By Steven K. Beckner
(MNI) – Chicago Federal Reserve Bank President Charles Evans said
Monday that the Fed should be prepared to let inflation rise to 3% so
long as unemployment remains high to combat what he sees as a “liquidity
trap” verging on a new Great Depression.
Unlike on other recent occasions, Evans did not explicitly advocate
further expansion of the Fed’s balance sheet to push down long-term
market interest rates. But he argued that the Fed’s policymaking Federal
Open Market Committee, of which he is a voting member, should commit to
keeping short-term rates near zero until the unemployment rate falls
below its “natural” rate so long as inflation does not exceed 3%.
Evans doubted whether core inflation would in fact go as high as 3%
given low rates of labor and other resource utilization, but said that
if he is wrong about the economy being in “a liquidity trap,” then his
proposed 3% inflation “safeguard” would trigger an exit from loose
monetary policy.
In fact, though, he spoke in the direst terms about the U.S.
economy, warning of a “clear and present danger that we risk repeating
the experience of the U.S. in the 1930s or that of Japan over the past
20 years.”
In such a situation, Evans cited research purporting to show that
it is appropriate to let inflation rise “above target” in remarks
prepared for Ball State University in Muncie, Indiana.
Evans did not define what he meant by the “natural rate” of
unemployment above which the Fed should keep the federal funds rate at
its current “exceptionally low” level of 0 to 25 basis points. But the
FOMC, in its November summary of economic projections, used a “longer
run” unemployment rate of 5.2% to 6.0%.
In his own previous formulations of his proposed “state
contingent” trigger system for providing “forward guidance” on the
path of the funds rate, Evans has said the FOMC should keep the rate
near zero until unemployment fell below 7% or inflation went above 3%.
Evans, who dissented at the Nov. 2 FOMC meeting when his
colleagues didn’t go along with his call for “additional policy
accommodation,” was quite gloomy about the outlook despite recent
upbeat economic data, including Friday’s November employment report
which showed a drop in the unemployment rate from 9.0% to 8.6%, a
120,000 non-farm payroll gain and a 72,000 upward revision to prior
months’ payrolls.
“Even with slightly firmer economic data that have come out
recently, the sense of building momentum seems absent,” he said.
“The outlook has weakened substantially.”
The FOMC’s projection of 2.5% to 2.9% real GDP growth in 2012 is
“not strong enough to make much of a dent in the unemployment rate and
other measures of resource slack,” he went on. “Without new
developments or changes in policy, I don’t believe the U.S. economy is
poised to achieve escape velocity anytime soon.”
In this climate, inflation is the least of the Fed’s worries, Evans
suggested. “With the unemployment rate still high and capacity
utilization low, resource slack continues to exert downward pressure on
prices.”
So Evans suggested the Fed is failing to fulfill its “dual mandate”
for maximum job growth and price stability.
“I think it is clear that the Fed has fallen short in achieving its
goal of maximum employment,” he said, adding, “I believe we run the risk
of missing on our inflation objective as well.”
Evans acknowledged that there are two camps among Fed policymakers:
— One group that sees high unemployment and slow growth as being
due to “structural impediments,” including labor market frictions,
regulatory burdens and policy uncertainties, and that therefore there is
little more the Fed can do to stimulate growth.
— Second, a group that believes the economy is in a “liquidity
trap” and that the Fed should aggressively ease monetary policy, if
necessary by unconventional methods.
A “liquidity trap is said to occur when short-term interest rates
are already at or near the zero bound and so cannot be cut further to
bring about negative real rates to decrease savings and spur consumption
and investment.
Evans said he finds the “liquid trap” scenario “more compelling”
and said he agrees with Harvard Professor and liquidity trap exponent
Kenneth Rogoff that, therefore, it’s OK to push inflation above the
Fed’s implicit target of around 2% or a bit less.
He said research by Rogoff and others shows that “the performance
of economies stuck in a liquidity trap can be vastly improved by
lowering real interest rates and lifting economic activity using an
appropriately prolonged and forward-looking period of accommodative
monetary policy.”
Admitting that he “could be wrong” and observing that the two
different scenarios call for diametrically opposite policies, Evans
offered what he called “a middle ground proposal.”
“The Fed could sharpen its forward guidance in two directions by
implementing a state-contingent policy,” he proposed. “The first part of
such a policy would be to communicate that we will keep the funds rate
at exceptionally low levels as long as unemployment is somewhat above
its natural rate.”
“The second part of the policy is to have an essential safeguard —
that is, a commitment to pull back on accommodation if inflation rises
above a particular threshold,” he continued. “This inflation safeguard
would insure us against the risks that the supply constraints central to
the structural impediments scenario are stronger than I think.”
“Rates would remain low as long as the conditions were unmet,” he
said, but he added that his proposal would give the FOMC an out.
If “the structural impediments scenario turns out to be
correct, inflation will rise more quickly and without any improvements
to the real side of the economy,” he said. “In such an adverse
situation, the inflation safeguard triggers an exit from the now-evident
excessive policy accommodation before inflation expectations become
unhinged.”
Evans, who is serving on an FOMC task on communications strategy,
conceded that, in that event, “We would suffer some policy loss in that
a 3% inflation rate is above our 2% target.”
But, contrary to other officials who have warned that above-target
inflation would lead to a rise in inflation expectations and in turn
actual inflation, Evans maintained there is no need to worry about that.
“We certainly have experienced inflation rates near 3% in the
recent past and have weathered them well,” he said. “And 3% won’t
unhinge long-run inflation expectations.”
** Market News International **
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