CHICAGO (MNI) – The following is the third and final part of the
full text of remarks by Chicago Federal Reserve President Charles Evans
Tuesday morning, giving his outlook for the economy, inflation and the
ongoing sovereign debt crisis in Europe:

Those who press me on higher inflation point to the Fed’s
accommodative policy and expanded balance sheet. We all know that too
much money chasing too few goods eventually will generate inflation.
But, currently, most of the funds used to increase our balance sheet are
sitting idly in bank reserves. And because banks are not lending those
reserves, they are not yet generating spending pressure. But, of course,
leaving the current highly accommodative monetary policy in place for
too long would eventually fuel such inflationary pressures.

With core inflation at 1-1/4 percent, I see the opposing forces of
resource gaps and accommodative monetary policy as roughly balancing out
over the medium term. As resource slack abates in a recovering economy,
I expect inflation to move up to about 1-3/4 percent by 2012.

What does all of this mean for monetary policy? Currently, policy
is, appropriately, very accommodative. But, eventually, we will have to
return to a more normal stance. Judging the appropriate timing and pace
for reducing accommodation poses a significant challenge for
policymakers over the next couple years. On the one hand, removing too
much accommodation prematurely could inhibit the recovery. On the other
hand, as I noted, if the Fed leaves the current level of accommodation
in place too long, inflationary pressures will eventually build. The
Fed’s decisions will be based on careful monitoring of business activity
and keeping an alert eye out for signs of changes in the inflation
outlook. In addition, the FOMC is making sure that it has the technical
tools it will need when it decides to reduce monetary accommodation.
Overall, I am confident that monetary policy will both support economic
growth and bring and keep inflation near my guideline of 2 percent over
the medium term.

As you can imagine, the crisis and recession have kept us busy. And
we are constantly alert to issues that may cause us to reassess our
outlook. With this in mind, I’d like to address a question that I have
been asked a lot lately: How will recent events in Europe affect the
U.S. economy?

There are a few channels through which the European sovereign debt
problems could influence us here. European efforts to lower debt will
likely weigh on their economic growth over the medium term. This will
translate into less demand by Europeans for U.S. products. In addition,
the dollar already has appreciated relative to the euro. This means that
European consumers find our products to be relatively more expensive
than before. At the same time, prices for European goods in terms of the
dollar have fallen, boosting our demand for European imports. All of
these channels work in the direction of lowering U.S. net exports,
which, all else being equal, would tend to reduce the outlook for U.S.
GDP growth.

However, a couple of factors suggest that these trade effects of
the European fiscal situation on the U.S. economy are likely to be
limited. Although the euro-11 economy is large, it represents only about
15 percent of U.S. exports. In comparison, our single largest trading
partner, Canada, accounted for over 19 percent of domestic exports last
year. And while the dollar has appreciated almost 18 percent relative to
the euro since late November, the broad dollar exchange rate that is a
trade-weighted average across all currencies has appreciated only 5.1
percent over the same period.

Nonetheless, if events in Europe evolve so that they have a more
severe and broad impact on financial markets, then the scope of the
problems for the U.S. could be magnified. Fortunately, our direct
exposure to European debt is limited. But an intensification of
liquidity or solvency problems in Europe and some related spillover
losses in U.S. markets could cause a marked increase in investor risk
aversion. More lenders could pull back on intermediation, restricting
the flow of credit to fund worthy spending projects of U.S. firms and
households.

To date, though, this doesn’t seem to have occurred. Notably, the
spreads between riskier and safer assets have risen some, but they are
still nothing at all like the spreads we observed during the height of
the financial panic. But this is a risk to monitor carefully.

Indeed, recognizing the importance of providing liquidity to
stressed financial markets, the Fed recently re-opened currency swaps
with the European Central Bank (ECB) and other major central banks. This
step seems prudent as the events in Europe have the potential to create
dollar funding pressures in world markets. As we did earlier, the
Federal Reserve today offers dollars in exchange for foreign currency
collateral-at a fixed exchange rate and a penalty rate. In this way
foreign central banks can extend dollar liquidity support to
creditworthy financial institutions facing temporary liquidity strains
in foreign credit markets. To date, these lines have not been tapped
much.

I’d like to conclude at this point, but I hope you’ll recall that
the answers to our three questions about future growth, inflation, and
the European debt crisis were three-and-a-half, no, and probably not
much, but we are being vigilant. Of course, the details behind these
short answers are key to understanding how we put the pieces together to
create a picture of the economy. I hope I have been able to convey some
of that to you today.

I look forward to your questions.

(3 of 3)

** Market News International Chicago Bureau: 708-784-1849 **

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