DETROIT (MNI) – The following are the remarks of Chicago Federal
Reserve Bank President Charles Evans Monday, prepared for the Michigan
Council on Economic Education on the topic of “Mandate Responsibilities:
Maintaining Credibility during a Time of Immense Economic Challenges:”
The Enormity of the Problem
In the summer of 2009, the U.S. economy began to emerge from its
deepest recession since the 1930s. But today, more than two years later,
conditions still aren’t much different from an economy actually in
recession. Gross domestic product (GDP) growth was barely positive in
the first half of 2011. The unemployment rate is 9.1 percent, much
higher than anything we had experienced for decades before the
recession. And job gains over the past several months have been barely
enough to keep pace with the natural growth in the labor force, so we’ve
made virtually no progress in closing the “jobs gap.”
With unemployment having lingered for so long at rates around 9
percent, it is perhaps natural that some would begin to think that
nothing more can be done to improve upon this situation. However, I
don’t agree. Before seriously contemplating doing nothing, it is
important to realize just how enormous this economic problem really is.
To put this in perspective, consider that prior to the recession, most
analysts thought the long-run trend growth rate of GDP was about 2-1/2
percent per year. Given the sharp drop in output during the recession
and lackluster early recovery, GDP is currently below its potential by
nearly 7 percent, or $1 trillion dollars.1 Just prior to the recession,
the unemployment rate averaged between 4-1/2 and 5 percent. It peaked at
10.1 percent during the recession and, as I just noted, is still 9.1
percent today. In terms of jobs, payroll employment is about 6-1/2
million below its pre-recession level. These are massive shortfalls in
output and employment.
It does not appear as if these gaps are going to be reduced
significantly any time soon. Real GDP growth has been anemic so far this
year. Gains in employment have slowed markedly. Even though credit
conditions overall have been improving, many households and small
businesses still seem to be having trouble getting credit. In addition,
the repair process in residential real estate markets is painstakingly
slow, and households are still in the process of paring debt and
adapting to the huge losses in real estate and financial wealth that
they experienced during the recession.
I largely agree with economists such as Paul Krugman, Mike Woodford
and others who see the economy as being in a liquidity trap: Short-term
nominal interest rates are stuck near zero, even while desired saving
still exceeds desired investment. This situation is the natural result
of the abundance of caution exercised by many households and businesses
that still worry that they have inadequate buffers of assets to cushion
against unexpected shocks. Such caution holds back spending below the
levels of our productive capacity. For example, I regularly hear from
business contacts that they do not want to risk hiring new workers until
they actually see an uptick in demand for their products. Most
businesses do not appear to be cutting back further at the moment, but
they would rather sit on cash than take the risk of further expansion.
Considering the substantial lost wealth that came with the Second
Great Contraction and the enormous uncertainty over the recovery today,
it is understandable why households, businesses and market participants
are exceedingly cautious. We seem to be following the tendency,
documented by Carmen Reinhart and Kenneth Rogoff, that recoveries from
economic downturns caused by large financial crises usually are
painfully slow. Accordingly, it is of the utmost importance for monetary
policymakers to respond appropriately.
Recently, many critics of the Fed’s actions have raised concerns
about the credibility of Fed policy. Credibility — that is, the general
belief that the Fed does what it can to achieve its mandated policy
objectives — is certainly a critical issue. Defining “credibility”
sounds easy, but there are several aspects to credibility. For example,
at any point in time, the Federal Reserve will likely need to
contemplate a series of current and future policy actions in order to
effectively influence the trajectory of the economy and better achieve
the goals of monetary policy. In order for households, businesses and
financial markets to conduct business in accordance with the Fed’s
planning, the public must believe that the Fed will carry out these
future actions as expected to achieve its well-understood objectives.
Credibility requires a clear public understanding of the Fed’s policy
objectives, as well as a belief by the public that the Fed’s actions are
consistent with achieving these objectives. Lower levels of credibility
would be associated with erratic and misunderstood policy actions that
seemed inconsistent with the stated objectives of monetary policy.
At this point, it would be useful to describe the typical way in
which monetary policy is set by central banks with any eye toward
discussing how deliberations should be evaluated for effectiveness and
credibility.
The Policy Decision Process
In setting monetary policy, a central bank like the Federal Reserve
must deliberate systematically about a wide variety of important issues.
Perhaps at the cost of oversimplifying, I will broadly characterize this
deliberative process as consisting of four steps.
First, members of the Federal Open Market Committee (FOMC) must
have a clear vision of the goals of monetary policy. In my mind, the
Federal Reserve Act is very clear in specifying that the Federal Reserve
has a dual mandate: The FOMC should provide for monetary and financial
conditions that support maximum employment and price stability.2 With
regard to inflation, we should seek to keep inflation near 2 percent
over the medium term. We should also remember that a 2 percent objective
should represent an average level of inflation, not an impenetrable
ceiling. With regard to our real economy mandate, we should minimize the
deviations of the actual path of the real economy from its potential
path (or more technically, its efficiently-achievable path).
1 Real GDP fell about 5 percent during the recession, and growth
has averaged about a 2-1/2 percent annual rate so far in the recovery.
(The number in the text was based on the difference between actual and
potential real GDP as calculated by the Congressional Budget Office
through 2011:Q2.)
From my earlier discussion of the immensity of the current problem,
we are far from minimizing these real deviations today.
Second, the FOMC needs to closely look at the plethora of data that
comes out every month in order to evaluate the outlook for the economy
and inflation, keeping in mind a variety of potential risk scenarios and
financial stability considerations. Four times each year, the FOMC
formally publishes forecasts in its Summary of Economic Projections. Of
course, it is crucial for each FOMC member to update his/her outlook for
each meeting.
Third, in evaluating the state of the economy and inflation
pressures, the FOMC must periodically step back and ask itself whether
something very different than normal is afoot. We all recognize that our
views about how the economy works are imperfect. So we must always ask
if we have seen anything that would move us away from our current
viewpoints and forecasting methodologies — and if things have changed
significantly, we must ask if achievable paths for our policy goals or
the channels through which monetary policy works have been altered in
any substantive way. These considerations would include questions about
whether we are facing structural economic change that lowers the
economy’s potential output, substantial financial impediments holding
back demand along the lines stressed by Reinhart and Rogoff, global
financial stress, and the like. A good portion of these concerns are
related to appropriate risk-management considerations.
Fourth, policymakers must make a decision regarding the stance and
course of monetary policy. They must ask if their forecasts are
consistent with their medium- and long-term policy objectives, and if
not, what then is the best response for monetary policy to influence the
trajectory of the economy and inflation in order to meet the FOMC’s
objectives?
That is a very quick summary of the necessary steps for effective
monetary policymaking.
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