SAVANNAH (MNI) – The following are the remarks of Atlanta Federal
Reserve Bank President Dennis Lockhart, prepared Monday for the Savannah
Rotary Club:

Savannah is a city where insiders use the shorthand of
initials-MGGE (Midnight in the Garden of Good and Evil) and SCAD
(Savannah College of Art and Design). Today I will talk about an
economic policy issue that, similarly, has been reduced to shorthand:
QE2. This is not the famous luxury ocean liner; QE stands for
quantitative easing, and the “2” denotes a second round of this policy
activity. QE2 is a policy option currently under consideration to
support the sputtering economic recovery and deal with two of its
by-products: high unemployment and low inflation that could spill over
into deflation.

This policy option is the issue of the moment among Fed watchers.
Commentators and market participants appear to have a high expectation
that the Federal Open Market Committee (FOMC) will decide to go forward
with another program of large-scale asset purchases (LSAP-another set of
initials used officially in the recent past). The Fed used this policy
tool starting at the end of 2008 until spring of 2010 when it purchased
$1.25 trillion of mortgage-backed securities, $300 billion of Treasury
securities and $175 billion of agency debt securities, creating fresh
money in the process to make the purchases. These actions were taken to
combat the recession at a point when there was no more scope for use of
the Fed’s more conventional policy tool, interest rate policy. The
policy rate still remains at its zero lower bound and, for all practical
purposes, cannot go lower. If something is to be done about the state of
the economy, quantitative easing is the leading option.

To opt for more quantitative easing at this juncture is a big
decision. Today I will walk you through the thicket of considerations
that lead me, at this moment, to be sympathetic to more monetary
stimulus in the near future. I take this view with a measure of
tentativeness. Some more economic data will be posted before the next
meetings of the FOMC in early November and mid December, and, as I
always do, I would factor in the deliberations of the committee in the
meeting before arriving at a final view.

I must emphasize that the views I will express are my personal
thoughts and may not reflect the views of my colleagues on the FOMC or
within the Federal Reserve.

State of the economy

The recent performance of the economy has been disappointing.
Growth has slowed from earlier in the year and unemployment remains
high. After a period of disinflation last year and early this year,
inflation has settled at a level considered by many to be unacceptably
low.

This experience is worse than many had forecast. Over the past few
months, a number of forecasters have written down their projections for
the remainder of 2010 and 2011. A year ago, looking ahead to 2010 and
2011, our forecast at the Federal Reserve Bank of Atlanta was less
optimistic than those of many forecasters, so we have not revised down
our outlook all that much. But overall it’s fair to say the consensus
outlook has deteriorated.

The Fed is mandated by Congress to pursue two policy goals-maximum
possible employment and price stability (or put differently, the
acceptable rate of inflation). The committee has the implicit
responsibility of defining the rate of inflation that over the longer
term constitutes price stability. In my view, that rate is around 2
percent.

With current inflation running at about 1 percent or a little
higher and with official unemployment measured at 9.6 percent, it’s
clear that the economy is not where we want it to be. In my mind, the
question is whether this situation is a call to immediate action.

To answer that question, I start with the outlook from today in the
absence of further monetary stimulus. As a starting point, I expect
final measures of third quarter GDP growth to be close to that in the
second quarter which came in at 1.6 percent. My current forecast sees a
modest increase in the rate of growth in the fourth quarter and further,
but still modest, improvement in 2011. In this forecast, inflation
remains low but with no further disinflation, and unemployment comes
down very gradually.

In my thinking, the range of plausible divergence from this
forecast is quite wide, and the risks are more to the downside. Very
importantly-and this is a key point for me-the fact that growth is so
sluggish and inflation so near zero presents the possibility of a
deflationary situation developing, with very serious implications for
employment. We want to avoid deflationary territory. Deflation can feed
on itself, turning into a deflationary spiral. This possibility is by no
means my base case expectation, but I don’t think it can be blithely
dismissed. For now it is a risk, not an actual developing feature of the
economy.

So, again, my staff and I see the prospect of continued slow but
gradually improving growth, with quite low but stable inflation and a
positive but frustrating pace of job creation. We have to ask: Is this
the best we can achieve?

Structural or cyclical?

Well, it’s debatable, and it revolves around the question of
whether the underlying problems of the economy-the obstacles to faster
recovery-are mostly structural or mostly cyclical. These words can mean
different things to different people and represent code words for an
array of conditions. I think of structural obstacles as very slow and
resistant to change and not responsive in the short term to monetary
stimulus. I use the term cyclical to encompass aspects of the economy
that are evolving on a shorter timeline that can be accelerated by
policy action.

There are a number of features of the current economic situation
that might be described as structural. Certain industries-homebuilding,
for example-are likely to operate at a much lower unit volume for a long
time, if not permanently. Well-informed opinion holds that the
commercial real estate sector will take several years to work through
the burden of property loan resolution. And the central debate focuses
on the degree to which unemployment reflects structural impediments.

In my opinion, the evidence either way is not conclusive. My best
assessment is some unemployment is structural in nature and some of it
represents weak demand. That so-called natural rate of unemployment is
probably now well above the very low level of joblessness we saw prior
to the recession, but it is not the current rate of 9.6 percent. There
is some labor resource slack that can be worked off with improved
consumer demand and business investment. But there is little scope for
monetary policy to have much effect on the mismatch between skills and
jobs caused by industrial dislocations and the skill erosion that can be
associated with long-term unemployment.

Although not usually classified as a structural issue, uncertainty
is a key factor constraining job growth and investment. I hear this
refrain often from business contacts about the current environment. They
cite the future of the economy itself as well as uncertainty related to
employee health care cost, regulatory uncertainty, and fiscal and tax
uncertainty. My contacts frequently make the point that much of this
uncertainty cannot be dispelled by monetary policy.

I do believe there is scope, at the margin, for further monetary
stimulus to induce households and businesses to overcome their current
spending caution, even while deleveraging. A quantitative easing program
of scale should have the effect of making credit cheaper and, if
successful in upgrading the outlook, more available as loan demand
rises.

This comment on the potential and effect of lower interest rates
raises a question: Through which channels or mechanisms would additional
stimulus have its intended positive effect on the economy? There are a
number of possible channels of influence. The credit channel is
certainly one. Skeptics, however, point out that there is no lack of
liquidity in the banking system. Today the Federal Reserve holds over
$960 billion of excess reserves of banks on its balance sheet. This
money is part of the monetary base but has not yet been transformed into
broad stimulus in the real economy through bank lending.

A second possible channel is called the portfolio balance effect.
If the Fed buys a significant portion of available Treasury securities,
for instance, investors may feel the need to migrate their holdings to
other assets that carry more risk, such as corporate bonds and equities.
The buying pressure in these asset classes could push up values and
generally improve the atmosphere that supports risk taking and spending.

A third channel is the dollar exchange rate and stimulus to net
exports. Speculation about QE2 has already caused a drop in the dollar’s
value on exchange markets and contributed to the rising concern over
competitive efforts among nations to influence the relative position of
currencies. Sellers of the dollar are responding to the prospect of
lower yields.

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