk-management
considerations. For inflation to take off rapidly, we would have to see a jump in inflationary
expectations. But inflationary expectations certainly have not taken off. Indeed, we may be
facing a quite different problem.
Many forecasters - myself included - assume that stable 2 percent inflation expectations will
be an important factor helping to pull actual inflation up. Over the past five years,
professional forecasters' projections for long-run inflation have been at the 2 percent target
and the Treasury Inflation-Protected Securities (TIPS) break-evens generally have been flat.
Yet actual inflation has only just recently made it back up to 1-1/2 percent. Moreover, we still
have not seen much at all in the way of higher inflation compensation being built into interest
rates or wages. So there is cause for concern that expectations might not produce as strong
a pull on inflation as we hope. This unusual situation has precedent, for example, in Japan,
where inflation expectations have remained stable, while inflation itself has lagged for a
prolonged period. Of course, there is a risk, too, that inflation expectations themselves could
fall-indeed, I would note that longer-dated TIPS break-evens have recently dropped to the
lower end of their post-crisis range.
Conclusion
As I think about the process of normalizing policy, I conclude that today's risk-management
calculus says we should err on the side of patience in removing highly accommodative
policy. We need to solidify our confidence that our ultimate exit from the ZLB will occur
smoothly - and that our escape can be sustained. A corollary to this conclusion is that we
should not shy away from policy prescriptions that imply forecasts of inflation that moderately
overshoot our 2 percent target for a limited time.
Such a policy strategy more properly balances expected costs and benefits. And it would
leave me with much more confidence that inflation will not stall out below target once we start
raising rates.
I agree with Atlanta Fed President Dennis Lockhart in thinking that we ought to be "whites of
their eyes" inflation fighters.3 The last thing we want to do is regress back into the ZLB.
Indeed, such a relapse would be a sign there was something else going on that was
preventing the economy from being as vibrant as we thought possible.
To summarize, I am very uncomfortable with calls to raise our policy rate sooner than later. I
favor delaying liftoff until I am more certain that we have sufficient momentum in place
toward our policy goals. And I think we should plan for our path of policy rate increases to be
shallow in order to be sure that the economy's momentum is sustainable in the presence of
less accommodative financial conditions. I look forward to the day when we can return to
business-as-usual monetary policy, but that time has not yet arrived.
References
Federal Open Market Committee, 2014, Summary of Economic Projections(external-pdf),
Washington, DC, September 17.
Kocherlakota, Narayana, 2013, "A time of testing," speech, St. Paul Chamber of Commerce,
St. Paul, MN, November 12.
Lockhart, Dennis, 2014, "Thoughts on liftoff," speech, Global Interdependence Center, Sixth
Annual Rocky Mountain Economic Summit, Jackson Hole, WY, July 11.