Charles L Evans: Monetary goals and strategy
Speech by Mr Charles L Evans, President of the Federal Reserve Bank of Chicago, at the
Annual Hyman P Minsky Conference on the State of the US and World Economies,
Washington, DC, 9 April 2014.
* * *
Accompanying charts can also be found on the Federal Reserve Bank of Chicago's website.
Introduction
Thank you Dimitri. Before proceeding with my comments today, I need to remind you that the
views I express are my own and are not necessarily shared by my colleagues on the Federal
Open Market Committee (FOMC) or within the Federal Reserve System.
The U.S. Congress created the Federal Reserve System 100 years ago, largely as a way to
provide an elastic currency that could mitigate the banking panics and other disruptions that
impaired economic activity and contributed to deflations in the late 1800s and early 1900s.
That mission has evolved into what is now known as our dual mandate - the Federal
Reserve's directive to help foster conditions that achieve both stable prices and maximum
employment. Over the Fed's 100 year history, three major historical episodes continue to
provide lessons for today (chart 1). First, in the 1930s, the U.S. economy experienced a
severe credit contraction and deflation during the Great Depression. Milton Friedman and
Anna Schwartz argued persuasively that inept monetary policy failed to combat these
destructive deflationary forces.1 Second, in the 1970s, U.S. monetary policy tried to do too
much to stimulate growth and reduce unemployment when unrecognized structural factors
stood in the way. Overly accommodative policy led to soaring rates of inflation. Third, the
Treasury Accord of 1951 reminds us that an essential feature of good monetary policy is an
independent central bank - one that is autonomous enough to make tough policy decisions.
But, democratically elected authorities don't just grant autonomy to unelected central
bankers, nor should they. The price of autonomy is accountability. In order to maintain
autonomy, we need to say what we are trying to accomplish and then honestly evaluate our
progress in a way that the public and their representatives can judge clearly.
The FOMC has recently made great strides in this direction by explicitly expositing a strategy
that reflects the three key lessons of its history. The Committee's "Statement of longer-run
goals and monetary policy strategy"2 was first made in January 2012 and has been
reaffirmed each year since (chart 2). In it, the Committee indicates that price stability is
understood to mean 2 percent inflation in the long run as measured by the annual change in
the price index for total personal consumption expenditures (what we refer to as the PCE
price index.) The 1930s' deflation and the 1970s' double-digit inflation clearly indicate that
the nation is well-served by the Fed having a long-run inflation objective and making sure it
achieves that objective within a reasonable period of time.
The employment mandate is more nuanced. Because maximum employment is determined
by nonmonetary factors that affect the structure of the labor market, we can't have a simple,
time-invariant goal. We do, however, project where we think the longer-run normal, or
"natural rate," of unemployment is currently. Today, our estimates for this rate generally
range between 5.2 percent and 5.6 percent. Such assessments can vary over time.
However, the most important determinants of the natural rate change only slowly, so today's
assessment is an important input into policy. Being explicit about it contributes greatly to our
accountability.
Accountability is key. Much as corporations require corporate scorecards and earnings calls
to explain quarterly performance, the Fed needs to regularly communicate its policy strategy
and evaluate how it's doing. And, when we are missing our policy goals, the public needs to
know what we are doing about it. We need to decide on the appropriate actions to achieve
our objectives and communicate them to the public. To that end, in our longer-run strategy
statement we've said that when the economy deviates from price stability or maximum
employment, we'll take a balanced policy approach that achieves both goals within a
reasonable period of time.
A clear articulation of the FOMC's goals and an explanation of how it views its policy misses
and plans to correct them help the public better anticipate the Fed's policy actions. In turn,
the public's improved understanding of FOMC policy actions increases their efficacy by
reducing uncertainty over future financial conditions and how those actions might evolve with
changes in the economic environment. So, what we clearly need is a scorecard that
communicates our accountability in a straightforward manner.
Keeping score when there are two goals
I like to illustrate our balanced approach to achieving our dual-mandate goals with what I
refer to as a bull's-eye scorecard (chart 3). The bull's-eye in the center illustrates where we
would like to be. In this case, the goals are 2 percent inflation over the medium term and
unemployment at its natural rate, taken here to be 5-1/4 percent, which is my long-run
projection. The scorecard shows an equal weighting of policy misses around our inflation and
unemployment objectives; that is, each circular ring is a collection of unemployment and
inflation rates that should be equally uncomfortable for FOMC participants.3 For example, it
tells us how the 9 percent unemployment rate we faced back in September 2011 can be
depicted in "inflation-loss equivalent units" by showing the inflation rate that gives an
equivalent loss when unemployment is at its sustainable rate. The answer is 5-1/2 percent
inflation! The greater the distance the circle is from the center of the target, the greater are
our policy misses. And the greater our policy misses, the greater are the social gains from
aggressive monetary and other public policy actions to correct them.
The bull's-eye scorecard approach has three benefits. First, it provides accountability by
clearly describing success and failure to achieve our mandated goals. Second, it renders
operational the concept of the FOMC's intent to take a balanced approach in achieving our
goals. Third, the bull's-eye guides the public's judgment of the FOMC's likely response to
current economic conditions. While we have made considerable progress toward our goals
since 2011, we still have some ways to go to reach the bull's-eye.
Missing on the full employment mandate
That's certainly clear in the case of our employment mandate. While we've made much
progress since the onset of the Great Recession when unemployment reached a high of
10 percent, 6.7 percent is still well above the 5-1/4 percent rate I think is the longer-run
normal. Indeed, 6.7 percent is higher than the 6.3 percent peak unemployment rate in the
previous recession.
Moreover, we have to ask ourselves if this gap is a good measure of the current degree of
slack in the labor market. For example, some of the decline in the unemployment rate over
the past four years reflects people dropping out of the labor force instead of finding jobs. Of
course, certain demographic factors such as the increasing number of baby boomers
reaching retirement age mean we should have expected to see a substantial drop in labor
force participation for reasons unrelated to cyclical job prospects and the health of the labor
market. But, when you take a detailed look, it appears that the labor force participation rate
has recently declined more than can be accounted for by demographic trends and other such
structural factors alone. In addition, the end of extended unemployment insurance benefits
and other factors likely have decreased the natural rate of unemployment that is our target.
So, the decline in the unemployment rate likely overstates to some degree the reduction of
slack in the labor market over the past year.
This discussion illustrates how difficult it is to judge where the labor market stands relative to
our full employment mandate. A while back, this wasn't such a critical issue: When the
unemployment rate stood at 9 or 10 percent, it obviously far exceeded the natural rate of
unemployment. Now, as the unemployment rate falls closer to its natural rate, disentangling
structural from cyclical changes becomes more important. Thus, at this juncture, it is prudent
to consider a wide range of indicators of labor market activity to better gauge the overall
health of the labor market. In the press conference following the March FOMC meeting,
Chair Janet Yellen indicated that, in addition to focusing on the official unemployment rate,
the Committee considers a wide range of data in assessing labor market conditions.4
These
include quit rates, layoffs and a variety of wage measures, as well as broader measures of
unemployment that include discouraged workers and those who would like to work more
hours.5 Generally, the evidence points to a still weak labor market. We still have some ways
to go to reach our employment mandate.
Below target on 2 percent inflation goal, too
Let's now turn to our price stability mandate. No one can doubt that we are undershooting
our 2 percent target. Total PCE prices rose just 0.9 percent over the past 12 months; that is a
substantial and serious miss. And, as the bull's-eye chart shows, this undershooting has
persisted for several years. Compounding these difficulties, below-target inflation is a
worldwide phenomenon and it is difficult to be confident that all policymakers around the
world have fully taken its challenge onboard. Persistent below-target inflation is very costly,
especially when it is accompanied by debt overhang, substantial resource slack, and weak
growth.
In the United States, the challenge of below-target inflation continues to be underappreciated
in public commentary. Mistakenly, many greatly exaggerate the risks of overly high inflation.
Before turning to inflation risks, let me mention one reason for some confusion. That is, some
commentaries minimize the current below-target inflation experience by citing the slightly
higher increases of the Consumer Price Index, or CPI. The CPI is the best-known single
measure of inflation, and its underlying trend currently is running at a bit above
1-1/2 percent. Many commentators compare the CPI against our 2 percent inflation
objective. Unfortunately, this is an apples and oranges comparison: The CPI tends to run
about a quarter to a half of a percentage point higher on average than the PCE index
because of its different market-basket composition and statistical construction. Accordingly, it
is much more accurate to describe the Fed's inflation objective in terms of the CPI to be
roughly 2-1/2 percent. So, against this 2-1/2 percent benchmark, CPI inflation also is quite
low relative to target. In any event, the PCE price index is the preferred inflation measure on
a number of theoretical grounds and the one chosen by the FOMC as its policy target;
therefore, we should judge the Committee's ultimate inflation performance using that index
relative to its 2 percent goal.
So, what is the inflation outlook in the current environment? Despite current low rates, I still
often hear people say that higher inflation is just around the corner. I confess that I am
somewhat exasperated by these repeated warnings given our current environment of very
low inflation. Many times, the strongest concerns are expressed by folks who said the same
thing back in 2009 and then in 2010 and, well, you get the picture. OK, five years later we still
need to carefully assess this very serious question. Let me offer five reasons why I still see
the economic environment as pointing to below-target inflation for several years.
First, many commentators see rising commodity prices as a harbinger of rising inflation
pressures. Certainly, back in 2008 and 2010 there were instances when energy and
commodity prices rose to high levels. This put pressure on inflation and also reduced
aggregate demand. There is a lot of evidence that these types of relative price increases
result in only transitory increases in consumer price levels.6 At the moment, even these
transitory upward pressures are absent, and the current weak state of global demand
contributes to downward pressures. Until something unexpected, and frankly positive,
happens with the world economy, commodity prices seem like an even more unlikely
propellant for strongly rising inflation than they usually would be.
Second, some say a classic warning sign of inflation is the enormous size of the Fed's
balance sheet and the greater than $2.5 trillion of excess reserves sitting on commercial
banks' books. Surely, they say, enormous increases in the monetary base are likely to be
accompanied by substantial price level increases. The problem with this story is that the
banks have not been lending these reserves nearly enough to generate big increases in
broad monetary aggregates. And even if they did, as an indicator of inflation, the monetary
aggregates lost their predictive content many decades ago. The evidence, again, is that
inflation remains low. But what if? What if lending picks up? Well, that would be really terrific.
Dramatically higher bank lending would surely be associated with higher loan demand and a
generally stronger economy. Strong growth and diminishing resource slack would be part of
this story, and a rising rate environment would be a natural force diminishing the rising
inflation pressures. In the meantime, monitoring the entire state of the economy along with
inflation seems like a sensible and appropriate safeguard against this currently low
probability scenario.
Third, another potential source of inflationary pressures would be rising inflation
expectations. Here, I mean a breakout of inflation expectations separate from any
fundamentals that might accompany the previously discussed cases of rising commodity
prices and stronger bank lending. One could think of this as the spontaneous combustion
theory of inflation. The story goes like this: Households and businesses simply wake up one
day and expect higher inflation is coming without any further improvement in economic
fundamentals. Without appealing to esoteric economic theories of sunspots, these
expectations don't seem sustainable in the current environment. Higher inflation expectations
would presumably get priced into higher bond-market yields and higher financing rates
generally. Until inflation actually rises - remember, this story has expectations rising first - ex
post real interest rates would be higher and that would presumably result in a higher debt
burden for borrowers. This would reduce aggregate demand. Lower demand and lower
growth would further reduce cost pressures, strongly suggesting that higher inflation
expectations would not be ratified by inflation experience, and thus, would not be sustained.
Frankly, this story just seems very unlikely.
Fourth, another more direct measure of potentially rising costs and hence inflation might be
stronger wage growth. The economic story here is a bit involved. Most economic research
indicates that rising wages are not a leading indicator of rising inflation, so wages are rarely
an early warning signal for future inflation. However, higher inflation would lead to higher
nominal wage growth. And the double-digit inflation experience of the 1970s suggests that
inappropriately accommodative monetary policy can amplify rising cost pressures, creating a
wage-price spiral. Clearly, unsustainably strong nominal wage increases would very likely be
symptomatic of rising inflation pressures. In terms of the current situation, there is good news
and bad news. The good news is that currently, wage increases are low and not symptomatic
of high inflation. The bad news is that, currently, low wage increases are symptomatic of
weak income growth and low aggregate demand. Stronger wage growth would likely result in
more customers walking through the doors of business establishments and leading to
stronger sales, more hiring and capacity expansion. During a normal and steady-growth
business expansion, nominal wages would typically grow at the rate of productivity
expansion plus compensation for inflation. If normal productivity growth is 1.5 percent and
inflation is at our 2 percent target, this would suggest a steady labor compensation increase
of 3-1/2 percent is sustainable without building inflation pressures. At today's 2 to 2-1/4
percent compensation growth rates and labor's historically low share of national income,
there is substantial room for stronger wage growth without inflation pressures building.
Fifth, do we really know that the public's expectations are for low inflation? Judging by
today's Treasury yield curve, inflation expectations remain below our target. If anyone was
expecting inflation to accelerate in the future, surely individual and institutional investors
would demand to be compensated for growing inflation risk. However, our Chicago Fed
affine term-structure model implies that the three-year-ahead average inflation expectations
priced into the Treasury yield curve currently are below 2 percent and remain so for quite a
number of years to come. Given today's unacceptably low inflation environment and the
wealth of inflation indicators that point to continued below-target inflation, I think we need
continued strongly accommodative monetary policy to get inflation back up to 2 percent
within a reasonable time frame. After all, notice that the red and green regions of the
bull'seye chart show modest inflation above 2 percent is much more acceptable than even
6 percent unemployment. The FOMC should be anxious to get to that bull's-eye region as
quickly as feasible given the long slow path to date.
The Fed's reaction function
I've spoken so far about how we are missing on our policy objectives. Obviously, the aim of
policy is to eliminate those misses. How do we hit the bull's-eye? What do we do
operationally in terms of policy tools? In normal times, the FOMC moves it's traditional policy
tool, the federal funds rate, in order to influence aggregate demand and with it economic
growth and inflation and disinflationary pressures.
Many economists have studied the relationship between actual Fed actions and sensible,
explicit policy rules that might capture the Fed's policy reaction function (chart 4). Historically,
Fed policy moves have been reasonably well described by simple policy rules, particularly
the 1999 version of the so-called Taylor rule,7 that relate the federal funds rate to the
differences of output (a proxy for employment) and inflation from their target levels and a
constant term that is meant to capture the equilibrium real interest rate and the Fed's inflation
target. However, this rule does not always describe policy well. For example, given
judgmental, but reasonable, choices for the Fed's inflation objective before it adopted a
2 percent objective, the Taylor rule misses during the 1990s are big. Actually, in some cases
they were bigger than those associated with the well-known and loud complaints lodged by
John Taylor against the Fed for its 2003-06 deviations from the rule.8
Why do these misses occur? Well, the economy and the policies that optimally close
deviations from our goals are more complicated than what can be captured by any simple
rule. Taylor clearly recognized this in his 1993 article in which he stated: "While the analysis
of these issues can be aided by quantitative methods, it is difficult to formulate them into a
precise algebraic formula. Moreover, there will be episodes where monetary policy will need
to be adjusted to deal with special factors. For example, the Federal Reserve provided
additional reserves to the banking system after the stock-market break of October 19, 1987,
and helped to prevent a contraction of liquidity and to restore confidence. The Fed would
need more than a simple policy rule as a guide in such cases."9
In fact, during the most extraordinary times, such as the 2008 financial crisis and its
aftermath, the Taylor rule completely breaks down. Its prescription would have been to set
policy rates at something like -5 percent in 2009. Such rates are just not feasible for the
simple reason that nominal interest rates cannot go below zero; that is, rates cannot breach
what we refer to as the zero lower bound, or ZLB. Moreover, there is no emergency
handbook that comes with the rule that says what to do in this event. An apparently unstated
branch of the Taylor 1993 rule includes setting the federal funds rate to zero during these
circumstances and then simply wait and presumably smile confidently in public while holding
to zero rates. As a rigid policy prescription, we are thus left with inaction. And inaction looks
like policy abdication because we are left doing nothing to try to make timely progress in
reducing policy misses. This rule cannot be the be-all and end-all for monetary policy; for a
policy rule that some say should be enshrined in the Federal Reserve Act explicitly to govern
the implementation of U.S. monetary policy, its prescriptions under the recent circumstances
we've faced are an absolute failure.
Furthermore, given that the Taylor rule has failed so badly and done so for so long, how can
we be confident that its prescriptions will still be a good policy to follow once the rule says
that the fed funds rate should rise above zero again? Indeed, that's what many versions of
the Taylor rule say today - that it's time now to begin to increase the fed funds rate. How can
we know if the policy prescriptions are from a reborn and healthy policy tool or perhaps
instead from one still suffering from a zombie-like hangover in terms of its prescriptions?
It's important to keep in mind that the Taylor rule's theoretical underpinnings are loose,
especially compared with the seminal 1979 John Taylor article10 on optimal monetary policy
in a rational expectations model with sticky prices. Indeed, the Taylor rule parameters are not
necessarily stable. In particular, consider the intercept term. The usual specification of the
rule assumes that this intercept term is a constant 2 percent equilibrium level of the real
interest rate. However, it is well known that equilibrium real rates of interest are not constant,
and modern macroeconomic models of optimal monetary policy all take this into account.
Assuming that the equilibrium real interest rate is constant is just as egregious an error as
failing to account for the time-varying nature of the natural rate of unemployment. We all
know that mis-specifying the natural rate of unemployment can lead to seriously
inappropriate monetary policy outcomes like double-digit inflation in the 1970s. It certainly
seems that the fallout from the financial crisis and persistent headwinds holding back
economic activity are consistent with the equilibrium real interest rate being lower than usual
today. Indeed, if you put any weight whatsoever on the secular stagnation hypothesis that
Larry Summers and Paul Krugman have described,11 an appropriate analysis would
recognize lower expected real rates of interest. In any event, the FOMC's latest policy
statement in March recognizes this possibility of lower real rates, as the Committee stated it
currently anticipates that "even after employment and inflation are near mandate-consistent
levels, economic conditions may, for some time, warrant keeping the target fed funds rate
below levels the Committee views as normal in the longer run."12
Conclusion
During Ben Bernanke's eight years as Fed Chair, the FOMC worked hard to make the Fed's
policy intentions clear; and I am confident that the FOMC under Chair Yellen will continue
along this same path. When the federal funds rate got stuck at zero and goal-oriented
monetary policy said to do more, we did more! We implemented the following: the first
quantitative easing program, or QE1, in March 2009;13 QE2 in fall 2010; the initial forward
guidance on the federal funds rate in August 2011; Operation Twist in fall 2011; the
openended QE3 in fall 2012; and the enhanced threshold forward guidance in December 2012. All
of these were ways to go beyond the policy inaction that was the prescription of simple
constrained policy rules, and do something to meet our policy mandates.
In conclusion, let me ask again, what is the accountability test? Much has been done;
however, looking at the bull's-eye scorecard, I would argue, if anything, the FOMC has been
less aggressive than the policy loss function calls for. And to me, in the current
circumstances, accountability and optimal policy mean we should be maintaining a large
degree of accommodation for some time. Policies that would instead place us on a slow glide
path toward our targets undermine the credibility of our claim that we will do our job and meet
mandated policy goals in a timely fashion. Timid policies would also increase the risk of
progress being stymied along the way by adverse shocks that might hit before policy gaps
are closed. The surest and quickest way to reach our objectives is to be aggressive. This
means, too, that we must be willing to overshoot our targets in a manageable fashion. Such
risks are optimal if the outcome of our policy actions implies smaller average deviations from
our targets over the medium term. We should be willing to undertake such policies and
clearly communicate our willingness to do so.
References
Board of Governors of the Federal Reserve System, 2013, "What are the Federal Reserve's
large-scale asset purchases?,"(external) Current FAQs, December 19.
Federal Open Market Committee, 2014a, press release(external), March 19.
Federal Open Market Committee, 2014b, Transcript(external-pdf) of Janet Yellen press
conference, March 19.
Federal Open Market Committee, 2014c, "Statement on longer-run goals and monetary
policy strategy,"(external-pdf) as amended January 28.
Evans, Charles L., and Jonas D. M. Fisher, 2011, "What are the implications of rising
commodity prices for inflation and monetary policy?,"(pdf) Chicago Fed Letter, Federal
Reserve Bank of Chicago, No. 286, May.
Friedman, Milton, and Anna J. Schwartz, 1963, A Monetary History of the United States,
1867-1960, Princeton, NJ: Princeton University Press.
Krugman, Paul, 2013, "Secular stagnation, coalmines, bubbles and Larry
Summers,"(external) New York Times, opinion pages, November 16.
Summers, Lawrence, 2013, speech(external), Fourteenth Annual Research Conference in
Honor of Stanley Fischer, International Monetary Fund, Washington, DC, November 8.
Taylor, John B., 2013, "A review of recent monetary policy," testimony(external-pdf) before
the U.S. House Committee on Financial Services, March 5.
Taylor, John B., 1999, "A historical analysis of monetary policy rules," (external-pdf)
Monetary Policy Rules, Chicago: University of Chicago Press, pp. 319-341.
Taylor, John B., 1993, "Discretion versus policy rules in practice,"(external)
CarnegieRochester Series on Public Policy, Vol. 39, Vol. 1, December, pp. 195-214.
Taylor, John B., 1979, "Estimation and control of a macroeconomic model with rational
expectations,"(external) Econometrica, Vol. 47, No. 5, September, pp. 1267-1286.